subject: Options Make Money – If You Manage Them Well [print this page] Options Make Money If You Manage Them Well
Options are powerful investment instruments, where both risks and returns can potentially be much greater than share trading. The trick is in using them to maximise upside, whilst limiting the downside.
Forming a View on Market / Stock Direction
Buying many types of options without a clear strategy is akin to placing a bet on the roulette wheel. It may give some thrills, but you might find you run out of capital rather quickly. Options are tools to either manage, or take advantage of expected future movements in a stock / stock market's direction. It is essential that an investor has a strong opinion, or conviction that a certain event or price movement (or lack thereof) is likely to unfold, before they trade in options.
Bear Strategies
Long Puts Put options give the buyer the right (but not the obligation) to sell a particular security, at a particular ("strike") price, before a given date in the future. In a falling (or "bear") market, this is a popular strategy, with the only risk being to the capital invested in the option. The more the underlying security falls, the more you profit. A bear put spread, where one buys a put at a higher strike price, and sells a put at a lower strike price, is an even lower risk strategy, albeit less profitable. Bear call spreads are a similar low risk strategy.
Bull Strategies
Long Calls Call options give the buyer the right (but not the obligation) to buy a particular security, at a particular ("strike") price, before a given date in the future. In a rising (or "bull") market, this is a popular strategy, with the only risk being to the capital invested in the option. The more the underlying security rises, the more you profit. Bull call spreads and bull put spreads are essentially bear call spreads and bear put spreads in reverse (as a bull has an opposite market view to a bear). These are low risk, but low return strategies.
Neutral Strategies
In a choppy market, with no trend either up or down, neutral option strategies can be employed. A "collar" can protect, or possibly profit from an underlying stock position. Several other strategies like "straddles", "strangles", "butterflies" and "condors" exist. Be clear on how they work, and their relative risks before employing them.
Covered Calls
Selling or "writing" covered calls allows the seller (writer) to collect the option premium for giving the buyer the right to purchase your underlying stock at a given ("strike") price, before a given date. You are "covered" because you own the underlying stock, otherwise you would be "naked". If your stock trades above the strike price, it is highly likely that you will be obligated to sell your stock to the covered call buyer. You have been compensated for this by the premium they have paid to you for the option, and also possibly by the rise in your stock to the strike price. If the stock doesn't reach the strike price, you keep your stock, and the covered call premium paid to you is yours to keep.
Stop or Trailing Losses
There are numerous options trading strategies. If you venture into higher risk strategies, be sure to manage the risk. Installing a stop loss, or trailing loss allows you to minimise your losses if a trade moves in the direction you are not expecting.
There are additional factors at play, such as the time decay of options, which has been excluded for simplicity. Options trading requires significantly more observation and active management than investing in managed funds. Have a clear strategy before trading to protect your capital.
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