Learning how to trade options helps expand your trading choices. It’s a powerful tool you can use to speculate on and hedge against market moves. But how do you know which strategy to use in a certain situation? Follow the examples below for an introduction in matching a suitable option strategy with your trading personality and market view. Here are the best options trading examples.
Simple Scalps
One of the simplest options trading strategies, scalping, typically takes a privileged market position to be consistently profitable. You must also be an extremely disciplined trader with a good understanding of the market and a solid internet connection. The following trades could take place over the space of seconds or even a second. Scalping is all about taking a little bit of profit with high-frequency trades, when possible, and giving the market no time to move significantly against you.
Riding a Rally: Buying Calls
Let’s say you buy 10 American Micro Devices (NASDAQ: AMD) $60 calls when the AMD price is $60 expiring in one month’s time on the 3rd Friday of next month. You pay a $2.70 premium for each option, totaling $2,700. AMD quickly moves up to $63 within a few days, and the now in-the-money $60 call option is worth $4.47 or $4,470 when you sell it, for a profit of $1,770.
You enjoy a 52.5% gain on the $2,700 invested into the option rather than a 5% gain on $60,000 invested, while your losses remain limited to the amount you initially paid for the option, making it one of the best options trading examples.
Playing the Dip: Buying Puts
You buy 8 Wal-Mart (NYSE: WMT) at-the-money puts each with a contract amount of 100 shares and struck at $130 for $1.31 to take advantage of what you think will be a short-term dip in the stock price. After a few minutes, the price of WMT dips from $130 to $128 and the put options are now worth $3.01 each. You profit by $1.70 per contract times 100 shares per contract and 8 contracts for a total gain of $1,360. That compares with making $2 on 800 shorted shares of the stock, which would be $1,600. While your gains may be lower in this scenario, your losses when buying the put option are limited to the premium initially paid, which is not the case with a short stock position.
Profit from Portfolio Protection
Check out a few more examples.
Skimming Off the Top: Covered Call Writing
Let’s say your cost basis per share for Micron Technology (NASDAQ: MU) is $48, and the current price of the stock is $58 per share. You do not want to sell your 500 shares and take on the tax liability. You sell 5 call options on 100 shares each covered by your underlying shares with a strike price of $62 that expires in a week. You take in $250 of the premium minus a nominal broker fee of $3 to sell the options. MU closes the week at a price of $61. The 5 options expire worthless and the options are not exercised. You keep the $250 premium less the $3 broker fee and all of your shares of MU stock. If the stock had instead declined in value, you would have had your losses buffered by the premium you received for selling the covered calls.
Getting Paid to Purchase: Selling a Naked Put
Apple (NASDAQ: AAPL) trades at $370, but you do not want to buy the stock unless it falls to $350. You sell a put at $350 for $16 on 100 shares that expire in 2 months and take in a premium of $1,600. In 2 months, AAPL shares are trading at $349. The option is assigned and you receive 100 shares of AAPL in your account the following Monday. Because of the premium you received, you essentially bought the shares at $334. Had the market gone the other way, your option would have expired worthless, leaving you with a $1,600 profit and no AAPL stock.
Playing Both Sides of the Fence
Learn more about buying a straddle and selling an iron condor below.
Earnings Season: Buying a Straddle
Let’s say Adobe (NASDAQ: ADBE) will report earnings during the week, and you don’t know what the report will show. You believe that the company will give an important announcement that will move the price of the stock substantially — you just don’t know which direction the move will be. The stock is currently trading at $530. You purchase an at-the-money (ATM) straddle expiring in about a month consisting of a call and put at the same $530 strike price. Both options have a price of $27.55 each or $2,755 in premium since they are based on 100 shares each, so you spend a total of $5,510 for the straddle.
The price of ADBE skyrockets quickly to $580 after the earnings announcement. The put loses much of its $2,755 value to trade at $10 and so is worth $1,000. The call rises $1 in an intrinsic value for each point for a total of $50 plus its remaining $10 in time value to trade at $6,000. The straddle now has a net value of $7,000, so your net profit, if you close the position out, is $1,770, less commissions.
Trading with an Iron Fist: Selling an Iron Condor
Let’s say you notice that Wal-Mart (NYSE: WMT) has been trading sideways for the past month and there are no indications that it will move away from that range. You set up an iron condor to take advantage of the net neutral movement.
The stock is trading at $120. You sell a put spread, selling a put at $115 and buying a put at $110. You also sell a call spread, selling a call at $125 and buying a call at $130. You receive a net credit of $550 for the purchase minus a $12 broker fee or $538. All of the options have the same expiration date. At this expiration date, WMT trades at $118. All 4 options expire worthless. You keep the $538 net premium you took in at the start of the short iron condor trade.
Using Synthetics
One more example! As you hunt for the right way to manage your portfolio, consider what synthetics can do for you as you trade options and allow them to diversify your investments.
Long-Term Dividend Capture: Long Put Hedge
Prudential Financial Inc (NYSE: PRU) was hit hard during the pandemic. Its dividend is at 6% and is paid in shares. You think the price will go up, but you want to receive the dividends while protecting your downside if another market crash occurs.
You decide to buy 1,000 shares and 10 long puts — a synthetic long call. The puts are LEAPS and expire 2 years from now, giving you time to collect 2 years of dividends. The stock is currently trading at $60 so you pay $60,000 to own them. You buy the puts at a strike price of $40 and pay a premium of $4.50 per share or $4,500 and $30 in broker fees. You have now purchased downside protection for your long 1,000-share position below $40.
At expiration after 2 years, PRU trades at $80 and you have received 2 years of dividends on 1,000 shares at 6% per annum, or 120 shares. The puts expire worthless. You now own 1,120 shares of PRU worth $89,600, which you sell for a profit of $29,600. You then deduct the option costs of $4,530 to get your net profit on the trades of $25,070.
