Start Your Options Trading Journey with Benzinga Options School
Options trading Strategies help traders hedge their positions and can result in higher returns than stock trading. Options strategies can also help investors protect or enhance their return on an underlying position. Options trading is complex, and knowing the fundamental strategies can make it easier to navigate the financial markets. Discover the best trading strategies that revolve around options.
What is Options Trading?
Options trading involves buying and selling Contracts that derive value from an underlying asset, like stocks. There are two types: call options (allowing the purchase of an asset at a set Price) and put options (allowing the sale at a set price). The option's value depends on the asset’s Market price relative to the strike price, leading to "moneyness": in-the-money (profitable), at-the-money (neutral), or out-of-the-money (unprofitable). Understanding these concepts is key to successful options trading.
Options Trading Strategies
Options trading strategies assist investors in improving trades and managing risks. Traders can use different options contracts to make profits or protect against market declines. These strategies include bullish, bearish, neutral, and income-generating types. Each type fits specific market conditions and investor goals. Understanding strategies like spreads, straddles, and covered calls is crucial. As trading evolves, mastering these strategies can provide an edge. This results in better decision-making and improved portfolio management.
Long Call or Put
A long call or put strategy involves simply purchasing the desired option. In the U.S. stock market, each stock options contract covers 100 shares. A stock option holder has the right to buy 100 shares of stock in the case of a call or sell 100 shares of stock in the case of a put at the option's strike price at any time up to and including its expiration date.
Investors and traders can purchase options as a way of limiting their downside risk when holding or shorting a stock. A long option position acts as an insurance policy by establishing a worst-case price and a loss limited to your initial premium paid for the option in case your market view turns out to be wrong.
Consider an example where you have a bullish view and buy one call option on 100 shares of stock with a strike price of A. Your downside is limited to the premium you paid in case the market declines, while your upside is potentially unlimited if the market rises. Your breakeven is equal to the strike price of the option plus the premium paid.
In the option payoff diagram above, the blue line represents the payoff of a call option position. Losses are limited to the initial premium paid below the strike price A, while the breakeven of the strategy is the point at which the diagonal line crosses the X-axis.
Naked Short Call or Put
A short call or put strategy involves simply selling or "writing" an option "naked," which means without having an underlying stock position. A stock option writer has an obligation to sell 100 shares of stock in the case of a sold call or buy 100 shares of stock in the case of a sold put at the option's strike price anytime up to and including the option's expiration date.
If your broker allows you to, you can sell put or call options as a way of taking in premium money when your market view is respectively bullish or bearish on the underlying stock. While your profits are limited to the premium paid, your potential losses would be unlimited in case your market view is wrong.
Consider a situation where you are bearish and decide to sell one call option on 100 shares of stock with a strike price of A. Your downside is potentially unlimited in case the market declines, while your upside is limited to the premium you took in if the market rises. Your breakeven is equal to the strike price of the stock minus the premium paid.
The payoff diagram of a covered call write strategy where you buy 100 shares of ABC stock at $100 per share and sell a call option on 100 shares with a 100 strike price for $5. As shown, the strategy has a breakeven share price of $95. Source: VantagePointSoftware
Bull or Bear Spreads
Options traders can use equal amounts of either calls or puts to create bullish or bearish strategies with limited upside and downside. In a so-called "vertical" spread, both options will have the same underlying asset and expiration date.
As an example, a trader with a mildly bullish view could buy a call at a lower strike price and sell a call at a higher strike price. This strategy would have a reduced net premium compared to buying the lower strike price call alone, although traders would not be able to profit from a rise in the underlying asset beyond the higher strike price of the sold call.
A payoff diagram of a bull call spread that involves buying a call with a strike price of A and selling a call with a strike price of B. The breakeven of the strategy is the point where the diagonal line crosses the X-axis. Source: Fyers
Additional Trading Strategies
In trading, expanding your strategies can improve performance and manage risk. Novice and experienced traders can refine their methods and adapt to market changes. Different strategies, like technical analysis and quantitative methods, offer unique advantages. Understanding these approaches helps traders navigate market fluctuations confidently. This guide will explore various trading strategies. We will outline their principles, execution, and benefits to help you make informed trading decisions.
Iron Condor
The Iron Condor strategy is a trading approach that combines a bull put spread and a bear call spread. It is designed to generate profits in low volatility situations when the underlying asset stays within a specified price range. The maximum profit occurs if the asset price remains within the limits of the sold options, while the risk is confined to the potential losses that arise if the asset price exceeds the strike prices of the long options.
Iron Butterfly
The Iron Butterfly strategy involves selling an at-the-money put and call, while also buying an out-of-the-money put and call. It is designed to generate profit when the asset price hovers around the strike price of the options sold. This strategy features a limited risk-reward profile, with potential losses arising if the asset price fluctuates significantly in either direction.
Long Strangle
The Long Strangle is a strategy where you purchase both a put option and a call option that are out-of-the-money, with different strike prices but the same expiration date. It profits from significant price changes in either direction, which makes it suitable for highly volatile markets. The maximum loss is limited to the premiums paid, while the potential for profit can be very high.
Long Straddle
The Long Straddle involves purchasing a put and a call option at the same strike price and expiration date. It is designed to benefit from significant price volatility in either direction, making it effective for situations where large price movements are expected. The risk involved is limited to the total premium paid for both options, while the potential for profit can be considerable.
Protective Collar
The Protective Collar is a strategy that combines purchasing an out-of-the-money put option and writing an out-of-the-money call option. This approach offers some protection against losses while also limiting potential gains. It is suitable for investors looking to hedge their current Investments, as it provides controlled risk and capped returns.
How to Choose the Right Options Trading Strategy
Picking the right options trading strategy is important for matching your approach with market views and Investment objectives. In a positive market outlook, strategies like covered calls and long calls enable investors to benefit from rising prices while also generating income and increasing their assets. In contrast, a negative market outlook can be managed with strategies such as protective puts or long puts, which are intended to protect against losses or benefit from decreasing asset values.
Risk-averse traders can use strategies like Cash-secured puts to buy stocks at a good price while preserving their Wealth in the options market. In situations with high volatility, strategies such as straddles and strangles allow traders to benefit from large price changes, no matter which direction they go.
It's important to understand options trading strategies and their goals so that investors can make informed investment choices, aiming for both wealth Growth and a balanced risk profile in different market situations.
Frequently Asked Questions
- Q: What advantages does options trading offer?
- A: Options trading can offer greater flexibility and potential for higher returns compared to stock trading, as it allows for strategies like hedging and leveraging. However, it also involves higher risks and complexity, making it unsuitable for all investors.
- Q: What is the safest options strategy?
- A: The safest options strategy is often considered to be the cash-secured put. In this strategy, an investor sells put options while holding enough cash to buy the underlying stock if the option is exercised, thereby limiting potential losses and allowing the investor to acquire stocks at a lower price.
- Q: What is the most consistent options strategy?
- A: The most consistent options strategy is typically the covered call, where an investor holds a long position in a stock and sells call options on the same stock to generate income. This strategy works well in a sideways market, providing steady returns while limiting potential upside if the stock price rises significantly.
