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How to choose an options trading strategy
The magic of options trading is that allows for a variety of strategies to be matched with different stock trading philosophies. Each strategy has a different profitability and risk tolerance level, and using a variety of strategies can spice up a portfolio very nicely! In this article, I will outline four different stock trading strategies, and how they can be matched with corresponding options trading strategies which you can apply to your portfolio. The main idea is to first focus on an underlying stock trading strategy, and then add significant leverage and power to the trade by using options. The most important factor when considering each of these strategies is the concept of TIME DECAY. The value of any option declines over time, until the day the option expires. This concept can be the major enemy of any option trade, eating into its profits, or it can be the key to successful and profitable option trading. Firstly, which Strategy?
There are generally four different strategies employed by stock traders, each of which has implications when applied to options: (i) Position Trading
Traders buy a stock and hold it for long periods of time, based on good fundamentals of the company. They will often wait for a stock to reach really good value, and then watch for institutional or insider buying before making a move. As the stock price increases, they look out for other buyers to step in and move the price even further.
APPROPRIATE OPTION STRATEGY
Buying calls and puts is NOT appropriate, because you pay large premiums for time value, most of which could be wiped out over time even as the stock gains in price. TIME DECAY is your enemy. Selling covered calls each month in the option cycle on the stock you already own can significantly reduce the cost you paid for the stock in the first trade. Even if the stock goes down, you can still come out a winner! (ii) Momentum or Trend trading
Once a stock has made clear move or breakout, the Momentum traders step in, and ride the stock up along a trend to its first major reversal. They hope to make shorter term profits from a rapid move in the price. Holding periods range from six weeks to six months.
APPROPRIATE OPTION STRATEGY
Buying calls and puts is NOT appropriate, because you pay large premiums for time value, most of which will be wiped out over time even as the stock gains in price. TIME DECAY is your enemy with Momentum Trading, unless you have a particularly strong and fast moving trend.
Selling Credit Spreads is a good strategy, and in fact can be very profitable, because as you sell spreads on the opposite leg from the stock's direction of momentum (e.g. selling put credit spreads in stock with a strongly bullish trend), you can repeatedly buy back the spreads for minimum cost and sell another spread closer in. This strategy can easily yield 10-15% profit per month. Time Decay is your secret weapon for trading this strategy.
Selling Naked Puts is a good strategy, and can be even more profitable than selling credit spreads. However, it leaves you a position of possibly having to buy a lot of stock if the trade goes against you, and so your broker requires you to have a lot of margin. (iii) Swing Trading Swing
Traders buy and sell swings or oscillations within a trend. Holding times are from between 2 and ten days. This is a shorter term trading technique that is more dependent on the trend direction than it is on fundamentals or technical indicators.
APPROPRIATE OPTION STRATEGY
If you have mastered the skill of identifying reversals or swings within a trend, and know how to plan an exit strategy, you will be able to start buying calls and puts, or DITM options, which will take you to real profits! With Swing Trading, holding times are short (2-10 days) and so you minimise the effect of your arch enemy, TIME DECAY. (iv) Day Trading
Day traders focus on the many small moves that happen during the trading day, mainly shown up by candlestick patterns. This strategy has a broker's requirement of a minimum of $25,000 to qualify, which knocks out many beginners.
APPROPRIATE OPTION STRATEGY
Option trading is not appropriate with this strategy. Broker fees for options trading are quite high, and Day Traders end up paying vast sums to their brokers. In Summary:
If you own at least 100 units of a stock that is not particularly trending in any particular direction, sell Covered Calls each month in the option cycle. You can reduce the net price that you originally paid for the stock by between 5-12% each month.
If you have at least $1,000 in your account, and can identify a trend, you can easily sell Credit Spreads or Sell Naked Puts each month in the option cycle.
If you have mastered Swing Trading principles, especially the idea of planning entries and exits, you can start to buy Calls and Puts, or DITM options and make phenomenal profits.
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Contributor's Note
For more information about applying the specific strategies mentioned, go to www.swing-trading-options.com
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PLEASE VISIT THE CONTRIBUTOR'S WEBSITE
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Good job explaining different Option strategies and matching them up to an underlying stock trading strategy. Thanks for the info!
CONTRIBUTOR'S REPLY
Thanks - hope you find a good strategy and have success trading options. May favourite strategy is selling credit spreads.
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