Proven Strategies for Trading Options
Option strategies afford traders and investors the opportunity to leverage their investment strategies while limiting risk for a specific period of time. Proven strategies for option traders take four forms: directional trades, neutral trades, hedge trades and covered call trades. Each strategy requires the trader to regularly monitor the trades. Options are for trading strategies, not long term investment. Retail investors should remember that brokerage fees and the spread between the bid and asked quote can significantly lower expected returns.
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Directional Trades
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Directional option trades simply require the trader to decide whether a stock is in a rising, declining or neutral trend. Rising trends require the trader to buy a call option. Declining trends require the purchase of a put option. Options give the right, but not the obligation, to purchase (call) or sell (put) the option seller's stock at a fixed price by a fixed date in the future.The fixed price is called the strike price. The trader makes money as long as the stock price exceeds the call price less commissions and the cost of the option.
Neutral Trades
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Neutral option trading is popular for investors seeking capital gains and some income. Traders buy a call in a stock they believe will rise before the option expiration date. Then the trader sells a call in the same stock at a higher strike price. If the stock rises modestly or sharply in value the investor keeps the capital gain up to the strike price of the second option. The trader also gains the income from the sale of the option that was sold. If the stock drops in price, the investor loses the price of the first option, but the loss is offset from the sale of the option that was sold.
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Hedge Trades
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Hedge trades are proven strategies to protect existing gains and reduce tax burdens. Investors with gains in a stock already held in their portfolio buy a put option. If the stock price declines, the trader sells the put option at a profit that offsets the loss of stock value. The trader then waits for the stock to return to higher prices. This is a popular strategy with stocks that pay large dividends that the investor does not wish to forgo, stocks with large capital gains or stocks with good long term appreciation but whose price is affected by declines in the broader market.
Covered Calls
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Covered calls are the most popular options trading strategy used by individuals and large stock portfolios. Covered call writing simply requires the trader to buy a stock and sell a call at a price higher than the current price of the stock. Covered calls allow the trader to receive the option premium from writing the call, all stock dividends, and capital gains up to the strike price. Judicious consideration must be given to the future price of the stock so as to avoid large declines. Covered call options are typically written on large, international companies that have low volatility.
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