Options Trading Strategies

So far, we’ve seen the four primary ways of trading options: buying calls, selling calls, buying puts, and selling puts. We’ve uncovered the risks and possibilities associated with each of these trading forms.

In this section of options trading strategies for beginners, things start getting interesting real fast, as we examine combined option techniques. Our ultimate objective will be to use basic trading themes in pursuit of a specific strategy.

As an investor (no matter what you’re investing in), it’s critical that you understand not only what your profit potentials are, but also the risks involved in any investment you undertake. In trying to achieve your profit goals, you should be able to identify what acceptable levels of risks you’re willing to assume. This, of course, will depend on your personality, point of view, tolerance for risk, perception of the market, financial position, and overall financial plan.

When people trade the markets they use different options trading strategies for entirely different reasons. Clearly, they’re trying to satisfy different goals.

For instance, as a conservative type trader, you might be looking to make profits only at the cost of assuming minimum risk. You then pursue an option strategy that reflects this philosophy, by putting a cap on your gain potential while also substantially limiting your exposure. Or another example, to protect the value of a long position you’ve acquired in the futures market, you might buy a put. This will give you downside protection,1 without the need to risk exercise. On the other hand, as a more speculative trader, you might be much more attracted to cheaper, near-expiration options that offer greater profit potential with greater risk.


1 Provides a form of ‘insurance’ in case of a drop in the price of the commodity.

Whatever your position may be, there’s probably a suitable option strategy for you. So let’s begin by going over some basic definitions, and then follow up with our examples.

There are 3 major types of combined strategies: Spreads, Straddles, and Hedges:

Spread Definition

A Spread is buying an option while selling another option of the same underlying commodity, with different strike prices and/or different expiration dates. This combination of buying and selling provides a way of putting the odds in your favor, while reducing risks in case the price of the underlying commodity moves adversely.

There are different varieties of spreads, and they can get very complex. We’ll go over the most common and simple ones here, and continue to periodically cover the more sophisticated spreads through our newsletter service.

 

Straddle Definition

A straddle is simultaneously buying and selling a call and a put for the same underlying commodity, with identical strike prices and expiration dates. The key here is that both the striking price and the expiration date of the call, or of the put, are the same.


Hedge Definition

A hedge is to protect one position with another position. For example, buying a put option to protect your long futures position in case of a price decline. Basically, the premise is that every trade that you make is offset with another trade that has the potential to earn you money if the market turns against you. Again, this is a form of insurance. You’re protecting your long position by covering yourself with a strategy that caps your risk in case of a price decline. Conversely, you protect your short position by covering yourself with a strategy that caps your risk in case of a price increase.

Let’s now take a closer look at each one of these techniques, by putting them through examples that can help you grasp the concept.

Go to Spread Option to continue tutorial.