Options Guide · Module 4

Core options strategies are the handful of building blocks from which every other strategy is assembled: buying a call or a put for direction with defined risk, selling a covered call for income, buying a protective put for insurance, and using vertical spreads to cut the cost of a directional bet. Each one has a maximum loss you can calculate before you place it, and a situation it is genuinely built for.

Learn these six and you can express almost any view, bullish, bearish or neutral, with risk you measured in advance rather than discovered afterwards. This module covers the payoff, the maximum loss and the right moment for each, with worked numbers throughout.

Match the strategy to your view

Beginners usually approach this backwards. They learn a strategy that sounds clever and then look for somewhere to use it. The order that works is the other way round: form a view first, then choose the instrument that expresses it.

A complete view has three parts, and most people only form the first. There is direction, meaning up or down. There is conviction, meaning how strongly you hold that view and therefore how much you are willing to pay for it. And there is what you expect volatility to do, which decides whether options are a cheap or expensive way to express anything at all. Each combination maps to a tool.

Read the right hand column before the left. Every row commits you to a maximum loss you can write down before placing the trade, and that is the property these six share and the reason they are the core.

Long call: bullish with defined risk

A long call is the simplest bullish trade there is. You buy a call, which gives you the right to buy at the strike.

Your maximum loss is the premium and nothing more, however badly the share behaves. Your maximum profit has no ceiling, because the share can keep rising. That asymmetry is the whole attraction, and it is worth noticing that it is the reason options exist at all.

The conditions that suit it follow from the Greeks in module 3. Low implied volatility is better, because you are buying premium and vega is positive, so cheap volatility means a cheap entry. A specific catalyst helps, because you are paying theta every day you wait and you want the move to arrive before the decay does real damage. And 30 to 60 days to expiry keeps you out of the steepest part of the decay curve.

One caution that catches beginners repeatedly. A long call needs the share to rise past the strike and past the premium you paid, before expiry. Being right about direction is not enough. You must be right about direction, size and timing at once, and that is three predictions rather than one.

Long put: bearish with defined risk

A long put is the bearish mirror image. You buy a put, which gives you the right to sell at the strike.

Maximum loss is again the premium. Maximum profit is the strike minus the premium, because the furthest a share can fall is to zero, so unlike the call there is a ceiling, however distant.

The point that matters most here is the comparison with short selling. If you sell a share short, your loss has no limit, because there is no ceiling on how high a share can rise, and a position that moves against you grows larger as it does so. A long put expresses the same bearish view with a loss you fixed at the moment you paid for it. You can be completely wrong and lose only what you put in. For most people that difference is the entire argument for using puts rather than shorting.

Covered call: income from shares you already own

A covered call turns shares you already hold into an income stream. You own the shares and sell an out of the money call against them, collecting the premium immediately.

The word covered is doing the important work. Selling a call on its own exposes you to unlimited loss, because you would have to buy the shares at any price to deliver them. Owning the shares already means you can simply hand over what you have, and that is what converts a dangerous position into a conservative one. The shares are the cover.

Sell one call against one contract’s worth of shares. In the United States that is 100 shares per contract. On UK listed equity options it is typically 1,000, so check the multiplier before you assume, as module 2 sets out.

It suits a neutral to mildly bullish view. Your maximum profit is (strike − purchase price) + premium, and your upside is capped above the strike, which is the price you pay for the income.

Be honest with yourself about the trade you have made. A covered call sounds like free money, and the premium does arrive immediately. What you have actually done is sell your upside. If you would be genuinely upset to lose the shares at that strike, either choose a higher one or do not sell the call, because the outcome you would find upsetting is precisely the one you have agreed to.

Protective put: insurance for a holding

A protective put is the opposite trade to a covered call. You keep your shares and buy a put to put a floor under them.

Your maximum loss becomes (share price − put strike) + premium paid, and you keep the entire upside if the share rises, because nothing has been sold away.

Treat it as exactly what it is, which is insurance. You pay a premium, you hope not to need it, and if nothing happens the premium is gone. That framing answers the question people ask about when to use it. Insurance is worth buying before a specific uncertain event, such as a results announcement or a regulatory decision you have a real position riding on. Running it permanently is expensive, because you are paying for cover in every quiet month as well as the turbulent one, and over years that cost compounds against your returns.

