How to Choose an Options Strategy?
Options trading is as simple as buying call options for rising stocks and put options for falling stocks.
However, once you go beyond the initial stage of call and put buying, the whole universe of thousands of options strategies open up before you. For the first time you see almost endless possibilities of making money through options strategies and you might wonder which options strategy is the best and which options strategy to use for each situation?
This article will attempt to provide some simple guidelines on how to choose the correct options strategy for your trading.
The two most common questions I hear from beginner options traders regarding options strategies are;
“Which options strategy is the best?”
And
“Which options strategy should I use when XXX happens?”
No Such Thing as the BEST Options Strategy
First of all, let us be clear that there is no such thing as a “Best Options Strategy”. Yes, repeat to yourself now that there is no such thing as the one options strategy that is fitted for all situations. All options strategies have pros and cons and all are good for the specific situation for which they are designed. As such, success in options trading is really the ability to execute the options strategy that best fits the situation you are in.
All Options Strategies Are Designed For Specific Situations
This brings us to the next and more important question of what options strategy to use when “XXX happens”.
As mentioned above, all options strategies are designed for specific situations and the more complex an options strategy, the more customizable it is towards a specific price goal. As such, understanding completely what is going on and being very accurate with your outlook becomes extremely important.
Yes, there is no magic in options trading. All options strategies profit only within their specific outlook and limitations. If the underlying stock did not perform within those specifications, the strategy will incur a loss no matter how complex it is unless suitable adjustments are made in a timely manner.
Consider the Size of Your Account
Another important consideration when choosing which options strategy to use is the size of your fund or the amount of money you intend to use towards each trade. Very complex options strategies can involve combinations of up to 4 or 5 different options contracts which can take up a significant amount of commission for small accounts. Commissions can be significant enough to totally eradicate the possibilities of profit.
Small accounts also run into problem with credit strategies and naked writes that involves significant margins, typically running up to $100,000. As such, if you have a small account size, most of the credit spreads would be beyond your consideration (which of course makes the decision making process a little simpler).
How to Choose an Options Strategy?
Let us then go through the steps to be taken in order to decide which options strategy to use:
1. Consider your account size and your account limitations. There are some options strategies that your account simply cannot execute due to either fund size or trading level.
2. Understand your exact situation. You need to be able to quantify the direction in which the underlying stock is going to travel, the price goal the underlying stock is reaching for, the amount of risk you are willing to take for that trade. The more exact you can be with these parameters and the more accurate your outlook is, the more money you can make using options strategies.
For instance, if QQQQ is trading at $40 right now and you think it is going to go upwards. If you are not sure to what price it might move up to but is sure that the upwards move is going to be very significant, you could only buy call options using money you are willing to lose for that trade. However, if you can be more specific and say that QQQQ is rising but might not go beyond $45 by expiration, then you could use a slightly more complex options strategy called Bull Call Spread ( http://www.optiontradingpedia.com/free_bull_call_spread.htm ) by writing an additional call options against the call options you have bought at the $45 strike price. If QQQQ rose to $45 before expiration and is expected to stay stagnant at $45 till expiration, you could instantly write another call option at $45 strike price and then buy further out of the money call options at the same time to transform the position into a Butterfly Spread ( http://www.optiontradingpedia.com/free_butterfly_spread.htm ) which is a neutral options strategy.
See how you can apply and evolve your options strategies as long as you can be specific with your outlook?
3. Consider your level of experience. Whatever options strategy you choose to use, make sure you have paper traded it for a significant period of time and completely understand its limitations and the kind of adjustments that can be made when things go wrong. Many options beginners start out with very complex options strategies and panic when things go wrong.
4. Start simple. Start with simple options strategies such as the long call / put and the bull call spread / bear put spread to get a feel of how options strategies can be built up using the building blocks of options spreads ( http://www.optiontradingpedia.com/options_spreads.htm ) .
In conclusion, there is no magic options strategies that win all the time. Knowing which options strategy to use is really a function of understanding your limits and the limits of the options strategy you are considering. Knowing your limits means knowing what you can and cannot do with your trading account as well as the level of risk you are willing to take and knowing the limits of the options strategy takes understanding exactly what it can and cannot do and then applying it to the exact situation you are facing. The more precise you can be with your outlook and the more accurate it is, the more rewarding your options trading will be.
Author Bio: Jason Ng is the Founder and Chief Option Strategist of Masters ‘O’ Equity Asset Management and author of Optiontradingpedia.com and Futurestradingpedia.com. Learn more about Options Trading and Futures Trading.
Category: Finances
Keywords: Options strategies, options strategy, Options Trading, Option Trading
