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After a few trades in the financial markets, we quickly realise the necessity of knowing our profit/loss potential in advance and managing our risks. However, knowing is not enough; we must apply!
Wisest traders employ alternative trading strategies to adapt to the changes in the markets. Options Trading is one of our most powerful instruments to achieve this. It grants us an unmatched versatility to capitalise on all market conditions, volatile or not. Using different Options Trading Strategies, we will develop the ability to find an opportunity in any situation.
What is Options Trading?
Basically, an option contract reserves us a certain price (known as the strike price) until the expiration and then gives us the right to buy or sell the underlying asset at a price that is lower or higher than the market price.
Expirations can range anywhere from a few hours to a few years. Similar to buying and selling in CFD trading; we open a call option if we expect the price to rise or a put option if we predict a drop. Options come at the cost of the premium, which is based on the current price volatility – higher volatility implies higher premium.
Buying Options vs Selling Options
There are two basic ways of trading options: buying (long) and selling (short). When our trade is profitable, the option is in-the-money (ITM); when our trade makes a loss, the option is out-of-the-money (OTM). If we break even, our trade would be at-the-money (ATM).
When we buy (long) call and put options, we trade congruently with our prediction. If the option is
- ITM: our profit is based on the difference between expiration and strike prices.
- OTM: our risk is limited to the premium.
When we sell (short) call and put options, we trade incongruently with our prediction. If the option is
- ITM: our profit is limited to the premium.
- OTM: our loss is based on the difference between expiration and strike prices.
In stock options, selling an option is basically facilitating an option holder’s right to exercise their option. Short call options may result in selling an asset at a strike price lower than the market price. Short put options may result in buying an asset at a strike price higher than the market price.
Since you would be the writer of the option and assume the risk, you earn the premium when the position is opened, regardless of the future direction.
Why Trade Options at AvaTrade?
Whether you are novice or expert in options trading, receiving comprehensive support can elevate your results significantly. AvaTrade’s state-of-the-art AvaOptions trading platform equips you with powerful market analysis and trading strategy tools to make informed decisions and trade options with confidence.
- AvaOptions Trading Platform: Simple, powerful, versatile both on desktop and mobile. Analyse the market trends using historical charts, volatility curves, and confidence intervals. Use built-in risk management tools to asses portfolio status and potential P/Ls of the options. Trade over 40 Forex currency pairs as options, spots, and 13 mix-and-match strategies. Mitigate your risk potential using stop loss orders.
- A Risk Management Tool for Spot Trading: As an inspiration to AvaTrade’s unique AvaProtect risk-limiting tool for CFDs, options can be used to hedge spot trading positions. For example, a long spot can be hedged by buying a put option. If you profit on the long spot, the only risk is the put option’s premium. If the long spot reaches stop loss, your profits on the put option would cover, and might even exceed the long spot’s losses.
- Options Keep Spot Biases Away: When trading spots, you are vulnerable to greed and hope and might hold onto positions too long. The expiration in options eliminates these psychological biases.
- Go Long with Fixed Risk, Unlimited Return: When you buy call or put options, you continue to enjoy the same return potential in spot trading, but the risk is limited to the premium you pay.
- Go Short with Fixed Return, Limited Risk: Selling call and put options earns you a fixed premium regardless of the direction, and you can limit your risk with stop loss orders like in spot trading.
- Make Use of More Opportunities: In spot trading, you can often skip opportunities because you aren’t fully sure. Since the risk of buying options is limited to the premium, you can take advantage of more opportunities.
Options Trading Strategies
The beauty of trading options comes from the ability to make choices for multiple parameters. Extensive control over the variables allows you to incorporate various trading strategies depending on different market conditions such as trend direction, duration, and volatility.
Basic Options Trading Strategies
- Long Call
A long call is an unlimited profit & fixed risk strategy, which involves buying a call option. You predict that the price of the underlying asset will rise; if the expiration price is higher than the strike price, the difference is your profit. Your maximum risk is limited to the premium you pay. Long calls are preferred when the market sentiment is bullish.
- Long Put
A Long Put is an unlimited profit & fixed risk strategy, which involves buying a put option. You predict that the price of the underlying asset will fall; if the expiration price is higher than the strike, you profit from the difference. The maximum risk potential is limited to the premium. Traders prefer trading long puts when the market has a bearish sentiment.
- Short Call
A Short call is a fixed profit & limited risk strategy, which involves selling a call option. You can short calls when the market sentiment is ambiguously bullish or strongly bearish, and predict that the asset price will fall. The shorting premium is your fixed return. If the option expires below the strike, you don’t incur any loss. If the expiration price is above the strike, the risk is limited to your stop loss.
