I have received the question of “What Options Trading Strategies Work ?”. To be honest there is no exact answer to this question. Let me explain.
Most traders understand that the market is a zero sum game so there is a winner and a loser, but with options you have the ability to make money when a stock does not have to move at all. Options provide the unique ability that you can be a winning trader just from having the stock not move at all.
Options add the element of “time value” to investing which dramatically increases the strategies you can use for trading vs. just trading directionally(long of short) like you do stocks, forex, or futures.
All options trading strategies are created to provide a specific risk/reward outcome so if you understand how to integrate technical analysis with options then you can have much more flexibility in your trading.
If you know what you are doing and understand how to apply a specific options strategy then you could say that all options will work. Most people new to options though try to understand too many strategies and just get overwhelmed. Best advice is to just stick to a couple strategies until you get a feel for it. There are many options traders that make a living just using a couple strategies all the time.
I wrote about various options strategies in a past post, Options Strategies but lets keep this post simple and cover a couple of the main options trading strategies. Once you understand these strategies then you can build onto them with other options strategies.
I will share the things to think about with each strategy below.
Options Income Strategies
Goal of income strategies is to sell options to collect premiums. With these strategies you want the stock to ideally not move or stay away from the strike price of the options you sold so you can have the options expire worthless.
Covered calls
A strategy used to generate income on a stock by selling near term calls for income premium against a stock that you own (or you can own deep in the money calls instead of owning the stock).
- Covered calls work well for non volatile stocks as your goal is to have the stock not move so that the calls you sells expire worthless.
- Covered calls are a useful strategy with index ETF’s and largecap stocks.
- You can implement basic technical analysis to look for resistance levels to sell calls at in order to increase the likelihood that the calls will expire worthless.
- You want time decay to occur because being short calls limits the upside to your stock(the stock will get called away from you at the strike price you sell at) so using weekly options can be useful with covered calls strategy if there is enough time premium in the calls.
- Most covered call sellers calculate out the % return that the covered call premium generates to determine whether to sell a covered call or not. For example. A stock trading at $100 has a call with $110 strike price selling for $1.30 that expires in 28days. $1.30/100 = 1.3% return in 28 days with $10 of additional upside potential($110 strike-$100current price).
- Generally it is useful to evaluate time to expiration, current support/resistance levels, and premium offered to calculate out if a covered call makes sense.
Credit Spreads
A very popular strategy which involved selling a near term option and simultaneously buying a farther out of the money option. Credit spreads can be used with puts or calls based on the direction that you think the underlying security will go. You can realize maximum profit with credit spreads when your short options expires worthless.
- Credit spreads are popular among directional traders because you profit not only when the stock moves in a specific direction but also if the stock doesn’t move at all. A credit spread trader is collecting premium and profits from time decay in the options.
- Credit spreads have continued to grow in popularity especially with the growth in weekly options. See Weekly options Credit spreads post.
- You generally want to have an understanding of technical analysis so you can understand where a stock is in regards to support and resistance.
- Credit spreads offer a defined risk/reward but the max loss is usually larger than the max reward with credit spreads. Therefore it is important to manage risk with this strategy or your losers will outweigh your winners.
- The farther out of the money you sell options, the lower the credit you will receive. Also the farther out in expiration you go, the high the premiums.
- Many credit spread traders will look at things suck as: probabilities for expiration, how much time premium(“Intrinsic Value”) is priced in, and volatility.
- The are many ways to trade credit spreads whether you trade weeklies for short term direction or sell far out of the money long term options. It really depends on your investment style and trading goals.
- For shorter term trading(like with weeklies) understanding technical indicators like oscillators, trend reading, candlestick patterns, and support/resistance levels are very useful with credit spreads.
There are many other option income strategies like diagonals, calendars, iron condors, ecetera…….many of which are just adding multi-leg variations of ones I covered above. Keep it simple at first for only a few strategies and then add variations as you get experience.
Directional Options Trading Strategies
Debit Spreads
Debit spreads are essentially the opposite of credit spreads in that you buy an option and sell a farther out of the money option. The long option which is closer to the money has a higher premium than the short option so it costs you a “Debit” in you account. The max loss with a debit spread is the debit amount.
- Debit spreads are a lower cost way of buying shares of a stock but you are limited in the upside(calls) or downside(puts) by the short option you sold.
- Debit spreads are popular with short term directional bets as you are fighting against time decay on your long options.
- It has become a popular strategy with weekly options by buying an in the money debit spread with less time value priced.
- You need to have a trading system or plan using technical analysis to trade debit spreads because your goal is a near term directional move.
- You need to evaluate how far in the money to buy the option(preferably 80+delta on your long call) and pay attention to time value priced into the option.
- For example. Stock is trading at $50. You believe the stock is at support and will bounce short term. You buy a $45call and sell a $50 call against it that expires in a week for a $2.70 debit (or $270 cost per spread). The max reward is $210 ($5 spread-debit of 2.70=2.30) so 230/270 = 85% return on amount risked. The max loss though it $270.
- TIP: look at the current volatility priced in so you don’t overpay for the option. This is a mistake option investors will make on a stock that sold off and has high volatility priced into the stock as once the stock settles down/bounces you could end up losing on the debit spread as lower volatility decreases the premiums. You want to be a SELLER of high volatility NOT a buyer so pay attention to volatility that is priced into any options you are buying or selling.
- TIP: spend time time looking at the risk/reward graphs of debit spreads to give you an idea of how they work at different prices relative to the spread you are evaluating.
Debit spreads is a core directional options strategy. By adding additional legs and expiration periods to a debit spread you will end up with other options strategies like ratio spread, calendar spreads, straddles,ecetera. Again, if you are trading directionally and using options like a debit spread to limit the capital needed(and limit risk) then stick to it a couple strategies until you jump up to more complicated ones.
If new to options check out the series of posts at : Learn Options Trading