Stock traders have a number of different strategy options to maximize their portfolios and increase their chances of success. Many traders enjoy participating in options trading, which is a way to earn income while hedging risk. Gaining a better understanding of options trading can help you decide whether you want to pursue it, as well as which strategy you plan to use when participating in this type of trading.
What is Options Trading?
Options trading allows you to sell or buy an asset by a certain date at a set price. You do not have an obligation to buy or sell, but you do have the option if a situation arises in which it makes financial sense to do so. Option stocks are also called derivatives because their values derive from the assets with which they are associated. Some of the benefits of options trading include lower risk, the option to speculate about stocks that may offer high yields and returns, and steady income.
Most contracts for stock options include 100 shares, although they can also be written for other assets, such as bonds, commodities, and currencies. Before you begin options trading, it is helpful to understand why this is a powerful way to diversify your portfolio. Options can provide protection and leverage, as well as offer higher earnings. No matter what your investment goals may be, you can often find a contract for options trading that complements those objectives. When the market is in a downturn, you can use options to hedge your risk and maintain income while minimizing major losses.
Options can also allow the opportunity to speculate on a specific stock in regard to the direction it might move. By participating in options trading, you can purchase a smaller number of shares of a stock that you think might move upward, giving you the chance to wager without taking a major risk in your portfolio. Speculation and options trading does come with some risk, so you could still enter into a contract for a stock that doesn’t perform as expected, but the option to sell whenever you desire gives you more control.
As you determine your own personal investment strategy, you can incorporate some of the best options trading strategies if they align with your goals and risk tolerance. Continuing to invest can also help you become more seasoned, which makes it easier to manage risk and bounce back from purchases that weren’t as successful as you had hoped.
- Options trading is a way to hedge risk by providing the option to buy or sell an asset at a set price by a certain date.
- Understanding the top options trading strategies can increase a trader’s chances of success.
- Five of the top options trading strategies are long call, collar, protective put, cash-covered put, and long call/short put spread.
- Long call is a basic strategy for beginners, allowing an investor to bet that a specific stock price will rise above the strike price by the expiration date.
- Collar is a protection strategy that caps both the upside and downside potential for an owned stock, helping to hedge risk.
- Protective put is another protection strategy that protects a current long position.
- Cash-covered put is a way to enhance a portfolio, allowing the investor to set aside cash to cover the total cost of stock at the strike price.
- Covered call is a strategy that involves selling a call option against a long stock value that an investor already owns.
- Long call/short-put spread is a combination strategy that allows investors to take bullish bets that only require a margin to cover the total risk.
Top Options Trading Strategies
Some of the top strategies for trading options include long call, collar, protective put, cash-covered put, covered call, and long call/short put spread.
When you are learning more about options trading, one of the more basic options trading strategies is often your best bet until you become more familiar with the process. Long call is a simple strategy that also has lower risk, although the profit potential is unlimited. In order to utilize this strategy, you will choose a stock you want to purchase as an option. By purchasing it, you are betting that its value will increase to above the strike price by the contract expiration date.
The long call options trading strategy is more bullish as the break-even price is only the premium paid plus the strike price. Call options are less expensive when the volatility of the market is lower, so it makes sense to invest this way during bullish markets, rather than bearish markets.
The collar options trading strategy is an option when you want to hedge risk and protect your current portfolio positions. When choosing this strategy, you are effectively capping the upside potential of your purchases, but you are also capping the downside potential. If you already own a stock, you can apply this strategy by selling a call option and buying a put option. The risk is the distance between the put strike price and the current price, while the profit potential is the distance between the call strike price and the current price.
When implementing the collar trading strategy, your break-even price falls between the put and call strike prices. Any basic margin accounts are eligible, and it works best with stocks that pay high dividends. Since both sides of the growth potential are capped, you can continue to earn dividends while maintaining protection from major risk.
The protective put is one of the best stock option strategies for those who want to mitigate risk as well. This strategy allows you to purchase one put option while protecting a long position. The risk is a bit more bearish, although you can only potentially lose the premium you paid. The profit potential is the appreciation of the stock capital minus the premium paid, while you can break even at the current stock price plus the premium paid.
When shopping for protective put stocks, it’s smart to find options when the IV index is lower and prior to a major market downturn.
Cash-covered put is a stock option strategy that can enhance the stocks you already own or improve your portfolio. You can employ this strategy by selling at least one put contract with enough money to equal the cost of 100 shares of a stock times each contract’s strike price. This option is bearish in nature, although the risk includes the price of the stock if it falls below the put strike price minus the premium paid. You can earn a profit equaling the premium paid, while you would break even at the strike price minus the premium amount that you paid.
Many experienced investors use this strategy when they want to collect additional premiums on a stock they already plan to purchase. A cash-covered put also works when a stock is a bullish bet and is already valuable.
A covered call options trading strategy allows you to sell a call option against a long stock value that you have within your portfolio. To employ this strategy, you would need to sell at least one call contract that doesn’t exceed the long stock’s total number of shares in your portfolio. This is an enhancement strategy because it allows you to make money on stocks you already own. When using the covered call strategy, the risk is about the same as the risk you take on by purchasing any stock, although the opportunity cost could increase the risk if what you purchase rises in value above the call strike price.
You would break even at the strike price plus the premium paid, while the profit potential is the premium you could earn on the stock you purchase. Investors commonly use covered calls when they think a stock could consolidate or stall out, but they don’t want to sell, rather choosing to wait for the next higher leg. Using the strategy can allow you to collect premiums while you wait to see what happens next.
Long Call/Short Put Spread
A long call/short put spread is a strategy that combines two other strategies for a more vertical option. For example, you may sell a put for $50 and buy a put for $55, which would give you $2.50 in premium. The break-even price in this example would be $52.50. It’s important to make sure the stock closes higher than the top strike price when it expires in order to maximize this strategy.
When employing the long call/short put spread strategy, the risk is the difference between the strike prices of each stock, minus the premium amount that you may have received. You could earn a high profit on the premiums. With a call spread, the break-even point is the strike price that is closer plus the premium received, while the put spread break-even point is the closer strike point minus any premium you received.
If you still have questions about options trading or would like to better understand these top strategies, our experts at Raging Bull can help. Schedule a complimentary training session with one of our experienced trainers, join a webinar, or download our e-book to learn more about trading and become an expert.