There are a lot of option strategies and each one of them should be used in the appropriate situation. The guide below is a summary of a series of articles about the stock strategies. This summary will help you to identify which strategy to use in which situation so you can maximise your profits and reduce your loses. I will update the list below as a find new information about the strategies or as I learn new ones.

Why buy calls?

• You believe a stock has a strong catalyst for appreciation over the coming months or few years.
• You want to benefit from a stock’s upside, but put less capital at risk than buying the stock outright.
• You want to leverage your bullish expectations on a stock you already own.

Why buy puts?

• You believe a stock is ripe for a fall and want to profit if it declines.
• You want to hedge against the bullish positions in your portfolio.
• You want to protect a position in your portfolio that you’re bullish on from a near-term downward move.

Why write puts?

• Income: To make money while waiting for your preferred buy price on a stock.
• Advantage: To buy stocks at a lower net cost.
• Profit: To earn income from stocks you believe will hold steady or increase modestly.

Why use covered calls?

• Income: To generate cash on a stable stock.
• Defense: To profit if a stock you own slips in price.
• A better sell price: To obtain a higher price when you’re ready to sell.

Why use protective collars?

Protective collars are useful in bear markets or when you’re uncertain about a stock’s valuation risk. They can also be a prudent way to protect your gains on stocks that have recently leaped in price, nearing your estimate of fair value.

Why use synthetic longs?

This option strategy works nearly the same as owning the underlying stock outright — except you don’t need to pay up front. Usually, you’ll set up a synthetic long on a stock if you foresee a strong catalyst for appreciation in the next 18 months or so.

Why use synthetic shorts?

If you’re looking to profit when stock prices slip, there’s a way to use options to mimic shorting a stock — but with distinct advantages.

Why use stock repair?

• You are down 15% to 25% on a stock and willing to forego profits to sell at breakeven.
• Not interested in averaging down or holding for the long haul.
• Using a margin-approved account and can write call options.

Why use diagonal calls?

• If you’re mildly bullish on a stock and want to generate income from a leveraged investment.
• To profit from a range-bound stock.
• If your underlying stock is chosen well, and you’re handed a little market luck, you can wake up a year or two hence with a significantly in-the-money call option that effectively costs you nothing.

Why buy a straddle?

• You believe a stock or index will move dramatically, but you don’t know which way.
• You believe volatility will increase in general, so the value of the options you’re buying will increase.
• You want to leverage potential returns when the underlying investment moves meaningfully in either direction, but limit your risk.

Why write a straddle?

• You believe a stock or index is going to hold steady or stay in a tight range.
• You believe a stock that was recently volatile will settle down considerably.
• You believe the market’s overall volatility is going to decrease.

Why use bull call spreads?

• Capital gains: To profit on a stock you feel relatively bullish on.
• Defense: To limit your capital at risk and lower your break-even point compared with just buying calls alone.
• Leverage: To land an oversized potential return on your net cost, although you sacrifice additional upside.

Why use bearish spreads?

• To profit on a falling stock or index while capping your risk.
• To earn strong percentage returns on a moderate move in an underlying investment.
• To lower the cost of bearish put option purchases.

Follow the practical way,
George Traganidas

Why use bearish spreads?

• To profit on a falling stock or index while capping your risk.
• To earn strong percentage returns on a moderate move in an underlying investment.
• To lower the cost of bearish put option purchases.

Earlier we introduced spreads — specifically Bull Call Spreads — explaining how they involve simultaneously buying and writing the same type of option (either calls or puts) on a stock, usually with a “spread” between the two strike prices. You can set up bullish, bearish, or neutral spreads, and they can be defensive or aggressive.

At Motley Fool Options, we’ll likely use bearish and neutral spreads more often than bullish spreads. Why? When you’re bearish and want to go short, it’s important to limit your risk. That’s exactly what spreads do — though they cap your potential profit in the process. When you’re bullish, it can pay to have unlimited upside potential and it’s less important to limit risk, sometimes making spreads a less appealing strategy. There are three key bearish spreads we’ll consider here, so let’s go over how they work.

Bear Put Spreads

The most common bearish spread involves buying a higher-strike put and financing some of the purchase by writing a lower-strike put with the same expiration date on the same underlying stock. The put you purchase will appreciate in value if the underlying stock declines. Since our potential loss is 100% of the capital we invest, we prefer setting up bear put spreads that can return at least 50% to 100%, making the risk worthwhile. Ideally, we’ll do this using strike prices that are within 20% of the current share price so we’re not reaching too far.

Let’s walk through an example. Suppose a retail company that sells poorly made, overpriced products is trading at what you deem a too-high $30 a share. The stock appears ripe for a decline, so you set up a bear put spread, buying $33 puts, which cost $5, and writing $28 puts, which pay $2.50, for a net debit of $2.50 per share. Since $5 separates the two strikes, the most you can make is $2.50 per share ($5 minus the $2.50 debit), or double your investment. The most you can lose is $2.50 per share as well. Your break-even price is $30.50, and if the stock falls below $28 by expiration, you make the full 100%; if it trades above $33, you lose your full investment. By choosing your strikes carefully and making sure the options pay a reasonable price, you’ve set up a bear put spread with strong profit potential.

To be especially defensive, you could set up a bear put spread with strikes above the current share price: In this case, you could buy $36 puts and write $32 puts on the $30 stock. As long as shares stay below $32, you’ll earn the full amount possible on your spread. However, defensive spreads usually don’t pay much. On the flipside, an aggressive bear put spread would use strike prices below the current share price, such as buying $28 puts and writing $25 puts. The $30 stock needs to fall below $25 for you to earn the full profit, but the profit will be handsome.

Usually, we’ll write moderately minded bear put spreads, similar to our first example.
Bear Call Spreads

Yes, Fools, you can use call options to make outright bearish investments. Bear call spreads have a compelling draw: You start with a net credit to your account. To set one up, you buy calls at a higher strike, and then write calls at a lower one. (Since lower-strike calls are always worth more, you always start this trade with a net credit.) As with all spreads, one side of your trade protects against the other, capping your risk.

Let’s assume you set up a bear call spread on the same $30 retailer from our bear put spread example. You buy calls at $33, which cost you $2, and then write calls at $28, which pay you $4; your net credit is $2 per share. If the stock ends below $28, both calls expire and you keep the $2 per share. If it rises above $33, you’d close both calls before expiration, and your cost would be the difference between the two strikes, or $5. Given your $2 credit, you’ve lost the maximum $3 per share.

To be most defensive, you would use strike prices above the underlying share price, or both out-of-the-money. This way, even if the stock goes up, as long as it stays below the lower of the two strikes, the spread will end profitably. Aggressive bear call spreads are rare (since bear put spreads work better for strong bearish cases), but these are initiated with both strikes below the share price.

Bear call spreads are popular because they start with a net credit, but they have disadvantages compared with bear put spreads. First, if you write an in-the-money call (which your lower-strike call often is), an early exercise will derail your strategy. Second, calls tend to hold time value longer than puts. A bear call spread will not respond as quickly as a bear put spread to a favorable move in the stock, thus forcing you to wait longer before you can close the trade for your desired profit. Finally, bear call spreads still require buying power. The difference between your strikes minus the credit you receive will be locked out of your account. Still, for the hedge- or short-minded investor, bear call spreads have merits.

Bearish Calendar Spreads

Calendar spreads are also called “time spreads,” because you’re using different expiration dates on your two trades. Selling a near-term put (expiring in a few months) and buying a longer-term one (expiring at least a few months later), both with same strike price, sets up a bearish put calendar spread. The idea is the near-term put that you write will lose value more rapidly than the longer-term put that you buy and finance the purchase of your put, especially if you’re able to write near-term puts a few times while waiting for your longer-term puts to pay off. But this strategy comes with a caveat.

