Options trading is a great way to diversify your investment portfolio and increase its yield. However, it can also carry a high level of risk. To mitigate this, there are several key strategies you need to be aware of.
In this guide, we’ll take you through seven of the best option trading strategies to help you maximize your profits and limit your losses.
1. Covered Call
The covered call is considered to be a neutral strategy that can help you generate income from premiums while also insuring against downside risk. With this strategy, you sell a call option on underlying assets that you own. It’s one of the most popular strategies in online options trading.
Example:
- You own 100 shares of stock which are currently trading at $60 per share.
- You sell a call option with an exercise price of $65 set to expire in one month.
- The buyer pays a premium of $300 ($3 per share).
- At expiration, the stock price is below $65 so the call option is worthless and you keep the premium while maintaining ownership of your underlying assets.
2. Married Put
The married put strategy involves buying put options on underlying assets you own. This helps to give you a form of insurance during times of market volatility. If the market experiences a downturn, the increasing value of the put option can offset the decrease in the value of the underlying assets.
Example:
- You own 100 shares of stock that are trading at $50 per share.
- You buy a put option with an exercise price of $45 and a premium of $200 ($2 per share) which expires in a month.
- At expiration, the price of the underlying assets is below $45.
- You can sell your 100 shares at the exercise price of $45 which limits your losses.
3. Bear Put Spread
With this strategy, you can benefit from modest declines in the prices of underlying stock. You do this by buying a put option with a higher exercise price and selling a put option with a lower exercise price on the same underlying assets.
Before this example, you need to be familiar with two terms:
- Out-of-the-money (OTM): Put options are OTM when the stock price is higher than the exercise price. Call options are OTM when the current market price of the underlying asset is lower than the exercise price.
- In-the-money (ITM): Put options are ITM when the market price is lower than the exercise price. Call options are ITM when the current market price of the underlying asset is higher than the exercise price.
Example:
- Stock ABC is trading at $60 per share. You have a bearish or neutral outlook on the stock.
- You buy a put option with an exercise price of $65 and you pay the premium of $400.
- You also sell a put option with an exercise price of $55 and you receive a premium of $200.
- The net cost is the difference between the premium paid and the premium received, which is $200.
- If the stock price is above $65 when the option expires, then both put options are OTM.
- Your losses are limited to the net cost of the spread which is $200.
4. Bull Call Spread
The bull call spread is similar to the bear put spread but you aim to make a profit from a moderate rise in the underlying asset price. The strategy involves selling a call option at a higher exercise price and buying a call option at a lower exercise price.
Example:
- Stock 123 is trading at $50 per share and you have a bullish outlook on it.
- You buy a call option on the stock with an exercise price of $55 and pay the premium of $300.
- At the same time, you sell a call option on the stock with an exercise price of $60 and receive a premium of $100.
- Therefore, the net cost of the bull call spread is $200.
- If the stock is at $58 when the contract expires then the sold option is worthless but the bought option is ITM.
- So, your maximum profit will be the difference between the two exercise prices minus the net premium.
5. Long Straddle
The long straddle strategy can help you profit from large increases or decreases in the price of the underlying asset. It involves buying a call option and a put option on an underlying asset that both have the same exercise price and expiration date.
- You buy a call and a put option on an underlying asset which both have an exercise price of $50, and both expire in 3 months.
- If the stock price is above $50 at expiration then your call option is profitable.
- If it’s below $50, then the put option is profitable.
- If the stock price doesn’t change, then both of your options are worthless and you incur the maximum loss.
6. Long Strangle
The long strangle is a cheaper option than the long straddle but the price of the underlying stock needs to move more for you to make a profit. For this strategy, you buy an OTM call option and an OTM put option on the same stock. Unlike the long straddle strategy, the exercise prices are different.
Example:
- You buy a call option with an exercise price of $65 and a put option with an exercise price of $45.
- You pay a premium of $200 for the call option and $100 for the put option.
- To make a profit, the stock price needs to be below $45 or above $65 when the contract expires.
- If the stock price is somewhere in between the two exercise prices ($55 for example) then both options will be worthless, meaning you’ll incur a loss.
7. Protective Collar
This strategy is used to hedge your existing long stock position. To do this, you buy an OTM put option and sell an OTM call option. This limits the upside and downside risks.
Example:
- You own 100 shares of LYT stock which is trading at $40 per share.
- You buy a put option with an exercise price of $35 and pay a premium of $200.
- You also sell a call option with an exercise price of $45 and receive a premium of $100.
- If the stock price finishes below $35 you can sell your shares at $35 which limits the downside.
- If it finishes above $45, the upside is capped at $45 plus the call premium you received.
Final Thoughts
While options trading presents exciting opportunities, you must choose strategies that align with your risk tolerance and investment objectives.
Through researching different strategies, practicing with virtual trading accounts, and seeking professional guidance, you can enjoy successful option trading endeavors.
