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Options Trading Strategies

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There are many types of traders and no single method or tactic will work for all of them. The vast range of objectives, styles, experience levels, and available capital makes this outcome impossible. Although the financial markets provide a virtually limitless number of profitable opportunities, you will not be a successful trader until you can:

1) Determine which prospects are suitable for your specific situation

2) Identify and correctly apply the appropriate strategy

3) Manage the position effectively

The first step in this process involves determining why you want to trade. Many people who buy and sell options have no clearly defined reason for participating in the derivatives market. As a result, they choose inappropriate strategies or they initiate trades in an inopportune manner, when it is counterproductive to their true interests. The next step is position selection and it involves two phases. These include: identifying a trade that will benefit from some type of future activity or trend in the underlying instrument; and verifying that the position is suitable for your portfolio, based on individual criteria such as risk-reward attitude, complexity, and financial condition. The final requirement for success is effective position management. Regardless of the strategy being employed, a trader will never achieve consistent, long-term profits without initiating timely exit and adjustment transactions.

Using Options Effectively

The options market is unique because it offers a variety of ways to earn income. The alternatives range from simple call and put positions to ratio spreads, butterflies, condors, and everything else in between. Along with this diversity comes risk, often substantial, thus it is essential for new traders to become familiar with common strategies and avoid those which are inappropriate for his or her portfolio. In order to make this assessment, each individual must determine their personal comfort threshold and stress level. They must also consider the unique emotional effects that money-related activities, such as managing a complex portfolio, will have on their psyche. For example, are you ordinarily a cautious person or do you feel comfortable traveling at warp speed? How will a specific type of trading affect you mentally? Can you handle the volatility of day-trading options or are you happier with conservative, longer-term plays.

After you have identified a suitable trading attitude, it is important to decide what type of market activity is most conducive to your individual style and demeanor. Some traders prefer strategies that profit from trending markets such as those characterized by a sustained advance or decline. Techniques that benefit from this type of movement include put or call buying and vertical spreads or similar combinations. Another tactic might be to focus on changes in volatility. Traders who use this approach buy or sell option “premium” in an attempt to profit from transitions in market character. Others employ neutral-outlook strategies such as sell strangles, calendar (horizontal) spreads, or ratio spreads when the technical character of the underlying issue is range-bound or static. Obviously, each category of price action demands a unique trading tactic. The key to developing a winning portfolio is to specialize in a specific kind of market activity and utilize strategies that perform well in that particular environment.

Choosing a style of trading that fits your personality is important, however it is also crucial to identify the appropriate time frame in which to participate in the market. From a practical standpoint, most investors are suited to longer-term plays as they require less attention and are easier to manage when a person has full-time commitments to work or family. Those who have the temperament and resources to follow the markets at all hours should consider short-term techniques based on intra-day data and momentum-based trends. Regardless of the method you prefer, it is essential to acquire the knowledge necessary to initiate and manage each position correctly and in a timely manner.

Strategy Selection

One of the primary goals of every trader is to generate consistent returns and mitigate risk. A thorough and deliberate approach to strategy selection is necessary to achieve this objective and fortunately, there are a variety of techniques from which to choose. A comprehensive directory of strategies is available from the Options Industry Council. Despite all of these choices, the majority of retail option traders use derivatives primarily to speculate on the directional movement of equities. While this purpose could just as easily be accomplished with the purchase (and/or sale) of shares of stock, the appealing feature of option ownership is leverage with limited risk. If a trader correctly predicts the market direction and takes the appropriate position, he can expect to make a profit, possible a very large one. Unfortunately, this approach has a relatively low probability of success and, as most option traders quickly discover, owning a call or put when the market moves in the predicted direction will not necessarily be profitable. The reason, of course, is while the trader is waiting for the option to rise in value, the position is at risk from adverse changes in fundamental pricing variables such as implied volatility. One method typically used to overcome this problem involves various combinations of long and short options or "spreads." This unique group of strategies derives its name from the act of simultaneously buying and selling options in different series, either vertically (price), horizontally (time), or both (diagonally). Options spreads are commonly used to reduce the cost and/or the risk of directional positions while providing a higher probability of a limited return. Other, more advanced methods of spreading – based on pricing disparities or volatility skews – are regularly used by professional option traders.

Although spreads and combinations are inherently more flexible and generally provide better risk-versus reward potential, less experienced market players often have difficulty selecting the appropriate level of complexity when evaluating different strategies. In many cases, the simplest approach is best however no strategy is without risk and given the diversity among traders, it is impossible to classify any particular technique as the absolute perfect method. Statistics suggest there are a plethora of favorable strategies available to the retail participant and even though each one has different attributes, they can all be useful in a trader's arsenal at the proper time. From a broad perspective, the best strategies have a number of common traits; precisely defined principles, ease of execution, and flexibility, but the overriding measure of success for any technique is its ability to protect and conserve portfolio capital while achieving consistent returns.

Since strategy selection is one of the principal components of the trading process, it stands to reason that a trader should completely understand the characteristics of any technique he intends to use in the options market. A person who is not thoroughly aware of the advantages and drawbacks of a particular approach will make uninformed, and therefore costly, decisions thus reducing his ability to maintain a steady stream of income. Also plainly evident is the fact that individual investment objectives are far more important than the merits of the technique itself. If a specific strategy is not, for one reason or another, suitable for a trader’s portfolio, then it should not be used, no matter how attractive it appears. Obviously, the quality of discernment – knowing how to distinguish genuine opportunities and recognize the difference between speculation and gambling – is one of the essential attributes of a disciplined, effective trader.

Profiting With Options

The wonderful thing about option trading is its diversity. There are an incredible number of strategies available; one for every type of market trend, character, and outlook. Positions involving combinations of calls and puts, with different strike prices and expiration months, along with the virtually limitless array of index and futures options, offer the astute trader a variety of ways to participate in the market. This assortment provides even the most conservative investor the ability to construct positions with an acceptable level of risk and reward in almost any situation. In addition, students of option pricing theory can identify combinations with potentially superior returns when the relationships between the options are theoretically skewed. While there is no "perfect" position, successful traders learn to maximize profits and hedge their risk in as many different ways as possible, limiting the effects of short-term volatility and market gyrations. Obviously, there is no way to completely eliminate risk but you can reduce it much more than that of an inexperienced trader who does not utilize all of the available strategies.

LINK FOR OIC http://www.optioneducation.net/investigator_2/disclaimer_frame.asp?goto=strategyExplorer

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