Basic Options Trading Strategies You Need to Know
As with anything in the trading world, options trading might seem intimidating and overwhelming at a glance. However, if you can get over a few key points, things will click into place. When it comes to trading, there are a few asset classes. You have stocks, bonds, ETFs, mutual funds, etc. Options are also an asset and they offer something that stocks and ETFs do not. In this article, we will discuss the basics of options trading strategies.
- What are Options?
- Basic Options Trading Strategies for Beginners
- Learn Effective Options Trading Strategies with AsiaForexMentor
What are Options?
If you are new to the whole game, we need to understand options trading for beginners. Options are contracts that give you the right to buy or sell a certain amount of assets at a certain price until expiry, but not the obligation. You can choose to exercise your right to the underlying asset if you want to, but you do not have to. You can buy options just like any other asset through your brokerage account.
When you buy an option, you would be charged a certain amount of “premium” by the seller for the right. If the market goes south for you, you can just let the option expire without getting any value from it. You would be at a loss, but the losses would never be higher than the premium. On the other hand, the option sellers have a greater risk, which is the reason why they require you to pay a premium for buying options from them.
Options can enhance your portfolio through added income, protection, and leverage. Depending on the current situation, your investment goal may require the purchase of options. A good example here would be to use options to hedge against a declining stock market to reduce downside losses. You can also use options to create recurring income. Moreover, options are speculative vehicles such as that for wagering in the direction of a stock.
Of course, similar to stocks and bonds, there are risks in options trading. There are speculations and risks involved, so if you do not know what you are doing, options trading is a good way of losing a lot of money.
Options belong to a group of security called derivatives. Options are derivatives because their values are tied to the value of something else. If you purchase an options contract, that means you have the right to buy or sell the underlying asset, but not the obligation to do so.
In options trading, you have call and put options, which are the rights to buy and sell the underlying asset respectively. So with options, you can do four things with them. You can buy/sell calls and puts.
How Options Work
When it comes to determining the value of options contract, it is all about understanding the probable future value. The more chance something is going to occur, the more expensive the option would get. For example, a call value for stock goes up because it is believed that the value for that stock would go up in the near future.
Options can expire, which is one of the reasons why options are risky. Plus, their values are tied to their expiration time. The less time until expiry, the less value an option has. This is because the probability of a price move in the underlying asset goes down. For this reason, traders consider options as a wasting asset. For instance, suppose you buy a one-month option. However, the stock does not move the way you want it to. Every passing day, the value of your option goes down.
Therefore, time is a component to the price of your option. A three-month option is going to worth more than a one-month option. On the flip side, the same option that expires in three months will cost you more than one that expires in a month.
Another contributing factor to option is volatility. Uncertainty raises the odds of an outcome. If volatility for an asset increases, the large price swings may result in substantial price move up and down. This makes it more likely for an event to occur, therefore increasing the price of the option.
Also read: Price Channels
Why Trade Options?
There are a number of reasons why people engage in options trading.
One of its most common use is as a speculation vehicle. Speculation is just a bet on future price movement. For instance, through fundamental or technical analysis, you believe that the price of a stock would go up. You then buy the stock, or a call option on the stock. The difference between the two is that options give you leverage. A call option is a lot cheaper than buying the stock outright. This means, you can spend a few dollars to acquire the rights to that stock without paying the full price.
An alternative use for options would be hedging. In their infancy, options were actually created for hedging purposes. The idea behind hedging with options is to reduce the risk at an affordable price. In a sense, options are little more than an insurance policy. Similar to how you have insurance for your health, house, and car, options are insurance for your investment against a downturn.
Suppose that you want to invest in technology stocks. However, you also want to lower your risk by limiting your losses. Through put options, you can limit your downside risk and enjoy all the benefits from the upside without investing a large amount of capital. Short-sellers can also benefit from options trading as well. They can use call options to limit losses if the price moves against them.
Basic Options Trading Strategies for Beginners
A lot of people often get into options trading without really understanding the fundamentals. Luckily, there are many strategies to help you minimize your loss and maximize your returns. With a bit of practice, preferably on a demo account, you can make some decent returns. With this in mind, here are some basic options trading strategies. India, US, UK, it does not matter where you are. These strategies are effective. Consider this your starter options strategies cheat sheet.
Also read: Ichimoku Article
With options calls, you just buy a naked call option. A naked call is when you sell call options on the market without actually owning the underlying security. The idea is that you collect the premium from the call option and hope that it expires worthless for the buyer. If it does, then you don’t have to pay a single penny to the buyer. If the price of the underlying asset goes up, you end up having to sell the asset at below-market price when your buyer decides to exercise their right to buy the asset. So, the profit then comes in the form of the premium you get from the buyer. However, this has a huge downside considering that the price can go up virtually endlessly.
Alternatively, you can also go for covered calls or buy-write. The idea is that you buy and write (sell) a call option on that asset simultaneously. The idea here is to create income from option premiums. In a way, you are covering both lanes here. If your asset goes down in price, your call option premium would limit your loss. If your asset goes up in price, your investment in that asset would limit the loss. That way, the risk is minimized.
