Introductory Guide to Options Strategies - Caterpillar (NYSE:CAT), Boeing (NYSE:BA)

Having read

Benzinga's introductory guide to stock options

, you must be wondering how these products can be used in a real financial situation. In this article, we will introduce various options strategies, and explain how they can be applied to your financial portfolio. Options strategies can take on two forms: covered or naked. As always, investing (especially with options) involves significant risk so be sure to do your due diligence before jumping in.

Options strategies

Long Straddle

An investor would utilize this particular strategy when they believe that a significant price movement in an underlying product will occur, but are unsure as to the particular direction of the move. A long straddle involves

purchasing

both a call option and a put option on the same underlying product. Both positions must have the same strike price and expiration date.

Risks & Rewards Potential profit = unlimited. Potential loss = limited to the initial purchase price. For every long straddle, the associated risk is minimal. The investor cannot, under any circumstance, lose more than his/her initial purchase price. The more the underlying product moves in either direction, the larger the profit will be. Conversely, if the underlying price of the product does not have a significant move in one direction or the other, the investor will either lose the entire purchase amount when the contracts expire worthless, or sell the contracts on the open market for a loss. Example:FedEx FDX is trading at $80 on June 1, and will be announcing earnings at the end of the week. An investor believes that the earnings report, whether good or bad, will cause a large move in the price of the stock and wants to profit accordingly. A July 80 put is trading at $2, while a July 80 call is also trading at $2. To enact a long straddle, the investor would purchase one contract of each (remember that each contract represents 100 shares, therefore we must multiply the price by 100). The total cost of this long straddle would be: Call ($2 x 100) + Put ($2 x 100) = $400. To calculate the breakeven points (2) on a long straddle, you have to add the total premiums paid to the call contract strike price (80 + 2 + 2 = Breakeven $84) and subtract the total premiums paid from the put contract strike price (80 – 2 – 2 = $76). Therefore, in order to earn a profit, shares of FedEx would have to move higher than $84 or lower than $76 by expiration day to offset the total purchase price of $400. Let's assume that expiration day comes, and the stock is trading $90. The put will have no value since it is deeply out of the money. The call, on the other hand, will be worth $10. The $10 can also be referred to as the intrinsic value (the “in-the-money” amount of the options premium). The price of an options contract includes two values – the time value and the intrinsic value. Time value decreases as the expiration date nears (eventually hitting $0 on the expiration date), while the intrinsic value is simply the difference between the contract strike price and the underlying product's trading price. In the case above, $90 (trading price) minus $80 (strike price), equals an intrinsic value of $10. The following profit and losses would occur in this scenario: The 80 call contract is trading at $10, which represents a profit of $8 per share ($10 of value minus the purchase price of $2). The put contract expires worthless at $0, which represents a total loss of $2 per share. Therefore, the call's profit equates to $800 ($8 x 100), while the loss on the put amounts to $200 - equaling a net gain of $600 on the trade. The same scenario would unfold if the stock were to fall to $70, only in reverse. The put option would be worth $10 ($80 minus $70), and the call option would be worthless. The profit on the put would amount to $800 ($10 x 100 = $1,000; minus the purchase price of $200 = $800). Subtract $200 for the loss on the call for a net profit of $600. Short Straddle An investor would utilize this strategy when they believe that the underlying product will have little to no price movement by the contract expiration date. A short straddle involves selling both a call option and a put option on the same underlying product. Just as in the long straddle, both contracts must have the same strike price and expiration date. Risks & Rewards Potential profit = limited to the total premium received from the initial sale(s). Potential loss = unlimited. The risks associated with a short straddle are significant considering that the potential risk is unlimited. For every short straddle initiated, the seller cannot, under any circumstance, profit more than the original premium received. The closer the stock stays to the strike price, the greater the profit will be. Conversely, because the seller is short a naked call, the maximum loss is unlimited, as there is no limit on how high the underlying product can climb. Example: Caterpillar CAT is trading at $80 on June 1, and an investor believes that the stock not deviate far from that price anytime in the near future. A July 80 put is trading at $2, while a July 80 call is also trading at $2. An investor will sell one contract of each and receive a premium from the buyer. Total Premium received: Call ($2*100) + Put ($2*100) = $400. To calculate the breakeven points on a short straddle, use the same process as when calculating breakevens for the long straddle. The call breakeven would be the strike price plus both premiums received ($80 + 4 = $84). Conversely, the put breakeven would