You’re generally hoping that the stock or index holds up long enough for your written puts to expire and then declines, making your purchased puts profitable. In other words, you’re bearish, but you want some time before prices decline — so perhaps you see a catalyst for decline on the distant horizon. That said, if the underlying investment falls rapidly, your long-term puts will have more value than the ones you wrote, and you could close both for a net profit.

Bearish calendar spreads using puts can be set up for very little cost. Your expectation should be that most times, you’ll lose your entire investment, but when it does work out, it will more than compensate for every loss. If your net cost for a put is $0.50, when the stock falls sharply, your profits will soar.

Building upon what you’ve learned, a calendar spread that uses the same strike prices and different expiration dates is called a horizontal spread. One that uses different strike prices and different expiration dates is called a diagonal spread. For example, you might write near-term puts at a higher strike for a larger payment and buy long-term puts at a lower strike to set up a diagonal bear put calendar spread. (Yes, it’s a mouthful!)

Follow-Up on Your Trades

You usually want to close the vulnerable leg of your spread soon before expiration to avoid it being exercised. Furthermore, if the underlying stock makes a dramatic move that makes one side of your trade especially profitable (generally, the written side), you can consider closing it early and writing new options at a more advantageous price for another payment. A dramatic move that earns you much of your spread’s potential profit long before expiration may merit closing the trade out entirely, although in many cases you’ll need to wait until right before expiration to achieve your maximum profit. A dramatic move against you may severely limit your potential responses, other than to salvage what value still remains.

There are many other follow-up possibilities with spreads — including turning them into entirely different option strategies.

Bearish Spread Tips

• In general, the best bearish spreads are initiated when the underlying stock is closer to the lower strike price rather than the higher one.
• As you consider spreads, remember the general rule of options investing: Sell time value, and buy intrinsic value (this suggests, for instance, that a bear call spread that pays a large credit is not the best use of the strategy when the credit involves selling intrinsic value).
• If you’re strongly bearish, but still risk averse, bear put spreads are best.
• If you’re moderately bearish, or just don’t believe a stock will increase above your lower strike, then out-of-the money bear call spreads may suit you.
• If you’re looking for a home run on an eventual sharp drop, a bearish calendar spread may be your ticket.

Why use bull call spreads?

• Capital gains: To profit on a stock you feel relatively bullish on.
• Defense: To limit your capital at risk and lower your break-even point compared with just buying calls alone.
• Leverage: To land an oversized potential return on your net cost, although you sacrifice additional upside.

Foolish facts to know:

• Bull call spreads consist of two legs: You write (“sell to open”) a call at a higher strike price and simultaneously buy (“buy to open”) a call at a lower strike price. So you’re writing a call and using the proceeds to purchase a call on the same stock, setting up a bullish position with reduced costs.
• Your maximum profit is the difference between the two strike prices, less the net cost to set up the spread.
• Your maximum loss is simply the cost to set up the position in the first place.
• Each call option contract, bought or written, represents 100 shares of the underlying stock. Always match the number of contracts written to the number of contracts bought.

You’ll typically need Level 3 or Level 4 options trading permission to trade spreads.

Welcome to our first lesson on spreads. Today’s topic: The bull call spread. If you’re modestly bullish (or even somewhat neutral) on a company, this options strategy can deliver you potentially outsized (albeit capped) returns with just a small move in the underlying stock. Your potential loss is 100% of the cash you put into the strategy, but that cost is offset by what you’re paid for the calls you write.

Bull call spreads strike a good balance between the advantage of a capped potential loss and the disadvantage of capping your potential gain. The drawback to a capped upside happens when the underlying stock rockets. You’ll have to be content with your profit, though one benefit is that you can possibly cash out months early (making your annualized profit pretty awesome). Now let’s look at how the bull call spread works.
What Is a Bull Call Spread?

A bull call spread works like so: On the same underlying stock, you buy (“buy to open”) a call option and simultaneously write (“sell to open”) a call option with a higher strike price, using the same expiration date. The purchased call leverages your gains on the underlying stock. Meanwhile, the written call pays for much of the cost of the purchased call and increases your leveraged returns. However — no free lunches — the bull call spread does this at the cost of your potential upside, which is capped. So, over the time frame of your options, it’s possible for the gains in the underlying stock to surpass the returns on the spread.

A bull call spread is a type of vertical spread, which is simply any options strategy in which you simultaneously buy and write options of the same type (either calls or puts) with the same expiration date, but with a “spread” between the strike prices (hence the name — clever). We’ll be covering more of these as we go along, but for now, back to the bull call spread — and how to set it up.

Setting Up the Trade

As a general rule, you want to make sure that the number of higher-strike price calls you write always matches the number of lower-strike price calls you buy. This ensures that your downside risk (represented by the written calls) is completely covered by the upside potential of the calls you buy. And because this is a bullish trade — that is, you are expecting the stock price to go up, taking the value of both options with it — you want to buy as much time as you can to let your bullish thesis play out.

For example, suppose you have a stock trading at $28. The furthest-out available options expire in just under a year and a half, and calls have the following prices quoted:

Setting up a nice, middle-of-the-road bull call spread, let’s say you buy (“buy to open”) the $25 strike calls, and then write (“sell to open”) an equal number of $30 strike-price calls. The net cost of the position (before commissions) is $2.50 per share. You now have about 17 months to watch the movement of the underlying stock — but absent closing the strategy early, you have capped both the potential losses and potential gains. Your profits are maximized if the stock price is above the higher strike price at expiration, while you risk a 100% loss of capital if the stock finishes below the lower strike price.

Both your profits and losses are capped. No matter how low the stock price goes, you can’t lose more than your original $2.50 per share invested. No matter how high the stock price goes, you can’t make more than $2.50 per share. But that’s not bad, Fools: If you bought 10 calls and wrote 10 calls, and the stock ended up above the higher strike price at expiration, you’d have an extra $2,500 jingling in your pockets after 17 months — less time than passes between successive Summer and Winter Olympics.

When to Use Bull Call Spreads

When using a bull call spread, your outlook on the underlying stock is bullish — you need a rising stock price (or at least a flat one, depending on how aggressive you make the spread) to achieve your maximum profit.

You don’t necessarily need to be wildly, wantonly bullish — a little dab’ll do ya. That’s because spreads can be constructed with varying degrees of aggressiveness. Conservative types can buy and sell both of the calls in-the-money (here, strike price = share price), limiting return but also limiting risk. Aggressive folks can buy and write both calls out-of-the-money (here, strike price is higher than share price) and put up some spectacular potential returns on paper. Using the stock and calls listed above, we can construct bull call spread positions tailored to your investing style:

Remember, our stock currently trades at $28. So if you follow the conservative strategy, you can actually stand to watch the stock fall by $3 over the life of the spread, still make a tidy profit, and still at least recover your capital even if the stock falls by 16% (to $23.50) between now and expiration.

But fair warning: It may be fun to model bull call spreads with potential returns running hundreds of percentage points in less than two years, but if the underlying stock has to rise 50% for you to make you big money, your odds of success are lower. In a baseball parlance, it’s far better to be a .320 hitter with an outstanding on-base percentage than a .250-hitting “big bat” who smacks tape-measure home runs — but also strikes out half the time. The latter is a crowd favorite; the former is a potential hall-of-famer.

Closing Early

If the stock goes up, and we’ve made most of our potential profit on this strategy, we’ll close early. Generally, if the spread, or at least the call we purchased, is in-the-money (here, strike price is lower than stock price) near expiration, it’s best to close it ahead of the final bell and avoid the added cost (commissions) of it being exercised. If there’s only 10% of the remaining profit to be realized, and a year until expiration, we’re happy to cash out early and pass out tea and medals.

