What Is a Bear Call Spread? How It Works

What Is a Bear Call Spread? How It Works

Like other aggressively-named options trading strategies, the bear call spread has more to do with numbers and market timing than it does with fur and fangs (or horns). But it’s yet another options trading strategy that can help you beef up your returns.

If you’re an options trader — or an aspiring one — you likely know many of the common strategies for trading options, including calls, puts, and bull put spreads.

But options strategies can get very complicated, very fast — and the bear call spread is no different. Here’s what to know about the bear call spread and how it works.

What is a Bear Call Spread?

A bear call spread is one of four basic vertical options spreads that traders put to regular use. It is the opposite of a bull call spread, and it’s particularly useful if you’re anticipating a bear market.

A trader utilizing a bear call spread strategy is trying to capitalize on a decrease in value of the option’s underlying asset. Hence, the “bear” in the strategy’s name. And as such, a trader would use a bear call spread only in the instance that they believed the underlying asset’s value was going to fall.

How Does a Bear Call Spread Work?

A trader creates a spread by buying and selling two call options at the same time, attached to the same underlying asset, with the same expiration date. The key difference is that the two call options have different strike prices. One call option one is a long call option strategy, and the other is short (similar to shorting a stock), with the short call having a lower strike price than the long call.

When the trader simultaneously purchases a long call and sells a short call (with a lower strike price), it creates a credit in the trader’s account, since the calls the trader is buying are less expensive than the calls the trader is selling. The short call generates income for the trader by creating a premium, and the long call helps limit the trader’s risk.

Setting up these two positions creates a spread, and the trader benefits when the underlying asset’s value declines. The maximum potential profit is capped at the value of the premium received.

If the underlying asset’s value increases, the spread can become a loser for the trader — but that maximum potential loss is capped at the difference between the strike prices of the two options, minus the premium.

Example of a Bear Call Spread Strategy

As an example, in its simplest form a bear call spread could involve a trader selling a short call option on stock XYZ, which expires in one month, with a strike price of $10, for a premium of $2. Simultaneously, they buy a call option with the same expiration and a strike price of $12 for a premium of $1. By selling the short calls, they’ve received a net premium of $1. Since an option contract typically controls 100 shares, their total credit is $100.

With that, a bear call spread has been set up. The trader has two calls with the same expiration date, but two different strike prices. The short call’s strike price is less than the long call’s strike price.

To continue this example, let’s say a month goes by, and the trader’s bearish instincts have proven correct. Stock XYZ’s price declines and their call options expire below the $10 strike price of the short call. They keep the net premium of $100, and walk away with a profit.

We should also consider the downside scenario where the stock price does not move in the trader’s favor. Suppose instead that XYZ climbs to $13 on expiration day. The trader closes out both contracts for a net loss of $2 per share, or $200 for each set of contracts. This is offset by the $100 they received upfront, so their net loss is just $100.

Finally, let’s analyze the breakeven point. This will occur at the strike price of the short call, plus the net premium received. In our example, the $10 lower strike, plus $1 of net premium, or $11.

Advantages & Disadvantages of a Bear Call Spread

Advantages

Disadvantages

Flexibility Capped potential gains
Capped potential losses Limited potential use
Relative simplicity The strategy could backfire completely

Advantages of a Bear Call Spread

There are some advantages to bear call spreads, which is why some traders use them to pad their returns.

•   Flexibility: There is a lot of wiggle room for traders in how they set up the strategy. Depending on the specific calls sold and purchased, traders can see a profit under a variety of scenarios, such as when the underlying asset’s value remains the same, or when it declines.

•   Capped potential losses: There’s a maximum that a trader can lose, and that can be comforting to some. These types of strategies are used not only to increase profits, but to limit risk, and limiting risk can be a very attractive attribute in a volatile market.

•   Relative simplicity: When you think about it, traders are really just making two transactions: Buying a call option, and selling another. Given that other options trading strategies involve even more moving parts, the fact that a bear call spread only requires two moves at the onset can be advantageous to some traders.

