The easiest way to learn options is with pictures so that you can begin to piece together strategies step-by-step. However, first we need to understand the four basic strategies. From that point, logic kicks in, and our learning can progress exponentially.
A risk profile chart shows us our profit/loss position for each trade. It differs from a standard price/time chart that we’re used to seeing to monitor 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 our risk profile for a long stock position. As the asset price rises above our purchase price (along the x-axis), we move into profit. Our risk is capped to what we paid, as is our breakeven point, and our potential reward is uncapped.
The reverse position is when we short a stock, in which case the opposite occurs. Here, as the stock price rises above our short price, our short position shows a loss, which can be unlimited as the stock continues to rise. Our risk is uncapped as the stock rises, and our potential reward is the price we shorted at, as is our breakeven point.
Now that we know how to interpret a risk profile chart, we can proceed with analyzing each strategy.
The four basic strategies that underpin your entire options trading knowledge are:
We should already know that owning an option exposes us to time decay, so typically we like to own options with expiration dates that are reasonably far away to give us a chance of our option increasing in value.
With options, we have the "Rule of the Opposites," where if one thing isn’t true, then the opposite must be true. Therefore, if time decay hurts us when we buy options, it must help us when we sell options. Because time value decreases (or time decay increases) exponentially during the last month to expiration, we typically don’t like to own options into that last month, but we do like to sell options with one month left to expiration.
With these four strategies, we 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.
We would short calls and puts with a month or less to expiration, thereby looking for short-term income as the option hopefully expires worthless.