How to create the right strategy for options, All About Options Strategy
Devise a strategy.
Options Trading Strategies: A Guide for Beginners
Establish option parameters. Let's breakdown what each of these steps involves. Option Objective The starting point when making any investment is your investment objectiveand options trading is no different. What objective do you want to achieve with your option trade?
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Is it to speculate on a bullish or bearish view of the underlying asset? Or is it to hedge potential downside risk on a stock in which you have a significant position?
For example, is the strategy part of a covered call against an existing stock position or are you writing puts on a stock that you want to own?
Using options to generate income is a vastly different approach compared to buying options to speculate or to hedge.
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Every option strategy has a well-defined risk and reward profile, so make sure you understand it thoroughly. Implied volatility lets you know whether other traders are expecting the stock to move a lot or not. High implied volatility will push up premiumsmaking writing an option more attractive, assuming the trader thinks volatility will not keep increasing which could increase the chance of the option being exercised.
Low implied volatility means cheaper option premiums, which is good for buying options if a trader expects the underlying stock will move enough to increase the value of the options. Identify Events Events can be classified into two broad categories: market-wide and stock-specific. Market-wide events are those that impact the broad markets, such as Federal Reserve announcements and economic data releases. Stock-specific events are things like earnings reports, product launches, and spinoffs.
An event can have a significant effect on implied volatility before its actual occurrence, and the event can have a huge impact on the stock price when it does occur. So do you want to capitalize on the surge in volatility before a key event, or would you rather wait on the sidelines until things settle down? Identifying events that may impact the underlying asset can help you decide on the appropriate time frame and expiration date for your option trade.
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Devise a Strategy Based on the analysis conducted in the previous steps, you now know your investment objective, desired risk-reward payoff, level of implied and historical volatility, and key events that may affect the underlying asset. Going through the four steps makes it much easier to identify a specific option strategy. You may, therefore, opt for a covered call writing strategywhich involves writing calls on some or all of the stocks in your portfolio.
Pick the Right Options to Trade in Six Steps
For example, you may want to buy a call with the longest possible expiration but at the lowest possible cost, in which case an out-of-the-money call may be suitable. Conversely, if you desire a call with a high delta, you may prefer an in-the-money option. ITM vs. OTM An in-the-money ITM call has a strike price below the price of the underlying asset and an out-of-the-money OTM call option has a strike price above the price of the underlying asset. Examples Using these Steps Here are two hypothetical examples where the six steps are used by different types of traders.
Earnings come out in just over two months, which means the options should extend about three months out. Strategy: Buy puts to hedge the risk of a decline in how to create the right strategy for options underlying stock.
This cost excludes commissions. If the stock drops, the investor is hedged, as the gain on the put option will likely offset the loss in the stock.
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Events: None, the company just had earnings so it will be a few months before the next earnings announcement. Strategy: Buy OTM calls to speculate on a surge in the stock price.
The maximum gain is theoretically infinite. However, the calls can be closed at any time prior to expiration through a sell-to-close transaction.
The Bottom Line While the wide range of strike prices and expiration dates may make it challenging for an inexperienced investor to zero in on a specific option, the six steps outlined here follow a logical thought process that may help in selecting an option to trade.