Best Option Trading Strategies - Different Types & Benefits
- 18 Sept 2024
- By: BlinkX Research Team
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Options trading includes a range of techniques that use asset volatility, market trends, and risk metrics, such as options Greeks, to formulate proper trading strategies. These methods enable investors to make well-informed choices, which is essential for carrying out options transactions. Therefore, anyone starting an options trading must know the best option strategy. Whether your level of expertise is high or low, becoming proficient with these best option strategies for the Indian market is essential. Imagine the potential of stock options, which can minimize risks and maximize your return on investment. Getting to understand these option trading strategies will help you in several ways. Let’s explore the option strategies with examples in this blog.
Types of Options Trading Strategies
Call and put options are two types of options. Call options grant the contract holder the right to purchase an underlying asset at the strike price before or on the expiration date, while put options grant the right but not the duty to sell the asset at the strike price. Investors commonly use call options when they believe the market is bullish, while put options are used when the market is negative.
Options trading techniques are classified into three groups based on market trends: bullish, bearish, and neutral. Bullish options are used when investors believe the underlying asset's price will rise, bearish options when it will fall, and neutral options when uncertain about the market trend. Apart from this, there are numerous strategies in options trading that you can check in the below:
Bullish Options Strategy
When trading options, if investors believe the market is bullish, they employ the following bullish options trading tactics to maximize gains while minimizing losses.
- Bull Call Spread
A Bull-Call spread is also one of the best option trading strategies for beginners. This option-selling strategy creates a range by combining two call options with different strike prices. Both options use the same underlying asset and have the same expiration date. However, the investor and traders buy one At-The-Money call option while concurrently selling one Out-Of-The-Money call option. A bull call spread is lucrative for the investor if the underlying asset's price, such as stocks, rises. The profit in this approach is restricted to the spread minus the net debit, but the loss is incurred if the stock price decreases. - Bull Put Spread
Like the Bull-Call spread, a Bull-Put spread is a strategy in options trading. Investors use two put options with different strike prices and the same expiration date to generate a range. However, the investor and traders buy one out-of-the-money put option while concurrently selling one in-the-money put option. Investors earn again if the underlying asset's price, such as stocks, rises on or before the expiration date. This technique is designed to generate a net credit, or the net amount received while incurring a loss, if the underlying asset's price falls below the strike price of the long put option. This strategy is considered the best option buying strategy. - Call Ratio Back Spread
This is a three-legged options strategy in which investors and traders purchase two out-of-the-money call options and sell one in-the-money call option. The profit potential is boundless. However, loss occurs if the price of the underlying asset remains within a specified range. - Synthetic Call
A synthetic call is one of the well-known option trading strategies for investors who have a positive long-term view of the underlying asset but are concerned about the negative risks. After forming a favorable view, the strategy involves purchasing options on the same underlying asset, such as stocks acquired through direct investment. If stock prices rise, the profit potential is boundless, but the loss risk is limited to the size of the premium.
Bearish Options Strategies
The financial market is dynamic, with volatility resulting from various external market conditions, which might cause the market to enter a negative trend. In such cases, options traders employ the following bearish options trading strategies.
- Bear Call Spread
This technique entails purchasing one Out-Of-Money call option with a higher strike price and simultaneously selling one In-Of-Money call option with a lower strike price, both with the same underlying asset and expiration date. The method is designed for a net credit, and investors earn if the cost of the underlying asset declines. - Bear Put Spread
Investors use this technique, similar to a bear call spread when they believe the underlying asset's price will decrease somewhat but not significantly. Using this method, investors buy one in-the-money put option while selling one out-of-the-money put option. The profit potential is restricted to the spread less the net debit, which is the difference between the premium paid and the premium received. - Strip
The Strip is a bearish to neutral three-legged strategy in which investors buy one call option, and two put options with the same underlying asset, strike price, and expiration date that are At-The-Money. Traders win from this approach if the underlying asset's price falls sufficiently before expiration. - Synthetic Put
When investors believe the market is in a negative trend and the underlying asset may lose strength in the short term, they employ the synthetic put technique. The approach is also synthetic long put since investors profit from the underlying asset's price drop.
Neutral Options Strategies
Investors with no notion where the underlying asset's price will go use neutral options methods. As a result, they employ the following neutral options trading strategies.