In less happy times, the underlying stock won’t cooperate with our bullish prognostications. In such cases, we’ll watch the stock closely, and if we believe the thesis has changed, we’ll close the spread before expiration, lick our wounds, and move onto the next idea.

Bottom Line on Bull Call Spreads

We’ll use bull call spreads on stocks we believe will increase in price at least moderately. The strategy has a nice mix of capped risk, lower up-front investment, and healthy prospective returns on investment, such that we’re perfectly happy to cede additional potential upside in the stock.

Why use spreads:

• To profit on the movement in a stock while capping your potential loss at a pre-determined amount — though you cap your potential profit as well.
• To purchase options with less cash up-front, which in turn helps leverage your potential returns.
• To earn sizable percentage gains even on modest moves in the underlying stock.

A spread is an option position in which you both buy (“buy to open”) and write (“sell to open”) options of the same type, usually with the same expiration date, on the same stock. The payment from the options you write helps offset the cost of the options you buy, limiting your initial cost. At the same time, the options — being opposites, because they’re both bought and written — counterbalance one another, capping your risk.

For example, you might write a call at one strike price and use the proceeds to buy a call at a lower strike price (with the same expiration date, on the same stock). This is called a “bull call” spread; your maximum potential profit is the difference between the strike prices, minus the net cost to initiate the trades. Because one option covers the risk in the other, your maximum loss is the amount you pay to set up the trade.

Why the name “spreads”? It refers to the difference between the two options’ strike prices, which largely determines your potential profit. But spreads don’t always use different strike prices, so the name may sometimes refer to the difference between the two options’ prices.

The Common Spreads

No matter what kind of spread we’re setting up, usually we’ll aim for at least a 50% return — ideally, 100% or more — to make the risk, which is a full loss of the investment, worthwhile. Here are some of the spreads you’ll encounter most often:

Bull call spread: A bullish strategy in which you write a call with a higher strike price (usually above the underlying stock’s current price) and buy a call with a lower strike price. You earn the full potential profit if the stock increases above the higher strike by expiration; you lose the full investment if the stock falls below the lower strike by expiration.

Bull put spread: A bullish strategy, even though it uses puts; you purchase lower-strike puts and write higher-strike puts, for a net credit. If the stock ends above the higher strike at expiration, you earn the maximum profit.

Bear put spread: A bearish strategy in which you write a put with a lower strike price (usually below the stock’s current price) to buy a put with a higher strike price. You earn the full profit if the stock declines below the lower strike by expiration; you lose your full investment if the stock increases above the higher strike by expiration.

Bear call spread: A bearish strategy that uses calls; you purchase higher-strike calls and write lower-strike calls, earning the full profit if the stock ends below the lower strike at expiration. Bear put spreads are generally superior to bear call spreads if you’re exceptionally bearish, but bear call spreads are attractive because they start with a credit and can use less buying power.

Butterfly spread: This neutral strategy combines a bull spread with a bear spread (there are four possible ways to set it up); you profit most if the underlying stock does not rise or fall much by expiration. Like all spreads, it has limited risk and limited profit potential.

Calendar spread: A generally neutral strategy in which you write a nearer-term option and purchase the same option (in this case, at the same strike price) but with a much later expiration date. Time erosion should cause the value of the nearer-term option (which you wrote) to decay more quickly than the longer-term option that you bought; if it works as intended, you’ll show an overall profit as the near-term option reaches expiration.

Ratio spreads: Also a generally neutral strategy, here you buy a certain number of calls (called a ratio call spread) or puts (called a ratio put spread) and then write a larger number of calls or puts (say, two for every one you’ve bought) that are out-of-the money. Your profit is maximized if the stock ends exactly at the strike price of the written options. Ratio spreads have increased risk because not all of your written options are “covered” by purchased options.

We’ll get into these and other spreads in greater detail in future Pro guides; for this introduction, we just want you to become familiar with the many terms and basics behind spread strategies. And — if you need to — you can take this opportunity to apply for approval to use spreads at your broker (it’s usually Level 4).

Learn the Language of Spreads

When setting up a spread trade, the combined premiums are labeled like so:

• Debit spread, or net debit: Here, you pay more in premiums to set up the spread than you collect.
• Credit spread, or net credit: Much less common than a net debit, in this case, the spread’s total option premiums collected pay you more than you need to pay out. In other words, the options you write pay you more than you need to shell out to buy the other options to complete your spread.
• Spread order: This kind of special order allows you to make two or more options trades (usually for a lower commission) with your broker at the same time — thus setting up your spread. Usually, the trade is entered as a limit order at the maximum net debit you’re willing to pay or the minimum net credit you want to receive. This is similar to using a limit price when trading a stock.

Moreover, spreads can be described more precisely depending on where the strike prices and expiration dates fall:

• Vertical spreads: The most common spreads fit this description, including basic bull and bear spreads. In a vertical spread, the options have different strike prices but the same expiration date. It’s called “vertical” because the strike prices are above and below one another in an option-quote chain.
• Horizontal spreads: In this case, the options have the same strike price (so they’re horizontal to one another in a quote chain) but different expiration dates.
• Diagonal spreads: Here, the options you buy have a later expiration date than the options you write, along with a different strike price. You can set up diagonal bull spreads, diagonal bear spreads, and diagonal butterfly spreads, to name a few. We’ll address why and how in later guides.

Now let’s illustrate what we’ve covered so far with a real-life (OK, a very fake) example.

A Vertical Bear Put Spread in Action

As the result of a questionable federal government-backed merger, a new company comes into existence called Fannie Madoff (Nasdaq: FMAD). Most investors are optimistic, pointing out that anything the Fed does, it does well, so they’re sure the firm will be a resounding success.

You, on the other hand, are fairly certain this house of cards will topple. The company has questionable management and is crippled with debt — yet investors continue to bid the stock higher. Since you don’t want to risk your net worth going short, you set up a bear put spread, limiting your potential losses.

With the stock trading at $34, to set up a bear put spread, you could write $32.50 puts for a $1.50 payment and use the proceeds to buy $35 puts for $2.50. Your net debit is $1 per share. That’s the most you can lose. How much can you make if Fannie Madoff faces the music? Since the difference between your strike prices is $2.50, and the trade cost you $1, the most you can make is the difference between the two, or $1.50 per share. That’s great, given that you only paid $1 to set up the trade. It’s a potential 150% return on your investment.

What are the possible outcomes? If the stock falls anywhere below $32.50 by expiration, you capture the maximum gain. For example, let’s say it falls to $30. The $35 puts you bought will be worth $5 per share, while the $32.50 puts you wrote will be worth ($2.50). You hold a net $2.50 profit following your $1 net investment, so you’ve cleared $1.50 per share while only risking $1.

On the flipside, if the Fed gives our fake Fannie another boost, and the stock is above $35 at expiration, your whole investment is lost — but at least you only paid a net $1 per share. Other possible outcomes: If the stock trades at various price points between the two strikes, you’ll have either a partial profit or partial loss when you exit the trade at expiration. (When to close a spread early is a topic for another day.) This is the essence of how a spread works: You limit your risk while potentially earning a large — though capped — percentage return on a lower out-of-pocket cost.

Spreads Ahead

To sum up, spreads involve both buying and writing the same type of option on the same stock, usually with different strike prices, while aiming to profit on the difference in strike price, after your net cost, between the two. Your maximum profit is capped to these price differences, and your maximum loss is the net debit that it takes to set up the trade.

Why write a straddle?

• You believe a stock or index is going to hold steady or stay in a tight range.
• You believe a stock that was recently volatile will settle down considerably.
• You believe the market’s overall volatility is going to decrease.

