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Options can be risky because they’re complex and typically expire worthless. However they can also help investors limit risk when used correctly.
This post will consider four strategies that can reduce losses and enhance gains for ordinary investors.
Traders may buy shares when they think a stock is going higher. This can make money if they’re right, but it can also generate significant losses if prices move in the wrong direction.
Traders can potentially overcome this danger with bullish call spreads, which can profit from a rally to a certain price. They can generate significant leverage, with the potential to earn several hundred percent from the underlying shares rising a few percent. This allows traders to risk relatively small amounts of capital relative to owning stock.
Bullish spreads involve buying calls at a lower strike and selling calls at a higher strike. The sale reduces the overall cost and increases leverage. It also limits potential gains because investor don’t make any additional profits if the stock jumps more than expected.
Traders may find spreads especially useful during earnings season because quarterly results can be “binary” events. Good results can spur sharp one-day moves and bad news can trigger violent drops. Holding shares through such events can expose investors to significant downside risk.
This article includes more on spreads.
Puts are the opposite of calls, giving investors the right to sell shares at a certain level. They can gain value when prices drop.
Traders might hold puts on stocks they own, hedging against price declines. That keeps the door open for unlimited upside (a potential benefit). However the strategy can be expensive, increasing the cost of the overall position.
Traders can reduce this outlay with put spreads, which are the opposite of call spreads mentioned above. (Traders buy puts at a higher strike and sell puts at a lower prices.) Put spreads can leverage a drop, helping investors hedge stock positions against declines. However they only offer limited protection.
See this article for more.
One of the most basic option strategies is the covered call. This involves selling calls against long positions in stocks or exchange-traded funds. (Traders would typically sell 1 call contract for every 100 shares owned.)
Consider an investor holding a stock that has rallied sharply. He or she may worry about a pullback but doesn’t want to dump their position. They could sell calls against the shares, with lower strikes protecting more of their gains. This reduces the amount of money they can ultimateLY make, but it also generates extra income thanks to time value.
See this article for more on covered calls.
A collar trade combines a covered call with a protective put. (The investor may use the credit from selling calls to buy puts, resulting in little immediate cost.)
This can provide a hedge against lower prices. However it also reduces potential profits if the stock continues to advance.
Tighter collars (with strikes closer to the share price) have more protection but less space to the upside. Wider collars are just the opposite.
In conclusion, options can be risky because they’re volatile and can expire worthless. However, used correctly, they can help reduce risk and enhance performance.
Options trading is not suitable for all investors. Your TradeStation Securities’ account application to trade options will be considered and approved or disapproved based on all relevant factors, including your trading experience. See www.TradeStation.com/DisclosureOptions. Visit www.TradeStation.com/Pricing for full details on the costs and fees associated with options.
Margin trading involves risks, and it is important that you fully understand those risks before trading on margin. The Margin Disclosure Statement outlines many of those risks, including that you can lose more funds than you deposit in your margin account; your brokerage firm can force the sale of securities in your account; your brokerage firm can sell your securities without contacting you; and you are not entitled to an extension of time on a margin call. Review the Margin Disclosure Statement at www.TradeStation.com/DisclosureMargin.
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