Combining options into strategies

A strategy is two or more positions held together, so their payoffs add up. Each one below is built from pieces you already know: shares, calls and puts.

All three use our running example: a stock at $100, options with 30 days left and 25% volatility. In each chart, the line marked At expiry is the profit or loss when the options run out. The line marked Today is what the position would show right now if the stock jumped straight to that price. Dots on the zero line are breakevens.

Covered call

You own 100 shares and sell one call against them. You collect $1.17 a share now for selling the $105 call, and in return you agree to sell your shares at $105 if the buyer asks.

It is like renting out a room in a house you own. You get steady rent, but you have promised to sell at a set price if the tenant wants to buy.

The most you can make is $617, once the stock reaches $105. The premium softens a fall, moving your breakeven down to $98.83. Below that you lose much as you would owning the shares alone.

Bull call spread

You buy the $100 call and sell the $110 call. Selling the higher strike pays for part of the lower one, so the spread costs $2.67 instead of $3.02.

Think of a cheaper ticket with a ceiling. You pay less to ride up, but the ride stops at $110.

The most you can lose is what you paid, $267. The most you can make is $733, if the stock finishes at $110 or higher. You break even at $102.67.

Long straddle

You buy a call and a put at the same $100 strike. Together they cost $5.71. You make money if the stock moves far enough in either direction.

It is a bet on a storm when you don’t know which way the wind will blow.

The stock has to finish below $94.29 or above $105.71 for you to profit at expiry. If it sits still, both options lose value every day, and at exactly $100 you lose the full $571. This is the position most exposed to the IV crush from chapter 6.