Setting Up the Trade

A straddle uses an identical number of calls and puts with the same strike price and expiration date on the same underlying stock or index. As you know from our Buying Straddles lesson in Options U., you buy identical calls and puts on a stock to profit in either direction from volatility, but you need a sharp and lasting move in either direction in order to profit overall. Inversely, writing the calls and puts is a way to profit from low or declining volatility. How? Simply by collecting option premium payments on either side of a potentially sleepy position. There are risks, of course, but let’s start with the basics:

• Write (“sell to open”) an equal number of puts and calls on the same stock or index.
• Use the same strike price and the same month of expiration on both options.
• The strike price with a straddle is “at-the-money” — as close to the current underlying stock or index price as possible.
• When you write an uncovered straddle, you don’t own the underlying stock, so your risk is high (more on this in a minute).
• When you write a covered straddle, you own the stock, lowering your risk on one side of the option trade. Here the straddle works like a covered call strategy — but your returns are potentially goosed with additional put-writing income, and you need to be ready to buy more shares of the stock if it falls, just like when you write any puts.

The most you can earn from the options when writing straddles is what the options pay you initially.

Uncovered Straddle Writing

When writing an uncovered straddle, you usually don’t intend to get the underlying stock involved. You’re just looking to profit on the value erosion of the options you write, and you’ll plan to “buy to close” them (or let them expire) once you’ve earned your targeted profit. (Note: You need a margin account to write an uncovered straddle.)

As an example, suppose a recently volatile stock just announced earnings, and you expect its volatility will now all but cease. The options still pay well, though, so you’d like to capture the option premium as income. The stock is trading at $25, so you write $25 calls and $25 puts and get paid $2 for each contract — that’s $4 total in option premiums per straddle you set up. This means as long as the stock ends the expiration period between $21 and $29 ($4 above or below $25), you’ll at least break even before commissions — and if the stock is between these prices, you earn a profit on the trade. (We’ll call this the “profit range.”)

• For example, if the stock ends the period at $27, the puts you wrote expire (giving you the full $2 value), and the calls break even, so the trade pays you $2 per share overall.
• If the stock ends lower in our profit range — let’s say $23 — the calls expire and the puts break even, so your profit is $2 per share overall here, too.

However, outside your profit range, it’s another story. With uncovered straddles, you face unlimited potential losses as the stock rises above $29 per share, and you facing growing losses (along with an obligation to buy the stock and wait for a recovery) the further it falls below $21.

As the table below shows, the maximum profit from an uncovered straddle occurs when the stock ends exactly at the strike price; you essentially keep the entire $4 per share you were paid in this example. Your total profit declines as the stock moves away from the strike price in either direction — which is why you want minimal volatility whenever you write straddles.

Take a minute to study the table to grasp how this works. As the stock rises, the naked (or uncovered) calls you wrote increase in value, working against you. As the stock declines, the puts you wrote work against you, but you’ll still profit anywhere between $22 and $28, and break even at $21 or $29. Remember, you were paid $2 for each call and put, or $4 total. But since you wrote the options, your desired outcome is that their value goes to $0, or as low as possible:

To help achieve a successful uncovered straddle, you want the widest possible profit range (in other words, you want to capture generous option premiums). In our example, the range is significant — $4 in either direction — assuming the underlying stock isn’t exceptionally volatile and your options expire in two to five months (rather than longer). But remember, the trade creates unlimited potential losses outside the profit range.

One way to greatly mitigate that risk: When you write your straddle, use some of your option proceeds to simultaneously buy far out-of-the-money calls and/or puts, too — with strike prices at the two ends of your profit range (for this example, you might buy $30 calls and $20 puts; or just buy calls to protect you on that side and be ready to buy the stock via your written puts if it falls). Doing so, you’ve hedged and “covered” your written straddle, and because buying these options generally costs little, you’ll still begin with a net credit from your option writing and keep that profit if the stock stays in a now slightly tighter range. For example, if you paid $0.80 total for the protective calls and puts, your profit range decreases by that amount on either side of the strike price. If you don’t buy protective options initially, be ready to do so if the trade starts to work strongly against you.

Given that a steady stock can suddenly make a big move for any number of reasons, it’s risky to write uncovered straddles without this added protection. However, another route is to simply own the underlying stock outright. Let’s take a look.

Covered Straddle Writing

Owning the underlying stock takes away all of the naked call option risk when writing a straddle. In fact, a covered straddle-writing strategy is basically a covered call strategy combined with put writing. The key difference with a straddle (as opposed to your typical call or put writing) is that both options start at-the-money, so you’re more likely to see your options exercised if you don’t close them. As with a covered call, it’s important that you’re ready to sell your stock if it rises. And as with writing puts, you need to be ready to buy more stock if it declines (or close the options early). The benefits of writing a covered straddle are two-fold:

1. Your profit can be higher and your profit range wider than with a mere covered call.
2. You have more ways to close your options profitably — and still keep your stock if you like.

Continuing our earlier example, let’s assume you want to write a straddle on a steady $25 stock — but in this case, you own the underlying shares. You write $25 calls and puts, getting paid $2 each, with the same expiration date. Since you own the stock, no matter how high it climbs, you’re covered on that side of your trade. Let’s consider some potential outcomes:

• You end up selling your stock via the covered calls, but you keep the $4 option premium you were paid on the puts and calls, netting a sell price of $29 (compared with just $27 if you’d only done a covered call and not a straddle).
• The stock declines below $25. You end up buying more shares, but at a net $21 given the total option premiums you were paid. You’ve added to your existing stock holding at a lower price.
• The stocks holds steady, around $24 to $26. You can “buy to close” both the calls and puts by expiration and capture much of the profit while keeping your existing shares. Nice!

Finally, as an example of the added flexibility here: Assume the stock increases to $28 by expiration, and you decide you want to keep your shares. Since you were paid $4 per share in option income, you could close your calls for $3, let your puts expire, still have a $1 per share profit on your straddle, and keep your stock. If you had only written covered calls and not a straddle, you’d need to book a loss on your calls if you wanted to keep your stock.

Taking Follow-Up Action

Writing uncovered straddles requires keeping a close tab on your trade. If the stock is moving sharply against you in either direction, you may want take action to limit your losses. One way to do so is to close the losing side of your straddle when the stock reaches your break-even price. In our example, if the stock rises to $29, you might close your call options for a loss and let your puts go, presumably to expiration, keeping your overall losses marginal. If the stock falls, just be ready to buy it via your puts. Uncovered straddles don’t usually lend themselves to rolling forward (to a later expiration date), rolling up (to higher strike prices), or rolling down (to lower strike prices), so you can’t depend on these defensive follow-up moves being readily available to you. As mentioned above, if you defensively buy out-of-the money protective calls (and puts, if you like) when you set up your straddle, your potential profit on the straddle is lower, but you won’t need to actively consider follow-up action.

Writing covered straddles is much less risky and requires less upkeep, but you still want to keep a watchful eye on your strategy, since only your calls are truly covered. You need to be ready to accept more shares if the stock falls below your puts’ strike price. For this reason, some investors will use a lower strike price on the puts they write, providing more leeway — but once you start to stagger strike prices on your calls and puts, you’re not using a straddle anymore, you’re using a strangle — and that’s next in our series!

Bottom Line on Writing Straddles

In Motley Fool Options, we’re not likely to write uncovered straddles without using some protective options as well. Writing covered straddles, however, is a sensible way to increase option profits on a covered call strategy with a tame stock as long as you’re also willing to buy more shares if need be. With this strategy, you have another tool to profit no matter what the market throws your way — in this case, even if the market goes nowhere.

Why buy a straddle?