Disadvantages of a Bear Call Spread

Bear call spreads can have their disadvantages.

•   Capped potential gains. Like other vertical spread strategies, potential gains are capped — in this case, at the initial net premium credited to the account.

•   Limited potential use. The strategy is best used when dealing with assets that are volatile and that may experience a decline in value. It’s hard to say when, or if, the right market conditions and an appropriate asset align in such a way that a trader would use the strategy to profit.

•   The strategy could backfire completely. The risk is that the underlying asset sees a dramatic rise in value, rather than a fall in value, as the trader predicted, blowing up their short call. This could mean that the trader has to buy the underlying asset at market value, potentially leading to a loss.

Bear Call Spread Considerations and Tips

There are a few other things worth keeping in mind when it comes to the bear call spread strategy.

•   There’s an early assignment risk. Since options can be exercised at any time, traders with short option positions should remember that they’re putting themselves at risk of early assignment — or, the trader needs to fulfill their obligation and may need to buy the underlying asset to do so.

•   The strategy can be used in variations. A bear call spread is only one of several vertical options spreads that traders can put to use. Depending on market conditions, it may be wise to use a bullish strategy instead.

•   This is all speculative! It’s critical to remember that options trading is speculative. There are no guarantees, and the risk of loss is real. No matter how good any trader thinks they are at predicting the market, things can go sideways at any point. It’s important for investors to calculate the risk-reward ratio before choosing their speculative tools.

The Takeaway

The bear call spread is one of many options trading strategies a trader may employ in trying to reap as much profit from their investments as possible. But as with all strategies, it is not foolproof, and positive results are never guaranteed.

When getting started with trading options, it can help to have educational resources about options on hand and a user-friendly platform, both of which SoFi offers. With SoFi, investors can trade options from the mobile app or the web platform.

Trade options with low fees through SoFi.


Photo credit: iStock/PeopleImages

SoFi Invest®

INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE

SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below: Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Before an investor begins trading options they should familiarize themselves with the Characteristics and Risks of Standardized Options . Tax considerations with options transactions are unique, investors should consult with their tax advisor to understand the impact to their taxes.
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How Are Leverage and Margin Similar and Different?

How Are Leverage and Margin Similar and Different?

Margin and leverage are often thought to be the same thing. However, while both can be used to amplify an investor’s buying power when trading stocks, they have some key differences.

Margin trading, or “buying stocks on margin” refers to the practice of borrowing money from your brokerage and using that to purchase stocks. You are taking out a loan to purchase more of whatever stock you are trading than you would be able to with a cash account. After buying an asset on margin, you’re likely to see amplified gains or losses because of the out of pocket investment compared to a cash account, or conversely, the margin call. You will also pay interest on the amount borrowed from the broker.

Leverage is the result of using margin, but it also has a much broader meaning and usage within the world of finance. In general, it refers to the concept of using borrowed money as a source of funds for an investment. When it comes to trading, it is important to understand what your leverage ratio is so that you know the amount of risk you are taking.

We’ll explain all the details of margin vs. leverage in this article.

Leverage vs Margin

A trader uses margin to trade with leverage. A margin account allows you to have increased buying power. Leverage lets you trade bigger positions than the amount of cash in your account. Leverage and margin have an inverse relationship — the higher the margin requirement, the lower your leverage ratio will be.

You can trade stocks and ETFs on margin to make use of leverage. However, you don’t necessarily need to use margin in order to increase your leverage; there are also leveraged ETFs that effectively accomplish the same goal, that can be purchased in a cash brokerage account.

In futures trading and forex trading, brokers often allow large leverage ratios. Since the leverage ratios in these markets are greater, the risk is amplified. New traders should learn the basics of trading on margin and might consider trading a stocks and options account before venturing into the high-risk world of futures and forex trading.

