ECONOMICS
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Feb 21st | 13.35 GMT
OPTIONS & DERIVATES TRADING
5 Basic Option Strategies For Beginners
By, CIFER | Updated March 5th, 2021
Overview
Learning some basic option strategies can give investors different methods of capitalising on market movements, periods of low volume and can be a useful tool for hedging against adverse movements in current positions. The options market provides different risk:reward ratios than traditional assets using more complex and strategic investment methods.
Upon first glance, it can appear daunting to newbies, and yes the options market can provide complex alternatives to professional investors; however, the options market can be beneficial to all market participants even using some of the basic strategies listed below.
1) Buying Puts (Long Puts)
A trader whose has a bearish bias on a particular asset could buy put options in order to capitalise on downside movement in the underlying asset. The benefit of buying puts rather than a traditional short selling position is the limited risks associated with buying options.
Example:
You believe Apple share price will fall due to poor earnings reports, traditionally you could short the stock at the current market price ie: $130, however, the upside for the share price is unlimited therefore your position is exposed to unlimited risk. Buying put options gives an alternative, you buy put options so your bias is bearish, but your risk is limited to the cost of that option - otherwise knows as the premium. Ultimately this strategy gives you unlimited profits but with limited risk.
Profits on the options are realised as the underlying asset moves in the traders favour (past the option strike price) the option value goes up - that is, the premium gets higher. Therefore, if you have paid $10 for an at the money option and then the share price falls, the premium on that option would rise to perhaps $13 as the asset sells off, thus giving the trader a profit of $3 for every option contract.
2) Buying Calls (Long Calls)
In a similar fashion to Long Puts, the reasons for using calls instead of buying the underlying asset are the same. Risk exposure with long calls is limited to the premium paid, however the profit potential is unlimited. As the asset value rises beyond the option strike price, so will the value of the option.
Buying call options can be used as an alternative to buy shares, allowing the trader exposure to a much larger position on the underlying asset for the same investment as they would get by buying ordinary shares.
3) Protective Put
Protective puts is a strategy used to reduce exposure on existing positions, essentially a long put but aimed at protecting downside instead of aiming to profit. If you already own shares in company A but wants to protect short term downside risk, the trader could execute this strategy by purchasing puts. If the share price were to take a dip, the initial share holding would lose value but the put options covered as a hedge would increase in value essentially leaving the investor in the same position.
If she share price were to continue climbing, the investor would simply lose the premium paid for the puts but still benefits from the rise in the underlying stock anyway. Consider it like an insurance policy for existing positions, otherwise known as hedging. Depending how close to to being 'at the money' the options are, the higher the premium the investor will pay for them, thus increasing the cost of they hedge.
Protective puts are also useful as an alternative to stop orders - instead of using a stop order which may work against you at times: for instance if the market takes a slight dip, takes you out of the position then continues in the original planned direction,
4) Covered Call
Another strategy that requires the trader to already be holding long positions on the underlying asset. Often executed once an investor has already seen good gains on a particular stock, but perhaps has a neutral/ bearish view in the short term.
Things To Remember:
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Covered call acts as a hedge against long stock positions during periods of low volume, as the premium collected would provide income while the stock is trading sideways
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If the investor has a very bearish or very bullish view, the strategy is not particularly effective as the liability on the option eats into potential profits if the stock rises fast
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If the stock plummets, the premium collected on the option would likely be less than the losses from the original position.
5) Long Strangle
This is an option strategy where the investor holds call and put options on the same asset, with the same expiration but with different strike prices.
Things To Remember:
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Strangles are useful to investors who believe the asset will experience a large move in the near future but unsure which direction, ie: important news announcments.
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The strategy is only profitable if the market does experience a large move, one option will expire with increased value, and one will expire worthless.
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The risk is limited - If the market goes sideways, the investor will simply lose the premiums paid on both options
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Final Remarks
The options market offers a more mathematical approach than traditional assets which can really work in the favour of market participants who have a firm grasp of it. It provides numerous methods of reducing risk and capitalising on low or high volume markets making it much more dynamic and adaptable than most assets.