Option Trading Strategies for Beginners
When you think of having an option, you think of having a choice. As a trader, you may want to have as many choices available as possible – choice is a common feature among all options contracts. You can choose to exercise an option or decide not to, depending on market circumstances. Moomoo’s platform offers options trading.
Option strategies can amplify both returns and losses and are often used for risk management. Some option strategies are relatively straightforward to put in place and are used to work toward achieving trading goals. This article will dive into option trading strategies for beginners with a few examples.
What Is Option Trading
An option is a derivatives contract that gives you the right, but not the obligation, to either buy or sell an asset by or at a predetermined time (expiration date) and prespecified price (strike price).
A put option gives you the right to sell the underlying asset, and a call option gives you the right to buy the underlying asset. To own an option, you need to pay a price called a premium. The premium is usually a small percentage of what you otherwise might pay to own the stock, providing leverage.
Options trading refers to using puts and calls individually or combining them for investment strategies. Most major liquid assets, like stocks and bonds, have options trading markets.
Importance of Learning Option Strategies as a Beginner
Options contracts are not commonly discussed in the news because they require additional understanding and may be completely new to beginner traders. When you buy an option, the maximum you can lose is the option premium, which limits your downside risk. For this reason, option strategies that involve buying options are generally safer than selling them, which can have a significant downside. However, when you are long calls for example, you may end up owning the underlying stock and will need the buying power to buy those shares and manage the risk of a falling share price.
As a beginner, trading strategies that have limited loss may be useful so that you don’t potentially lose as much money. Once you’ve learned beginner strategies, you can study additional strategies like the iron condor or iron butterfly.
Starter Option Trading Strategies
Most traders aren’t prepared and are not advised to trade options without a bit of education. You can educate yourself on the fundamentals of options, trading strategies, and common option-trading mistakes to avoid, like lack of preparation, poor discipline, or inconsistent strategy use. Below are a few starter option trading strategies — using stocks as the underlying asset — to get to know.
Long Call
A call option is the option to buy a stock at the strike price by the expiration date. Long call positions are implemented by paying a price — the premium — to buy a call option.
The theoretical maximum you can lose on the trade is the premium, and the option can expire worthless, that’s when options enter expiration out of the money and expire without any remaining value, even if you’ve paid the premium. If the stock rises above the strike price plus the premium, you can exercise the option profitably.
For example, if a stock is trading at $50 and you buy a call option priced at $1 with a strike price of $55, you will profit if the sock rises above $56 at expiration, not accounting for any fees or expenses. Your maximum loss is the premium of $1.
Covered Call
A covered call strategy combines a long stock position with selling a call on the same stock. Although you have a downside if the stock falls, you receive the premium from selling the call. In return, your upside is capped at the level of the strike price plus the premium.
For example, if you buy a stock trading at $50 and sell the call option, as in the previous example, at $1 dollar with a strike price of $55, you start losing if the stock trades below
$49. You keep the $1 option premium and profit on your long stock position up to a stock price of $55 at expiration.
Long Put
To go long on a put option, you pay the option premium and receive the right to sell a stock at a strike price by or on the expiration date.
If you think a stock will fall by more than the cost of the put option, you could profit from buying a put. The most you can lose is the option premium, but the option can expire without value.
To illustrate, on a stock trading at $50, you might buy a put option priced at $1 with a strike price of $45, you will profit if the stock falls below $44 at expiration. Your maximum loss is the $1 premium.
Short Put - Cash Secured
Holding a short put position means selling a put option and receiving the premium, which is the maximum profit. You risk a loss when the stock drops below the strike price minus the option premium received. However, a cash-secured put where the cash is held as collateral is a means of buying a stock below the current market price. You must be willing to buy the stock and take on the risk of a long stock position.
This is how it works: if a stock is trading at $50 and you sell a put option priced at $1 with a strike price of $45, your maximum profit on the option is the $1 premium. You also would need to hold $4,500 in cash in your brokerage account in case the option is assigned, it will be used to pay for shares of the assigned put.
Married Put
A married put is similar to a covered call in that an option is combined with a long stock position. Also known as a protective put, it is a long put combined with a long stock position. You hedge your long stock position with a put that can help manage downside risk if the stock drops below the strike price minus your option premium. Your theoretical maximum loss is the cost of the option premium, and you won’t get that back. Your long stock position is also subject to risk if the stock price falls below your entry point.
So if you buy a stock trading at $50 and pay $5 for a put option with a strike price of $50, your maximum loss for the long option position is the premium paid for the put option. If the stock price rises, you can keep the profits. If the stock falls to $45, you lose the option premium paid of $5 and the $5 drop in the stock.
Long Straddle
A long straddle is a combination strategy where you buy a call and a put option with the same strike price and expiration date. Your maximum loss is the option premiums paid, and your profit potential increases the more the stock moves away from the strike price.
For example, you can buy a call and a put option with a $50 strike price and the same expiration date. You might pay $5 per option and profit if the stock moves more than $10 in either direction. Your theoretical maximum loss is the option premium paid upfront.
You Can Learn Option Strategies
Option trading is a type of investment strategy that provides option holders the choice to use the option. Most option traders will not exercise an option unless it is a profitable move. Profitability depends on factors like the option premium, the current stock price, the stock price at expiration and the strike price. Keep in mind, if the option expires in the money, then more than likely the long option will automatically be exercised by the broker.
While option strategies can amplify both returns and losses, they are often used for risk management. It is possible to learn options strategies for beginners that involve limited loss where you pay a premium upfront, in some ways, this is similar to insurance.
Some common starter option trading strategies include long call, covered call, long put, cash secured put and married put, which can be implemented using stocks as the underlying asset. Ultimately, day traders or longer-term investors use options to help manage risk and as a tool to potentially achieve their trading goals.
Frequently Asked Questions About Option Trading Strategies
1. What are some option strategies for beginners to consider?
The strategies to consider for beginners usually involves buying options where the theoretical maximum loss is the premium paid.
2. What is the riskiest option strategy?
The riskiest option strategy is to sell uncovered call options where your loss is theoretically unlimited.
3. What is a common option strategy?
A common option strategy is to buy options and speculate on either the increase or decline of a stock price.