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Options Trading Strategies for Beginners
Most serious investors have heard about different types of options trading strategies.
But, beginners in Options trading tend to begin with little understanding of it.
In their hurry to explore the different strategies, they end up with deep losses.
Thus, it is very important to get the basics about Options trading strategies right.
So, what are Options?
These are a type of derivative contract.
The unique aspect about these is there is no obligation to buy or sell contracts.
This is the main difference between futures & forward contracts and these options.
Both of these have the right as well as obligation to buy or sell at a pre-decided date.
Most investors choose to invest in options to minimize risk.
Key Options Trading Terms
But you must familiarize with basic terms of options trading strategies first.
You use these terms in option trade quite often.
A clear understanding of these will help you execute the strategies successfully.
Also, you can interpret strategies a lot easier when you know these terms well.
It is almost like the ‘A, B, C’ of options trade.
Without these, it is quite difficult to navigate through complicated options trading strategies.
This is more like a deposit made for a future date.
It gives the investor the right to buy a pre-decided set of shares at a fixed price.
The time duration is also fixed.
But, the Call gives the owner the right to buy.
But the owner has no obligation to buy.
As an investor, you can also choose to sit tight and not take any action.
Perhaps it is easier to explain with an example.
Let’s say; you are a promoter and interested in developing a piece of land.
But the plot that you want to buy needs some regulatory nods.
Only then it would be profitable.
So you strike a deal with the owner to buy it at a fixed price anytime over the next four years.
Let’s say; you pay a certain amount to the landowner to block the deal.
Now when the approvals come after two years, you can buy the land at the pre-decided price.
This holds true even if the price of the land escalates.
Supposing the approval comes a year after the pre-fixed 4 years.
As a promoter, you sit tight for five years and then buy it at market rate.
The landowner, in any case, keeps the money you gave to block the contract.
This is how you execute a Call Option.
The next term that you must master is ‘Put’.
In very simple terms it denotes a sell call in options trade.
This gives the investor the right to sell a fixed amount of shares at a fixed price.
The time duration is also fixed.
But if the conditions are not favorable, the owner can choose to sit on the investment.
They can then sell it at a time when they get the best rates or most advantage.
Here again, let me use an example to put my point through.
Let’s say I have a basket of stocks.
But I expect the Index to slip further in 6 months.
Looking at my exposure, I decide I can only stomach 5% loss on my investment.
So I buy a Put Option that sees the Index 5% lower in 6 months.
So the advantage is, even if the Index crashes 20%, I lose only 5%.
However, if the markets rise instead, I lose the premium or the blocking amount I paid.
So I used the Put Option to minimize my losses.
Well, this is another key terminology in options trading strategies.
You always create a Put or call at a fixed rate.
This is the price at which you can buy or sell your options.
This is the Strike Price in an option.
In case of Calls, the stock price has to go above the strike price to clock profit.
The reverse happens in case of Put Options.
The option will be profitable only when the price is below this level.
But option has to move above or below the strike price before expiry.
Only then the investor can book the profit.
Exercising the Option
It is self-explanatory in many ways.
It means or refers to the action that the investor takes.
In case of Call Option, the investor exercises the option by buying it.
The reverse happens in Put Option.
The investor exercises the option by selling it at the strike price.
In short, it refers to any investor action at the strike price.
However, you must remember the options also give the investor option to not exercise it.
If conditions are not favorable, investors can choose not to exercise the option too.
They can take an action at a later date depending on conditions.
Well, that brings us to the next point.
The expiry date is the day on which the options contract expires.
This means you cannot exercise the option after that date.
If you remember the land example, I discussed earlier.
When the promoters decide to buy the land after 5 years instead of 4, he has to pay market price.
So the strike price is valid only till the expiry date.
After that, the market forces come to play.
Most options expire on the third Friday of every month.
In some cases, there could be a few long-term contracts too.
These options might expire at the end of the quarter or any other pre-decided duration.
But you must remember, these are not the norm
It only happens very rarely.
There are some contracts that stretch even for 6 months.
Beyond this date, you cannot enjoy the benefits of the contract terms.
This is the abbreviation for The Chicago Board of Option Exchange.
The question is why you need to know this.
Well, that’s because it is the world’s largest exchange for options trade.
They offer a huge range of options in stocks, indices and commodities.
Traders use this exchange to construct several strategies.
They range from simple to complex strategies.
Why Are Option Trading Better Than Direct Ownership?
As a beginner exploring options trading strategies, it is important to understand the advantage.
Well, first of all, these can result in great returns if you execute the strategy well.
You avoid direct exposure to the asset.
This means your risk-reward ratio remains biased in your favor.
Options provide attractive leverage opportunity.
Basic options strategies are quite simple to master.
You can make them work in your favor.
Here is a list of some of the most effective options trading strategies for beginners.
Even new traders can benefit from these strategies.
Going Long On a Call
In simple terms, it means you buy a Call Option and go long on it.
It is a rather straightforward strategy.
Here you are assuming that the stock will go well above the strike price before expiry.
Suppose, you buy a stock that is trading at $50/share.
The call that you buy is available at $5.
Let’s assume the Call will expire in 6 months and each contract has 100 shares.
So at $5, the premium is around $500.
Assuming that the call goes above the strike price, you can calculate the potential payoff.