- Long and Short Straddles
The long straddle is the best strategy for option trading that consists of purchasing an In-The-Money call and putting options with the same underlying asset, strike price, and expiration date. Profit potential is infinite in this method, while loss potential is limited. The short straddle consists of selling call and put options with the same underlying asset, strike price, and expiration date. - Long and Short Strangles
The options strangle strategy is similar to the straddle options strategy, but purchasing an out-of-the-money call distinguishes it and puts options. Using the long strangle strategy, you buy one out-of-the-money call option and one out-of-the-money put option. Profit potential is limitless, whereas loss potential is restricted to the net premium. Selling one out-of-the-money put option and one out-of-the-money call option constitutes the short straddle. The greatest profit is the premium received, but the maximum loss is indefinite. - Long and Short Butterfly
This technique combines bull and bear spreads with a set profit and risk, and the options are the same distance from the At-The-Money options. The long butterfly call spread consists of purchasing one In-The-Money call option, selling two At-The-Money call options, and then purchasing one Out-Of-The-Money call option. The short butterfly spread consists of selling one In-The-Money call option, purchasing two At-The-Money call options, and then selling one Out-Of-The-Money call option. - Long and Short Iron Condor
This best option trading strategy consists of one long and one short put option and one long and one short call option with separate strike prices and the same expiry date. Unlike a bull put spread, the iron condor approach is a four-legged method that allows investors, innovators, and traders to gain from the market's low volatility. The profit potential is greatest when the underlying asset's price is between the middle strike price at the time of expiry.
Other Strategies
Other strategies include covered call and married put. Here is a detailed explanation of these strategies.
- Covered Call
In this scenario, the trader would buy a stock and then sell a call option. In this strategy, a trader can take a neutral position on a stock but still profit from the premium received regardless of whether the stock price rises or falls. - Married Put
This strategy involves buying a stock and buying a put option on that stock. In this strategy, the put option acts as a stop loss. This allows you to sell at the strike price regardless of the stock’s value.
Various other options can also be used, including synthetic calls and puts, call ratio back spreads, etc. By predicting risk and market trends, you can devise multi-legged option strategies involving multiple option contracts.
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Table of Content
- Types of Options Trading Strategies
- Advantages and Disadvantages of Option Trading
- What are the Levels of Options Trading?
- Which are Some of the Best Options Strategies
- Risk Management in Options Trading
Advantages and Disadvantages of Option Trading
Here are the advantages and disadvantages of option trading.
Advantages | Disadvantages |
| Higher Leverage: Options give more leveraging power, allowing investors to manage positions with a lesser investment via leveraging through brokers. | Unlimited Losses: Option sellers suffer potentially infinite losses if the buyer exercises their right, whereas sellers are bound to purchase or sell at the agreed-upon price. |
| Limited Downside: Option purchasers have the right, but not the responsibility, to exercise the contract. They can restrict their losses to the premium paid if the contract is not exercised. | Margin Requirements: Traders must have a minimum margin in their brokerage accounts. Failure to do so may result in margin calls or the liquidation of positions. |
| Predetermined Price: Investors can set the stock price to a specific level, providing a hedge against direct investments and potentially minimizing losses. | Complexity: Options trading requires understanding complicated terminologies and methods, which may be time-consuming and difficult for traders to learn and execute flawlessly. |
What are the Levels of Options Trading?
Options trading generally has four levels assigned by a broker, which determine the approval given by a broker up to a certain level while the customer maintains a margin account. Here are the four levels of options trading.
- Level 1: Using protective puts and covered calls when the investor or trader already owns the underlying security.
- Level 2: Using straddles and strangles along with long calls and puts.
- Level 3: The use of multiple options spreads that consist of buying and simultaneously selling the same underlying asset and expiration date.
- Level 4: Writing (selling) options, such as naked options, with the risk of unlimited losses.
Which are Some of the Best Options Strategies
The best options trading strategies involve the Bull Call Spread, which involves buying and selling of call options at different strike prices to make a profit from the moderate increase in the price. Other options include the Bear Put Spread, which helps an investor to profit due to a moderate drop in price. It is achieved by buying and selling put options.
Lastly, the Moving Average Crossover Strategy is based on moving averages to determine the change in trend, which is excellent for market momentum. These are the varieties to suit different market conditions and risk appetites.
Risk Management in Options Trading
No advanced strategy is beyond the reach of risk management. Here are some basic principles to think about when taking your options trading to the next level:
- Position Sizing: Determine the portfolio percentage that you will risk on a single trade. This limits the overall portfolio risk and prevents overexposure to one particular asset or even strategy.
- Don't Over-Leverage: With great power comes great responsibility, and great leverage magnifies returns in both directions. Do not use a higher degree of leverage than you can afford to lose without significant impact.
- Stop Losses: One good practice could be using stop orders on the exit of the trade once the option's price moves against you by a certain percent, for protection of your capital and avoidance of emotional decision-making.
- Diversification of Strategies: The use of varied strategies spreads your risk over the variations in the market. This means that when one of your strategies is not rewarding you, there is always the chance that the other one will cover up the loss.
Conclusion
New market participants may find options trading intimidating, but there are a number of option strategies that can limit risk and increase returns. You can explore effective option trading strategies for potential gains in the BlinkX stock market app. Some strategies, such as butterfly, have several offsetting options. For those already invested in the underlying asset, covered calls, collars, and married puts are among the options; straddles and strangles can be used when the market moves.
