Many traders today make the mistake of venturing into options trading with a very limited understanding or appreciation of the various options trading strategies that they can utilize. They fail to realize that without a proper strategy, the likelihood of making bad trades and loosing money increases significantly, resulting in self doubt and dwindling confidence in their trading abilities. They may start to believe that they aren’t good enough, or that they can’t be as successful as other traders. However, that’s not necessarily the case. Many successful traders are simply utilizing the right options trading strategy which you too can start learning about today.
The main purpose of a trading strategy is to help you limit your risk exposure and maximize your returns, and if you don’t have one this could prove to be very costly. Popular trading strategies include Covered calls, Married Put Strategy, Long Straddle Strategy, Long Strangle Strategy, Protective Collar Strategy, Bear Put Spread, Long Call Butterfly Spread and Iron Butterfly. However, this article will focus on some basic options trading strategies for beginners, such as selling covered calls, buying protective puts, and buying the put.
Options Trading Strategies for beginners
Selling covered calls
Selling covered calls is one of the simplest yet most effective trading strategies available to options traders today. Simply put, you are selling someone else the right to buy stocks (underlying asset) from you at a certain price (the strike price) before a specified date (the expiration date). The buyer also pays a premium to you, the seller for that right. If the seller of a call option owns the underlying security, the option is considered “covered” because the seller can deliver the security without purchasing it on the market. If you think that your stocks are currently overvalued or close to it, you can consider selling covered calls. Investors may also see great long-term value or potential in a stock but in the short term may seek to profit or earn premiums by selling call options.
Let’s say you own 100 ABC stocks currently trading at $30 per share. You believe that ABC stocks will rise to $40 within 12 months, so you tell your broker that you’re willing to sell at $35 within six months. The call option is currently trading for a premium of $1 and since you own 100 shares, you would receive $100 upfront.
If the stock is trading over $35 on the expiration date, then the person who bought your call option will exercise the right to buy your stock from you at $35/share. You get $3,500 plus the original $100 received upfront, from selling the option, for a total of $3,600.
If the stock falls below $35 on the expiration date then the call option expires worthless, you keep the $100 premium that you earned, and keep your stock, with no further obligation.
Once you understand the basics of covered calls, you can take full advantage of this useful method to hedge as well as grow your investment portfolio.
Buying protective puts
Buying a protective put is another options trading strategy for beginners. It gives you, the trader, the right to sell your stock at strike price and comes in handy when you have a bullish outlook but still want to protect the value of your stocks if there is a downturn. Protective puts are habitually used as an alternative to stop orders. The price that you’ll receive for your stock is predetermined and you have full control over when you choose to exercise your option.
How a Protective Put Works
When a protective put is implemented, a floor price is set, which is the point beyond which an investor or trader will cease to lose money, even if the underlying asset’s price continues to drop. A protective put essentially limits downside losses, while preserving the upside of unlimited potential gains.
Let’s look at a protective put scenario.
Let’s say you purchased 100 shares of ABC stock for $10 per share. The price of the stock increased to $20 giving you a potential profit of $10 per share, however you are not quite ready to sell, as you feel the stock could appreciate more. You also do not want to risk losing the $10 potential profit. In such a case you can consider purchasing a put option for the stock to protect some of your gains.
So, you decide to buy a put option with a strike price of $15 for 75 cents, with a worst-case scenario of selling your stock for $15 per share. If your stock price eventually drops back to $10 or below, you gain on the put option from $15 and below. At any price below the $15 strike price, you are hedged until the option expires.
If your stock price falls back to $10, exercising your options position would still earn you a profit of $4.25 per share, ($15 strike price minus your $10 initial purchase price minus the 0.75 cents premium you paid for the put option). If you didn’t buy the protective put option, and your stock dropped to $10, you would not have made a profit.
Buying a put
Buying the put otherwise known as the collar, is another strategy that involves running a protective and a covered call simultaneously, where the covered call helps to pay for the protective put. Essentially you are holding shares of an underlying stock while simultaneously buying protective puts and selling call options against your holdings.
With this strategy traders are limiting the downside on the stock for less than it would cost to only buy a put option. This trading strategy is usually used by traders after a long position in a stock has experienced significant gains and they now wish to protect themselves from an unforeseen sharp drop in the price of the underlying security.
New Options traders may sometimes be too eager to start trading options without the appropriate knowledge or training. It’s essential that traders, especially new option traders take the time to learn the basics of options trading, build a solid foundation, understand how options work and then implement some of these effective options trading strategies to help them succeed and achieve their trading goals. There are plenty of opportunities to learn and a ton of resources available to sharpen your options trading skills and improve your chances of consistent successful trades.