Best Options Trading Strategies

Best Option Trading Strategies Every Trader Should Know 

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Trading options has become an increasingly popular investment strategy among retail and professional traders over the past few years. In this article, we will cover the best options trading strategies, platforms, and data providers.

What is options trading?

Options are a type of derivative, and they give buyers the right to buy or sell a security at a predetermined price at a given point in time in the future. When you buy an options contract you pay a premium for the right to do this. When investors trade options contracts they are making bets on the future price of a security and hoping to capitalize on the difference in price from the stated price in the contract. Options investors can either purchase or sell a “put” or a “call”. Puts give the investor the right to sell the security in the future at the predetermined price, and Calls give the investor the right to buy the security in the future at the predetermined price.

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What is an options trading strategy?

Most options investors develop a trading strategy in an effort to decrease their risk and/or increase their upside potential. There are plenty of basic strategies that beginners can get comfortable with, as well as advanced strategies that quant funds and larger institutions put into play. Investors must predict three things as part of their options trading strategy: Will the stock price go up or down? By how much? When?

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Best options trading strategies for beginners

The simplest way to start trading options as a beginner is to buy “calls”. If you are bullish about a stock and think the price will rise, this is a good fit for you because your losses are limited to the premium you paid to execute the trade, and you can pay less money to do this than the actual price of the stock.

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A similar options trading strategy that is great for beginners is buying “puts”. If you are bearish about a stock and think the price will fall, this is a great strategy for you. The value of your option will increase as the price of the stock goes down, but your losses will be limited if the stock price ends up higher than the strike price.

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Buying calls and buying puts are the opposite of each other: calls allow you to purchase a stock at a set price, and puts allow you to sell a stock at a set price – however, it is quite common to sell an in-the-money option contract before expiration and collect the premiums instead of taking custody of the underlying shares.

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Ready to get a bit more advanced? Covered calls are more complicated than simply buying puts and calls, but as a beginner it is a good strategy to get comfortable with. The first step with a covered call is to actually buy shares of a stock, 100 shares to be exact, as option contracts typically represent 100 shares of the underlying security. Then, you sell a call option against those shares. If the stock price goes up, the value of your shares go up, but your profit is capped at the strike price you sold the call at. For example, if you purchased 100 shares of AAPL at $100 a share,  sold a covered call with a strike price of $120 a share, and the stock went to $125 before expiration, you would have made $2000 + the Covered Call Premium, and would miss out on the additional $500 in profit. However,  if the stock price goes down, you are slightly “covered” since you’ll get a premium from selling your call options. Using the same example as before, but now the price of AAPL goes down to $95 a share, well you would have lost $500 less the premium you paid. Therefore, with a Covered Call Strategy you are ultimately capping your upside potential, but at the same time, protecting your downside risk.

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One last strategy to check out as a beginner is Protective Puts and can be considered like purchasing insurance for your portfolio. Similar to a covered call, the first step here is to actually buy or own shares of a stock that you want to protect. Then, if you feel like the market is going to enter bearish territory or that the company may have a bad earning session but you don’t want to part ways with the stock and incur capital gains  you buy a put. This method does require you to pay the premium to buy the put, but it gives you downside protection in case the stock price falls.

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Covered calls and protective puts are the reverse of each other: covered calls make you money if the stock price goes down, and protective puts make sure you don’t lose money if that happens.

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Best trading strategies for all options traders

Okay - now you are familiar with the basics and the foundational strategies for trading options. If you feel comfortable with this, you can start to explore more advanced strategies.

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For example, a Long Straddle involves buying a stock, and a call, and a put at the same strike price and expiration. This is a little expensive since you pay two premiums but it allows you to capitalize off future stock price movements without having to bet on which direction they’ll go. This strategy is often deployed when an investor believes a big bullish or bearish move is going to occur for a particular security. Married Puts or Protective Puts involve purchasing the underlying stock while also purchasing put options for the same number of shares. This functions as an insurance policy because it has a price floor. You do pay a premium if the stock price falls, but your downside is limited and your upside is limitless.  

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Much like a Long Straddle, a Long Strangle involves buying a put option and a call option at the same time, with the same expiration dates, but at different strike prices. This is a good strategy if you are confident the stock price of a security will trade in a range-bound manner for the foreseeable future.

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A Vertical Spread strategy involves buying two puts OR two calls, with the same expiration date, but with different strike prices in each direction. Your position will increase in value as the stock price rises if you have taken a bullish position, and it will increase in value as the stock prices decreases if you have taken a bearish position.

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As you venture into more complex and advanced options trading strategies, one thing to be extremely aware and cautious of are Naked Options. You’ve executed a naked option strategy if you buy a put or a call without owning the underlying stock, or a long option, or anything to decrease your risk. As the name suggests, there is no hedge involved in this strategy - which means you have the potential for catastrophic losses.

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How to choose a good options trading strategy

Obviously, this is risky business. When choosing an options trading strategy, it’s best to level with yourself: are you a beginner or do you have experience? Beginners should stick with the basics, buying puts and calls, and branching into covered calls and protective puts if they feel comfortable. It’s risky to delve into more advanced strategies like straddles and spreads if you are a beginner. Definitely stay away from naked options if you are a beginner, as these are not for the faint of heart. Risk control policies such as setting a stop loss should be implemented to prevent blowing up your account! Once you are familiar with the details and behaviors or different options trading strategies, you can branch into more advanced strategies. 

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What to do before trying out your options trading strategy

Beginners should consider using a stock options trading simulator while they are learning. There are lots of free and affordable websites that offer “paper trading” so that you can practice trading options without risking any real money. Check out Power E*Trade, TD Ameritrade Think or Swim, or TradeStation to get started.

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Once you’re ready to invest real money in an options trading strategy, you’re going to need to find a high quality source of financial data. This part is tricky, so be careful. Large traditional vendors charge tens of thousands of dollars, and smaller upstart data websites have questionable data quality and reliability. 

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At Intrinio, we offer a high-quality, affordable, easy-to-use options data feed. Intrinio options data packages offer historical and real-time options prices. Our options API is a great choice for you if you are programmatically analyzing options data to determine your strategies. If you aren’t technical, check out websites like CheddarFlow or ORATS to get started.

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Conclusion

Lots of new investors are nervous about trading options - and for good reason. Unless you know what you are doing, trading options can be very risky. If you are a beginner, be sure to select simple options trading strategies, structure them correctly to reduce risk, test them out with a paper trading simulator, and find a reliable provider of options data. If you’re curious about how to get started, our team at Intrinio is always here to help. Feel free to chat with us at any time to start a free trial of options data and get trading!

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