Introduction to option strategies

Option strategies are a combination of buying and selling different types of options (calls/puts), sometimes combined with Stock/ETF ownership (or shorting) to form a trading strategy.

Before jumping into the world of strategies, make sure you understand the basics of options first.

Remember: Options strategies are organized by level. Certain strategies are not available in registered accounts (TFSA/RRSP/FHSA). The first two strategies covered in this article are popular with traders using Registered accounts. Spreads however, covered in the last 2 sections, are only available using a Margin account.

This article will focus on 4 introductory strategies:

• Covered Call
• Married Put
• Vertical Call
• Vertical Put

A (long) covered call is an option strategy in which a trader holds (is long) a position on a stock/ETF and subsequently sells (writes, or is short) a call option on the same security in order to earn premiums (as a form of income for many investors).

Options level required to trade this strategy: Level 2

Available in a Registered account? - Yes

Strategy benefits

• Receive income from the option premium when you sell call options.
• Offset (some) losses if your stock depreciates in value.

Strategy downsides

• May lose your stocks (being “called away”) if the stock value rises beyond the strike price of the option, and the contract is exercised.
• Even if your stock rises in share price significantly, your gains are capped by the strike price (plus the option premium received).
• If the stock drops in price significantly, the option premium you receive will not be enough to offset your losses in share price.

Setting up the strategy

• Buy (or already own) at least 100 shares of an underlying stock or ETF.
• Sell a call option on the same underlying security.

There are 2 main goals traders have with this strategy:

1. Goal: Sell call option on the underlying stock/ETF to produce supplementary income.
   • Ideal result at expiry: Security should be close to the strike price, but not above it.
2. Goal: Sell stock/ETF at expiry, while earning additional profit from selling the call option.
   • Ideal result at expiry: Security should be slightly above the strike price, so the call option is assigned.

Covered call example

You own 100 shares of ABC stock valued at $45. In the short term (less than 30 days) you expect the stock price to rise slightly to a maximum value of $48.

You sell a $50 strike call option on ABC stock that expires in 30 days, which earns you an option premium valued at $100 ($1 x 100 shares = $100).

Note: One option contract = 100 shares.

This means that the buyer of the call option has the right to purchase the stock at a $50 strike price prior to the 30-day expiration date.

Possible results:

1. ABC shares go up slightly for the next 30 days, rising to $47.50, but still well below the strike price of $50
   • The call option expires worthless, and you keep the call option premium ($100)
   • Because the shares went by $2.50, your 100 shares gained $250 in value.
   • Your total profit would be $350.
2. ABC shares drop slightly to $44, lower than their initial value
   • The call option expires worthless, and you keep the call option premium ($100)
   • Because the shares went down by $1, your 100 shares lost $100 in value.
   • Since the option premium offsets the share depreciation, you break even.
3. ABC shares rise above the strike price, to $52, and the call option is exercised by the buyer
   • Even though the call option is exercised, you still keep the call option premium ($100).
   • You are forced to sell your shares at the strike price ($50), which is a $5 gain from your $45 starting value, for a $500 gain.
   • Your total profit would be $600
   • ...however, this is only because your profit upside was capped at the $50 strike price. If you had sold your 100 shares at $52, you would have seen a $700 profit instead.
4. ABC shares drop well below the strike price, to $40
   • The call option expires worthless, and you keep the call option premium ($100)
   • You incur significant loss by owning the shares themselves. At a $5 per share loss, your 100 shares lose a total of $500 value.
   • However, the call option premium does soften this a little, and you only see a total loss of -$400

Margin requirements

Learn more about the margin requirement of the underlying asset(s) in the linked article.

Covered call Margin Requirement formula:

Let’s take a look at the MR of the example from above

The “In the money” value of the call option is $0 because the short call is “out of the money”. (Strike is $50, share price is lower at $45)

If we reference our MR formula above, we’d enter -$100 (0-$100) in the first row because the ITM amount is $0, and the Market value of the call is $1x100=$100.

Then, let’s compare the value of Option 1 and 2 to see which is greater.

