For many, investing in the financial markets has been a scary and risky task. The expert or the novice all have to watch out for the market volatility and uncertainties for a profitable investment. Traders can invest their funds in various markets like stock, forex, cryptocurrency, commodities, indices, and metals or their CFDs. It’s up to the investor what they choose for trading.
But with investing, one has a lot more to do than selecting the market and instruments for trade. They have to research, analyze the market, study the terminologies, understand the trading strategies and trading platforms along with many small yet important factors.
We’ll be discovering the concept and aspects of option strategy with this article. Getting into the depth of the topic and its elements. Readers, by the end of this article, will be able to know the meaning of option strategy, its types, and its use in financial market trading. Let’s drive in and know the art of mastering option strategy.
Defining Option Strategy
Options strategy is a useful strategy where investors trade simultaneously or often in the mix for buying and selling the options. The options could be one or more in number depending upon the choice of the investors. These options differ from one another in terms of one or more variables.
The strategy has different types, which make it a popular trading strategy among investors for trading in the financial markets. They can use an options strategy that is suitable for their instrument and supports the trader for a profitable investment. There are two options: call options and put options further divided based on the trading style.
Investors use the option strategy for hedging the market risks and for seeking profits from the anticipated market moves. They can have other options in the market to invest their funds and minimize the risks associated with the instrument. Thus, focusing on other market instruments for balancing the loss of other investments.
Call options are the type of options that acts as a derivative contract between the two trade parties. In this, the buyer of the call option of the instrument gets the right to exercise the buying of a particular instrument with the call option seller for a certain period of time. Moreover, the call option does not have the obligation of buying the instrument.
The call option holder can buy or sell the instrument in the market for a set price. The holder can buy the security at an agreed quantity with no obligation from another party that is buying or selling the instrument. It has a time limit (expiration date) and price (strike price). The seller of the instrument can sell it to the buyer if he agrees, with the buyer paying a premium for having the rights.
In the call option, the trader using it has the right to “call the stock away” from the seller.
Put options are also a derivative agreement that gives the purchaser of a put option the right to sell the primary security at a strike price and a specific time period. In financial market trading, the put option is considered as a negative sentiment of the future value of the underlying instrument.
It is called put options as the trader or owner of the put options has the right to put the instrument to sell. The put options could be mixed with other trading derivatives and is a good option for hedging in the market. With the put option, if the traders have a European style of investment, then it is equivalent to having a corresponding call option with the selling of an appropriate forward contract, termed as put-call parity.
The put options are mostly famous in the stock market trading as these protect the trader against the decline of the stock price in the market below the specified price.
Read about Strangle and Straddle: Which Option Strategy to Choose.
Options Trading Styles
Options are traded in two different styles: American and European. The two trading styles are different from one another and are defined below for the understanding of the readers. The styles are generally called the American option and the European option. Let’s know them better and what makes them different.
The American option or style of trading is an option contract that allows the investors to exercise their option right anytime before the day of its expiration. Thus, the trader can use their option before the date specified in the contract or the day of expiration. No later than that, they’ll have the right to use it and trade in the market.
With this style of trading, the investors can capture their profits when the price of the instrument moves in their favor and have the advantage of the dividends as well if trading stocks.
It has the contract timeframe outlined for the option holders to exercise their rights. Traders can buy and sell the instrument as per their right of call or put it at the exercise price on or prior to the close date. Mostly the last day to exercise the American options is Friday of the week, and on a monthly basis, it is the third Friday of the month.
The European option is the opposite of the American option; hence, where traders are allowed to execute their right only on the day of expiration of the contract. Traders cannot use it before or after the date mentioned on the contract as the expiration date.
The style limits the execution of the trade to its expiry date, hence the underlying security if it moves at a price, then the investor won’t be able to exercise the right early for taking profits. They can only trade on the maturity of the option. Most of the market indexes use European-style options.
The time frame of the European style option is defined for traders to exercise their rights. They can buy or sell the underlying asset at a specific contract price. These options generally trade on the over-the-counter market.
Mastering Option Strategies
Now that readers are familiar with what options trading is, its types and style of trading. They can move on to the topic of mastering the option strategy and what are various options strategies available in the market. Here, we have discussed the option strategies individually for a brighter view of the strategies for the traders.
