In case you got interested in trading options recently, you’re not alone. Options trading is gaining momentum quickly. In 2020 alone the number of contracts traded reached the record high of 7.52 Billion. Compared to the previous year, that’s a 52.4 percent increase.
One of the many reasons why options have become so popular is that they have a potential to produce profits that are several times larger than the initial investment and create sophisticated positions that are impossible to achieve using the traditional assets. On the downside, trading options is related to certain risks.
Options are types of contracts that allow investors to buy or sell stocks or ETFs at a specific time with a specific rate (which is also called a strike price). What’s more, investors have the right to buy or sell but not the obligation. Stock options ownership doesn’t give investors stake in the company like actual stocks and shares do. The contact type represents a potential for ownership and not an actual ownership. In order to gain a stock through stock options, the contract needs to be exercised.
Apart from solely trading options for profits, options are widely used for hedging the risks in investing due to their ability to trade assets at predetermined prices at specific moments. If the market moves against the hedged position, investors lose potential earnings but that’s the price they’re willing to pay for insurance.
Trading options might seem very simple at first glance but for novice traders a lot can be foreign and challenging in this field, including terminology, expiration dates and more. In this article we’ll discuss the best option trading strategies in easy to understand terms to make learning easier for you.
Before starting investing in options, make sure to understand its terminology. When it comes to option order types, there are two types to choose from: Put and Call options.
You might be wondering what happens to the options that expire. Well, they lose value and can become worthless. On the other hand, options generally last a long time and their value decreases when they’re nearing expiration. The option prices can also be affected by market volatility as the expiration date is getting closer. In order to avoid unnecessary losses, it’s better to have a plan and know what you are going to do with the Call or Put options before you buy.
The total amount investors pay to purchase options is called Premium. Premiums are not refundable.
There are various trading strategies developed to sell or buy options due to the fact that there can be many combinations depending on expiration date, strike price and order type. We’ll discuss the best and most popular ones that are practiced by investors today.
The long call option trading strategy is very popular among both seasoned and novice traders. The strategy simply implies that the underlying stock is going to increase in price before its expiration date.
When you buy a long call, you are cheering for the stock price to go up in value so that you can exercise your right to buy the asset. Usually investors immediately sell stocks or ETFs after exercising the option to rake in profits.
Now let’s talk about the risks and rewards involved with the Long Call option strategy. As already mentioned, options are great for insurance policy. No matter what happens, investors are guaranteed not to lose more than the amount paid for premium plus the commissions. Investors experience the Maximum loss if the price of the underlying stock remains less than or equal to the strike price of the Long Call.
As for the rewards, there’s no theoretical limit to how high stock prices can go. And therefore, the long call option strategy has no ceiling in terms of profitability. On the other hand, stock prices don’t increase infinitely in real life. The rewards at the end of the day are dependent on stock performance. Conducting technical and fundamental analysis on each stock can give you a better idea when planning to buy a long call option.
Whenever an investor exercises his or her right to purchase an option, costs are increased by Strike price. In order to reach the Break Even point, the underlying stock price needs to increase in value and equal the sum of Premium and Strike price.
The Long put strategy is used by traders who believe that the stock price will fall in value sharply before the option contract expires.
The maximum gain a trader can make is the strike price at which he or she sells the security, minus the premium price paid for purchasing the option.
In case the price of the stock doesn’t fall during the lifetime of the option, the trader loses the premium paid for purchasing the put option.
Both Long Put and Long Call options benefit from high volatility. When volatility increases, the chances of the price falling in the desired direction during the lifetime of the option increases. On the other hand, decrease in volatility decreases the value of contracts.
Covered call option trading strategy is utilized by traders that are expecting the price of the security to have low volatility during the lifetime of the option. When a trader has a short-term neutral view on the asset and holds the asset for a longer period of time, he or she is using the short option position to generate income from the premium.
Now let’s see this example: Let’s say George has purchased Tesla stock and expects the price of the company to increase over the next 5 years. Simultaneously, he doesn’t believe there’ll be much changes in the course of the next 6 months in terms of price. The current price of a Tesla stock is 720 USD. George sells a call option on Tesla stock for 730 USD with an expiration date of 6 months. By utilizing the cover strategy, George earns the premium of 10 USD per share.
Covered call is seen as a potentially lower risk strategy. As you already know, lower the risk, the lower the possibility of high rewards. Covered calls limit any potential for gaining bigger rewards in case the stock price keeps rising above break even level.
In case investors are expecting that the price of the security remains the same or rises until the option expires, they use the short put trading strategy. If the options expire worthless, the investors keep the premiums.
In the option markets, there are only two bull market strategies:
The difference between the both strategies is risk and reward ratios. In order for Long Call to become profitable, the price of the underlying stock needs to increase so that it covers the strike price and the premium. The sky’s the limit in terms of how much you can earn with a Long Call strategy, but the risks are higher. On the other hand, investors take less risks when using the short put strategy and the potential reward is limited to the premium price.
The married put strategy is used as an insurance policy for trading stocks. The strategy is often referred to as the protective put.
To see the example of the Married Put strategy, let’s say a trader buys 100 shares. Simultaneously he or she buys the same amount of put options. The put option holder has the right (not obligation) to sell the shares at the strike price. The strategy protects traders’ investments from downside risks by establishing a protective price floor in the event of the stock’s negative performance.
On the other hand, if the stock doesn’t fall sharply in value, investors lose the premium amount paid for purchasing the option.
Options trading can be risky for most investors. Mainly thanks to the complexity. Which is why it’s important to learn as much as possible about the security type before investing.
Furthermore, each strategy comes with its own risks and rewards. Risks are affected by the stock of your preference, trading strategy and risk exposure.
Trading options can play various roles for different investors. The first and foremost thing to do is to answer the questions: why do you want to trade options? Do you want to hedge your risks or do you want to profit from price action?
Keep in mind that not all of the option trading strategies are complex. The ones we have already discussed are among the most popular ones and they’re easy to understand.
To sum everything up, option trading enables investors to buy or sell securities with predetermined prices in predetermined time frames. Depending on whether you’re betting the price will increase or decrease, you are offered Call and Put option order types. There are multiple trading strategies developed for option traders. Some are more complex than others. Before starting to invest in options it’s important to think about the reasons why you want to trade them. Plan your trades in advance by calculating the potential losses and winnings.
Investors trade options for various reasons. Some use options to hedge their risks. While others trade options to rake in profits. Trading options enable investors to develop highly complex trading strategies that are not available when trading regular securities.
It depends on who you ask. The more you trade and more you learn, the better you become at trading certain asset classes. In general, trading options is not difficult. The concept is simple to understand and most strategies are easy to be utilized. On the other hand, many traders develop complex trading strategies for investing in options.
Premium is the total amount investors pay to purchase options. Depending on the trading strategy used, premium is expenditure for some traders and revenue for others.
Break even points are calculated differently for each trading strategy. In simple words, break even points are reached when expenses are equal to the earnings.