Option 1 is the lesser of:

• The margin required on the underlying security
  • $1,350 calculated as $4,500 *  0.3 representing a 30% MR on the underlying

Or

• The margin required on the total exercise value
  • $1,500 calculated as $5,000 * 0.3  representing a 30% MR on the potential exercise value
  • Remember: 1 contract = 100 shares, so the $50 strike represents $5,000 worth of ABC

Therefore, the smaller value of $1,350 is our value for Option 1.

Then, let’s compare this with option 2 to see which is greater:

• Option 2 is calculated as 15% of $4,500 (100 shares of ABC at $45/share) which equals $675 (4,500*0.15).

When we compare Option 1 and 2, we can see that Option 1 at $1,350 is greater.

You can also view the margin required during a trade in the Order Confirmation window.

Check out the margin requirements of other strategies on our Stock & options margin requirements page.

Once you own a position, in the Edge Desktop trading platform, you can also add a custom “RTBP” column that represents the amount of margin utilized by the position.

Profit and loss explained

Maximum profit

Maximum profit = [(strike price – stock purchase price) x number of shares] + (option premium x number of option contracts x number of shares per contract)

Maximum loss

Maximum loss = (stock purchase price x number of shares) – (option premium x number of option contracts x number of shares)

Although you receive a premium when you sell a call option, most of the risk comes from owning the underlying asset(s) themselves because the stock/ETF may actually drop in value before the option’s expiry date.

Break-even at expiration

Break-even point = stock/ETF purchase price – option premium received per share.

A (long) married put is an option strategy in which a trader purchases (longs) a put option while simultaneously buying (or already owning) an equivalent number of shares of the underlying stock/ETF. This protects (hedges) the trader against the potential drop of the share price.

You can think of long married puts as a form of “insurance” for securities you already own, this is often called “hedging”.

Options level required to trade this strategy: Level 1

Available in a Registered account? - Yes

Strategy benefits

• Hold your stocks while insuring against any losses.

Strategy downsides

• Reduces your profit due to the option premium paid on the put options.

Setting up the strategy

You buy a put option and simultaneously purchase (or already own) an equivalent number of shares of the same underlying stock/ETF.

When choosing the strike price, consider the following:

• The further out of the money the strike price is, the cheaper the premium will be. However, this strategy offers you less downside protection.
• The further in the money the strike is, the more expensive the option premium will be. As a result, this strategy offers more downside protection.

Married put example

You purchase 100 shares of ABC stock valued at $26 per share. To protect yourself against the potential depreciation of the shares, you simultaneously purchase a put option with a strike price of $24 for a $75 premium (0.75 option premium x 100 shares) with a 30-day expiration.

Although your initial cost to purchase the put is $75, this also caps your total potential loss at $275 [($26 – $24) x 100 + $75].

As the buyer of the put option, you have the right to sell the stock at a $24 strike price before the option expiry date.

Possible results:

• ABC shares drop significantly over the next 30 days to $20, well below the purchase price of $26.
  • You would exercise the put option to sell your shares for $24 and cap your loss at $275
  • If you were just holding the shares without the put option, you would have seen a $600 loss [($26 - $20) x 100)] instead
• ABC shares rise to $30 over the next 30 days, well above the $24 strike price.
  • The put option expires worthless, but you can now sell your stock at the higher price and realize a profit.
  • In this case, the price rose $4 per share, so you profit $400 from the growth of your 100 shares. Minus the option premium you paid, your total profit is $325.
• ABC shares stay the same in value at $26 per share
  • Your put option expires worthless. Since there was no change in the value of the security, your total loss is $75.

Margin requirements

Learn more about the margin requirement of the underlying asset(s) in the linked article.

Married put margin requirement:

The value of either 1 or 2, whichever is greater:

1. The sum of: ($75+$275=$350 from the example above)
   • 100% of the market value of the put option ($75 from our example)
   • And
   • The lesser of: (calculated as $275 from our example)
     • The normal margin required on the underlying security (50% MR of $2,600 is $1,300 from our example)
     • Or
     • The out-of-the-money amount of the put option. [(26-24)x100 = $200]
     • Plus the market value of the put option ($75)
     • Minus any in-the-money amount of the option. ($0)
       • Total = $275 ($275+$0)
2. 5% of the market value of the underlying security ($130 from the example, calculated as (100 x $26) x 0.05)

You can also view the margin required during a trade in the Order Confirmation window.