Note one interaction with module 2. Implied volatility is usually highest exactly when you most want protection, because everyone else wants it too. Insurance is dearest during the storm.

Bull call spread: cheaper bullishness

A bull call spread reduces the cost of being bullish. You buy a call at a lower strike and sell a call at a higher strike, both at the same expiry.

The premium you receive on the sold leg pays for part of the leg you bought, which makes this a net debit trade, meaning money leaves your account but less of it. The price of that discount is a ceiling on the profit, because above the higher strike your gains on the long call are matched by losses on the short one.

• Maximum profit = spread width − net debit.
• Maximum loss = the net debit.
• Breakeven = lower strike + net debit.

Work through one. Buy the 100p call and sell the 110p call for a net debit of 4p. The spread width is 10p, so maximum profit is 10 − 4 = 6p, maximum loss is the 4p you paid, and breakeven is 104p.

Now compare that with buying the 100p call on its own. Suppose the single call costs 6p and the 110p call brings in 2p, giving the 4p net debit above. Two things improved. Your outlay fell from 6p to 4p, so a total loss costs you a third less. And your breakeven fell from 106p to 104p, which means the share has less distance to travel before you make anything. What you surrendered is everything above 110p.

So the question to ask is not whether a spread is better than a single call. It is how far you actually expect the share to go. If your view is a move to about 108p, the ceiling at 110p costs you nothing you expected to receive, and you got there more cheaply with a nearer breakeven. If you genuinely expect 130p, the spread throws away most of the reason you were interested.

Bear put spread: cheaper bearishness

A bear put spread is the same idea pointed downwards. You buy a put at a higher strike and sell a put at a lower strike at the same expiry, again for a net debit.

Maximum profit is the spread width minus the net debit. Maximum loss is the net debit. Breakeven is the higher strike minus the net debit.

The reasoning is identical to the bull call spread, and so is the question you should ask. You are trading away the part of the move you do not expect, in return for a cheaper entry and a nearer breakeven. Since a share can only fall to zero, the downside case has a natural floor anyway, which makes giving up the far tail less costly than it is on the bullish side.

Naked options against spreads

So when do you buy a single option, and when do you build a spread?

A single option, sometimes called naked, is simpler to place and manage, keeps the full upside, but risks the whole premium and needs a larger move to reach breakeven. A spread costs less, lowers the breakeven, and caps both the loss and the profit. There is no universally better answer, only a better answer for a given view.

Implied volatility should be part of the decision, and here it is worth being precise, because the two families are often described loosely.

• A high IV rank favours strategies that sell premium, because you are being paid unusually well by that share’s own standards. Covered calls belong here, as do credit spreads, where you receive more for the leg you sell than you pay for the leg you buy.
• A low IV rank favours strategies that buy premium, because it is unusually cheap. Long calls, long puts and debit spreads all belong here.

Both spreads taught in this module, the bull call spread and the bear put spread, are debit spreads. On balance they buy premium rather than sell it, so they sit on the low IV rank side alongside single long options, not with the covered call. It is a common confusion, because a spread contains a sold leg and that leg makes it feel like a seller’s position. What decides the label is the net direction of the money, and on these two the money leaves your account.

Managing the position: when to exit

Entry is only half the trade, and it is the half beginners think about. Disciplined exits are what separate consistent traders from the rest, largely because they are decided in advance, when you are calm, rather than in the moment, when you are not.

Three rules are widely used, and each has a reason behind it worth understanding rather than memorising.

• Take profit at around 50% of the maximum. The last portion of a position’s potential profit is the slowest and most expensive to collect, since you must hold through the steepest part of the decay curve to capture it. Closing once you have half removes that exposure and frees the capital.
• Cut a loss at around 50% of the premium paid. A stop decided beforehand preserves capital and, more importantly, removes the decision from the moment when you are least able to make it well. Options do not recover the way shares sometimes do, because expiry is a deadline that does not move.
• Close spreads near 21 days to expiry. Gamma rises sharply in the final three weeks, as module 3 explains, so delta starts moving quickly and a comfortable position can swing against you in a session. You are also giving up the least valuable time, since by then the remaining premium is small.

None of these are laws, and each can be argued with in a particular case. The point is to have decided which rules you follow before you have money at stake, because a position you are already losing on is the worst possible place to work out your policy on losses.