BEFORE you choose an Options Trading Strategy, you need to understand how you want options to work in your portfolio. A particular strategy is successful only if it performs in a way that helps you meet your investment goals.
One of the benefits of basic options strategies is the flexibility they offer—they can complement portfolios in many different ways. So it’s worth taking the time to identify a goal that suits you and your financial plan. Once you’ve chosen a goal, you’ll have narrowed the range of options trading strategies to use.
Once you’ve decided on an appropriate basic options strategy, it’s important to stay focused. If it seems that the market or underlying security isn’t moving in the direction you predicted, it’s possible that you’ll minimize your losses by exiting early.
But it’s also possible that you’ll miss out on a future beneficial change in direction. That’s why many experts recommend that you designate an exit strategy or cut-off point ahead of time, and hold firm.
Basic options strategies are usually the way to begin investing with options. By mastering these types of options strategies, you’ll prepare yourself for more advancedstrategies.
An option is a contract written by a seller that conveys to the buyer the right — but not the
obligation — to buy or sell a particular asset, at a particular price (Strike price/Exercise price) in the future.
Options can be used for hedging, taking a view on the future direction of the market, for arbitrage, or for implementing strategies that can help in generating income for investors under various market conditions.
STRATEGY 1: BUYING CALL
Buying a call is the most basic of all options strategies. It constitutes the first options trade
for someone already familiar with buying/selling stocks and would now want to trade options.
Buying a Call means you are very bullish and expect the underlying stock /index to rise in the future.
For aggressive investors who are bullish about the prospects for a stock/index, buying calls can be an excellent way to capture the upside potential with limited downside risk.
When to Use: The investor is very bullish on the stock/ index.
Risk: Limited to the Premium.
(Maximum loss if market expires at or below the option strike price).
Breakeven: Strike Price + Premium
Analysis: This strategy limits the downside risk to the extent of the premium paid, but the potential return is unlimited.
A long call option is the simplest way to benefit if you believe that the market will make an upward
move and is the most common choice among first-time investors in Options.
STRATEGY 2: BUYING PUT
Buying Put is a Bearish strategy. To take advantage of a falling market an investor can buy Put options.
Buying a Put is the opposite of buying a Call. When you buy a Call, you are bullish about the
stock/index. When an investor is bearish, he can buy a Put option.
A Put Option gives the buyer of the Put a right to sell the stock (to the Put seller) at a pre-specified price and thereby limit his risk.
When to use:
The investor is bearish about the stock /index.
Risk: Limited to the amount of premium paid. Maximum loss if stock/index expires at or above the option strike price.
Analysis: A bearish investor can profit from declining stock price by buying Puts. He limits his risk to the amount of premium paid but his profit potential remains unlimited. This is a widely used strategy when an investor is bearish
STRATEGY 3: STRADDLE
A straddle is a volatility strategy and is used when the stock price/index is expected to show
This strategy involves buying a call as well as putting on the same stock/index for the same maturity and strike price, to take advantage of a movement in either direction, a soaring or plummeting value of the stock/index.
If the price of the stock index increases, the call is exercised while the put expires worthless.
And if the price of the stock/index decreases, the put is exercised, the call expires worthless.
Either way, if the stock/ index shows volatility to cover the cost of the trade, profits are to be made.
With Straddles, the investor is direction neutral.
All that he is looking out for is the stock/index to break out exponentially in either direction.
When to Use: The investor thinks that the underlying stock/index will experience significant volatility in the near term.
Risk: Limited to the initial premium paid.
Upper Breakeven Point = Strike Price
of Long Call + Net Premium Paid;
Lower Breakeven Point = Strike Price
of Long Put – Net Premium Paid.