Options are best tool for risk management and position trading. However, novice traders need to use the right strategy and take advantage of options trading.
How options work?
Options holder has the liberty to sell or buy an underlying asset at specific price before or on its expiry date.
Options are of two types. During calls the holder gets right to buy and in puts the holder gets right to sell. In-the-money [ITM] for calls is when strike price is less than underlying price. At-the-money [ATM] for call is when strike and underlying price is equal.
Out-of-the-money [OTM] for call is when strike price is more than underlying price. For puts reverse of calls is true. When option is bought the loss-level is limited to its premium. Alternatively, loss risk is dramatically unlimited, when naked option is sold.
Traders use options to hedge an open position or try to assume volatility direction or apply in certain spread strategies. With options, traders get an idea of the actual risk to be taken, while opening a position. However, the risk will rely on strike choice, time value and volatility.
Whatever type of options trading strategies a trader makes use of, it is crucial to be organized and probability minded to stay in the game for long time. The strategy selected will depend on your goal and market judgment.
Covered call [buy-write]
An investor holds long position of an asset and sells or writes call options on the same asset, so as to generate more income from this trade. Investors apply this strategy, when there is short term neutral view. Thus, he holds long and short position simultaneously, so as to earn profits from options premium.
Bear & bull spreads
In bull spread, a call of an underlying asset is purchased and simultaneously the call of same asset is written [sold] with high strike. Traders can sell a put and at the same time buy a put with low strike. However, both need to have same expiry date.
In bear spread, call is purchased and call of low strike is sold. Bear spread with put options can be made by purchasing one and selling at low strike. Expiration date in both cases need to be same.
Simultaneously a short and long position is established on same underlying instrument but expiry date is different. This strategy enables trader to balance the loss triggered due to time decay and volatility differences.
Iron condor strategy is safe and easy alternative for beginners. You can enter from long or short side. Entering short iron condor means a trader is looking to gain from short movements in either direction. The trade is profitable as long as price stays within strike. In case, the movement is opposite there is a huge loss. Trader seeking the exact opposite enters long iron condor.
- Create an exit and entry strategy
- Stay disciplined
- Have clear trading plans for each position before opening
- Opening a position on the basis of gut increases overconfidence with early earnings and soon they even lose their deposits
- Research is crucial
- Learn how to use trading tools, which helps to visualize existing positions with numerous variables
The kind of strategy applied does not matter, but options trader needs to concentrate on using leverage strategically.