Risky Option Strategies (All You Need to Know)
Learn all about risky option strategies and how they can help you make money in the stock market.
Traders often begin trading options without having a thorough understanding of the various options techniques at their disposal. And for this reason, they believe all option strategies are equally risky.
But there are various trading methods that can both reduce risk and increase profit. Traders can learn how to benefit from the flexibility and power that stock options provide with some education, patience, and practice.
This article will help you understand which are the riskier option strategies available to you (as well as which are the least risky!) and how they can be used to your advantage.
This strategy involves selling (writing) a call option against the shares of a stock that you already own, or simultaneously buying the shares of that specific stock. For the position to be considered "covered," you will need to hold 100 shares of the stock for each call contract you sell.
This is a highly common approach because it produces income and lowers some of the risk associated with selling an unprotected (naked) call, which can eventually lead to unlimited losses. The trade-off is that you have to be prepared to sell your shares at the short strike price (which is a predetermined price), limiting the upside profit potential of the strategy.
In a married put strategy, an investor buys an asset, such as stock shares, and at the same time buys put options covering an equal number of shares. Each contract for a put option is worth 100 shares, and the holder has the right to sell the stock at the strike price.
When holding a stock, an investor may decide to adopt this method to minimize the downside risk of the underlying asset, in this case, the shares of a company. This tactic works like an insurance policy; it sets a price floor if the stock price drops significantly. It is sometimes referred to as a protective put because of this.
When you already own the underlying asset, you can use a protective collar approach by buying an out-of-the-money (OTM) put option and simultaneously writing an OTM call option (with the same expiration). Investors frequently employ this tactic following significant profits on a long stock investment. As the long put helps lock in the potential sale price, this enables investors to have downside protection. The trade-off is that they might be forced to sell shares at a predetermined price, giving up the chance to make more money in case the stock moves higher before the expiration date.
When a trader simultaneously buys a call and a put option with the same strike price and expiration date on the same underlying asset, this is known as a long straddle options strategy. When a trader believes the price of the underlying asset will move noticeably outside of a certain range but is unsure of which direction the move will go, he can employ this approach.
The potential gains from this method are theoretically limitless for the trader. On the other hand, the greatest loss the trader can sustain is capped at the total cost paid to purchase the two option contracts.
An out-of-the-money call option and an out-of-the-money put option are simultaneously purchased on the same underlying asset with the same expiration date in a long strangle options strategy by the trader. This approach is employed by a trader who anticipates a very significant change in the price of the underlying asset, but who is unsure of the direction in which the movement will occur.
As for the long straddle, the potential gains from this strategy are potentially limitless, while the greatest loss the trader can sustain is determined by the amount paid to purchase the two out-of-the-money option contracts.
Bear Put Spread
A type of vertical spread is the bear put spread method. In this approach, the investor buys a certain number of put options at a certain strike price while concurrently selling an equal number of puts at a lower strike price.
Both options have the same expiration date and are related to the same underlying asset. When a trader is bearish on the underlying asset and anticipates a decrease in the asset's price, he can adopt this approach.
The trader has to pay a net debit when opening this kind of spread. The amount paid corresponds also to the maximum risk on the position. The maximum profit achievable in such a strategy corresponds to the width of the spread (distance between the short and the long strikes) minus the amount paid to open the position.
Bull Call Spread
A trader uses a bull call spread strategy when he simultaneously purchases calls at one strike price and sells the same quantity of calls at a higher strike price. The underlying asset and expiration date of both call options will be the same.
When a trader is bullish about the underlying asset and anticipates an increase in the asset's price, he can use this type of vertical spread strategy.
By employing this technique, the trader lowers the net premium paid but also limits the trade's potential gain (compared to buying a naked call option outright).
The trader receives a net credit when opening this kind of spread. The amount received also corresponds to the maximum profit on the position. The maximum loss achievable in such a strategy corresponds to the width of the spread (distance between the short and the long strikes) minus the amount received to open the position.
The trader simultaneously opens both a bull put spread and a bear call spread when using the iron condor strategy. The bull put spread is created by selling one out-of-the-money put and buying one out-of-the-money put with a lower strike. The bear call spread is established by selling one out-of-the-money call and buying one out-of-the-money call with a higher strike price.
All of the options are based on the same underlying asset and have the same expiration date. Usually, the spread widths on the put and call sides are equal. This trading method is designed to profit from a stock with medium-low volatility and generate a net premium when opening the position. This option strategy is popular among traders because it tends to have a high probability of producing consistent income.
With the iron butterfly strategy, a trader will sell an at-the-money put and buy an out-of-money put. He will also sell an at-the-money call and buy an out-of-the-money call at the same time. All of the options are based on the same underlying asset and have the same expiration date.
Although this tactic includes both calls and puts, it is akin to a butterfly spread (as opposed to one or the other). Essentially, this strategy consists of selling an at-the-money straddle and purchasing safety "wings" for protection.
The design can also be compared to two spreads. It is typical for both spreads to be the same width. The further out-of-the-money call create an hedge against unlimited losses. The long put that is out-of-the-money guards against losses from the short put strike to zero.
Depending on the strike prices of the deployed options, both profit and loss are constrained to fall within a particular range. Due to the substantial income it can produce and the better likelihood of success with non-volatile stocks, most professional traders like using this kind of strategy.
Options trading may sound complex, but there are many strategies that investors and traders can use to get the best returns from their capital.
The key points to take away from this article are:
- When you hold a stake in the underlying shares already, covered calls, collars, and married puts can be used.
- Long straddles and long strangles make money when the market moves up or down.
- Vertical spreads (with two or more legs) require simultaneously selling one (or more) option(s) while purchasing one (or more) option(s) at different strikes but with the same expiration date.
Remember that the options are financial products that carry significant risk. If you have no trading experience, you should seek out professional investment advice before putting any money at risk. Each individual investor should evaluate his or her financial situation and investment objectives before selecting an investment strategy and getting involved in options or stock trading. Potential losses in option trading can exceed the invested capital.
All the content is published and provided for informational and entertainment purposes only. None of the information contained in the content constitutes a recommendation that any particular security, portfolio of securities, transaction, or investment strategy is suitable for any specific person. You understand that the Content Creator is not advising, and will not advise you personally, concerning the nature, potential, value, or suitability of any particular security, portfolio of securities, transaction, investment strategy, or other matter. All of the information contained in the content can not be considered to be investment advice. Such information is impersonal and not tailored to the investment needs of any specific person. Make sure you have checked with your financial advisor and tax accountant to make sure you are suitable to execute what is discussed on this website.
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