Choosing the Right Trading Strategy
In our guide to getting started with options trading, we went into detail about the various steps involved in trading options; including the preparation required, choosing a broker, finding opportunities to trade, and writing a trading plan. Arguably the most important step of all is planning individual trades i.e. deciding when to enter a position and what position to enter.
You might know absolutely everything there is to know about options trading, but unless you are able to put that knowledge to use, make good decisions about what trades to make, and when you are unlikely to make much money. The hardest part of planning each individual trade, probably, is choosing which strategy to use.
This is especially true if you are relatively new to trading options, or if you don’t have a broad understanding of the different strategies that can be used. Even experienced traders can sometimes struggle to determine what the best strategy to use is, although it's fair to say that the more options trading experience you gain the easier such decisions become.
In reality, there's actually no such thing as the right strategy. There are many factors to take into consideration, and a strategy that might be suitable in one situation could be completely inappropriate for a different set of circumstances. A lot also depends on the individual too, because what is right for one trader might not be right for another.
We would never claim to be able to tell you exactly which strategy you should be using for any situation, but we can offer advice on how you can make that decision yourself. On this page, we look at a number of the considerations you need to be taking into account.
If you are relatively new to trading options, then we would suggest that you spend some time working out the best strategy to use each and every time you enter a new position. As you become more experienced, you will have a better idea about how each strategy works and the process for making a decision should become more straightforward for you.
- What is your Outlook?
- Risk versus Reward
- Single Position or Options Spread?
- Required Trading Levels
- Complexity of Strategy
- Summary
What is Your Outlook?
Your outlook on an underlying security is basically what you expect to happen to its price, such as whether you predict the price will rise or whether you predict it to fall. In many forms of investing, these are the only two outlooks that it's possible to profit from. For example, stock traders can buy stocks that they expect to go up in value or short sell stocks that they expect to go down in value; they are basically the only two ways they can generate profits.
Options traders, however, have four potential outlooks to consider: bullish (expecting the price to rise), bearish (expecting the price to fall), neutral (expecting the price not to move, or at least remain relatively stable), and volatile (expecting significant swings in price). Although this means there's a lot more to think about, it also creates plenty more opportunities to make money.
With so many strategies available, it's actually possible to fine tune your outlook to help you choose a suitable one. If you have a bullish outlook, for example, you could further categorize that outlook into either moderately bullish (expecting a small increase in price) or significantly bullish (expecting a large increase in price).
By being more precise in your outlook, it's much easier to choose a suitable strategy. For instance, if you expected an underlying security to increase significantly in price you would know not to use a strategy that returned a profit on a small price increase and didn’t keep generating profits if the price continued to rise.
You can also combine outlooks too. You might expect the price of an underlying security to be stable in the short term, for instance, but increase in the long term. Alternatively you might predict that the price would remain quite stable, but also think it possible that the price would fall. There are strategies you can use that are suitable in both those scenarios. This examples serve to illustrate just how flexible options trading is, but also highlights the importance of being as accurate as possible in your outlook and acting accordingly.
As we have already mentioned, you will naturally find it easier to choose a strategy that is suitable for your outlook as you learn more about the different types and start using them. You might find it more difficult, though, until you have gained a fair amount of experience. We have produced a selection tool that can help with you with the decision, by making recommendations based on what your outlook for an underlying security is.
You can find this tool here.
Risk Versus Reward
Risk management is something that you need to consider when choosing which strategies to use. The risk profiles of the various strategies can be very different; some come with unlimited risk, while others have fixed maximum losses. You can help determine whether a risk profile suits your own attitude to risk by learning how to use risk graphs. You also need to take into account the risk to reward ratio too, because this will basically show you how much you can potentially profit in relation to how much you can potentially lose.
Single Position or Options Spread?
Options trading strategies mostly involves creating spreads, which means you combine multiple positions to effectively enter one overall position. The biggest benefits of using these spreads is that they can be used to limit risk, reduce the upfront costs of taking a position, or create a position that can benefit from more than one outcome.
As such, there's usually a good case for using spreads rather than entering a single position. Entering a single position, which is basically just buying or writing one type of options contract, does have a couple of advantages too though.
First, as there are fewer transactions involved, the commissions you will pay for entering a single position will be less than for creating spreads. This can make a significant difference to the profitability of trades, particularly if you are making relatively small ones. Also, spreads can sometimes limit the potential profitability of a trade whereas taking a single position might generate higher returns. Therefore, although we would suggest that spreads are generally the better choice, there will be occasions where a single position is worth considering.
Required Trading Levels
Your account with your broker will be assigned a trading level, and this will to some extent determine which you use. Brokers assign a trading level to accounts for regulatory reasons and to protect their customers from taking higher risks than they should; this is based largely on their experience and financial situation. A low trading level will only allow you to use certain strategies, because the ones that carry a high level of risk will require a higher trading level. As such, this is something you clearly need to take into account when deciding upon your approach in any given situation.
Complexity of Strategy
Options trading strategies come with varying degrees of complexity. There are a number that are relatively simple, typically those that involve just one or two transactions. There are also some that are more complicated too, requiring three or more transactions. The complexity of a strategy is definitely something that you need to think about when deciding which one to use, as it affects a number of aspects of your trading.
For one thing, as we have already mentioned above, the more transactions that are required, the more you will pay in broker commissions. This can have a big impact on your potential returns, particularly if you are trading on a small budget, so you really need to take this into account.
Using the more complicated strategies can also make it harder to work out what the potential profits and losses of a trade are, and what price movements will be best for you. Deciding upon the ideal entry and exit points of a position is a key part of planning a trade, and this is generally a lot easier to do when you are using the simpler strategies. This isn't to say that you should never use the complex ones, because they can often be the best choice, but you should be aware of the added difficulties this can create.
The more complicated ones also give you something else to think about, whether to carry out all the required transactions simultaneously, or whether to place each order individually. A number of online brokers include functionality that allows you to simply select your preferred strategy, and then the orders that it requires will automatically be executed at the same time. This makes life a lot easier.
However, if you choose to use legging, the process for placing each order involved individually, you will need to determine the best point to place each order. This does make things a little more complicated, but legging into, and out of, positions can help you generate higher profits if you get the timing right.
Summary
If you want to be truly successful at options trading, consistently making money, maximizing your potential profits and limiting your potential losses, then being able to accurately predict price movements of financial instruments is unlikely to be enough by itself.
If you can do this, and buy and sell options based on those financial instruments accordingly, then there is of course money to be made. However, to make the most out of your predictions and control your exposure to risk at the same time you really need to be able to choose the most appropriate strategy for any given situation.
Unfortunately, there's no single best way to decide what that might be and you need to take many factors into account. We should also point out that you don’t have to use a pre-determined strategy and you can always develop your own. However, we would suggest that you only start developing your own once you have been trading for a while and been reasonably successful.
As a very general rule, we would advise beginners to stick to the more basic strategies, but that still leaves plenty of choice. As you get more experienced, you will almost certainly want to consider some of the more advanced and complex ones, giving you even more to choose from.
The best advice we can give is that you learn as much as you can about the most commonly used options trading strategies, and try and get a good idea of how each of them works and their advantages and disadvantages. Then, whenever you identify an opportunity, you'll be able to determine which strategy is the most suitable based on your outlook and your own personal circumstances and objectives.
Remember, you can always refer to our selection tool for help in finding a suitable strategy for the various outlooks you may have. We also provide detailed information on most of the strategies you will ever need to use, divided into the following categories: