Options are popular financial instruments that offer investors and traders flexibility through the use of leverage and the ability to hedge against unfavourable market movements.
Option trading can be complex for new market participants, and can expose traders to big losses. It is imperative for traders to learn useful option trading strategies to reduce risk and optimise their trades.
We have put together some of the most commonly used option trading strategies and important trading metrics that option traders use.
What is option trading?
Option trading is the buying and selling of financial instruments called options.
Options are derivative contracts that give the holder the right to buy or sell an underlying asset at a predefined price on or before a specific date. The underlying asset can be stocks, indices, fixed-income assets, foreign exchange, commodities and exchange-traded funds (ETFs).
Option contracts differ from futures contracts because the holder is not obligated to buy or sell the asset. An option contract usually represents the right to buy or sell 100 units of an underlying asset. Margins can be used to trade option contracts.
The two most basic types of option contracts are call and put options. A call option allows the contract holder to buy the underlying asset at a stated price within the predefined time frame. A put option gives the contract holder the right to sell the underlying asset at a stated price within the predefined time period.
Option contracts can differ with respect to their expiration dates. For example, American options can be exercised at any given time before they are due. European options can only be exercised on the expiration date.
There are special option contracts called perpetual options that come without an expiration date. However, their use is limited and trading only takes place over-the-counter (OTC).
In OTC markets, assets change hands directly between counter parties without the need for a centralised exchange. Trading in OTC markets is usually facilitated by a network of brokers.
How do options work?
A trader will buy a call and sell a put depending on their outlook for the underlying asset. Typically, a call option has a bullish buyer and a bearish seller, whereas a put option has a bearish buyer and a bullish seller.
Let’s take a look at an option trading example. A trader is bullish about stock X that is currently trading at $48. Instead of buying 100 shares of X, the trader purchases an X September 50 call contract with a strike price of $50. The premium of the contract will be about $2 and the total price of the contract $200 ($2 x 100).
Let’s say that the contract’s expiration date is the last Friday of the month. For the option contract to be ‘in-the-money’, X has to trade above the strike price of $50. Furthermore, since a premium paid per share is $2, X would have to trade at $52 for the trade to break even.
If X rises to $60 before expiration, the premium on the X September 50 call contract will rise to about $10. The contract will now be worth $1,000 ($10 x 100). If a trader sells the contract with X trading at $60, they would book a profit equal to the difference between the contract’s buying and selling prices, which in this case is $800 ($1000 – $200).
However, if the market goes against the trader and X drops below the strike price of $50 on the expiration date, the option contract will be deemed ‘out-of-the-money’ and will expire worthless. This will result in the trader losing all their initial investment.
What is an option trading strategy?
There are various strategies for option trading that traders can apply to both limit risk and maximise profits. Although, please note that all trading contains risk. The four most basic types of option strategies are long call, short call, long put and short put.
A long call is when a trader buys a call option in anticipation that the underlying stock will increase in price.
According to options trading analytics firm WiseTrader founder Guy Cohen’s book The Bible of Option Strategies, the advantage of a long call is that it is cheaper than buying the stock, offers uncapped profit potential and leverage.
Cohen also pointed out that its disadvantages include the potential for a 100% loss on the initial investment and risk of high leverage if the market moves against the trade.
A short call is when a trader sells or shorts a call option in anticipating that the stock price will fall.
According to Cohen, this strategy can be profitable when the stock is in a downtrend or range bound. However, the risk potential is uncapped if the stock price rises.
A long put is typically bought by an options trader with a bearish outlook on the underlying stock.
A long puts allow traders to speculate on the declining prices and can be executed using more leverage compared to shorting the stock. However, long puts can result in 100% loss, depending on the strike price, expiration dates and underlying asset.
A short put is when a trader sells a put option where they relinquish their right to sell. Short puts allow traders to profit from a rising or range bound stock, but can expose holders to unlimited risks.
“Not a strategy for the inexperienced. You must only use this strategy on stocks you’d love to own at the put strike price you’re selling at,” Cohen said.
“The problem is that if you were to be exercised, you’d be buying a stock that is falling. The way to avoid this is to position the put strike around an area of strong support within the context of a rising trend.”
Covered calls are another common type of option trades. A trader sells a call option contract and simultaneously purchases the underlying asset to reduce risk.
This way the trader’s short call is covered by their long position, if the price of the asset rises. A trader with a naked position does not have this cover, which may result in relatively more losses versus a covered position. However, of course, all trading contains risk.
“In many cases, the best time to sell covered calls is either at the same time you establish a long equity position, or once the equity position has already begun to move in your favor.”
A married put is when a trader purchases a stock and buys put options for an equal number of shares at the same time. A married put is also known as a protective put.
A married put hedges against losses when the price of a stock drops. Put options become profitable when the price of the underlying asset falls, so traders can use a married put as an insurance policy when building long positions in a stock.
The main drawback of a married put is that the trader will lose their premium on their put options if the price of the stock doesn’t fall.
Key risks associated with option trading strategies
Options are a flexible financial instrument that offer investors various methods to earn returns and hedge their positions. However, there are risks that come with options trading, some of which are listed below:
Options are complex financial instruments that can be difficult to understand for a new trader.
Option trading strategies are integral to option trading which depend on the bullish, bearish and neutral outlooks for the underlying asset and the risk tolerance of the investor. Traders may find it difficult to choose a suitable option trading strategy.
An options trader needs to be well-versed with the concepts of fundamental and technical analysis to evaluate the outlook for the underlying asset. This is referred to as underlying asset risk.
Options trading can expose traders to unlimited risk.
Options contracts are leveraged trading instruments which can multiply losses as well as profits
Returns from options trading depend on various factors such as strike price, expiration dates, market volatility and hedging strategies.
Option trading is more complex than spot trading, as the trader has to select a strike price, expiration date and open position based on their market outlook for the underlying asset. Learning about the underlying asset and various trading strategies is vital.
Always conduct your own due diligence before trading. Remember that your decision to trade or invest should depend on your risk tolerance, expertise in the market, portfolio size and goals. Never trade money that you cannot afford to lose.
What are the basic options strategies?
The four most basic types of option strategies are long call, short call, long put and short put. Remember, options trading contains risk and you should always conduct your own due diligence before opening a position.
What is the safest option strategy?
Each option strategy comes with its risks and benefits. A trader must study and understand which option trading strategies suit their market outlook and risk tolerance.
Which option trading strategy is the most profitable?
Each option strategy comes with its risks of losses. Traders should always conduct their own research to evaluate what option trading strategy would suit their risk tolerance and preferred approach.