Options trading is one of the most popular securities among advanced, long-time traders. That doesn’t mean that a beginner can do it. That’s why we’ve created this simple guidebook for those who want to learn it. You’re in for a treat: we got 10 options trading strategies for you.
But mere option trading strategies won’t work if you don’t know its basics. So we’ll kick this discussion off with the elementary things you should learn about options.
What are options?
Options are one kind of a derivative security.
But wait, what are derivative securities? Well, derivatives are securities whose prices are reliant upon or derived from an underlying asset.
Now, going back to the main topic, options are derivatives because their prices are linked to something else. To be specific, options are contracts. Like other contracts, options give you the ability to buy or sell underlying assets on/before a given date and time. However, you’re not obliged to do that.
Your right to buy is called your call option, and your right to sell is called the put option. You might find it difficult at first to differentiate options from futures/forward contracts.
Here’s the trick: just remember that a futures contract gives you both the rights and the obligation to buy or sell at some point.
Basically, you have the option to buy or sell in the future, but not the obligation.
Reasons for Using Options
You find a variety of reasons to use options, but we listed some of the most common reasons investors have.
Speculation means betting on the future price of something. When you speculate, you may think that the price of the underlying asset will go up or down. You choice then would be to try to profit by selling the asset at a higher price.
If you’re a speculator, you will try using call options rather than buy the stock right off the bat. This is because options offer leverage. However, just as this is a reason to use options, it’s also a reason why many find it risky.
Why? When you’re speculating, you’re not only predicting the direction of the stock’s movement. You’re also trying to know the intensity and timing of such a move.
You have to be right in a lot of things—from the direction to the time and amount of change.
If there’s a reason why options are created, it’s because of hedging. When you’re hedging, you are reducing risk at a reasonable price. From this perspective, you may think of options as your insurance policy. Simply put, you can use options to make your investments safe.
Some critics of options trading say that you wouldn’t need a hedge if you were really sure about your bet. However, that doesn’t change the fact that hedging can protect you from losses.
Of course, who wouldn’t want to take advantage of a stock’s upside while minimizing risks?
Read further Strategies Used in Hedge Funds
When we say you’re spreading, we mean that you use two or more options positions. Essentially, spreading mixes speculation and hedging. It means you’re also minimizing the possible benefits you could get.
Many traders use this technique due to its cheap implementation costs. When you’re spreading, you typically buy one option and then sell another. You can guess by now how flexible options are.
You can “customize” a spread that can let you profit from any kind of market movement.
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Since we’re talking about spreads, you should know about a special kind of a spread. It’s called “synthetic.” Its purpose is to build a position that moves exactly like another, but without you controlling the other asset.
How Options Contracts Work
It must already be clear to you that options trading is basically a bet on future accounts. If something has a high probability of happening, the more expensive an option could be.
Thus, it’s not a far jump to conclude that the higher the volatility of the underlying asset, the more odds we have to face. If the asset price move erratically in both directions, the event you bet on is likelier to happen.
Types of Options
Aside from calling them calls and puts, there are still other ways to classify options contracts.
American and European Options
One way of categorizing options is taking into account their duration and expiration.
A short-term option is one that expires in a year or even shorter. Meanwhile, long-term options with expirations greater than a year are long-term equity anticipation securities, or LEAPs.
LEAPs can provide chances to control and manage risks and speculate. Because of this, they are almost identical to regular options. However, LEAPs provide these chances for a longer period of time. LEAPs are available on most issues but not on stocks.
You can exercise American options at any time between the purchase date and the time of expiry. Most exchange-traded options are similar to this.
European options, meanwhile, are different from American options in that you can exercise them only on their expiry date. Most options on stock indexes are European options.
An American option usually is more expensive than a similar European option. This is because being able to exercise the option early has some value in itself.
Just like other securities, options are traded on exchanges.
For instance, in the United States, there are various physical and electronic exchanges. You can only trade options directly between counterparties using an exchange. You call these over-the-counter (OTC) options.
Oftentimes, financial institutions use OTC options to fix specific events not available among listed options.
There are market makers who are required to “make” a market with two sides in an option. Their goal is to provide liquidity to options markets. If they use theoretical pricing models, market makers can use arbitrage in their favor, as well as theoretical mispricings between the options’ perceived value and its market price.
Other Types of Options
Aside from those two, there are still other types of options.
The simple call and put options we first tackled are also sometimes called the plain vanilla options. Plain vanilla options are as plain as you can imagine.
