Options trading allows traders to take advantage of price swings without paying for the underlying security. It is beneficial for those who prefer a more hands-off approach and wishes to avoid monitoring stocks or those with minimal capital as it costs less than buying the actual shares. Options traders should use strategies when trading to maximize their return on investment (ROI).
Buy and sell options
Buying and selling options is a simple strategy that consists of two steps: buying a call or put option and selling the same type of option at a higher price. To better understand this strategy, consider an investor who expects a significant stock to rally in the next few weeks. The investor could buy a share/contract now and hope for growth.
However, if he feels that he can get it cheaper with waiting, this strategy would be suitable as he can buy the share/contract now and sell them when they increase in value later. He can also do the reverse; sell now but repurchase it later when it is cheaper (known as “buy to open” and “sell to close”).
Using a long straddle involves buying both a call and put option with the same expiration date and strike price. It is usually used when traders expect little movement in the price of an underlying security, quite like Strategy 1.
Of course, there is always the possibility that the stock skyrockets or plummets; should that happen, then this strategy can be very profitable for you. If you think about it carefully, you might realize how risky it can be as well: if the stock doesn’t move at all (or moves too much), then your return on investment will be zero. To avoid such a scenario, look for strategies where losses are limited.
Covered call writing
A covered call writing strategy includes owning a stock and selling a call option against it. In this way, you gain from the premium received from the sale and dividends on shares that you hold. However, if the underlying security price rises, your returns will be capped to strike price minus current stock price (minus premiums collected). This strategy also works best to generate income, and don’t mind tying up your capital in long term investments.
An iron condor is an options spread strategy where one simultaneously buys and sells put and call options for stocks with similar expirations but different strike prices. Using covered call writing, buy Puts/Calls at strikes H1 and L1 while selling those at H2 and L2. The H1-L1 strangle your “body” while the H2-L2 strangle the “wings”. This strategy works best if you expect a moderate rise or decline in a stock’s price but have no strong view of whether it will go up or down.
This strategy involves owning stocks and selling call options against them, much like writing covered calls, but you also own the underlying security this time. In other words, you sell call options on shares that you already own. One benefit of this strategy is that you can hold onto your investment for a more extended period since your capital isn’t tied up to options premiums. However, your returns are capped at the strike price plus the premiums received.
You can use this strategy to hedge investments, especially if you are holding a large number of stocks in one particular company. With this strategy, you would simultaneously buy puts on all your stocks or any fraction thereof that makes up 5% or less of your portfolio value. If done correctly, you will secure the price floor for all your holdings should anything go wrong with one of them.
This way, you are immune to losses from an individual stock falling into distress as long as it doesn’t affect more than 5% of your portfolio value. However, because these contracts have no premium associated with them, you can limit your returns. If nothing happens within the time frame of the options, you won’t gain anything.
The strategy is similar to that in protective puts, but this time you are hedging against falling while still providing yourself with returns on your investments. You do this by buying out-of-the-money puts for protection and simultaneously selling out-of-the-money calls slightly to receive a premium.
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