- Short Put
A Short Put is a fixed profit & limited risk strategy which involves selling a put option. You can short puts when an ambiguously bearish or strongly bullish market is present, and you predict an increase in the asset price. Your return is fixed at the premium. You profit if the expiration price is above the strike; but, if it is below the strike, you incur losses up to your stop loss.
Volatility-based Double Option Trading Strategies
- Long Straddle
A Long Straddle is an unlimited profit & fixed risk strategy which involves buying a call and a put option at the same strike price and expiration. You use long straddle when you expect high volatility after a market event, but unsure about the direction. Your return is based on the difference between the expiration and strike prices of the winning in-the-money (ITM) option. You profit if the ITM return is higher than the premium of the losing out-of-the-money (OTM) option.
- Short Straddle
A Short Straddle is a fixed profit & limited risk strategy which involves selling a call option and a put option at the same strike price and expiration. A short straddle is used when you expect low volatility. Total premium earned is your maximum profit potential. Risk is theoretically unlimited without a stop loss order and based on the difference between the expiration and strike prices of the losing OTM option.
- Long Strangle
A Long Strangle is an unlimited profit & fixed risk strategy which involves buying a put option at a low strike price and a call option at a high strike price, at the same expiration. You use long strangle to capitalise on upcoming high volatility in either direction. The profit potential is unlimited and based on the difference between the expiration and strike prices of winning ITM option. Maximum risk occurs when the expiration price is in between the strikes and both positions expire OTM, causing you to pay premium for both.
- Short Strangle
A Short Strangle is a fixed profit & limited risk strategy which involves selling a put option at a low strike price and a call option at a high strike price, at the same expiration. Short strangle is used when you expect the asset price to trade flat until expiration. You earn premium from both options and fully profit if the market price is between the strikes at the expiry. However, if the expiration price is beyond one of the strikes, only one option would be ITM. The other option would have unlimited loss potential, which you would limit your risk using stop loss.
- Long Combination
A Long Combination is an unlimited profit & unlimited risk strategy which involves a long call and a short put at the same strike price and expiration. Long combination is employed when you want to profit on the price increase while avoiding margin costs. The profitability is based on the difference between expiration and strike prices of the long call plus short put’s premium. The maximum risk is theoretically unlimited without stop loss and based on short put’s losses when the expiration price is below the strike, plus long call’s premium.
- Short Combination
A Short Combination is an unlimited profit & unlimited risk strategy which involves a short call and a long put at the same strike price and expiration. A Short combination works similarly to the long combination. Profit is based on the long put’s strike, and expiration price differences, plus short call’s premium, and the risk is based on the short call’s distance, plus long put’s premium.
Spread-based Double Option Trading Strategies
- Long Call Spread
Long (Bull) Call Spread is a limited profit & fixed risk strategy which involves buying a low-strike call option and selling a high-strike call option, at the same expiration. You trade Long Call Spreads when there is a clear uptrend. The long call is the main trade, and the short call acts as the take profit order, but with a premium gain. Your maximum profit is limited to the difference between the strikes (i.e. spread), plus the short call premium. Beyond the high strike, long call profits and short call losses will cancel each other out. The risk is fixed to the premium you will pay for a long call, if the expiration price is below the low strike.
- Short Call Spread
A Short (Bear) Call Spread is a fixed profit & limited risk strategy which involves selling a low-strike call option and buying a high-strike call option, at the same expiration. Short Call Spreads are preferred when the markets are declining to recover from a recent rally. Your profit is fixed to short call premium, and your risk is limited to the spread, plus the long call premium if the expiration price is in between the strikes.
- Long Put Spread
A Long (Bull) Put Spread is a fixed profit & limited risk strategy which involves selling a high-strike put and buying a low-strike put, at the same expiration. This strategy is utilised when you expect a recovery increase after a strong downtrend. If the options expire above the high strike, the profit is generated from the net premium. The maximum risk emerges when the expiration price is below the low strike and calculated as the spread plus long put premium.
- Short Put Spread
A Short (Bear) Put Spread is a limited profit & fixed risk strategy which involves buying a high-strike put and selling a low-strike put, at the same expiration. When bears control the market, you can trade Short Put Spread – the long put would be the main trade, and the short put would take profit. The spread between the strikes plus the short put premium would be your maximum profit. The risk is limited to the long put premium, which you would pay only if the options expire above the high strike.
Option & Spot Combination Trading Strategies
- Covered Call
A Covered call is a limited profit & limited risk strategy, which involves buying a spot asset and selling a high-strike call. You can use Covered Call when you expect the asset price to rise and then trade flat. The short call serves as a premium-paying take profit, and the expiry is usually between 30 and 60 days, which gives the stock enough room to decline after the rally. Your profit is limited to the spread between the spot buy and option strike prices plus the short call premium. If the expiration price is below the buy price, your spot trade will suffer losses; thus, a stop loss is required.
