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The Only 3 Options Trading Strategies You’ll Ever Need David Penn Senior Editor, TradingMarkets
THE ONLY 3 OPTIONS STRATEGIES YOU’LL EVER NEED Why trade options? We published a brief article at TradingMarkets.com on the five reasons why more and more traders are turning to options back in February. And whether it is the power of leverage, the ability to tightly control risk, or the opportunity to exploit market direction up or down as well as volatility (high or low), the fact of the matter is that traders are turned on to options like never before. But even as more and more traders are turning to options, many would-be options traders remain on the sidelines. Why? Because while options trading is more popular and accessible than ever before, options are still considered mysterious trading vehicles— especially compared to stocks. How many times have you visited an options broker’s website only to find yourself paralyzed by talk of Greeks, vertical calendar spreads and limited reward/unlimited risk trading scenarios? How many times have you been told by some wiseguy that 99% of all options traders lose money? Who needs these headaches when you can always just trade stocks? Is trading options for me? We believe that any serious trader can successfully trade options. Not only that, but equipped with only three different options strategies, the average trader can take advantage of virtually all of the same sorts of market opportunities that the veterans of the options trading world exploit every single day. These three strategies are really the only three options trading strategies that you will ever need. Why waste your time with complicated, low reward/high risk techniques when any one of these three options trading strategies will allow you to successfully trade rising markets and falling markets, as well as the changes in volatility that make all market movement possible. Moreover, we’ll even show you how to use options to defend your stock positions from market risk through simple hedging strategies that can protect your portfolio from severe drawdowns without unduly limiting your returns. Why only three strategies? In putting together this list of “The Only 3 Options Strategies You’ll Ever Need”, there were three criteria that we at TradingMarkets believed must be met: 1. All the strategies should offer high—even unlimited—potential for reward, with minimal risk.
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2. The strategies, taken together, should provide new options traders with the ability to trade advancing markets, declining markets, as well as market volatility itself. 3. All the strategies should be easy to understand, easy to trade, easy to manage and easy to exit. These three factors should be important for all options traders. But they are especially key for those new to options trading, as well as those who are more interested in making money with options than becoming the next Nobel Prize winner in options pricing models. Options trading can sometimes devolve into “angels on the head of a pin” type ruminations and calculations which, while ultimately helpful in expanding our knowledge of how options work, can be both distracting and dangerous for the average options trader. This is especially so when new options traders believe they are not “really” trading options unless they are engaged in the most complicated, multi-legged, low reward/high risk strategies available. That’s why we at TradingMarkets have prepared “The Only 3 Options Strategies You’ll Ever Need”. By simply focusing on those things that make options such efficient and flexible trading vehicles and mastering just a few basic strategies to take advantage of those attributes, options traders can gain a huge advantage over that nefarious 99% of options traders we are told are doing nothing but paying for their brokers’ vacation homes. # 1 BUY CALLS ON DIPS, BUY PUTS ON RALLIES The most basic options strategy that every beginning options trader should know is simple buying of calls and puts. Remember, a call option gives the owner the right, but not the obligation to buy stock in the future at a specific price. Conversely, a put option gives the owner the right, but not the obligation to sell stock in the future at a specific price. Armed with this strategy alone, the average options trader has what he or she needs to trade both bull and bear markets. But what will truly maximize an options traders’ chances of success is not the mere buying of calls and puts, but the timing. Unlike buyers of stock, options buyers are always on the clock, as time decay consistently works against them, eroding the value of their calls and puts every day that the expiration date draws nearer. There are a number of ways to deal with time decay, especially for short-term traders. Buying only deep in-the-money calls and puts is one key strategy that short-term traders learn quickly to deploy in order to combat time decay. But in addition to this, options traders can and should use the TradingMarkets approach to trading—buying calls when strong markets are on the retreat and buying puts when weak markets are bouncing—as a way of ensuring that they are always buying options when the likelihood of them being cheap is at its greatest.