Recommended: Margin Trading vs Futures: Compared and Explained

A Closer Look at Margin

Margin trading is a method by which your portfolio holdings are used as collateral to acquire a loan from a broker. Margin is the difference between an investor’s account value and the loan they request from a broker to execute a trade. An investor can use proceeds from the loan to invest in more securities like stocks, bonds, and exchange-traded funds (ETFs).

Margin trading can also allow you to diversify your portfolio with other assets without having to use more equity.

How Margin Trading Works

Margin trading works by using loan proceeds to invest in more assets. The goal is to enhance returns, but there also can be drawbacks.

Pros vs Cons of Margin Trading

Pros

Cons

Increases buying power Must meet and maintain margin requirements
Greater return potential Higher risk than trading a cash account
Ability to diversify into other assets You must pay interest on borrowed funds

Increase your buying power with a margin loan from SoFi.

Borrow against your current investments at just 12%* and start margin trading.


*For full margin details, see terms.

A Closer Look at Leverage

Leverage in finance is a word used to describe borrowing money to increase returns. Investors might borrow capital from a broker or bank in order to make trades that are larger than your account’s equity, increasing your trading power. Companies might use leverage to invest in parts of their business that they hope will ultimately raise the value of the company.

How Leverage Works

Leverage in a stock account is the result of borrowing money to trade securities, using an account’s margin feature. Leverage can work to the benefit or detriment of an investor depending on the movements of an account’s holdings.

Companies often use leverage to amplify returns on their investment projects, and the same logic applies to trading equities. You may see huge returns on the upside — or see your account value drop rapidly if the market moves against you. Trading with leverage is riskier than strictly using your own cash.

Futures and forex trading often use high leverage ratios versus a stock trading account. For example, let’s say you purchased $100,000 of assets based on the value of a stock index, and posted a margin deposit of $2,000. Your leverage ratio is 50:1. If the underlying index rises 1%, your assets would increase to $101,000. Your equity would go up by 50% to $3,000.

If the trade works against you, though, your account balance would dwindle quickly. If the index falls to $99,000, your equity would be just $1,000. You might face a margin call requiring you to deposit more cash or securities.

Pros and Cons of Leverage Trading

Pros

Cons

Potential for enhanced returns with a minimal deposit Losses can happen fast, leading to margin calls
Greater access to high-priced stocks Borrowing fees and margin interest can be costly
Access to many markets with limited capital Managing multiple leveraged positions can be cumbersome

The Takeaway

Margin trading and leverage can be used to enhance returns, but there are risks you should consider. It is important to weigh the pros and cons of both strategies to determine what trading method works best for you. Knowing the differences between margin vs. leverage is important before trading.

A margin account with stocks allows you to borrow against cash and securities when trading stocks online. Leverage measures the increase in trading power because of using margin.

It’s important to understand your personal risk tolerance before trading on margin and using leverage. Risk-averse investors might prefer a cash account; for those more comfortable with risk, trading with borrowed funds might be appealing.

If you’re ready to try your hand at options trading, a user-friendly options trading platform like SoFi’s can feel easier to navigate. Investors can trade from either the mobile app or web platform, and they can reference a library of educational content about options.

Pay low fees when you start options trading with SoFi.

FAQ

Is leverage the same as margin?

Leverage is different from margin. You use a margin account to increase your leverage ratio when trading stocks. Futures and forex trading requires a trader to post margin to use leverage.

Can you trade without leverage?

Yes. You can trade securities with cash in your account. This method also avoids paying interest on margin balances. The downside is you will not be able to amplify returns as you would when trading on margin or with leverage.

You can also trade leveraged ETFs without a margin trading account.

What is margin in stock trading?

Margin in stock trading happens when an investor takes out a loan on an investment with the goal of seeing that asset’s price rise. When the investment is sold, the borrowed funds are returned to the lender, but you as the investor keep the profits. The downside is if the security’s price drops, you will see enhanced losses. In either event, you owe the lender interest on borrowed funds.


