How to use the Right Option Strategy?

There are many different option strategies with many different risk – reward depending upon one’s view on direction and or volatility. How does the individual trader select the best strategy?

In short, the individual trader must choose the strategy that matches his or her own trading goals and psychology, based on knowledge of how each strategy performs. Each strategy has its own unique risk/reward characteristics. Say you’re trying to pick the right strategy to play an expected rally. The first strategy that comes to mind is the simple call purchase.

However, the simple call purchase is a position that responds dramatically to every move in the underlying. And once the underlying has moved your way to a certain extent, the call option, now more expensive, gains or loses even more money with every move in its underlying. In other words, its delta, or sensitivity to the underlying, has increased. This is where trouble can arise. Increased stress on the trader, now trying to pick an appropriate selling point, may contribute to a bad decision.

For example, a sudden (but not great) drop in the underlying can lower the price of the option and cause the trader remorse that he did not sell earlier. Now he must decide whether to sell and lock in whatever gain he has before the stock drops any further. On the other hand, a sudden rise in the stock can easily double the value of the call option, possibly leading the trader to feel euphoric and smug, emotions just as dangerous to successful trading as anxiety!

It takes a strong, disciplined trader to profit from simple call purchases consistently. The trader must understand the kind of position he is using and be disciplined—using an objective, a stop, and perhaps a trailing stop. For the more conservative trader, less aggressive positions can be found among the various types of spreads. Spreads allow the trader more time to make an exit decision. You can even hold a spread all the way to expiration without concern over rapid time decay.

A computer simulation can help in selecting the best spread to use. Under different conditions, with a different target or time frame or a different volatility environment, another strategy might perform better. You never know until you run a simulation. Select the strategy that will perform the best based on your expectations for the underlying, and at the same time will match your trading temperament. Don’t pick an aggressive strategy like a call purchase just because it looks like you could make a little more profit. As I mentioned before, successful traders are unemotional, unstressed traders.

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Happy Trading!!!

Cheers.