Learn the Basics of Options Trading: Effective Strategies for Newbies
Every trader has at least one goal in common; to make money. And learning about different options trading strategies will provide you with the information you need to accomplish this goal. Therefore, take the time to review the top seven options trading strategies listed below. In fact, the way you create daily wealth may change forever.
There are many strategies available to traders. But let’s learn the basics first and pretty soon you’ll be ready to tackle the more complex strategies. So, let’s get started…
Understanding Options Trading Strategies
1. Long Call – Capture Outsized Gains from Higher Stock Prices
This is one of the preferred strategies for traders who are bullish. This means you are betting the stock price will rise and do so by buying calls. Call options are contracts that give their holder the right – but not the obligation – to buy shares at a certain price. It’s essentially a bet that the price of the underlying stock will rise above the option’s strike price and the contracts will give their owner the ability to buy at a discount. When that happens, those calls are referred to as “in the money.” If a call option’s strike price is above the price of its underlying security, it’s referred to as “out of the money.”
Let’s use stock “X” as an example. A trader is betting that X shares will exceed $250 per share by the third Friday in July. The higher the share price goes over the strike price, the more money the trader will make.
For this hypothetical example, let’s say that stock X trades for around $248, just under your $250 strike price. The July 15th $250 options trade for around $4.35. This means that X’s stock would have to be at $254.35 for the trader to break even. So, say you lock out and news of a new product drops the day after the trader bought their calls. This news caused X’s share price to climb to $256.35. That means the trader exceeded their breakeven point by $2 and their options are now worth $6.35.
This is good for a gain of 45% (you entered the calls for $4.35 and they moved up to $6.35). This is an example using intrinsic value to show you how you can profit from going long on a call option. In many cases, a big move up in the stock can hand you even bigger moves on the options. You may experience bigger returns as a result.
2. Long Put: How to Profit from Downward Stock Movements – With Less Risk Than Short selling
This is one of the preferred options trading strategies for traders who are bearish. This means the trader is betting the stock price will fall. A put works the opposite way of a call. If a put options strike price is above the stock’s market price, it’s in the money. If the strike price is below the stock’s market price, it’s out of the money. And if a trader buys a put option, they are expecting the stock price to fall below the strike price by expiration. Puts give the holder the right – but, again, not the obligation – to sell shares of a stock at a certain price.
Let’s use stock “X” as an example again. And the trader takes stock X’s current $248 price and buys puts that expire on July 15th with a strike price of $247.50, for a premium (cost) of $5.20. For these puts, their breakeven point would be $242.30. Just like with the calls, but in reverse. If stock X moves below that breakeven point, the trader will profit. Say news of a scandal breaks, and stock X’s share price drops to $238 over the course of a few days. The traders put would climb to $9.50. As a result, they could sell them for a gain of 82.7% and a $4.30 profit.
Two Part Trading Strategy
3. Covered Call: Unlock Additional Income from Your Stocks
Choosing what options trading strategies work best for you can be challenging if you’re not versed in all the different types. So let’s continue with a two-part strategy known as a covered call.
This strategy requires the lowest level of permission from your broker and can be done in any type of account. It also requires the trader to own shares of the underlying stock (100 shares for every option contract). It is important to note that the trader is selling to open the calls against their position.
They will buy a stock, at least 100 shares and sell an option against their holdings. When a trader does this, they are reducing their cost by the option premium received. In exchange for that reduction, they also limit their upside to the strike price of the option sold.
For example, if you buy stock “Y” for $10 and you sell an option with a $12 strike for $1, your cost is now $9. However, your upside is limited to the spread between $9 and $12. If the shares expire below the option strike price, you keep the stock and the option premium. If the shares are above the price at or before expiration, the shares can be called or taken out of your account as long as you are paid the strike price. Writing a covered call involves selling an option against a stock you already own. This generates income while you are holding it. It’s a great strategy for income seekers.
4. Bull Call Spread: Going Long for A Lower Cost
A bull call spread is the simplest type of spread. It’s often referred to as a vertical call spread. For this strategy, you would buy a lower strike call and sell a higher strike call. It is very similar to doing a covered call trade with a stock where you buy the stock and sell an option against it.
The goal is to reduce your cost by selling an option against the option that you bought. The options can be really expensive and this is a way to reduce your cost. The bull call spread or vertical call spread is when you are betting on the price of the shares moving higher. When you are betting the shares will move lower, you would use a bear put spread. This is otherwise known as a vertical put spread, which I explain in more detail below.
5. Bear Put Spread: Lowering Your Hedge Costs
A bear put spread is the same concept as a bull call spread. But instead of using calls, you are using puts. You buy a put at the higher strike price and sell another put, with the same expiration date, at a lower price.
Let’s say you buy a $10 put for $2 and sell a $5 put for $1. Your cost would be $1 and your spread would be $5. You are betting the shares will go to $5 or lower to collect the whole spread. But, any move below $9 will result in a profit.
If the stock was at $20 and you expected it to drop to $15, you would buy to open the $20 strike option and sell to open the $15 strike option. If the $20 put was at $3 and the $15 put was at $1.50, your cost would be $1.50 and your spread would be $5.
This strategy is not a pure short position. It’s a hedge, meaning that you have to have long positions which you are trying to protect. Since this strategy is a spread, your losses will be limited as both the long and short sides of the trade will go lower. One should only use this strategy if they understand how a hedge trade works.
Win Both Ways Options Trading Strategies
6. Long Strangle: Win Not Matter Which Way A Stock Moves
A strangle is one of the most popular strategies and best applied in situations where the underlying shares are volatile and prone to rapid moves in either direction. It’s sister strategy is called a straddle, which I’ll explain in a bit. This strategy allows you to profit no matter which way the stock moves, as long as a stock moves a certain amount in either direction. A trader will buy an out-of-the-money call option and a put option at the same time with the same expiration date. Yet, they will have different strike prices. The put strike price should be below the call strike price.
Let’s say you’re looking at shares in company “A”. It’s currently trading at $15. But it’s incredibly volatile and an earnings announcement is coming that could really move the stock. As such, you think it could rapidly drop to $5 or shoot up to $25. You’d be looking to buy puts with a strike price below $15 and calls with a strike price above $15.
You find two perfect ones, puts with a strike price of $10 and calls with a strike price of $20. You will need company A to drop to $8 or rise to $22 to break even. However, any move above $22 or below $8 will net you the profit you’re looking for. So, say the shares move down to $5 like you predicted. You would make $5 minus the $2 you paid for the put and the call. That’d be a net return of $3, or 150% on the entire trade.
The same would be true if the share price shot up to $25. Strangles are best played around earnings season, which is when companies report earnings. And those reports can lead to big swings in stock prices. Now let’s get into the last of the top seven options trading strategies every investor should know.
7. Long Straddle: Up or Down Movement… You Win
Straddles and strangles are two strategies that allow a trader to benefit whether a stock moves up or down. So, let’s discuss what the key difference is between these two strategies. A straddle is very similar to a strangle, in that an investor will buy a call option and a put option at the same time. But both options should have the same strike price AND expiration date.
In a straddle, typically you will get something back (unless they pin it at your strike exactly). Strangles and straddles are pretty much up to the investor to decide what fits their personal style and trading needs.
The Bottom Line
The main advantage of options is that they give you leverage on the markets to help you maximize your gains. There are a variety of options trading strategies for investors to profit from. And today, you’ve learned some of the most popular ones. Take time to learn the process and pretty soon your goal to make money will come.
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