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Options Strategy: A Par-3 Course on Puts and Calls

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January 7, 2015
Options Strategy: A Par-3 Course on Puts and Calls

Drive for show, putt for dough—so goes a golfer’s mantra.

Weekend duffers may not know the precise variation of loft and length between their 6- and 7-irons, but they would surely tell you their driver is for distance and their putter is for accuracy. In golf, your choice of clubs depends on your location and balances the question of accuracy versus distance. A similar philosophy can be applied to the options markets.

So with that in mind, let’s lay out three basic combinations of puts and calls many traders see as worth considering for your “bag.”

Long Single Options. Like a 300-yard tee shot, the most directional and aggressive among basic options trades is buying (aka going long) calls or puts—it is one of the most risky but it can also be the most “brag-worthy.” A long call option provides the right, but not the obligation, to buy shares of an underlying stock at a certain price (the call becomes more valuable as the stock price rises). A long put confers the right to sell shares of the stock at a certain price (it becomes more valuable as the stock price falls).

Higher premium costs (relative to spread-based options strategies) can work against you, as can declining volatility and time decay. That means the price of the underlying stock needs to move in the right direction, and do so quickly. With this position, your form and timing are critical to land on the “fairway.”

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FIGURE 1: OPTIONS ON OPTIONS. Several options-based strategies can be found on Trade Architect by clicking on “Select Strategy” under the “Options Chain” tab. Source: The TD Ameritrade Trade Architect® platform. For illustrative purposes only.

Debit Spreads. On the golf course, your approach to the green requires both distance and accuracy. A debit spread involves buying a primary call or put and simultaneously selling another call or put against it. Compared to a stand-alone long option, this reduces the cost and dampens the sensitivity to time and volatility.

Debit spreads are still a directional position, but may risk less capital because of the offsetting nature of the spread. The price of the underlying stock still needs to move in your favor, but if it does not the loss may be lower than with a long option on its own. 

Credit Spreads. On the green, a light touch and forgiving surface matters a lot; distance, not so much. A credit spread involves selling a primary call or put and simultaneously buying another call or put for protection from the risks of a true short position. You collect the difference in premium between the two, minus transaction costs.

Credit spreads are the least directional of these three strategies and only require the underlying price to stay in the vicinity of where you want it. With a credit spread, you’re collecting premium instead of paying it upfront, meaning cost and time decay actually work in your favor, though rising volatility can be a risk.

It’s worth pointing out that these positions form the basis of many popular option strategies. The strike prices can be adjusted depending on how aggressive you want to be. Overall, keep in mind that the goal is to become proficient in choosing the correct strategy for the course, and then adapting to the conditions.  

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