Before start trading in option (buy or sell) you require a strategy, and before choosing 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. If you expect to increase your income from the stocks you own, you will choose a different strategy from an investor who want to purchase a stock at lower price. One of the advantage of options is the flexibility they offer they can complement portfolios in many ways. Once you’ve chosen your goal, you can narrow down the strategies that can be used.
SIMPLE AND NOT-SO-SIMPLE
Some of the options strategies are relatively simple to understand such as writing covered calls. There are some complicated strategies that require two or more options, say for example spreads and collars. These types of strategies are often used to further limit the risk associated with options. But there return also limited. Simple strategies are usually the way to begin trading in options. By understanding simple strategies, you’ll be to procced to more advanced options trading. In general, the more complicated options strategies are appropriate only for experienced investors.
AN OVERVIEW OF STRATEGIES
It’s helpful to have an overview of the implications of various options strategies. Once you understand the basics, you’ll be ready to learn more about how each strategy can work for you—and what the potential risks are.
| Strategies | Objective | Your market forecast | Potential risk | Potential return |
|---|---|---|---|---|
|
Call buying |
Profit from the increase in the price of the underlying security, or Lock in a good purchase price
|
Neutral to bullish |
Limited to the premium paid |
Theoretically unlimited |
|
Call writing |
Profit from the premium received, or lower net cost of purchasing
A stock
|
Neutral to bearish, though covered call writing may be bullish |
Unlimited for naked call writing, limited for covered
Call writing
|
Limited to the premium received |
|
Put buying |
Profit from the decrease in the price of the underlying security or protect against losses on stock already held |
Neutral to bearish |
Limited to the premium paid |
Substantial, as the stock price approaches zero |
|
Put writing |
Profit from the premium received, or lower net purchase price |
Neutral to bullish, though cash-secured puts may
Be bearish
|
Substantial, as the stock price approaches zero |
Limited to the premium received |
|
Spreads |
Profit from the difference in values of the options written and purchased |
Bullish or bearish, depending on the particular spread |
Limited |
Limited |
|
Collars |
Protect unrealized profits |
Neutral or bullish |
Limited |
Limited |
AN OVERVIEW OF STRATEGIES
If the market or underlying assets isn’t moving in the direction you predicted, it’s probable 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 it recommended to designate an exit strategy or cut-off point or stop loss ahead of time and hold firm.
Precaution
Overleveraging. One of the advantages of options is that the leverage they offer. By investing a small amount, you can earn a higher return. But it’s very important to remember that leverage has a potential downside also. A small decline in value lead to a larger percentage loss. Investors who aren’t aware of these risks are in danger of overleveraging and might face bigger losses than they expect.
Lack of understanding. Another mistake some options traders make lack of understanding of what they’ve agreed to. An option is a contract, and its terms must be met upon exercise. For example, it’s important to understand that if you write a covered call, there is a very real chance that your stock will be called away from you. It’s also important to understand how an option is likely to behave as expiration nears and to understand that once an option expires, it has no value.
Not doing enough research. A serious mistake that some options traders make is not researching the underlying instrument. Options are derivatives, and their value depends on the price behaviour of the underlying. You have to research available options data and be confident in your reasons for thinking that a particular stock will move in a certain direction before a certain date. You should also be alert to any pending corporate actions such as splits and mergers.
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