Last Updated on June 11, 2023
Option trading, when executed properly, can be one of the most effective methods for long-term wealth accumulation. If you’re new to investing or the stock market, the terms “Option Strategies” or “Option Trading Strategies” might be unfamiliar, but don’t fret—we’re here to help!
An Option is essentially a contract that allows an investor to buy or sell an underlying asset, like a stock or an index, at a predetermined price, over a specific timeframe, in return for a premium paid by the buyer to the seller.
In this article, we’ll delve into some of the top Option Trading Strategies that we believe every investor or trader should be familiar with.
Our Best Option Trading Strategies
What is options trading?
Options trading involves leveraging a financial instrument that derives its value from an underlying security. An option contract represents an agreement between a buyer and a seller, granting the buyer the right, but not the obligation, to buy or sell the underlying security at a predetermined price within a specific timeframe.
Option contracts comprise three primary elements that influence their cost, known as the premium: the price of the underlying security, the strike price of the option contract, and the expiration date.
Options trading empowers investors with greater flexibility compared to simply buying and selling stocks. Traders often utilize options to generate income, speculate on future prices, and hedge existing positions in their investment portfolio. Options are available for a wide range of stocks and exchange-traded funds (ETFs).
Best Option Trading Strategies Every Investor Should Be Aware Of
Here are some of the top Option Trading Strategies that you might want to consider. Whether you choose to implement these strategies will depend on your trading style, but having a basic understanding of how they work will make you more adaptable to changing market conditions.
Bullish Option Trading Strategies
Let’s start with Bullish Option Trading Strategies:
- Bull Call Spread: This is a Debt Spreads category strategy. If you’re bullish on a stock or ETF but don’t want to risk buying shares outright, consider buying a call option for a lower-risk bullish trade. However, even Call Options can be expensive and may expose you to more risk than you’re comfortable with. To reduce your initial cost and risk, you could buy a Bull Call Spread. This involves buying a long call option to express your bullish views, but offsetting some of that cost by selling a short call option against it.
- Bull Put Spread: This strategy is used when an options trader believes that the price of the underlying asset will moderately increase in the near future. This option falls under the Credit Spreads category. It involves selling a put option and buying a put option with a lower strike. In this situation, theta decay would benefit you as the Short-Put Option will start losing value faster than your Long-Put Option position.
- Bull Call Ratio Backspread: This trade requires a trader to be very bullish on the stock. It involves selling one or more at-the-money or out-of-the-money calls and buying two or three calls that are longer in the money than the call that was sold.
- Synthetic Call: To start a Synthetic Call, also known as a Synthetic Long Call, an investor buys and holds shares. To hedge against a decline in the stock’s price, the investor also buys an at-the-money put option on the same stock.
Bearish Option Trading Strategies
Next, let’s look at Bearish Option Trading Strategies:
- Bear Call Spread: This strategy is used when one’s outlook on the market is largely bearish. It involves selling a shorter-term call option while simultaneously buying a longer-term call option with the same underlying commodity and time frame of the expiration date but a higher strike price.
- Bear Put Spread: This strategy is used when a trader or investor predicts that the price of a security or asset will slightly decline. It involves selling a put option and purchasing a put option with a lower strike.
- Strip: This strategy is used when an investor is bullish on volatility and bearish on the direction of the market. It involves buying two lots of “At-the-Money Put Options” and “At-the-Money Call Options”.
- Synthetic Put: This strategy involves selling stock short and purchasing a call. It mimics a Long-Put Option by holding both a Short Stock position and a Long Call Option on the same stock.
Neutral Option Trading Strategies
Now, let’s look at Neutral Option Trading Strategies:
- Long Strangles & Short Straddles: The Long Strangle strategy is used when the trader anticipates high volatility in the underlying stock shortly. It involves buying slightly OTM Put Options and slightly OTM Call Options with the same underlying asset and expiry date. The maximum loss is the net premium paid, whereas the maximum profit is when the underlying moves significantly upwards or downwards. The Short Strangle is a variation of the Short Straddle. It aims to increase the profitability of the trade for the option seller by widening the breakeven points. This necessitates significantly more change in the underlying stock/index.
- Long Straddles & Short Straddles: A Long Straddle is one of the simplest market-neutral trading strategies to execute. It doesn’t matter which direction the market moves after it has been applied. As long as the market moves, a profit and loss are produced. In a Long Straddle Options Strategy, a trader essentially purchases a long call and a long put. A Short Call and a Short put are purchased with the same underlying asset, expiration date, and strike price as part of the Short Straddle Options Strategy. This strategy is applied during times when the market is least volatile.
