The textbook definition of an option is as follows: The right, but not the obligation, to buy or sell a specified asset at a predetermined price over a predetermined time.
Buying a Put
Buying a put is a bearish strategy that requires a price drop in the underlying instrument (stock or ETF). Nonetheless, the most critical factor in trading puts profitably is an ability to predict the future price moves of the underlying instrument.
The investment return on a put is the profit or loss divided by the initial investment. The formula is the following:
Return = (profit or loss)/initial investment
For example, if you buy a S&P 500 (NYSE: SPY) option for $4 and sell it for $6, for a profit of $2, your return on investment is 50% (2 divided by 4 equals 0.5, or 50 percent). Annualizing the return will give you another perspective on the return. If this particular trade covered 3 month from beginning to end, you would have made a 200 percent annualized return.
However, in most cases, the return on investment is not the major criterion of buying a put. The main reason for buying is leverage. You can gain large percentage gains with a small investment. The low price of puts makes discussions of rates of return almost meaningless when examined on a trade by trade basis. Many of your trades may make 200 percent, but your losses may be 100 percent. These are large percentages simply because the initial investment is so low.
Selling a Put
Selling a put is a bullish strategy. Put sellers want the price of the underlying stock or ETF to rise so they may buy back the put at a lower price or simply let the instrument expire worthless. The ideal situation for a put seller is for the price of the stock or ETF to move above the put’s strike price at expiration, thus rendering the put worthless. The put seller will have captured all of the premium as profit.
A call backspread strategy should be employed on an underlying security that has a realistic chance of an explosive move higher.
A poor man’s covered call is similar to a traditional covered call strategy, with one exception in the mechanics.
Mini options trade exactly the same way as standard options. But because they are new, they are available only on a few underlying stocks and ETFs.
One of the most popular of all options strategies are covered calls, a trading technique that can generate rich income streams on a regular basis.
During a live event on Wednesday, Andy Crowder and I revealed three simple strategies for collecting extra income as part of our Income for Life Plan.