Beginner's Guide To Options Trading Strategies (2024)

What Is Options Trading

Options trading is the buying and selling of options contracts in the market, usually on a public exchange. Options are often the next level of security that new investors learn about following their initial entry into the finance world. As derivatives, which are securities whose values are a function of a separate underlying security or index, options have another layer of complexity compared to a typical security. There are three critical factors when considering trading options versus trading a typical security:

• Pricing is multifactorial; deciding to trade in options means tracking several metrics that aren't present in trading other securities.
• Leverage is inherently present in options trading, so losses tend to be as magnified as gains.
• Trading long options positions is more short-term than long-term; you're looking for an event, and holding your investment typically means a loss of principal versus an eventual turnaround.

For investors looking to quickly digest the basics of options trading, it’s helpful to go over some fundamental definitions, different strategies, and to provide actionable advice for investors who want to start trading options.

Basics of Options Trading

The basics of options trading are mostly the same as the typical execution of trading other securities. You start with your thesis on a given asset, deciding whether its price will increase or decrease over a certain period of time. Then, you use your preferred trading platform to take your position in the relevant option. Here, however, is where the details of options trading comes into play. First, understand that options involve a contract between the buyer (or the holder) and the seller (or the writer). Much like engaging in a normal security transaction, there are two sides to a given contract and they're essentially betting against each other. Buying an option involves paying a premium to the writer, this is just the price of the option itself. The writer of the option hopes to collect this without having to deliver on the option contract itself. The buyer of the option pays that premium with the assumption that they'll be able to execute an optimal market transaction. This is where, depending on the direction you choose in your thesis (increase or decrease), you can pick between a few option selections. Let's start with the two main types of options:

• A call option gives the buyer the right to buy the underlying asset at a specific price within a certain time frame.
• A put option gives the buyer the right to sell the underlying asset at a specific price within a certain time frame.

Notice that we use precise language with options: investors have the "right" to buy, which means they don't have to necessarily exercise this right. This isn't like the usual market order of buying or selling a security, where the investor is obligated to do so. This nuance is part of the strategy around trading options; sometimes, it's in the best interest of the investor to choose not to exercise their option.

I mentioned "a specific price" and "a certain time frame" when defining the two types of options. Within the contract (which is technically what an option is), this specific price is known as the exercise or strike price; this is the price of the option that the two participants in the option contract agree on. The "certain time frame" relates to the option's expiration date, which is when the contract can no longer be exercised. This was alluded to when discussing whether an investor chooses to exercise the option or not. American-style options can be exercised anytime before this expiration date or on it, while European-style options can only be exercised on the exact date.

So how does an investor decide whether to exercise their option or not? This will depend primarily on the moneyness of the option. Moneyness is defined as the relationship between an option's exercise price and the underlying asset's price (usually a security's market price). This is also known as the option's intrinsic value. You’ve probably heard the phrases "in-the-money" or "out-of-the-money"; these are referring to moneyness. Options can also be "at-the-money" when the intrinsic value nets out to zero.

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Benefits And Risks Of Options Trading

Let's consider the benefits and risks of options trading before we dive into the different strategies and considerations around the practice. First, the benefits:

• Investors can use options to speculate on price movement with less principal and lower transaction costs, yet still have magnified returns. Of course, this is a highly idealized, best-case scenario, but it can happen when an investor is careful and savvy.
• Options can be used to hedge portfolio positions. Hedging is when an investor enters a position solely meant to offset an existing position's potential risk. This is more common with institutions, but retail investors can still use this strategy to protect themselves from upside/downside risk.
• Overall, using options can open up portfolio management possibilities that otherwise wouldn't be available or would be difficult to incorporate.

The downsides of option trading include:

• A greater degree of risk relative to other trading methods. In the same way that your gains can be amplified, your losses with options can also be much worse than expected. Depending on the approach, investors can even face unlimited losses.
• The complexity around options trading is much greater than typical market participation. Even the simplest pricing model for an option isn't necessarily easy to understand, and the degree of active management of open options positions is far greater than the more passive "set and forget" style of investing that most people understand.
• Options trading is inherently short-term in nature, so there will likely be tax consequences that wouldn't otherwise be present in other security investments.

