Trading in the financial markets can be a risky endeavor with just as much potential for reward as gain. Basic Options contracts are no exception to this rule and carry significant risks. Therefore, those who attempt to utilize these financial instruments must be well-versed in their use.
This guide is intended to serve as a reference point for inexperienced traders to acquire the foundational knowledge required to trade basic options contracts in the financial markets. We will cover the basics of what options are, how to develop an effective trading strategy and the top four options trading strategies that are currently available.
What are the basics of Options and Options Trading?
So, what exactly are options contracts? The standard definition of an option is that “it is a contract that gives the purchaser the right, but not the obligation, to buy or sell an underlying asset at a specific price on or before a certain date”. As such, an option, much like a bond or a stock, operates like securities.
Simply put, options are binding contracts with defined terms that provide the purchaser with a series of options when they enter into the agreement that would either maximize gains or minimize losses in the event that a trade does not go as planned.
Options trading is therefore the practice of buying and selling these contracts with the intention of earning a profit from the price fluctuations of the underlying assets. These underlying assets can be anything from stocks to bonds, or even indices.
Pros of Options Trading
- Cost-Efficient - Traders are able to secure significantly higher amounts of leverage than they would be able to when trading stocks.
- Higher Returns - Due to the leveraged nature of options contracts, traders are able to secure much higher rates of return when trading options contracts.
- Strategy - Options traders are able to employ the use of a more varied list of strategies giving them an advantage over traders who utilize other instruments.
Cons of Options Trading
- Risk - Leverage is a double-edged sword and traders can also endure more catastrophic losses when trading options contracts than they would when simply trading stocks.
- Time Decay - Options contracts have expiration dates. As the expiration date draws closer, the value of the options contract begins to decline.
- Complexity - Options are fairly sophisticated financial instruments making them reasonably difficult to trade. As such, they are generally unsuitable for new investors or those with little experience in the financial markets.
How do you create a Basic Options Trading Strategy?
There are a number of strategies for trading options that we will explore below. Each strategy will incur its own level of risk, complexity, and sophistication. As such, the strategy each individual trader chooses to employ will be dependent on their individual circumstances.
When determining which strategy is right for you, consider your level of risk tolerance, financial goals/objectives, and understanding of both the financial markets and options.
Using Options Trading to buy/sell Stocks
As we know, options can be used to trade on a number of different underlying assets, including stocks. Traders can therefore use options contracts as a way to hedge their stock investments and protect themselves from risk while minimizing losses.
Through the use of options, traders are able to leverage their positions and control much larger sums of capital than they would otherwise be able to if they purchased the underlying stocks directly. As a result of this leverage, using options to buy or sell stocks allows traders to maximize the impact of that specific stock’s price action.
When should you use Options Trading?
It should be noted at the outset that only traders with a sufficient level of experience and understanding should attempt to use options. These financial instruments are significantly more complex than the simple purchase of equities and their use of leverage makes them much higher risk.
That said, options trading has a number of benefits and there is a range of situations in which using options is especially useful. As we noted above, options can be used to hedge your position and protect against potential market risk. If you find yourself in a market downturn and would like to protect yourself from further losses, options are a fantastic tool.
Since options make use of leverage they also provide greater returns when the market moves in your favor. As such, it would make sense for you to trade options when you are confident about the price direction of an underlying asset. If a trader believes that stock Y will move X amount by a specific date then they would be well advised to purchase an options contract to maximize returns.
What are the different Options Trading Strategies?
Now that we have covered the basics of options trading, let’s take a look at some of the most popular options trading strategies that traders use to capitalize on these innovative securities.
It is important to note that when trading options, the key to success is found in selecting the appropriate strategy for each specific option in the context of your own circumstances.
One of the most efficient methods of losing money when trading options is randomly assigning various strategies to them. Now, let’s take a look at some of the most popular strategies.
Butterfly Spread Options Strategy
We will begin with the Butterfly Spread strategy, one of the more complex strategies on our list. This particular strategy employs the use of four separate call or put purchases and can be deployed as both a bullish and bearish strategy.
To successfully execute this strategy, you will need to purchase one out-of-the-money call/put, write two at-the-money call/puts, and purchase one out-of-the-money call/put. If you’re utilizing the Butterfly Spread strategy it is because you believe that the price of the underlying asset will be roughly the same when the option expires as when you purchased it. For this reason, the strategy is relatively neutral with limited risk and can be approached from either a bullish or bearish perspective.
Let’s take a look at how this strategy would work in the context of a long call butterfly spread example.
Butterfly Spread Strategy Example:
Let us assume that a trader purchases one $40 call for $600, writes two $50 puts for $300 each and then purchases a second $60 call for $200. The total debt incurred by the trader to initiate this would be $200.
If the price of the underlying asset at the beginning of the options contract is $50 and closes at the same price, the two put options and the $60 call will expire worthless.
However, the initial call option purchased for $600 keeps its value of $600. As a result, when deducting the initial $200 of debt needed to complete the spread, the investors will yield a total profit of $400.
- Using this strategy allows you to incur a limited amount of risk. The only amount that is at risk is the premium that the trader pays to initiate the spread. Further, this amount can be at least partially offset by selling the two options which are at-the-money.
