Options Trading Strategies That You Should Know About

Options Trading Strategies That You Should Know About

Option trading strategies for beginners

Did you know that the options game has several strategies that can both limit your risk and maximize returns? Unfortunately, way too many traders jump into the game with zero or limited understanding of these strategies or how to implement them. By putting a little extra effort, it’s possible to use options as your trading vehicle all the while taking advantage of its full power and flexibility. This article aims to provide pointers that will have you go in the right direction and possibly shorten the learning curve.

Options Trading Strategies That You Should Know About

These are some of the best options trading strategy.

  1. Covered Call

You can engage in a buy-write strategy or a basic covered call over and above buying a naked call option. This strategy allows you to purchase assets in their entirety and at the same time sell (write) a call option on these very assets. The volume of assets owned must correspond numerically to the assets beneath the call option. This position is often used by investors who have a temporary position and an impartial opinion on the assets; want to generate extra profit (by receiving call premium) or who are seeking protection against a latent decline in the original value of an asset.

  1. Married Put

This strategy involves the simultaneous purchase of a put option by an investor who currently owns or is purchasing a specific asset such as shares. The purchase will be for an equal number of shares. This strategy is used by investors when they are optimistic about the price of the asset, and they wish to guard themselves against latent short-term losses. Essentially, this strategy works like an insurance policy and sets up a floor in the event the asset’s price takes a dramatic plunge.

  1. Bull Call Spread

This strategy involves the purchase of call options at a set strike price and the simultaneous sale of these calls at a much higher strike price. In a bull call strategy, both call options have a similar underlying asset and expiration. When an investor is optimistic and expects the price of an underlying asset to rise, they will often use this kind of vertical strategy.

  1. Bear Put Spread

Bear put spread, just like the bull call spread is a form of the vertical spread. Here the investor simultaneously buys put options at a set price and sells the exact number of puts for a lower strike price. Both options have a similar underlying asset and expiration dates. This method offers limited gains and losses and is used by investors who are bearish.

  1. Protective Collar

An investor will purchase puts using the out-of-the-money option and simultaneously write call options via –out-of-the-money option – both have the same underlying assets for example shares. Investors normally implement this strategy when long-held stocks have provided substantial gains. In doing so, the investor is able to lock in their gains without selling their shares.

  1. Long Straddle

In this strategy, the investor will purchase call and put options using the same underlying asset, strike price, and expiration dates. This is done simultaneously. Investors implement this strategy when they are optimistic about a significant movement in the price of an underlying asset and, but they cannot tell for sure which direction it will take. Using this strategy permits the investor to retain unlimited gains while limiting losses to the cost of options and contracts.

  1. Long Strangle

In the long strangle method, an investor will use different strike prices to purchase a call option and a put option that have the same underlying asset and maturity. Typically, the strike price of the put will be much lower than the call option strike price; however, the two options are out-of-the-money. Investors who apply this strategy are optimistic about huge movements in the price of an underlying asset but cannot tell which direction it will take. Losses are restricted to the costs of the two options. Long Strangles is cheaper than Long straddles since the options are bought out of the money.

  1. Butterfly Spread

All of the above strategies require the combination of two different contracts or positions. In the butterfly spread options strategy, investors merge the bull spread strategy and the bear spread strategy, and they make use of three different strike prices. Let us illustrate how this works – an investor will purchase one call option (put option) at the lowest (or the highest) strike price, as they sell two call options (put options) at a higher (or lower) strike price then sell one more call option (put option) at a much higher (or lower) strike price.

  1. Iron Condor

The iron condor is an interesting strategy. Here, investors hold both a long position and a short position at the same time in two separates strangle strategies. This strategy is quite complex and requires time to master its application.

  1. Iron Butterfly

This is the final options strategy that we will mention here. The strategy combines either short or long straddle while simultaneously purchasing or selling a strangle. The iron butterfly may seem similar to the butterfly spread. However, this strategy differs in that it makes use of both puts or calls as opposed to using one or the other. Both profits and losses are restricted to a specific range which depends on the strike prices for the options used. To limit risk and cut costs investors will mostly apply the option of out-of-the-money.

Getting Acquainted with Options Trading

There are many traders who consider a position in the stock options as stock substitutes with less required capital and higher leverage. This is because a trader a can use options to bet on the route the stock price will take just like the stock. In spite of this, the characteristics of options differ from those of stocks, and there’s a need for beginner options trader to learn the terminologies applicable in options.

Options 101

Options come in two forms namely calls and puts. When you purchase a call option, you receive the right (but not the obligation) to buy a stock, any time before the option expires, at the strike balance. When you purchase a put option, again you get the right (but not the obligation) to sell a stock, at any time before expiration date at the strike price.

