Before jumping into trading options, traders should brush up on understanding the strategies that can be used if they are looking to be successful in trading. There are plenty of strategies available that help limit risk and maximise potential returns. With a little effort, traders can learn how to take advantage of what these strategies provide when they begin options trading with a broker such as Saxo. Below, we have listed and explained a few key options trading strategies that traders should know.
What are options?
For those not in the know, options are financial derivatives that give holders the right, but not the obligation, to purchase or sell an underlying asset at a predetermined price, at a specific time somewhere in the future. These contracts provide traders and investors with the opportunity to speculate on price movements, hedge against risk, and create complex trading strategies. There are two main types of options traders should know:
Call options: A call option gives holders the right to buy the underlying asset at the strike price on or before the expiration date. Call options are usually used in bullish markets, as the holder benefits from the underlying asset’s price appreciation.
Put options: A put option gives the holder the right to sell the underlying asset at the strike price on or before the expiration date. Put options are often used in bearish markets, as the holder benefits from the underlying asset’s price decline.
Options are generally traded on various financial instruments, such as commodities, stocks, indices, and currencies, to name a few. Each option contract represents a specific quantity of the underlying asset, known as the contract size.
Options trading strategies to know
Options trading offers a wide range of strategies that cater to various market conditions and risk profiles. Below we have listed a few key options trading strategies that traders should know and understand.
This strategy involves the trader selling a call option (otherwise known as going short) but with a slight difference. Here, the trader sells the call but also purchases the underlying asset. This is considered a popular options trading strategy because it not only allows traders to potentially generate an income but also reduces risk. The trade-off is that traders must be willing to sell their shares at a set price – otherwise known as the short strike price. In order to execute this strategy, a trader must purchase the underlying option, and then simultaneously sell a call option on the same assets.
In this strategy, a trader buys an asset and also buys a put option at the same time for an equivalent number of assets. Traders may choose to use this particular strategy as a way of protecting their downside risk when holding an asset. In a sense, this strategy functions very much like an insurance policy – it establishes a price floor in the event the asset’s price falls unexpectedly. This is also why it is known as a protective put.
Bear put spread
The bear put spread strategy is a type of vertical spread. Here, the trader buys put options at a specific strike price while at the same time selling the same number of puts at a lower strike price. Both options are bought for the same underlying asset, and they have the same expiration date. This strategy is often used when the trader has a bearish belief about the underlying asset and expects that the asset’s price will decline sometime in the future. The strategy offers both limited gains and limited losses for traders.
Bull call spread
In a bull call spread, a trader buys calls at a specific strike price while at the same time also selling the same number of calls at a higher strike price. Both call options will have the same underlying asset and expiration date.
This is another type of vertical spread strategy and is often used when a trader is bullish on the underlying asset. This means they expect a moderate increase in the asset’s price sometime in the future. By using this strategy, traders are able to limit the upside on their trades while also reducing the net premium spent.
This is a neutral strategy that involves selling both a bear call spread and a bull put spread at the same time. This strategy allows traders to benefit from limited price movements in the underlying asset.
This is another neutral strategy that combines both a bear and bull spread with the same strike price to create a middle strike option. It is often used when a trader expects minimal price movements in the underlying asset.
A protective collar strategy is done by buying an out-of-the-money (OTM) put option while at the same time writing an OTM call option (with the same expiration date) when a trader already owns the underlying asset. This strategy is typically used by traders after a long position has experienced substantial gains. This means traders have downside protection by putting a lock on potential sale prices. That said, the trade-off of this strategy is that traders may be obligated to sell their assets at a higher price, thereby forgoing the potential for higher profits.
A long straddle options trading strategy takes place when a trader buys a call and put option at the same time on the same underlying asset with the same expiration date and strike price. A trader will usually use this strategy if they believe that the price of the underlying asset will move significantly out of a specific range, but they are not sure which direction the underlying asset will take.
Technically, this strategy allows traders to have the opportunity for unlimited gains. Additionally, the maximum loss traders can experience is limited to the cost of both options contracts combined.
Overall. It is essential traders remember that each strategy has its own unique risk and reward characteristics. Therefore, it is important to understand the intricacies of these strategies, practice with demo accounts, and use them based on your market outlook, risk tolerance, and investment goals. Additionally, options trading involves risks, and it is crucial to manage risk appropriately and avoid using strategies that are beyond your level of expertise.