How to Choose the Best Options Strategy
Choosing the right options strategy can be challenging. There are many approaches in the derivatives market. Options trading includes various strategies for different goals. These can be hedging risk, leveraging capital, or generating income. To manage this complexity, know your risk tolerance and investment goals. You should also understand market conditions. Key concepts like volatility, time decay, and asset characteristics are important for selecting a strategy. This guide will cover essential criteria and practical tips to help you find the best options strategy. Making informed choices will align with your financial goals. Whether you want to start simple or explore advanced tactics, the right strategy can affect your trading success.
Define Your Goals
Successful options trading starts with clearly defined objectives. First, determine what you want to achieve. Are you looking for income generation through consistent premium collection? Or are you interested in hedging your existing investments to protect against potential losses? You may also seek to profit from short-term market movements or volatility. Alternatively, you might focus on capital preservation, maintaining your investments' value while exploring market opportunities. Understanding your specific goals is essential. They will form the basis of your trading approach and affect your strategy selection and risk tolerance. By setting clear objectives, you can develop a focused trading plan that aligns with your financial goals.
Assess Your Risk Tolerance
Evaluating your risk tolerance is an important step in options trading. It influences how you choose strategies that fit your financial situation and comfort with risk. Start by considering your overall financial health. This includes your income, savings, and investment goals. Also think about your ability to handle potential losses. Different trading strategies have different levels of risk. For example, selling naked calls or puts can lead to large losses. This requires having substantial capital reserves to manage potential liabilities. On the other hand, buying calls or puts limits your risk to the premium paid. This allows you to know your maximum loss upfront. Buying options is a more conservative choice for those with lower risk tolerance. It provides peace of mind and allows trading without the fear of severe losses. Ultimately, understanding your risk tolerance will help you choose options strategies that match both your financial goals and comfort level. This way, you can participate in the market with confidence and control.
Understand Market Conditions
A solid understanding of the current market environment is essential for successful options trading. Different strategies work best under specific market conditions. Start by determining if the market is bullish, bearish, or sideways. In a bull market, prices rise and investor sentiment is positive. Strategies such as bull spreads or buying call options can take advantage of this upward movement while managing risk. In a bear market, prices decline. Here, bear spreads or buying put options help traders profit from falling prices. Recognizing a sideways market is also important. This situation occurs when prices fluctuate within a narrow range. Strategies like iron condors or selling options can be used to collect premiums from time decay in this environment. Market volatility is another key factor. In high-volatility conditions, strategies like straddles or strangles may work better. These strategies allow traders to benefit from large price swings in either direction. By paying attention to these market dynamics, you can make informed decisions about which strategies to use. This helps enhance your chances of success while managing risk effectively.
Consider Time Horizon
Evaluating your time horizon is important in options trading. It influences your strategy and investment approach. Start by considering how long you plan to hold your options. Think about your financial goals during that time.Short-term strategies focus on quick price movements. Day trading options require active market monitoring. This often involves buying and selling options within one trading day to take advantage of small price changes. This approach needs a significant time commitment and a good understanding of technical analysis to spot opportunities quickly.Long-term strategies, like buying long-term equity anticipation securities (LEAPS), involve holding options for months or years. This allows investors to leverage their positions while waiting for larger price changes. A longer-term view helps traders manage short-term volatility and focus on wider market trends.By aligning your trading strategies with your timeframe, you can improve your chances of success. This will help you create a coherent approach to options trading that fits your investment style and objectives.
Educate Yourself on Strategies
Understanding options strategies is important for successful trading. Each strategy has its own risk and reward profile. Start by exploring common strategies like covered calls. This involves selling call options against shares you own. It generates income and provides downside protection in a flat or slightly bullish market. Protective puts involve buying put options on your shares. This acts as insurance against significant declines and is useful in bearish or uncertain conditions. Another strategy is the iron condor. This involves selling out-of-the-money call and put options while buying further out-of-the-money options for protection. It can profit from low volatility in sideways markets.Straddles involve buying both call and put options at the same strike price. This can benefit from significant price movements in either direction, especially in volatile markets. By understanding these strategies, you can tailor your trading approach to fit your financial goals and market conditions. This knowledge helps you make informed decisions and increases your chances of success in the options market.
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Compare the Best Options Brokers
The way that you connect to the options market can impact the overall success of your strategy. Even the best trading tactics might fall short if you can’t find the right option pricing data or experience lag or slippage at the time of order execution. Here are some of the best brokers for options traders.
- Best For:Inexpensive Options TradingVIEW PROS & CONS:securely through Tradier's website
- Best For:Active and Global TradersVIEW PROS & CONS:Securely through Interactive Brokers’ website
- Best For:Global Broker for Short SellingVIEW PROS & CONS:securely through TradeZero's website
Consider Whether Options are Right for You
Properly used options can allow you to engage in strategies and encapsulate market views that would otherwise be difficult for stock traders. Modern technology allows you to learn and implement everything from simple long calls to more sophisticated strategies. Traders and investors need education about how to make the most of this incredible market because it can otherwise become a missed opportunity or a very expensive hobby. Study the above best options trading examples to up your game!
Frequently Asked Questions
What are the best brokers for practicing options trading?
Several brokers that allow you to practice trading options include E*TRADE, TradeStation and OptionsXpress.
What do I need to look for when analyzing options?
Some of the things include the rewards, risks, goals, volatility, strategy and events.
Are options profitable?
Options can be profitable, but like any investment, they come with risk. You should only invest money you can afford to lose, research your investment carefully and only buy into options you understand.
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