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Sounds simple? It is. But there is nothing harder to do as a trader than to step up an make a bullish bet on a market that is falling—and that is as true for options traders as it is for stock traders. And buying puts when markets are making new, short-term highs is often the last thing on an options traders’ mind—even when those short-term highs are still below such key levels as the 200-day moving average. But that is exactly what successful options traders must do. Buying call options, for example, after stocks have already advanced and make their breakouts can be one of the most frustrating, money losing ways to trade options ever invented. What options trader hasn’t suffered through buying calls just as a stock is breaking out to new highs, only to have that breakout fail hard enough and long enough to make the options trader decide to cut his or her losses. We all know what happens next: the stock recovers and once again resumes its upward path. The big difference between options trading and stock trading is revealed every time this situation happens. When breakouts initially fail with stocks, the near-term losses in terms of points or percentages tend to be slight. However, options premiums are a different story. When breakouts initially fail for those trading options, the value of those call options for example will evaporate faster than a pint of ice cream on a hot plate. And those plunging premiums are often more than enough to send many options traders scurrying for the exits. Using PowerRatings to help you choose what options to buy will go a long way to preventing options traders from making this mistake. Our PowerRatings, particularly our Short Term PowerRatings, are based entirely on buying weakness and selling strength. We also make a point of noting which stocks in our PowerRatings lists are optionable. These optionable high PowerRatings stocks are the ones that options traders should focus their call purchasing on, just as those optionable low PowerRatings stocks are the ones that options traders should focus their put buying on. #2 BUY STRADDLES / BUY STRANGLES A famous options trader and author of several acclaimed books on options trading and pricing once wrote that he considered straddles to be among his favorite ways to trade options. Straddles, he said, were also an ideal way for new options traders to make money with this relatively straightforward, easy to understand approach. The options trader who uses straddles is one who buys a call and a put, at the same strike price and expiration date. Because the call and put are at the same strike price, they will probably not be the same price in dollar terms. This means that the trader will inevitably end up buying more of one option than the other—though in the end, the dollar value of the call side of the straddle and the put side of the straddle should be roughly equal.
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Why would a trader do this? One of the benefits of trading straddles is that a trader does not have to know which direction he or she believes a stock will move. If a trader simply anticipates an increase in short-term volatility, but is unsure of direction, buying a straddle is one of the best, most easy to build, options strategies available. And because the trader is buying his or her calls and puts, we once again have the optimal situation of limited risk (only the cost of the options) and virtually unlimited reward potential. Straddle or Strangle? One interesting variation of the straddle that new options traders should be aware of is the strangle. In most respects, the strangle is all but identical to the straddle: both involve buying equal dollar amounts of calls and puts at the same strike price and with the same expiration date. The key difference is that with straddles, the options purchased are typically at- or in-the-money. With strangles, the calls and puts are typically out-themoney. What is the difference? Although very similar, because the straddle involves at- or inthe-money options, the straddle is a less leveraged bet on volatility than is the strangle. Another way of saying this is that straddles are relatively more conservative ways to trade volatility compared to the strangle. If an options trader believes that an increase in volatility is in the making, but is unsure both of the direction that volatility will move the underlying stock as well as the magnitude of the volatility, the more conservative straddle tends to be the better play. If, on the other hand, the options trader suspects that a coming increase in volatility will be sizable, he or she may want to buy cheaper, riskier options that are farther out in order to increase the leverage—and the potential profit gains—of the trade. #3 BUY PROTECTION FOR STOCKS / HEDGING Aside from buying calls and puts, and buying straddles and strangles, there is one other basic options strategy that every options trader should know. That involves buying or selling options as a hedge or protection for a stock portfolio. Selling options is typically one of the riskiest things an options trader can do. All of the strategies discussed so far have involved buying options rather than selling them. And as you have seen, one primary benefit of buying options is that risk is both up front and limited. Covered Calls Unfortunately, the situation is the opposite for those who sell options. The options seller takes his or her money up front, the premium paid for the option sold. Then the waiting game begins. If the seller of a call option, for example, sees that option begin to increase in price, then the options seller will have to cover his or her position by buying calls or the underlying stock. Failure to do so could result in potentially catastrophic losses should the option and its underlying stock continue to advance. Page | 5
