Options trading strategies

Before you start trading options, you need to have a strategy. You need to know your investment goals and to find a strategy that will help you achieve them. If you want to protect yourself against potential losses on shares you already own, you'll choose a different strategy than a trader who wants to take advantage of the increased leverage that options can provide.

Basic strategies

If you're new to options trading, the best way to get started is probably with a few simple strategies.

Buying a "call" option

Buying a call option is a popular strategy for all levels of investors. With this strategy, you buy call options on a stock that you think is going up. If the stock price is higher than the strike price plus the premium paid on the expiration date, you make a profit. If you're wrong, you risk losing your entire premium.

Most call option contracts are sold before expiration, where the premium is higher. However, you can also buy the underlying security at any time before the expiration date if that is your goal.

To make a profit with this strategy, you need to have good timing and you need to know when you need to get out of the contract. If you wait too long and the stock doesn't rise high enough or fast enough, the option might not be worth exercising or selling.

Some investors choose to buy call options rather than buying stocks on margin. These options offer the same leverage, but carry less risk. If you buy a stock on margin with a CFD and the stock goes down, you may receive a margin call and be forced to add cash or liquidate assets to meet it. The only risk you run by buying call options is losing the premium.

Buying a short option (a Put)

Buying a put option is very similar to buying call options, except that here you think the stock will fall. You can use this strategy as insurance against losses on assets already held or to make a profit in a bear market. If you think the market, or a particular stock, is falling, then this strategy might be worth considering.

This strategy is often used by those who own stocks to lock in a sell price and protect themselves against a stock price drop.

It can also be used to speculate on stocks you don't own. When the stock price goes down, the premium on the option goes up, allowing you to make a profit. This can be attractive in a bear market and is an alternative to shorting stocks.

Selling a covered option (a Covered Call)

Another simple strategy is to write a covered call option. What this means is that you sell a call option for stocks you already own, or you buy stocks at the same time that you sell the call option. You receive a sum of money in the form of a premium up front and you hope that the call option will never be exercised. A trader may choose this strategy to generate additional profits on a stock that he thinks isn't headed higher, at least in the short term. This way, the covered call option acts as a dividend on the stock.

The risk associated with a covered call option is that it will be exercised and you'll have to be prepared to sell your shares to cover it. However, if the stock goes up, you can protect yourself by buying a call option of the same series that you sold and by closing out your position. The premium paid for doing this should be more or less equal to the amount you received when you sold your original call option.

Buying a covered option (Married Put)

The strategy where you buy a put option on a stock that you already own (or that you buy along with a put option) is known as a "married put". Traders use this strategy to protect themselves against losses if the stock price drops dramatically. It basically works like an insurance policy.

Price gap (spread) strategies

A spread strategy involves two trades which are typically executed at the same time. Spread strategies are a bit more advanced than the basic hedged strategies covered above, but they are useful and worth checking out. The most common type of spread is the vertical spread, in which one option has a higher strike price than the other. In a spread, each trade is called a leg. The advantage of a spread is that your risk and potential losses are minimised. The downside is that your profits are also limited.

Bull Call Spread

This type of vertical spread is used by bullish traders. Here, you can buy call options on a stock at a certain strike price while simultaneously selling a call option on the same stock at a higher strike price. Both options have the same expiration date.

Bear Put Spread

This is also a vertical spread. With this strategy, you buy put options at a certain strike price and then sell the same number of put options at a lower strike price, both on the same underlying stock with the same expiration date. This is a strategy for bearish traders who think that the stock price will fall. It is used as an alternative to shorting a stock.

Calendar/time Spread

A calendar spread consists of buying an option with one expiration date and selling another with a different expiration date. The exercise price of each option is the same. With this strategy, the idea is to take advantage of a shortened time period.

Butterfly spreads

Butterfly spreads are somewhat complicated and are best used by more experienced traders. With this strategy, traders combine an upward spread strategy and a downward spread strategy, using three different strike prices.

