What is an option trading strategy, what are its types and other questions answered

Investor portfolios generally comprise a variety of asset classes, such as stocks, bonds, ETFs, and mutual funds, among others. Another asset type is options, and when used properly, they can provide many benefits beyond what trading stocks and ETFs alone can.

And though options trading may first seem complicated, it becomes simple with the right knowledge of a few strategies. To help you gain that understanding, we talk in detail about what an options trading strategy is, its types, and the advantages and disadvantages associated with it.

What is an options trading strategy?

There are two types of derivatives contracts in Indian equity markets - futures and options. Options contract gives the buyer the right but not the obligation to sell or buy the underlying security at a predetermined price. The seller of the option must deliver the security if the option buyer exercises the option.

Options can be of two types considering the right they give to the buyer of the option - call option and put option. A call option gives the option buyer the right but not the obligation to buy the underlying security at a predetermined price from the option seller, who is also called the option writer. A put option gives the option buyer the right but not the obligation to sell the underlying security at a predetermined price.

An options trading strategy combines futures and options, or two separate options, to produce a product with specified risk, defined rewards, or both. You can use a variety of options trading tactics, from a simple approach to complex, detailed strategies. However, in general, trading on rising prices is done by trading call options, and trading on falling prices is done by trading put options.

Types of option trading

Options trading may appear complicated, but there are several commonly used strategies that traders apply to increase returns, predict market movement, or hedge current positions. Here are four of the most common types of option trading strategies:

Covered Call:

The covered call is a highly common strategy because it generates income and lowers some of the risk associated with holding a position in a single stock. Using this strategy, you buy the underlying stock as usual while also writing—or selling—a call option on the same shares.

Married Put:

In a married or protective put strategy, a trader purchases a stock and simultaneously buys put options covering an equal number of shares. When holding a stock, an investor may decide to adopt this method to minimize risk.

Bull Call Spread:

A trader uses a bull call spread strategy when they simultaneously purchase calls at one strike price and sell the same quantity of calls at a higher strike price. Using this technique, the trader can limit the trade's potential gain while lowering the net premium expense.

Long Straddle:

A long straddle options strategy is when a trader simultaneously buys a call and a put option on the same underlying stock. Again, the strike price and expiration period remain the same. This approach is frequently used by traders who think the value of the underlying stock will fluctuate noticeably outside of a certain range but are unsure of the direction the move will follow.

Advantages of option trading

Higher Returns:

Compared to purchasing shares in the cash segment, trading options provide substantially higher profits. With the right knowledge and accurate use of trading strategies, options traders can earn higher profits and amplify returns.

Cost-Efficient:

Options are cost-efficient and have a tremendous amount of leverage. A trader can obtain an options position at a significantly lesser margin than an equivalent stock position. Options also give you the ability to invest with very little initial capital.

Hedging:

Options trading provides hedging of risks. It also allows the systematic transfer of risk. Depending on how you trade, options trading can be less risky for investors than equities because of lower financial commitment. Also, they are more resistant to the potential adverse impact of gap openings.

Disadvantages of option trading

High Commissions:

Compared to trading stocks, trading options is more expensive as it involves high commissions. While most full-service brokers charge high fees for trading options, some brokers allow traders to trade with lesser commissions, such as Sharekhan.

Less Liquidity:

Some options have lesser liquidity which makes it very challenging for traders to make entries and exit from the trade. Unless you are trading one of the most attractive stocks or indices, the option you are trading will have relatively little volume due to high fluctuations.

Non-availability for all stocks:

All the stocks traded on the exchanges do not have their options contract.

FAQs

Q. What is options trading strategy?

Option trading strategies involve purchasing calls or puts, selling calls or puts, or doing both simultaneously to minimize losses and maximize profits.

Q. What is the best option strategy for beginners?

Buying calls is an excellent options trading strategy for beginners and investors who are confident of a rise in the values of a specific stock, ETF, or index.

Q. What are the four basic options strategies?

The most basic options trading strategies for beginners are buying calls, buying puts, buying protected puts, and selling covered calls.

Conclusion

Before you get into options, it's ideal to have a reasonably firm grasp of trading under your belt. Then the next step is to describe your investment goals, such as capital preservation, income generation, growth, or speculation. And like any other kind of investing, it is advisable to do your homework before you start and use online models to get a sense of how options trading operates before you try it out for real.