In our complete guide to the best options trading strategy, we will go through a list of strategies by order of complexity. We must first stress that trading options may seem complex at first, but things will become clearer with practice.
Trading options is risky but depending on the trading strategy, it may have limited downside or no limit at all. We will also evaluate how risky each options trading strategy is and the possible risk-reward profile.
First, let’s just get acquainted with the fundamentals of any options trading strategy and its terminology. All strategies involve one or both types of options contracts: Call and Put.
Here is the main terminology associated with options trading:
- Exercise: The act of carrying through your option to buy or sell a given asset in the terms defined in the contract.
- Strike: This is the price at which the option contract stipulates an asset is exchanged if the option is exercised.
- Expiry: Is the date by which the buyer of the option must exercise their right to take delivery of the underlying asset.
- Premium: Amount of money paid by the option buyer to the seller.
- Long: An investor or trader who has bought an option.
- Short: An investor or trader who has sold an option.
- Vega: The value of volatility in the premium of an option.
- Time Value: This is the value of the premium given by the number of days to expiry.
- In The Money: This means the strike price is below the current market price for a call option, or above the current market price for a put option.
- Out Of The Money: When the strike price is above the market price for a call option, or below the market price for a put option.
- At The Money: Here the strike price is at the same level as the market price for either call or put.
A call option gives the buyer of this contract the right, but not the obligation, to buy an asset at a future date. The option contract also stipulates the price at which the asset will be exchanged and the quantity.
The seller, or writer, of the option, must make delivery of the underlying assets on or before the expiry date if the option buyer exercises his right. In the agreed amount and at the price stipulated in the contract. The writer of an option will earn the premium paid by the buyer if the latter does not exercise their right.
On the other hand, the writer has a very high maximum risk of loss. In theory, the price of the asset could rise considerably. In which case, the option writer would have to buy the asset in the market and sell it for a loss to the option buyer at the agreed strike price.
A put option gives the buyer of this option the right to sell an asset at a predetermined strike, expiry date, and quantity. The seller of the put option receives a premium for writing this option. If the market goes down, lower than the strike price, before the expiry, the buyer can exercise the option and sell the asset to the writer of the option.
If the price of the asset remains the same or goes up, then the option buyer does nothing. The option expires worthless, and the option seller will keep the premium in full. Being a put seller is not as risky as short-selling stocks, for example.
As a seller of a put option, you may be obliged to buy stocks at the strike price at or before the expiry date. However, your maximum loss is the price of the stock. While a short seller of stocks could see the price of that stock double and therefore has much more risk.
Best Option Trading Strategies: Single Option Strategies
Before we get into some of the more complex best options strategies, let’s look at single-leg options strategies using stocks as the underlying asset.
Long Call Option
With a long call option, you buy the right to take delivery of the stock if the price goes above the strike price before expiry. Having said that, if the price of the underlying stock moves up sufficiently before the expiry your call option will be worth more than the price you paid for it.
Bearing this in mind, you may opt to sell your call option at this point rather than wait for the expiry date. You could also exercise the option and take delivery of the stock. However, this would give you a new position and a new risk profile.
For most options traders, the target profit is a percentage increase of the premium of the option. And the exit strategy would be before the expiry date. There are two reasons for this. First, if the stock price has risen substantially you would want to cash in on the profit, as what goes up may also go down.
Second, the value of the option is also determined by the time value, or Theta in options jargon. As time goes by this value decreases since there is less time to the expiry date. So, the longer you hold options, everything else unchanged, then your option is worth less.
Long call options have no profit limit, as in theory, the price of the underlying stock is not limited. While your loss is limited by the cost of the option.
Setting Up Trades
Setting up an options trading strategy is complicated. You need to find the ones that are most likely to have large moves to take advantage of a long call option trade. Rockwell Trading are experts in the field of options trading and have the technology to filter thousands of stocks to find the trades with the highest chances of profit.
Long Put Option
Buying a put, or going long, gives you the right to sell stocks at the strike price before the expiry date. If you believe the price of a stock is headed south this can be a profitable strategy. So, when you go long a put and the stock price falls your option will be worth more.
