Before you buy or sell options, you need a strategy. But before you choose an options strategy, you need to understand how you want options to work in your portfolio.

A particular strategy is successful only if it performs in a way that helps you meet your investment goals. If you hope to increase the income you receive from your stocks, you’ll choose a different strategy from an investor who wants to lock in a purchase price for a stock she’d like to own.

One of the benefits of options is their flexibility — they complement portfolios in many ways. So it’s worth taking the time to identify a goal that suits you and your financial plan. Once you’ve chosen a goal, you’ll have narrowed the range of strategies to use. As with any investment, only some strategies will be appropriate for your objective.

What is an options strategy?

When done correctly, options trading is one of the most effective ways to build wealth over the long term. Options come in two varieties, calls and puts, and you can buy or sell either type. Call options (often called Calls) give the buyer the right to purchase a specific stock at the option’s strike price. Put options, often known as Puts, provide the buyer with the right to sell a particular stock at the option’s strike price.

Buying calls or puts, selling puts or calls, or both, are referred to as option trading strategies used to restrict losses and increase profits indefinitely. Using options strategies, traders can benefit from changes in the underlying assets dependent on the state of the market (i.e., bullish, bearish, or neutral).

options strategies compared

A typical option strategy involves buying and selling at least two to three different options (each with different strikes and/or time to expiry), and the portfolio’s value may fluctuate highly complexly.

Understanding the basic options strategies

Options trading strategies can be generally divided into groups. There are four ways to trade them: call, put, spread, and straddle. As previously stated, a call is a contract that allows the owner the right to purchase a stock at a specific price on or before the option’s expiration date. On the other hand, the owner of a put has the right to sell a stock at a specific price on or before the option’s expiration date.

Spread and straddles are two options that can be used to manage risk. Buying the same type of option with the same expiration date but a different strike price comes in a spread. When you purchase an option with a lower strike price and an option with a higher strike price with the same expiration date, you are creating a straddle.

Some options strategies, such as writing covered calls, are relatively simple to understand and execute. However, more complicated strategies, such as spreads and collars, require two opening transactions. As a result, these strategies are often used to further limit the risk associated with options, but they may also limit potential return.

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When you limit risk, there is usually a trade-off. Simple options strategies are generally the way to begin investing with options. By mastering simple strategies, you’ll prepare yourself for advanced options trading. Generally, the more complicated options strategies are appropriate only for experienced investors.

How and when to exit?

Once you’ve decided on an appropriate options strategy, staying focused is essential. That might seem obvious, but the fast pace of the options market and the complicated nature of certain transactions make it difficult for some inexperienced investors to stick to their plans. Nevertheless, if the market or underlying security isn’t moving in the direction you predicted, it’s possible that you’ll minimize your losses by exiting early.

But it’s also possible that you’ll miss out on a future beneficial change in direction. That’s why many experts recommend that you designate an exit strategy or cut-off point ahead of time and hold firm. For example, if you plan to sell a covered call, you might decide that if the option moves 20% in-the-money before expiration, the loss you’d face if the options were exercised and assigned to you is unacceptable. But if it moves only 10% in-the-money, you’d be confident there remains enough chance of it moving out-of-the-money to make it worth the potential loss.

What are three common options trading mistakes?

By learning some of the most common mistakes that options investors make, you’ll have a better chance of avoiding them.

Overleveraging. One of the benefits of options is the potential they offer for leverage. By investing a small amount, you can earn a significant percentage return. It’s essential, however, to remember that leverage has a potential downside too. A slight decline in value can mean a significant percentage loss. Investors who aren’t aware of the risks of leverage are in danger of overleveraging and might face bigger losses than expected.

Lack of understanding. Another mistake some options traders make is not fully understanding what they’ve agreed to. An option is a contract, and its terms must be met upon exercise. It’s important to understand that if you write a covered call, for example, there is a very real chance that your stock will be called away from you. It’s also essential to understand how an option is likely to behave as expiration nears and to understand that once an option expires, it has no value.

Not doing research. Some options investors make a serious mistake by not researching the underlying instrument. Options are derivatives, and their value depends on the price behavior of another financial product — a stock, in the case of equity options. You have to research available options data and be confident in your reasons for thinking that a particular stock will move in a specific direction before a certain date. You should also be alert to any pending corporate actions, such as splits and mergers.

What are things to know before trading in options?

Before starting, ensure you understand the risks and rewards associated with options trading because it can be complicated. Options trading has benefits over trading underlying assets, such as downside protection and leveraged returns, but it also has drawbacks, such as the need to pay the premium in advance. Before using any options strategy, weigh the risks and benefits of the present situation in the markets (or the state of the particular stock).

It’s helpful to have an overview of the implications of various options strategies. Once you understand the basics, you’ll be ready to learn more about how each strategy can work for you — and what the potential risks are. Calculate your strategy’s high benefit and maximum loss, as well as the situations in which you might experience them. Smart option investing requires having realistic expectations.

Introduction To Options Strategies by Inna Rosputnia

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