Photo credit: iStock/DuxX

SoFi Invest®

INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE

SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below: Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

Third-Party Brand Mentions: No brands, products, or companies mentioned are affiliated with SoFi, nor do they endorse or sponsor this article. Third-party trademarks referenced herein are property of their respective owners.

Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Before an investor begins trading options they should familiarize themselves with the Characteristics and Risks of Standardized Options . Tax considerations with options transactions are unique, investors should consult with their tax advisor to understand the impact to their taxes.
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Guide to Jade Lizards

Guide to Jade Lizards

A Jade Lizard is an advanced options strategy that requires taking three different positions. It is a slightly bullish strategy typically used by traders who want to profit from high levels of market volatility.

Traders who use the Jade Lizard strategy must monitor their position and have a plan for exit to avoid the potential for significant losses. The maximum profit for a Jade Lizard strategy is the initial premium received when opening the trade.

What Is a Jade Lizard Option Strategy?

With a Jade Lizard trade, you will enter into three different options positions on the same underlying stock through your brokerage account. The first two positions require selling a call spread, which involves selling a call option at one strike price and buying a call option with the same expiration at a higher strike price. The third and final option position is a put at an even lower strike price.

With a Jade Lizard, these options are usually at out-of-the-money strike prices. The strikes should be selected such that the total premium received from selling the call spread and selling the put option are greater than the width of the call spread. Don’t worry — if it’s not clear what that means, we’ll illustrate in the example that follows.

How Does a Jade Lizard Work?

A Jade Lizard option trade is a neutral to bullish options strategy, which means that you should anticipate the price of your underlying stock to stay the same or go up. With a Jade Lizard options strategy, you are hoping to capture the premium that comes with higher levels of implied volatility, so the ideal environment to execute the trade is one where volatility is elevated.

Setting Up a Jade Lizard

When you set up a Jade Lizard, you should initially be collecting premium from both the call spread and put that you are selling. The key concept of setting up a Jade Lizard is that you want the total amount of premium that you collect initially to be more than the width of your call spread.

As an example, say that stock ABC is trading around $60. You could sell a 58/62/63 Jade Lizard, at these hypothetical prices, on options expiring in 30 days:

•   Sell ABC 62 Call for 1.25

•   Buy ABC 63 Call for 0.90

•   Sell ABC 58 Put for 0.75

Your net credit is $1.10 ($1.25 minus $0.90 plus $0.75), so you collect $110 for each contract that you implement (since one contract typically controls 100 shares of the underlying stock). In our example, you have no risk should the stock move to the upside. To illustrate how, suppose the stock trades above 63 on expiration day. The put option expires worthless, and your maximum loss on the call spread is $100, which is less than the $110 you collected up front. On the other hand, you do have nearly unlimited downside risk if the underlying stock goes to 0. This is the main reason that the Jade Lizard options strategy only makes sense for stocks where you have a neutral to bullish outlook.

Maximum Profit

You will achieve your maximum profit if the options expire with the underlying stock having a price in between the strike price of your put option and the strike price of your lower call option. In our example above, if the stock closes between $58 and $62, then all three options expire worthless and your profit is the $1.10 in initial premium that you collected.

Maximum Loss

In a Jade Lizard strategy, you have nearly unlimited downside exposure, since you are selling a put option. A put option increases in value as the price of the underlying stock goes down. Since you are short the put option, as the stock price goes down you could be on the hook for the difference between the strike price of the put and the price of the underlying stock.

Breakeven Point

The breakeven point for a Jade Lizard on the downside is the difference between the strike price of the put option and the initial premium collected. In our earlier example, we collected $1.10 in net premium, so our breakeven point is $56.90 (the difference between $58.00 and $1.10).

There is also a potential breakeven point to the upside. Ideally with a Jade Lizard, you collect more in initial premium than the width of your call spread. In our example, we collected $1.10 in initial premium and our call spread is only $1 wide (between $62 and $63).

