Options are excellent tools for both position trading and risk management, but finding the right strategy is key to using these tools to your advantage. Beginners have several options when choosing a strategy, but first you should understand what options are and how they work.
An option gives its holder the right, but not the obligation, to buy or sell the underlying asset at a specified price on or before its expiration date. There are two types of options: a call, which gives the holder the right to buy the option, and a put, which gives its holder the right to sell the option. A call is in-the-money when its strike price (the price at which a contract can be exercised) is less than the underlying price, at-the-money when the strike price equals the price of the underlying and out-of-the-money when the strike price is greater than the underlying. The reverse is true for puts. When you buy an option, your level of loss is limited to the option’s price, or premium. When you sell a naked option, your risk of loss is theoretically unlimited.
Options can be used to hedge an existing position, initiate a directional play or, in the case of certain spread strategies, try to predict the direction of volatility. Options can help you determine the exact risk you take in a position. The risk depends on strike selection, volatility and time value.
No matter what strategy they use, new options traders need to focus on the strategic use of leverage, says Kevin Cook, options instructor at ONN TV. “Being systematic and probability-minded pays off greatly in the long run,” he says, advising that instead of buying out-of-the-money options just because they are cheap, new traders should look at closer-to-the-money option spreads that have a higher probability of success. He gives this example: If you are bullish on gold and want to use the GLD exchange-traded fund, which is currently trading at $111.00, instead of spending 45 cents on the June 125 call looking for a home run, you have a greater chance of making profits by buying the June 110/111 call spread for 55¢.
Picking the proper options strategy to use depends on your market opinion and what your goal is.
In a covered call (also called a buy-write), you hold a long position in an underlying asset and sell a call against that underlying asset. Your market opinion would be neutral to bullish on the underlying asset. On the risk vs. reward front, your maximum profit is limited and your maximum loss is substantial. If volatility increases, it has a negative effect, and if it decreases, it has a positive effect.
When the underlying moves against you, the short calls offset some of your loss. Traders often will use this strategy in an attempt to match overall market returns with reduced volatility.