Two Types of Bullish Bets

09/12/2008 12:00 am EST

Focus: STRATEGIES

Michael Shulman

Editor, Short-Side Trader

When options traders are bullish on the direction of the underlying instrument's price (i.e., they expect the price of the stock to go up), they can either buy call options or sell put options.

Before deciding which strategy is right for you when you're looking to profit from upside action, it's wise to weigh the risks versus the potential benefits. First, take into consideration whether you would prefer to pay a debit to purchase a call (and earn it back, preferably with a profit, during the life of the trade) or instead collect a credit upfront when you short (i.e., sell to open) a put. (The goal with the short option is to keep the credit as well as to garner additional profits.)

With either strategy, you benefit from an upward movement in the stock, and profitability is determined by the stock price staying above the strike price of the option you hold.

Be careful when putting your capital at risk.

While it sounds like a quick-win strategy to collect a credit as soon as you initiate the trade, with such instant gratification comes greater risk. When you buy a call, the most you can lose on the trade is what you put into it. So, if you buy a $1 call and it cracks, you lose $100 per contract, as well as any commissions you paid. But with a short put, the losses can be more substantial, which I'll explain in a moment.

Second, it's helpful to keep in mind whether you own (or want to own) the stock. As a general rule of thumb, it is less risky to buy a call or put without owning the stock (you can also short without owning the stock, but often times that's a move better left to professional traders), and if your position becomes profitable, you can either close your long option directly or exercise it to buy stock at the strike price of the option you hold.

Use stocks as a safety net.

On the flipside, anytime you decide to short an option, you may want to consider owning the stock as a hedge in case the trade goes against you and you are assigned by the option buyer to provide them with shares of stock at the strike price of the call you initially sold.

For example, a short call paired with long stock is a covered call, which simply says that if your stock is "called" away from you, you literally have it "covered" because you must part with your stock if the call buyer so chooses. The good news there, though, is that you already have the stock and are not scrambling to buy shares just to sell to keep up your end of the bargain.

In the case of short puts, if you wrote a May 20 put and the stock price dropped to $15 on bad news, not only would your position not be a profitable one for you, but it would instead be profitable to the put buyer (who had "bought to open" that option), who can choose to "put" shares to you at the strike price (or, $20), even though it's $5 per share above the market value. Thus, you would own shares at a higher price than you could turn around and sell them for.

A premium play.

On the other hand, if the stock price remained steady or even spiked, your risk of being assigned would dissipate, as your short put options would be in the money and you would be able to keep the premium you had collected when you initiated the trade, along with any profits. And with the long calls, your upside can be unlimited, as an option you purchased for $1 can go up several cents or even several dollars, depending on how much the price of the underlying stock moves.

Although there are risks with any type of options play, you can experiment with different risk/reward strategies and cash flow opportunities to decide the best way to trade that fits the amount of risk you want to take versus the types of profits you want to make.

Related Articles on STRATEGIES