Bullish Strategies for the Novice

Keep it Simple

Bull
The Bullish Investor. Google Images/ Janette Muniz

This article is designed to offer enough information so that an options novice can begin trading by making informed trade decisions. But -- there is much more that you should plan to learn about how options work, before using the options market on a regular basis.

An Introduction to the Basics.

  1. There are two types of option: calls and puts.
  2. Owners of call options have the right to buy 100 shares of a specified stock  at a fixed price (the strike price) for a limited time (until the option expires). Owners of put options have the right to sell 100 shares of a specified stock at the strike price for a limited time. 
  1. The market value of call options tends to move higher as stock prices increase. The market value of put options tends to move higher as stock prices decrease.
  2. Important: Factors other than the stock price affect the price of options in the marketplace. Thus, it is possible for the call owner to lose money when the stock price moves higher. A discussion of those other factors is available here
  3. Hedging. It is often advisable to offset part of your risk when trading. To hedge an option position, buy one option and sell another option of the same type. You probably are familiar with the phrase "hedging your bet." That phrase originated from the investment world. You will learn far more about hedging as you continue your options education.

    Risk reduction comes with a cost: profits are limited. For most investors, less risk is important, making limited profits an acceptable trade-off.

 

Some Basic Bullish Option Strategies

For the bullish trader, the general strategy is to own call options or combinations of calls.

The more subtle, less used strategy, is to sell put options or combinations of puts (spreads).

  • Buy call options. It is important to know which options to buy and which to avoid. If you decide to buy options, I encourage you to buy options that are in the money. Translation: Buy options where the strike price is lower than the current stock price. Warning: It is tempting to invest as little cash as possible and buy low-priced call options (where the strike price is higher than the price of the stock). Please avoid doing that because the chances of success are small.

    Knowing whether current option prices are relatively cheap or expensive allows you to make smart decisions about buying or selling. Alas, it takes an understanding of implied volatility before you can appreciate whether options are priced reasonably. That is okay for now, but plan on reading about implied volatility before becoming an active trader.

    Be careful that the options expiration date comes after your predicted stock price change. Once the option expires, it is too late for you to profit when the stock price rises.

     
  • Buy call spreads. Similar to buying calls, the trader also sells one call option (with a higher strike price and the same expiration date). For example, with XYZ trading near $47 per share, a typical call spread (often referred to as a "bull call spread") consists of:

    Buy XYZ calls with a strike price of 45 and 
    Sell an equal number
     of XYZ calls with a 50 strike price.

    The cost of buying the (in the money) $45 call is reduced by the premium collected from selling the (out of the money) $50 call. This limits profits, but reduces your investment cost.

 

  • Sell put options. The sale of naked (unhedged) options is usually too risky for any option trader -- and especially for novices who may not know how to avoid blowing up a trading account. However, if you believe the stock price is headed higher, and if you are willing to buy stock (at the strike price), then it is acceptable to sell a naked put option. Be certain that you do not sell too many options.

    Sell only out of the money put options. Translation: The put strike price is lower than the current stock price. Warning: Never sell more puts than your account can tolerate. You should have enough cash in your account to pay for 100 shares at the strike price for each put sold. 

     

    • Sell put spreads. Sell one out-of-the-money put and buy another put. The one you buy is bought for protection (i.e., it limits losses) and is even farther out of the money than the put you bought.  For example, with the stock trading near $47 per share, you may want to buy puts with a strike of $40 and sell puts with a strike of $45. The cash premium that you collect (the put sold is more expensive than the put bought) represents your maximum possible profit for the trade.

      Selling put spreads is equivalent to adopting the collar strategy. 

    Those are four decent bullish possibilities for the new option trader, If you understand the rationale for trading spreads, then I encourage you to trade spreads rather than buying calls or selling puts. Although profits are limited, most of the time the spread strategy works out better -- especially because the cost of making the trade is significantly reduced.