Straddle (Long)

Straddles are used by traders who thinks a stock will move significantly in one direction or another, but aren't sure which direction it will go. In this strategy, you buy (or sell) both a call and a put option on a stock with the same strike price and expiration date. These options offer unlimited profit potential while limiting risk.

Iron Condor

The Iron Condor is a complex strategy that consists of simultaneously holding a long position and a short position in two different "strangle" strategies. With this strategy, traders sell an out-of-the-money (OTM) put option, buy another OTM put option with a lower strike price, sell an OTM call option and buy another option purchase option OTM at a higher strike price. This strategy offers limited risk and a good probability of making a small profit.

Iron Butterfly

This is another complex strategy that combines both limited risk and limited profit. In the Iron Butterfly strategy, traders buy an OTM put option, sell an OTM put option, sell an at-the-money (ATM) call option and buy another higher strike OTM call option. Not to be confused with the 1960s rock group from San Diego that carries the same name!

Naked Calls

A naked call is a risky investment strategy in which you sell call options on an underlying security without owning it. It's risky because if the call option buyer exercises the option, then you must buy the stock at the current market price in order to fill the buyer's order. The risk in this case is unlimited, because there is no way to control the stock's market price.

Collars (Protective)

With this strategy, you buy an out-of-the-money put option while selling an out-of-the-money call option on the same stock with the same expiration date. This strategy is used by traders to lock in a profit without selling the stock.

Strangle (Long)

With this strategy, you buy both a put and a call option, both usually OTM, on the same stock with the same expiration date, but with different strike prices. This strategy is used when traders are unsure of the direction a stock is taking.

Strategies according to market outlook

Below is a list of strategies to use depending on your market expectations, whether in terms of the market as a whole or for a specific security.

Neutral strategies

• Butterfly Spreads
• Calendar Spreads
• Collars
• Iron Condors
• Married Puts
• Straddles
• Strangles

Strategies for bull markets

• Bull Call Spreads
• Bull Put Spreads
• Collars
• Covered Calls
• Long Calls
• Married Puts
• Short Puts

Strategies for bear markets

• Bear Call Spreads
• Bear Put Spreads
• Long Puts
• Naked Calls
• Short Calls
  

Exit strategies

It's key that you plan your exit strategy before you start trading to avoid incurring unnecessary losses. You can exit, or close, your position at any time before the expiration date. The timing of your exit is very important and can mean the difference between profits or losses. Before you begin, you need to decide how you're going to exit if your option is out-of-the-money, at-the-money, or in-the-money.

Closing positions

One of the ways to get out of the market is to close out your option. To do this, you can either buy an option that you sold or sell an option that you bought. Basically, it's about reversing your position. If the premium has increased since you bought the option, then you make a profit. If the premium has gone down, you can cut your losses and sell.

As an option seller (writer), you're almost never obligated to fulfill the obligation to buy the underlying security, as you can liquidate your position before it is exercised.

Again, timing is everything when it comes to options trading and you need to watch your investments closely to know when it's time to sell, either to take your profits or to cut your losses and move on. The closer you get to the expiration date, the more volatile options become, so you need to monitor them even more closely.

Renewing positions

If you don't want to close your options, you can renew them. This involves liquidating your existing position and opening a new one that's identical to the one you just sold, but with a new expiration date, a new strike price, or possibly both.

Exercising options

If you're an option holder, you can opt to exercise your option and buy the underlying security. This usually only makes sense if the option is in-the-money, because in the other two cases this wouldn't make sense.

If you're the seller (writer) of an option, you have no control over whether or not the option buyer decides to exercise it.

Once you've considered the possible scenarios and chosen your exit strategies for each case, it's important that you monitor your positions closely and follow your plan. Options trading is fast paced and it can be easy to get caught up in the moment and lose sight of your long term goals. Don't let your emotions dominate you. Stick to your plan and you'll be much more likely to see your profits increase in the long run.