Many investors are under the erroneous belief that all option trading strategies are risky. While it is certainly true that there are a few techniques that have a tendency to increase a portfolio’s overall volatility, using options can be an extremely profitable way to stabilize your earnings while simultaneously reducing your overall market risk.
When an investor elects to buy an option, they are essentially buying the right to purchase a predetermined number of shares of stock from the seller at a predetermined price (known as the strike price) on, or before, some date in the future. If the price of the stock goes above the strike price, the investor has the right, but not the obligation, to buy the stock at the predetermined price. If the price of the stock stays below the strike price, the option expires worthless and the buyer loses the amount invested.
Option Trading Strategies
Bull Market Expectation
For the sake of this example, let’s assume that the buyer has exercised their right to purchase the stock at the strike price. If they believe that the price of the stock will continue to increase over the next few months, the buyer may elect to hold onto the stock to further increase their profits. In a bull market (i.e. stock values are on the rise), this strategy may prove to be extremely profitable.
Bear Market Expectation
If, however, the buyer of the option expects that value of the stock to decrease, they may ultimately elect to sell their newly purchased stock in order to realize their profits. Another equally profitable technique would be to start writing covered calls against this security. Assuming that the investor has purchased at least 100 shares of stock, writing covered calls afford the investor the opportunity to earn some additional income, in the form of cash premiums, while also protecting them from a slightly downward decline in the value of their stock positions.
All investments involve at least some element of risk. Before trying out any of these option trading strategies you should seek the advice of a certified financial planner.