Options trading may be an additional way for investors who are keen to diversify their portfolios. While options trading can be risky, investors may use some options strategies as safeguards. The Options Clearing Corporations offers a helpful document that discusses the characteristics and risks of options, which can be found on their website.
Here are some must-know options trading strategies, categorised by market sentiment.
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Bullish strategies are trading strategies used with the expectation that the price of a particular asset or the market price will rise. Investors may use these strategies to gain on upward price movement and manage risks.
Let us have a look at the bullish strategies:
Covered call strategies involve selling a call option against the shares of stock you already own. Investors or traders usually use this strategy to generate income from the premiums received.
This strategy may be used when investors anticipate a slight upward movement in the stock position.
Investors should regularly monitor the performance of the stock price when using this strategy. They need to be prepared to either roll the call option or let the shares get called away if the stock price exceeds the strike price. However, the risk is that the writer of a covered call forgoes upside stock appreciation above the strike price if assigned.
A married put options strategy involves buying a put option while simultaneously buying the underlying stock. This strategy may potentially protect against market downsides. However, the risk is that the buyer of the put might lose the premium they paid to purchase the option.
A married put strategy may be effective when investors expect shares of stock to rise but want to limit loss potential in the event of a significant downturn.
Investors need to monitor the stock’s performance carefully and consider adjusting their position per the market situation.
A bull call spread refers to buying a call option with a lower strike price and simultaneously selling one with a higher strike price.
This strategy may be deployed when traders anticipate a moderate rise in the stock price.
Investors may apply this strategy and monitor the stock’s movement consistently. However, there is a risk that an investor might lose the premium they paid to purchase the options if not exercised.
Bearish strategies are employed when traders expect the price of a specific asset or the market as a whole to fall. Deliberate application of this strategy may help generate potential profit from falling prices or protect against losses during market downturns. However, if the market or asset price does not fall as expected, the bearish strategy may result in losses.
Here are two bearish trade strategies:
A bear put spread involves buying a put option with a higher strike price and simultaneously selling a put option with a lower strike price.
This strategy may be used when investors anticipate a moderate decline in the stock price.
This strategy may lead to positive outcomes on timely consideration of closing the trade when the stock price stabilises or shows signs of rising. It can also result in losses if the stock price continues to fall. In addition to high transaction costs, there is a risk that an investor could lose the premium they paid to purchase the options if not exercised.
A protective collar combines owning the underlying stock, buying a put option, and selling a call option to create a limited-risk strategy.
This strategy may be used when investors expect a slight decline in the stock price but want to protect against significant losses.
The protective collar strategy generally involves safeguarding gains while also allowing for potential upside. However, if the underlying asset experiences a significant price increase, the protective collar strategy may limit the potential profit that could have been realised if the asset had been held without the collar. In addition to high transaction costs, there is a risk that premiums spent on options might not be recovered. Investors generally consider rolling the options a further time to the expiration date if they find the protective collar necessary and the stock remains within the desired range.
Neutral or non-directional strategies are primarily used when an investor expects the price of an asset to remain relatively stable or is uncertain about its future direction. They seek to maximize profits by capitalizing on factors other than the price movement of the asset. However, if the market or asset price does not remain stable as expected, the neutral strategy may result in losses.
Here are some common neutral options strategies:
A long straddle is a strategy that involves buying a call option and a put option with the same strike price and option expiration date.
This strategy is commonly applied when investors anticipate significant price volatility but are still determining the direction.
The long straddle strategy is often managed by adjusting the profit target based on the stock’s volatility. Investors may consider booking partial profits and tightening the stop-loss order if the stock moves significantly in either direction to secure gains. Additionally, a volatility-based exit strategy, such as selling options, may be used once volatility reaches a certain level. It’s important to be mindful of high transaction costs and the possible risk that premiums spent on options might not be recovered.
A long strangle involves buying a call option and a put option with different strike prices but the same expiration date.
Investors use this strategy when they expect significant price volatility but are unsure about the direction.
Investors may consider adjusting the strike prices if the stock’s price approaches one of the options. They may take profits on one side of the strangle if the stock experiences a significant move in one direction while keeping the other side open for potential gains. However, if the stock price does not move as expected, the long strangle strategy may result in losses. Regularly reassessing the trade and closing the position might be necessary if the stock’s volatility decreases. It’s important to be aware of high transaction costs and the potential risk of not recovering premiums spent on options.
A long call butterfly spread involves buying two call options with lower and higher strike prices while selling two call options with an intermediate strike price at the same time frame.
This strategy is applied when investors expect the stock price to remain range-bound.
Manage this strategy by monitoring the stock’s price movements and adjusting the strike prices of the options to maintain the desired risk-reward profile. Capitalize on profits if the stock price reaches the upper or lower break-even points. Don’t forget to consider adjusting the position by considering to roll the options or open new spreads to capture potential additional gains. Rolling options out to a later expiration date for additional premium extends the trade’s duration and moves the break-even point without allocating additional capital or increasing risk. In addition to high transaction costs, there’s also a possible risk that premiums paid for options might not be recovered.
An iron condor strategy combines selling an out-of-the-money put spread and an out-of-the-money call spread. This constitutes a limited-risk strategy.
This strategy is usually used when traders anticipate the stock price to remain within a specific range.
Investors can effectively manage an iron condor strategy by considering adjustments to the strike price if the stock moves closer to either spread. It is necessary to regularly assess the overall risk-reward profile and make necessary adjustments to maintain a suitable balance. In addition to high transaction costs, there’s also a possible risk that premiums paid for options might not be recovered.
An iron butterfly combines selling an at-the-money put spread and an at-the-money call spread, resulting in a limited-risk strategy.