A covered call is viable when you have a short-term position in the stock and a neutral opinion about the future direction. In other words, you do not expect drastic movement in the market. If you only expect a minor increase or decrease in the underlying asset price, then this strategy would work best. So, you can generate income by selling the call to get the premium or guard against a potential decline in the stock’s value.
In this strategy, you buy an asset, let’s say stock, and also buy put options for an equivalent number of shares. The goal is to protect against the depreciation in the stock’s price. Using this strategy, you may lose a small amount of money even in the worst possible scenario. The upside is that you can benefit from price appreciation from the bought asset. The downside is that the put options you bought may come with a hefty premium, which can cut into your profit margin. What you get with this strategy is insurance by creating a price floor just in case the price plummets.
The married put strategy is a bullish strategy that traders use when they are unsure of the near-term potential of the stock. When you own the stock and a put option to cover it, you can reap the benefit of the stock ownership such as getting dividends and the right to vote. There is an unlimited upside since the stock price can go up infinitely. However, should it fall, the put option comes into play. Simply put, at the moment of the purchase of the put option, if the asset is traded at the strike price, your loss would just be the price you paid for the option. Nothing more.
Bull Call Spread
This strategy is particularly effective in capitalizing on a limited price increase in an asset. The idea is to use two call options to create a range of lower and upper strike prices. You choose the asset you think will go up in price slightly in a certain period of time. Then, you buy a call option for a strike price above the current market, with an expiration date of your choosing, and pay the premium. Then, you sell a call option at a higher strike price with the same expiration date and collect the premium.
The idea is to use the premium you get from your call option to cover the premium you paid for the call option. Again, the idea is to limit your loss if things go wrong. As you might expect, the trade-off here is that your gains are also limited. Many traders make use of this strategy when there is high volatility.
Also read: Gartley Pattern
Bear Put Spread
In the event that you expect to see a massive price decrease in the foreseeable future, you use this strategy to capitalize or limit the loss if you wish to hold onto the option trade. This strategy involves you buying put options and selling the same number of puts on the same asset at a lower strike price, at the same expiration date. Your profit then would be the price difference between the two strike prices, minus the net cost of the options.
Similar to the Bull Call Spread strategy, the upsides are that you get to limit your loss since selling the put option helps cover the price of buying the put option and then some. The downside is that your gains would be limited as well.
If you think that the underlying asset would decrease in value by a certain amount, then the right play would be to go for the bear put spread strategy. However, if the stock price goes much lower than anticipated, then you forfeit the additional profit.
This strategy is best implemented when you expect an explosive price movement. You typically see this strategy in motion before news reports such as the passage of a law, an earnings release, the result of an election, etc. Traders assume that the market is anxious about the upcoming event, and so the overall sentiment is uncertain and trading volume is small. When the anticipated event occurs, it can lead to a breakout in the market as traders let out their pent-up bullishness and bearishness, which generate volatility in the market.
Since you do not know whether the event would send the market in a bullish or bearish spiral, the logical strategy would be to go for the long straddle. You simply buy a long call and a long put on the same asset with the same strike price and expiration date. With this strategy in place, it does not matter whichever way the market moves. You profit either way.
The profit or loss depends on how much the price moves. The more, the better. Therein lies the risk. Suppose that the market would not react strongly to the event. But no one would know for sure until the event occurs. Traders may raise prices in anticipation of the explosive price movement. That means, you spend a fair amount of money on buying the options. If there is no strong movement, your options may expire worthless, therefore creating a loss.
Learn Effective Options Trading Strategies with AsiaForexMentor
Of course, these strategies depend on your trading style. Pick one that suits your methods and with a bit of practice, you will see yourself making some money. As you might suspect, it might be easier said than done. What you need to understand is that there is no guaranteed profit option strategy. All the options trading strategies books you read will tell you that the strategy only works in certain circumstances. The most you can find is the most successful options strategy but even that only puts you in a situation with a high probability of returns.
As a novice trader, your best bet to get started is to read online articles like this or download and read options trading strategies pdf to orient yourself in the ways of the trade. When you understand the basics, you can try out strategies you discover in your research. The initial education phase will take a while, especially if you have a day job and want to make some more money on the side. But it is well worth the effort.
From there, you want to practice what you learned. The best way to do so would be through a demo account. There, you would have a safe environment to try things out. A demo account comes with virtual currency and real market data to play around with. That way, you can see how well you would do as if you were in the real market. Many trading platforms provide a demo account for free, so there is no reason not to have one.
If you are new to the game and want to get started trading as soon as possible, consider enrolling in our One Core program. At AsiaForexMentor, we are cited as one of the best trading academies out there. With our course, you will understand our versatile ROI-based trading system that enables you to work in virtually every market so long as it has a chart. For this reason, we are usually the final stop for trading education for many traders. We equip them with an effective trading system and they go on to make a decent living just by trading.
If there is only one thing to take away from this, it would be our five-part trading course that you can get for absolutely free. It provides some fundamental trading tips to enhance your trading effectiveness. With the value we provide in our free material, you will understand the value we provide in our full course. We will equip you with everything you need to know about options trading strategies and more.