Options trading has evolved into a popular way of managing market risks and taking price-directional bets without holding the asset itself. An option is a contract that bestows upon the holder the right to buy or sell an asset at a specified price within or on a given date. There, therefore, exist two types of options: the ones that give the owner the right to buy or call options and put options that give the owner the right to sell.
Option trading offers flexibility to investors and traders by allowing them to set up different strategies depending on existing market conditions, their risk appetite, and their expounded investing objectives. Several structured approaches exist to navigate this segment of the derivatives market.
- Covered Call Strategy
A covered call strategy is one where a trader buys an asset long and simultaneously sells a call option on the same asset. This strategy is taken when the expectation is for limited upward movement in the asset price. The premium the trader receives from selling the call option acts as a cushion against a drop in the value of the asset.
If the asset stays below the strike price of the sold call option, the option expires worthless, and the trader gets to keep the premium along with the asset. Otherwise, if the price exceeds the strike price, the asset will be sold at an agreed price, and the premium will be kept.
- Protective Put Strategy
A protective put is one in which an investor holds the asset long and buys a put option on the same asset. This strategy offers a means of limiting a potential loss while still providing for a gain should the price of the asset rise.
If the price of the asset falls below the strike price of the put option, the trader will sell the asset for the put option’s strike price, thereby capping his losses. However, if the price increases, the trader will profit on that move with his losses capped only by the premium of the put option.
- Straddle Strategy
A straddle strategy involves buying both a call option and a put option with the same strike price and expiry date. This tactic is mostly used when there is expected to be some major price movement, but the direction of that movement is uncertain.
If the asset price shoots up, the call option gains in value. If the asset price drops, it is the put option that adds value. The combined position aims to profit from increased price volatility, with risk being limited to the combined premiums paid for both options.
- Strangle Strategy
In a mechanism similar to that of a straddle, the strangle strategy consists of the simultaneous purchase of a call option and a put option with one common expiry date but differing strike prices, the former being lower and the latter higher.
This strategy is used if the trader expects a large price movement but at a lower cost than with a straddle. The position profits from big price movements in either direction, with the risk limited to the premiums paid.
- Options and Index Futures Combination
Many traders combine strategies of options trading with index futures positions as a method of managing market risk or hedging broader portfolio exposure. Index futures are seller contracts to redeem a market index at a future date.
For instance, the trader can trade a call or put an option on an index while also taking an offsetting position in index futures. If the market moves against its options position, profits realized in the index futures position will offset losses, and vice versa. This choice is often made during market volatility or just before critical economic announcements.
Conclusion
Option trading deals with a myriad of strategies adaptable depending on market conditions, level of risk, and trading goals. Covered calls, protective puts, jackpot pullback, and strangle, along with a combination of options with index futures positions, are some of the popular strategies utilized in the derivatives market. Through well-structured applied strategies, traders elevate risk management, modify market exposure, and advance interest in several market manifestations while managing position size. Successful application of such option strategies requires a clear understanding of option contracts’ specifications, pricing dynamics, and risk management prerequisites.
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