So if the stock closes anywhere above $63 when the options expire, your put will be worthless and your call spread will cost you $1 to close out, or $100 per set of contracts. That will leave you with a profit of $10 per set of contracts.

Exit Strategy

The exit strategy for a Jade Lizard involves purchasing back the options you sold using a buy to close order. When setting up the trade, it’s a good idea to set target profit at which you would buy back the options.

In our example, where we received $1.10 per share, you might look to close out the Jade Lizard when you could buy your options back for around $0.55 per share, 50% of the initial premium you received. The options may decline in value due to movement of the underlying stock, or time decay as the options get closer to their expiration.

Maintaining a Jade Lizard

A Jade Lizard is not a set-it-and-forget-it options strategy. Because of the unlimited downside risk, you’ll want to monitor your position, especially if the price of the underlying stock starts to go down. In that scenario, you may want to close out your position or roll down the strike prices of your short call spread.

Pros and Cons of the Jade Lizard Strategy

Here are some pros and cons of the Jade Lizard strategy:

Pros of the Jade Lizard strategy

Cons of the Jade Lizard strategy

No risk of losses from upward price movement in the underlying Significant risk of downward price movement in the underlying
Immediate collection of the net premium Profits capped to the amount of premium initially received

Alternatives to Jade Lizards

One alternative to the Jade Lizard strategy is a strategy called the Big Lizard. With a Jade Lizard, you typically sell out-of-the-money options. With a Big Lizard strategy, the options that you sell are at-the-money, meaning that their strike price is close to the price of the underlying stock.

Investing With SoFi

The Jade Lizard strategy is an advanced strategy that options traders use when they have a bullish to neutral outlook on a stock. The strategy’s maximum upside is equal to the premium received when opening the trade, while the downside risk is essentially uncapped.

Learning about different options strategies can be a great way to further understand the stock market and how to invest. From there, you might consider an options trading platform like the one offered by SoFi. This platform has an intuitive and approachable design and allows investors to trade options from the mobile app or web platform. And if you aren’t done learning, there are educational resources about options available to explore.

Trade options with low fees through SoFi.

FAQ

How are Jade Lizards managed?

When opening a Jade Lizard options strategy, you want to make sure to keep an eye on the underlying stock until the options’ expiration date. Since a Jade Lizard comes with no upside risk, you should especially monitor negative moves in the stock price. In that case, you could close out your position or roll your call spread to a lower stock price, earning more premium.

How do reverse Jade Lizards differ from Jade Lizards?

In a reverse Jade Lizard, also known as a twisted sister option, you sell a put spread, being long the put option with the lower stock price. Additionally you sell a call with a higher strike price.

As the name suggests, a reverse Jade Lizard is the opposite of a regular Jade Lizard, and makes sense when you have a neutral to bearish outlook on a stock. You have risk of losses due to downard price movement and unlimited loss potential from upward price movement, due to the short call.

What is the maximum payoff of a Jade Lizard?

The maximum payoff or profit of a Jade Lizard is capped to the total initial premium that you receive when you open the position. This is equal to the amount you get for selling the put and short leg of the spread minus the amount of premium for the long leg of the call spread.


Photo credit: iStock/ipopba

SoFi Invest®

INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE

SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below: Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.

Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Before an investor begins trading options they should familiarize themselves with the Characteristics and Risks of Standardized Options . Tax considerations with options transactions are unique, investors should consult with their tax advisor to understand the impact to their taxes.
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What Does At the Money Mean in Options Trading?

What Does At the Money Mean in Options Trading?

An at-the-money (ATM) option is one where the strike price is at or very near the current price of the underlying stock itself. At the money options have no intrinsic value.

Options traders must understand the difference between the three types of options “moneyness: “at the money,” “in the money,” and “out-of-the money.”

What Is At the Money?

At the money means that a given option’s strike price is identical to the price of the underlying stock itself. Both a call option and a put option can be at the money at the same time, if their strike price is the same as the price of the stock.