Meanwhile, because of options’ versatility, they can come is different sizes and shapes. Non-standard options are called exotic options. Exotic options can be variations on the payoff profiles of the plain vanillas. They can also be completely different products sporting some traits suitable for options trading.
Among other types of options are break-outs, break-in, barrier options, lookback options, Asian options, and Bermuda options.
Options prices can be models using Black-Scholes and others. Therefore, options risks can be modeled and understood. This is particularly good because you can’t do such models on other asset classes.
Different risks associated to options trading have Greek letter names. Let’s take a look at them.
Delta refers to the change in option price per unit change in the underlying price. This represents a directional risk.
You can interpret delta as the hedge ratio, or the equivalent position in the underlying security.
Gamma is the change in delta for each unit change in the underlying security. This one shows the speed at which the delta will move if the underlying security moves.
You should keep an eye on this. This is because it tells you how much greater your directional risk increases as the underlying moves. Keep in mind too that lower volatility means fewer gammas.
Theta refers to the change in option price per unit change in time. It’s also called the time decay risk.
Theta represents the amount of value loss an option has as time passes. Long-term options decay at a slower rate compared to near-term options. As the opposite of gamma, it represents the trade-off between the passing time and the moving underlying security.
Vega refers to the volatility risk or the change in option price per unit change in volatility.
For instance, if the option sports 2 vegas and the volume rises up 1 percent, the option value gains by $2. Long-term options have the greatest vegas.
Rho refers to the interest rate risk or the change in option price per unit change in interest rates.
If a position has positive Rho, an increase with the interest rate will help it. A decrease in interest rate in turn helps a position with negative Rho.
Options Trading Strategies
Now that you know all the basics and the important concepts, let’s get into some options trading strategies.
You can try to engage in simple covered call or buy-write strategy. Using this strategy, you could buy an asset right off the bat. Then you simultaneously write or sell a call option on those same assets.
The volume of assets that you own should be equal to the number of underlying assets of the call option.
You can do this when you have a short-term position and a neutral opinion on the assets. You’re trying to earn extra profits or to protect yourself from a possible fall in the asset’s value.
You can also try to buy a particular asset and buy a put option for the same amount of asset.
You can use this strategy if you feel optimistic on the asset’s price and want to veer from short-term losses.
Bull Call Spread
In this strategy, you buy call options at a specific strike price. At the same time, you sell the equal number of calls at a higher strike price. Remember that both of the call options should have the same expiration month and underlying asset.
You may try using this if you are bullish and you expect a modest rise on the underlying asset’s price.
Bear Put Spread
This is another vertical spread, just like the bull call spread. Using this strategy, you can buy put options at a certain strike price. Then, you sell the same number of puts at a lower strike price.
The two options should expire on the same date, and they should have the same underlying asset.
If you feel bearish and you expect the price to decline, this strategy could be useful. However, just as it offers limited losses, it also offers limited gains.
You use this strategy when you buy a call and a put option bearing the same strike price, underlying asset, and expiration date at the same time.
This strategy is for traders who believe the price of the underlying asset will move substantially but who are unsure of which direction.
This can allow you to keep unlimited gains. The loss is also limited to the cost of both options contracts.
When you use a protective collar strategy, you buy an out-of-the-money put option and writing an out-of-the-money call option for the underlying asset.
You can use this after a long position in a stock that has had substantial gains. You can lock in profits without selling your shares.
Using this, you buy a call and put option with the same maturity and underlying asset, but different strike prices.
You can place the put strike price below the call strike price. Both of these options should be out of the money.
You can use this strategy if you think the underlying asset’s price will move significantly but unsure about the direction. You can limit losses to the cost of both options.
Strangles are usually cheaper than straddles since you buy options out of the money.
This strategy uses the combination of a bull spread and bear spread strategies. The butter strategy also uses three strike prices.
For example, you buy one call/put option at the lowest strike price. Then you sell two call/put options at a higher or lower strike price. You then buy one last call/put option at an even higher/lower strike price.
In the iron condor strategy, you hold a long and short position in two strangle strategies. This is a little tricky, and you may have to take time to learn. You have to practice it over and over again.
In this strategy, you combine a long or short straddle with the purchase of a strangle. This look similar to a butterfly spread, but it uses both opposing calls and puts.
You can limit your loss and profits within a specified range, which depend on the strike prices of your options. You can use out-of-the-money options if you want to cut loss and limit risk.
Options trading is a very good way of trading if you have the patience to learn the strategies. Each strategy offers different benefits and advantages. However, you should definitely accumulate more experience before you jump in and try options trading.
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