Options trading is a type of securities trading in which the trader has the right, but not the obligation (hence, the ‘option’), to buy or sell an underlying asset at a certain predetermined price. This is known as the strike price. They must make the transaction within a certain predetermined timeframe.
Over the years, options trading has become a popular trading method for its flexibility and versatility. However, beginners may find it difficult to get started, and intermediate traders may find it difficult to advance. This is because there is an abundance of strategies out there, which can become confusing.
In this article, we seek to break down 6 types of options trading strategies. Read on to learn more.
6 types of Options Trading strategies
When trading options, there are many strategies that traders use to increase their chances of profit and to manage risk. Within each type there are more variations, depending on the market direction. However, having a general understanding of how each type works is a good starting point.
One of the most common trading strategies that traders use is the spread. A spread involves buying and selling options at the same time, with the goal of limiting risk. Buying a spread also increases a trader’s chances of making a profit. However, traders who use spreads must consider including the cost of the premiums they pay for two contracts when calculating their breakeven point.
Some common types of spreads are bull call spreads and bear put spreads.
The iron condor is a third type of strategy within this category. It is when a trader uses four contracts (buying a put at Strike Price A, selling a put at Strike Price B, selling a call at Strike Price C, and buying a call at Strike Price D). Traders use an iron condor when they anticipate minimal movement in the market. It can be complicated, so beginners may want to leave this to the advanced options traders.
Straddles and strangles
The second type of options trading strategy is the straddle or the strangle. These are a pair of strategies that both involve buying both a call option and a put option, with the same expiry date and strike price. The difference depends on the trader’s market prediction.
If the trader believes the price of their underlying asset will move significantly in either direction, they will use a straddle. However, if they believe the price of their underlying asset will move significantly but are not sure which direction it will move in, they will buy a strangle.
The third type of options trading strategy is the butterfly spread. The butterfly involves buying one call option at a certain strike price, selling two call options at a higher strike price, and buying a second call option at an even higher strike price. Traders use butterflies when they believe their underlying asset price will not move substantially by the expiry date and want to make the most of their trade.
Next, traders also use collars. This is a strategy that allows traders to hedge existing positions. It involves buying a put at one strike price and selling a call at another strike price, while already owning the asset with the current asset price between the two strike prices.
Often, traders who anticipate or suspect market volatility may not want to give up their existing positions. When a trader sees a nice run-up in the asset price and wants to protect their unrealised profits, they can use the collar as a risk management technique.
There are traders who utilise the collar in every trade they place. For example, for every 100 shares they purchase in the stock market, they will sell one out-of-the-money contract and buy one out-of-the-money contract. However, while it does limit any risks and downsides, it also limits earning potential.
The fifth strategy that traders employ is the covered call. This is when a trader holds a long position in an asset already. The covered call involves selling call options on the same asset to an options contract buyer, to generate even more income from the asset. This is especially powerful when the market shows a strong bullish trend and there is great momentum.
Finally, traders may employ the protective put. This is again when a trader already holds a long position in an asset. They purchase a put option which allows them to sell the asset at a certain price at the contract’s expiry. This is a great way to protect an existing position, and it is a risk management technique that is popular amongst intermediate and advanced options traders.
Why people trade options
Above we have covered six of the most common types of options trading strategies. As mentioned, there are different variations in each strategy type, and there may also be prerequisites for some strategies.
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The latter includes the covered call and the protective put, where you must already have a long position open for the underlying asset you want to trade.
If you would like to buy options in Singapore but you are on the fence about this decision, below are some reasons why certain traders enjoy using options to potentially generate income.
Options trading allows traders to speculate on the future price movements of an asset. However, traders can also buy options contracts to hedge their risk in existing investments. This means they can create new positions to make a profit or to limit their risk on existing positions when markets are volatile.
Use of leverage
Options trading allows users to access leverage, so they can control a larger amount of an asset with a small initial deposit or investment. This can lead to greater exposure in the market, which in turn can lead to greater potential returns. However, this also has the potential to magnify losses – therefore, traders should always use leverage with caution.
The underlying asset in an options trade can be a stock, index, commodity, currency, or more, and there is a large variety of options a trader can choose when using this type of financial derivative. This makes it easy for traders to diversify their portfolios and speculate on the instruments they prefer.
However, traders would do well to remember that different markets perform differently, regardless of their trading method. For example, what drives the commodity market will differ from what drives the stock or forex market. Therefore, on top of learning how options trading works, they should gain a firm understanding of how different financial markets work.
Options are also cost-effective, especially in volatile markets. Traders pay a premium to buy the option to buy or sell an asset. If the market goes against their predictions, they can choose not to exercise the option and let the contract expire worthlessly. All they would lose then is the premium they paid for the contract, greatly limiting the risk of trading.
The bottom line
Options trading is a more complex trading method than simply buying an asset or trading a Contract for Difference (CFD). Nevertheless, traders who take the time to hone their skills will find there is order to how options work. If you are just starting out options trading, you can pick one or two strategies to stick with. With practice and experience, you will be able to get the hang of them and advance to more complex strategies.