Options Trading Strategies
With the stock market getting tougher to navigate every day, it is good to know the various strategies that a trader can use to gain the maximum profit. Traders these days must understand that instead of jumping on the first opportunity that they come across, they should know about the various techniques the experts use in order to gain the maximum profit out of their trades. These strategies can help minimise risk and maximise returns. With just a little effort, traders can learn how to take advantage of the flexibility of any stock.
Top Options Trading Strategies
If you are worried that you might spend a long time on the stock alone, this is the perfect strategy for you. The only drawback here is that you must be willing to sell your stocks at a price lower than the strike price. All you need to do is, purchase the underlying stock and write a call option for that simultaneously. Investors use this strategy when they have a neutral opinion on where the stock might go and hold a short-term position on the stock.
Investors who are worried that they might incur a high loss on a stock usually use this strategy. This strategy makes sure that the investor receives a base price in case the stock value falls sharply. The investor, while buying the stocks, must simultaneously purchase the put option for an equivalent number of shares. The holder of the put option can sell the shares at the strike price, and the contract costs 100 shares.
Bull Call Spread
Investors buy stocks at a specific price while selling them at a higher price simultaneously in this technique. Both call options will have the same expiration date and underlying asset in this technique. This vertical strategy is used by an investor when he feels that there won’t be much increase in the price of the stock anytime soon. While the investor reduces his upside on the asset, he also reduces the net premium spent, making it an ideal situation overall.
Bear Put Spread
This strategy is used when the investor feels that the price of a stock may fall in the near future. The investor will purchase put options for a trade while selling put options at a lower rate. Both put options will have the same underlying asset and expiration date. This strategy minimises both losses as well as gains. Upside may be limited in this technique, but the premium spent is reduced as well, making it a perfect technique for bearish stocks.
This strategy is for stocks that have been held for a long time now and have been providing substantial gains. A trader just needs to purchase an out-of-the-money put option and simultaneously write an out-of-the-money call option. The drawback here is that the trader might have to sell the stocks at a higher price and might lose his chance of earning high profits in the future. This technique is a mix of the covered collar and long put.
This strategy comes into play when an investor buys the call and the put option for a trade simultaneously. They both will have the same strike price and expiration date. Investors use this strategy when they feel that the price of the stock is expected to stay in a range, but they are unsure of the direction of the move. The gain that a trader can get from this strategy does not have a cap, but the loss can be equal to the costs of both options contracts combined.
It may sound similar to the previous strategy discussed, but is different in its own ways. The investors who use this strategy are worried that there may be large fluctuations in the price of the stock, but they are confused about the direction it may go in. Investors buy the put option, call option with a different strike price, an out of the money call option and out of the money put option for the same stock, with the same expiration date. This strategy becomes favourable when the price of the stock has huge movements in any direction giving the investor ample profits.
Long Call Butterfly Spread
This strategy does not require the investor to hold two different positions over a stock. Using the call option, the investor combines both the bear spread strategy and bull spread strategy. All the options are for the same underlying asset and expiration date. Three different strike prices are also used. Here the maximum profit is made when the stock remains unchanged until the point of expiration. The loss can occur only if the stock falls at a lower strike or below.
This strategy makes the investor hold a simultaneous bull put spread and a bear call spread. The investor sells an OTM bull put spread and buys another bull put spread at a lower strike price. The investor also sells the OTM call option and buys another call option for a higher strike. All options have the same underlying asset and the expiration date. If a trader feels they may end up earning a small amount of premium, they may use this strategy.
The trader will sell an at-the-money put option and buy an out-of-the-money put option. At the same time, he will sell an at-the-money call and buy an out-of-the-money call option. All the options will have the same expiration date and same underlying asset. This technique may look like a butterfly spread, but it combines both types of options. Profit and loss both are limited within a range in this technique, and they depend on the strike prices of the options used. Thus, the correct trading strategy can help you save thousands, if not lakhs and also help ensure you against the losses you might incur. However, it is the trader’s aptitude to know exactly what strategy suits best. Correct choices may help you go a long way in this trade, and the above techniques are just the tip of the iceberg. So, better information and learning can help protect you against other losses in the market.
Bull Put Spread
It involves creating a spread by buying 1 OTM put option and selling 1 ITM put option. The primary aim of the short put is to generate income, whereas the long put option is purchased to limit downside risk.
A Bull Put Spread will be your preferred strategy when:
- The market has declined, causing the put option premium to increase
- Volatility in the market is on the higher side
- Considerable time to expiry
The put options have the same underlying assets and expiration but different strike prices. It is an option strategy when one’s outlook is moderately bullish. The investor earns a profit when the underlying asset stays steady or rises.
A Bull Put Spread always results in a net credit, and therefore, it is also called a credit spread.
Bull Call Ratio Backspread
It is a bullish strategy. Using the spread, you can make money as long as the market stays bullish. When you implement the strategy, you can experience:
- Unlimited profit when the market goes up
- Limited profit if the market goes down
- A predefined loss if it stays in a range
The strategy involves buying 2 OTM call options and selling 1 ITM call option. It is done to limit losses when the trader expects the underlying security to rise significantly.
It’s a Bull Call Ratio Backspread strategy as long as the 2:1 ratio is maintained. Besides, the trader must confirm that the call options have the same underlying security and expiration.
The Synthetic Call is a bullish strategy adopted when the trader feels concerned about the near-term volatility of the market. The trader would buy the underlying and, at the same time, purchase put options as insurance against the underlying’s price fall. The strike price of the put options can be the current price (ATM) or slightly below the current price (OTM).
It gives you the benefit of owning the underlying security while creating a safety net against unexpected price movements. You experience the benefit when the security price rises. But if the price falls, you can exercise the puts to limit your losses.
