Best option strategy
Best option strategy
best option strategies
It would be helpful if we were given multiple lifetimes in which to perfect our methods of trading and investing. Unfortunately, all we have is this life and the present moment. And that means a lot of trial and error.
But trial and error doesn't mean that you must make the same mistakes as everyone else.
Or the same number.
A large part of the trial portion consists of educating yourself in order to cut down on the error portion. And the purpose of educating yourself, when it comes to option trading, is to eliminate as many potential mistakes as possible beforehand.
Option Trading Warning
best option strategies
For example, I know myself well enough now to realize that pure speculative trading does NOT suit my personality (although, from time to time, I'm still tempted).
The Hybrid Investor-Trader
I suspect, however, that there are a lot of people out there like me. We may not have the pure mathematical skills to ever become great, professional, full-time traders, and even if we could be successful at it, we still lack the necessary personality to even want to be great, professional, full-time traders.
The idea of investing via mutual funds or ETFs is also unappealing. It seems wrong somehow, a waste of potential, and boring as hell. Oh, and one other thing - it doesn't work any better than straight buy and hold.
Additionally, we're not the kind of people who abdicate our investing either, who simply hand over our money and let someone else manage it for us, just spare us the details, ala Bernie Madoff.
We may not be pure traders, but we recognize that the details are still important.
The 3 Best Option Strategies for Everyday Traders/Investors
So I've actually thought a great deal about what the best option strategies are from a structural standpoint.
- Are there effective option trading strategies that don't require professional grade expertise with technical analysis?
- Are there any relatively simple option strategies or methods available to increase one's returns without having to take excessive risks?
- If these strategies exist and if they're effective, what makes them effective?
Full disclosure - what follows are my own subjective opinions, formed out of my own personal experiences and biases:
I can identify three separate TYPES of option strategies that can be very profitable
- Method #1 - Leveraged Investing
- Method #2 - Writing Covered Call Options for Income
- Method #3 - Calendar Spread Trading
Watch video about best option strategyTop 3 Options Trading Strategies for Monthly Income
More information about best option strategy
During the past few weeks, we’ve been looking at how investors can harness trading techniques to boost their longer-term performance in the near to intermediate term.
The thing is, using options is a lot easier than trying to pick a favorite strategy.
In fact, this very question can start an argument between experienced and even professional traders!
- One trader might argue that selling covered calls against your long stock positions is the best strategy because it reduces your risk but still allows for a profit.
- Another might argue that "selling to open" put options is a better strategy because you can essentially get paid to buy stock.
- Sometimes, when volatility is very high, and the market is swinging up and down, "straddling" an equity at or between strike prices can allow you to make money on a really big moves in either direction.
In the straddle strategy, you would buy a call option (as an upside bet) and buy a put option (as a downside bet) at the same strike price, in the same expiration month. Generally you look to make more on the winning "leg" of the trade than you would lose on the other side of it.
When you hear comments like these, all you’re hearing is one trader’s preference for a particular risk-reward profile.
It’s OK for an investor, or even a professional trader, to have a favorite strategy or be more comfortable with one strategy than another.
Be careful when anyone tells you that a particular strategy is always superior to another. They either don’t understand options or want to sell you something.
Traders who tout superior option strategies focus on one aspect of the strategy — either risk or reward — and completely neglect the counterpart.
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They make comments such as, "Buying calls is superior to owning stock because the return on investment is much higher."
It’s easy to make them consider the risk side. Just reply, "Sure, but lottery tickets are superior to calls because the return on investment is even higher!"
Don’t spend your time looking for the superior option strategy. It doesn’t exist.
Understanding Risk and Reward
To understand the relationship between risk and reward with options, we need to look at profit and loss diagrams.
For example, let’s revisit the earlier comment. Are call options superior to stock? Assume one investor buys stock for and another buys the call for .
We can plot the profit and loss at expiration for each position, and we will get the following diagram:
a trader who buys stock at will make profit if the stock is trading for
The diagram also shows that the long call buyer (blue) will lose if the stock is or below and will break even if the stock is . At a stock price of , the call buyer will make profit (the call option will be worth but the trader paid )
Notice the profit and loss diagram for stock (red). It is superior to (lies above) the profit and loss line for the long call (blue) for all stock prices above . This is because the call option buyer is effectively paying for the stock ( strike for a cost of ).
- If the stock stays above , the long stock position is the better strategy (the red line is above the blue line).
- If the stock price falls below , the call option becomes the better strategy (the blue line is above the red line), as the long call can’t lose more than the premium. Niether strategy is always "better" than the other. The answer depends on your outlook of the stock and the amount of risk you are willing to accept.
An investor who believes the stock will stay above is better off buying stock. Of course, there is a trade-off of accepting a potential maximum loss.
Conversely, an investor who believes the stock is heading higher but doesn’t want the exposure to the downside is better off buying the call.
The trade-off is that he will pay for the stock instead of , but in return, can’t lose more than the option premium.
- When traders grow concerned with downside risk, they will bid up the price of the call.
- If they feel the price of the call is too high relative to the stock, they will sell the call (either naked or covered).
What about naked puts? This strategy must be better than buying stock outright since you are actually paid to buy the stock, right?
Let’s look at the profit and loss diagram between stock purchased for and a naked put sold for :
Again, in some areas of the chart, the long stock position dominates, and not in others. The long stock position is better when stock prices are above . With the stock above , the long stock investor will realize unlimited profits, while the naked put writer profits only by the premium received from the sale of the put.
However, if the stock goes below , the naked put is the better strategy. Below a stock price, both investors lose but the naked put seller is ahead because he received the cash premium.
Maybe a long call is better than a naked put? Some may reason that the long call position makes more money if the stock rises and loses less if it falls, and so is a better strategy. Let’s assume a long call and short put each trade at :
Looking at the above chart, we see that the long call position (red) does dominate for all stock prices above and below . If the stock stays between these prices, the naked put is clearly the better choice. Your outlook on the stock and tolerance for risk will determine which strategy is best for you.
Option strategies come in all shapes and sizes. Now you should have a better understanding why. Different strategies alter the risk-reward relationships and it is up to you, the trader, to decide which is best.
Don’t be afraid to alter a strategy to meet your taste — that is what option trading is all about. If you accept somebody’s strategy as the "best," you are, by default, accepting his or her risk tolerances too.
If those tolerances are different from yours, you will eventually learn (the expensive way) that no strategy is always superior to another.
- Covered Calls: The Short Road to Long-Term Stock Gains
- Selling Puts: Get Paid a Dowry Before Committing to an Equity
- Why Options (and Options Traders) are Good for the Market