Check out the margin requirements of other strategies on our Stock & options margin requirements page.

Once you own a position, in the Edge Desktop trading platform, you can also add a custom “RTBP” column.

Profit and loss explained

Maximum profit

Maximum profit = [(current stock price – original purchase price) x number of shares] – (option premium paid x number of option contracts x number of shares)

Maximum loss

Maximum loss = [(strike price - current stock price) x number of shares] + (option premium x number of contracts x number of shares)

Break-even at expiration

Break-even point = purchase price + option premium paid per share.

A vertical call spread is an option strategy in which a trader buys and sells (writes) a short and long call option of the same underlying symbol simultaneously. The call options must have identical expiration dates but different strike prices.

The term ‘vertical’ comes from the position of the strike prices above and below each other. This is different from a ‘calendar’, or ‘horizontal’ spread where the strike’s are identical, but the expiration date is different.

There are two types of Vertical call spreads:

• Bull: Used by a trader who thinks the security’s price will rise before the call options expire. This strategy may be used by a trader who wants to offset the cost of purchasing the long call option by selling a short call option. However, keep in mind that this also limits the potential profit.
• Bear: Used by a trader who thinks the security’s price will fall before the call options expire. This strategy may be used by a trader who wants to reduce their overall risk by having the higher strike as upside protection rather than selling the uncovered (naked) call on its own.

Options level required to trade this strategy: Level 3

Available in a Registered account? - No, Margin accounts only.

Strategy benefits

• Cost savings when implementing a bullish call spread due to the premium received from selling the short call.
• Reduced risk when implementing a bearish call spread by having the higher strike as upside protection rather than selling the uncovered (naked) call on its own.

Strategy downsides

• Profit is limited to the premium received when implementing a bearish call spread.
• Profit potential is capped when implementing a bullish call spread.

Setting up the strategies

Bull Vertical Call

• Buy one call option on the underlying stock/ETF.
• Sell (write) one call option on the same underlying stock/ETF with a higher strike price than the long option above.

Ideally you want the stock price to be above the short call’s strike at expiration.

Bear Vertical Call

• Buy one call option on the underlying stock.
• Sell one call option on the same underlying stock, with a strike price below the long call option.

Ideally you want the stock to be below the short call’s strike at expiration.

Margin requirements

100% of the market value of the spread.

Plus

The value of either 1 or 2, whichever is greater:

1. The lesser of:
   • The normal minimum margin requirement for the short option, plus the market value of the short option.
   • Or
   • The spread loss amount, if any, that would result if both options were exercised.
2. 5% of the spread loss amount, if any, that would result if both options were exercised.

Check out the margin requirements of other strategies on our Stock & options margin requirements page.

Bull vertical call example

You believe that ABC shares currently trading at $50 will rise moderately, so you buy (long) a call option with a $45 strike for $500 and sell (write/short) a call option with a $55 strike for $100. Your initial investment would be a debit of $400.

This strategy means that you:

• As the buyer of the call option, have the right to buy the shares at $45 before the expiration date.
• And
• As the seller of the call option, have the obligation to sell the shares at $55 before the expiration date, if the option is exercised.

Possible results

1. At expiration, the stock’s price closes at $56, meaning both options expire in the money (i.e. the strike prices – $45 and $55 – are both below the market price of the stock).
   • In this case both call options would be exercised. The intrinsic value of the call options would be as follows:
     • $1,100 for the long call ($56 - $45) x 100
     • -$100 for the short call ($55 - $56) x 100
   • Your spread value would be $1,000 minus your initial investment of $400, which would leave you with a profit of $600.
2. At expiration, the shares close at $39, meaning both options expire worthless. Your initial investment of $400 would be lost.

