By Chris Ebert

einsteinTo the uninitiated, option trading can appear to be a highly complex field, fit for only the most educated mathematicians and institutionally-trained experts. That is true to some degree, but it is also true that almost anyone is capable of learning to trade options.

The main problem traders face when they enter the world of options is the vastness. The world of options encompasses a much larger area than similar financial instruments, for example the stock market; and anyone who has ever traded stocks knows that the stock market is no small place. In many cases there are hundreds of options for any given individual stock, and those options can be structured in, literally, thousands of different combinations.

Being so vast, option trading can be intimidating – but not if a trader knows where to start. It’s not necessary to learn everything about options all at once. However, it can also be dangerous to learn the wrong things first. Many a trader has found financial ruin by gaining a little bit of knowledge about options and then attempting to use that small amount of knowledge to tackle a problem that requires a much greater level of understanding and experience than the trader possesses. An option trader needs guidance to succeed, especially when just starting out.

Twelve Step Program for Option Beginners

When a trader is a beginner in the world of options, it can be helpful to put some things into perspective. There are thousands, perhaps tens of thousands of strategies people use when they trade options. But there are only three basic strategies. All the rest are derived from those three. So, it makes sense that a beginner should learn the three basic strategies first.

It is not necessary to master each strategy right away. The beginner simply needs to understand how options work – they work much differently than stocks, for example – and by understanding the different ways options can be used the beginner will start to appreciate the value of learning more about them. A trader who sees the value will want to learn and be less likely to be intimidated.

The three basic strategies are as follows:

  1. Covered Call trading
  2. Long Call trading
  3. Long Straddle trading

It is not necessary for a beginner to study each of those strategies in great detail. It is sufficient just to memorize the names and to learn some basics of how each strategy works. Not all option traders use every strategy. In fact, it is possible for a trader to learn how to use one strategy only, learn how to do it well, and to only use that one strategy over and over throughout a trading career. Nevertheless, it makes sense to know what’s out there, even if a trader never uses the other strategies.

For each of the three strategies listed above, there is one additional strategy that will essentially produce the same outcome.

  1. Covered Call trading is essentially identical to Naked Put trading
  2. Long Call trading is essentially identical to Married Put trading
  3. Long Straddle trading is essentially identical to Long Strangle trading

2TwinsThere are certain requirements that must be met for those trades to be identical, but the beginner does not initially need to be concerned with those requirements. The important thing is for the beginner to understand that there are only three basic strategies and that each one can be structured two different ways, for a total of six basic strategies.

For each of those six strategies there exists an identical but opposite strategy. The opposite strategy will yield the opposite result. For example if one strategy returns a profit, the opposite strategy will return a loss essentially equal to the profit on the first. Again, there are requirements that must be met for the profit and loss to be equal, but the beginner need only understand that every option strategy has an opposite.

  1. Covered Call trading is the opposite of Married Call trading
  2. Naked Put trading is the opposite of Long Put trading
  3. Long Call trading is the opposite of Naked Call trading
  4. Married Put trading is the opposite of Covered Put trading
  5. Long Straddle trading is the opposite of Short Straddle trading
  6. Long Strangle trading is the opposite of Short Strangle trading

Since, as mentioned earlier, some of the strategies are identical, it is possible to simplify all twelve strategies into just three basic categories.

  • A.  Covered Calls and Naked Puts are the opposite of Married Calls and Long Puts
  • B.  Long Calls and Married Puts are the opposite of Naked Calls and Covered Puts
  • C.  Long Straddles and Long Strangles are the opposite of Short Straddles and Short Strangles

Perhaps the best first task for a beginning option trader is to memorize those three categories: A, B and C. All option trades either fit into one of those three categories or else they are a combination of trades from two or more categories. It can take some time to learn how the three categories work, so a beginner need not initially be concerned with combinations, known in the options world as spreads, but rather the three categories.

Keeping Things Simple

By starting with just three basic categories the options world becomes much narrower. The task of the beginner is to learn the basic structure of just twelve strategies and discover how those strategies fit into just three categories – certainly less daunting than taking on the entirety of options in one massive gulp.

Once the trader has accomplished this task, the world of options will almost certainly appear clearer and more understandable. Having discovered a way to categorize all options in just three simple categories, it should then become much easier to learn the value of combining categories to form option spread trades. However, many traders are successful using any one of the twelve strategies without ever considering spreads.

It makes perfect sense, then, that a beginner need not be concerned with tackling the topic of combination spreads. Knowing the basic twelve is all that some traders require to find one or two strategies that work well with that specific trader’s plans and expectations and which also fit the trader’s personality and emotions. The basic twelve provide the fundamentals. Learning the fundamentals provides a solid foundation. With a solid foundation a trader may later build upon it, for example to form combination spreads; but it all starts with a good foundation.