The premium on the option will rise as the stock price falls lower. And if it goes below the strike price you may exercise your right to sell the stock, then buy it back in the market. However, most options traders will exit their options trade once the premium has reached their profit target.
For the reasons mentioned above, time value decay and the fact of cashing in on your profits will drive most options buyers to sell their options before expiry. Your maximum profit is limited to the price of the stock. While your loss is limited to the cost of the option.
Short Call Option
In this trade, you would sell a call option and receive the premium for writing the contract. If the price of the stock goes up, you may find that the option buyer exercises their right to take delivery of the stock.
If the strike price of the option was $10, and the stock price goes to $20 you would lose $10 on each stock. Whereas the premium you received may have been only a few dollars. Of course, your loss would be offset slightly by the premium you received.
In this case, your maximum profit is limited to the cost of the option, while your downside is unlimited as the price of the stock could, in theory, multiply.
However, most options expire worthless. This is why many traders, investors, and hedge funds write options. There is a very high chance they will expire worthless. One of the main components that determine the cost of an option is Vega.
Vega is the measure of the volatility of a stock. The more volatile the more value a stock option premium has. Some options traders prefer selling options that have high volatility, so they reap a high premium. However, this is also riskier as higher volatility may cause the stock’s price to rocket.
Other traders prefer selling low volatility options, with all likelihood the stock’s price doesn’t move much and the option expires worthless. This allows the option writer to cash in smaller amounts of premium but with less risky stocks.
Using the services of a company like Rockwell Trading can help you find these trades. They will filter out the good apples from the bad allowing you to concentrate on options trades that have a higher possibility of success.
Short Put Option
Short put options allow the seller of the put option to receive a premium for writing the contract. The seller of the put option makes a profit when the price of the stock remains stable or increases. In this case, the put option will expire worthless.
However, if the price of the stock falls, the put option writer may find themselves long of the underlying stock. This would happen if the stock price fell below the strike price. Which may or may not be a bad thing.
If you have a large enough portfolio, and the stock has long-term potential you may want to hold the stock in your investment portfolio. However, as with call options sellers, put option sellers will walk away with the premium of their options most of the time.
Also, be aware that if you sell an option, and the market moves against you, you can exit the position by buying the option. Your loss will be limited by the difference between the premium you received to write the option and the premium you paid to buy the option. Both options contracts must have the same strike, expiry, and quantity.
Best Options Strategies: Multiple Leg Options Strategies
Now we have understood how simple put and call options work and their profit and loss profiles, we can get into some more complex multi-leg options trades. Most of these options trades are used to limit either the amount of premium paid or to limit the risk taken in writing options.
They also allow for options traders with a particularly bullish or bearish view to put on trades despite limiting their income or their profit target. We are going to have a look at some of the best options trading strategies that can limit your losses and reduce risk.
Other strategies we are going to look at are a play on volatility, and we’ll get to that a bit further down. Basically, you are not concerned with the general direction of the market, but with how volatile the market may get.
Vertical Put Credit Spread
This trade consists of writing one put option and buying another with slightly different strike prices. The contract will have the same expiry and the same quantity. But the put option you sell has a higher strike. The put option you buy has a strike that is below that.
Let’s take an example; stock ABC has a quote of $105, you write a put option with a strike of $100 and buy a put option with a strike of $95. Let’s say the put option you sold gave you a premium of $3, and the one you bought cost you $1.
So, if the price of stock ABC remains the same or increases both put options will expire worthless. In this scenario, you walk away with a profit of $3 – $1 which equals $2 for each share. If the price of ABC drops below $95, you will see the buyer of the put option you sold exercise their right and sell you the ABC stock at $100.
However, simultaneously you will exercise your right on the put option you bought and sell those shares on at $95. In this scenario, you would lose $100 – $95, less the net premium of $2 which equals $3.
So, this strategy is a way of selling put options but also limiting your total loss possible by giving up some of the premium of the put you sell.
Vertical Call Credit Spread
This options trading strategy requires you to buy a call option and sell a call option. The options must have the same expiry and quantity. However, the strike on the short call will be lower than the strike on the long call.
This is a similar strategy to the vertical put credit spread, but in this scenario, you take advantage of a market that will remain steady or fall lower. If the price of ABC stock falls, both call options will expire worthless. And you will keep the difference between the premium you paid writing the short call and the cost of your long call.