• You believe a stock or index will move dramatically, but you don’t know which way.
• You believe volatility will increase in general, so the value of the options you’re buying will increase.
• You want to leverage potential returns when the underlying investment moves meaningfully in either direction, but limit your risk.

Have you ever thought a stock was about to make a significant move — but you didn’t know which direction it would go? Maybe a big earnings announcement is looming, an acquisition is pending, or a stock has recently soared and could keep going — or turn at any moment. Most investors would sit on their hands, unsure what to do. But if you buy an option straddle, you can set yourself up to profit whether the stock goes up or down, while risking only the small cost of a few options. This makes buying a straddle attractive as a bullish or bearish strategy. In fact, buying a straddle can be superior to shorting a high-flying stock outright, since you’ll profit even if it keeps rising — but also profit if it finally flames out.

Whether bearish or bullish, this strategy positions you to make money as long as the underlying stock is especially volatile in one direction, moving at least (as a general guideline) 10% to 30% in the coming weeks or months. The strategy works because you gain a much larger profit on one side of your straddle than you lose on the other (more on that later). And, to answer your burning question, it’s called a “straddle” because your calls and puts sit symmetrically on either side of the same strike price — while expiring in the same month, on the same stock.

Pros and Cons

Before we walk you through an example, let’s go over what can go right or wrong. On the plus side, when you buy a straddle, your profit potential is unlimited: The more the underlying stock moves in one direction, the more you can profit on that side of your trade. However, as with any option you buy (as opposed to writing options), you can lose your whole investment. In this case, if the stock stays tightly range-bound, the options would eventually expire with little or no value.

The clock also plays a large role, as the biggest drag on a straddle purchase is the time-value erosion of the options. Buying a call and a put, you’ve paid two option premiums, and with each passing week their time value erodes unless the stock’s volatility increases. If the underlying stock doesn’t make a significant move in either direction, your options will steadily lose value. Plus, the underlying stock needs to move enough so that one side of your straddle (either the calls or puts) gains enough value to offset the losses on the other side.

A Straddle in Action

Now let’s “straddle up” and see how the strategy works. Here are the basics:

• You buy (“buy to open”) an equal number of calls and puts on the underlying stock or index (usually you’ll do this as a stand-alone strategy, so you won’t own the underlying stock).
• The strike prices of the calls and puts should typically be the closest available to the current price of the underlying stock or index (“at the money”).
• The expiration month on the calls and puts should be the same, and usually you’ll choose an expiration up to four months ahead if you expect volatility soon, or six months or longer if you want more time. Having more time for the strategy to work can be an advantage, but will cost more up front.

Let’s run an example. Suppose you believe a stock will move aggressively, in one direction or another, depending on the company’s outlook in its next quarterly report. The shares trade at $17.50, so you could set up a straddle that expires in four months, buying the appropriate $17.50 puts for $1.50 each and $17.50 calls, also for $1.50 each. Your combined cost is $3.00 ($300).

Say management sees business improving, and the stock runs to $22.50 the next month. Your calls are now worth at least $5 each (or $500), up from $1.50, while the puts are worth very little — you’re losing money on them. Overall, though, your $300 investment is worth more than $500, a gain of more than 66%. On the flipside, if management’s quarterly guidance is weak and the stock falls to $12.50, your puts are worth at least $5 each and your calls have little value. Your profit in this case, as with the opposite side of the spectrum, is around 66%.

What if your thesis is wrong, and the stock stays within a few dollars of $17.50 for a few months? You’re losing money on both the calls and puts in this case, and you might want to close them (“sell to close”) early to get some capital back — unless you believe volatility will increase significantly and soon. Since you paid $3 combined for the options, the stock needs to move at least $3, in either direction, by expiration for you to at least break-even on the strategy.

Taking Follow-Up Action

Straddles can benefit from more active management once the position is in place. There are two ways to potentially boost your profits while being defensive:

• If the price of the underlying stock increases to the next higher strike price (compared to the strike price you used to set up the trade), you may want to — depending on the number of contracts in play and your commission costs — close your existing puts and buy puts at that next-higher strike price to increase your profit potential. This is called “rolling up” the puts.
• Inversely, if the underlying stock declines to the next lower strike price, you could consider selling your calls and buying new calls at that next-lower strike price. This is called “rolling down” the calls.

While increasing the total cost of your strategy, these follow-up moves increase your chance for higher profits on any subsequent stock move. Roll up and roll down sparingly, though — reacting to every zig and zag in the stock can be a big detriment when you consider the commissions, option premium costs, and the fact the stock could easily swing the other way again.

Closing a Straddle

If your original thesis holds true and a stock makes a big move, you’ll make more money on one side of your straddle trade than you’ll lose on the other. If you believe volatility is then subsiding, consider closing (“sell to close”) both of your positions to lock in your profit. If you wait until expiration, you may slowly lose extra value in your options, or the stock may reverse on you again.

If your strategy isn’t working in time, you may want to close one or both positions early to recoup some capital and rethink your strategy. Your calls and puts serve to hedge each other in the early going. However, both options will steadily lose value if the stock isn’t making a large enough move one way or another.

Finally, although it’s unorthodox, if you earn a quick profit on one side of your straddle, you may want to lock in that profit and let the losing side stay active. You won’t have much value left on that side anyway, and if the stock reverses, you may regain some of the losing option’s value without risking the profits you’ve already secured on the closed side.

Bottom Line on Buying Straddles

If you believe a stock is going to move significantly — but you don’t know which way — buying a straddle is a way to profit in either direction. The enemy of the straddle-buying Fool is a stable or merry-go-round stock price, as the value of your purchased options will steadily erode unless the stock makes a lasting, meaningful move in one direction or another. But if you expect a big move either up or down, consider buying a straddle.

Why use strangles?

• You buy (“buy to open”) a strangle to profit on a sharp move in a stock, whether up or down.
• You write (“sell to open”) a covered strangle to profit when a stock stays within a wide range — or, if it doesn’t, to get a better buy price on new shares or a higher sell price on existing shares.

A strangle is similar to a straddle (see Options U. lessons on buying straddles and writing straddles for a refresher): You’re using call and put options on the same underlying stock, typically with the same expiration date. As with a straddle, you buy a strangle to profit on high volatility. Inversely, you write a strangle to profit when a stock stays within a predetermined price range or is relatively stable. The bonus: Writing a strangle offers more flexibility than writing a straddle because you “split the strikes” — set it up with a different strike price on your calls than on your puts — and you use strike prices that are “out-of-the-money,” or well above or below the stock’s current price, giving you more room to profit. Writing a covered strangle is actually no different than owning a stock and writing covered calls on it to sell higher, and simultaneously writing puts to potentially buy more shares lower. You’re combining these two common strategies, generating higher options premiums on a trade.

Let’s take a look.

Setting Up the Trade

Here’s how to initiate a strangle (no necks necessary):

• To buy a strangle, buy to open an equal number of calls and puts on a stock, typically each out-of-the money by one or two strike prices, with the same expiration date.
• To write a covered strangle, sell to open puts and calls, also out-of-the money and usually with the same expiration date. However, the number of puts you write is dependent on how many additional 100 share blocks you’d like to potentially buy, and the number of calls you write will depend on how many 100 share blocks you already own and would be willing to sell at a higher price. Ideally, you own a 50% allocation and would happily buy 50% more.
• To place a strangle trade, most brokers have a special option order-entry page for strangles.

Usually, you write (or if it’s a buying strategy, buy) both sides of your strangle at the same time, but sometimes you can increase your option payments by “legging into” the strategy — setting up one side of your trade at a different time than the other. For example, you might write calls on your targeted stock when it’s near the high end of your expected range and then write puts when it’s nearer the low end. However, since nobody can predict future prices and you don’t want to miss one side of your trade, usually you set up both legs of your strangle simultaneously, typically doing so when the stock is somewhere between the strike prices on your calls and puts.

