Stock Options Trading Strategies Basics

There are numerous option trading strategies for trading stock options effectively. Options trading strategies can range from the simple to the outright extremely complex.

Some investors have used options to hedge their risk in their portfolios. This technique is often referred to as putting on portfolio insurance. An investor who owns IBM's stock may want to buffer their downside risk by purchasing IBM put options. The logic here is that if IBM's stock begins to fall in price the put options will begin to increase in value therefore offset the investor's downside risk.

Another common option trading strategy used by investors is known as the “covered call”. A covered call is similar to the example above, but rather than buying a put option the investor will sell a call option. Here's how it works. In our example our investor already owns shares of IBM stock. The investor owns IBM's stock because they anticipate the price of IBM shares will increase. As no investor has a crystal ball the possibility that the price of IBM shares will decrease is also an important consideration. To protect themselves from any downward price movement and investor may sell a call option. You may ask what exactly does this do?

Let's look at a few covered call scenarios.

If the price of IBM moves upward then the shares of IBM increase in value and the call option price also increases. Since the investor was selling the call option the call option loses value as the price of IBM increases.

If the price of IBM shares stays the same the value of the call option will decrease over time and eventually expire worthless. If the call option expires worthless the investor gets to keep the call option premium as a profit in their account.

If the price of IBM shares move downward then IBM decreases in value and the call option decreases in value also. This serves as a hedge for the investor because although the IBM shares had decreased in value selling the call option has become profitable.

A covered call strategy can be an excellent way for an investor to generate income during those periods when they feel either neutral or bearish toward the stock that they own.