In this age of decimal stock pricing, it is rare for an option’s strike price to exactly equal the price of the underlying stock — so the at-the-money strike is usually considered the one closest to the stock’s price.

Understanding At the Money

Usually, an option that is at the money will have a delta of around 0.50 for an at the money call option and -0.50 for a put option. This means that for every $1 of movement of the underlying stock, the option will move about 50 cents.

Some options traders employ more complicated strategies, such as an at the money straddle, which involves buying or selling both an at-the-money call and an at-the-money put with the same expiration date.

At the Money vs In the Money vs Out of the Money

Usually there is one option strike price considered at the money, with any other strike prices being either in the money (ITM) or out of the money (OTM). The difference between ITM and OTM is that an in-the-money option is one that has intrinsic value, meaning it would be profitable to exercise it today.

For calls, being in the money means a strike price lower than the stock’s price. For put options, a strike price that is higher than the stock’s price is considered in the money.

Out-of-the money options are just the opposite. They have no intrinsic value, and if an option is out of the money at expiration it will expire worthless.

Consider the following call or put options for stock ABC with a current price of 55.

Option

Strike price

ATM / ITM / OTM

ABC Call option 55 At the money
ABC Put option 55 At the money
ABC Call option 70 Out of the money
ABC Put option 70 In the money
ABC Call option 40 In the money
ABC Put option 40 Out of the money

Recommended: Call vs. Put Options: The Differences

At the Money and Near the Money

An option is considered near the money usually if it is within 50 cents of the price of the underlying stock. However, it is common for investors to use the terms “near the money” and “at the money” interchangeably.

This is because stocks are priced to the nearest cent, while option strike prices are usually only to the nearest dollar or half-dollar, depending on the magnitude of the underlying stock price. So it is rare for a stock to have an option that exactly matches any specific strike price.

Pricing At-the-Money Options

Because an at-the-money option has a strike price exactly the same as the price of the underlying stock, it has no intrinsic value. Any value in an ATM option is made up of extrinsic value or time value. While you could make more money with an option than just by purchasing the stock if the stock moves in the direction you anticipate, you also stand to completely lose your investment if the stock moves against you.

At the Money and Volatility Smile

The volatility smile refers to the phenomenon that implied volatility is generally lower for at-the-money options than it is for options that are in the money or out of the money. The term “volatility smile” reflects a graph of implied volatility against the strike price of an option, which appears as an upwards-opening parabola, similar to a smile.

Pros and Cons of Trading At-the-Money Options

Here are some pros and cons of trading at-the-money options:

Pros of trading at-the-money options

Cons of trading at-the-money options

Less-expensive than at-the-money options More expensive than out-of-the-money options
Can protect you from downside risk on stocks you already own ATM options have no intrinsic value and may expire worthless
If the stock moves in a different direction than you anticipate, you could lose your entire investment

The Takeaway

Understanding the difference between options that are at the money (ATM), in the money (ITM) and out of the money (OTM) is crucial if you want to trade options through your brokerage account. Prices with these three different types of options contracts react differently to movements in the price of the underlying stock, so make sure you buy the right one based on your overall strategy.

An options trading platform that provides educational resources about options can be a good way to continue learning as you go. SoFi offers this alongside its user-friendly options trading platform, where investors can trade options from the mobile app or web platform.

Trade options with low fees through SoFi.

FAQ

What does buying at the money mean?

When you buy an at-the-money option, you are buying an option whose strike price is at or near the price of the underlying stock. An option that is at the money generally has a delta value of around positive or negative 0.50, depending on if it is a call or a put. That means its price will move about 50 cents for every dollar that the price of the underlying stock moves.

How do at the money and in the money differ?

An at-the-money option is one whose strike price is at or near the price of the underlying stock. An in-the-money option is one with a strike price that would be exercised if the option closed today. An at-the-money call option is one whose strike is lower than the stock price, while an at-the-money put option is one whose strike price is higher than the stock price.

