An option is the right, but not the obligation, to buy or sell a stock or other security for a specified price on or before a specific date.

    Typically, the average investor's experience is limited to trading in stocks, mutual funds and perhaps bonds. Whether you're an active trader or simply interested in adding diversity to your Registered Savings Plan or Registered Income Fund, options are financial instruments that can be used effectively under almost every market condition and for almost every investment goal.


    Did you know that you may already be using a form of options as part of everyday life?
Do you pay an insurance premium every year for house, auto, and medical coverage?
If so, you have purchased insurance as a safeguard against a fire in your home, a crash in your car, or large medical bills. Similarly, options on stocks or indexes can be used to protect and insure the future value of your portfolios.


    Much like stocks, options can be used to take a position on the market in an effort to capitalize on upward or downward market moves. Unlike stocks, however, options can provide an investor the benefits of leverage over a position in an individual stock or basket of stocks that reflect the broader market. At the same time, options buyers can also take advantage of predetermined, limited investment risk. Conversely, options
Writers assume significant risk if they do not hedge (or limit the risk of) their positions.


    Puts and Calls - Puts and Calls are the two basic types of options strategies. A Call is the right to buy a security at a predetermined price, while a put is the right to sell a security, also at a predetermined price. The person, who purchases an option, whether it is a put or a call, is referred to as the option buyer. Conversely, the person who originally sells the put or call is the option seller or writer.


Buying Calls

If you’re Bullish

    Buying an XYZ July 50 call option gives you the right to purchase 100 shares of XYZ common stock at a cost of $50 per share at any time before the option expires in July. The right to buy stock at a fixed price becomes more valuable as the price of the underlying stock increases.

    Assume that the price of the underlying shares was $50 at the time you bought your option and the premium you paid was $3.50 (or $350). If the price of XYZ stock climbs to $55 before your option expires and the premium rises to $5.50 you have two choices in disposing of your in-the-money option:

    You can exercise your option and buy the underlying XYZ stock for $50 a share for a total cost of $5,350 (including the Option premium) and simultaneously sell the shares on the stock market for $5,500 yielding a net profit of $150. You can close out your position by selling the option contract for $550, collecting the difference between the premium received and paid, $200. In this case, you make a profit of 57% ($200/$350), whereas your profit on an outright stock purchase, given the same price movement, would be only 10% ($55-$50/$50).The profitability of similar examples will depend on how the time remaining until expiration affects the premium. Remember, time value declines sharply as an option nears its expiration date. Also influencing your decision will be whether or not you wish to own the stock.

    If the price of XYZ instead fell to $45 and the option premium fell to $1.00, you could sell your option to partially offset the premium you paid. Otherwise, the option would expire worthless and your loss would be the total amount of the premium paid -($350). In most cases, the loss on the option would be less than what you would have lost had you bought the underlying shares outright, $262.50 versus $500 in this example.


Buying Puts

If you’re Bearish

    Buying an XYZ July 50 put gives you the right to sell 100 shares of XYZ stock at $50 per share at any time before the option expire in July. This right to sell stock at a fixed price becomes more valuable as the stock price declines.
Assume that the price of the underlying shares was $50 at the time you bought your option and the premium you paid was $4 (or $400). If the price of XYZ falls to $45 before July and the premium rises to $6, you have two choices in disposing of your put option which is now in-the-money:

    You can buy 100 shares of XYZ stock at $45 per share and simultaneously exercise your put option to sell XYZ at $50 per share, netting a profit of $100 ($500 profit on the stock less the $400 Option premium).


    You can sell your put option contract, collecting the difference between the premium paid and the premium received, which is $200 in this case.
If, however, the holder has chosen not to act, their maximum loss using this strategy would be the total cost of the put option ($400). The profitability of similar examples depends on how the time remaining until expiration affects the premium. Remember, time value declines sharply as an option nears its expiration date.

    If XYZ prices instead had climbed to $55 prior to expiration and the premium fell to $1.50, your put option would be out-of-the-money. You could still sell your option for $150, partially offsetting its original price. In most cases, the cost of this strategy will be less than what you would have lost had you shorted XYZ stock instead of purchasing the put option, $250 versus $500 in this case.

    This strategy allows you to benefit from downward price movements while limiting losses, if prices increase, to the premium paid.

Selling Calls (Covered Call Writing) -:

Covered Call Options

Who Should Consider Covered Calls?

    An investor who is neutral to moderately bullish on some equities in their portfolio. An investor who is willing to limit their upside potential in exchange for some downside protection.

An investor who would like to be paid for assuming the obligation of selling a particular stock at a specified price.

    The strategy would work equally well for in a margin or registered account. Although this strategy may not be suitable for everyone, any of the investors above may benefit from using the covered call.


Definition

    Covered call writing is either the simultaneous purchase of stock and the sale of a call option or the sale of a call option against a stock currently held by an investor. Generally, one call option is sold for every 100 shares of stock. The writer receives cash for selling the call but will be obligated to sell the stock at the strike price of the call if the option is exercised buy the buyer. In other words, an investor is "paid" to agree to sell their holdings at a certain level (the strike price). In exchange for being paid, the investor gives up any increase in the stock above the strike price.

