Options trading can be a part of almost any trader's arsenal. Trading strategies involving options can accomplish a surprising number of investment goals including:
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Income Generation: One of the more conservative options strategies is using a covered call to generate income for yourself. You own the underlying stock, write a call against that stock, and collect the options premium.
- Protection: You can use options to protect the gains on a stock you hold through purchasing a protective put. If the stock price goes down, your losses are covered by the put.
- Leverage: The amount of buying power required to put on an option position is usually substantially less than the amount of buying power required to purchase underlying stock shares
- Speculation: Whether you think a stock is going up, down, sideways or just plain moving big, there is usually an options strategy that meets your needs.
Remember, while some strategies are more conservative than others, all of them involve risk. You need to carefully understand these risks before trading options. Simply click through each strategy for a detailed discussion of benefits and risks for each.
Option Trading Strategy #1: Income Generation
Covered calls can be used to generate predictable, if modest, income over a period of time. They are not risk free, but many experts consider covered calls to be a conservative options trading strategy that, when managed properly, can generate a modest, steady income.
Option Trading Strategy #2: Protection
Say you hold a stock that has turned a profit about you want to hold it long term. But you're worried this position may have short term downside right. What do you do? One alternative is to buy a protective put. That way, if the price of the stock goes down, your stock is protected. Of course, that comes at a cost (the option premium).
Option Trading Strategy #3: Leverage
Each option contract gives the buyer the right to buy (or sell) 100 shares of a stock. So let's say you're interested in a stock trading at $100 per share and you have $1000 to invest. You could buy 10 shares of the stock for $1000 and you're in the market. Now let's say you can buy call options at a price of $4. Since each contract controls 100 shares of the stock, for $400 ($4 * 100) you can control 100 shares*! If the option expires out of the money you're out $400. But if the underlying shares go up, you have 10 times the leverage for less than half the cost!
Option Trading Strategy #4: Speculation
Options are considered risky and most often are used for short-term speculation.
Some strategies have open-ended upside potential (i.e. gains are theoretically unlimited). This includes: long calls, long puts, straddles and strangles. The chart above categorizes these strategies as "open-ended speculation" strategies.
Most spreads and combo trades are somewhat hedged, although they are still considered speculative in nature. In return for providing some loss limit on the downside, they also can cap upside potential in the event of a dramatic increase in the price of the underlying stock. The chart above refers to these strategies as "hedged speculation".
*These examples omit the costs associated with trading options, and you'll need to figure that into your overall returns. At Zecco Trading, options commissions are just $4.50 per trade and $0.50 per contract.