be the strike price minus both premiums received ($80 – 4 = $76). If the price moves above $84 or below $76, the seller of the straddle would lose money. Let's assume that the shares of Caterpillar are trading at $80 on expiration day. In this ideal scenario, the seller would receive the maximum profit ($400) since both the call and put have no value. Now let's assume that on expiration date the stock is trading $90. The put will have no value since it is deep out of the money, while the call will be worth $10. The following profit and losses would occur: Call position: The contract would be trading at $10, which represents a loss to the option writer of $10 (intrinsic value) -$2 (premium received) = $8 per share. Put position: The contract would be trading at $0 (expire worthless), which represents a total gain of $2 per share. The total loss can then be calculated by adding the total gain from the shot put position ($200) to the total loss from the short call position ($800), which equates to a total loss of $600. Bull Call Spread (Debit Call Spread) A bull call spread is used when an investor wants to initiate a long position, but wishes to reduce the overall cost. To accomplish this, he/she will buy a call contract and simultaneously sell a call contract with a higher strike price. The contracts must have the same expiration date. Such a move would reduce the cost of initiating the position, but also limits the potential profit. Risks Involved For every bull call spread, the risk associated is minimal. The investor cannot, under any circumstance, lose more than his initial investment. Example:Shares of Boeing BA are trading at $50. An investor thinks the stock will increase in the short term, but is somewhat apprehensive and wants to hedge his bet. To initiate the bull call spread, the investor would purchase a December call contract with a strike price of 55 (trading at $6) and sell a call December call contract (trading at $3) with a strike price of 60. The investor has entered a long position by paying a premium of $600 (6 x 100), but has reduced the cost of his position by selling the 60 call for $300 (3 x $100). This amounts to a total premium paid of $300. The breakeven point for bull call spreads can be found by adding the net premium paid to the lower strike price. In this case, the breakeven point would be $58.00 (55 + 3 = 58). Let's assume that the price of Boeing's stock rises above $60. In this scenario, it is likely that both of the contracts will be exercised. In such a case, the investor would buy the stock for $55, but then would be obliged to sell the shares it to fulfill his short call position at $60. The profit, therefore, would amount to: $500 (gross profit on the sale) minus $300 (net premium initially paid) for a total net profit of $200. This is the maximum profit that the investor can enjoy (remember, a bull call spread is most profitable when both contracts are exercised). If shares of Boeing do not rise above $55, both option contracts will expire worthless and the investor will lose the total net premium paid ($300). This is the maximum loss that the investor can experience. Bear Call Spread (Credit Call Spread) A bearish call spread is used when an investor wants to initiate a short position, but wishes to reduce the overall cost. To accomplish this, he/she will buy a call contract and simultaneously sell a lower strike call contract. Just as with the bull call spread, the contracts must have the same expiration date. Such a move would reduce the cost of initiating the position, but also limits the potential profit. Risks Involved Just as with the bull call spread, the risk associated with a bear call spread is minimal, as the investor limits the potential loss from the naked short position by purchasing a call contract as well. Example: Shares of Goldman Sachs GS are trading at $96.00. An investor thinks the stock will decrease in the short term, but is worried about a possible bear trap and wants to hedge the position. To initiate the bear call spread, the investor would purchase a December 95 call contract for $2 ($200) and sell a December $85 call contract for $9 ($900). The investor receives a total premium of $700 ($900 - $200). The breakeven point for a bear call spread can be found by adding the net premium to the lower strike price. In this case, the breakeven point would be $92.00 ($85 + 7). If the investor is wrong, and the price of Goldman's stock rises, the loss is limited to 10 (95 minus 85), minus the net premium of 7 received, for a maximum possible loss of $300. Conversely, if shares of Goldman plunges below $85, both contracts would expire worthless, and the investor would receive the maximum possible profit (net premium received), which in this case is $700. Conclusion As you can see, options offer investors a wide variety of strategies that simply do not exist in traditional “buy and sell” investing. The strategies outlined above are considered relatively simple in the options world, yet can be extremely profitable when properly applied - and without a large amount of capital. The best part about options strategies is that they allow the investor to establish concrete trade parameters and greatly limit the associated risk. As any good trader will tell you, protection of capital is of the utmost importance, and options allow investors to do just that. Look for the next part in our series, which will delve a bit deeper into the world of options and highlight some of the more complex strategies that can be applied to your portfolio.

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