subject: Common Option Strategies Tested In The Marketplace [print this page] There are common option strategies that have been tested in the marketplace and are used regularly by investors. In options trading it is the spread strategies that take front and center because they focus on maximizing profits while limiting losses. Spread strategies also take advantage of the full capabilities of the options market by utilizing both puts and calls in a number of investing formulas. How complex the trade becomes largely depends on the trading knowledge of the investor and market conditions.
Option trading with puts or calls is the simplest strategy in many ways. In fact, the largest category of option trading among self-directed traders is the purchase of call options. Though that is an excellent way to begin trading, it is only using one-half of a versatile equation. Instead, even beginning investors use spread trading to improve market performance.
Spreads represent one of the primary types of option strategies that use both purchases and sales of options. A vertical spread strategy, by definition, involves purchasing and selling options and the various options will have different strike prices and/or they will have different expiration dates. In effect, you are buying and selling at the same time, or another way to say it is that you are trading long and short.
Some of the more common spread option strategies used including the following:
- Bull spreads: used when the market is expected to move higher
- Bear spreads: used when the market is expected to move lower
- Volatility spreads: the put and call are purchased at the same strike price with the expectation volatility is about to hit the market
- Risk reversal spreads: put and call are purchased for underlying futures that are expected to move in the same direction
- Butterfly spreads: involves three steps composed of option purchases, selling options and then purchasing another option
- Straddles: combination of purchases or sales of puts and calls (includes strangles)
- Credit spreads: used in volatile markets where monetary risk is to be limited
Each of these strategies could fill pages with explanations and examples. The fact is that advanced investors will even combine multiple strategies. When combining two or more option strategies, it is necessary to thoroughly understand the options market and have the means of closely tracking complex transactions.
Deciding on a Strategy
Choosing the right strategy to implement is dependent on a number of factors. For example, you should understand how the market price movements and direction will impact option trading. You have to understand price action and pricing of the option. You even must decide if you will be a holder or a writer of options.
What separates beginning traders from experienced traders is the ability to apply hedging strategies to minimize risk. Since options traders must be willing to risk loss of their entire investment, learning how to hedge to your advantage is important. The goal of options trading is always to limit risk taking as much as possible in the pursuit of profits.
The spread strategies are designed to add a type of hedging to options investing because risk is lowered through the purchases and selling of puts and calls in different configurations. The good news is that the more you trade in options, the easier it will be to learn new option strategies.