The market has numerous option strategies which limit risk and maximize the returns on investments. Traders can understand and apply them in trade with some effort and take advantage of the market flexibility and power of the options.
The covered call is a strategy that could be used with calls for simply buying the naked call option. Even traders can structure their basic covered call or the buy-write. A covered call is a highly popular options strategy as it generates income for the traders and reduces the risks of the instruments.
However, it has a trade-off where investors have to sell their instruments at the specified price or the short strike price. For implementing the strategy, traders have to first purchase the underlying instrument and then simultaneously sell a call option on the instrument.
For example, if an investor uses the call option on stocks that represent 50 shares per call option. Here every 50 shares of the stock that the investor buys would simultaneously sell one call option against the shares.
It is called a covered call due to the fact that the strategy in the situation when the stock or instrument price increases rapidly, then the investor’s short call is covered with the long instrument position. The strategy is used by investors when they have a short-term position or a neutral opinion on the direction of the instrument.
The married put option strategy is also frequently used by investors. In this strategy, the investor buys the asset and then simultaneously purchases put options for the same number of assets. The put option holder gets the right to sell the asset at the strike price, and each contract of the married put is worth 100 shares if trading in stocks.
Traders can use the strategy for protection from the downside risk of the assets. Operating in the same style as an insurance policy, the strategy establishes a price floor when the assets price falls sharply while trading. Let’s take an example, suppose an investor purchases 100 shares of stock and then buys one put option simultaneously.
The strategy is good for investors as it protects from the downside risk of the market in case of negative fluctuations in the price of the assets. In addition, the trader will have the right to participate in all the upside opportunities when the asset value increases.
The only disadvantage of the strategy is that if the assets do not fall in their value, the investor loses the premium amount paid for the put option.
Bull Call Spread
The bull call spread strategy is great for trading in the markets. With the strategy, an investor simultaneously purchases the calls at a set price while selling the same amount of calls at a high strike price. In this options trading strategy, both the call options will have the same expiry date and underlying asset.
It is a vertical spread strategy used by the investors in the case when there is a bullish on the underlying asset, and the investor expects a moderate rise in the value of the traded asset. With the strategy, investors are able to limit their upside of the trade and reduce the net premium spent on the trade.
Bear Put Spread
Bear put spread is another vertical spread strategy that allows the investors to trade simultaneously by purchasing the put options and selling the same amount of puts at a low strike price in the market. Here both the options are bought for the same underlying asset with the same expiration date.
Traders use the strategy when they are in the bearish sentiment of the underlying asset and expect a decline in the asset’s price. With the strategy, investors can have both limited losses and limited gains from the trade.
Long Call Butterfly Spread
Long butterfly spread with the use of call options requires the combination of bull spread and bear spread strategy. In addition, it will also have three different strike prices. All the option strategy is the same for underlying assets and has the same expiry date.
For instance, traders can construct a long butterfly spread by buying one in-the-money call option at a lower strike price and selling two at-the-money call options and then buying one out-of-the-money call option. In the butterfly spread, if traders want to have it balanced, then they should check with the graph formed out of it, and it should have the same wing widths.
The protective collar strategy is carried out by the investors by purchasing the out-of-the-money (OTM) put option and then simultaneously writing an OTM call option with a similar expiration date. However, with this, the trader should already own the underlying asset.
A protective collar strategy is suitable for the investors who, after a long position in the market, have experienced substantial profits. The trader can have downside protection as long as the put helps them lock in the sale price of the underlying asset.
Although, it has a trade-off that the put may have the obligation of selling the assets at a high price. Thus, forgoing the potential future gains.
Options trading is a profitable investment if traders understand its use and how they can make the best out of the various options trading strategies. The article has given a detailed overview of options trading, its types, and strategies. But has mainly focused on the option strategy and giving the operation of each strategy mentioned and what they do to help investors earn.
Traders can invest in options through online brokers offering this service. They can check with the broker that is regulated and has the best market services for supporting the trade. For example, ABInvesting is a good brokerage service provider where traders can invest in options. However, it requires expertise and knowledge of the market as the markets are highly volatile.