Daniel is a retired business executive who now devotes most of his free time to trading stocks and stock options in the stock market.
As you have probably found out, there are dozens of strategies and systems that one can employ when investing in options. If you are a beginning options investor or trader do not be overwhelmed, by this multitude of different option trading strategies. You only need to learn a few basic strategies and these should be enough to allow you to start investing in options profitably.
The strategies listed below are the ones that a beginning options trader will most want to use. These option strategies are not only used by beginners but are widely, and I mean widely, used by the general investing public, professionals, as well as financial institutions.
These are the most popular option trading systems in the industry. They are briefly summarized below for your guidance to give you an idea of what each strategy entails.
Strategy No. 1: Buying Calls
Buying call options is perhaps the easiest way, and it is, in fact, the most popular way, to enter the options trading arena. It is also, far and away the most frequently used options trading strategy by options investors. The main reason for this is that it offers the investor the opportunity to acquire rights to a particular stock issue with very little capital investment versus the large capital required to purchase the stock outright.
Not only does it require little capital to enter a trade, buying call options provides the biggest profit potential if the trade goes in the direction the investor predicted: much bigger profit potential than owning the underlying stock.
But of course, as is always the case, the bigger the profit potential, the greater the risk. While the risk is greater, there is, at the same time, a safety feature in the strategy in that the risk is limited. Should the underlying stock perform negatively, the options investor knows the exact amount of his potential loss, while if he were a stock buyer his loss could escalate rapidly and continuously if the stock goes on a downward spiral.
This feature of providing potentially immense profits versus very limited and defined losses is what makes the buying of calls so popular with the investing public.
Strategy No. 2: Buying Puts
This simple options trading strategy is the one to use if the investor sees the market heading in a totally different direction from what the call option buyer views. In this method, the speculative investor buys put options in the belief that the underlying stock of his choice is or will be moving downward.
We can say that buying put options is the exact opposite of buying calls. Again, like buying calls it is also a very popular option trading strategy because of its simplicity. Similar to calls options, puts have the ability to provide extremely high profits when the underlying stock goes in the direction predicted. Moreover, like call options, puts offer the advantage of limited loss in case the situation goes against the investor.
More than anything else it has now become the favorite trading style of those stock speculators who specialize in short-selling stocks. Short-selling stocks is a very risky investment proposition and is in fact very closely monitored by stockbrokers. Only very qualified stock investors are allowed to engage in short selling stocks.
Short sellers are required to maintain a large capital balance in their broker account and have to go through a process of strict screening. On the other hand, a put option buyer does not have to go through all this investigative process. By simply buying put options, he can achieve the same objective as the stock short seller, that is, to profit on a stock that is going in a downward direction. The put option buyer is also not required to have a large capital balance with his broker.
For more details on how to use put options in place of short-selling stocks, see my article, This Is How to Safely Short Sell Stocks.
One very large group of put buyers are those stock owners who want some kind of protection against their stock losing value in a downward movement. This is called buying protective puts, and it is something like buying insurance. The stockholder buys protective puts to cover or limit any potential price loss in a declining stock he/she owns. There is a more detailed description of how put options are used as insurance for stocks in the article Insurance Against Investment Loss?.
Strategy No. 3: Covered Calls
Now we move on to a slightly higher level of trading: selling call options against stock that you own. Here again is a trading system that is widely popular not only with the investing public but also with financial institutions that have a portfolio of stocks.
In this system, you, the stock owner, sell instead of buy call options. This method introduces you to the system of selling call options to enhance your returns on your stock holdings and to offer downward limited price protection on your stocks. In effect, you acquire two positive outcomes when you use this strategy, increases returns on your stock and you get some protection against a downward price movement.
Strategy No. 4: Cash-Secured Puts
Where buying puts is likened as the opposite of buying calls, the cash-secured put strategy is the opposite of the covered-calls strategy. In this instance, an investor sells puts against the liquid cash balance in his broker account or its cash equivalent.
There are two groups of investors who use this strategy. The more common ones are those who sell puts in anticipation of a stock’s declining price so that they can then purchase the stock at a lower or discounted price.
The other group of investors is those who have excess cash which they don’t want to tie up in a stock but which they would like to put to work generating some income. By selling puts against their cash deposits they receive cash from the sale of puts in a very similar fashion to receiving dividends.
As I said at the beginning of this page, there are only a few basic strategies that the novice options trader needs to learn to start investing in options: the four strategies laid out above.
These are the main strategies that you will be using throughout your options trading career. You may branch out to the other more complex trading systems but I can assure you these four mentioned here will always be your backbone trading systems.
To get you started in your options education I recommend the book "Options Trading: Strategy Guide for Beginners. This is a very easy read for the beginning options student. The book is short enough to enable the newbie to get started in no time at all. The strategies mentioned above are explained in more detail. One important feature is the section on how to avoid mistakes in the options business.
This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.
© 2018 Daniel Mollat