Generally speaking, the basics of trading stocks are fairly straightforward. To the greatest extent possible, the goal is to buy stocks that will increase in value and to sell stocks before they are about to decrease in value. However, even once you are able to grasp this basic concept, the stock market—as a whole—immediately begins to become a bit more complicated. One of the more complicated components of the stock market that some novice traders tend to overlook is the options market.
Options contracts are contracts that give the holder the right to buy or sell a stock at a specific price at a specific point in time. If you have the right to buy a stock for $75, but the stock is trading at $100, this contract will be inherently valuable (also known as “in the money”) because you could immediately make a $25 by simply buying and then immediately selling. An options contract that gives you the right to buy a stock for $125, on the other hand, will be useless if the stock is selling on the market for $100 or any lesser value (also known as “out of the money”).
As you can see, options can be rather tricky because they require you to have a reliable understanding of what the underlying asset (a security, a commodity, or even real estate) will likely be worth in the future. Options contracts are desirable for a variety of different reasons. Options not only make it possible to access positions that would otherwise be unaffordable (such as going long on Berkshire Hathaway Class A stock), but they also make it possible to access more complicated positions, as well. But perhaps most importantly, traders pursue options because these contracts help them limit their exposure to risk in various different situations.
The best options trading strategies will involve many of the same mechanisms as the best stock trading strategies, only with an additional layer of speculation (beyond going up or down, you’ll also speculate how high or how low the underlying asset will move). Fortunately, there are many strategies you can utilize to make your options trading a bit more effective. Below, we will discuss six options trading strategies that will help you manage risk and maximize the probability of generating strong returns.
1. Bull Call Spread
For many options trading strategies, one of the most important factors for you to keep in mind will be whether you believe the asset is moving in a bullish (price will go up) or a bearish (price will go down) direction. Call options are options contracts that give you the right to buy—or “to call”—an asset a specific strike price at some point in the future. Keeping these things in mind, it is easy to see why any strategy with the term “bull call” in it will involve purchasing the right to buy, assuming that prices will rise. In essence, a bull call spread is a “vertical spread” strategy in which an investor will buy a call at a specific price while also selling call options at an even higher strike price. In this scenario, the breakeven point for the investor will be somewhere between the lower and higher strike price. As the price approaches the strike price, their profit will increase (though the upside of the position will be limited).
2. Covered Call
The covered call trading strategy, like most options trading strategies, is one of the most effective methods for traders to limit their exposure to long-term risk. It is also extremely popular for both amateurs and for seasoned traders. This particular strategy involves simultaneously involves purchasing shares of stock and along with corresponding call options. By doing this, the trader can protect themselves from declines in the stock’s underlying value. One reason why this particular approach is popular is that the breakeven point will be below the strike price, which helps reduce the risk of speculation.
3. Bear Put Spread
Put options give the trader the right to sell at a specific price in the future and, naturally, a bearish put strategy is ideal for traders who want the option to sell and also believe the price of the underlying asset is likely to decrease. Essentially, the bear put spread is the exact inverse of the bull call spread. Both positions have both limited upsides and limited downsides, with a reasonable window of opportunity for earning a profit. In general, this strategy is ideal for traders who anticipate a mild decrease (rather than an extreme decrease) in the underlying asset’s market value.
4. Married Put
This is yet another strategy that involves the simultaneous purchase of both the underlying asset and corresponding options. In many ways, the married put effectively creates an “insurance policy” because it functionally establishes a price floor. Even if the stock’s value were to, hypothetically, fall to zero, the presence of the put options risks the trader’s exposure to market uncertainty. While selling at the strike price will yield a net loss, this loss will be limited; once the cost of the put can be overcome, this position has unlimited upside potential.
5. Iron Condor
The Iron Condor options strategy gives traders a considerable amount of flexibility, due to the fact that they can control precisely where the “range of profitability” might be. The profit-loss graph for this particular strategy (along with the iron butterfly, mentioned below) is symmetrical. To successfully complete an iron condor trade, the investor will simultaneously purchase bull put spreads, along with a bear call spread. Due to the graph’s symmetrical nature, this strategy is most useful in predictable markets. It is also useful for traders who simply want to control their exposure to risk (and are willing to lose a little bit of reward potential).
6. Iron Butterfly
The iron butterfly options strategy is one that is rather complex but is also an excellent risk-reward management tool. To execute this strategy, the trader will need to enter into four positions: an at-the-money put, an out-of-the-money put, an at-the-money call, and an out-of-the-money call. In doing so, they will create a controlled range of profitability, while simultaneously limiting their downside exposure.
Conclusion
By adding options trading strategies to your financial strategy and your general approach to the market, you can control your exposure to risk and take advantage of various market conditions. While you will certainly want to learn more about options trading before assuming any real risk, each of these six approaches can help get you pointed in the right direction.
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