Equity and Index Options Explained

10

Basic Option Strategy

We have already seen that options may be traded as an alternative to trading an underlying share. For example, if we want to profit from a share rising in price, then we have the following three basic choices:

1. Buy the share itself (either the physical shares or stock futures, CFDs, etc.)
2. Buy some calls
3. Sell some puts

Other things being equal, all three of the above choices will deliver a profit if the share price rises and a loss if it falls. All three are “bullish” choices. So are they the same? No! Indeed, the only thing that unites the three choices is their “bullish” nature. Consider the profit and loss profiles of the three choices:

1. Buying the actual share, whether physically or via a CFD, potential profit to the upside is unlimited and is (depending upon the specific share price) matched by commensurately big losses to the downside (limited only by zero). Buying the actual share is, to all intents and purposes, a 50/50 “shot”. Big potential profits matched by big potential losses.
2. Buy some calls. Our potential profits to the upside are unlimited and, if we are wrong and the share price falls, we can only lose the premium paid for the call. Even if the company goes bust and the share price falls to zero, we can only lose the price paid for the options. Unlimited potential profit against limited risk.
3. Sell some puts. Our potential losses to the downside are large, limited only by zero and our profits to the upside are limited to the premium received ...