Buying a Strangle

Buying a strangle (also called a long strangle) is a way to profit if a stock makes a dramatic move in either direction. Since you’re buying out-of-the money options that have relatively small value attached, your cost can be marginal. Your potential gains are unlimited, but it’s easy to lose most or all of your investment.

As an example, let’s assume a volatile stock is trading at $12.50. You believe it will be exceptionally volatile in either direction, perhaps on some key news event. You can purchase a $10 put expiring in nine months for $1.00, and purchase a $15 call expiring the same time, also for $1. If you buy one contract of each, you’ve invested just $200 plus commissions to enter the strategy, showing a frequent advantage of a long strangle: low costs to initiate.

However, because your options are far out-of-the money (or far from the strike prices), the stock must make a dramatic move in either direction for you to ultimately make money, either falling below $8 or rising above $17. Because you paid $2 for your options, your $10 puts don’t end profitably unless the stock falls below $8, and vice versa on the call side. If the stock doesn’t move much, your options will steadily lose value and expire worthless if you don’t sell early.

Buying a strangle works best if a stock makes a meaningful move quickly. This way, your calls or puts will see a significant percentage gain long before expiration, offsetting the loss on the other side of your strangle, and you can book an early profit by selling both (or sell the profitable side and hold the losing side if you believe the stock will snap back). But it’s not easy. Using out-of-the-money options makes buying a strangle cheaper than buying a straddle (which uses more expensive at-the-money options), but it also means you’re more likely to lose your full investment unless you get extreme volatility soon.

It follows, then, that writing a strangle puts the odds in your favor.

Writing a Covered Strangle

Writing a covered strangle (also called a short covered strangle) is a way to profit on a stock that you own and would be willing to either buy more of lower or sell your existing shares higher. Writing strangles can be superior to writing straddles because splitting the strike prices provides more flexibility and room for profit. The options won’t pay as much as a straddle, but the stock has more room to roam.

For example, say you own shares of Motley Fool Options recommendation Western Union (NYSE: WU), and you’re willing to buy more if the stock declines meaningfully; or, you’re willing to sell your existing shares higher. With the stock recently around $16, you could write the $15 puts expiring in five months for $0.65, and write $17.50 covered calls expiring at the same time for $$0.60, collecting $1.25 in total options premiums (or nearly 8% of the current share price).

Consider the possible outcomes:

• Western Union ends the expiration period anywhere between $15 and $17.50: You keep the $1.25 per share the options paid you, and keep your shares, too, and can consider writing a strangle again.
• Western Union increases above $17.50 by expiration: You’re on the hook to sell your existing shares for a net $18.75, including the $1.25 the options paid you.
• Western Union falls below $15: You’re obligated to buy new shares at a net $13.75, again including the $1.25 the options paid you. You’ve now doubled your position in Western Union, lowering your cost basis along the way.

Of course, in most cases you could also “buy to close” your options early or right before expiration, and still have a profit on the combined options trades assuming the stock hasn’t moved too dramatically — in this case, as long as it’s between $13.75 to $18.75.

As you can see, a covered strangle can give you an exceptionally wide profit range while paying healthy income. Whenever you write puts, you need to be confident in the stock that you’re exposing yourself to and ready to buy it (again, it’s best to write strangles when you own half an allocation in a stock and would happily double it). And whenever you write covered calls, you must be ready to sell your existing shares if they increase in price. However, given how much the two combined options pay you with a strangle, you have more flexibility — or possibility — to close your options early if you wish, keep your shares, and still have a profit.

The Pluses of Writing Strangles

The combined payment you receive from the options you write, added to the strike price on both sides of your trade, tells you the potential sell price on your existing shares, or buy price for more shares — and creates your range in which to profit on the options alone. A $10 stock with a strangle that pays $1 on each side gives you a range of $8 to $12 in which to profit. Typically, a written strangle range will be 10% to 20% on either side. To write an attractive strangle, generally follow our numerical guidelines provided for writing puts and writing covered calls, since that’s all you’re really doing on the same stock. Even owning a 50% stake, the advantage of writing a strangle includes the potential to capture meaningful upside up to a point — almost as much upside (about 75% or so on average) as if you owned a full stake in the stock, thanks to the options payments — while subjecting yourself to the risk of a full position only at a reasonably lower average price.

Follow-Up on Writing Strangles

The closer to either edge of your option profit range (with our Western Union example, $13.75 and $18.75 are the two edges) that the stock trades by expiration, the more likely you are to let one side of your trade be exercised, either buying more shares or selling your existing shares, since your intention was to get the stock involved on the far edges of your trade. Meanwhile, one side of your strangle will always expire for the full cash gain. If the stock is between your strike prices, both sides will expire for a full gain. If the stock hasn’t wandered too far, but one of your written options is modestly in-the-money, you may want to close it before expiration (your trade is still profitable) if you’d rather set up a new strangle. If the shares fall sharply, you need to be ready to buy more and wait. If they soar, you’ll need to sell anyway and be content with the profit you booked. As with writing puts or covered calls, once you’ve made most of your money (85% or more), it may be worthwhile to close the option and write a new one, later one for a higher payment. Just be mindful of the obligations tied to both sides of your strangle.

Writing Uncovered Strangles

While not owning a stock, some daring investors write uncovered strangles when they strongly believe the stock won’t break above a certain price. You may not own a $10 stock, but want to collect $2 in strangle premiums. As long as the stock is between $8 and $12 by expiration, you could close your options, not get the stock involved, and book a partial profit. But with a naked strangle, if the stock soars, your potential losses are unlimited because your written calls aren’t covered by existing shares. We’re unlikely to partake in this risky strategy without also buying calls to protect ourselves — it’s not worth the unlimited risk to collect a limited premium.

The Foolish Bottom Line on Strangles

Buying a strangle is a way to profit if a stock makes a severe move in either direction — but if it doesn’t, you risk whatever you invested in the calls and puts. On the other hand, writing a covered strangle is a way to generate option profits on a position if you already own at least 100 shares, would be happy to add at least 100 more shares at a lower price, or sell your existing shares higher. More flexible than just writing covered calls, and providing more upside than just writing puts, covered strangle-writing provides a wide window for profits on a strong company that you believe will stay in a range or slowly trend higher.

Recap: Straddle vs. Strangle

• Straddle: Use an equal number of puts and calls, on the same stock, with the same expiration date and strike price (one “at-the-money”).
• Strangle: Use an equal number of puts and calls, on the same stock, usually with the same expiration date but with differing strike prices (both “out-of-the money”).

Why use diagonal calls?

1. If you’re mildly bullish on a stock and want to generate income from a leveraged investment.
2. To profit from a range-bound stock.
3. If your underlying stock is chosen well, and you’re handed a little market luck, you can wake up a year or two hence with a significantly in-the-money call option that effectively costs you nothing.

Foolish facts to know:

• A “diagonalized” position involves two options — one purchased, one written — that differ in both expiration date and strike price.
• Like a bull call spread, a diagonal call consists of two legs: a purchased lower-strike call and a written higher-strike call, but with the added twist that the purchased call expires as far in the future as possible, while the written call expires in the near term.
• The maximum loss is simply the cost to set up the position.
• You’ll need Level 3 or 4 option trading permission (and a margin account) to trade diagonal calls.

You’re already familiar with the concept of writing a call against an underlying stock to produce income, as with a covered call. And you’re familiar with the bull call spread, in which you simultaneously purchase and sell calls with a “spread” between the strike prices. Think of the diagonal call, also known as a diagonal call spread, as the lovely and talented offspring of the two strategies — one that allows you to earn a significant profit while harboring the added potential for serious capital gains down the road. And you don’t need to be more than mildly bullish on the underlying company.

