Options trading allows investors to limit their risk and leverage their capital, but it can also expose them to amplified losses. It’s one of the most flexible trading styles because of the many different strategies available.
There is no one best options trading strategy that’s right for every investor, so it’s crucial to learn about your choices before you put your money in play.
The Best Options Trading Strategy Depends on You
Options traders have dozens of strategies at their disposal. The best one depends on your investment style, goals and risk tolerance. The following is an introduction to some of the most common tactics for options trading that might be a good fit for you.
1. Long Calls
Long calls involve buying a call option, which gives the buyer the right to purchase an underlying asset at a specified price, called the strike price, on or before a specified date, called the expiration date. Investors use long calls when they believe the underlying asset will increase in value.
2. Long Puts
This strategy involves buying a put option, which gives the buyer the right to sell the underlying asset at the strike price on or before the expiration date. Use long puts when you believe the asset will lose value.
3. Covered Calls
Covered calls are a two-part strategy where the investor buys stock and sells calls simultaneously. Called a “strike write,” the process limits risk but also caps potential gains.
4. Protective Puts
Protective puts involve buying put options on a stock you already own on a share-for-share basis. This strategy provides downside protection for the investor if the stock price falls.
With straddles, you buy a call option and a put option with the same strike price and expiration date. Investors use them when they expect the underlying asset to experience significant volatility in either direction.
Similar to straddles, strangles involve buying call and put options with the same expiration date but different strike prices. Investors use this strategy when they predict volatility but are unsure which direction the price will move.
7. Calendar Spreads
With calendar spreads, you buy and sell the same type of option — call or put — for the same security at the same strike price with slightly different expiration dates. Experienced traders use this strategy to take advantage of expected volatility over time.
8. Iron Condors
Iron condors involve two call options and two put options, one long and one short each. They all have different strike prices but the same expiration date. Investors use them in the hopes of gaining the maximum profit potential from all four options.
9. Butterfly Spreads
This neutral strategy has low risk and low potential for profit. It’s similar to a straddle, but the call and put options have three different strike prices. Butterflies can be a relatively safe play when you expect modest volatility in either direction.
10. Cash-Secured Puts
This strategy involves writing a put option while simultaneously depositing cash in your account equal to the put option’s strike price to cover the cost of buying the stock. Cash-secured puts are typically used to generate income or acquire a stock below market value.
What Is the Safest Options Trading Strategy?
There is no truly safe investment, but options trading offers opportunities to hedge your bets and limit the potential downside. Here’s a look at some strategies that can mitigate risk:
- Covered calls: By selling a call option on a stock you already own, you limit your risk because you cannot lose more than the amount you paid for the stock.
- Cash-covered puts: Because you cannot lose more than the amount of cash you have set aside to cover the put option, cash-covered puts cap your potential losses.
- Protective collars: As the name implies, this strategy offers protection by limiting your risk on both the upside and downside. Investors protect themselves by writing a call option and buying a put option with the same expiration date as a hedge.
- Iron condors: By using two put options and two call options instead of one of each, you can limit your risk even more than you would with a protective collar.
Which Is the Easiest Options Trading Strategy?
The easiest options trading strategy is buying calls. This strategy is a good choice for beginners because it is relatively straightforward, has limited risk and allows you to control shares at a fraction of the full price.
When you buy a call option, you purchase the right — but not the obligation — to buy a stock at the strike price on or before the expiration date. If the stock price exceeds the strike price at expiration, you can exercise your option to buy and profit from the difference.
However, if the stock price is below the strike price at expiration, your option will expire and you will lose your investment — but the maximum loss is the price you paid for the option to buy.
Which Indicator Is Best for Options Trading?
Same as with strategies, there is no single best indicator for options trading. The best indicator for you will depend on your trading style and strategy. Some of the most popular indicators for options trading include:
- Relative Strength Index: This momentum indicator measures the speed and magnitude of price changes. Investors use it to identify overbought and oversold conditions in the price of a security.
- Bollinger Bands: Bollinger Bands are a volatility indicator that investors use to identify potential support and resistance levels.
- Put-Call Ratio: The put-call ratio is a market sentiment indicator that reveals the total number of open put options (bearish) divided by the number of open call options (bullish).
Beginners shouldn’t feel intimidated by options trading, but they should understand the risks, which can be significant. Options trading uses leverage, which can magnify your profits, but also your losses. Also, options expire on a certain date. If you don’t close your position in time, you can lose the entire amount you invested. Finally, options are also more volatile than stocks and, therefore, harder to predict.