Common Options Trading Strategies

Now that we've established the fundamentals around options trading, let's move into the common strategies being deployed in the market. Many of these are well-known, although the details on how to execute them may be unfamiliar to newer investors. We'll give a brief definition for each, then break down the strategy and execution behind them.

Long Call Strategy

A long call strategy is likely the first approach that investors will take when dipping their toes into the options trading pool. An investor uses this strategy when they expect the price of the underlying security to increase in the future, so mainly for price speculation. More precisely, the price of that security needs to outpace the cost of the option premium on or before the expiration date. Let's go through an example:

• Assume Company A is currently trading at $10 a share. A call option for Company A grants 100 of its shares (a standard contract covers 100 shares) at a strike price of $10. The premium for this option is $1.00, so the total premium costs would be $100.
• The investor holds this option until the expiration date, at which point Company A is trading at $20. The investor exercises the right to buy 100 Company A shares at the strike price of $10 from the call writer, an outflow of $1,000. They then sell these shares at the current market price of $20, an inflow of $2,000.
• Ignoring transaction and opportunity costs, we can calculate the investor's profit as such: $2000 - $1000 - $100 = $900.

Long Put Strategy

A long put strategy is used when an investor is bearish on an asset (let's assume a stock), so they buy a put option to reflect this sentiment. Puts are also a common hedging instrument for investors holding long positions in the option's underlying security. For price speculation, a long put strategy is a less risky approach than short-selling since this play requires less leverage and your losses are limited to what you paid for the option contract. To profit, the underlying asset needs to drop below the cost of the premium on or before the expiration date. This would work as follows:

• Assume Company A is trading at $20 a share. A put option for Company A grants 100 of its shares at a strike price of $20. The premium for this option is $1.50, so the total premium costs would be $150 (note that put options tend to be pricier than call options, though not always).
• The investor holds this option until the expiration date, at which point Company A's share price has dropped to $10. The investor chooses to exercise their right to sell 100 Company A shares at the strike price of $20, an inflow of $2,000. The writer of the put option contract will then have to buy at this price of $2,000, even though the market price is $1,000 ($10 x 100). So in effect, the put investor is closing their position by buying Company A shares at $1,000, then selling those shares to the contract writer for $2,000.
• Ignoring transaction and opportunity costs, we can calculate the investor's profit as such: $2,000 - $1,000 - $150 (the premium price) = $850.

Bull Call Spread

A bull call spread strategy is used by investors who have a bullish outlook on an underlying asset, but want to limit their downside at the cost of also capping their upside. This is done by simultaneously buying a call option and selling (i.e. writing) a call option. Both options should have the same expiration date, although the written call option should have a higher strike price. How an investor would profit with this strategy is best shown through a brief example:

• Assume Company A is trading at $11 a share. An investor is bullish so they buy a call option at a strike price of $10 for $150 and sell a call option at a strike price of $14 for $50. At this point, the investor has experienced an outlay of $100 ($150-$50).
• The investor's prediction pans out and Company A's share price rises to $15 at the time of expiration of both options. The intrinsic value of the bought call option is now $500 and the intrinsic value of the sold call option is now $100. The spread's value is now at $400 ($500-$100).
• Factoring in the previous outlay of $100, the investor ends up with a profit of $300. If both calls would've expired out-of-the-money, then the investor would've only lost their initial $100 outlay.

Bear Put Spread Strategy

Investors run a bear put spread when they expect a lower value in a given security. Like a bull call spread, an investor would utilize this strategy to protect their initial investment by limiting its upside. To execute this, the investor buys a put option and sells a put option, both of which have the same expiration date. However, the sold put option would have a lower exercise price than the bought option. Let's walk through an example:

• Assume Company A is trading at $22 a share. An investor is bearish so they purchase a put option at a strike price of $19 for $200 and write a put option at a strike price of $16 for $50. The total outlay so far by the investor is $150.
• Company A's share price drops to $15 at the time of expiration for the options. The bought put's intrinsic value is now $400 and the sold put's intrinsic value is now $100, so the spread's value is now at $300 ($400-$100).
• Subtracting the initial outlay of $150 gives the investor a profit of $150. Had the options expired out-of-the-money, the investor would've instead lost $150.