To set it up, you buy (“buy to open”) long-term (almost always LEAPS) “in-the-money” call options (rather than purchasing the stock, as with a covered call) and write (“sell to open”) a nearer-term call with a higher strike price; then, provided your underlying stock and the long-term call option are chosen well, and the market cooperates, you seek to repeatedly write these shorter-term calls with higher strike prices throughout the life of your purchased calls. But be warned: Diagonal calls retain significant (leveraged) downside if the underlying stock craters, and because you own options rather than the stock (as with a covered call), your interim losses can be substantial. Still, applied judiciously, diagonal calls can make even the largest, lumbering blue chip look exciting. Let’s start with the basics.

What Is a Diagonal Call?

The general rules for diagonal calls are:

• The purchased call leverages the gains on the underlying stock, while the written call reduces your overall cost and increases the leveraged returns. However, no free lunches: It does this by reducing your gains above the written call strike as compared with a covered call.
• Always match the number of higher-strike calls written with the number of lower-strike calls purchased to mitigate the downside risk exposure of the written calls.
• This is not a “set-and-forget” trade; you need to actively manage the short-term written calls to maximize gains (or mitigate losses). You may be (and are hoping to) writing multiple short-term calls throughout the life of the long-term purchased call.
• Ideal candidates are stable blue-chip stocks that will let the options strategy do the heavy lifting for enhanced returns. I favor big companies (a market cap of at least $10 billion, preferably at least $25 billion) with low debt-to-capital ratios and a history of strong returns on equity, free cash flow, and earnings-per-share growth.

How It Works

To see a diagonal call in action, suppose you have a stock trading at $24.50 with the following options available:

*LEAPS

To set up your diagonal call, you would purchase (“buy to open”) the $20 LEAPS, and then write (“sell to open”) an equal number of the $26 calls. The net cost of the position is $7.20 per share.

What’s Next: The First Interim Period

When your written call reaches expiration in two months, it will retain only intrinsic value, while the purchased call will have significant remaining time value. The stock price at that time will dictate your follow-up action.

We can use hypothetical future stock prices to forecast the purchased call’s value at this time. Using a Black-Scholes option-pricing model, which we’ll cover in more detail later in Options U., the following prices/profits would exist at short call expiration.

When your initial written call expires, there are three possible outcomes:

1. If the stock price is the same as the written call’s strike, you earn the maximum profit for what we’re calling this interim period. This is because both the intrinsic value and the time value of the written option are zero. (However, in practice, we would roll the call forward if the stock price was hovering around the written call’s strike price.)
2. If the stock price finishes above the written call’s strike at expiration, we still profit, albeit at a lesser rate the further the stock climbs. In extreme cases, the stock price can run so far that the overall position turns into a loss. However, we’d most likely close the position before ever reaching that point.
3. If the stock price is below the written call’s strike at its expiration, we can enter a loss position fairly quickly. However, because we still own that long-term call, we can write subsequent higher-strike calls against it to mitigate our loss.

Graphically, we depict the profit potential of a diagonal call as:

Subsequent Steps: How Diagonal Calls Can Work Out Really Well

Arguably, the best outcome from a diagonal call sees the written call expire worthless, with the stock price just below the written call strike at expiration. You get (near) the maximum profit for the period, and can then write a new near-term option at a higher strike (allowing for more upside appreciation of your underlying purchased call); then, that call expires worthless near its strike, after which you write a third call, and so on.

Circling back to our example, imagine that in two months, the stock price is $25.75. Our original $26 written call expires worthless. Now, the two-month $27.50 strike calls would sell for about $0.80 — so we can write these, bringing our total cash from call writing to $1.75, and we repeat the waiting game. This second written leg increases our total potential return (to 59% if the stock price ends at the newly written call strike at expiration), decreases our lower break-even price, practically eliminates the potential for an overall loss if the stock runs away on us, and still leaves us two years to continue writing — ideally ever-higher striking — calls.

Thus, it’s possible that you could completely recover all of the cash you initially put into the position. If you’re doing this into a steadily rising market, on a solid, steady underlying stock, you can end up with an essentially free deep-in-the-money call option, which you can sell or exercise at your leisure.

What Can Go Wrong?

We’re looking to make some pretty hefty gains with a diagonal call, but remember, there are no free lunches! Those prospective gains come at the cost of levered downside losses (in other words, a diagonal call position suffers more as the stock declines than does simple stock ownership. Our profit suffers as the written call rises in value, versus the capped profit of a covered call, or the unfettered profit of simply owning the underlying stock.

This is why we recommend applying this strategy to big, stalwart blue chips. Such companies, if you’ve selected well, will not run away and hide on you.

You also need to pay extra attention to a diagonal call; if it looks like it’s going to be well in-the-money, it may perhaps be better to close early with a decent profit rather than hoping for the stock to come back.

Finally, things can become … pear-shaped. Imagine our stock fell to $12 at expiration of the first written call. That call will expire worthless, providing but mild comfort when you realize you’re left with a 26-month LEAP that’s now significantly out-of-the-money, and you’re unlikely to find prices on new calls to write that would allow you to profitably exit the position. You’re stuck — either you write a call for income that will practically lock in a loss (and hope the stock rises slowly enough that you see a series of such calls expire worthless), or you sit with your now out-of-the-money call and hope the stock goes back up such that call writing again becomes profitable. Either way, when the word “hope” makes it into your investment thesis, something has gone wrong.

Closing Early/Follow-up Action

We’ll rarely hold our purchased call all the way to expiration (if we do, it’s because we’ve had a nicely cooperative stock and are now significantly in-the-money). Most of the time, we’ll “sell to close” our purchased call, then use that money to buy back the written call in the event the stock price has moved significantly past the written call’s strike — ideally, this is delayed as long as possible, and we have a whole string of “expired worthless” written calls in our wake. We’ll also consider closing the position if something has changed for the worse with the underlying business.

Bottom Line on Diagonal Calls

It’s best to use diagonal calls on steady blue-chip companies, leveraging their slow and steady progress to gain outsized returns. We’ll target attractive returns-on-investment, while ideally managing our positions to nurture and grow a few “free” in-the-money calls along the way. The lower up-front investment and potential eye-popping returns make us willing to shoulder the leveraged loss potential on the downside, while ceding some of our upside gains.

Diagonal Call vs. Covered Call: Maximum Profit

Covered call: Your maximum profit occurs at any price above the written call’s strike.

Diagonal call: Your maximum profit occurs at the written call’s strike, after which it tapers off, back toward zero. In fact, it’s possible for the underlying stock to rise sufficiently during the lifespan of the written option so as to create an overall loss on the position.

Who should use the stock repair strategy? Someone who is:

• Down 15% to 25% on a stock and willing to forego profits to sell at breakeven.
• Not interested in averaging down or holding for the long haul.
• Using a margin-approved account and can write call options.

At some point, every investor gets stuck hanging onto a stock that has declined 20% or so and never seems to recover. This guide will teach you how to use options to exit laggard positions at breakeven. The “stock repair” option strategy not only recoups your initial investment, but frees up your cash for new, stronger buys.

But first, a reality check: Stock repair does not protect you from additional downside in the shares you already own — nor does it offer you a profit above your break-even price. The strategy can, however, lower your cost basis in your losing stock and allow you to exit the position at breakeven without introducing any additional risk.
Setting It Up

To set up a stock repair, for every 100 shares of a losing stock you (woefully) own:

1. Buy one call option at a strike price below the current share price.
2. Sell (write) two call options at a strike price above the current share price.
3. Use the same expiration date for the options you buy and sell.
4. Typically, use options that expire in 90 days or less.

