Options trading can be an intimidating area for novice investors. However, understanding the basics and available strategies is essential for successful investing. This article will explore six of the most common options trading strategies you must understand as a novice trader.
Long-call buying
The first strategy is long-call buying, which involves purchasing a stock with the expectation that its price will rise. Long calls are generally used by traders who believe the underlying asset’s value will increase rapidly or over a short period. With this strategy, you’ll have the right to purchase shares at a predetermined price (the strike price) regardless of how much they cost on the open market. If you’re correct in your prediction and the stock rises in value, you can pocket the difference between your purchase price and the new market price.
Long-put buying
The second strategy is long-put buying, which involves purchasing a stock with the expectation that its price will decline. Long puts are generally used by traders who believe the underlying asset’s price will decrease rapidly or over a short period. With this strategy, you’ll have the right to sell shares at a predetermined price (the strike price) regardless of how much they cost on the open market. If you’re correct in your prediction and the stock falls in value, you can pocket the difference between your sale price and the new market price.
Covered call writing
The third strategy is covered call writing, which involves selling an option that gives someone else the right to purchase shares from you. If a trader believes a stock will remain relatively flat over time, this can be an effective strategy. When writing covered calls, the investor receives a premium for giving up potential upside if the stock rises above the strike price.
Short-call writing
The fourth strategy is short-call writing, which involves selling an option that gives someone else the right to purchase shares from you at a predetermined price (the strike price). It’s generally used by traders who believe the underlying asset’s value will stay steady or decline over time. If correct and the stock remains below or declines in value, then they keep any premiums received while also avoiding losses due to being long on the stock.
Short-put writing
The fifth strategy is short-put writing, which involves buying an option that gives someone else the right to sell shares to you at a predetermined price (the strike price). It’s generally used by traders who believe the underlying asset’s value will stay steady or rise over time. If correct and the stock remains above or value increases, they keep any premiums received while avoiding losses due to being short on the stock.
Spread trading
Finally, spread trading is another popular options trading strategy, which involves simultaneously buying and selling two options with different strike prices and the same expiration date. Spread traders aim to take advantage of directional moves of the underlying asset instead of gains or losses due to changes in the underlying stock price.
What are the risks of using these strategies?
Options trading carries certain risks that must be considered. Potential losses due to considerable market volatility are one of the most significant risks. For example, if the underlying asset moves in an unexpected direction before the option’s expiration date, you could end up with a significant loss. Additionally, options carry time decay and liquidity risk. Time decay refers to options losing value over time as they approach their expiration date. Liquidity risk means finding buyers or sellers to close a position can be challenging.
Options trading also carries counterparty risk, the risk that one party in a transaction may not fulfil its obligations under the terms of an agreement and defaults on payment. Finally, investors should be aware of market maker pricing, when firms offer different prices depending on the size of a trader’s order, thus creating an unequal playing field for novice traders compared to experienced traders with access to better prices.
Options trading involves numerous risks that novice traders must understand before entering any trade. While making returns using options trading strategies is possible, it’s also important to be aware of all possible risks to make informed decisions about your trades.
Conclusion
There are a variety of options trading strategies available to novice investors. Understanding these strategies and their application to various market situations is critical for successful investing. Long-call buying, long-put buying, covered call writing, short-call writing, short-put writing and spread trading are six of the most common strategies that all options traders must understand. With an understanding of these strategies, you’ll be better positioned to make informed decisions when investing in the stock market.