Straddle Strategy

A straddle strategy differs from the previous strategies that we discussed in that both a call and a put are required. This strategy is used by investors that expect volatility in the underlying asset, but don't want to predict which direction the price will go. In this article, we'll focus on long straddles rather than short straddles (we’ll also look at long strangles in the next section). A long straddle is performed by buying a call and put for the same underlying asset that have matching strike prices and expiration dates. These options are also bought at-the-money. Upside potential is unlimited while the possible downside is limited to the initial cost of the options. This may sound good, but investors should understand that you'll usually need to at least predict moderate volatility to get the needed price movement for a profit. Let's look at an example:

• Assume Company A is trading at $20 a share. An investor deploys a long straddle position by buying a put at a strike price of $20 for $100 and a buying a call at a strike price of $20 for $100. The total outlay here is $200, which is also the most that the investor can lose.
• The company experiences a downswing in its price after earnings, leaving it trading at $15 a share. The call option in the straddle would be allowed to expire (since it is out-of-the-money) but the put option would be exercised since its intrinsic value would be $500.
• After factoring in the initial outlay of $200, the investor's profit in this trade is $300.

Strangle Strategy

Applying a long strangle strategy is similar to a long straddle play in that a call option and a put option are involved, both purchased at the same expiration date. However, they need to be out-of-the-money as opposed to at-the-money like in a straddle, and they don't need to be the same strike price. Otherwise, the potential payoff and possible risk share similar profiles to straddles, although the underlying assets price movement needs to be much more pronounced. Here's a hypothetical setup:

• Assume Company A is trading at $30 a share. The strangle position is set up by an investor through the purchase of a call with a strike price of $35 for $200 and the purchase of a put with a strike price of $25 for $200. The investor would spend $400 in total here and this is their maximum potential loss.
• As the options reach their expiration, Company A's share price is $40. Therefore, the put option component of this strangle would expire worthless but the call option would have an intrinsic value of $500.
• Subtracting the initial $400 outlay leaves the investor with a profit of $100 from this strategy.

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Options Analysis Tools

Don't overthink the tools you need to perform your options analysis. Occam's razor applies here: the simplest choices are typically the best. Feel free to build a toolset that's as simple as a web browser, a spreadsheet and your trading platform, but here are some other recommendations:

• A reliable overall information provider: this can be as direct as accessing the option chain data on your brokerage platform (like Thinkorswim for TD Ameritrade) or you can find these metrics from exchanges like the Chicago Board Options Exchange. Information also includes definitions and concepts about options, such as if you need a refresher on how to construct a strangle. The CFA Institute is an excellent free resource for this.
• A volatility monitor: particularly for the more advanced strategies, volatility is a factor that's critical when trading options. Again, you should simply be able to access volatility data through your trading platform, but if not, you'll want to consider finding a source for this information.
• An advanced math calculator: what this means is any application that allows an investor to input options data and readily draw conclusions from the output. For example, the application should involve usage of the Black-Scholes model, the classic formula for option pricing, and should also help investors evaluate what are known as "the Greeks," which are statistical measures of an option contract's price sensitivity to certain environmental factors (such as the change in price of the underlying asset).

Developing A Trading Plan

Getting into options trading can feel like being swept up in a whirlwind. There's so much going on and so much to consider, it's easy to feel lost once you land on your feet again. But investors can stay stable by developing a trading plan before deploying their capital. The steps are simple:

Set Clear Goals

What do you hope to accomplish? Recall that options trading grants a great deal of flexibility in how investors can manage their portfolios. It's this expansiveness in possibilities that can overwhelm investors, so start by establishing why you want to trade in the first place. This could include to speculate on asset prices, to protect your existing positions, or diversify your portfolio.

