Managing Risk, Maximizing Reward With Options

Things have been moving a pace in both my regular and IRA trading accounts. My primary account has benefitted 100 percent from my March goal of aiming for consistency over home-run trades (and I encourage any struggling trader reading this to check out my trading blog for that journey). As for my IRA account, there has been some friction between me and the platform I use for that particular endeavor, but trading a retirement account was always going to be a challenge.

Given that things have settled to a relative normalcy as far as drastic market-wide moves and sentiment, I’ve wanted for a while to use this space to talk about a few different option strategies myself and some of the WT students use to manage risk and reward in an up-and-down market like we’ve seen over the past month.

Options Plays

Options are a whole category of trading vehicle on their own, and libraries of books have been written on their topology and physics. Suffice to say, options are agreements between two parties looking to transact a trade for (usually) 100 shares of certain stock at a predetermined price and time.

Whether the author of the options contract is buying (call option) or selling (put option) the asset represented by the contract, they will set a price that the stock has to reach for the contract to be executable and receive a premium for originating the contract. If it reaches that price (strike price) the person who bought the contract can choose to execute and actually purchase the shares. However, at any time they can also sell the contract to another party for a premium or simply hold the contract until it expires worthless.

That truncated summary should paint a picture of the basic composition of options. But the reason some traders love options is because they allow for a an almost infinite amount strategy. Since options contracts are timed agreements, they gain and lose value depending on the amount of time left for them to be fulfilled and the underlying asset’s proximity to being in-the-money and therefore executable.

What Are Your Options?

We’ve discussed a whole selection of options strategies on the warrior trading blog, but I want to focus on a few right now that work best in the current market climate.

Calendar Spread - This is a seemingly straightforward strategy that traders can use on either long or short positions to hedge against short-term uncertainty. However, it does require a strong sense of how a particular stock is going act over the course of the options.

Traders need only take a long or short position using either a call or a put while also taking a contrary position with a shorter time frame but the same strike. The initial position will profit if the stock hits its strike price but doesn’t move beyond the premium paid for the contrary position. The second contract acts a hedge against risk by allowing the trader an out if the price moves against their first contract.

Butterfly Spread - One of the options strategies most well-suited for wavering market, butterfly spreads rely on the odds that a stock will likely make a small move over a given period.

Traders can either take a long or short position. In the case of the former, the trader buys two call options, one with a high strike price and one with a lower price, while also selling two call options in between. Ideally, the stock will rise above the lowest call option’s strike price while remaining below the mid-range short calls and the trader can make a profit on both the rise in value of the stock while also offsetting the cost of the premium on the two long calls.

Short Butterfly spreads operate under a similar strategy, except traders sell two put options that lie in between two short puts purchased with the same expiration date as the two long puts. The trade profits if the stock falls below the highest option but remains above the two mid-range puts.

Straddle - The epitome of volatile market strategies, straddles can also be used for long or short positions, although the long is more common. Traders enter this strategy by taking both a long and short options position, like buying a call and a put, that both have the same strike price around where the stock is trading.

As mentioned, this trade works best in a high volatility market in which there isn’t clear sentiment about which a stock will go next. Either option profits once the stock moves beyond the premium paid for either option contract in either direction (long strike plus the premium paid or short strike less the premium paid)

Options aren’t the easiest thing to handle, and new traders might want to first experiment with stock trading to get a sense of how trading works. However, knowing these strategies can be a huge asset for those looking for new ideas or approaches to their portfolios.