Before you buy or sell options you need a strategy, and before you choose an options strategy, you need to understand how you want options to work in your portfolio.
A particular strategy is sucessful 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, for example, 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 the flexibility they offer — they complement portfollos in many different 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 type of investment, only some of the strategies will be appropriate for your objective.
Types of options strategies
Some options strategies, such as writing covered calls, are relatively simple to understand and execute. There are more complicated strategies, however, such as spreads and collars, that require two opening transactions. These strategies are often used to further limit the risk associated with options, but they may also limit potential return.
When you limit risk, there is usually a trade-off. Simple options strategies are usually the way to begin investing with options. By mastering simple strategies, you’ll prepare yourself for advanced options trading. In general, the more complicated options strategies are appropriate only for experienced investors.
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.
How and when to exit?
Once you’ve decided on an appropriate options strategy, it’s important to stay focused. 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 plan. If it seems that 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 ifthe option were exercised and assigned to you is unacceptable. But if it moves only 10% in-the-money, you’d be confident that there remains enough chance of it moving out-of the-money to make it worth the potential loss.
3 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 very important, however, to remember that leverage has a potential downside too. A small decline in value can mean a large percentage loss.
Investors who aren’t aware of the risks of leverage are in danger of overleveraging, and might face bigger losses than they 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 important 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. A serious mistake that some options investors make is 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 certain direction before a certain date. You should also be alert to any pending corporate actions such as splits and mergers.
Introduction To Options Strategies by Inna Rosputnia
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