Nowadays, trading with options has become very widely used by many investors looking for additional ways of generating income.
By definition, an option is a contract between two parties.
The buyer acquires the prerogative to buy or sell an asset at a specific price before a particular date.
Over time, the value of the underlying stock is called ‘volatility’, usually denoted by the Greek the letter ‘sigma’ (σ). Traders often use volatility in conjunction with other factors when making their trading decisions.
We will look at some of the most commonly used options trading techniques in Europe:
Call spreads
The call spread is most useful when you expect a moderate rise in share prices but don’t want to be exposed to unlimited potential losses if your forecast turns out wrong.
A limited loss potential means they’re most often traded by conservative investors who don’t want to take significant risks with their investment capital.
This technique has a net debt, which means you pay more to establish it than the amount of profit you can make if your prediction is correct.
One reason for this is buying options are usually cheaper than selling them.
The other reason is that traders often sell their options quite close to expiration, so they can’t afford to offer very high premiums due to limited time value.
Put spreads
This strategy involves two simultaneous transactions: one long and one short put option with the same expiry date but different strike prices.
It’s another conservative trading method with a net debit or credit entry.
An investor would use it when they think the price of an underlying stock will rise moderately over time but believe there may be volatility before then.
Like the call spread, it’s used by traders who want to limit their potential losses.
Again, because it has limited loss potential, this strategy is best suited for conservative investors.
Straddles/Strangle
This options trading technique requires a lot of knowledge and experience to be executed as there is unlimited risk involved.
It involves two put/call options with different strike prices being bought simultaneously, with the same expiry date.
Investors believe that they can predict where the price of an underlying security will surpass a particular point or fall below another point within a specific period – before expiration – but they do not have a strong opinion on whether it will rise or fall after that.
Ratio Spreads
A ratio spread is a variation of the bull and bear spreads and strategies and consists of placing two different trades simultaneously where one trade is twice as large as the other.
The investor believes that the minor loss will be offset by the more considerable gain or vice versa.
It’s another limited risk strategy because there are preset profit targets for each part of this trading technique.
Ratio spreads are based on the same underlying asset having equal expiry dates but different strike prices.
This options trading method is best suited to traders who enjoy analysing market patterns.
Still, it requires an experienced outlook towards predicting what shares will do before they reach their target price, so timing is crucial with this strategy.
Candlesticks
This technique is used when you are looking for a rapid change in the underlying security price.
It’s also helpful in spotting market conditions that are overextended in either direction, making it ideal for day traders who want to make small but frequent profits from quick moves.
However, they can be misleading if you misuse them, so it’s essential to stick to tried and tested rules with candlesticks.
Cut losses and let profits run
This is one of the most straightforward option trading strategies to follow and one that many novice traders find hard to put into practice because it goes against human instinct, which is usually to hold on for as long as possible.
It’s based on the idea that investors should cut their losses quickly and let profits run if they are big enough, so you should only enter a trade if you have an upcoming event or catalyst that can influence prices profoundly either way.
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