Investors and Traders who seek to enhance the performance of their portfolio should consider using stock options as part of their trading strategies. The versatility of stock options trading strategies allows them to be used both by the conservative investor to protect his/her portfolio as well as the rank speculator who seeks to generate outrageous profits. The ways in which stock options can be used to complement trading strategies are limited only by the imagination of the knowledgeable investor or trader. Below is a description of simple ways in which new investors and traders can apply these powerful instruments both safely and successfully.
Most folks who begin investing and/or trading in the stock market buy and sell stocks directly. Those who are successful in their efforts at investing or trading usually trial many trading strategies before they find a strategy that works for them. They generally perform some sort of analysis (either fundamental or technical) to decide when to get in, and then follow a rule to decide when to exit the trade (i.e. sell the stock). By following such an approach, a disciplined investor/trader can generate a decent rate of return. However, by learning to use stock options trading strategies as part of their routine trading, either by themselves or in combination with a stock purchase, the knowledgeable investor and trader can have a far greater advantage over the pure stock investor or trader. A detailed in-depth discussion of the intricacies of stock options trading strategies is beyond the scope of this webpage, however, there a many resources that can found online that go over the basics of stock options – a list of some of them can be found on the ‘Investing and Trading Resources’ page. Those who wish to learn to trade options successfully should read more than the ‘basics’, and learn the intricacies of the ‘greeks’ – delta, gamma, vega and theta, implied volatility and its effects on options prices, and the relationship between gamma and theta.
What I hope to go over here are some of the ‘secrets’ of options trading strategies – these are inherently ‘beyond the basics’, and if you do not understand them, take the time to go back and learn the basics of stock options.
Of course, you are welcome to have a different point of view – I welcome your comments!
KEY SECRETS OF OPTIONS TRADING STRATEGIES
ABOUT IMPLIED VOLATILITY (IV)
- It is crucial to know how high Implied volatility is currently compared to where it was in the past.
- The effects of IV are greatest at the ‘at the money’ (ATM) strike, and less so further away from the ATM strike.
- Vega, which quantifies the effects of IV on the strike, is higher in longer term options and lower in shorter term options.
- The effects of IV are minimized when a trade consists of both long and short options – for example a spread, butterfly or condor. However, ‘unbalanced’ long and short legs can result in a net effect with some resultant IV effects.
ABOUT DELTA and GAMMA
- The ATM strike has a delta of about 50.
- Both delta and gamma have a ‘normal’ distribution about the ATM strike.
- The effects of gamma are greater for shorter term options than for longer term options.
- Theta is greater with shorter term (greatest in the last week of an options life) when compared to longer term options.
- Theta also has a ‘normal’ distribution about the ATM strike.
- Theta decay has a direct relationship with gamma – as an option nears its expiration date, both gamma and theta decay rise. A popular phrase in option trader circles is “Theta is the price you pay for Gamma”.
ESSENTIAL OPTIONS TRADING STRATEGIES
The following are some of the options trading strategies that I have found immensely useful in my own trading; you are invited browse through my list and decide if one or more may be some you would consider using yourself. I will add to this list over the next many weeks – if you have some options trading strategies that you favor and have found to be useful, I’d love to hear from you – please leave me a comment.
Before picking any strategy, one needs to consider the following aspects of the stock and its associated option chain(s).
Answer the following questions about the stock – usually this may be discerned by an examination of the stock price chart, occasionally by some aspect of fundamental analysis or news reports of some impending change, and, the associated stock option volatility charts.
- How high (or low) do you think the stock rise (or fall) to?
- By when do you think it will reach its target price?
- Is IV higher or lower than its past historical ranges?
A. BUYING THE CALL OR PUT
Remember, a call is an option contract that gives you a right for a period of time (until the ‘expiration date’) to buy the stock at a certain price (the ‘strike price’); a put is an option contract that gives you a right until the expiration date to sell the stock at the strike price. You get to choose which option contract (call or put) you wish to buy – which strike price and which expiration date depends on your outlook for the stock.
Typically, I will buy a call (or put) if I am extremely bullish (or bearish) about a given stock based on either a technical pattern or a news event. In this case, I expect the stock to move rapidly in the direction that favors my call (or put) – up for the call/down for the put. Which month option I buy depends on how fast I think stock will move – remember, the near term options (1 month or less) will make more money faster than longer term options (3 months or more). The ‘price you pay’ when you buy an option contract is theta decay. If your option does not move fast enough to get past the ‘break-even’ point (premium paid for options plus strike price), you will lose money. For situations where you expect a strong move of the stock, a good choice would be an option in the 1 to 3 months range about 1 strike out-of-the-money (OTM)(with a delta of about 25 to 30), as this would give you the ‘best bang for your buck’ and allow you to buy more options for the same dollar amount of money compared with buying fewer options ATM or in-the-money (ITM).
B. BUYING A CALL OR PUT SPREAD
Remember, a ‘spread’ involves buying and option contract and selling another one simultaneously. With a ‘bull call spread’, you buy call and sell one with a higher strike price; with a ‘bear put spread’, you buy a put and sell a put at a strike lower than the one you bought. Like with buying individual stock options, you get to choose which pair of option contracts (calls or puts) you wish to buy – here again, which strikes and which expiration date depends on your outlook for the stock.
In comparison to buying the call or put outright, you may wish to consider a spread in the following instances:-
- The option premiums are high (as with higher priced stocks) – in this case, buying the spread will allow you to buy more numbers of spreads for the same amount of money than buying the call or put alone.
- IV is high in comparison to its past historical norms – in this case, the ‘inflationary’ effects of high IV on the price of the options purchased is minimized by the same effects on the prices of the options sold.
- You don’t expect a ‘runaway’ stock movement – this is because with a ‘runaway’ stock move, you can make far more profit with the single option than with the spread as, with the spread, the option sold limits your profitability.
For either of the above strategies to work, investors and traders need a sound understanding of technical analysis and how to interpret market psychology by ‘reading stock charts’. For a succinct review of the basics of market psychology and technical analysis, sign up for Market Club’s FREE 10 lesson Trading Course.
USING OPTIONS STRATEGIES TO PROTECT STOCK INVESTMENTS
Investors who are primarily ‘stock investors’ should consider learning about stock options and how stock options can help protect their stock portfolios. In the current financial environment, the stock market gyrates wildly almost daily, which can cause the ‘pure stock investor’ to lose much very dramatically, sometimes even overnight! Those who wish to protect their investments from such losses can do so rather easily by the use of stock options.
The above options trading strategies work best when using stocks with highly liquid options (see ‘Why Liquidity is Important’) and a philosophy to ‘limit losses while letting your profits run’ (see ‘The Stock Market Game’). As you get more experience in the markets and with different options trading strategies, you will find that you favor some over others – this happens to everybody. The right options trading strategies for you are ultimately the ones you understand well, and can use to make money consistently. For a simple 3-step method (with illustrations) of how to increase your chances of maximal profit with an automatic exit when the market moves in your favor, see ‘How to Trade Stock Options‘ and ‘How to Trade Stock Options Pictorial Guide‘.