However when the seller of a call actually owns the underlying stock, he or she is relatively protected from the dangers of the underlying stock appreciating—in fact, the seller of a call who also owns the underlying stock would see the value of his stock appreciate. By selling the call, though, the options trader would have provided some protection or insurance in the event that the market or the underlying stocks had moved lower. Yes, the value of his or her stock portfolio would suffer in this situation, but the premiums received from selling the call options could go a long way toward limiting overall losses. This approach to trading options—selling calls in stock that the trader owns—is called covered calls, and is one of the more popular ways to trade options. For many, covered calls are almost less a way of “trading” options and more a way of simply hedging their portfolio against both stock and market risk. Protective Puts An even simpler hedging strategy allows the options trader to avoid selling options entirely. Rather than selling a call to hedge a stock portfolio, options traders can simply buy puts. By buying one put for every 100 shares of a given stock, an options trader can completely hedge his or her entire stock portfolio from downside risks. The leverage involved in options is what makes these sort of hedging strategies possible, with a put option bought for a few hundred dollars being able to effectively hedge thousands of dollars worth of stock. If the value of the stock goes down, then the options trader who has used protective puts will see an increase in the value of his or her put options, which would offset losses in the stock portfolio. If the value of the underlying stock goes up, then the same options trader merely chalks up the price of the protective puts as the cost of “insurance”—no different from fire insurance, auto insurance or life insurance. This is often a small price to pay for the comfort of a stock portfolio that will be in good shape if the markets move up and more than able to weather the storm during those times when the markets move down. Hedging and Market Returns One of the biggest criticisms against using options as hedging instruments is that the cost of the hedge will be so great as to limit the return potential of the underlying investment or trade. While this is certainly possible, our research and work in hedging long-only stock trading portfolios suggests that the threat of a correctly applied hedge to a portfolio’s returns is very much overblown. For just one example, we at TradingMarkets ran a test comparing hedged and unhedged versions of one of our more popular and successful stock trading systems. The unhedged version had a compound annual growth rate (CAGR) of 280.9% from 1995 through October 2007. The hedged version, over the same time period, produced a comparable CAGR of 270%. Page | 6
But what were really dramatic were the drawdown comparisons. The unhedged portfolio, for example, had a maximum daily drawdown of 41.52%. The hedged version? 26.51%. Average drawdowns, the number of drawdown days and months were all lower in the hedged version—while still delivering outstanding results. WHAT YOU DON’T KNOW ABOUT OPTIONS CAN SAVE YOU MONEY Are simple options strategies really as effective as complicated options strategies? When you stop and consider how many options strategies are explicitly designed to limit your ability to make money and maximize your ability to lose money, it does make you wonder sometimes. That is not to say that any strategy not mentioned here is a terrible risk/reward proposition. There are plenty of complicated options strategies that also limit risk while providing great opportunities for profit. But the question is: why are you trading options? If you are trading options because they appear to be a different but fascinating way to make money by trading the markets, then why not seek out the simplest, most straightforward options strategies—especially if they tend to be the ones that limit risk and maximize reward? For too many traders, the flexibility of options can be a trap, tempting them to spend more time learning all the different things they CAN do with options instead of focusing on the main thing all traders are supposed to want to do: maximize gains and limit risk. We at TradingMarkets think that one of the best ways to maximize gains and limit risk remains not just in knowing what to buy, but in knowing when to buy. This is where our Short-Term PowerRatings can be an especially potent tool for options traders. By understanding exactly when a stock is a strong stock in pullback mode, and when a stock is a weak stock in bounce mode, options traders can reduce the likelihood of buying options when they are overpriced. And next to getting time and direction right, nothing else is more important when it comes to buying puts and calls than buying cheap and selling dear. So if you trade options—or want to—consider this offer of a 7-day free trial to our ShortTerm PowerRatings as an opportunity to add another powerful, analytic tool to your options trading toolkit. Visit TradingMarkets.com or call us at 1-888-484-8220 and try our Short-Term PowerRatings today—they aren’t just for stock jockeys any more! ***
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