Want to jump straight to the best options broker? Most people prefer Interactive Brokers for their options trades.
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.
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
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 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 expires 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 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.
One more example!
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.
Best Option Strategy
The options strategy you use should be based on current market conditions. For instance, selling at the money calls is a bearish strategy that works best in a sideways or declining market. In a bull market, simply holding stocks outperforms selling puts.
In a volatile market, the most effective options strategies involve following established directional trends. The major stock indexes do not always correlate well with each other, so stick to what you know as long as you also follow sound portfolio diversification techniques.
The best option strategy to use can also depend on your personality. For example, can you deal emotionally with getting a small known income to take a substantial unknown risk that short options trading offers? If not, then buying or spreading options may offer the greater security you prefer.
For best results in the current uncertain economic atmosphere, you may want to take a more conservative approach. To get more information on options and experience using them, take a look at every options trading example and try them in a demo account first.
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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.
Bonus: Interactive Brokers
With Interactive Brokers you'll get:
- Commissions from USD 0.15 to 0.65 per US option contract
- Trade options globally on 30+ market centers
- Professional trading platforms and advanced options trading tools
IBKR has powerful, award-winning trading platforms and tools available on desktop, mobile, and web. View market data, positions and trade multiple asset classes and products side-by-side on a single screen.
Easily trade and monitor your IBKR account on-the-go from your iOS or Android device (tablet or smartphone).
Save Money With Gatsby
When you use Gatsby to trade options, you can start with just $10, trade with no commissions or contract fees and build a complete portfolio. Yes, you can execute all your options strategies on the platform, use the mobile app if you like and learn about options trading from the platform if you’re new. But, you can also:
- Use the proprietary risk meter to protect yourself
- Earn rewards on your investments
- Learn how to use the platform quickly
- Invest in stocks and ETFs to build out your portfolio
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.
Frequently Asked Questions
Several brokers that allow you to practice trading options include E*TRADE, TradeStation and OptionsXpress.
Some of the things include the rewards, risks, goals, volatility, strategy and events.
Related content: Options vs Stocks
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