Options are excellent tools for both position trading and risk management, but finding the right strategy is key to using these tools to your advantage. Beginners have several options when choosing a strategy, but first you should understand what options are and how they work.
An option gives its holder the right, but not the obligation, to buy or sell the underlying asset at a specified price on or before its expiration date. There are two types of options: a call, which gives the holder the right to buy the option, and a put, which gives its holder the right to sell the option. A call is in the money when its strike price (the price at which a contract can be exercised) is less than the underlying price, at the money when the strike price equals the price of the underlying and out of the money when the strike price is greater than the underlying. The reverse is true for puts. When you buy an option, your level of loss is limited to the option’s price, or premium. When you sell a naked option, your risk of loss is theoretically unlimited.
Options can be used to hedge an existing position, initiate a directional play or, in the case of certain spread strategies, try to predict the direction of volatility. Options can help you determine the exact risk you take in a position. The risk depends on strike selection, volatility and time value.
In a covered call (also called a buy write), you hold a long position in an underlying asset and sell a call against that underlying asset. Your market opinion would be neutral to bullish on the underlying asset. On the risk vs. reward front, your maximum profit is limited and your maximum loss is substantial. If volatility increases, it has a negative effect, and if it decreases, it has a positive effect.
When the underlying moves against you, the short calls offset some of your loss. Traders often will use this strategy in an attempt to match overall market returns with reduced volatility.
BULL & BEAR SPREADS
Bull call spreads and bear put spreads also are called vertical spreads because they occur in the same month and they have two different strikes. Unlike with the covered call strategy, your risk with the bull and bear spread strategies is more easily quantified.
In a bull call spread, you buy a call on the underlying asset while simultaneously writing (selling) a call on the same underlying asset with the same expiration month at a higher strike price. You should use it when you think the market will go up somewhat, or think it’s more likely to rise than fall (in other words, you have a bullish or moderately bullish outlook). Your likelihood for profit is limited, as is your risk, because the price paid for the call with the lower strike price is partially offset by the premium received from writing the call with a higher strike price, so you have less risk of losing the entire premium paid for the call.
In a bear put spread, you buy a put on an underlying asset while writing a put on the same underlying asset with the same expiration month, but at a lower strike price. You should use this strategy when you think the market will fall somewhat or is more likely to fall than rise, as you’re capitalizing on a decrease in the price of the underlying asset.
Another strategy used in options is calendar, or time, spreads. In a calendar spread, you establish your position by entering a long and short position at the same time on the same underlying asset, but with different delivery months.
The point of this strategy is, time decay happens much more quickly the closer we get to expiration. The theory is that when you short the front month option, you’ve got that quickly-evaporating time premium working with you, faster than the decay in the further out option that you bought. Just like the call and put spreads, you’re paying a debit for the spread and the further out you go in time, the bigger that debit’s going to be. You’re looking for a stock at expiration to be at the strike that you have put this spread on.
The further out you go in time, the more volatility you buy in the spread. Please notes that if you pick an out of the money strike and the maximum spread, for this to work to your benefit the underlying has to go up to that strike for this spread to be at its widest point of expiration. If you pick the at the money strike, you want the [underlying] to hang out around that strike, and if you pick the in the money, you want the [underlying] to go down. You are long volatility in this spread. You want to be cognizant of volatility levels.
The iron condor is a strategy that can be a good introduction for beginning options traders to option selling. It can be a relatively safe way to sell options because you can’t lose on both sides of the trade. Here, you pick a likely trading range for an underlying asset and sell out of the money option spreads around that range. If you collect a total premium of $1,000 for selling two $2,500 wide spreads both an out of the money call spread and an out of the money put spread, your total risk is only $1,500 because the commodity can’t go through both spreads at expiration. You have spread the risk across a wider range of possible prices. If your trading range thesis changes or volatility explodes and threatens to put one of the spreads in the money, you can exit one or both spreads at any time. Collecting $1,000 against $1,500 of risk offers you a potential return on risk of 67%.
The market outlook for the iron condor is neutral. You’re trying to be strategic with your use of leverage. You’re trying to be systematic and probability minded, looking at what the best odds in the long run [are] if you did this consistently.
An iron condor can be entered from the short side or the long side. A trader who enters a short iron condor is looking to profit from a range bound underlying asset. As long as the underlying asset stays within the inside strikes by expiration, the trade will be profitable. If it moves outside of the inside strikes by expiration, the trader will take a loss, which could be as high as the difference between the sold call/put and the purchased call/put. A trader who enters a long iron condor is looking for the exact opposite, or, a large move in one direction or the other by expiration.
DO'S AND DON'TS.
As with any type of trading, with beginning options strategies, having a trading plan and having an exit strategy are crucial. Everybody has a plan for when to get into a particular stock or index, but few think it through to the point of when to take profits or cut losses.
Traders should stay disciplined by writing down their plan, which should include when and where to take profits or losses if things go your way or go against you. You want to start with a thesis about where the underlying commodity or financial instrument could go in a certain time frame. Next, you have to visualize the potential scenarios that might unfold and how you will feel about your trade thesis at each turn. Options traders can eliminate stress and doubt by having a clear trading plan for every single position before they enter the order.