Bull vertical call profit and loss explained

Maximum profit

Maximum profit = [(strike price of short call – strike price of long call)] x (number of contracts) x 100 – option premium paid

Maximum loss

Maximum loss = option premium paid

Break-even at expiration

Break-even point = strike price of long call + long call premium per share – short option premium per share

Bear vertical call example

You believe that ABC shares currently trading at $50 will fall in the near future, so you buy (long) a call option with a strike of $54 for $100 and sell (short) a call option with a strike of $45 for $500. Your initial credit would be $400.

This strategy means that you:

• As the buyer of the call option, have the right to buy the shares at $54 before the expiration date
• And
• As the seller of the call option, have the obligation to sell the shares at $45 before the expiration date if the option is exercised.

Possible results

1. At expiration, the stock’s price closes at $44, meaning both options expire worthless.
   • As a result, you keep the $400 credit as profit.
2. At expiration, the shares close at $55, meaning both options expire in the money (i.e. the strike prices – $45 and $54 – are both below the market price of the stock).
   • In this case, both call options would be exercised. The intrinsic value of the call options would be as follows:
     • -$1,000 for the short call (55 - 45 ) x 100
     • $100 for the long call (55 - 54) x 100
   • The spread value would be -$900 plus your initial credit of $400, leaving you with a total loss of $500.

Bear vertical call profit and loss explained

Maximum profit

Maximum profit = (short option premium – long option premium) x number of contracts x 100

Maximum loss

Maximum loss = [(strike price of long call – strike price of short call) x number of contracts x 100] – NET option premium received

Break-even at expiration

Break-even point = strike price of short call + short option premium per share – long option premium per share

A vertical put spread is an option strategy in which a trader buys and sells a short and long put option of the same underlying symbol simultaneously. The put options must have identical expiration dates but different strike prices.

The term ‘vertical’ comes from the position of the strike prices above and below each other. This is different from a ‘calendar’, or ‘horizontal’ spread where the strike’s are identical, but the expiration date is different.

There are two types of Vertical put spreads:

• Bull: Used by a trader who thinks the security’s price will rise before the put options expire. This is a credit strategy and may be used by a trader who wants to limit their risk by buying a long put option. However, keep in mind that this also limits the potential profit.
• Bear: Used by a trader who thinks the security’s price will fall before the put options expire. This is a debit strategy and may be used by a trader who wants to offset the cost of purchasing the long put option by selling a short put option. However, keep in mind that this limits the maximum profit to the difference between the put strike prices minus the premium paid if the underlying stock price falls below the long put option strike price.

Options level required to trade this strategy: Level 3

Available in a Registered account? - No, Margin accounts only.

Strategy benefits

• Limits your total potential risk.
• Offsets the cost of the put option by selling a less expensive put option.

Strategy downsides

• Limits the maximum profit to the initial option premium received if the underlying stock price rises above the short put option strike price

Setting up the strategies

Bull Vertical Put

• Buy one put option on the underlying stock/ETF.
• Sell (write) one put option on the same underlying stock/ETF with a higher strike price than the long option above.

Ideally you want the stock price to be above the short put’s strike at expiration.

Bear Vertical Put

• Buy one put option on the underlying stock.
• Sell one put option on the same underlying stock, with a strike price below the long put option.

Ideally you want the stock to be below the long put’s strike at expiration.

Margin requirements

100% of the market value of the spread.

Plus

The value of either 1 or 2, whichever is greater:

1. The lesser of:
   • The normal minimum margin requirement for the short option, plus the market value of the short option.
   • Or
   • The spread loss amount, if any, that would result if both options were exercised.
2. 5% of the spread loss amount, if any, that would result if both options were exercised.

Check out the margin requirements of other strategies on our Stock & options margin requirements page.

Bull vertical put example

You believe that ABC shares currently trading at $23 will rise moderately, so you buy (long) a put option with a strike of $20 for $125 and sell (short) a put option with a strike of $27 for $300. You would receive an initial credit of $175.

This strategy means that you:

• As the buyer of the put option, have the right to sell the shares at $20 before or at the expiration date.
• And
• As the seller of the put option, have the obligation to buy the shares at $27 before or at the expiration date, if the option is exercised by the buyer.

