According to many, making unconventional trade moves (atypical for the general public) gives traders the superior edge needed to avoid the pitfalls of simple buy-and-hold investing. Options contracts are something that most casual investors often overlook when they start putting their money to work. Yet, these contracts that allow people to speculate on the future direction of individual securities or the overall stock market combine specificity with flexibility and act as an attractive hedging tool even when you are investing in impact companies focused on sustainability.
For the uninformed, options get classified as financial derivatives that supply buyers the possibility, but not the obligation, to sell or buy an underlying security by a specific date at an agreed-upon price. As mentioned, they give investors risk-reduction strategies, get utilized as a hedging device, offer low-cost approaches for speculators to go short or long in the market with limited downside risk, and deliver spread and combinations tactics to traders that can be super limber.
Options have been around for more than four decades but are now turning heads regarding newbies to the investment sphere. That is so because of the belief they are too sophisticated for newcomers. Plus, the labels dangerous and risky have gotten unjustifiably attached to them by media outlets, making them seem like a problematic financial instrument when that does not have to be so. Below, we get into option portfolio management and how everyone can take advantage of these contracts en route to attaining sizeable monetary gains.
How Options Can Generate Income
There are multiple ways that options can generate income. Before that gets explained, it must get outlined that two types of options exist. They are calls and puts. The first gives traders the right to buy securities within a specified period, while the latter gives them the right to sell. Also, three categories of positions are in play in options trading, much like in other types. These are shorting, predicting that a stock’s value will fall. A long investing position estimates that its price will grow, and neutral means that the prediction is that it shall remain consistent.
Some more established widely used options strategies are covered calls, married puts, the protective collar, and the strangle and straddle option approaches.
With a covered call, investors purchase shares in a stock. Then they select to offload a call options contract to get the shares for a premium. Regardless of what occurs, they keep the premium from the sale, which offsets any losses in the case of the price dropping.
Also called a protective put, a married one is a similar maneuver to a covered call. Though, here, traders own shares in a stock. Plus, they have a put option to sell them. In a protective collar, traders own stock and vend a covered call while purchasing a protective put. That functions well with a neutral position that aims to hedge against the stock’s price dropping, coming with little risk. Note that the premium paid for buying the put option can get offset via offloading the call option.
A strangle strategy begins by getting a call and put options on securities with the same expiration date. It is a game plan utilized with multiple options contracts when one is confident that they know the direction that the underlying asset will move in the short and long term. The risk here is the cost of the premiums paid for the options contracts.
In a straddle option, investors get a put and call for the same asset and expiration date. The approach differs from the strangle in that traders purchase the put and call for the identical strike price, and they are unsure of the direction it will go. Again, the primary hazard here is the premiums paid on the contract. If the asset plummets, investors end in the black, and if it goes past the call strike price substantially, then there is little limiting profitability. Thus, the security must be volatile enough to offset the costs of the contracts.
Trading Volatility: Taking Advantage of Price Movements
Without question, options can supply leverage, meaning traders can pay small premiums, relatively minor ones, for market exposure in regard to the contract value. So, they can notch decent gains from noted dramatic favorable movements in the underlying product. Though, if the underlying stock does not drop or jump in the anticipated timeframe of the option, then the leverage could dramatically augment the investment’s percentage loss. Those are its downside implications.
Prices are continuously adjusting in financial markets. That is a positive because traders would not make money if they did not change. However, sometimes, these shifts happen more quickly than others. As volatility increases, so does the potential to make money quicker. That said, higher volatility also means greater risk. Once one gets a fair-value price, they can utilize appropriate options tactics based on their acceptable risk. It is vital to never trade anything on emotions. To have a plan and stick to it, modifying fair-value estimates for positions, particularly regarding the longer-term options where conditions will likely change. Never panic when things go negative for a week or even a month. Be confident in the conducted research and the projected price expectations. When a trader spreads risk, several misfired positions will not significantly affect the long-term overall performance of his portfolio.
Renowned strategies traders use to capitalize on securities that exhibit high volatility are buying puts, writing calls, shorting straddles or strangles, ratio writing, and performing iron condors. The latter two did not get discussed, and in an iron condor, the investor, on the same expiration date, combines a bear call spread with a bull put one, attempting to capitalize on a volatility retreat that shall result in the stock trading in a narrow range during the options’ lifespan. In this strategy, the maximum gain usually equals the net premium received. Ratio writing means nothing more than writing more options than purchased. And, in its most rudimentary form, it utilizes a two-to-one ratio with two options, written or sold, for every bought. The logic in play here is to capitalize on a substantial fall in implied volatility before the deadline of the option expires.
Leveraging Options to Increase Your Returns
In options trading, investors can boost their buying power by using leverage. Therefore, with less capital, they can still effectively control more prominent positions, and when a trade goes their way, the returns can be more than decent. In the eyes of many, leverage is the best advantage that options have over other financial tools, and why they are a preferred instrument for those who do not have sizeable capital to invest. That is so because options customarily cost far less than stocks. Hence, if an investor has $5,000 in their account, they can buy options contracts on a specific security that permits control, let us say, of $50,000 in value. They can earn more from the same price gains from the traded underlying stock. And that can get also get leveraged to protect profits and make them.
Know that, as an unwritten rule, a limit of the fifty-to-one leverage ratio in stock trading gets enforced. Therefore, when someone buys a stock for $50, investors can only offload it short for $2.50. Nevertheless, options contracts have no leverage cap built-in, meaning it is possible to utilize the leverage of five hundred to one. Call ones allow a leverage one-to-one hundred. So, for instance, purchasing a call option contract on a stock trading at $50 should cost $500. Yet, if the stock jumps by $60, the call option will go to $5,000. $5,000 – $500 = $4,500. Ergo, the trader will snag a profit of $4,500, getting an effective 500% ROI.
Combining Options with Technical Analysis
Technical analysis is a tool that uses patterns in market data to spot trends and make predictions. Hundreds of technical indicators exist that traders can use to try and make valid estimations on how things will develop depending on the type of security and investment style utilized. When it comes to options trading, the implementation of technical analysis is somewhat of a controversial topic that stems from evidence showing that multiple hedge funds have proven in the past that timing the market accurately is extremely hard to do, as no magic indicators can get found that consistently give ideal sell and buy signals. Still, technical analysis provides everyone a context to what is occurring on the market and should not get neglected by anyone.
The best approach is to keep things simple and use a 200-day moving average. Other indicators to look into are volume profiles, the relative strength index, the intraday momentum one, and Bollinger bonds as a way to measure volatility.
Managing Risk When Trading Options
Without question, figuring out how to properly manage risk for stock options is likely the most crucial step in working towards maximizing profits using this investment tool. Most experts suggest focusing on trades that provide consistent 5-10% returns instead of trying to hit home runs. Also, they recommend placing orders to sell or buy specific stocks once they hit a certain price. That gets called a stop-loss, and it has gotten created to restrict an investor’s loss on a security position. Another handy risk mediating time is sizing positions within a portfolio using a distinct dollar amount an investor is willing to trade. Diversifying trades and paying for quality forecasting software is also a must to lower the odds of facing option trading losses.
The Bottom Line
It is paramount that everyone considering to trade options has a clear plan on how they will go about this endeavor and stick to their predefined objectives, not moving the goalposts as they go. Options carry no guarantees and remember that as the holder, you risk the entire sum of the premium you pay, and as the writer, you accumulate much higher risk. Those serious about this practice should buy reputable forecasting/market monitoring software and place stop-loss orders.