This strategy is used when investors anticipate low volatility and expect the stock price to remain close to the current level.
Using this strategy requires continuous evaluation of stock prices and adjusting the strike prices if the stock approaches one of the options. Investors can take profits once the stock reaches a desired target price level. They may also consider adjusting their position by rolling the options or opening new positions. However, this strategy has a negative vega. This means that the net credit for establishing an Iron Butterfly rises when volatility rises (and the spread loses money). When volatility falls, the net credit of an Iron Butterfly falls (and the spread makes money).
Investors need to regularly monitor the position and be prepared to close it if the stock moves significantly beyond the desired ranges. Along with the consideration of high transaction costs, investors should be aware of the possible risk that the premiums paid for options might not be recovered.
In general, options contracts are traded in lots of 100 shares of stock. Traders may require anywhere from a few hundred to several thousand dollars to trade options. This is an approximate estimate, considering the premium cost and assuming one option contract.
The amount of money required to trade options varies depending on various factors, including:
Options are traded on assets like stocks, exchange-traded funds (ETFs), or indices, and the price of these assets can vary widely. Options on high-priced stocks like Amazon or Google, for instance, would generally require more capital compared to options on lower-priced stocks.
The strike price is the predetermined price at which an option can be exercised. In-the-money options with lower strike prices generally have higher premiums. This means that they require more capital to trade.
The amount required also depends on how many contracts you want to trade. Usually, each options contract contains 100 shares of the underlying asset. The cost of each contract must be multiplied by the number of contracts you wish to trade. This can be sustained by continuously checking the options’ expiration date when they are rendered null and void. The options expiration time is more specific and should be distinct from the last time to trade that option.
It is important to know that all options have transaction costs and option strategies that call for multiple purchases and/or sales of options contracts, such as spreads, collars, and straddles, and others, may incur significant transaction costs.
Investors can consider the following additional factors while buying options:
Sufficient Funds and Margin Requirements: Investors should ensure they have sufficient funds to cover potential losses and meet margin requirements when trading options. Options trading can involve considerable risks that may impact the premium paid for an options contract. Additionally, certain strategies might necessitate maintaining a specific amount of money in the trading account as collateral, commonly known as the margin requirement.
Brokerage Service Requirements: Different brokerage services have varying minimum account balance requirements. Investors can consult brokers for accurate information about their minimum balance and margin requirements.
Variable Investment Amount: The amount of money required to trade options can vary significantly, as discussed earlier in the article. Investors should be aware that carefully considering their risk tolerance, investment goals, and financial capabilities is important before engaging in options trading.
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You can keep these steps in mind while starting your options trading journey:
You should have a solid understanding of options before you begin. You can learn about the different options strategies, risk management techniques, and terminology used in options trading. There are numerous educational resources available, including books and online courses about option trading. These resources often come with tutorials that can help you gain knowledge and build confidence.
You can choose a trustworthy and reputable brokerage firm that offers options trading services. It is helpful to research different brokers, compare their fees, platforms, and tools, and select one that suits your needs. Once you’ve chosen a broker, you can follow their account opening process, which may involve providing personal information and completing the necessary paperwork.
You will need to deposit funds into your account after it is set up. The amount you deposit will depend on your investment strategy and risk tolerance. It is important to have enough capital to cover potential losses and meet margin requirements.
It helps to have a concrete trading plan to begin options trading. You can start by defining your investment objectives and establishing guidelines for position sizing, and entry and exit points. You can also work on risk management strategies that align with your risk tolerance. A well-thought-out plan can help you remain disciplined and make informed trading decisions.
Consider using virtual trading platforms that simulate real market conditions. This can be helpful in analysing results and identifying your areas of strength. You can begin trading gradually with small positions to start the actual trading journey.
Choosing a reputable broker or trading platform is critical to options trading. A reliable broker offers robust tools, real-time data, and a user-friendly interface to execute trades efficiently. They provide educational resources and support to help you navigate the complexities of options trading. The right platform gives you confidence in trading, access to diverse options contracts, and reliable customer service.
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There is no universal checklist for entering options trades. Here’s what you need to consider:
1. Assumption: The assumptions underlying your trade, such as the anticipated direction of an underlying asset’s price movement, the period horizon, and technical factors that influence your investment decisions
2. Liquidity: Make sure the options contracts you plan to trade have sufficient trading volume and tight bid-ask spreads.
3. Implied Volatility and IV Rank: Understand the current level of implied volatility and its rank relative to historical levels to know whether options premiums are expensive or inexpensive.
4. Binary Events: Consider any upcoming binary events, such as earnings announcements, economic reports, or regulatory decisions, that could impact an underlying asset.
5. Strategy: Consider that different strategies, such as covered calls, straddles, or vertical spreads, offer varying risk-reward profiles and align with different market conditions.
6. Return On Capital: Evaluate the potential return on capital for each options trade. You must aim for a favourable risk-reward balance that aligns with your financial objectives.
You can close a winning trade by exercising your options contract. Based on your strategy and goals, you can choose any one of these options:
Here’s what you need to consider while closing a losing options trade:
1. Cut losses with a stop-loss order: You can set a stop-loss level before you enter a trade, which is the price at which the trade will be automatically closed out if it reaches that level, to limit your losses and protect your capital.
2. Sell to close: You can close the position by reselling any options contracts that are depreciating.
3. Adjust or roll the trade: You may have the flexibility to adjust or roll the trade to minimize losses. For instance, the options may need to be rolled to a later expiration date, or their strike prices may need to be changed.
Options trading, like any form of investing, carries risk. No strategy guarantees profitability or absolute safety. Some strategies potentially allow for advanced risk-management abilities. They include covered call writing, cash-secured puts, and collar strategies.