The Synthetic Put strategy involves a short stock position and a long call opinion on the same stock. It plays out when the trader has gone short on the stocks but, at the same time, wants to hedge the upside risks. So, he buys an at-the-money (ATM) long call. If the stock price falls, the trader will short the stocks, but if there is an unexpected rise in the stock price, he will exercise the option to limit his losses.
It is a bearish strategy when the trader is concerned about a potential near-time rise in the stock price.
Bear Call Spread
The Bear Call Spread strategy works when the view of the market is slightly bearish. It involves creating a spread using call options. The trader sells a call option, collecting the premium upfront. At the same time, he will buy a call option on the same underlying security and expiration but at a slightly higher strike price. Since the call sold always has a lower strike price than the call purchased, the premium collected on the first leg of the strategy is always more than the amount paid for the second leg of the strategy.
A Strip strategy applies to a situation when the trader is expecting a significant movement in the asset’s price but is unsure of the direction it will take. A Strip is a market-neutral strategy that allows for profitable trades in varying market scenarios when the outlook is slightly bearish.
Strip involves buying 2 ATM puts and 1 ATM call. It allows for a large profit if the stock price moves upward or downward during the expiration. However, more gains are made if stocks move significantly downward.
A Short Straddle is a strategy adopted when the trader believes that the underlying stock price will not move significantly during the life of the contract. It involves selling 1 call and 1 put option for the same strike price and expiration date. The profit from the strategy is the premiums collected, while the possibility of potential loss is unlimited.
What Are The Levels of Options Trading?
Brokers assign levels to options strategies based on the risks and complexities involved. The traders should have approval from the brokerage to trade at different levels and maintain a margin account accordingly. For instance, covered calls and protective puts are level 1 strategies because the trader owns the underlying stocks. Hence, the risk level is low. Similarly, writing naked options involves significant risks and is therefore, level 4 in options trading.
Advantages and Disadvantages of Trading Options
Advantages of Trading Options
- Leverage: Options allow you to control a bigger position in the market for a relatively smaller investment. Leverage can help you amplify your gains if the trade goes in your direction.
- Hedging: Options can be used effectively as a risk management tool against potential losses. For example, you can use a put option to safeguard against a decline in the value of your holdings.
- Versatile: You can work out different option strategies according to market conditions, which makes it a versatile tool to apply. Whether the market condition is bullish, bearish, or neutral, you can use options to capitalise on your market outlook.
- Income generation: You can generate income by selling options. When options expire worthless, you can earn income from the premium collected.
Disadvantages of Trading Options
- Complexities: Options trading is more complex than trading stocks. It involved decisions regarding the time, direction, and price of the underlying asset. Options trading is not suitable for new or beginner traders.
- Time decay: Options are time-bound contracts, meaning their value erodes quickly if the asset price doesn’t move in the direction of the trade within the time frame of the options contract.
- Uncertainty of gains: Options strategies are based on future expectations of the price movement. You can earn a profit only when the trade moves in the predicted direction.
- Agreement signing: Options trading in India requires traders to sign an agreement with the broker. It is a requirement asked for by SEBI. The agreement contains a disclosure of the risks involved in options trading.
- High volatility risk: Volatility is the reason behind the changing options’ values. When volatility rises, it makes options more valuable. Conversely, the options can lose value even if the underlying asset price doesn’t move significantly.
There are several strategies that traders use when buying options in India. One common strategy is the “covered call,” where traders buy shares of a stock and sell call options on those shares to generate income. There is no one-size-fits-all strategy for options trading. The best strategy depends on the trader’s goals, risk tolerance, and market conditions. Some commonly used options trading strategies include: Covered Call No options strategy can be considered the safest, as the risks and potential rewards of any given strategy will depend on a variety of factors, including market conditions, the specific options being traded, and the investor’s individual risk tolerance and investment goals. The riskiest option strategy can vary depending on market conditions and individual circumstances. However, naked call writing, short straddles/strangles, and directional bets using out-of-the-money options are considered to be highly risky. Here are some basic steps for beginners in India to start trading options: Learn the basics Option selling can be a complex and risky strategy that requires a thorough understanding of market dynamics and risk management techniques to imply any strategy that can work. Therefore, there is no one best strategy.
What is the best strategy for options buying?
It’s important to note that the best strategy for options buying will depend on the individual trader’s goals, risk tolerance, and market outlook. It’s always a good idea to thoroughly research and test any strategy before putting it into practice.
Which strategy is best for options trading?
Bull Call Spread
Bear Put Spread
What is the safest options strategy?
What is the riskiest option strategy?
It’s important to understand the risks involved with any option strategy and use proper risk management techniques, such as limiting position size and using stop-loss orders.
How do I start trading options for beginners?
Choose a broker
Open an account
Fund your account
Monitor your trades
Practice good risk management
Which strategy is best for option selling?
There are several strategies that traders use when buying options in India. One common strategy is the “covered call,” where traders buy shares of a stock and sell call options on those shares to generate income.
There is no one-size-fits-all strategy for options trading. The best strategy depends on the trader’s goals, risk tolerance, and market conditions. Some commonly used options trading strategies include:
No options strategy can be considered the safest, as the risks and potential rewards of any given strategy will depend on a variety of factors, including market conditions, the specific options being traded, and the investor’s individual risk tolerance and investment goals.
The riskiest option strategy can vary depending on market conditions and individual circumstances. However, naked call writing, short straddles/strangles, and directional bets using out-of-the-money options are considered to be highly risky.
Here are some basic steps for beginners in India to start trading options:
Learn the basics
Option selling can be a complex and risky strategy that requires a thorough understanding of market dynamics and risk management techniques to imply any strategy that can work. Therefore, there is no one best strategy.