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Option Trading

Terminology

Options Trader

An option trader utilizes specific option trading strategies which typically involve numerous options of various strike prices and expires.

Speculator

A Speculator is a stock investor who buys shares in small companies which have the potential to significantly improve their financial position. Alternatively speculators buy stocks without consideration to the company's financial position and focus solely on the stock price. Speculation is generally a high risk strategy that can also be extremely profitable. Speculators are primarily interested in short-term capital gains and usually only hold their positions for short time periods.

Stock Investor

Stock Investor's buy shares in companies that are perceived to increase in value over the coming years.

Stock Trader

Stock Trader's buy shares in companies where the stock price is expected to increase in the short term (usually days to weeks) and then sell the stock either at a predetermined price level or when a stop-loss is triggered.

Option Trading Strategies

Stock Option Trading Strategies - picture of an animated stock trader checking a chart for trading options as the market trends higher over time with increasing prices

Various market participants use options for a variety of reasons. These market participants can be broadly split into two distinct groups.

Market participants use options:

  • The first group consists of those market participants who exclusively trade options and they are referred to as Options Traders. These market participants typically utilize their entire account for the sole purpose of trading options.
  • The second group are those market participants who only use options as a supplementary tactic for their primary stock investing, trading or speculative strategies. These market participants only occasionally utilize options and any option tactics only utilize a small portion of their account. Their primary focus is on stocks.

The purpose of this article is to provide stock traders, investors and speculators with an overview of the option strategies most commonly used by options traders. These strategies may at first seem quite different from the usual buy a stock and sell a stock tactics with which most market participants are familiar with.

Strategies utilized by option traders typically incorporate the principle of the spread. The spread is a financial concept where a strategy profits from the difference between the price movements of two or more financial instruments. In the case of options trading, the financial instruments are options.

Stock Option Trading Strategies - picture of sign saying trader in large font dark blue capital letters on a light blue glass background

Option traders also usually incorporate the time decay into their strategies by including short sold options. Generally option trading strategies involve two to four different option contracts for the stock and may use combinations of call and/or put options along with long and/or short options.

While option traders are solely interested in the price moves of the options, they are still dependant on the price moves of the stock. The strategies utilized still require the option trader to have a view on the stock's price movement. The three basic views are that the stock price will rise, that stock price will decline or that the stock price will not move much and essentially trade in a trading range.

The strategies used by options traders are designed to provide different profit and loss characteristics. Some strategies are designed to limit the loss which also generally limits the profit potential. Other strategies are designed to profit when the stock price does not move much, while other strategies profit when the stock price moves either up or down or both.

Some common two option strategies are:

Two option strategies:

  • Call Spread: This strategy has a limited profit when the stock price rises and has a limited loss when the stock price declines.
  • Put Spread: This strategy has a limited profit when the stock price declines and has a limited loss when the stock price rises.
  • Long Call and Put: This strategy has a unlimited profit when the stock price rises or declines and has a limited loss when the stock price does not move much.
  • Short Call and Put: This strategy has a limited profit when the stock price does not move much and has an unlimited loss when the stock price rises or declines.

Some common three option strategies are:

Three option strategies:

  • Long Butterfly: This strategy has a limited profit when the stock price does not move much and has a limited loss when the stock price rises or declines.
  • Short Butterfly Call: This strategy has a limited profit when the stock price does not move much and has a limited loss when the stock price rises or declines.
  • Short Butterfly Put: This strategy has a limited profit when the stock price rises or declines and has a limited loss when the stock price does not move much.

Some common four option strategies are:

Four option strategies:

  • Iron Condor: This strategy has a limited profit when the stock price does not move much and has a limited loss when the stock price rises or declines.
  • Reverse Iron Condor: This strategy has a limited profit when the stock price rises or declines and has a limited loss when the stock price does not more much.
  • Iron Butterfly: This strategy has a limited profit when the stock price does not move much and has a limited loss when the stock price rises or declines.

While there are many more strategies which option traders use the above are the more commonly used strategies.

As a general rule option traders are not interested in exercising options or in being assigned on short sold options. Their sole interest is in profiting from the options directly.

Options traders do face an increased risk due to the complexity of their strategies.

The Options Clearing Corporation (OCC) has published a document called "The Characteristics and Risks of Standardized Options" which is available from the Chicago Board Options Exchange (CBOE) in a PDF format. A detailed summary of the risks is provided in the article Risk Considerations with Options.

Most of the risks outlined in the OCC document are common sense but beginner option traders are mostly caught out by these risks.

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