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- How to Decide Which Option is Best
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What is the Best Option Strategy
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There are many ways to lose money trading options and no doubt you have figured out a few of them – I know I have. But that doesn’t mean you have to make the same mistakes as everyone else – a large part of being an options trader consists of constantly educating yourself in order to cut down on the error portion of your losses.
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That is the main purpose of education, to eliminate as many potential mistakes as possible beforehand. For as long as options have been trading, there have been seminars and books from “experts” with opinions as to which option strategies are the best.
Covered calls are best because they have limited risk and unlimited profit potential. Naked puts are than Covered Calls because you can earn premium income and set yourself up for buying the stock below the current price. The Iron Condor is the best strategy because it allows you to make money when the market is not moving at all.
If you’ve been trading options for a while, you no doubt have heard many others. When you hear comments such as these, all that you are hearing are opinions of one person’s preference for a particular risk-reward profile. In order to really understand option trading, you need to understand that all option strategies come with their own set of risks and rewards and that the market will price them accordingly.
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Be leery of anyone telling you that a particular option strategy is superior to another. They either do not really understand options or they are just trying to sell you something. The best option strategy is… one that directly matches your own risk and reward tolerances for a given outlook on the underlying given the current market environment.
In your personal quest for the best option strategies, the most important thing is to adopt a trading or investing philosophy that suits your personality.
Many option traders focus on the shorter-term and prefer pure speculative trading (and I think everyone, no matter their preference, is tempted to do this from time to time).
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But it takes a person with the right mixture of analytical intelligence, technical training, and psychological fortitude to succeed at it in the long term. Even if you do have the analytical skills and trading knowledge needed, if you lack the necessary personality you will never do well at this.
But just because you are not a speculative trader doesn’t mean you have to be content with a simple buy and hold strategy either. There are many ways to trade options.
Chances are that you first got interested in options because you found buy and hold investing using stocks, mutual funds and/or ETFs unappealing to you.
That is the personality part of the equation. Investing that way seems wrong to you, a waste of time and boring on top of it. You are also probably not the type of person who wants to abdicate your investing decisions either, simply handing over your money to let someone else manage it for you like Bernie Madoff. Whether it is managing your money or doing some work on your house, there is a certain level of satisfaction that comes from knowing that you did it yourself, that your effort paid off.
Like anything you choose to do on your own, it takes a certain amount of time to learn what should be done and even more time to gain the experience to do it well. In options, there is a certain level of option trading knowledge a trader should have.
You need to learn to dissect a position into its component parts and see if you are willing to accept the associated risks. Learn the various strategies and how to tailor them to match your needs.
Don’t spend your time looking for the one superior option strategy. It doesn’t exist. To fully understand the relationship between risk and reward with options, the easiest thing to do is to look at risk diagrams. When you compare the profit and loss diagrams of any two strategies, there will always be a part of the diagram where either strategy dominates.
Let’s look at a simple example, one often cited as reason to use options in even the most elementary books on options: That buying a call option is superior to owning the stock.
Consider a stock that is currently trading for $50 a share with the February at-the money call options (controlling 100 shares) with a $50 strike price selling for $1.38.
Comparing a position of 100 shares of the stock to one long call option, the illustration below shows the profit and loss at expiration for each position for various prices of the underlying stock. If the stock is at $52 on the February expiration day you would make a $2 profit per share ($200 total) and if it is trading for $48 on the February expiration day you would lose $2 a share (again, $200 total). You would break even if the stock was still trading at $50.
The call buyer will lose $1.38 per share ($138) if the stock is $50 or below on the February expiration date and you would break even if the stock is $51.38. At a stock price of $52, the $50 call buyer will make a $0.62 profit per share (the call option will be worth $2.00, less cost of $1.38, for a total gain of $62).
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So the profit and loss from the stock is superior to the call option for smaller movement in the market. Additionally, the dollar return from owning the stock remains superior no matter how much the stock rises in price.
But of course there are reasons to consider buying the call option instead of the stock. The first downside to owning the stock over a call is that if the market falls more that $1.38, you will lose more money (loss from the call option is limited to the $1.38 initially paid). The second downside is the amount of capital required. Buying 100 shares of the stock (no margin) would cost you $5,000.
Buying the call requires an outlay of just $138.
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It is not that one strategy is clearly better than the other; which one is the best depends on your outlook for the stock and the amount of risk you are willing to accept. Pick any two option strategies and compare their profit and loss diagrams. You will always see that one strategy dominates another over a given range of underlying prices.
But you can compare any two strategies, long or short positions, changing strike prices, etc. but it will not matter; one strategy will never dominate another for all possible prices.
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That is the reason we highlight a different option strategy in each DiscoverOptions newsletter. In Each Option Strategy of the Month we show the risk/reward profile, give you a brief explanation of the strategy and important points to consider, and explain how other variables affect it.
We also publish many articles looking at the various strategies in depth, all of which are available in the educational section of the DiscoverOptions website. We hope this encourages you to become familiar with all of them. Strategies come in all shapes and sizes. Different strategies come with different risk-reward relationships and it is up to you to decide which is best. Don’t be afraid to alter the strategy to meet your tastes.
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That is what option trading is all about. If you accept somebody else’s strategy as the “best” you are by default accepting his or her risk tolerances also. If those tolerances are not in line with yours, you will eventually learn, the expensive way, that no strategy is superior to another.