Common Options Strategies, Explained

The subject of options is one of the most intimidating topics for many investors, new and seasoned alike. But there are really only a few basics to understand, and then a world of new investing opportunity can open up. In this clip, our Motley Fool Options pro explains the ins and outs of some of the most common options investing strategies -- how they work, what they mean, and how investors can use them to their advantage.

Dylan Lewis: What are some of the other really common option moves that you guys use in Motley Fool Options?

JP Bennett: The two basics, put writing, we already touched on, and the other one that is normally a great strategy for beginners is covered calls. In a covered call, you already own the underlying stock. So, you own 100 shares of Apple (AAPL +0.33%), let's say. And you layer on top of that selling calls. So, Apple is trading around $140, you can potentially say, "Sell the $145 call." So, basically, what you're doing is increasing the income that you're going to generate from a given position. You're going to get the dividend from Apple, but in addition to that, you're also going to generate that option income. Now, the potential downfall of that is that you have to sell those shares at $145 if the stock ends above it and you don't do anything. Again, little side note, there are a bunch of different things you could do as you get close to the expiration if you don't want to sell shares. But that's the biggest risk of writing covered calls. So, one of the cornerstones of that is never write covered calls on stocks you don't want to sell, because eventually, you're going to end up in a position where the stock skyrockets, and you just sit there and you're like, "I should not have covered those shares." That extra $2 per share in income really doesn't offset the sting of a stock moving $15-$20 by the time expiration comes.

Lewis: Yeah. And one thing that I think is probably worth clarifying for listeners is when options get exercised. I think that might be something that's a little bit confusing. It might be that you write puts and I take the other side of it, and I pay a premium for that. But, if the strike price doesn't wind up being somewhere that's opportune for me to exercise it, it will just wind up expiring, and I'll eat that premium.

Bennett: Yeah. In most cases, the person that's taking the other side of the trade is a market maker. Think about Wall Street, he's one of those guys on Wall Street with his computer, he's basically hedging out a bunch of positions and doing stuff like that. In the vast majority of cases, you have to wait until you get really close to expiration for those options to be exercised, because an options premium is composed of two components. There is the intrinsic value, which is the discrepancy between the current stock price and the strike price. If you bought calls of Apple at $140 and it goes up to $145, you now have $5 of intrinsic value because you're essentially buying the stock at $5 below the current market price. The other component is the component that decays away over time, and that's what's referred to as time value. That is a function of some of the things we referred to in the past. That component kind of withers away. So, when you're selling options, that's the component you want to go away over time. If you have bought an option, it doesn't make sense to exercise it unless there really isn't all that much time value left.

Now, there are certain instances, like I said. For every general rule of thumb, there are those exceptions. There's something referred to as dividend poaching, and things like that. But for the vast majority of cases, unless there's no time value left on the option, those options won't be exercised. So, one of the great things, here at The Motley Fool, we're long-term investors, we like to think in the long term. Because options are instruments that have a small lifespan, maybe three or four months, especially when you're writing puts, that's a sweet spot for where we're targeting, they can [...] on value pretty significantly over that time. You sell the put option and the stock falls, the value may increased by a smaller percentage in terms of dollars -- so, the stock falls $1, maybe your puts only change by $0.50. But, in terms of percentages, the move is going to be a lot greater. So, you can see those fluctuating values and just think to yourself, "Oh my gosh, what did I get myself into?" But, you just have to sit pat and have that long-term, "Here's why I initially did the strategy, we're going to ride it out and wait and see and let that time out," because that time value component is going to fluctuate significantly. But over time, because, say you buy an option that expires in four months -- that's worth a lot more, because a lot more can happen in four months than if you bought an option that expires five days from now. The odds of the stock moving over the course of three or four months is a lot higher than over the course of five days. So, the time value, all things equal, ceteris paribus, the option that expires in three or four months from now is going to have a lot more time value than the one that expires in five days.