Now that you have a clearer idea of exactly how trade options work and the different aspects and types of options, we can cover the different strategies you might want to consider.
Option Trading Strategies
Here are some of the best options strategies for beginners to consider.
Buying Calls (Long Call)
This type of position is preferred among traders who are either bullish on a specific index or stock and don’t want to risk capital in the event of downside movement, or want to take leveraged profit on a bearish market.
Because options are leveraged instruments, they enable traders to amplify the benefit by risking smaller amounts than would otherwise be required if the underlying asset traded itself. Standard options on a single stock has the same size as 100 equity shares. Investors can take advantage of leveraging options by trading options.
The main risk of this strategy is that the trader’s potential loss is limited to the premium they pay. Potential profit has no limits, which means the payoff will increase as much as the underlying asset price rises.
Buying Puts (Long Put)
This strategy is ideal for traders who are either bearish on an underlying return but don’t want to risk any adverse movement in short sell strategies, or wish to take advantage of leveraged position.
If the trader is bearish on the market, they can short sell assets such as Microsoft (MSFT), for instance. However, purchasing a put option on the shares is another alternative strategy. A put option will enable the trader to benefit from the position if the stock price falls. If the price increases, on the other hand, the trader can allow the option to expire worthless, solely losing the premium.
is the price of the option multiplied by the size of the contract. Since payoff function of the long put is defined as the max, the maximum profit from the strategy is capped, as the stock price can’t decrease below zero.
This is the preferred position for traders who either expect no change or only a slight increase in the underlying price, or want to limit the upside potential of an option in exchange for limited protection for the downside.
This strategy consists of a short position in a call option, with a long position in the underlying asset. The long position makes sure that the shortcall writer will deliver the underlying price if the long trader exercises the option. Using an “out of the money” call option, traders collect a small sum of premium, which also allows for limited upside potential. The collected premium covers the potential downside losses to an extent.
The risk that comes with this strategy is that if the share price goes over $45 by the expiration date, the short call option will be exercised and the trader will need to deliver the entire stock portfolio. Shares whose prices drop below $39 will make the option expire worthless, but the stock portfolio will also lose value.
This position is good for traders who own the underlying asset, and also want protection for the downside. The strategy involves a long position in the underlying asset, along with a long put option position.
An alternative strategy would entail selling the underlying asset, but the trader might not want to liquidate the portfolio, which could be because they expect high capital gain over the long term and subsequently wants protection for the short run.
If the underlying price increases at maturity, the option will expire worthless and the traders will lose the premium, while still having the benefit of the increased underlying price that they are holding. However, if the underlying price goes down, the trader’s portfolio position will lose value, but this loss is largely covered up by the gain from the put option position that’s exercised under the circumstances at the time. This essentially makes the protective put position an insurance strategy.
The one risk that comes with this strategy is if the underlying price drops, the potential loss of the overall strategy is limited by the difference between the strike price and stock price, plus the option’s premium.
Options Trading Tips
Want to make sure your options trading strategies result in success? Here are some tips to consider when trading:
- Use options as risk-reducing investment tools rather than gambling instruments.
- Manage risk carefully, avoiding holding positions that can potentially result in significant loss.
- Don’t invest in too many option contracts when trading, as it’s easy to over-trade with affordable option contracts, particularly when selling.
- Don’t overspend. Instead, stay within your allotted budget to avoid having your account wiped out by an unexpected event.
- Limit losses by buying one option for every option sold, which means selling spreads instead of naked options, which leads us to our next point.
- Selling naked options is considerable less risky than buying stock, but it isn’t without its downside risk. Ultimately, it’s reasonable to sell naked puts, but only if you want to buy the shares
These tips can help make options trading go more smoothly, with minimal mistakes along the way.
If you would like additional information about options trading and become an expert trader through comprehensive courses, contact Sheridan Mentoring today.