10 Options Trading Strategies You Should Know

10 Options Trading Strategies You Should Know

Investing with options, an advanced trader will tell you that it is all about customization. Rewards can be high so can the risk and your choices are plenty. But getting started isn’t easy, and there is potential for costly mistakes.

Traders jump into the options game too often with little or no understanding of how many options trading strategies are available to reduce their risk and maximize return. With a little bit of effort, however, traders can learn how to take advantage of the flexibility and full power of options as a trading vehicle.

This article will focus on options trading strategies. But first, let’s discuss first the things you should know before trading options.

Business team hands at work with financial reports and a laptop regarding trading options.
Business team hands at work with financial reports and a laptop regarding trading options.

Things You Should Know Before You Trade Options

Option trading is for the DIY investor

Typically, option traders are self-directed investors. Basically, they don’t work directly with a financial advisor to help manage their options trading portfolio. As a do-it-yourself (DIY) investor, you are in full control of your trading decisions and transactions. But that doesn’t mean you’re alone.

There are plenty of communities that bring traders together to discuss things like current market outlook and options trading strategies.

Most beginners start with stock options       

Options based on equities, more commonly known as “stock options,” typically are a natural lead for traders new to options. Stock options are listed on exchanges like the NYSE in the form of a quote. It is important to understand the details of a stock option quote before you make a move. For example, the cost and expiration date.

There are different types of options. 

Options are contracts that give the owner the right to buy or sell an asset at a fixed price. That specific period could be as short as a day or as long as years depending on option contract type. Fortunately, there are only two types of standard option contracts: a call and a put.

call option contract gives the owner the right to purchase 100 shares of a specified security at a specified price within a specified time frame.

put option contract gives the owner the right to sell 100 shares of a specified security at a specified price within a specified time frame.

It’s important to note, for both types of option contracts, the owner is not obligated to exercise his or her right to buy or sell.

Options trade on different underlying securities

Options can be used in many ways. It’s either speculate or reduce risk, and trade on several different kinds of underlying securities. The most common underlying securities are equities, indexes, or ETFs (Exchange Traded Funds).

There are quite a few differences between options based on indexes versus those based on equities and ETFs. It’s important to know the differences before you start trading.

Option trading is all about calculated risk     

If statistics and probability are in your wheelhouse, chances are volatility and trading options will be, too. As an individual trader, you really only need to concern yourself with two forms of volatility: historical volatility and implied volatility.

Historical volatility represents the past and how much the stock price fluctuated on a day-to-day basis over a one-year period.

Implied volatility is based on what the marketplace is “implying” the volatility of the stock will be in the future.

Option traders speak their own lingo        

When trading options, you can buy a call or sell a put. You can be long or shortand neither has anything to do with your height. Consequently, you can also be in-the, at-the, or out-the-money. Those are just a few of many commonly used words you’ll hear in a room full of option traders.

Simply put, it pays to get your terminology straight. That’s why we decided to create an option trading glossary to help you keep track of it all.

Option traders borrow from the Greeks  

Options traders use the Greek Alphabet to reference how option prices are expected to change in the market. It is critical to success when trading options. The most common ones referenced are Delta, Gamma, and Theta.

Although these handy Greek references can help explain the various factors driving movement in option pricing and can collectively indicate how the marketplace expects an option’s price to change, the values are theoretical in nature. In other words, it is never a 100% guarantee that these forecasts will be correct.

Option trading starts with your financial goals

Just like many successful investors, options traders have a clear understanding of their financial goals and desired position in the market. The way you approach and think about money, in general, will have a direct impact on how you trade options. The best thing you can do before you fund your account and start trading is to define your investing goals.

10 options trading strategies you should know

options trading strategies infographic

  1. Covered Call

Aside from buying a naked call option, you can also use a basic covered call or buy-write strategy. In this strategy, you would purchase the assets outright, and simultaneously write a call option on those same assets. Your volume of assets owned should be equivalent to the number of assets underlying the call option.

Investors will often use this position when they have a short-term position and a neutral opinion on the assets. They are also looking to generate additional profits, or protect against a potential decline in the underlying asset’s value.

See Also: What is Position Trading?

  1. Married Put

In a married put strategy, an investor who purchases or currently owns a particular asset, simultaneously purchases a put option for an equivalent number of shares.

Investors will use this strategy when they are bullish on the asset’s price. Also, they will use it to protect themselves against potential short-term losses. This strategy essentially functions like an insurance policy, and establishes a floor should the asset’s price plunge dramatically.

  1. Bull Call Spread

In a bull call spread strategy, an investor will simultaneously buy call options at a specific strike price and sell the same number of calls at a higher strike price.

Both call options will have the same expiration month and underlying asset. This type of vertical spread strategy is often used when an investor is bullish and expects a moderate rise in the price of the underlying asset.

  1. Bear Put Spread

The bear put spread strategy is another form of vertical spread​ like the bull call spread. In this strategy, the investor will simultaneously purchase put options at a specific strike price and sell the same number of puts at a lower strike price.

Both options would be for the same underlying asset and have the same expiration date. This method is used when the trader is bearish and expects the underlying asset’s price to decline. It offers both limited gains and limited losses.

  1. Protective Collar

A protective collar strategy is the purchase of an out-of-the-money put option and writing an out-of-the-money call option simultaneously. This strategy is often used by investors after a long position in a stock has experienced substantial gains. In this way, investors can lock in profits without selling their shares.

  1. Long Straddle

A long straddle options strategy is when investors purchase both a call and put option with the same strike price.

An investor will often use this strategy when he/she believes the price of the underlying asset will move significantly. But he/she is unsure of which direction the move will take. This strategy lets the investor maintain unlimited gains, while the loss is limited to the cost of both options contracts.

  1. Long Strangle

In a long strangle options strategy, the investor purchases a call and put option with the same maturity and underlying asset, but with different strike prices. The put strike price will typically be below the strike price of the call option, and both options will be out of the money.

An investor who uses this strategy believes the underlying asset’s price will experience a large movement. But he/she is unsure of which direction the move will take. Losses are limited to the costs of both options. Strangles will typically be less expensive than straddles because the options are purchased out of the money.

  1. Butterfly Spread

In a butterfly spread options strategy, an investor will combine both a bull spread strategy and a bear spread strategy. It will also use three different strike prices.

For example, one type of butterfly spread involves purchasing one call (put) option at the lowest (highest) strike price, while selling two call (put) options at a higher (lower) strike price, and then one last call (put) option at an even higher (lower) strike price.

  1. Iron Condor

An even more interesting strategy is the iron condor. In this strategy, the investor simultaneously holds a long and short position in two different strangle strategies. The iron condor is a fairly complex strategy that definitely requires time to learn, and practice to master.

  1. Iron Butterfly

Finally in this strategy, an investor will combine either a long or short straddle with the simultaneous purchase or sale of a strangle. Although similar to a butterfly spread, this strategy differs because it uses both calls and puts.

Profit and loss are both limited within a specific range, depending on the strike prices of the options used. Investors will often use out-of-the-money options in an effort to cut costs while limiting risk.

See Also: Pros and Cons of Swing Trading

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