These option trades result in minimal or no cash outlay for you because the call you buy is paid for by the two calls you sell. Plus, the strategy does not bring new risk to your stock — your options are neutral and covered: They largely cancel each other out, and the first call option you sell (or write) is covered by the 100 shares of stock you already own, while the second call you sell is covered by the new call you just bought. Got that? Let’s turn to an example to show how it works.

Repair That Dog!

Assume you purchased 100 shares of a stock at $40 per share, and it now trades at $30. You’re down 25%, lack hope for the stock’s recovery, and don’t want to hold your shares any longer. At the same time, you don’t believe there’s high risk left in the stock — otherwise, you’d simply sell. It seems your best move to get to breakeven is to initiate a stock repair strategy.

To start, you purchase a $30 call option for $2.50 that expires in 60 days. You then sell two $35 call options for $1.25 each. Your option trades have paid for themselves. Your positions look like this:

• Original stock, bought at $40, is now $30
• Buy one $30 call option costing $2.50
• Sell two $35 call options for $2.50 total income

Here are your possible outcomes:

As you can see, the stock repair strategy has three possible results: (1) no change at all if the stock doesn’t move or declines; (2) a lower cost basis if the stock ticks up; or (3) a break-even sale if the stock cooperates even halfway.

But what if you set up a stock repair trade only to change your mind and turn bullish on your stock again? The situation is salvageable. Let’s say your stock returns to $40 on good news, and you wish to keep owning it. In that case, you can close all of your option trades at or near breakeven (they’ll largely cancel each other out) and continue to hold the stock.

Choosing Your Strike Prices

In general, this strategy works best when you’re down about 20% on a stock. You buy your lower-priced call options at a strike price that is about 20% below your stock’s start price (or, at about the current share price), and you write your two other call options at the midway point between the current share price and your stock’s start price, splitting the two. So, in another example, if you bought 100 shares of a stock at $50 that is now $40, to repair it, you’d buy one $40 call and write two $45 calls.

Bottom Line

When you’re down a reasonable amount on a lagging stock and simply want out at breakeven, setting up a stock repair strategy may help you meet your goal more quickly. The strategy does not increase or decrease your risk in owning the stock, but (unless you close the options early) it does limit your upside to your break-even price. You must be happy to just breakeven and confident the stock won’t fall sharply while you wait.

Feeling bearish? If you’re looking to profit when stock prices slip, there’s a way to use options to mimic shorting a stock — but with distinct advantages. To set up this “synthetic short” position, you sell a call option and simultaneously buy a put option, using the same strike price and expiration date for each. Unlike a covered call strategy (detailed in Writing Covered Calls), in this case you do not own the underlying stock, so when you sell (or write) the call, it’s a “naked” call.

That means, just as when you short a stock outright, your potential losses are unlimited with synthetic shorts — so this is a risky strategy. But your potential profits are hefty, and the strategy provides advantages when compared to traditional shorting.

First, you don’t need to borrow shares of a stock to short it when using options — often, the stocks you want to short most are the most difficult to obtain for a traditional short sale. Second, the amount of money you need to risk up front is typically much smaller with a synthetic short, given the leverage provided by options. Third, unlike when you short a stock outright, you don’t need to cover any dividend payments yourself. Finally, both opening and closing a synthetic short can be done quickly, while the traditional shorting method sometimes involves a lot of waiting. To get a handle on how this strategy works, let’s run an example.

Sell a Naked Call, Buy a Put

Brave soul that you are, let’s say you want to bet against one of Warren Buffett’s recent investments. Volatile Goldman Sachs (NYSE: GS) has jumped to $100 per share, and you believe there’s profit to be had by shorting it over the next few months (remember, shorting usually involves a narrow time frame). Borrowing shares to short is difficult, and the stock pays nearly a 2% dividend — which you don’t want to cover yourself — so a synthetic short is your best route.

Although your shorting thesis only covers a few months, you want to use LEAP options so you have more time to be correct if need be. Choosing options that are as close to Goldman’s current share price as possible, you simultaneously sell the January 2011 $100 calls (which will pay you $32 each) and buy the January 2011 $100 puts (which will cost you $29). This results in a $3 per share credit to you. You’re now effectively short Goldman Sachs — and Buffett (how do you even sleep at night?).

In the ideal situation for you, Goldman declines 20% or more over the next few months and pushes both your calls and puts toward sizable profits. Your thesis has played out, and you should close your position — both options — profitably while you can.

The terrifying outcome (here’s that risk we mentioned) would be if Goldman soared. Your options would show large losses, and you would either need to take your lumps and close them or wait and hope for Goldman to fall. Because you have naked calls, by their expiration you’ll be required to buy Goldman stock at the going market price if it sits above $100 per share, and then deliver the shares at $100 per share for an instant loss — just as if you’d shorted the stock outright.

Another risk with an underwater call option is that it could be exercised early, forcing you to buy the stock and deliver it sooner than you wanted. It’s rare that an option is exercised early, but — especially when you don’t own the underlying shares — you need to be aware that it could happen. You also need to maintain enough buying power to cover your naked call obligations, and those broker requirements will be updated daily if the stock increases against your position.

Splitting the Strikes

If this example sounds too risky, you can add a little breathing room to your synthetic short by “splitting the strikes” (we covered this in our Synthetic Long Guide as well). To do this, you still sell your naked calls and buy your puts with the same expiration date, but you use different strike prices.

For example, rather than using the $100 strike price, assume you sell the January 2011 $115 calls on Goldman for $24 each and buy the $85 puts for $24 each. This gives you a sleep-aiding 15% window before your naked call’s strike price is hit. The lower strike on the put does make it more difficult to ultimately profit from the stock’s decline, but in the short term, the $85 put will move nearly as much as the $100 put when Goldman declines. So, it’s still attractive, and you’re still effectively short Goldman, but with less risk.

Just Buy the Puts

Remember, you can also invest against a stock by simply buying put options on it and foregoing selling naked calls to finance your put purchase, as we discussed in Options for Beginners. Sure, you need to come up with all the money to buy the puts yourself, and if you’re wrong on the trade, most or all of that money will be lost. But that’s the most you can lose with a put purchase, so your risk is known. You won’t have to worry about the potentially unlimited losses that a naked call entails.

Bottom Line

Despite the recent rout, the market’s long-term trend remains up, so a Foolish investor should only “go short” carefully and in special situations. Business is Darwinian by nature, companies come and go every year, and synthetic shorts provide a way to invest against the losers. We prefer to short companies with high debt, weak or no profits, few growth prospects, a low CAPS score, and inflated valuations. A synthetic short is also well-suited for shorting a market index to hedge your portfolio. Naturally, an index doesn’t present as much upside risk as an individual company. In closing, while synthetic shorts are as risky as selling short outright and shouldn’t be taken lightly, the advantages of the strategy over straight shorting earn it a rightful place in our tool box.

Synthetic Shorts Synopsis

• To replicate shorting a stock with options, you sell a naked call and buy a put option simultaneously.
• For a straight synthetic short, you sell a call and buy a put with the same strike price, the one that is as close to the current share price as possible.
• Use the same expiration date for both the call and put.
• Be careful — selling naked calls is risky! The higher the stock goes, the greater your potential loss.
• Use LEAPs so you have more time to be proven right.
• Once you have your desired profit, close the options — shorts usually involve a narrow time frame.
• To take on less risk, “split the strikes” and use a higher call strike price.
• Consider synthetic shorts on indexes (like SPY) as a portfolio hedge.
• For less risk shorting with options, simply buy puts and forego writing naked calls.