Options trading

The key distinction between options and stocks is that, whereas stocks give you ownership of a certain percentage of the company, options are simply contracts that grant you the privilege to trade the stock at a particular price and by a particular date. You need to remember that every option transaction has two sides – for every put or call option bought, there is someone else selling it.

When traders sell options, they have essentially created security that did not exist before the sale. This is referred to as ‘writing an option.’ It is one of the chief sources of options because of neither the options exchange nor the associated company issue options. Writing a call may obligate you to sell shares, anytime before expiration date at the strike price while writing a put may obligate you to buy shares anytime before expiration date at the strike price.

Stock trading is comparable to gambling at the casino where gamblers are all betting against the house. If by chance all the customers are lucky, they could all win.

Options trading can be compared to betting on the horses at a racetrack whereby pari-mutuel betting is applied. Each person bets against every other person that is also betting and the track takes a small cut because they are the ones providing the facilities. Trading options just like horse racing is a zero-sum sport. A gain for the options buyer is a loss for the options seller and the other way around. A payoff diagram for the options purchase must mirror the seller’s payoff diagram.

Basic Terms Review

Understanding basic options pricing terms can prove quite helpful for anyone who wants to learn about options.

Below is a review of the terminology used in basic options.

  • American Options – These are options that can be effected at any point before expiration of the contract. American options are the most exchange-traded options.
  • At-the-Money – This option has a strike price equivalent to the current price of its underlying security.
  • Call – An option that gives its holder the right to purchase the underlying security at specific prices for specified and fixed period of time.
  • Contract – This is an option that denotes 100 shares of original stock.
  • Covered Call – This is an option strategy whereby the call option writer holds an extended (long) position in the original security by share-for-share.
  • Covered Put – An options strategy whereby the put option writer holds a brief (short) position in the original security by share-for-share.
  • Covered Writer – This is an option seller who holds the option’s original security as a shield against the option.
  • Date – This is the actual date that an option expires. This usually occurs at the close of business hours ((4:00 p.m. ET) on the third Friday of the options expiration month
  • Derivative – This is an investment product that receives its value from an original asset. Options are derivatives.
  • Early Exercise – This is exercising an option before the expiration date. Early exercise can take place with American-style options.
  • European Options – These are options that are exercised during a specific time period just before the expiry date
  • Holder – This is an investor who purchases an option and makes payment to the writer
  • In-the-Money – This is an option that possesses intrinsic value. A call option will be considered in-the-money in the event the original security is greater than the strike price
  • LEAPS – These are publicly traded options whose expiration dates exceed one year

Options Pricing

Option pricing speaks of the amount per share that an option trades at. Options are derivative contracts which afford the holder or buyer the right (not obligation) to purchase or sell the original instrument at a set price on or before the expiry date, i.e. a specified future date. While the options holder is not obligated to execute the option, the seller is. An option writer (seller) is obligated to purchase or sell the original instrument should the option be exercised.

Depending on the strategy used, options can provide a host of benefits such as leverage and security of limited risk. Options can also safeguard or increase your portfolio in fluctuating markets, i.e. the rising, fall and neutrality of markets.

Irrespective of your reasons for options trading or the strategies that you use, it is vital to have an understanding of how options are priced.

Option Types

Option Types

Options come in two basic styles namely American and European. The American-style option allows you to exercise your option at any time starting from the date of purchase to the expiry date. As we mentioned earlier, exchange-traded options are mostly American style. Also, all stock options are also American style. Index options are mostly European style, and European-style options are only exercised on the expiry date.

In the event a call option’s strike price is higher than the market price, the call is considered out-of-the-money, and if the strike price is lower than the stock price, then it is considered in-the-money.  Now, Put options work in the opposite way i.e. the put is considered out-of-the-money if the strike price is lower than the stock price, while in-the-money is if the strike price is higher than the stock price.

It is worth noting that the availability of options is not just at any price. Stock options are normally traded when strike prices are in intervals of $0.5 and $1. Higher-priced stocks can be traded at intervals of $2.50 or $5. Additionally, only strike prices that are within a reasonable range of the current stock price can normally be traded. Far off out-of-the –money or in-the-money options may not be available.

All stock options will expire on a particular date also referred to as the expiration date. For standard listed options, the expiration date can be nine months from the date the options were first listed for trading. LEAPS or longer-term option contracts are also obtainable on many stocks, and their expiration dates can go as far as three years from the date they were first listed.

Options expire at the close of business on Friday unless the Friday is a market holiday. In this case, expiration dates are pushed back one business day. Expiration of monthly options occurs on the third Friday in the expiration month. Weekly options will expire on the subsequent Friday in a month

The settlement period for shares is three days while options settle the following day. It is crucial for you to execute or trade your option before the end of the day on Friday for you to settle on the expiry date.

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