Since options started being trading in exchanges, few people actually use options in their trading or investment. However, recently the market has changed. In 2005, 1.5 billion contracts are being traded in the USA. In CBOE alone, more than $200 billion worth of option contracts are being traded.
More and more individual traders and institutional money managers are interested in options mainly because of their leveraged profit opportunities, ability to limit risk, ability to profit in any market environment, and the flexibility to create various strategies. What this means is that now traders and investors are able to combine different option contracts with different strike prices and different expiration dates to create profitable and suitable strategies for the market environment.
Now the question is how do we use options to replace our current trading or investment strategies? A better question is not only to replace, but to replace in a way that boosts profit potentials and reduces risks.
In stocks there are only two things you can do. You can buy the stock and profit when the price goes up or you can sell short the stock and profit when the price goes down. In futures, you can do the same, that is to buy or to sell short futures contracts. Another thing you can do in futures is to do a time spread. In this article, we will be covering how to use options to replace buying and selling the underlying instruments.
To replace buying stocks or futures with options, there are several things you can do to benefit from price rise. You can buy call options, bull call spread or call ratio backspread. If you have $100,000 and you plan to buy 2000 XYZ shares at $50 and hold it for 12 months, you would have to spend the whole $100,000. By buying the stock you risk all $100,000 if the stock's price plummets. The alternative is to buy 20 call options for $7,000 (assuming $350 per contract), and keep the remaining $93,000 in AAA bonds that gives a good yield. Your risk is limited to the $7,000 you paid for the call option, but you probably get it back from yield from the bond. Because of the leverage effect in call options, it still gives you the unlimited upside profit if the stock price rise. Alternatively, you can buy more calls options for this stock or other stocks because your risk is limited.
Another strategy you can do is bull call spread. In the above example, 20 bull call spread might cost you $4,000 (assuming $200 per contract). Bull call spreads give you a lower breakeven point compared to call options, so you will profit faster when the stock price moves up. The only setback is that the upside profit potential is limited.
You can also do a call ratio back backspread in which you sell a lower strike call option and buy a higher number of higher strike options. You would want your choice of option to give you a credit to open this position. This strategy gives you unlimited upside profit potential, and some profit even if the market falls. You make losses if the market moves up slightly and slowly.
To replace selling stocks or futures, you can do the reverse. You can buy put options, bear put spread or put ratio backspread (sell a higher strike put and buy a higher number of lower strike put).
For these options strategies, you can limit your risk. If you were to buy the stocks or futures, you risk the total of $100,000, and by selling short, you risk more than that.
With options, you need to take into consideration the time element. You have to anticipate the speed of the market movement, and buy the appropriate expiration time. Do you expect the market to move in a few days, weeks, months or years? This influences your decision on options expiration and options' strike price. If your duration is longer, you can buy more contracts of cheaper out-of-the money options.
So, to choose the best strategy to adapt your current trading or investment style, calculate your total risk and plot a risk profile for each strategy. Evaluate the risk versus reward, and pick one that suits your current system the best.
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