Is it best to buy at the money?

There are several different strategies for trading options, and the strategy you trade will help decide whether it’s a good idea to buy at the money. It can certainly be profitable to buy or sell at-the-money options, but other strategies for making money with options exist as well.


Photo credit: iStock/DMEPhotography

SoFi Invest®

INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE

SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below: Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.

Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Before an investor begins trading options they should familiarize themselves with the Characteristics and Risks of Standardized Options . Tax considerations with options transactions are unique, investors should consult with their tax advisor to understand the impact to their taxes.
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A Guide to Collars in Options Trading

A collar is an options strategy used by traders to protect themselves against heavy losses. The strategy, also known as a hedge wrapper, involves taking a long position in an underlying stock, buying an out-of-the-money put, and selling an out-of-the-money call.

Essentially with an option collar, you’re buying a protective put and a covered call at the same time on a stock that you already own or have long exposure to. While collars in options protect against heavy losses, they also limit potential gains. Read on to learn more about collar breakeven points, max loss, and max profit.

What Is a Collar Option?

In collar options strategies, an options trader limits the range of their returns by taking a long position in the underlying stock, buying a lower strike put, and selling a higher strike call. Typically, the stock price will be between the two strike prices. A trader uses a collar when they are bullish on the underlying stock but want to be protected against the risk of large losses.

A collar is also a useful option strategy when the goal is to protect unrealized gains on the stock.

How Do Collars Work?

A collar works by protecting a trader’s existing long stock position by buying a put option, limiting any further losses should the stock price fall below the strike of the put. At the same time, the sale of an out-of-the-money call helps finance the trade, making the cost of protection cheaper than purchasing a put on the underlying shares, with the trade-off that gains will be capped should the stock rise above the strike of the call. The trader constructs a collar through their brokerage when they think there could be near-term weakness in the stock but do not want to sell their stock position.

Buying a put gives the trader the right, but not the obligation, to sell the stock at the put’s strike price. Selling the call obligates the writer to sell the stock at the call’s strike if the option is assigned. Meanwhile, the trader remains long shares of the underlying stock.

Maximum Profit

The short call position in a collar option strategy caps upside, limiting the maximum potential profit. The max profit depends on if the investor established the options trade at a net debit or a net credit.

•   Net debit: Maximum profit = Call strike price – stock price – net debit, or

•   Net credit: Maximum profit = Call strike price – stock price + net credit = max profit

At a high level, the trader makes the most money when the stock price is at or above the call’s strike at expiration.

Maximum Loss

The protective put limits losses in the event the underlying share price falls below the put’s strike. So either

•   Net debit: Maximum loss = Stock price – put strike price – net debit paid, or

•   Net credit: Maximum loss = Stock price – put strike price + net credit received

Breakeven Points

Once established, a collar option has two possible break even points – again, dependent on whether the trade was executed at a net credit or debit.

•   Net debit: Break even point = current stock price + net debit, or

•   Net credit: Break even point = current stock price – net credit

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Impact of Price Changes

A collar keeps a trader’s long-term bullish stance but it protects unrealized profits from a short-term share price decline. If the underlying stock price rises, the collar provides some exposure to upside gains, capped at the short call’s strike. The real value of a collar comes if the stock price drops through the long put strike. The collar protects the trader from further losses.

Another way to look at the impact of price changes is to view it from a perspective of time – a collar can help a trader with a short-term bearish outlook but a bullish long term view. Collars have a positive Delta.

Impact of Volatility Changes

Changes in volatility have a relatively smaller impact on a collar options strategy versus other options trades because the trader has simultaneous long and short option positions. The collar trade usually has a near-zero vega.

Recommended: What Are the Greeks in Options Trading?

Impact of Time

With a collar options trade, the effect of time decay depends on how close the stock price is to the option strike prices.

