Question

What is option trading strategies (hedging, speculative strategies to bet on price direction and volatility)?

Answer 1

Answer:

Traders often jump into trading options with little understanding of options strategies. There are many strategies available that limit risk and maximize return. With a little effort, traders can learn how to take advantage of the flexibility and power options offer.Hence options comes into picture.

Different types of option trading strategies are:

1. Covered Call

With calls, one strategy is simply to buy a naked call option. You can also structure a basic covered call or buy-write. This is a very popular strategy because it generates income and reduces some risk of being long stock alone. The trade-off is that you must be willing to sell your shares at a set price: the short strike price. To execute the strategy, you purchase the underlying stock as you normally would, and simultaneously write (or sell) a call option on those same shares.

Example:In this example we are using a call option on a stock, which represents 100 shares of stock per call option. For every 100 shares of stock you buy, you simultaneously sell 1 call option against it. It is referred to as a covered call because in the event that a stock rockets higher in price, your short call is covered by the long stock position. Investors might use this strategy when they have a short-term position in the stock and a neutral opinion on its direction. They might be looking to generate income (through the sale of the call premium), or protect against a potential decline in the underlying stock’s value.

2. Married Put

In a married put strategy, an investor purchases an asset (in this example, shares of stock), and simultaneously purchases put options for an equivalent number of shares. The holder of a put option has the right to sell stock at the strike price. Each contract is worth 100 shares. The reason an investor would use this strategy is simply to protect their downside risk when holding a stock. This strategy functions just like an insurance policy, and establishes a price floor should the stock's price fall sharply.

Example:An example of a married put would be if an investor buys 100 shares of stock and buys one put option simultaneously. This strategy is appealing because an investor is protected to the downside should a negative event occur. At the same time, the investor would participate in all of the upside if the stock gains in value. The only downside to this strategy occurs if the stock does not fall, in which case the investor loses the premium paid for the put option.

3. Bull Call Spread

In a bull call spread strategy, an investor will simultaneously buy calls at a specific strike price and sell the same number of calls at a higher strike price. Both call options will have the same expiration and underlying asset. This type of vertical spread strategy is often used when an investor is bullish on the underlying and expects a moderate rise in the price of the asset. The investor limits his/her upside on the trade, but reduces the net premium spent compared to buying a naked call option outright.

4. Bear Put Spread

The bear put spread strategy is another form of vertical spread. In this strategy, the investor will simultaneously purchase put options at a specific strike price and sell the same number of puts at a lower strike price. Both options would be for the same underlying asset and have the same expiration date. This strategy is used when the trader is bearish and expects the underlying asset's price to decline. It offers both limited losses and limited gains.

5. Protective Collar

A protective collar strategy is performed by purchasing an out-of-the-money put option and simultaneously writing an out-of-the-money call option for the same underlying asset and expiration. This strategy is often used by investors after a long position in a stock has experienced substantial gains. This options combination allows investors to have downside protection (long puts to lock in profits), while having the trade-off of potentially being obligated to sell shares at a higher price (selling higher = more profit than at current stock levels).

Example:A simple example would be if an investor is long 100 shares of IBM at $50 and IBM has risen to $100 as of January 1^st. The investor could construct a protective collar by selling one IBM March 15^th 105 call and simultaneously buying one IBM March 95 put. The trader is protected below $95 until March 15^th, with the trade-off of potentially having the obligation to sell his/her shares at $105.