Call and Put Strategies
Calls and puts are derivative financial instruments. They are called options because they give the holder the ability to take certain actions in trading, but they do not obligate him to do so. The financial product on which they are based, often common stock or an exchange rate, is called the underlying. A call is the option to buy the underlying for a certain amount. This amount is called the strike price. A put is the opposite of a call: it gives the holder the ability to sell the underlying at the strike price. There are two classes of options -- American and European. The holder may exercise an American option at any point between the time he buys it and its expiration date; a European option may be exercised only at expiration.
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Basic Call or Put
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The simplest strategy is to purchase a call or a put. This is called taking a long position in the option. The holder then chooses to exercise the option only if it is in-the-money, which means that it is profitable to exercise the option. For example, if a call has a strike price that is $5 below the market price, then it is in-the-money since the holder can exercise the option and then immediately sell the underlying to make a profit. If an investor holds shares of underlying stock and then purchases a put, his strategy is referred to as a protective put.
Another option is to sell, or write, the basic options. This is called taking a short position. An investor who is short in calls and holds the underlying stock has a covered call. If the investor is short in puts, but deposits enough cash with his brokerage firm to meet his obligations if the holders exercise the put, then he is using a cash-secured put strategy.
Straddle
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A straddle is a combination of an equal amount of calls and puts that have the same underlying, strike price and expiration date. Investors purchase straddles to benefit from volatility in stock prices in either direction. Straddle holders often engage in an activity called gamma scalping, where they lock in profits from large swings by participating in the spot market. Effectively, gamma scalpers reset their straddle positions so that they are poised to benefit from volatility again, rather than vulnerable to a loss of unrealized profit due to a swing in the opposite direction.
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Strangle
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A strangle is a strategy in which an investor purchases the same amount of a call and a put on the same underlying. The difference between a straddle and a strangle is that, while the strike prices on the options involved in a straddle are the same, the put has a lower strike price than the call in a strangle.
Collar
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A collar is a protective put combined with a short call. A collar holder is thus long in a put, short in the equivalent call and long in the underlying in an amount equal to the amount of put that he holds. Generally, the calls and puts involved in a collar are out-of-the-money, which means that the strike price of the call is above market price and the strike price of the put is below market price. Collars can be structured to protect the holder of a stock from taking losses; the tradeoff is that they limit his profit. If the collar does prevent losses, it is known as a costless collar.
Married Puts and Married Calls
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Married puts and married calls are opposite strategies. In a married put, the investor purchases a put and shares of the underlying. He holds the same assets as an investor who uses the protective put strategy. The difference is that in a protective put the buyer must hold the underlying before he buys the put, while in a married put they are purchased concurrently. In a married call, an investor buys calls and sells short an equivalent amount of the underlying.
Bull Call Spread and Bear Put Spread
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These two strategies are methods of modifying traditional call and put strategies to reduce the risk associated with them. They are used when the investor thinks that the price of the underlying will go up in the case of the bull strategy, or down in the case of the bear strategy. However, he is not certain enough to only purchase a call or a put. In a bull call spread, the investor buys and writes calls on the same underlying with the same expiration date. The call that he purchases has a lower strike price than the one that he writes. The bear put spread is the opposite: the investor buys puts with a higher strike price than the ones that he writes.
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