Possible results

1. At expiration, the shares close at $18, meaning both put options expire in the money (i.e. the strike prices are above the price of the underlying stock).
   • In this case, both put options would be exercised. The intrinsic value of the put options would be as follows:
     • $200 for the long put (20 - 18) x 100
     • -$900 for the short put (27 - 18) x 100
   • The spread value would be -$700. After applying the initial $175 credit, you are left with a total loss of -$525
2. At expiration, the stock’s price closes at $28, meaning both put options expire worthless. As a result, you keep the $175 credit as profit.

Bull vertical put profit and loss explained

Maximum profit

Maximum profit = option premium received – option premium paid

Maximum loss

Maximum loss = strike price of short put – strike price of long put – net option premium received

Break-even at expiration

Break-even point = strike price of short put – net option premium received per share

Bear vertical put example

Let’s say that ABC shares are trading at $28 in August. You believe that the price will fall in the near future so you purchase a September put option with a strike price of $30 for $400 and sell (short) a September put option with a strike price of $25 for $100. To enter into this strategy, your initial investment would be a debit of $300.

This strategy means that you:

• As the buyer of the put option, have the right to sell the shares at $30 before or at the expiration date.
• And
• As the seller of the put option, have the obligation to buy the shares at $25 before or at the expiration date, if the option is exercised by the buyer.

Possible results

1. At expiration, if the shares closed at $37, both options would expire worthless.
   • As a result, you would lose your initial investment of $300
2. ABC shares drop to $24 at expiration, meaning both put options would expire in the money.
   • The intrinsic value of each put would be as follows:
     • $600 for the long put (30 - 24) x 100
     • -$100 for the short put (25 - 24) x 100
   • The spread value would be $500; minus the initial debit of $300, this would give you a total profit of $200.

Bear vertical put profit and loss explained

Maximum profit

Maximum profit = strike price of long put option – strike of short put option – option premium paid + option premium received

Maximum loss

Maximum loss = option premium paid – option premium received

Break-even at expiration

Break-even point = strike price of long put – option premium paid per share

This article does not disclose all of the risks and other significant aspects of trading in options. In light of the risks, you should undertake such transactions only if you understand the nature of the contracts (and contractual relationships) into which you are entering and the extent of your exposure to risk.

Trading in options is not suitable for many members of the public. You should carefully consider whether trading is appropriate for you in light of your experience, objectives, financial resources and other relevant circumstances.

Transactions in Options carry a high degree of risk. Purchasers and sellers of Options should familiarize themselves with the type of Option (i.e. put or call) which they contemplate trading and the associated risks.

You should calculate the extent to which the value of the Options must increase for your position to become profitable, taking into Account the premium and all transaction costs.

The purchaser of Options may offset or exercise the Options or allow the Options to expire. The exercise of an Option results either in a cash settlement or in the purchaser acquiring or delivering the underlying asset.

If the purchased Options expire worthless, you will suffer a total loss of your investment which will consist of the Option premium plus transaction costs.

If you are contemplating purchasing deep out of the money Options, you should be aware that the chance of such Options becoming profitable ordinarily is very remote.

Selling (‘writing’ or ‘shorting’) an Option generally entails considerably greater risk than purchasing Options.

Although the premium received by the seller is fixed, the seller may sustain a loss well in excess of that amount. The seller will be liable for additional Margin to maintain the position if the market moves unfavourably.

The seller will also be exposed to the risk of the purchaser exercising the Option and the seller will be obligated to either settle the Option in cash or to acquire or deliver the underlying asset.

If the Option is ‘covered’ by the seller holding a corresponding position in the underlying asset or another Option, the risk may be reduced.

If the Option is not covered, the risk of loss can be unlimited.

Certain exchanges in some jurisdictions permit deferred payment of the Option premium, exposing the purchaser to liability for Margin payments not exceeding the amount of the premium.

The purchaser is still subject to the risk of losing the premium and transaction costs. When the Option is exercised or expires, the purchaser is responsible for any unpaid premium outstanding at that time.

Note: The information in this blog is for educational purposes only and should not be used or construed as financial or investment advice by any individual. Information obtained from third parties is believed to be reliable, but no representations or warranty, expressed or implied, is made by Questrade, Inc., its affiliates or any other person to its accuracy.