Choosing the Best Option Strategy Jim Graham Choosing which option strategy to use is one of the most difficult decisions for an option trader.
Your outlook on an underlying security is basically what you expect to happen to its price, such as whether you predict the price will rise or whether you predict it to fall. In many forms of investing, these are the only two outlooks that it's possible to profit from.
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For example, stock traders can buy stocks that they expect to go up in value or short sell stocks that they expect to go down in value; they are basically the only two ways they can generate profits.
Options traders, however, have four potential outlooks to consider: bullish expecting the price to risebearish expecting the price to fallneutral expecting the price not to move, or at least remain relatively stableand volatile expecting significant swings in price. Although this means there's a lot more to think about, it also creates plenty more opportunities to make money. With so many strategies available, it's actually possible to fine tune your outlook to help you choose a suitable one.
If you have a bullish outlook, for example, you could further categorize that outlook into either moderately bullish expecting a small increase in price or significantly bullish expecting a large increase in price. By being more precise in your outlook, it's much easier to choose a suitable strategy.
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You can also combine outlooks too. You might expect the price of an underlying security to be stable in the short term, for instance, but increase in the long term.
Alternatively you might predict that the price would remain quite stable, but also think it possible that the price would fall. There are strategies you can use that are suitable in both those scenarios.
This examples serve to illustrate just how flexible options trading is, but also highlights the importance of being as accurate as possible in your outlook and acting accordingly. As we have already mentioned, you will naturally find it easier to choose a strategy that is suitable for your outlook as you learn more about the different types and start using them. You might find it more difficult, though, until you have gained a fair amount of experience.
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We have produced a selection tool that can help with you with the decision, by making recommendations based on what your outlook for an underlying security is.
You can find this tool here. Risk Versus Reward Risk management is something that you need to consider when choosing which strategies to use.
Choosing the right strategy
The risk profiles of the various strategies can be very different; some come with unlimited risk, while robot in options have fixed maximum losses.
You can help determine whether a risk profile suits your own attitude to risk by learning how how to choose an options strategy use risk graphs.
Understanding how options work in your portfolio will help you choose an options strategy.
You also need to take into account the risk to reward ratio too, because this will basically show you how much you can potentially profit in relation to how much you can potentially lose. Single Position or Options How to choose an options strategy Options trading strategies mostly involves creating spreads, which means you combine multiple positions to effectively enter one overall position.
The biggest benefits of using these spreads is that they can be used to limit risk, reduce the upfront costs of taking a position, or create a position that can benefit from more than one outcome.
The Bottom Line The strike price of an option is the price at which a put or call option can be exercised. It is also known as the exercise price.
As such, there's usually a good case for using spreads rather than entering a single position. Entering a single position, which is basically just buying or writing one type of options contract, does have a couple of advantages too though.
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First, as there are fewer transactions involved, the commissions you will pay for entering a single position will be less than for creating spreads. This can make a significant difference to the profitability of trades, particularly if you are making Eurobond options small ones.
Also, spreads can sometimes limit the potential profitability of a trade whereas taking a single position might generate higher returns. Therefore, although we would suggest that spreads are generally the better choice, there will be occasions where a single position is worth considering.
Choosing the Best Option Strategy
Required Trading Levels Your account with your broker will be assigned a trading level, and this will to some extent determine which you use. Brokers assign a trading level to accounts for regulatory reasons and to protect their customers from taking higher risks than they should; this is based largely on their experience and financial situation.
A low trading level will only allow you to use certain strategies, because the ones that carry a high level of risk will require a higher trading level. As such, this is something you clearly need to take into account when deciding upon your approach in any given situation.
Complexity of Strategy Options trading strategies come with varying degrees of complexity.