Options trading is very volatile, allowing traders to make profits very quickly. However, the potential risk of losing is also very high. As a result, traders need carefully thought out trading strategies so that they can minimize their risks.
Trading strategies can either be simple or complex. However, all option trading strategies are based on the two types of options; call and put options. This article will discuss five strategies that investors use in options trading.
1. Long Call
This strategy involves buying a call option and is known as going long. In this case, the trader expects the stock to rise and exceed the strike price by the expiration date. The benefit of this strategy is that the gains from the trade are uncapped.
The upside of going long is that the gains are theoretically unlimited. If the stock price continues to rise before the expiry date, then the call option rises too. This reason has made long calls popular among traders.
The downside of going long is that you risk losing your entire investment if the stock price drops. If the stock price falls below the exercise price, the call option becomes worthless, and you lose all the premium you paid.
Going long is a good choice when you expect the stock price to rise significantly before expiration. If the stock price settles just a little above the strike price, you will still be in the money. However, you may fail to recover the premium paid and end up with a net loss.
2. Covered Call
The trader sells a call option in this strategy, known as going short, but with a twist. The trader sells a call but simultaneously buys the security underlying the option. Owning the security converts a possibly risky trade, the short call, into a safer trade that can generate income. In a short call, traders expect the stock price to be below the strike price. If the stock price exceeds the exercise price, the owner sells the stock at the strike price to the call buyer.
The upside of this strategy is capped at the premium received, irrespective of how high the stock rises. The trader cannot make more than the premium, and the short call offsets gains with the price rise.
The downside will result in a complete loss of the security investment if the stock price goes to zero. A covered call exposes you to significant risk because you can only recover the premium but not the investment cost.
A covered call can help generate income when you own the stock and don’t expect its price to rise significantly. This strategy can convert existing securities into cash, which is popular with advanced investors who need income.
3. Long Put
This strategy involves buying a put option, where the traders assume that the stock price will fall below the strike price. The benefit of this strategy can be multiple times the initial investment if the stock price falls significantly.
However, a stock price can never go below zero, which caps the potential rewards, unlike in a long call where stock prices can rise indefinitely.
The downside of this strategy is capped at the premium amount. If the stock price closes above the exercise price, the put option becomes worthless, and the trader losses the entire premium amount. This strategy is ideal when you expect the stock price to fall below the strike price.
4. Short Put
In this strategy, the trader sells a put and expects the stock to rise above the strike price. The trader receives a cash premium for selling the put, which is the highest amount a short put can earn. If the stock price closes below the exercise, the trader buys the stock at the strike price.
The downside of this strategy would be the price of the stock going down to zero. In such a case, the investor would lose the entire value of the investment minus the premium received.
The strategy is ideal when you expect the stock price to close above the strike price or at the strike price. In such a case, the trader can keep the entire premium received.
5. Married Put
The married put strategy is similar to a long put but with a twist. The owner of the underlying security buys a put. This is a hedged strategy, where the trader assumes the stock price will rise but mitigates his loss if the stock price falls.
The upside of this strategy is theoretically uncapped because the stock price can rise indefinitely. The premium will be the cost of hedging against a price drop, and the downside is only the premium paid.
A married put is ideal when you assume that the stock price will rise, but you think there is a chance it might fall.
Although options are considered high risk, traders have several strategies that they can use to limit the risks or reduce the effects of such events. However, it is important to understand both the downside and upside of each strategy.