Intro to Alternative Option Trading
- Written by Carley Garner
Options offer traders an unlimited number of strategies with various levels of risk and reward. Unfortunately, many retail traders are stuck in a long option only "rut" and may not be aware of the potential flexibility offered by alternative option strategies. There is certainly a time and a place for buying outright options, but in my opinion most circumstances seem to favor an alternate approach.
The purpose of this article is to briefly outline a few of my favorite option strategies in an attempt to introduce you to the possibilities. It is not intended, however, to provide you with all of the tools and knowledge that you will need to immediately participate in the markets with this new found knowledge. Nonetheless, I believe this to be a valuable stepping stone and hopefully an eye opening experience.
This writing is a small sample of the possibilities available to traders through option trading. For a more comprehensive explanation of these and alternative option strategies be sure pick up a copy of "Commodity Options" which will be on the shelves in early 2009. We will also be adding a series of option trading educational articles to this site.
Please note that the trading examples in this article do not include commissions or fees due to the fact that there is such a wide spectrum of rates. Therefore, all premium collected must be reduced by the amount that you pay in commission and you must add commission to all premium paid. Don’t forget, that each separate contract is charged a commission. Thus, a three-legged option spread involves three separate commission charges.
Short Option Trading
I have witnessed beginning traders lured to the markets in droves looking to participate in long option strategies. Their attraction stems from the fact that option buyers are faced with the prospects of unlimited profit potential and limited risk in the amount of premium paid plus commissions and fees.
The hazard in this type of mindset is that although one’s losses are limited, it is highly likely that an option buyer will lose some or all of the value of the option. Several studies suggest that more options than not expire worthless, accordingly it seems logical that by simply selling options as opposed to buying them is a preferential strategy.
Contrary to what many might seem to be the case, it is possible to buy a call option and lose money even if the market goes up. This is due to time value erosion and decreases in volatility or demand for the instrument. On the other hand, the seller of that same call could be profitable despite the fact that the futures price increased assuming that time value and or volatility has eroded.
Unlike buying a call, selling a call option is a bearish strategy. Call option sellers believe that the market will decline in the opposite direction of the strike price or at least manage to stay below it.
I have found that it may be preferential for option sellers to initiate positions on a day in which the market is going against the soon to be position. In essence, Call options should ideally be sold during times of elevated market prices and thus elevated call premium. This could mean that the market is approaching the top of a trading range, or simply overbought. Selling against the trend may seem like account suicide, but it can often be justified by inflated premiums.