The Best Stock Option Trading Strategies to Make A Profit

A Call gives the owner of the option the right to purchase a certain number of shares at a certain price. Writing a covered call is to sell someone a call option, which is the right to purchase a stock that you own at a specified price. The buyer of the call would pay you a cash premium for it.

Maximum Profit:

The maximum profit is earned when the price of the share rises above the strike price and the call is exercised. In this situation, your profit would be the premium.

Maximum Loss:

The maximum loss you can incur is if the price of the share drops drastically. In such a scenario, your loss would be offset a little by the cash premium.

Covered Call Writing is an effective strategy in almost every kind of market – A bullish market, bearish market, or range bound market. However, it is most effective in either a mild bull market or a quiet one. This strategy is typically used by traders to generate short term income at low risk, or to increase their returns in slow markets.

Here's a more detailed guide on how to write covered calls: https://www.ally.com/do-it-right/investing/4-tips-for-writing-covered-calls/

2. Bull Call Spread

In the bull call spread, the options trader simultaneously buys calls at a lower strike price and sells an equal volume of calls at a higher strike price. The trader receives the cash premium for the sold calls and pays the cash premium for the calls at the lower strike price. As the call with the lower strike price has a higher value, an initial capital outlay is necessary.

Purchasing calls at a lower strike price is also known as a long call leg, while the calls sold at the higher strike prices are known as the short call leg. The bull call spread can be hard to understand, so we’ve put together some examples to illustrate it better.

An Example: Stock PPP

Let’s say that stock PPP is trading at $50.00 currently. The trader expects the price of PPP to trade between $50.50 and $51.50 in one month. To capitalize on this, the trader purchases 10 contracts for a strike price of $50.50 which is trading at $1. He simultaneously sells 10 contracts for a strike price of $51.50, which is trading at $0.50. Both of these call options will expire in one month.

The trader’s initial capital outlay will be calculated as such:

($1x100x10) – ($0.50x100x10) = $1000-$500 = $500

Each contract represents a 100 shares, so we have 1000 shares worth of calls purchased at $1000, and 1000 shares worth of calls at a higher strike price sold at $500.

Scenario 1:

PPP rises to $53 after a month.

The profit on the long call leg of the trade will be: ($53-50.50) x 1000 = $2500
The loss on the short call leg of the trade will be: ($51.50-53) x 1000 = -$1500

The trader’s gain on the spread will therefore be: $2500 - $1500 - $500 (The initial difference in cash premiums) = $500.

Scenario 2:

PPP rises to $51 after a month.

The profit on the long call leg will be:
($51-50.50) x 1000 = $500

The $51.50 Call Option will be worthless as it is out of the money.
The total profit will be $500 - $500 = $0

Scenario 3:

PPP drops to $49.50

Both call options are out of the money and therefore worthless.

The trader’s return will be $-500, which is a loss.

Why Do Traders Use the Bull Call Spread?

- When using a bull call spread, traders are able to limit their downside risk to just the net premium paid.

- Traders can use leverage to trade the bull call spread, as the bull call spread has a clearly defined risk-reward profile.

Maximum Profit:

The maximum return from a bull call spread is when the price of the underlying stock or asset rises to a value that’s at equal to or above that of the strike price of the call sold. The upside is limited to the difference between the strike prices of the call options, minus the net premium outlay and commissions paid to brokers.

Maximum Loss:

In the Bull Call Spread, the maximum loss is limited to the net premium outlay.

3. Bear Put Spread

The Bear Put Spread is frequently used as an alternative to shorting shares. A bear put spread has limited risk and limited upside, while a short selling shares will have unlimited risk. A bear put spread trade strategy enables the trader to easily manage his risk/reward profile.

What exactly is a Bear Put Spread

A bear put spread is the opposite of a bull call spread, where the trader buys a put with a higher strike price and simultaneously sells a put with a lower strike price. Both of these options will have the same volume and the same expiry date.

Bear Put Spread: An Example

We won’t go into a detailed example as this strategy is similar to that of the bull call. spread. Let’s say that stock PPP is trading at $50. If a trader expects PPP to trade between $46 and $49 in 2 months’ time, the trader will buy puts with a strike price of $49, and sell puts with a strike price of $46. This means that when the price of the stock goes below $49, the put option will be in the money.

However, note that a profit is only realized when the earnings from the put option covers the initial capital outlay.

