Best Option Trading Strategies You Should Know

Since the COVID-19 lockdown, interest in options trading has gone through the roof as it offers a high potential for returns even as it carries a high amount of risk.In this article, we will take a look at common option trading strategies that you should know if you want to fine-tune your trading style.

Options are financial products that derive their value from assets like stocks, ETFs , indexes , and cryptocurrency. An options contract lets you buy or sell the underlying asset at a specific price and date, but you're not required to do so. This is why they are called "options."Think of it like making a reservation at a restaurant – you have the option to go, but you don't have to. There are two types of options contracts: call options, which let you buy an asset at a set price, and put options, which let you sell an asset at a set price. Selling an options contract can earn you a premium.People trade options to speculate on price movements, hedge against fluctuations, or generate income.Also read: Factors Affecting Stock Market To make money through options trading, you must learn effective strategies.

Investors get excited when they see the prices of their stocks going up. This is called a bullish cycle. During this time, prices tend to stay high for a while. You can use trading strategies to make the most of this cycle.

Long Call Option

This is one of the most straightforward trading strategies. You place a call option that gives you the right to buy the underlying asset at a specific price if you wish to do so. For instance, suppose Company ABC's stock is currently trading at ₹100, and you believe it has the potential to rise over the next few months. Hence, you can deploy the long call option and buy a contract for ₹10 with a strike price of ₹200. If the actual price jumps above ₹200 before expiration, you will have profited from the price increase.

Bull Call Spread

This strategy involves buying and selling multiple call options at once. More specifically, it involves buying a lower strike call option and simultaneously selling a higher strike call option with the same expiration date—the profit you pocket is earned from the differences in the strike prices of the contracts. For example, let's assume you buy a ₹500 call option for ₹100 and sell a ₹700 call option for ₹50. Initially, you have a net debt of ₹50. However, once the stock rises, you earn ₹150 (₹700 - ₹500 - your initial debt of ₹50). This strategy is extremely useful for hedging your risk since the maximum loss is typically limited to the initial cost of setting up the spread, which is ₹50 in this case.

Bull Call Butterfly Spread

Even bullish cycles have several phases, and you might find yourself in a situation where there is limited potential for upsides. In such a scenario, you may find the bull call butterfly spread extremely helpful. It involves a combination of call options with different strike prices to create a profit zone centred around the current stock price. For example, if stock ABC is currently trading at ₹100 and you believe it will slightly increase over the short-term, you can buy 1 call option for ₹10, sell 2 call options (strike price of ₹100) for ₹14, and buy another call option (strike price ₹105) for ₹5. Notice how we have hedged our bets by buying at different strike prices. Your net premium comes up to ₹1. In case the underlying asset's value expires at the middle price, you would have pocketed ₹100 (since each contract typically represents 100 shares).Also read: Best Share Market Tips For Beginners

Bear cycles are challenging for ordinary investors. They are characterised by declining prices across the board, very limited upside potential, and major corrections. However, there are ways through which you can profit from price decreases as well, most of which involve 'going short' or betting against the market.

Long Put Option

As simple as they come, a long-put option involves selling an options contract and profiting from the price decrease. For example, suppose you believe that Company ABC's stock, trading at ₹100, will decline in the coming months. You can buy an ₹80 put option for ₹50. Once the price dips below ₹80, you can exercise your right to sell the asset and pocket the price decrease.

Bear Put Spread

The bear put spread is ideal for those with a bearish outlook on the asset but also wish to limit their loss potential. Similar to its bullish counterpart, this strategy involves buying a put option with a lower strike price and simultaneously selling a put option with a higher strike price, both with the same expiration date. Here's how it works: Suppose Company ABC's stock is trading at ₹100, and you believe the price will go down in the future. Buy a ₹100 put option for ₹10 and sell a ₹95 put option for ₹5. This creates a net debit of ₹5. If the stock price drops below ₹50, you can profit from the price decrease.

Put Ratio Spread

The put-ratio spread involves three legs of buying and selling at different strike prices in such a way that the ratio of short to long contracts is 2:1. A bear put spread is a strategy that involves selling one put option while simultaneously buying another put option with a lower strike price, both with the same expiration date. This combination is designed to reduce the upfront cost of the trade, making it a net credit strategy. The maximum profit you can achieve is the difference between the strike prices of the two put options, plus the net premium received when initiating the trade. For example, if you have a bearish outlook on Company ABC's stock, which is currently trading at ₹100 per share, you expect the stock price to decline, but you also want to limit your potential losses. In the first leg of the strategy, buy a ₹80 put option for ₹10. In the second leg, you buy another ₹80 put option for ₹10 and in the third, you sell ₹60 for ₹3. In this scenario your maximum profit is ₹23, maximum loss is ₹7, and the breakeven point is ₹77.Also read: What is Equity Trading in the Share Market?

