Strangles: A strangle consists of the simultaneous purchase (a long strangle) or sale (a short strangle) of a call and a put on the same underlying security with different strike prices and/or expiration dates. The example provide below is a Strangle with different strike prices with the same expiration. The concepts of the strangle are very similar to the concepts of a straddle.

As a buyer of this strangle, we have to chose which strike price we want. We will use the 45C/40P. This means that we are buy a call option with a $45 strike price and also buying a put option with a $40 strike price. There is a little more risk in using a strangle position because there is a dead zone where you will make no money. With the stock price at $41.85, the dead zone with this stock is between $40 and $45. In this case, we would pay $2.00 to establish this position.

In order to profit from this transaction as a buyer, the stock price must either exceed $45, where you will profit from the call option, or the stock price must drop lower than $40, where you will profit from the put option. Once again, this is good for high volatility plays. Generally, if using the same expiration but different strike prices, the strangle will tend to cost less than the straddle because of the “dead zone” that exists in the strategy. The size of the dead zone depends on the stock price and how the options are priced. Since our stock is priced in a reasonable zone, the spread is only $5. Stocks like Google that trade in the $500 rage have a spread of $10. Stocks that trade under $10 generally have a spread of $2.50.

As a seller of this strangle, we would receive $1.80 from the buyer. Our maximum profit range will occur if the stock price expires between $40 and $45. Since we receive the premium from a buyer, our true range at expiration is from $46.80 or $38.20. At either extreme, we will make a profit of $0. Once again, we hope for little volatility but the range for making the maximum profit is much wider than the straddle, where the maximum profit is obtained if the stock closes at the strike price.

Straddles: A straddle consists of the simultaneous purchase (a long straddle) or sale (a short straddle) of a call and a put on the same underlying security with the same strike price and expiration date. Below you see a quote screen for a Straddle. As a Buyer of a Straddle with a $45 Strike, we would pay $4.65. As the seller, we would receive $4.35. In this example, the quote is two days before Options Expiration so trading is volatile.

As a buyer, if the stock drops significantly from $45, we will gain from the $45 put we purchased. If the stock rises significantly from $45, we will gain from the $45 call we purchased. The farther the stock deviates from $45, the more money we can make. Since our cost is $4.65, in order to have any profit, the stock price would either have to rise above $49.65 or drop below $40.35. Otherwise we will have a net loss on the position. The worst thing that could happen, as a buyer, is if the stock closed at $45.00. The buyer of a straddle is hoping for huge volatility in the stock price.

As a seller of a straddle, the best trade for us is if the stock closed at $45.00 exactly. This way, neither the call nor the put option is exercised. Any deviation from the Strike Price and at least one of the options will be exercised. Our ideal range would be for the stock to trade between $40.65 and $49.35. At either end, we would break even on the trade. Anything in between and we will have a profit. The seller of a straddle is hoping for less volatility in the stock price.

Spread: A spread position is a position consisting of two parts, each of which alone would profit from opposite directional price moves. As an order, spread involves the simultaneous purchase and sale of one or more option contracts of the same type (call or put) on the same underlying security with different strike prices and/or expiration dates. Some of the common types of spreads include the Vertical Call Spread, Vertical Put Spread, Calendar Call Spread, and Calendar Put Spread. We will go over these in a different post.

LEAPS: This stands for Long-term Equity AnticiPation Securities, and are also known as long dated options. These options have a minimum expiration of 9 months to as long as 39 months. Currently, equity LEAPS have two series at any time with a January expiration. For example, in October 2004, LEAPS were available with expirations of January 2006 and January 2007.

One would buy LEAPS if you have a long term outlook.

Besides buying the simple call or put, there are many other strategies one can use when trading in options. I will be providing some definitions below that are used by a popular online trading company as well as showing some screen shots of the different types of quotes. There are different reasons for taking on a certain position and we will address those over the next few days.

Everything you see here is my opinion. I have expounded on the definitions provided the online company. Some companies that provide online trading services include TD Ameritrade, E*TRADE, Scottrade, Fidelity, and Schwab. There are others but these are the most well-known.

Covered Call: This is a safer way to become familiar with options. This is a strategy where an option is written against current stock holdings. For example, if you had 400 shares of MSFT, you would Write (Sell) 4 MSFT July $30 options where July is the Expiration Month and $30 is the Strike Price. In this case, current stock price of MSFT is $27.55. One would use this strategy to hedge one’s position. If the stock closes over $30, the contract will most likely be exercised by the buyer. As the Writer/Seller of the contract, you would deliver the stock to the Buyer and he would pay you $30 per share. If the option expired and the stock price were less than $30 per share, the Writer/Seller of the contract would be able to keep the premium, thus reducing the cost basis of the stock. One would use this strategy if you expect the stock to trade within a trading range not to exceed the strike price. This transaction can also be known as a Buy-Write Strategy.

Covered Put: This is similar to the Covered Call but reverse and generally requires higher Options Access. Here, you would Write/Sell a put option and you would also be Short the underlying security. Let’s use our MSFT example. If you short MSFT at $27.55 and Wrote/Sold put options at $25.00, you would profit as the stock price declines. But, since you sold a put option, if the stock price dropped lower than $25, the buy of the option would exercise and you would have to buy the stock at $25. But you still have the profit from your original short of the position. One would use this strategy expecting the stock price to decrease, but not go lower than the strike price. This transaction can also be known as a Sell-Write strategy.

The next set of terms are in-the-money (ITM), at-the-money (ATM), and out-of-the-money (OTM) options. To determine the money status of an option depends on which point of view we are to assume. If one is Long the option, we have purchased the option and will decide whether or not to exercise the option. If one is Short the option, we have sold the option to a buyer and have the obligation to meet the terms of the contract if it is exercised. We will use the following examples from those who are Buyers and are taking a Long position.

We have a Call Option that has a Strike Price of $100. An option would be ITM if the stock price were $100.01 or greater. An option would be ATM if the stock price were exactly $100.00. An option would be OTM if the stock were $99.99 or less.

We have a Put Option that has a Strike Price of $100. An option would be ITM if the stock price were $99.99 or less. An option would be ATM if the stock price were exactly $100.00. An option would be OTM if the stock were $100.00 or more.

As a buyer of an option, you want your options to expire ITM. But just because an option expires ITM doesn’t mean that a buyer wants to exercise the option. If the option is $0.01 ITM, it may cost more to exercise the option and sell the stock than to let the option expire worthless.

As a seller, you want your options to expire OTM. If an option expires OTM, there is nothing more a seller needs to do. The option expires worthless and there is no longer an obligation to buy the stock in the case of a put, or sell the stock in the case of a call.

There are many more terms when dealing with options and we will eventually cover those in an Advanced Options Terminology section. There are also just as many different options strategies that one can use. Each strategy is used for a different purpose. Whether you are hedging a position or purely speculating, options is another way to enhance your position.