Why Use the Bear Put Spread

Traders use the bear put spread when they expect a modest decline in the price of the underlying asset in the short term. Instead of buying just a put option, the trader attempts to earn more by selling the puts with a lower strike price.

Maximum Profit:

The maximum profit is realized when the price of the underlying asset falls to a value that is lower or equal to the lower strike price. However, the maximum profit will be the difference between the strike prices multiplied by the number of shares, minus the initial premium outlay and any commissions charged by the broker.

Maximum Loss:

​The risk of the bear put spread trading strategy is limited to the initial premium outlay. The options will expire worthless when prices rise above the higher strike price.

4. Protective Collar

The protective collar is a great option trading strategy that helps an investor to lock in gains after their asset has appreciated significantly. Using a protective collar can also help to reduce capital gains tax.

There are two aspects to a protective collar trading strategy. The first part of its implementation is to lock in your gains or minimize the potential of a loss from a particular stock. Assuming that your stock has the ticker AAA.

The trader will first purchase a put on ticker AAA, which gives him the right, but not the obligation to sell AAA at the specified price before the expiration date. With this put option, the trader is effectively securing profits at that strike price.

However, the purchase of this put option isn’t free of charge either. The trader will have to find a way to pay for the put bought on ticker AAA. Here comes the second part of the protective collar trading strategy.

The Funding

The second aspect of the protective collar strategy calls for the trader to sell (or write) a call option on AAA. This gives the buyer of the option the right, but not the obligation, to purchase shares of AAA the specified share price before the expiry date of the contract.

Trading Example:

Let’s say that you own 1000 shares of AAA, which is priced at $100 per share. You bought AAA at $50 per share, which means that you currently have paper profits of $50,000.

Wanting to lock in your gains, you purchase a put with a strike price of $90, which costs roughly $10. This means that you will have an initial outlay of $10,000. You would also lock in a profit of $90,000-$50,000 = $40,000

However, this also comes at a price of the $10,000 cash premium on the put option that you would have to fork out.

Let’s say that writing a call option on AAA for a strike price of $130 can net you $11 a share. This will get you $11,000 for selling the call, and you actually profit from $1 a share, or the $1000 difference between the call and put options.

Minimal Downside Risk, Significant Upside Potential

In this case, having the protective collar has limited your downside risk to almost nothing, while keeping your upside potential to ($130-100) x 1000. This upside potential will be realized when prices rise above $130 and the call option is exercised.

Maximum Profit:

The maximum profit from the protective collar strategy is realized when the price of the underlying asset rises to a value above the strike price of the written call option.

Maximum Loss:

The maximum loss, or the minimum profit in this case, will be when stock prices drop below the strike price of the purchased puts. In this case, the premiums from the call options will still be there, but you will have to either exercise the put option, or sell the put option for its market value which would have increased in value.

Tax Savings

Should you foresee a market downturn, selling a stock when it has appreciated significantly would require you to fork out a significant bit of capital gains tax on your profit.

By using the protective collar strategy, you can protect yourself against a market downturn without having to pay the capital gains tax. If the price doesn’t drop below the put option strike price, you won’t have to sell the stock. However, if it does and you are forced to exercise the put option or sell the put option, you’ll still have to pay tax.

Here's another explanation: http://www.investopedia.com/articles/optioninvestor/07/protective_collar.asp​

5. The Long Straddle

A straddle is achieved when the trader holds an equal volume of puts and calls, with the same strike price and expiration dates. A straddle is usually a play on the volatility of the market.

There are two kinds of straddles – The long straddle and the short straddle.

The long straddle is an options strategy where the trader purchases an equal volume of put and call options at the same strike price and expiration date. The purpose of this is to allow the trader to make a profit when the market moves in either direction.

Profiting From Increased Volatility

The long straddle aims to profit from increased market volatility. When the market breaks to either side, the trader will earn a profit. If the market price of the underlying asset increases beyond the strike price of the call option, the trader can exercise the call option, or sell the call option for a significant profit. The put option will either be held till the market swings in the other direction, or expire worthless. The long straddle can be played when such events that cause market volatility occur:

- Important upcoming news or earnings predictions

- Uncertain market conditions

An Expensive Play

However, the long straddle can be a rather expensive play. Options that are in-the-money and at-the-money are more costly than out-of-the-money options. This means that the trader will have to pay a significant premium to do a long straddle.

The value of the options also decrease closer to the expiration date. This means that if the market does not experience much volatility, the trader might be losing value on his options as time passes.

6. The Short Straddle