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An Easy Guide To Understanding How Options Trading Works

Trading options is a great way for new investors to try their hand at investing without paying too much upfront. While some traders use options as a more advanced trading strategy, there is a large contingent of people who see options as an option on their investment strategy rather than the foundation. Traders with this mindset often buy calls and put them as insurance policies against future market movements. This article aims to explain how options trading works and go over a few common strategies.

Vertical Spreads

Option trading strategies are often broken into two distinct groups, vertical spreads, and iron condors. Vertical spreads are a pair of options that have the same strike price but different expiration dates. You have to Keep in mind when buying vertical spreads that they’re also known as money spreads because they generate income on the trade even if there’s no movement in the underlying asset.

A trader might buy an option with a strike price of $10 and an expiration date next month. That same trader might then sell a similar option with a strike price of $9 that expires in six months. This trade would cost money upfront but puts the trader at an advantage if the underlying value drops by one dollar either before or after expiration. 

The stock is trading at $10. A trader buys the option for $2 and sells one with a strike price of $9 and an expiration date in six months for $1. This trade costs the investor $1 upfront but, if the price of the stock drops to below $8 before expiry, he will make $2 (the difference between the strike and sale prices) off of his original $1 investment.

The beauty of this strategy is that it only requires an upfront cash outlay rather than a large margin deposit on a typical trading account. A larger investor using iron condors might have to put down several thousand dollars to control the same number of shares as this trader does with his $1 option.

The risk in this strategy is that the stock could go up instead of down. In that case, the trader would miss out on the appreciation and lose money to boot since he’s still paying $1 for a $9 strike price.

Palette Construction

Another effective options trading strategy is known as palette construction. This strategy effectively involves selling a call and a put on the same asset to offset the cost of buying one or more options in a separate trade. The goal of this strategy is to buy a stock, index, or other assets at a predetermined price in case it drops below that point before expiration. While this sounds risky, it can actually be a safe strategy because traders will already be in the trade if the price falls. They’ll only miss out on any appreciation above that target price.

For example, a trader might buy shares of GOOG at $700 and sell an $800 strike price call for $10, and an $800 strike price put for $15. If the shares go up to $805, they’ll sell at the higher price and make a net profit of $495 (minus commission). This strategy is known as a low vol/high delta play, and it’s especially effective in an up-trending market.

Selling Naked Puts

A final options strategy is known as naked put selling. This is one of the riskiest strategies because it requires investors to sell puts on assets they don’t own. They’re effectively betting that the price will stay above the strike price long enough for them to buy the assets at a discount before expiration. If traders are wrong, they could lose a huge amount of money. For example, an investor might sell a put for $10 on a stock currently trading at $80 with an expiration date in 30 days. If the price never drops below that level before the end of the month, they’ll make a net profit of $200 (minus commission).

However, if the price drops to $70, they’ll be forced to purchase 100 shares at a higher price. If they paid $800 for those assets, they would lose a net of $120 (minus commission).

The biggest risk in this strategy is that it’s not hedged against loss. A trader who sells naked puts on their portfolio has no protection if their assets fall. As such, they should only use this strategy for highly liquid and stable stocks.

Another big problem with the naked put is that it requires a margin account because traders own no underlying asset. If those funds aren’t available on the initial deposit, any loss could force investors to sell off actual holdings to cover their debts.

Options trading is a complex field, but it can be made more manageable with the right tools. Many of these strategies are meant to work in tandem, so traders should consider using two or three at once to increase their overall returns. As is always the case when taking risks with trading, investors need to understand what they’re getting into before putting real money on the line.

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Daniel is a tech enthusiast and marketing student. He is completing his degree in marketing. He started Techlectual to follow his passion for writing and research about the latest technologies. He is co-founder of Techlectual.com. He also loves to travel and playing games on ps4.

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Daniel Jose: Daniel is a tech enthusiast and marketing student. He is completing his degree in marketing. He started Techlectual to follow his passion for writing and research about the latest technologies. He is co-founder of Techlectual.com. He also loves to travel and playing games on ps4.