Stock traders may find that they are often stuck holding losing positions far too long or unable to take advantage of their winning ideas because the market moves too quickly. An option strategy is something every stock trader should have in their tool belt if they want to take control of their portfolio and optimize returns.
Options are flexible securities that give the investor the right, but not the duty, to buy or sell a stock at a noncontroversial price within a specified time frame. The flexibility allows investors to tailor risk-reward profiles for each trade based on how much capital they have available, their risk tolerance, and where they think the underlying security will be trading by expiration. As with all options strategies, countless variations can be used depending on your specific investment goals.
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A covered call occurs when you own shares that you want to continue holding long-term and collect extra cash. To do this, you sell an out-of-the-money (OTM) call at a higher strike price than your current stock price, collecting money for selling the contract. If the stock doesn’t go above your strike price by expiration, then you don’t have to repurchase it. You keep the premium income collected for selling the contract, which you can invest elsewhere. The covered call has a break-even point at expiration where your stock price equals strike price plus premium collected.
This is a bullish strategy involving selling a put at a higher strike price than where the underlying security is currently trading. The speculator collects money for selling the contract, and if the stock doesn’t fall below your strike price by expiration, you don’t have to repurchase it from the buyer of the put. Again, the income from the premium collection can be used elsewhere. This strategy generates additional revenue and lessens the risk on existing positions because you own stock that can rise in value while offsetting any short-term losses until expiration.
Long straddle / strangle
Long straddle or strangle involves buying both a put and call, with the same expiration date on the same underlying security. The long straddle or strangle generates income off option premiums while speculating how high or low the market will move over time. You enter into both a put and call with the same expiration date but different strike prices. Suppose the underlying security moves either way before expiry. In that case, you are required to repurchase it at that new higher / lower price, respectively, allowing you to make money off volatility while limiting risk because if it doesn’t move by expiration, then you don’t have to take the loss.
An iron condor is a popular strategy when the market is experiencing lower volatility. The speculator will sell out-of-the-money put and call options on underlying security to generate income while also limiting risk by selling spreads equidistant from the current stock price. Ideally, you would look for underlying with low volatility but higher IV percentile rankings to execute this strategy.
A ratio spread is one of the most effective ways to generate extra returns on your stock trades. The speculator will use a 1:2 or even higher risk-reward ratio while looking for cheap underlying with high implied volatility (IV%). You can achieve this by purchasing or trading in options depending on where you think the underlying security will be trading by expiration. For example, if an IV% of 30% is too pricey, you can buy put options at 25%, sell two options at 30%, and take in premiums on all three contracts. On expiry, you would end up owning 100 shares of that underlying security if it was between $25-30 per share while only losing money on the out-of-the-money options. You lose money on the more expensive options but retain earnings on the more desirable underlying if it’s above or below that range.