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Strategies for New Options Traders

When trading options, you can choose from a wide range of strategies. The choice depends on what you are trying to achieve. Options are versatile investment tools, and while most beginners feel that the only thing they want to achieve is “making money,” there are other considerations.

How do you want to use options in your portfolio?

The primary goal of options traders is almost always to make money. However, experienced traders learn that options can be used to gain other desirable characteristics for their investment portfolios. For example, options can be used to:

Manage risk:

This is the primary motivation that many investors have for trading options. Yes, you are still aiming for profits, but options allow you to pursue those profits with less risk on the trade. Furthermore, basic strategies allow you to define the maximum potential loss of any trade – something that an investor holding stocks cannot always do (even with a stop-loss order in place, on any given morning, any stock can drop significantly – much lower than the stop-loss price). A greater likelihood of achieving profits against limited losses is something that most traders can appreciate.

Hedge or reduce the risk of holding existing positions in your portfolio:

You can buy and/or sell options that hedge existing positions. Some of these methods can define profits, while others do not. When a trader learns how to understand how options work, it becomes easier to decide whether you prefer to pay cash (think of it as an insurance policy) to adequately protect your portfolio or to collect premiums to accept limited protection only.

Protect your investments from a massive shock in the stock market:

This doesn’t happen often, but we’ve seen some very strong bear markets in our lifetime, and there will undoubtedly be more. You can protect your investments against a massive shock in the stock market by buying options that shield you from large price declines.

Adjust your expectations of the stock market:

This is particularly important for experienced traders. For example, you may want to take an optimistic stance on a particular stock or index, but options allow you to define your expectations more precisely. For instance, you can maximize your profit potential by predicting the magnitude of a stock price change accurately.

Before you begin

You must be cautious. Beginners should understand one fixed principle when trading: do not put money at risk unless you are completely sure that you understand exactly what you are doing. There is nothing wrong with paying for advice, but you must do your part and make sure that the trade is suitable for your risk tolerance (see point number 5). Additionally, if you do not understand what must happen to the trade for you to make a profit (and how you can lose money), there is no reason to execute the trade.

If you start trading any options strategy without a proper understanding of how each of these strategies works and what you are trying to achieve by using them, it becomes impossible to manage the trade efficiently. In other words, when trading options, you cannot rely on a buy-and-hold philosophy.

Options are designed to be traded, not necessarily actively, but when you execute a trade, there is always an appropriate time to exit. Hopefully, it will be with a profit, but a good financial manager (you) knows when the trade is not working well and that it is essential to exit the position. If you have to take a loss, so be it. Do not hold onto a losing trade hoping it will return to break even.

Strategies

Recommended for Options

The following shortlist of strategies includes the methods that I recommend.

Writing Covered Calls

This is a great way for beginners to learn all about options. Many beginners in options understand the stock market and have some investment experience. Therefore, starting with an option strategy that involves owning the stock is a logical way to introduce investors to the world of options.

To implement this strategy, buy 100 shares (or more, in multiples of 100), or use the shares you already own and sell one call option for every 100 shares.

When selling a call option, a cash premium is collected, and this money is yours, regardless of what happens in the future.

When you sell (write) a call option:

  • You become obligated to sell 100 shares of the stock at a specified price, known as the strike price – for a limited time – but only when the option holder chooses to exercise the option and you are assigned a notice of exercise. This notice is simply a message from your broker that your short option has been exercised and you have automatically sold 100 shares at the strike price. Your option position disappears (once exercised, the option no longer exists) and the shares are removed from your account. Cash will appear when the sale of the shares settles in three days. You, as the option seller, have no say in whether the option will be exercised or not. This decision rests with the option holder. If that seems unfair, just remember that the buyer paid cash for that right. The option is a binding contract that specifies the strike price and expiration date. Your obligation to sell your shares lasts for a limited time – until expiration. If the option holder fails to exercise their rights by that date (the cutoff time is approximately 30 minutes after the market closes on expiration day), your obligation ends, and the call option expires worthless. The cash (premium) you collected when selling the option is not part of the contract. This premium simply describes the transaction that took place on the field at one of the options exchanges.

When writing a covered call, there are only two possible outcomes:

  • The option is exercised, and the shares are sold at the price agreed upon in the contract (the strike price). Additionally, you can keep the cash premium. The option expires worthless. You’re ahead of the game with the cash premium collected. You still own the shares and can – if you choose – write another call option and collect another premium.

There is a lot to learn about this strategy, but this is enough for the purposes of a basic introductory discussion. If it sounds appealing, it’s time to start learning more deeply about the details of how to implement writing covered calls. Don’t jump into the action by making a few trades. If writing covered calls doesn’t seem appealing, take advantage of another strategy from the list.

Selling Naked Puts

When selling a naked put option (i.e., the stock price is above the strike price), a cash premium is collected. This money is yours, regardless of what happens next. There are two possible outcomes for this trade:

  • The option expires worthless (the stock price is above the strike price), and your profit is the cash premium collected.
  • When expiration time comes, the stock price is below the strike price. This means the option holder will exercise their right to sell 100 shares of the stock at the strike price, and you are obligated to buy those shares. The transaction occurs automatically, just as it does when you are assigned a notice of exercise on the call option you sold when writing covered calls.

When selling a put option, you were prepared to buy the shares at the strike price. If you are assigned a notice of exercise, you may not want to own the shares anymore. But look at it this way: if you had bought a share at market price earlier (when selling the put option instead), you would have paid a higher price and would not have collected the cash premium.

Spreads

Credit

Instead of selling uncovered naked options, a trader can sell one option and buy another. The bought option acts as insurance, limiting losses. It also reduces the potential profit, but I urge you to believe that limiting losses is key to your future success and that accepting smaller profits is a reasonable price to ensure you won’t incur a large loss that you cannot handle. We all want to be optimistic, but winning traders know that the main goal is to prevent financial disaster. Check the losses. Check it out.

Although this is one of the most popular options strategies (for good reasons), new options traders must understand the basics of trading individual options before entering spread trading. Why? Because it’s easier to understand how the spread works when you know how its components function.

Collars

These are the most cautious strategies listed here. They are for those who care more about preserving their capital than trying to earn more money. Collars are a slightly optimistic position with capped gains and limited losses.

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Source: https://www.thebalancemoney.com/strategies-for-new-option-traders-4097712


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