There are a lot of option trading strategies and methods to learn.
Let’s get them all out on the table:
- Covered Call
- Married Put
- Bull Call Spread
- Bear Put Spread
- Protective Collar
- Long Straddle
- Long Strangle
- Butterfly Spread
- Iron Condor
- Iron Butterfly
Of course, there is also the simple buying a call option or a put option. Traders also have the ability to short sell a call option or put option. The same holds true for a put option and any one of the strategies listed above.
In total, that’s 24 option trading strategies… and those are just a start.
However, in this article, I am going to talk about none of them. There are some very good reasons for not jumping in right away that you should know.
Let’s take a big step back. First of all, it would take a lot of time to offer a proper explanation. I’m not referring to a long article or a lengthy e-book.
It would take a course spanning days or weeks to explain options and all those strategies. At least that would be the case if you wanted a comprehensive understanding.
What I am going to share here is something different. You will be learning the key options characteristics of these option trading strategies. Each is a must-know before diving into the world of derivatives.
Understanding them will put you in a much better position to tackle the specifics in the future. So let’s get started. We’re going to cover three characteristics to consider before trading options.
Option Trading Strategies – Characteristic #1:
Most traders overlook one fundamental fact about stock options. They miss the reality that they are in fact derivative. The word derivative means “based on something else” or “derived from something else.”
That “something else” is stock prices. Stock options add an extra layer of unpredictability and risk to trading stocks.
Underlying much of the movement of an option is the stock price itself. Are you consistent at buying low and selling high? How about short selling high and buying to cover lower?
If not, the only thing options are going to do is make your trading life harder.
Here’s tip number one. Start thing simple. Buy and sell trading products like stocks where you only have to think about one thing. That one thing is the direction of the stock.
To give you a small glimpse of the complication, the stock direction is only one variable. Options have five times that number of variables.
Option Trading Strategies – Characteristic #2:
All options expire.
Sometimes they expire in days. Sometime after weeks or months. Still, others expire only after years have passed.
The most hazardous of the five complexities mentioned above is time decay. In layman’s terms, time decay is the fact that all options expire.
Here’s a fun way to think about it that has helped me and other traders and clients alike. Imagine you have the choice to sell bananas or keychains. The bananas in this example represent options while the keychains represent stock.
First the (options) bananas…
You choose to sell the bananas because you see that there’s a better profit potential.
Of course, who doesn’t like a banana?
You go and buy the bananas and then try to sell them at a higher price. It’s a competitive market, and the price goes up and down. You are not quite experienced in selling bananas yet.
“Options expire like a ticking time bomb. Beware time decay. Factor it into your plan.”
But the fast increases and decreases in prices are exciting. You jump in and buy some. To your dismay, the price fails to skyrocket upwards.
By the end of the third day, your bananas are going brown, and you’d be happy to sell them for a fraction of what you paid.
By the end of the week, they are a worthless pile of fly-infested mush.
Now for the (regular stock) keychains…
Compare that to the situation of trading keychains (our stand-in for a regular stock trade). You may be equally inexperienced with trading keychains as you are bananas. But the keychains will not rot on you thus giving you ample time to sell them in the future.
With keychains, you can be patient. You don’t have to get rid of them before they rot. By selecting your product to sell with care, you removed time decay from your selling.
It works the same way in trading. By selecting your trading product with care, you can remove time decay from your trading.
So, here is tip number two. It is like the first tip with some added weight. Start trading products like stocks and Forex that do not lose value over time.
Save yourself from the added urgency of a countdown to holding something worthless. Succeed without time decay first, and then see if you still want to add the complexity of options.
Option Trading Strategies – Characteristic #3:
When you buy options, you are buying insurance. Buying puts means you are buying insurance against the price of a stock going down. Buying calls means that you are buying insurance against the price of a stock going up.
Think of some other insurance types including auto, home, and life insurance. Those policies, much like options contracts, involve a premium.
That premium corresponds to the likelihood of the event happening. For financial options, that event is the stock price going where you think it’s going.
Options and other types of insurance share lots of characteristics. One very important one is that the premium is always more than the probabilistic value of the option.
Insurance policies are not designed to lose money for the company selling them. The same holds true for options contracts.
At this point, you may be thinking, “Great! In that case, I should sell as many options as I can and be like the big players.”
But hold on there for a moment!
You have the right idea. Selling insurance and options selling strategies are both businesses. Each one has a lot of competition and moving parts.
But beware. All the gritty details are beyond the scope of this article. The deceptively simple idea of selling options can hide the actual complexity involved.
Options selling strategies also involve a lot of risks. Those risks can be much larger than outright positions in non-derivative trading products.
Remember that options are insurance. They most often trade for prices higher than the history dictates. Selling them can be a good strategy. But successful options selling involves a very specialized trading strategy. Make sure you have one before you start trading in this market.
Option Trading Strategies (The End Or The Beginning?)
Now you have a respectable start to understanding options trading strategies. You know they are complex. You know they carry high risk. This is usually the point where I would say something like “now you know enough to be dangerous.” In this case, it is the exact opposite.
Now you know the very nature of options. Options have the potential to amplify performance. They amplify both good and bad performance.
An options buyer pays for that two-way performance boost in many ways.
The price that gets paid is always too high when a trader does not know what they are doing. “Keep it simple” is sound advice that I give over and over. Far from nagging or because there’s nothing else to say, I reiterate it because it’s the best way to trade well.
Options are specialized tools used in a high-risk and high-competition market. If you decide you want to trade them, make sure to do what’s right for you, your trading account and your future as a trader.
Learn, trade and excel in a more forgiving market first. Build, improve and hone your skills. And then move to options trading once you can justify the extra risks and costs involved.
For more day trading techniques, tools & strategies, check out these articles:
- 7 Best Methods To Learn How To Day Trade
- 3 Forex Trading Methods That Work
- Top 5 Online Forums For Active Traders
Know these three key characteristics before you consider option trading strategies.
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