Techniques to use when trading the options market

One of the most important decisions you will have to make as an options trader is which type of trading strategy you plan on using. Get it from Saxo, who has some of the best techniques to date.

There are two main types of options trading strategies, directional trading and volatility trading.

Directional Trading

This type of trade involves making a bet that the price for a particular asset will go up or down within a certain time frame.

For example, if you believe that the Nikkei 225 Index (NKY) will increase by 10% in six months, then you can purchase an at-the-money call option with about five months until expiration. If your prediction is correct, this means you would be able to buy NKY shares at a lower price than they are currently worth because your option will increase in value as NKY increases.

If, on the other hand, you are wrong and the price of NKY decreases, then your option will lose its value.

Another advantage to directional trading is that an incorrect prediction won’t result in a complete loss of capital if you use at-the-money options or slightly out-of-the-money options with only about 30 days until expiration.

This means that although your position may be losing money, you can still hold onto it until it expires. If there is no movement within 30 days, most options contracts expire worthlessly, so this strategy has less room for error than volatility trading techniques do

Volatility Trading

This type of trade involves wagering that the implied volatility of an underlying asset will increase or decrease within a certain period. Implied volatility is essentially the anticipated directional movement of an asset based on current market factors such as recent price movements and trading volume.

If you believe that implied volatility for an underlying stock, currency, index or commodity will increase by 10% over the next 30 days, then one options strategy to exploit this would be to purchase out-of-the-money call options at 30 days until expiration.

This strategy is great because it’s less risky than directional trading since no matter what direction the market goes in, your position won’t lose more than it can afford to lose.

The downside to this type of trade is if you are wrong and implied volatility decreases instead of increasing, your option will lose its value, and you will be left holding a worthless position.

Another downfall to this trading strategy is that time decay (theta) works against you since your option’s value decreases by the minute.

To compensate for this, volatility traders usually trade at-the-money options since these have the highest chance of increasing in price due to higher levels of implied volatility.

When selecting an option’s strike price for either type of trade, one other consideration is how much money you are willing to risk losing if your prediction is incorrect. If you believe that NKY stock will increase by 10% within six months but want to hedge yourself just in case, then buying one six month call option might not be enough.

You could consider purchasing two call options with the same expiration date – one that is at the money and another that is slightly out-of-the-money. This way, even if you are wrong about NKY increasing in value, you will still have some of your initial capital back.

To make money on this trade, however, you will need to be right about the direction of movement for NKY.

Another way to hedge your bets is by purchasing both an at-the-money call option and an out-of-the-money put option with the same expiration date. This decreases your initial capital investment and increases your risk since if NKY increases in value, then the price of your call option will also increase.

However, if NKY decreases in value, then you will still be able to hold onto and benefit from your put option (which, in theory, should increase in price along with a decrease in stock).

While directional trading techniques leave little room for error, volatility trading strategies provide more safety regarding not losing.

Covered Call

The Covered Call approach can be considered an enhanced indexing strategy. A trader places a bet on the call option while maintaining a long position in the underlying index.

The short call position is settled on the monthly expiration day, and a new position is created on the same date.

When entering into the position, the additional short call position would produce a call Premium return. Still, if the short-sold call option is ITM at expiration (i.e., when the underlying index reaches above its strike level), it may result in a potential loss during settlement.

Short Strangle

The Short Strangle is a more refined design than the Covered Call since holding a position in the underlying index is not required. Every month, a short position in a call option and a put option with the same Moneyness is opened in the Short Strangle method.

There is no underlying return because there is no underlying index. The only source of income is premium money from selling call and put options, which has a similar risk profile to the Covered Call technique.