Neutral option trading strategies are your best friend when you expect little to no movement in the underlying asset price. In such situations, the straddle, iron condor, and butterfly are some neutral options trading strategies that will help you skilfully navigate these situations.

Long and Short Straddles:

Straddles are one of the simplest market-neutral option strategies you can apply. A long straddle involves buying a call and a put option simultaneously for the same strike price and expiration date. Similarly, a short straddle involves selling a call and a put for the same strike price and expiration date.Once the order is placed, the straddle will produce a profit or loss as long as the market moves, regardless of direction.

Long and Short Butterfly:

Butterfly options strategies involve a combination of a bull and a bear spread. These strategies allow traders to fix their risks while earning a limited profit when the underlying asset price moves.Long butterfly is a market-neutral strategy but it is bearish, that is when the trader expects very low volatility in the asset price movement.Meanwhile, the short butterfly is applied when the market is neutral but the trader is bullish on the asset price volatility.

Long and Short Iron Condor:

The iron condor is a delta-neutral option strategy that involves two put and two call options.An iron condor is an extension of the iron butterfly. The high and low strike price options on either wing of the spread allow limiting upside and downside losses, while the profit is capped at the premium received. For this strategy, the maximum profit earned is when the asset price equals the average of the strike price of the contracts on expiration.Also read: Risk Management in the Stock Market?

Intraday trading is a short-term investment strategy where traders buy and sell financial assets within the same trading day. Intraday trading can be a great way to potentially earn quick profits, leverage small price movements, and actively participate in the financial markets. However, it comes with high risk due to the volatile nature of short-term trading.Some of the popular intra-day trading strategies are as follows:

Momentum Strategy:

Momentum refers to an asset's tendency to sustain its current price direction. Momentum investors aim to profit by strategically entering positions in stocks before a notable trend shift occurs, capitalising on the existing price momentum.

Breakout Strategy:

Breakout trading style involves tracking stocks that have broken out of a price range in which they usually trade. A breakout happens when a stock price moves above the resistance and falls below the support level. Breakout traders try to identify the key price levels and take positions before others when the stock enters a new price range.

Reversal Strategy:

In reverse strategies, traders identify trend reversals and take positions against the prevailing market direction, often using leverage to seek profits. Technical patterns like head and shoulders, double tops, and double bottoms are tools that aid contrarian traders in adopting this strategy.Also read: What Are Futures and Options (F&O)?: A Beginner Guide

Depending on the level of risk and complexity of the trade involved, there are four generally accepted levels of options trading. All the strategies discussed in this article fall into one of these four levels. These are:

Level 1 (Covered Calls):

Allows for the buying and selling of covered calls.

Level 2 (Protective Puts and Covered Calls):

Permits the trading of protective puts and additional strategies involving covered calls.

Level 3 (Spreads and Uncovered Options):

Adds the ability to trade spreads, including credit and debit spreads.

Level 4 (Advanced Options and Naked Trading):

Grants access to more advanced strategies, such as naked options and complex multi-leg trades, involving higher risk.

Options offer versatility in trading strategies, from simple to complex. This allows both veterans and novice traders to utilise these strategies.Without risk management, your potential for losses can be unlimited. By using the strategies mentioned above, you can manage this risk factor and keep your losses to a minimum.Options offer leverage, enabling traders to control a larger position with a smaller amount of capital. This can greatly amplify your profits, provided your bet turns out to be right.

It's not everyone's cup of tea to understand some of the more advanced options trading strategies out there. You have to consider multiple factors like strike prices, expiration dates, and implied volatility to trade effectively.Options contracts are subject to time decay, which means they lose value as they approach their expiration date.Options require accurate market timing. If the anticipated price move doesn't occur within the specified timeframe, options can expire worthless, leading to losses.How much money do you need to start trading options? It's a common misconception that you need a significant amount of capital to start trading options. On the contrary, options can be a flexible and cost-effective way to trade your favourite asset. This is because options allow you to trade the underlying asset without actually owning it and for a fraction of the actual cost. You can start trading even with ₹1000.Also read: What are stocks with embedded derivative options?

First, open a trading and demat account with a reputable stockbroker. Next, complete the KYC requirements and choose a suitable trading platform. You can also place a few practice trades to get the hang of the market. Finally, analyse the market, conduct your market research, and execute your first trade.

You do not necessarily need a fortune to start trading options. Options offer a flexible and cost-effective way to make money on underlying assets without actually owning them. With the right knowledge and strategies, you can maximise your gains and become a successful options trader. Open an account with your favourite broker and embark on your options trading journey today.