Choose An Appropriate Options Trading Strategy

Once you've decided on your goals, you can then move on to choosing the right strategy to achieve them. A few examples of how to decide include:

• If you have a bullish outlook, go with a long call strategy
• If you're bearish, go with a long put strategy
• If you're risk averse but want to capture upside, try a bull call spread
• If you expect volatility but don't have a directional bias, try a long straddle

Options can be powerful for wealth-building as well as wealth preservation in an imaginative investor's hands, so don't be afraid to try more advanced strategies once you've tried the more basic approaches.

Set Entry And Exit Points

This could be done by placing strict buy and limit orders, but at a holistic level, investors can just track the intrinsic value of their options until they're above breakeven. Generally, your entry point for an option play is when you're statistically confident that its underlying asset price is trending in your expected direction. Your exit point will be more straightforward, like when your option is in-the-money. However, sometimes you'll want to leave a position to prematurely avoid taking further losses, so bear in mind what strategy you're using and at what point your losses reach their maximum.

How To Place Options Trades

Placing an option trade is not unlike other security transactions. For this walkthrough, let's assume you're looking to speculate and have a generally bullish outlook on the market for the next three months (assume you read this in September).

Select The Underlying Asset

Assets with large trading volumes and moderate-to-high popularity are preferable for option trades, as they'll present a greater variety of strike prices and expirations dates while also providing better liquidity. In our example, selecting the SPY would be a good choice given that it fits the previous description.

Choosing The Right Option Contract

Recall that typically, investors want to buy calls or sell puts if they're bullish and buy puts or sell calls when they're bearish. The expiration date will depend on the investor's timeline (i.e. by when their expected price movement should happen) and the strike price will depend on how much the investor is willing to risk for their expected upside. For our example, a SPY call that's at-the-money that expires in three months (when your bullish outlook is expected to end) would be sufficient.

Placing A Buy Or Sell Order

A buy order would work in our scenario, since we're bullish and we're using a long call strategy. Typically most investors, but especially new ones, will execute buy orders as part of trying to achieve a magnified return, although selling options can work if you prefer this risk profile and would rather collect premiums instead. In our scenario, we'd place a buy-to-open order with our brokerage. Then, in three months and assuming the option is in-the-money, we'd close our position with a sell-to-close order.

Managing Open Positions

At this point, how to manage your open option positions should be a familiar concept. Essentially, keep an eye on your underlying asset's market price, the volatility of this asset as well as that of your options, and the intrinsic value of your options. Be aware of your timeline too, as you don't want to look at the date on your phone or computer and then realize your in-the-money options expired before you exercised them!

Options Trading Tips For Success

Throughout this article, we’ve covered a variety of options-related topics, but let’s end on a few final trading tips for success:

• Stay vigilant: Managing investments should always come with a sense of attentiveness, but options trading turns that need up tremendously. The sheer number of metrics, values and environmental factors that could impact your trade means that investors need to be detail-oriented and perhaps even a bit paranoid when it comes to observing how their trade is turning out. Remember that options trades are typically short term in nature, so not paying attention for even a few days could mean your profit window opened and then immediately closed. Do your best to always stay on top of how your strategy is unfolding.
• Consider investor psychology: Of all the elements potentially driving your options plays, investor psychology can have the greatest outsized impact. You can run multiple Monte Carlo simulations, work in as many extraneous factors as you can think of and yet something as simple as how a certain group of traders feel about a given asset can throw off your entire strategy. The best you can do is track sentiment trends and look out for keyword news alerts, then try to predict how investors may react based on historical precedent, but understand that there’s no reliable model for investor psychology. Sometimes, just knowing that investors will react at all can be enough to decide on closing your position to capture your options play’s intrinsic value rather than waiting to get a greater return.
• Commit to your approach: There’s no point in having a system for finding market opportunities or for determining the best profit strategy if you don’t stick with it. Particularly with trading and its short-term nature, when you create a model for how you want to participate in the market, part of being successful is not deviating from your plan. Now, that’s not to say that you can’t be wrong or that there isn’t room for improvement. But that’s where the prep work comes in, where back-testing and paper trading preparation can help you find the holes in your system before you deploy it.

I hope this guide on options was instructive. As always, be sure to perform your own due diligence when investing and only risk what you’re able to afford losing. Good luck!

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