The easiest way to learn options is with pictures so that you can begin to piece together strategies step-by-step. However, first you need to understand the four basic strategies. From that point, logic kicks in, and your learning can progress exponentially.
A risk profile chart shows your profit/loss position for each trade. It differs from a standard price/time chart that you’re used to seeing when you’re monitoring stock prices.
There are four easy steps to creating a risk profile chart:
Step 1: Y axis for profit/loss position
Step 2: X axis for underlying asset price range
Step 3: Breakeven line
Step 4: Risk profile line
This chart shows your risk profile for a long stock position. As the asset price rises above your purchase price (along the x-axis), you move into profit. Your risk is capped to what you paid, as is your breakeven point, and your potential reward is uncapped.
The reverse position is when you short a stock, in which case the opposite occurs. Here, as the stock price rises above your short price, your short position shows a loss, which can be unlimited as the stock continues to rise. Your risk is uncapped as the stock rises, and your potential reward is the price you shorted at, as is your breakeven point.
Now that you know how to interpret a risk profile chart, you can proceed with analyzing each strategy.
The four basic strategies that underpin your entire options trading knowledge are
- Long call
- Short call
- Long put
- Short put
You should already know that owning an option exposes you to time decay, so typically you like to own options with expiration dates that are reasonably far away to give yourself a chance of your option increasing in value.
With options, my “Rule of the Opposites” states that if one thing isn’t true, then the opposite must be true. Therefore, if time decay hurts you when you buy options, it must help you when you sell options. Because time value decreases (or time decay increases) exponentially during the last month to expiration, you typically don’t like to own options into that last month, but you do like to sell options with one month left to expiration.
With these four strategies, you would buy calls and puts with at least three months (or more) left to expiration, thereby looking for the options to increase in value during that time.
You would short calls and puts with a month or less to expiration, thereby looking for short-term income as the option hopefully expires worthless.
The Four Basic Options Risk Profiles
Imagine that the dotted lines are mirrors and see how each strategy is the opposite of the one on the other side of the mirror.
Buying a Call
Buying a Put
Writing a Call
Writing a Put