Options trading strategies: Simple Ways to Trade Options
What is an option?
It is a financial instrument based on a financial asset such as a stock or equity. Options enable the trader to either buy or sell the asset at hand. Assets come with expiry dates before which the trader should sell or buy. And the price at which this takes place is known as the strike or trigger price.
You can buy options through an online exchange or broker. Options can either be a call or put option. Put options allow the trader to sell the asset at a specific price and time. On the other hand, call options allow traders to buy options at a specific price and time.
When trading options, you need to keep in mind the open interest and trading volume. These are the most crucial aspects to consider making huge profits. If you want to invest in commodities such as oil, then you should buy options.
To determine risk in each option, traders use Greek terms, they include:
Options trading strategies
In this strategy, a trader will “go long” anticipating that the stock will rise above the strike price by expiration. Going long is uncapped meaning that a trader can multiply their investment by a huge margin. It is mostly used by traders who want to take advantage of stock soaring prices.
Also, traders that are confident of a shift in stock price, use this strategy. The best part, if the stock moves in the wrong direction, a trader can sell the call before expiration. The downside, you can lose your entire initial premium.
This strategy involves selling a call option or going short. However, the trader will sell the call and buy the stock underlying the option. In this case, you will buy 100 shares per call sold. As such, it turns a potentially risky trade into an income-generating one.
Here, the trader expects the price to go below the strike price by expiration. However, if it finishes above the strike price, the trader ought to sell the stock at the strike price to the call buyer. That said, if it stays flat at the strike price, the trader would keep the stock and the premium.
You can use this strategy if you own the stock and expect the price to stay flat. It is also an ideal source of income, hence becoming a favorite for older investors.
Traders using this strategy expect the stock price to be below the strike price at expiration. It is somehow similar to a long call only that you expect the price to decline. The downside, you can lose your entire premium should the price rise. And if the price declines significantly, you’ll stand to pocket more from your owned puts.
You should use this strategy if you expect the stock price to be below the strike price at expiration. However, if the decline is minimal, you stand to lose on your premium.
Married put is somehow similar to the long put strategy but with a slight twist. Here, a trader owns the stock and buys a put. In short, it is a safe bet. While you expect the stock price to rise, the put prevents losses should the price decline. The best part, as long as the stock price continues rising, you’ll pocket many times your premium.
With this strategy, you can sell your stocks at the strike price with each contract being worth 100 shares. It is an ideal strategy if you expect the price to rise significantly but are still skeptical it may fall. It acts like insurance affording you a base price should the price reduce significantly.
Here, the trader goes short or sells a put expecting the price will be above the strike price at expiration. After selling the put, the trader will get cash in return. However, should the price go below the strike price, they must buy the stock at the strike price.
Most traders use this strategy to generate income. That is, they sell to other investors how to predict the prices will decline. However, you should not sell all your puts since you’ll have to buy the stocks should the price fall.
In this strategy, the trader sells and buys a put and call. However, the trader buys at-the-money and sells out-of-money respectively. Both call and put have to be under one stock. It is somewhat similar to butterfly spread with the main difference being you have to buy and sell both. The best part, it allows you to increase income while reducing profits and risks.
Also, the strategy allows you to invest minimal capital while offering a steady income. And should the price move in the wrong direction, you can choose to close the trade to avoid losses. While the profits and losses are limited to a specific range, most traders use it, due to its reduced volatility.
Iron condor involves a long and short put plus a long and short call. Each option has to have its strike price, however, the expiration date should be the same. To earn maximum profit, the stock price should close in the middle of the strike prices.
The iron condor is an extension of the iron butterfly and its payoffs are similar to a condor spread. It is ideal for stocks will low volatility. If you want to earn small amounts of your premium, this is the strategy to use.
Synthetic call strategy
This strategy uses put option and stock shares to stimulate the performance of a call option. Here, the trader buys an holding share and an at-the-money put option of the same asset. This is to protect against the depreciation of the stock price. Most traders will equate this strategy to an insurance policy.
It is a recommended strategy if your goal is to preserve capital rather than make a profit. Most novice traders use this strategy since it comes with a safety net that protects them from high losses. As such, they can learn the ropes while still trading.
Protective collar strategy
This strategy protects you from short-term volatility in stock prices. It provides the trader a cost-effective way of protecting their asset against losses. Furthermore, it allows you to make money when the market bounces back. It comes with a long position, put option, and a call option. Both the call and put options have the same expiration date.
The downside to this strategy is that you are trading a stock’s upside for downside protection. As such, you reduce your profit margin. It works well if the price drops but becomes useless should the price rise.
In this strategy, a trader purchases a long call and a long put of the stock with similar expiration dates and strike prices. The strategy bets on the price of the stock going higher or lower. Traders forecast that the asset will move to high volatility in the event of news happening.
Ideally, it is used before a news report, election results, or Fed action. And since they are not sure of the outcome, they place their trade o profit in both ways. The downside, the market might not react hysterically to news or other happenings.
Advantages of trading options
Thanks to their exceptional leveraging power, options provide a trader with a cost-effective trading option. Besides, it allows you to save on money compared to buying stocks. If you want to buy 100 shares of a $50 stock, you’ll have to shell out $5000.
However, if you were to buy two $10 calls each worth 50 shares you’d only shell out $1000. As such, you’d be left with $4000 at your disposal.
If you use options in the right way, you are poised to reduce risk compared to owing equities. They require less financial commitment and are less affected by volatility in the market. Besides, they are safer compared to stocks since you don’t have to constantly set stop-loss order.
Another major benefit is their high returns compared to stocks and equities. Besides, as an investor, you’ll spend less money compared to investing in stocks.
Offer more investment alternatives
Options are flexible compared to other investment options.
Options trading affords you control that few financial instruments can. For example, you can decide when to sell or buy and at what price. Besides, they have high returns and you can choose from a wide array of options.