When trading options, you can choose from a wide variety of strategies. The choice depends on just what you are trying to accomplish. Options are very versatile investment tools, and although most beginners feel that the only thing they want to accomplish is to "make money" there are other considerations.
- Trading options offers multiple advantages, from hedging against risk to zeroing in on ways to maximize your overall portfolio as you gain experience.
- You can begin learning about options without too much risk through covered call writing, selling one call option for every 100 shares you own.
- Naked puts, credit spreads, and collars can also help you get your feet wet, but do your research first so you fully understand how these tools work.
How Do You Want to Use Options in Your Portfolio?
The primary goal for options traders is almost always making money. However, more experienced traders learn to appreciate that options can be used to obtain other desirable characteristics for their investment portfolios. For example, options can be used to:
- Manage risk: This is the principal rationale that many investors have for trading options. Yes, you still seek to earn profits, but options allow you to go after those profits with less risk of losing money on the trade. In addition, the basic strategies allow you to establish a maximum possible loss for any trade — something that the investor who owns stock cannot always do (Even with a stop-loss order in place, on any given morning any stock can gap lower — far lower than the stop-loss price). Higher probability of earning a profit coupled with limited losses is something that most traders can appreciate.
- Hedge, or reduce the risk of owning positions that are already in your portfolio: You can buy and or sell options that hedge existing positions. Some of these methods limit profits, while others do not. When a trader learns to understand how options work, it becomes easier to decide whether you prefer to pay cash (think of it as an insurance policy) for good portfolio protection or to collect a premium to accept only limited protection.
- Protect your holdings against a huge stock market surprise: They don't occur very often, but we have seen some very volatile downside stock markets in our lifetime, and no doubt, there will be others.
- Tweak stock market predictions: This one is especially important for experienced traders. For example, you may want to adopt a bullish position on a given stock or index, but options allow you to pinpoint your expectations. One example: You can maximize your profit potential by correctly predicting the size of the stock's price change.
Before You Start
A word of caution is in order. Rookies must understand one firm principle when trading: Never place money at risk unless you are certain that you understand exactly what you are doing. There is nothing inherently wrong with paying for advice, but you must do your part and be certain that the trade is suitable for your risk tolerance (see #5). Plus, if you do not understand what has to happen for the position to make money (and how it can lose money), then there is no reason to make the trade.
If you begin trading any options strategy without a firm understanding of how each of these strategies works and what you are trying to accomplish when using them, then it becomes impossible to manage the trade efficiently. In other words, when trading options you cannot adopt a buy and hold philosophy.
Options are designed to be traded, not necessarily actively, but when you make a trade, there is always an opportune time to exit. Hopefully with a profit, but a good risk manager (that's you) knows when a specific trade is not working and that it is necessary to get out of the position. If you must take a loss, so be it. Never hold a losing trade hoping that it will get back to break even.
Recommended Strategies for Options
The following short list of strategies contains the methods that I recommend.
- Covered call writing
- Cash-secured sale of naked puts
- Credit and debit spreads
For more sophisticated traders:
- Iron Condors
- Diagonal, and double diagonal spreads
These are six strategies recommended for options traders. There are other good strategies available, but these methods are considered the easiest to understand. When getting started with options, it is advantageous to work with strategies that allow you to be confident that you know how to open, manage, and close your positions.
At the top of the list is covered call writing (CCW). This is a wonderful way for rookies to learn all about options. Many option rookies already understand the stock market and have investing experience. Thus, beginning with an option strategy that includes stock ownership is a logical way to introduce investors to the world of stock options.
To implement this strategy, buy 100 shares (or more, in multiples of 100), or use shares you already own and sell one call option for every 100 shares.
When selling a call option, a cash premium is collected, and that money is yours to keep, no matter what happens in the future.
When you sell (write) a call option:
- You become obligated to sell 100 shares of stock at a specific price, known as the strike price — for a limited time — but only when the option owner elects to exercise the option and you are assigned an exercise notice. That notice is simply a message from your broker telling you that your short option was exercised and that you automatically sold 100 shares at the strike price. Your option position has disappeared (once exercised, the option no longer exists) and the stock has been removed from your account. The cash will appear when the stock sale settles in three days.
- You, as the option seller, have no say about whether the option is exercised or not. That decision belongs to the option owner. If that does not seem fair, just remember that the buyer paid cash to obtain that right.
- An option is a binding contract that describes the strike price and expiration date. The obligation to sell your shares lasts for a limited time — until the expiration date. If the option owner fails to exercise when that date arrives (the cutoff time is roughly 30 minutes after the market closes on expiration day), your obligation ends, and the call option expires worthless.
- The cash (premium) that you collected when selling the option is not part of the contract. That premium only describes the trade that was made on the floor of one of the option exchanges.
When you write a covered call, there are only two possible outcomes:
- The call is exercised, and the stock is sold at the price that you agreed upon in the contract (the strike price). In addition, you get to keep the cash premium.
- The option expires worthless. You are ahead of the game by the cash premium collected. You still own the stock and may — if you so choose — write another call option and collect another premium.
There is much more to learn about this strategy, but this should suffice for the purposes of a basic introductory discussion. If it sounds appealing, then it is time to begin learning much more about the details of how to implement covered call writing. Don't jump into action by making a few trades. If CCW is unappealing, then consider another strategy from the list.
When you sell an out-of-the-money put option (i.e., the stock price is higher than the put strike price), a cash premium is collected. That cash is yours to keep, no matter what else happens. There are two possible outcomes of this trade:
- The option expires worthless (the stock price is above the strike price), and your profit is the cash collected.
- When expiration arrives, the stock price is below the strike price. That means the option owner will exercise his rights to sell 100 shares of stock at the strike price, and you are obligated to buy those shares. The transaction is made automatically, just as when you are assigned an exercise notice on the call you sold when writing covered calls.
When selling the put option, you were willing to buy stock at the strike. If and when you are assigned an exercise notice, you may no longer want to own the stock. But look at it this way: If you had bought a stock at its market price earlier (when you sold the put option instead), you would have paid a higher price, and you would not have collected the cash premium.
Instead of selling unprotected (naked) options, the trader can sell one put and buy another. The put purchased acts as an insurance policy, limiting loss. It also reduces profit potential, but I urge you to believe that limiting losses is the key to your future success and that accepting smaller profits is a reasonable price to pay for being certain that you never incur a loss that is too large to handle. We all want to be positive thinkers, but winning traders know that the main objective is to prevent a monetary disaster. Loss limits accomplish that.
Although this is one of the most popular (for good reasons) option strategies, newer option traders should understand the basics of trading individual options before getting into spread trading. Why? Because it is easier to understand how a spread works when you know how its components work.
This is the most conservative of the strategies listed here. It is for people who are more interested in preserving their capital than in trying to earn a lot more money. The collar is a slightly bullish position with limited gains and limited losses.