Options Trading Strategies
We need to understand how we can trade them online, and the various strategies that are available to us as traders. Being a flexible instrument there are many to chose from, and many levels of risk from very low to very high. I do not advocate high risk option trading strategies unless you are a very experienced trader, and for myself, I only trade the lower risk profile trades. Let’s have a look at them and see how they work in practice.
Option Trading Strategy: The Covered Call
Of all the options strategies, covered call writing is perhaps one of the most widely accessible since it represents a relatively low risk approach to options trading, and yet it is often only used by small numbers of traders and investors, who have taken the time to fully understand the opportunities this strategy offers. I firmly believe that it provides an excellent stepping stone between the world of traditional cash markets such as stocks and shares, that we all know and understand, to the slightly more complex world of derivatives and options. The two elements come together using equity options and provide unique opportunities for both trader and investor alike. For the investor there is the opportunity to derive additional income from an existing portfolio, and for a trader a strategy to produce income from holding shares and stocks for relatively short periods. Herein lies one of the issues that you must address immediately. If you are someone who falls in love with their stocks then this strategy is probably not for you I’m afraid. It is more suited to the speculator or to an investor who is more interested in making money, rather than holding beloved shares year after year and never considering the prospect that there may be better returns available by letting some of the ‘children’ leave home! Covered call writing is a favourite of mine and I have a separate site which explains this strategy in more detail. Call writing is a low volatility strategy where we are looking for sideways movement in the markets or instrument.
Options Trading Strategy: The Long Straddle
Again this is one of my favourites and I have a separate site to explain it in more detail. The long straddle again is a low risk trading strategy, but in this case we are looking for good volatility in the markets or underlying stock to make the trade work. The trade involves buying an ATM put option and an ATM call option with the same strike price and expiry. The trade is typically used when an impending announcement is due, but we have no idea which way the stock will move – so this is a directionless trade – we don’t care! It simply has to move in order to move the trading position into profit. The converse of the long straddle is the short straddle which is extremely high risk as we are then trading naked – not something I recommend. For an explanation of this term see the covered call site which explains this in detail.
Options Trading Strategies: The Collar
Again, another low risk option trading strategy, and in some cases it is possible to create a risk less trade. The strategy works well over longer time periods and therefore involves using LEAP options. The trade involved three elements as follows. Firstly we buy the underlying stock for as many contracts we propose to buy ( I suggest you always start your option trading with the minimum which is one). We would then buy a LEAP put option ATM or close to the stock price, and finally sell a LEAP call OTM. If the difference between the premiums on the call and the put, plus the difference between the stock price and put strike price come to a negative number, then you have a free trade. The returns won’t be great, but risk and reward do go hand in hand in trading!
More Options Strategies: The Butterfly
The butterfly option is a strategy which is one that can be traded either using puts or calls and is essentially one used when markets and stocks are moving sideways. It is a more complex strategy than those outlined above as there are three elements to the trade. If we take the long call butterfly, then the first step is to buy an ITM call option, followed by selling 2 ATM the call options, and finally buying an OTM call all with the same expiry. This is a longer term trade so typically you would look for options 2 to 3 months out. The trade works if markets move sideways and ideally where HV is greater than IV with an expectation of falling HV over the period of the trade.