- Naturally, where there is a low risk there is also low reward. The potential for a large return is non-existent when using this strategy. Also, if the trader is wrong and the price of the underlying asset does not remain the same they run the risk of all the options expiring worthless. In our example, this situation would have led to the total loss of the $200 premiums paid.
Iron Condor Options Strategy
There are two alternative forms of the Iron Condor strategy; long and short. The successful execution of this strategy requires that traders hold both long and short positions in two separate strangle strategies. To achieve this, a web of complicated calls and puts is needed.
When implementing this strategy, traders will need to buy or sell calls and puts with the same expiration date that are all out-of-the-money while ordering them lowest to highest. For example, sell a put, buy a put, sell a call, buy a call. As you can imagine, this particular strategy, much like the Butterfly Spread, is sufficiently complex and should only be attempted by experienced options traders.
Like the Butterfly Spread, this strategy should be used by traders who believe the market will remain relatively neutral over the duration of the options contracts. The duration for which they maintain this strategy will depend on how long the market will remain neutral.
If they believe the market will not remain neutral for long, they will utilize a short condor strategy.
However, if they believe the price of the underlying asset will trade sideways for some time, they will likely implement a long Iron Condor. For the purposes of this article, let us look at how a long Iron Condor might work in practice.
Iron Condor Options Strategy Example:
Let us assume that the price of the underlying security is $50 in May 2022 and the investor chooses to use a long Iron Condor. In this example, the trader would purchase a combination of bear call and bull put spreads.
To do this, the trader would buy options for June 2022 which would include the following:
- A $200 put with a strike price of $40
- Write a $300 put with a strike price of $45
- Write a $300 call with a strike price of $55
- Buy a $200 call with a strike price of $60.
In doing the above, the trader finds themselves in a position to make a profit of $200 assuming the stock is still trading around $50 at the time the options expire. However, in the event that the price of the underlying asset is trading above $60 or below $40, the trader in this example will lose the intrinsic value of each options contract as well as the potential $200 return.
- The rewards of using the strategy are the net credit that the trader would secure at the beginning of the trade.
- While the returns of this strategy are fixed, the risk of significant loss is disturbingly high. If the trader is wrong about the price movements of the underlying asset for the duration of the options contract, it is entirely possible for the trader to sustain painful losses.
Basic Long Call Options Strategy
Unlike the two strategies discussed above, the Long Call strategy is pleasantly straightforward and can be implemented by options traders of any skill level.
As the name suggests, the Long Call strategy involves a trader purchasing a call option that they believe will increase well above the strike price before the option expires. This strategy is especially beneficial to new investors as it incurs a very limited amount of risk while the potential return is essentially unlimited.
As with the other strategies, let us look at the Long Call strategy in the context of a real-world example.
Long Call Options Strategy Example
Assume that the price of the underlying security is $50 and the investor purchases a call option for $100 with a strike price of $50. Now, in this example, by the time the contract expires the price of the underlying security has doubled to $100.
As you know, a call option is worth 100 shares and so in this example, the trader has secured a profit of $5000 minus the initial $100 used to purchase the option.
- The strategy is incredibly simple when compared to other strategies on this list. It maintains the potential for almost unlimited reward while only incurring limited risk.
- Naturally, if the trader is wrong about the direction in which the price of the underlying security will move, the trader will lose the premium paid and the option will expire worthless.
Basic Short Call Options Strategy
The Short Call strategy capitalizes on down trending markets and would have been an ideal strategy to implement at the end of 2021 when markets began their multi-month decline.
Although this strategy is also straightforward, the level of risk it incurs is significantly higher than other strategies on this list. For this reason, we do not recommend that traders implement a Short Call strategy unless they are confident about the price direction of the underlying asset.
The Short Call strategy requires that an investor write a put option when they believe the price of a security is about to fall. In order to secure a profit, the value of the security would need to fall below the strike price of the option.
To gain a significant profit using this strategy, the trader would need to purchase the put by the expiration date. If they failed to do this, they would only be left with the premium that was paid by the buyer to purchase the option.
The omnipresent risk of this strategy is the fact that markets occasionally rally, especially during a significant downturn. If volatility was high and the price of the underlying asset rallied, traders would not only lose the premium that was paid but also be at risk for theoretically limitless funds beyond this. For this reason, we recommend inexperienced traders refrain from implementing this strategy into their options trading plans.
- The strategy is straightforward and requires no initial investment on behalf of the seller. As a result, the Short Call strategy can be implemented by anyone who is confident in a major downtrend taking place that would impact the price of the underlying asset.
- As with any short selling, the losses are theoretically unlimited as there is no limit to the amount that a security could rise. To put this into context, imagine the losses that could have been sustained by traders who used the Short Call strategy on GameStop prior to their initial rally.
Although the four strategies listed above are among some of the most popular basic options trading strategies, they are far from the only ones that exist. As you’ll have likely figured out by now, options trading strategies can be incredibly versatile in that they are either highly complex or suspiciously simple.
Many inexperienced traders believe that the more complicated a strategy, the more risk is incurred when executing it. However, this could not be further from the truth. Many of the highest risk options trading strategies are actually very straightforward to understand.
Options are a tool that should be in every investor's skill set. The ability to make use of such a diverse range of strategies opens traders up to the potential of significantly higher returns (and losses).
Therefore, regardless of your experience level, it is recommended that you begin to learn how to combine your trading strategies with these innovative financial instruments as soon as possible