Regardless of whether you’re an investment pro or a total novice, you need to know about options trading. It’s one of the many choices in the field of investing in securities, and is often one of the least risky choices, compared to stocks.
After all, when buying or selling options, you don’t actually need to exercise it at the buy/sell point. In other words, options trading gives you the right to buy or sell securities, but you’re not technically obliged to at any point.
What types of options are there?
The first kind of option is known as a put option. To get this option, you have to pay a premium. Essentially, what you’re paying for is the right to sell a certain amount of shares of fixed security or commodity, over a certain period of time. You’re not obligated to sell a security in the duration of the contract, but if you do, it has to be at a specified, predetermined price. This price of the stock is known as the strike price.
The second type of option is a call option, which is essentially the reverse of a put option. You also pay a premium to buy the call option contract, which Instead of giving you the right to sell, gives you the right to buy a certain amount of shares of a fixed security or commodity, over a certain period of time. Again, you’re not obligated to buy anything before the contract expires, but if you do, you buy at the predetermined strike price.
Essentially, both kinds of options allow you to either buy or sell stocks at a predetermined price and conditions laid out by the contract. Think of it as a downpayment of sorts, which allows you to buy or sell an asset at a certain price whenever you want before the contract expires. Needless to say, if you use options well, they can bring about significant benefits to you regardless of what your trading goals are.
Want to learn how to use options well but not sure where to start? Here are 3 fundamental options trading strategies you should know to get you started on proper and profitable options trading.
1. Net Debit Spreads Strategy
The gist of this strategy is simply cash outflow first, and inflow hopefully later. In other words, you have to pay some money in order to enter the trade in the first place. The goal of a net debit spreads strategy is to limit losses incurred should the options you buy expire without you gaining anything from them.
It’s actually not as complicated as it sounds—all you have to do to get started is buy and sell options from the same class, making sure you’re buying more than you’re selling.
2. Credit Spreads Strategy
Similar to the previous strategy, the credit spreads strategy helps to limit the potential risks and losses. As usual, you need to buy and sell options on the same asset class to get started. The catch is that while these options should have the same expiration date, you get them with different strike prices.
Again, depending on your own risk analysis and the proper preparation, you can opt for either a credit put spread or a credit call spread.
To employ a credit put spread strategy, key in on two put options, selling one at a higher strike price and getting the other at a lower strike price. Once the trade opens, if the underlying market rises, you would gain a net premium. If the stock price is above the higher strike price, congratulations, you’ve earned a profit.
As for the credit call spread, key in on two call options, buying one with a higher strike price and selling the other at a lower strike price. Should the stock price be at or below the lower strike price, you will get the profits. Take note that the profit is always capped at the premium you get!
In both cases, the obvious benefit is that you limit your overall potential losses to the difference between the strike prices of your chosen options. In a way, the risks are laid out even before you make a decision, so you won’t be caught by surprise even in the event of a major turnaround of the share price’s direction.
3. Covered Call Strategy
The key objective of this options trading strategy is to maximize the profit from the purchase of an asset that you think will increase in value in the future, also known as a long position. You get the profit from the premium from selling the options contract.
To get started on this, you have to sell a call option on the asset you currently have a long position on, thereby allowing the buyer to, well, buy the underlying shares should they decide to. The best assets to utilize this strategy are those that will increase in value in the long run but see little to no price movement in the near future.
Logic would tell you that at this first stage, the cash outflow will be pretty high, especially since you’re selling less than you’re purchasing. The more expensive you buy, the more money you’ll need to put up, and the higher the cash outflow.
Depending on your outlook, you can choose either a debit call spread or a debit put spread. If you choose the former, you would want the underlying price to increase and expire at or above the higher strike price for maximum profits. As for the latter, you would require the market price to be below the strike price.
In both cases, your maximum loss is limited to the premiums you’ve paid and the additional costs you would have paid upfront, so it’s definitely a controllable and relatively less risky trading strategy.
Essentially, this means that you’ll have a short-term hedge against any losses to your current position. Even if you lose and have to provide the amount of underlying asset to the buyer at the strike price, you’ll be able to offset it with the premium you get for selling the call option in the first place.
To conclude, these three strategies are the main ones that you should know as a beginner to options trading. They all carry some form of risk, as with every type of securities trading, so the important thing is to do your homework before applying any of the strategies. One way to do so is by researching online; for instance, this original article – business24-7 is a good source of information to help you better understand options trading!