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Strategies for New Option Traders

Sebencapital

Published
22/12/23
Strategies for New Option Traders

In options trading, there's a range of strategies to pick from, depending on your goals. Options are flexible investment tools, and while many beginners focus on making money, there are other important factors to consider.

Key Takeaways

  • Engaging in options trading brings various benefits, like managing risk and finding ways to boost your overall investment portfolio as you learn more.
  • A low-risk way to start exploring options is through covered call writing, where you sell one call option for every 100 shares you hold.
  • Other strategies like naked puts, credit spreads, and collars can also be helpful, but it's crucial to research them thoroughly to grasp how these tools operate before using them.

How Do You Want to Use Options in Your Portfolio?

Options traders typically aim to make money as their main goal. However, seasoned traders realize that options offer other valuable traits for their investment portfolios. For instance, options can be utilized to:

  • 1. Risk Management: Options trading enables investors to pursue profits with less risk. Basic strategies set a maximum potential loss for any trade, providing a level of protection that stockholders might not have.
  • 2. Hedging Existing Positions: Traders can buy or sell options to hedge existing positions in their portfolio, reducing risks. Some methods limit profits, while others don't, offering flexibility in choosing between portfolio protection or limited protection with premiums.
  • 3. Protection Against Market Surprises: Options can safeguard holdings in case of unexpected market downturns, offering a shield during volatile stock market periods.
  • 4. Refining Market Predictions: Experienced traders can use options to fine-tune their market expectations. For instance, they can take a bullish stance on a stock or index while pinpointing specific expectations, maximizing profit potential by accurately predicting stock price changes.

Before You Start

Newcomers to options trading should adhere to a fundamental rule: never risk money unless you fully comprehend the trade. While seeking advice isn't wrong, it's crucial to ensure the trade aligns with your risk tolerance. If you don't grasp how the trade makes or loses money, it's best to avoid it.

Trading any options strategy without understanding its workings and objectives makes efficient trade management impossible. Options are meant to be actively traded. Every trade has an opportune exit time. A skilled risk manager recognizes when a trade isn't working and exits, even at a loss. Holding onto a losing trade in hopes of breaking even isn't advisable.

Recommended Strategies for Options

Here's a condensed list of strategies I suggest.

  • Writing covered calls
  • Selling puts with cash backing
  • Credit and debit spreads
  • Collars

For experienced traders:

  • Iron Condors
  • Diagonal, and double diagonal spreads

Here are six strategies that options traders often use. While there are more strategies out there, these are seen as the simplest to grasp. Starting with options, it's best to choose strategies that make you feel confident in your ability to open, handle, and wrap up your positions.

Covered Calls

At the top of the list is covered call writing (CCW). This is a great starting point for beginners looking to learn about options. Many newcomers to options already have some understanding of the stock market and experience in investing. So, starting with a strategy that involves owning stocks is a good way to introduce them to stock options.

To use this strategy, buy at least 100 shares of a stock or use shares you already own, then sell one call option for every 100 shares you have.

When you sell a call option, you collect a cash premium, and that money is yours to keep, no matter what happens later on.

When you sell (write) a call option:

  • When you sell a call option, you're agreeing to sell 100 shares of a stock at a fixed price, known as the strike price, for a certain period. However, this only happens if the option buyer decides to use their right to buy and you receive an exercise notice from your broker. This notice tells you that your option was exercised, and you've sold 100 shares at the strike price. The option you sold disappears once exercised, and the stock is taken out of your account. The money from the stock sale will show up in about three days.
  • As the seller, you don't have control over whether the option is exercised. That choice belongs to the buyer who paid for that right. Even though this might seem unfair, the buyer paid for this privilege.
  • An option is a contract setting the strike price and expiration date. Your obligation to sell your shares exists until the expiration date. If the option buyer doesn't exercise the option by the expiration time (roughly 30 minutes after the market closes on expiration day), your obligation ends, and the call option becomes worthless.
  • The cash you received when selling the option is separate from the contract. It represents the trade made on the option exchange and isn't part of the agreement itself.

When you sell a covered call, there are two possible outcomes:

  • The call gets used, and your stock sells at the price agreed upon in the contract (called the strike price). You also keep the cash you received as a premium.
  • The option expires with no action. You've made profit from the cash premium and still hold the stock. If you want, you can sell another call option and get another premium.

This covers the basics of this strategy. If you're interested, it's time to dig deeper into how to use covered call writing. Take your time to learn more before making any trades. If this strategy doesn't seem right for you, explore other options from the list.

Naked Puts

When you sell an out-of-the-money put option (where the stock price is higher than the put's strike price), you receive a cash payment upfront. There are two potential outcomes:

  • The option expires without any action, and your profit is the cash you collected.
  • At expiration, if the stock price is below the strike price, the option owner can sell 100 shares at the strike price, and you must buy those shares. This happens automatically.


When you sold the put option, you agreed to buy stock at the strike price. If you end up having to buy the stock, you might reconsider owning it. However, remember that by selling the put, you avoided buying the stock earlier at a higher price and didn't receive the cash premium.

Credit Spreads

Instead of selling options without protection, a trader can sell one put and buy another as a safety net, limiting potential losses. While this reduces potential profits, it's crucial to prioritize limiting losses for long-term success. Even though everyone wants to make gains, successful traders focus on preventing big losses.

This strategy, known as a spread, is popular for good reasons. But it's important for new option traders to first understand the basics of individual options trading before delving into spread trading. Why? Because knowing how individual options work helps in understanding how spreads function.

Collars

The collar strategy is the safest among these strategies. It's ideal for those more focused on safeguarding their money than making big profits. A collar represents a slightly optimistic position with gains and losses capped at a specific level.

Written by Sauravsingh

Techpreneur and adept trader, Sauravsingh Tomar seamlessly blends the worlds of technology and finance. With rich experience in Forex and Stock markets, he's not only a trading maven but also a pioneer in innovative digital solutions. Beyond charts and code, Sauravsingh is a passionate mentor, guiding many towards financial and technological success. In his downtime, he's often found exploring new places or immersed in a compelling read.

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