Which strategy is best for you?

A quick recap. So far, we've introduced the two types of options -- calls and puts. We've highlighted that there are two sides to a transaction -- the buyer and seller. We've discussed how to get option quotes, what those quoted prices mean, and a little about how they change with various external factors. Now, let's try to tie these concepts together graphically, laying out the profit and losses from four basic option strategies. We'll use the following options on Dell (Nasdaq: DELL), whose shares are trading at \$22.50, to illustrate:

Option

Call

Put

Symbol

DLQHX

DLQTX

Strike Price

\$22.50

\$22.50

Expiry

Aug-07

Aug-07

Option Price

\$1.85

\$1.35

Basic strategy 1: The long (buy) call
Buying a call gives us the right to buy Dell for \$22.50 until the third week of August 2007. We would pay \$185 per contract (remember that options are sold in contracts of 100) for that right. How much can we make, and how much can we lose?

The loss part is easy. No matter how far Dell falls between today and expiry, our risk of loss is capped at the \$185 per contract we're investing. If the market gets crushed, there's blood in the streets, dogs and cats are marrying each other, and Dell goes to \$14 -- no problem. A bad situation, perhaps, for those who simply bought Dell shares outright and are now sitting on an \$850 loss, but reasonably comfortable for our call buyer. On the other hand, there's (theoretically) no limit to how high Dell could go before expiry. And any rise in Dell's stock price will be matched, dollar for dollar, with a rise in the price of the call.

We can represent our profits and losses in both a tabular format and graphically with a simple two-axis plot. Profit equals the intrinsic value of the option less the cost to initially purchase the option. The horizontal axis shows the stock price at expiry, while the vertical axis shows the profit/loss potential. The shaded blue area above the horizontal axis is where the option is profitable, while the shaded blue area below the horizontal axis shows when the option buyer faces a loss.

Stock Price At Expiry

Profit/(Loss) At Expiry

\$15

(\$1.85)

\$20

(\$1.85)

\$22.50

(\$1.85)

\$24

(\$0.35)

\$25

\$0.65

\$30

\$5.65

Note that, though the option has a strike price of \$22.50, the option buyer doesn't actually make a profit until the stock goes above \$24.35 (the cost of the option plus the strike price). Also note that if the option expires when the stock price is between the break-even price and the strike price, the option buyer is still better off exercising, since some of the loss taken on the initial call buy can be recouped.

Basic strategy 2: The long (buy) put
We can similarly show a risk profile for any option position. Perhaps we're bearish on Dell's prospects and are seeking to profit by buying a put option. In such a case, our maximum loss is \$135, while our maximum profit would occur if Dell went bankrupt before our option expiry (don't hold your breath).

Stock Price At Expiry

Profit/(Loss) At Expiry

\$15

\$6.15

\$20

\$1.15

\$21.50

(\$0.35)

\$22.50

(\$1.35)

\$25

(\$1.35)

\$30

(\$1.35)

Basic strategy 3: The short (sell) call
What about the other side of the trade? Somebody is always selling the options that the counterparties are buying. The profit payouts of the option writers are the mirror opposites to those of the option buyers. So where a call buyer has a capped downside risk and unlimited upside, the call writer has a capped profit potential and an unlimited downside risk (hmm ... that doesn't sound like much fun).

Stock Price At Expiry

Profit/(Loss) At Expiry

\$15

\$1.85

\$20

\$1.85

\$22.50

\$1.85

\$24

\$0.35

\$25

(\$0.65)

\$30

(\$5.65)

Those who go short calls are generally down on the stock's prospects, at least until expiration. In isolation, those who go short calls are playing with fire with that potential unlimited downside.

Basic strategy 4: short (sell) put
Finally, the short put mirrors the profit and loss profile of the long put and is generally employed by those who are bullish on the underlying stock. The maximum potential profit is equal to the money received upfront from the put sale, while the maximum loss occurs if the stock goes to zero. Someone who believes that Dell will do just fine in the near term may sell puts to gain extra income.

Stock Price At Expiry

Profit/(Loss) At Expiry

\$15

(\$6.15)

\$20

(\$1.15)

\$21.50

\$0.35

\$22.50

\$1.35

\$25

\$1.35

\$30

\$1.35

Check out more of our options series here