Even given just twelve basic strategies, it can still be a difficult task for a beginner to choose which of those twelve is best for a particular stock or for a particular trading environment. Some strategies work well in bullish up-trends, others in bearish downtrends. Still others work best in sideways markets with little or no trend; and there are even some that are best for massive trends regardless of whether the trend is up or down.

The following chart shows, in a general way, which of the twelve strategies tend to be profitable in any given environment. The key at the bottom of the chart uses the same notation for the option categories as used above. For example A+ is used to reveal the likely profitability of Covered Calls and Naked Puts. B+ connotes profits for Long Calls and Married Puts, and C+ shows profits for Long Straddles and Long Strangles.

Stocks and Options at a Glance 11-15-15

click on chart to enlarge

It should be noted that the options shown in the chart are very specific. The beginner does not need to initially worry about the specifics; there will be time for that at a later date. The options shown are for a very specific strike price and very specific expiration date and for a very specific index, the S&P 500. But the chart also applies to any individual stock or any other stock index.

The beginner will eventually need to learn how the specifics, the strike price and the expiration date, affect options before attempting to place a trade with real funds. But, in order for the beginner to absorb the information and process it in the mind, the main concern should be to discover which options work best for a given situation. Strike prices and expiration dates are complex topics that should be left for a time when the twelve basic strategies have been studied sufficiently.

It can be seen on the chart that a specific strategy, for example an A+ strategy tends to do well when stock prices are rising or moving sideways. Others, such as an A- strategy tend to do well only in sharp downturns for stock prices. The depiction of each combination, for example, A+ B+ C+, is not an opinion; it is a statement of fact. Given the parameters for each situation, for example, sharply declining stock prices, it is a fact that options will tend to perform as indicated for each category A, B and C.

Facts and Opinions

The “You are Here” indicator is an interpretation – an opinion. While the interpretation is based on many years of experience, nobody knows for certain where stock prices are going next. The You are Here symbol only indicates to 100% certainty where stock prices are at the moment. There is no guarantee that stock prices will follow the expected path tomorrow or at any time in the future. The You are Here symbol only tells two things for certain: where stock prices are today, and which option strategies are profitable or unprofitable today. Any forward-looking inference drawn from projections beyond today is inherently uncertain. Anybody can make a prediction, yet even the most educated prediction can be proven wrong.you are here

It is always up to the individual trader to decide whether the interpretation fits his or her own interpretation or whether to ignore it. It is risky and often inadvisable to base one’s trades on other people’s opinions. That’s just as true with option trading as it is with stocks or any other financial instrument.

For the beginning option trader, though, despite the fact that the You are Here symbol yields an interpretation of the future for stock prices (an interpretation which may or may not prove to be accurate) it is nevertheless an accurate depiction for today. It is therefore possible, by viewing the You are Here symbol, to see which types of option trades are currently profitable and which are not. By studying how the stock market affects the profitability and unprofitability of the twelve basic option strategies, the beginner may, over a period of months or years,  learn to associate specific strategies with market environments that are conducive to those strategies.

Taking the Next Step

When a beginner has learned to associate specific option strategies with specific trading environments, it will almost certainly be easier to take the next step. If one knows which strategy is likely to work best, one can then learn how specific attributes of the option, such as the strike price and expiration date, are likely to affect the outcome of the trade.

Also, by discovering which strategies perform poorly in certain specific environments, the trader will quickly learn the risks associated if the market environment experiences a shift. It is just as important, if not more important, for an option trader to learn the risks associated with each of the twelve basic strategies, as it is to learn the potential rewards.

A successful option trader must not only choose the best strategy to potentially profit from the expected market environment, but also find a way to limit loss if the market does not perform as expected. It all starts by learning just twelve basic strategies and fitting them into just three simple categories.

* Option strategies referenced above are analyzed for profit or loss on expiration day only and are opened using an at-the-money strike price, 4-months to expiration, using options traded on a broad-based ETF such as $SPY (NYSEARCA:SPY)

The preceding is a post by Christopher Ebert, Chief Options Strategist at Astrology Traders (which offers subscribers unique stock-trading perspectives and options education) and co-author of the popular option trading book “Show Me Your Options!” Chris uses his engineering background to mix and match options as a means of preserving portfolio wealth while outpacing inflation. Questions about constructing a specific option trade, or option trading in general, may be entered in the comment section below, or emailed to OptionScientist@zentrader.ca

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