Time decay works to the trader’s benefit when the underlying stock price rallies up to the short call’s strike. On the flip side, the impact of time hinders the trade when the stock price nears the long put’s strike. When the stock price is about equally between the two strikes, time decay is neutral since both option prices erode at approximately the same rate. So, while the short put value drops, the long call offsets those gains from time decay.

Pros and Cons of Collars

Pros

Cons

Limits losses from a falling share price Limits gains from a rising share price
Allows for some upside exposure Exposes the trader to some risk of loss
Cheaper than only buying puts Can be a complicated strategy for new traders
Ownership of the stock retained

Collar Option Examples

Here’s a collar option example that will help put these concepts into context: Suppose a trader is long shares of XYZ stock that currently trades at $100. The trader worries about limits to near-term upside and wants to protect against a material share price decline. A collar strategy is a good trade to address these beliefs.

The trader sells a covered call at the $110 strike, receives a $5 premium, and buys a protective put at the $90 strike at a cost of $4. The net credit is $1 and the trader has not paid any commissions. With these two options trades, the trader has capped their upside at the call’s strike and the downside at the put’s strike. The breakeven point is $99 (the current stock price minus the net credit).

Let’s say the stock rallies to the call’s strike by expiration. In this case, the trader makes $10 on the long stock position, keeps the $5 call premium, and lets the put expire worthless. The gain is $11 (the stock price gain plus the options’ net credit received).

If the stock price drops to $80, the trader loses $20 on the stock position, keeps the $5 call premium, and makes $6 on the $90 strike long put. Thus, the net loss is just $9. The trader benefitted from the collar as opposed to just owning the stock which was down $20. The payoff diagram below shows how losses are limited in our trade scenario, but gains are also capped at the $110 mark.

Collar Payoff Diagram

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Reasons to Consider Using a Collar Option Strategy

A collar is an effective strategy when an investor expects a stock to trade sideways or down over a period. A trader might also use it when they expect a stock to go up over time and do not want to sell their shares, but they do want to protect unrealized gains – perhaps for tax reasons. A collar option trade is less bearish than buying puts outright, but it protects a trader from large losses. Also, selling the upside call helps finance the protective position.

Limiting Risk

A collar option strategy limits risk beyond the protective put’s strike. Even if a stock price goes to zero, the trader’s loss maxes out at the protective put’s strike.

Protecting an Asset

Another way to protect your stock position is to implement a protective put. With a protective put, a trader buys a put in addition to their long position in the underlying stock. This trade would be more expensive than a collar, since there is no sale of a call option to offset the cost of buying the put, but retains the unlimited upside of the underlying stock position.

The Takeaway

A collar is a strategy whereby a trader protects an unrealized gain on a stock at a reduced cost while still allowing some upside equity participation. Traders might use this strategy for tax purposes, or to limit the overall risk in their portfolio.

While SoFi does not currently offer options traders, it does help investors learn more about options. Investors can also get started by opening a brokerage account on the SoFi Invest investment platform where you can build a portfolio of stocks and exchange-traded funds.

FAQ

What is the maximum profit on a collar option?

The maximum profit on a collar is when the stock price rallies up to the call’s strike price. Above that level, gains are constant since the long stock position is offset by the short call.

Maximum profit = (call option strike price – net of option premiums) – stock purchase price

What is maximum loss on a collar option?

The maximum loss on a collar option trade is when the stock price declines to the put’s strike price. Below that level, losses are limited since the long stock position is offset by the long put.

Maximum Loss = stock purchase price – (put option strike price – net of option premiums)

What is breakeven on a collar option?

The breakeven on a collar strategy at expiration is the current stock price minus the net credit received or the current stock price plus the net debit paid.

Breakeven = stock price + put option premium paid – call option premium received


Photo credit: iStock/gorodenkoff

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Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Before an investor begins trading options they should familiarize themselves with the Characteristics and Risks of Standardized Options . Tax considerations with options transactions are unique, investors should consult with their tax advisor to understand the impact to their taxes.
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