Intraday Option Trading Strategies
Here are the Intraday Option Trading Strategies:
- Gap and Go Strategy: The Gap and Go Strategy involves identifying stocks with minimal pre-market trading volume. The opening price of these stocks creates a gap from the previous day’s closing price. If the stock opens higher than the previous day’s closing price, it is known as a gap up. Conversely, if it opens lower, it is called a gap down. Intraday traders employing this strategy look for such stocks and purchase them with the belief that the gap will close before the market closes for the day.
- Momentum Strategy: The Momentum Strategy is designed to capitalize on market momentum by identifying stocks that are poised for a significant change in trend. Traders make buying or selling decisions based on the latest news, takeover announcements, quarterly earnings reports, and other relevant factors. Intraday traders need to closely monitor news related to stocks on their watchlist and execute buying or selling orders accordingly. Quick decision-making is crucial due to the fluctuating nature of share prices influenced by external factors. The duration for which traders hold shares depends on market momentum, making this strategy the preferred choice for intraday trading.
- Scalping Strategy: The Scalping Strategy focuses on profiting from small price changes in securities. This approach is commonly used by intraday traders involved in buying and selling commodities, including those engaged in high-frequency trading. Fundamental and technical setups are of limited relevance in this strategy, as price action plays a more significant role. Traders employing the scalping strategy should select liquid and volatile stocks and ensure the placement of stop-loss orders for all trades.
- Breakout Strategy: Timing plays a pivotal role in the Breakout Strategy, which involves buying and selling securities within the same day. Traders aim to identify stocks that have broken out of their usual trading range or are about to enter a new price range. Key threshold points are identified where share prices experience significant increases or decreases. If a stock price surpasses the threshold point, intraday traders consider entering long positions and buying shares. Conversely, if the stock price falls below the threshold point, traders consider short positions or selling shares.
- Reversal Strategy: The Reversal Strategy is a high-risk trading approach that involves making investment decisions contrary to the prevailing market trend based on careful analysis and calculations. This strategy is more challenging compared to other methods as it requires extensive knowledge of the market and accurate identification of pullbacks and strengths.
- Moving Average Crossover Strategy: The Moving Average Crossover Strategy is a successful intraday trading approach in which traders monitor the crossover of stock prices or other financial instruments with a moving average line. When prices move above the moving average, it indicates an uptrend, suggesting long positions or buying opportunities. Conversely, when prices fall below the moving average, it signals a downtrend, prompting traders to consider short positions or sell their shares.
Stocks vs. options
Most investors are familiar with stocks, which involve a relatively straightforward process: buying shares of a company and aiming to sell them at a higher price later. On the other hand, options are more intricate, yet they offer investors increased flexibility and the ability to take advantage of bullish, bearish, and neutral market conditions.
One key distinction is that every options contract has an expiration date, adding a temporal element to each position. Options pricing is influenced by various factors and constantly fluctuates based on market conditions and movements in the price of the underlying asset.
Stocks and options can be combined to hedge positions or generate passive income.
Strategies with Uncapped Risk
Strategies with uncapped risk involve trades where the potential loss is undefined or limitless at the time of entry. This type of risk is commonly associated with selling naked or uncovered options.
For instance, when selling a naked call option, the writer of the option is obligated to sell shares at the specified strike price if the stock is assigned. Since the price of a stock can potentially rise indefinitely, the risk involved is not clearly defined. Selling a call option with a strike price of $100 for $2.00 may offer a potential profit of $200, but it also exposes the seller to unlimited losses if the underlying stock significantly increases in value.
In contrast to strategies with defined risk, engaging in naked options requires maintaining a higher margin in the trading account and allocating more capital to sustain the position. The amount of margin necessary for an uncapped risk strategy may vary and is not fixed. If market volatility increases, the brokerage firm may raise margin requirements to ensure that there is enough funds in the account to cover potential stock assignments.
We have discussed the most significant Option Trading Strategies. We hope this information enhances your understanding of these concepts. Traders can employ several low-risk fundamental strategies as alternatives to the typically high-risk nature of options trading. By utilizing options, even risk-averse traders can potentially increase their overall returns. However, it is essential to comprehend the associated risks of any investment and evaluate whether the potential gains justify them.