An option is a financial derivative in the stock market that allows traders to speculate on the price movement of an underlying asset. It is a financial agreement giving the buyer the right, not the obligation, to buy or sell an underlying asset (like a stock) at the specific (preset) price on or before the expiration date.
There are two types of contracts in options trading, i.e., call options, which give the holder (buyer) the right to buy the underlying asset. The second is put options, which give the holder (buyer) the right to sell the underlying asset.
The primary use of the option trading strategy is to manage risk and potentially enhance returns in financial markets. It provides flexibility to speculate on price movements, hedge existing positions, or generate income through a lower capital investment.
Grabbing and cutting out profits from option trading is no less than coming out of an open lion cage. Although profit always comes from risk.
That’s the rule of trading, and knowing how to manage the risk is the art of making profits. There are a lot of effective and proven strategies that help traders determine the optimal price momentum of the stock and make profits on their trade.
In this useful and informative guide, we will show you the exact roadmap of how option trading works in the real life, and along with that, we will also cover few effective strategies that you can follow or implement in your trading experience to get a guaranteed return from your investment.
How the Option Trading Works?
An option is a contract giving the buyer the right, not the obligation, to buy (call) or sell (put) an underlying asset at a specific price on or before a certain date. Option trading typically involves a few important terms, which are as follows:
- Call Option (CE): Gives the holder the right to buy an asset.
- Put Option (PE): Gives the holder the right to sell an asset.
- Strike Price: Also known as the exercise price, at which the underlying asset can be bought or sold.
- Expiration Date: The date on which the option contract expires.
- Premium: The price paid by the buyer to purchase the option contract.
- In-the-Money (ITM): In a call trade, the strike price is less than the market price, whereas in a put trade, the strike price is more than the market price.
- Out-of-the-Money (OTM): In a call trade, the strike price is more than the market price, whereas in a put trade, the strike price is less than the market price.
Making profits in option trading is typically all about how accurately you can determine the future price event of the particular asset. The less time there is until expiry, the less value an option will have.
In short, options trading allows traders to gain profits from price movements in the underlying stock without actually owning it.
It’s because the chances of a price movement in the underlying stock diminish as we draw closer to the expiry.
Fluctuations in the option prices can be determined with the help of the intrinsic value and extrinsic value, also known as the time value.
Option Premium = Intrinsic Value (IV) + Extrinsic Value (EV)
The intrinsic value of an option is the amount by which the option is in the money (ITM). It means how much profit you would make if you exercised it right now.
For a call option, IV = current stock price – strike price.
For a put option, IV = Strike price – current stock price
If the option is out of the money (OTM), the intrinsic value is $0.
The extrinsic value, also known as time value, is the part of the option’s price that reflects the value of the possibility that the option might turn profitable before it expires.
Extrinsic value = Option premium – Intrinsic value
Popular and Effective Option Trading Strategies
Every trader has its own unique trading style. That doesn’t mean that a strategy that he/she follows may bring positive results for everyone. Although it’s important for traders to understand and implement popular and effective option trading strategies that have been proven to be successful in order to increase the chances of profitable trade.
- Long Strangle
In this strategy, you can buy a call and put option with a different strike price, i.e., an OTM call option and an OTM put option, simultaneously on the same underlying asset with the same expiration date.
Traders go for this strategy when they believe that the underlying asset’s price will move significantly but are not sure of the direction.
This strategy is best used during high-volatility environments when the stock experiences large price fluctuations in any direction.
In this strategy, losses are limited to the cost paid to enter both options.
- Bear Put Spread
Under this strategy, you buy put options at a specific strike price and sell the same number of puts at a comparable lower strike price.
Both options are purchased for the same underlying asset and have the same expiration date. It goes well when a trader has a bearish sentiment about the underlying asset and expects the asset’s price to fall over the time.
Potential losses and gains are both limited in this strategy.
- Covered Call
The most popular strategy in the options trading is the covered call, also known as a buy-write transaction.
In order to implement this strategy, traders buy the underlying stock as usual and simualteneously write – or sell – a call option on those same shares.
This approach is famous amongst the traders as it helps to generate more revenue, and on the safer side, it also reduces the some risk of being long on the stock alone.
It’s mostly used for holding a short-term position in the stock.
- Protective Collar
This strategy is implemented by purchasing an out-of-the-money put option and simultaneously writing an OTM call option when you already own the underlying asset.
This strategy is a part of the neutral trade setup. It indicates that the investor is looking to protect their investment from the potential downside risk while also potentially generating profits.
It is best to use when holding a long-term position in a stock that has substantial gains.
As a result of this strategy, traders have to sell shares at a higher price than the current market value if the stock price rises.
- Long Call Butterfly Spread
In the long call butterfly spread strategy using call options, you’ll combine both a bull spread strategy and a bear spread strategy. It means you will also be using three different price strikes.
A long butterfly spread can be constructed by purchasing one ITM call option at a lower strike price, selling two ATM call options, and buying one OTM call option.
Traders usually enter this strategy when they think that the stock will not move much before the expiration.
The Ending Note
Option trading strategies are versatile and can be used in various market conditions to achieve different objectives. The journey towards achieving a profitable portfolio through option trading is not as easy and simple as it may look in newspapers or billionaire profiles.
But with the right knowledge, patience, and hard work, one can easily navigate through the complexities and uncertainties of the market to potentially achieve consistent profits over the time. Start following and implementing the above strategies in your trading life, and don’t wait for minimal gains, and neither expect to become richer in a night. Keep learning and stay hustling.