For example, if you want to put on a vertical call credit spread on stock XYZ, the stock is trading at $100. You would sell a call option with a strike at $105 for $3 and buy a call option with a strike at $110 for $1. If the price of stock XYZ remains the same or falls you will keep the difference between the two options.
If XYZ’s stock price rises above $110 a share you will deliver those stocks at $105 and immediately exercise your call option at$110. In this way, your maximum loss would be $105-110 plus the net premium of $2 which equals $3.
This options strategy consists of being long of volatility. Let me explain that. So, you feel that there is going to be a major move in this stock, either up or down, but it’s going to be a large move. This is what is known as volatility. Remember we mentioned above, Vega is one of the biggest components in the cost of an option.
So, if you think volatility is going up, of course, you would buy it. In the retail market, there is no way to trade volatility, but you can set up an options strategy that will allow you to take advantage of rising volatility.
The strategy is achieved by buying a call and a put option simultaneously, with the same expiry, and quantity but different strikes. Some traders prefer to use at the money strikes; however, this may be expensive.
Most traders opt for a strike out of the money for both options which can greatly reduce the premiums for each. In this case, the call strike would be higher than the current market price, and the put strike would be lower than the current market price for the stock.
In the chart below we can see how a long straddle with at the money (ATM) strikes will be more expensive than one with out of the money strikes. However, it takes less movement of price, or less volatility to become profitable with ATM strikes.
Again, most options traders put on a long straddle with an exit strategy before the options expire. As mentioned above this is to take advantage of cashing in your profits when the target is reached, and to avoid the loss of time value.
As you probably imagine by now, a short straddle strategy is achieved when you sell both call and put options. In a similar way to the long straddle, you could put on this trade with both strikes at the money.
Most straddle sellers would prefer to set the strike prices of both options at the money. This would allow them to receive higher premiums. And because they believe volatility is going to decline, they are not so concerned about the extra risk.
By selling a straddle you are taking the view that volatility will fall over the life of the straddle. This means the options will expire worthless. Since a shrinking volatility measure would mean the underlying stock price is not moving significantly up or down.
Selling any option always carries a high amount of tail risk, this is an unlikely but plausible negative event of great extent. However, most often options expire with no value. This is also due to time decay, as mentioned earlier. As the expiry date gets closer an option is worth a little bit less every day.
Trading stock options is risky, and you need to educate yourself with as much knowledge as possible. Rockwell Trading has one of the best options trading courses we have seen in the industry. They can guide you from your current level to expert, with full hands-on experience.
Also, and we can’t say it often enough, successful traders never trade alone. Yet you know institutional traders have a very high success rate.
Although I have met some junior traders that didn’t make it to becoming a trader. But when that did happen, it was often a personal choice, rather than incapacity.
While retail traders are known to fail between 80 and 90 percent of the time. And what is the biggest factor that differentiates retail from institutional traders? Institutional traders have large teams of analysts and economists that back them up
This is where Rockwell Trading comes in. You don’t need to go it all alone. You have to stay on top of so much information and it is true that today’s technology makes information accessible.
But how much of that information can you really process quickly and in a meaningful way? Rockwell trading can help find a high percentage of winning trades. They can set up all the trade parameters such as stop loss, profit target, and exit strategy.
Rockwell trading will also educate you with the best options trading course around to become a self-sufficient options trader. You Can read more about them in our review here.
Do I Need a Specialized Account to Trade Options?
In general, yes, most brokers will want you to have a separate account for your options trading.
Can I Trade Options Through My Retirement Account?
Yes, you can trade options on most retirement accounts, although you may not be allowed to trade on a margin. Also, you won’t be able to sell naked options
Should I trade Before Earnings?
We strongly recommend NOT trading before earnings announcements as the market can move in large gaps from close to open. We also strongly recommend you close any positions opened before an earnings announcement. Top-tier companies such as Rockwell Trading will always alert you to the earnings schedule of all stocks they track.
Do I Pay Taxes on Income from Options Trading?
In general, yes you do. Depending on the type of contract the IRS may consider your trades for short-term or long-term capital gains. Other factors also come into play such as the complexity of the trade.