Selling Puts (Protective Put Writing)

Protective Put

This segment begins with examples of situations in which buying protective puts might make good investment sense.

Who Should Consider Using Protective Puts?

    An investor who currently holds a stock, but does not want to sell because he believes the stock may rise in value. This investor would like to be able to participate in the rise without risking all of their profit (if any).
An investor who is considering purchasing a stock but is concerned with downside risk. Today, investors are often concerned with the many uncertainties of the stock market. During bull markets, investors are worried about market corrections, and during bear markets, they are worried that their stocks could fall further. This uncertainty can lead to reluctance to invest, and strong up moves might be missed. Buying puts against an existing stock position or simultaneously purchasing stock and puts can supply the
Insurance needed to overcome the uncertainty of the marketplace. People insure their valuable assets, but most investors have not realized that many of their stock positions also can be insured. That is exactly what a protective put does. Typically, by paying a relatively small premium (compared to the market value of the stock), an investor knows that no matter how far the stock drops, it can be sold at the strike price of the put anytime up until the put expires.


    Although a protective put may not be suitable for all investors, this strategy can provide the protection needed to invest in individual stocks in volatile markets because it ensures limited downside risk and unlimited profit potential for the life of the option.


Definition

    Buying a protective put involves the purchase of one put contract for every 100 shares of stock already owned or purchased. A put gives the owner the right but not the obligation to sell the underlying security at a certain price (the strike or exercise price) up to the expiration date. Purchasing a put against stock is similar to purchasing insurance. The investor will pay a premium (the cost of the put) to insure against a loss in the stock position. No matter what happens to the price of the stock, the put owner can sell it at the strike price at any time prior to expiration.


An Overview of Bull Spread Trading - An Option Trade Type -:

    A Bull Spread, a type of option trade, is created by buying a call option on a stock with a certain strike price (right to sell stock at a predetermined price, called the Strike price, at any time before the expiration date) and selling a call option on the same stock with a higher strike price. This strategy could also be implemented by selling put options on a stock with a certain strike price and buying a put option on the same stock with a lower strike price.


Bull Spread Facts
Facts about Bull Spreads:

* Both the strikes must have the same expiration date.

* Bull Spreads are used when traders are bullish yet want limited risk.

* Maximum loss is when the stock is below the lower strike price and maximum profit when the stock is above the higher strike price.

* These strategies require higher commissions since they involve buying or selling multiple positions. Bull spreads although can be created with either calls or puts. The following illustration of call option gives a clear picture of this form of trading.

    If XYZ is trading at $32, you could create a bull spread by purchasing 1 XYZ JUN 30 CALL for $3 and at the same time selling 1 XYZ JUN 35 CALL for $1. This option trade would be a net-debit of $2. In other words, it would cost you $2 to create the spread ($3 to buy the JUN 30 CALL less $1 received from the sale of the JUN 35 CALL).

    Bull Spreads works in a manner that the profit and loss from the two calls (or putts) are used to offset one another. So, the maximum one can lose with a bull spread is only the cost of the spread.

    In the above example you can lose a maximum of $2. In addition, the maximum you can gain from a bull spread is the difference between the two strike prices less the cost of the spread. In this case, it is $3 (35 - 30 - 2).


Bear Spread, A Popular and Successful Option Strategy -:

    Like the Bull Spread, an option strategy, Bear Spread can be created with either calls or puts. The bear spread with calls involve the purchase of one call (higher strike) and the sale of a call with a strike price lower than the long call. This is done as a credit spread. The maximum profit is the amount of the credit. The spread becomes profitable if the underlying security, which was sold, closes below the strike price. Both options have the same expiration date.
Maximum profit = net amount of the credit received
Maximum risk = difference between the two strike prices - net credit received + commissions
Following is an illustration of the put bear spread option strategy created by buying a put with a higher strike price and selling a put with a lower strike price.
With XYZ trading at $33 you could create a put bear spread by selling 1 XYZ JUN 30 PUT for $1 and buying 1 XYZ JUN 35 PUT for $3, giving you a net-debit of $2.
Maximum profit in the put bear spread can be earned when the underlying stock trades below the lower strike price, $30 in this example. Conversely, the spread's maximum loss is reached when the stock trades above the higher strike price, in this case $35. Again, the maximum loss with a put bear spread is the cost of the spread itself, while the maximum profit is the difference between the strike prices less the cost of the spread.

Bear Spread Facts -:
Facts about the option strategy Bear Spread:

* There must be an equal number of options on either side of the spread and all the options must have the same expiration date

* A higher strike price is purchased and a lower strike price is sold.

* Bear spreads may require higher commissions since they involve buying or selling multiple positions.

* Finally, you make money if the underlying stock goes down and lose money if the underlying security rises in price.

    Don’t try any of the above given strategy on your own. As I always say that Option Trading is tricky. I have just posted the possible Option Trading Strategies. Just read them to understand the Basics. Kindly I request not to do any experiments with your money

Good Luck!!
Dakhsh