Options trading is a form of derivative trading that requires traders to buy a contract. This contract gives them the right – but not the obligation – to buy or sell an underlying instrument at a predetermined price on a predetermined date. Traders buy options at a price called a ‘premium’. If they decide to not exercise the options contract, they can let it expire worthlessly.
If you are a trader looking for intermediate strategies, below are 4 you can use. This article will describe what the strategy is, how to set it up, and the suitable market conditions for the strategy. But before that, let us take a look at why options trading may be a good idea for those who want to speculate on stock prices.
Why trade stock options?
The first benefit of trading options is the fact that traders do not have to buy or sell the underlying stock. Instead, they can speculate on stock price movements and potentially profit from them. This makes it much easier to trade, and there are plenty of stocks available for speculation.
Traders also find options attractive because of the ability to limit losses. When you are unsure of how the market will go, traders may buy an option instead of buying the stock directly. This way, if the market does perform unpredictably, traders can simply let the options contract expire. The maximum amount of money they can lose then is limited to the premium of the contract.
Thirdly, options trading allows for the use of leverage. This can greatly magnify profits (or losses) when trading, without the need for a large amount of seed capital.
Finally, people trade stock options not just to speculate, but also as a hedge. When they have a large, existing number of shares of a company they want to keep holding, they can use options to ride out bumps in the market.
For example, a person who holds stocks in a company may predict the market will crash. To prevent himself from huge losses, he can purchase an options contract that allows him to profit off bearish markets. If his prediction is true, his options contract will hedge his original, existing position. If his prediction is false, he can simply let the options contract expire worthlessly.
Long call
The first intermediate options trading strategy we will explore is the long call. This is when a trader buys a call at a specific strike price while the stock price is at or above the strike price.
How it works
A long call is essentially an agreement that gives you the right to buy an underlying stock at a certain strike price. Say you have decided that the strike price is A. When you buy the long call, you mitigate the risk of buying the stock outright. This limits your potential for losses to the premium of the contract. You break even when the market reaches Strike Price A, and your profits cover the cost of the options contract.
When to execute the strategy
You should execute the strategy when the market is bullish.
Long put
The second intermediate options trading strategy is the long put. This is the ‘opposite’ of the long call, and it is when a trader buys a put at a specific strike price while the stock price is at or below the strike price.
How it works
A long put essentially gives you the right to sell an underling stock at your determined strike price. A long put is useful when you predict the market will continue to be bearish. Of course, there are other ways to profit from bearish markets – such as short-selling a stock. However, the benefit of the long put is that it protects you from the theoretically unlimited risk you may face if the stock price suddenly rises.
This is because even if the stock price does go up, you can always let your options contract expire worthlessly. You break even when the market reaches the strike price you determined, and your profits cover the cost of the options contract.
When to execute the strategy
You should execute the strategy when the market is bearish.
Long call spread
Moving on, we will also examine the long call spread. Some traders may refer to this strategy as the bull call spread or the vertical spread as well. It is when a trader buys a call at Strike Price A and sells one at Strike Price B, with the current stock price either above Strike Price A or below Strike Price B.
How it works
The long call spread works as it gives you the right to buy a stock at Strike Price A, and it gives you the right to sell the stock at Strike Price B. This means that you limit your risk hugely no matter which way the markets go. You break even when the market price reaches Strike Price A, and your profits cover the prices of your options contracts.
When to execute the strategy
You should execute the strategy when the market tends bullish, but you are worried it may dip and turn bearish.
Long put spread
Finally, intermediate traders may also trade with a long put spread, otherwise known as a bear put spread or a vertical spread. It is when a trader sells a put at Strike Price A and buys one at Strike Price B, with the current stock price either at or below Strike Price B but above Strike Price A.
How it works
The long put spread works in an almost opposite way compared to the long call spread. It gives you the right to sell the stock when it reaches Strike price B, while it gives you the right to buy the stock at Strike Price A. It limits your risk hugely no matter which way the markets go. You break even when the market price reaches Strike Price B, and your profits cover the prices of your options contracts.
When to execute the strategy
You should execute the strategy when the market tends bearish, but you are worried it may rise unexpectedly and become bullish.
Tips on executing options trading strategies
Regardless of the strategy you choose to use, it is important to remember a few things when trading options:
Options are complex
Stock options trading is more complex than trading stocks directly. This is because contract providers may price contracts differently depending on the stock and industry. Contracts also take into account different factors, such as the current state of the market, its time decay, and the quantity of the stocks you want to speculate on. Do not underestimate the complexity of options trading, as that can only cost you in the long run.
Don’t go overboard with leverage
Another reminder for intermediate options traders is not to go overboard with leverage. It is easy to magnify your position with the use of leverage as it is exciting to make huge profits. However, there are no guarantees in trading, which means there is also a huge potential for loss if you go overboard with leverage.
The bottom line
Options trading can be more complicated, but if you are an intermediate trader who is ready to take your technique to the next level, the above strategies are great to start with. When trading, always remember that there is risk involved and there are no guarantees of profits. Therefore, you should never trade more than you can afford to lose.
