Before you move on to more advanced options trading strategies it’s important to get started with the basics. In this guide, we’ll take a look at the primary that you can use options. These include:
Ready? Let’s get started.
Before we jump into some basic options strategies that will allow you to trade in any market condition, we first have to look at an options position graph. The position graph allows us to visualise our profit potential and risk when constructing and trading an options strategy.
The foremost question behind any trading strategy is simple – what is the risk that you are taking vs. what do you expect the market to do? With options trading strategies we need a way to clearly define our profit and risk potential.
If the market does not follow your bias, then how big is your risk and very importantly can you define this before you enter a trade – or do you trade blindly, hoping that you will simply make money if the market moves in your intended direction?
Do you know, before you enter, your profit potential and have a way to manage your position?
To answer all these questions, options traders use what is called a position graph to illustrate their options strategy, and how their profit and loss potential will be affected by the underlying market they are trading options on.
Here is our basic position graph:
Above we have a basic position graph and for the examples that follow, we will be using a red line to plot the risk and profit potential of a trade position on the expiry day. Later we will add a blue line that will show a position on the entry day.
The left axis shows us the profit (above 0) or the loss (below 0) of a position, while the horizontal axis shows us the instrument's price – going up (to the right) or going down (to the left).
The position above actually shows a long position (1 contract) in the Australian Dollar futures with the underlying price at 65.43 and how much money you stand to make or lose depending on what the price does.
Reading the position graph on this market, you will have unlimited profit potential if the Australian Dollar moves up and unlimited loss if you are wrong and the market moves down (without considering a stop loss).
Now that we explained what an options position graph does, we can next look at some basic options trading strategies.
The position graph above again shows the Australian Dollar Futures but this time it displays what would happen if we bought a CALL option at a strike price of 66.5, while the currency traded at 65.43. This time we added the blue line to show the Call option position on entry day. Remember that the red line shows the options position on the expiry day.
Similar to our previous example, buying a Call option will give us unlimited profit potential if the market goes up but if we were wrong and the market dropped lower, then our maximum loss will be limited to only $100.
Buying a call option allows us to manage our risk, whereby if we bought the underlying currency and the market dropped lower from 65.43 to 65, then we would have lost $430 but with this call option position the same drop in price would only result in a loss of $60.
On the other hand, if the market went up to 66.00 we would have seen a $570 profit in the underlying but with the Call option, we will only see a $150 profit. Although we reduced our exposure to risk, for that advantage we have also reduced the rate at which we make money.
Trading the underlying currency would also require a sizable amount of margin while you could buy an option for as little as $150.
Although buying a Call or Put option drastically REDUCES the risk you take in your trading, it also gives you more freedom by allowing the market more room to move in. Initially, you will be making money slower, but the rate at which you make money will pick up as the market moves further into profit.
Previously we had a look at what would've happened if we bought a call option and determined that our overall position had unlimited profit potential with limited risk.
When it comes to selling a call or put on their own (also referred to as naked options selling), such a position opens the door to unlimited risk with limited profit potential – basically the reverse of what buying an option would do.
This particular strategy is considered very risky and reserved for the more experienced options trader or someone that can keep a close eye on their position to avoid large potential losses.
The position graph above shows the risk and reward potential of selling a “naked” put in the Australian Dollar futures. In this example, we will have limited our profit to $540 but the position graph clearly shows the unlimited downside risk.
With unlimited risk potential comes higher margin requirements, meaning that you would need a larger account to be able to trade this strategy.
The advantage of this particular strategy, however, is that unlike other strategies where the market needs to move in one particular direction for you to make money, all the market needs to do in this instance is to stay above the 65.5 dollar level until the expiry date of the options contract for you to keep the $540.
Our final example on how options can be used shows what would happen if we were to sell the same put at 65.5 but simultaneously sell a call option at the same strike to create an options combination.
When we trade the underlying currency on its own, we cannot simultaneously buy and sell the same instrument because they will cancel each other out. However, with options we can trade with both CALLS and PUTS simultaneously – there are many different combinations using this principle which in turn gives us many different options trading strategies to choose from.
The strategy above will be ideal for a level trading market and will turn profitable if the market stays between the 64.5 to 66.5 price levels over a period of time (theta decay). The maximum profit potential of $1000 will be realised if the price closes at the 65.5 price level on the expiry day.
Most traders who trade this strategy will, however, exit prior to the expiry day by only taking a certain percentage of the maximum profit potential in this trade.
Here we have the same strategy but our profit potential on this trade is limited to around $380. If you look at the immediate position risk (blue line), then even if this market dropped from 65.5 to 64.5 in one day (which will be a $1,000 loss in the underlying), then we will only take a loss of $70 with this options combination.
Having the ability to do this greatly reduces the risk in the trade and for that, the Exchange will recognise it and in turn reduce our trading margins – enabling us to trade with smaller accounts.
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