Key takeaways

• There are four basic options trades: buying a call, selling a call, buying a put, and selling a put.

• If investors believe the underlying asset price will increase, they could buy a call or sell a put. On the contrary, if investors think the underlying asset price will decline, they could sell a call or buy a put.

Understanding four basic options strategies

Since there are two types of options, puts and calls, either one can be either bought or sold, we obtain a total of four basic option strategies: buying a call, selling a call, buying a put, and selling a put. Let's break it down one by one:

Buying a Call

The buyer of a call option hopes that the underlying asset's price will rise beyond the strike price before the expiration date. Their profit will come from the premium, which equals the sale proceeds, minus strike price and any transactional fees associated with the sale. If the price does not increase beyond the strike price, the buyer will not exercise the option. The buyer will suffer a loss equal to the premium of the call option.

Selling a Call

Call option seller sells call options with the hope that the option becomes worthless at the expiry date. They make money by pocketing the premiums paid to them. Their profit will be reduced or may result in a net loss if the option buyer exercises their option profitably when the underlying security price rises above the option strike price.

Buying a Put

Traders buy a put option to magnify the profit from a stock's decline. A trader can profit from stock prices below the strike price until the option expires for a small upfront cost. By buying a put, you usually expect the stock price to fall before the option expires. It can be helpful to think of buying puts as a form of insurance against a stock decline. If it does fall below the strike price, you'll earn money from the "insurance."

Selling a put

If you're looking to trade options, you can sell them as well as buy them. Here are the advantages of selling puts. The payoff for put sellers is precisely the reverse of those for buyers. Sellers expect the stock to stay flat or rise above the strike price, making the put worthless.