- Fig Leaf
A Fig Leaf (known as Leveraged Covered Call) is a limited profit & limited risk strategy which involves buying a LEAPS call and selling a call option at different expirations with the prediction that the price of the underlying asset will have a limited rise. The profit potential is based on the good performance of the LEAPS call until the expiry and the short call’s premium. The risk potential is based on the poor performance of the LEAPS call and the debit paid to execute it. You can trade fig leaf when you want to avoid the costs of purchasing the stocks.
- Protective Put
A Protective Put is an unlimited profit & limited risk strategy, which involves buying a spot asset and buying a put option. It is essentially a hedging strategy which aims to cover for the potential spot losses. We prefer a protective put to manage our risk when an uptrend is ambiguous. Profits are mainly based on the spot trade, minus the long put premium. The main risk is the premium; if the expiration price is below the spot buy, the losses would be covered by the long put.
A Collar is a limited profit & limited risk strategy which involves buying a spot asset, a low-strike long put and a high-strike short call. A Collar is a combination of Covered Call and Protective Put, and you use it to manage your risk when the direction is uncertain. You profit from the price appreciation until the short call, plus net premium. Risk potential is limited to the long put strike, plus net premium.
Advanced Options Trading Strategies
- Iron Butterfly
Iron Butterfly is a fixed profit & limited risk strategy, which involves two call options and two put options, at the same expiration but three different strike prices. You can recruit an iron butterfly when you expect markets to have low volatility after a market event. First, you determine low, middle, and high strikes. Then, you trade low-strike long put; middle-strike short call and put; and high-strike long call. You gain the net premium If the expiration price is between the high and low strikes. If the options expire beyond high or low strikes, your loss is limited to the spread between the middle strike and low or high strike, depending on the direction.
- Iron Condor
An Iron Condor is a fixed profit & limited risk strategy which involves two call options and two put options, at the same expiration but four different strike prices. An iron condor is used when the asset price will trade in a range with low volatility. First, you determine a low, low-mid, high-mid, and high strikes. Then, you trade low-strike long put; low-mid-strike short put; high-mid-strike short call; high-strike long call. If the expiration price is between low-mid and high-mid strikes, you profit from net premium. Your maximum risk emerges when expiration price is between either low and low-mid strikes (short/long put spread) or high-mid and high (short/long call spread) strikes.
- Double Diagonal
Double Diagonal is a fixed profit & limited risk strategy which involves trading 30-day short call and put and 60-day long call and put. You can use double diagonal instead of iron condor when the low volatility trend appears long term. First, you identify four strikes and trade short put/call and long/put call as in iron condor. One difference is that short put/call, forming the inner range, should have 30-day expirations, while the long put/call, forming the outer range, should have 60-day expirations. Your profit is fixed to the net premiums. If the 30-day expiration is within the inner range, you can reopen short put/call positions with the same expiry of long put/call and have another profit opportunity. The maximum risk potential is limited to the difference between the strike prices of short/long calls or short/long puts, depending on the direction, if the expiration price is out of the range.
- Option of the Wisest
Options Trading is the perfect toolkit for you to take advantage of any type of price trend. Although it may initially appear as relatively more complicated, it gives you a level of control which other trading methods can’t even suggest. Once you grasp the logic of trading options, you will be introduced to a new and easier way of realising the profit potential of the financial markets.
Main Options Trading FAQ
What is the best strategy for options trading?
With dozens of options strategies to choose from how does one decide which one is the best for options trading? Many “expert” recommend selling options rather than buying options. Generally speaking the best strategy for options trading is one that you understand, and that matches with your personality. Of course it goes without saying that the strategy also needs to be profitable. If you can combine these three traits into the trading strategy you use then it will be the best options trading strategy for you.
Which options strategy is most profitable?
There are many option trading strategies and the act of options trading is known to offer great potential. But which options strategy is the most profitable? Many expert traders consider the strategy of selling puts to be the most profitable of all options strategies. While it does work best in an upward trending market, it can also work in a sideways market. And those willing to sell long-term in the money puts can secure very excellent returns thanks to the power of time decay in options. These longer-term in-the-money options can be profitable no matter which direction the market takes.
How do you master options trading?
The idea of “mastering” options trading is actually unattainable since the markets are forever changing. There are some things that can be done to come as close as possible to mastery however. These include becoming familiar with all the basic options trading strategies, because without knowing what strategies are possible there’s no way to become a master. It also includes becoming familiar with all the different markets you can trade options on, and then choosing the one that is most suited to your trading philosophy. Finally, becoming a master of options trading, like becoming the master of anything, relies on constant study and practice.
Which options trading strategy can fit your style best? Open a demo account on AvaOptions and start practicing. Once you are ready to trade options with confidence, you can switch to a real account and start enjoying fixed return potential with full control.