The upside is close to $5000 or even higher while the downside would be $500 at the most.
So, this kind of option trading strategy will help you earn a higher profit.
If you are not too worried about the loss you can suffer, the profit prospect is quite large.
Since you don’t own the stock, you limit your risk exposure.
The downside even in case of huge fall will be only the total premium cost.
Thus the reward prospect is much higher than the risk profile.
Long On a Put
It means you buy a Put Option and go long on that.
This is also one of the most common options trading strategies for beginners.
You are betting that the stock price will fall below strike price and remain there till expiry.
So in this case, if we take the same example, the $5 premium is for prices to fall.
While the extent of profit exceeds the $5000 mark, the downside is again limited.
At the most, you will book a loss of $500.
This is the initial premium that you paid.
Technically the extent of profit is infinite.
If the stock price slips below the strike rate, profits can be even higher.
The Short Strategy
Exactly the reverse happens if you go short on a Put or a Call.
So a Short Put is the opposite of a Long Put
In case of a Short Put, the investor sells the Put.
But, the pay off in case of a Short Put is modest.
The extent of loss is much higher.
The question then is why you would want to use this strategy?
Investors most times short a Put Option, to get a more favorable buying rate.
An investor may also short to get out of the premium obligation.
The larger losses in case of the trade going wrong are a major deterrent.
So it is a strategy that investors would only apply to average out loss prospects.
But as an investor, you must be careful.
You must remember if the price falls below the strike price on expiry, you will have to buy the stock.
If it remains above the strike price, you can preserve cash or reemploy the strategy.
This one again is among the most talked about options Trading strategies.
This is an effective strategy for both beginners and market pro.
This is not a one-dimensional strategy.
Things begin to get complicated at this juncture in options trading.
This strategy has two parts.
First of all, you, as an investor, must also have shares of the underlying stock.
The next part you need to sell a call on the stock.
The basic assumption in this strategy is that the stock price will be flat or slip below the strike price.
So you get the premium from selling the call and the stock too.
You can write a new covered call.
Investors must remember that if the stock price rises, they have to deliver it to the buyer.
This strategy is a big favorite for investors looking to generate more income.
But you must remember that this strategy does not have a huge upside.
At the most, it is the premium you paid for the Call.
The loss potential in comparison is huge.
So then why is it such a big favorite among investors?
Well, there are two elements.
Investors execute this strategy when they expect prices to remain flat.
Moreover, this strategy helps them get a better selling price.
The next options trading strategy that we will discuss is the Credit Spread.
In this, you have to buy one Call Option and sell one
It could also buy and sale Put Options.
You must, however, remember to choose both Calls or Puts with same expiry dates.
So, you sell the one which has a higher price and buy a cheaper one.
Therefore, it is called Credit Spread.
It reflects the cash that you have in hand.
However, both the profit and the loss potential, in this case, is lower.
This strategy is also sometimes considered as a signal for the markets.
When you start a Call Spread, it normally indicates a bearish trend.
However, a Put spread indicates bullish market indicator.
The moderate pace of profit and losses makes it ideal for beginners.
Sell Iron Condors
Most market experts feel this is an effective options trading strategy for beginners.
It is also known as short Iron Condors.
This strategy helps you to extract profit even from rangebound trades.
The first step is to sell a put spread.
In this, you sell one put and then buy another one at a lower rate.
In the next step, you sell a Call and buy a next one at a higher strike price
So the Put and the Call you sold are at a higher rate than what you bought.
The question at this juncture is how it can make money for you?
In this case, it is profitable when the share price remains in a range between the two sets of the strike price.
This is, therefore, a celebrating rangebound market.
You will lose money the moment the share prices move too much in any direction.
In case the stock price breaches either the Put or the Call strike prices, you clock maximum losses.
You can use this strategy across a wide range of options.
You just need to be careful about the strike prices.
This is one of the slightly more elegant options trading strategies.
But it works beautifully for both veterans and beginners.
The trick is identifying the right levels for clocking maximum profit.
Moreover, this takes your options trade a step higher in terms of sophistication.
As the word married indicates, you combine two options trade in this strategy.
So here you combine a Long Put and actual shares of the underlying stock.
You buy 1 Put for every 100 shares of this stock.
On the one hand, the actual stock helps you take advantage of the price appreciation.
On the other, the Long Put limits the downside.
In other words, it hedges the loss potential for an investor.
The upside, in this case, is completely dependent on the share price.
Only if it rises, you get a profit.
Meanwhile the downside most times is only to the extent of the premium for the Long Put.
So, the investor can continue holding the stock for as much gain as possible.
The potential loss will never breach the premium amount.
This provides both a sense of safety and confidence to beginners in this trade.
A Profitable Portfolio with the Minimum Risk
Therefore, options trading strategies for beginners must have a simple approach.
It is all about creating a profitable portfolio with the least amount of risk.
Minimum risk or low risk exposure is a key factor to remember.
This is because most times beginners are not prepared for the challenges of the stock market.
They might not be very competent to assess their risk exposure.
Moreover, beginners may not have a huge amount of base capitals.
So capital preservation is extremely important.
In this situation, it is always better to go for options with limited downside potential.
Good options trading strategies should also give beginners the necessary confidence to trade and make profit.
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