Selection Tool for Trading Strategies
One of the hardest challenges that options traders face when entering a new position is choosing the right strategy to maximize their potential profits and/or limit their potential losses.
Options trading is a very flexible form of investment, and it's possible to profit from several different outlooks over above simply expecting a financial instrument to rise or fall in price: such as stable or neutral prices, volatile prices, large or small price movements, and more. However, in order to do so a trader must choose an appropriate options trading strategy and this isn't always an obvious choice.
There isn't necessarily always a right decision in any given circumstance, because traders will have different attitudes towards risk and individual investment objectives that need to be taken into consideration. There are strategies, though, that are particularly suitable for certain outlooks. For example, if you are expecting a moderate fall in the price of an underlying security, then there are a few that are specifically constructed to profit from such an expectation.
We have compiled this straightforward, yet very useful, selection tool to help you choose an options trading strategy that is well suited for whatever your outlook on an underlying security is. To use the tool, you simply need to look at the table below and click on the relevant outlook you have for an underlying security.
The outlooks are divided into four broad categories – price increase, price fall, stable/neutral price, and volatile price – and each of these four categories consists of a number of more precise expectations. Clicking on the relevant expectation will take you to a list of strategies that we recommend for that particular outlook. You can then choose which of the recommendations you feel is best for you.
Please be aware that our lists are by no means exhaustive and there may well be other strategies that are more suitable for your own personal circumstances. This tool is purely meant as a guide to give you our advice on what we think the best trading strategies are for any given outlook.
Moderate Rise
If you are expecting an underlying security to increase in price, but only expect a small increase, then the following strategies are recommended:
Key Advantage - Reduces the upfront costs compared to simply buying calls.
Key Disadvantage - Profits are limited if the underlying security rises significantly.
Key Advantage - Can still profit if the underlying security does not rise in price.
Key Disadvantage - Limited profits if the underlying security rises significantly in price.
Key Advantage - Simple strategy with only one option involved, therefore low commissions.
Key Disadvantage - Significant losses possible if underlying security falls dramatically.
Significant Rise
The following strategies are recommended for when you expect the price of an underlying security to rise significantly:
Key Advantage - No limits to the profit that can be made.
Key Disadvantage - No protection if the price of the underlying security falls or fails to move.
Key Advantage - Some protection if the price of the underlying security falls or fails to move.
Key Disadvantage - Potential profits are lower than with the Long Call.
Rise to a Specific Level
If you are predicting that the price of an underlying security will rise to a specific level, you can maximize your potential profits by using the following strategies:
Key Advantage - Losses are limited if the underlying security does not perform as expected.
Key Disadvantage - Requires multiple transactions so the commissions paid will be higher.
Key Advantage - High potential return on investment.
Key Disadvantage - Higher commissions due to multiple transactions.
Moderate Fall
If you are forecasting the price of an underlying security to fall, but only by a small amount, then the following options trading strategies are recommended:
Key Advantage – Lower upfront costs than buying puts.
Key Disadvantage - Profits are limited if the underlying security falls significantly in price.
Key Advantage – Can still generate profits even if the underlying security fails to move in price.
Key Disadvantage – Limited profits if the price of the underlying security falls significantly.
Key Advantage – Will still make a return if the underlying security remains stable.
Key Disadvantage – Losses are unlimited if the underlying security increases dramatically in price.
Significant Fall
Key Advantage – Simple strategy involving just one trade, therefore low commissions.
Key Disadvantage – No protection if the price of the underlying security rises or fails to move.
Key Advantage – Some protection if the price of the underlying security rises or fails to move.
Key Disadvantage – Lower potential profits than the Long Put.
Fall to a Specific Level
If you are expecting the underlying security to fall in price, and are reasonably confident that it will fall to a specific level, then the following strategy can help maximize your profits:
Key Advantage – Losses are limited if the price of the underlying security does not move as expected.
Key Disadvantage – The multiple transactions required mean incurring higher commissions.
No Move
The following strategies are recommended for when you forecast that the price of an underlying security will stay the same for a period of time:
Key Advantage – You will receive an upfront payment when using this strategy.
Key Disadvantage – Large losses are possible if the price underlying security does move too much.
Key Advantage – Can also profit if the price of the underlying security does move a little.
Key Disadvantage – Profits are fairly limited.
Key Advantage – This strategy has low upfront costs.
Key Disadvantage – The multiple transactions this strategy requires mean higher commission costs.
No Move or Small Move in Either Direction
The following strategies are suitable for when you believe the price of the underlying security will remain relatively stable but might move a little in either direction.
Key Advantage – Can profit from three circumstances; stable price, small increase, or small fall.
Key Disadvantage – There is the possibility of large losses from big price moves.
Key Advantage – The potential losses are limited.
Key Disadvantage – The potential profits are lower than comparable strategies.
Key Advantage – Can profit from a wider range of price moves than other similar strategies.
Key Disadvantage – Potential profits are limited.
Stable in Short Term with a Breakout in Long Term
If you believe that the price of an underlying security will remain relatively stable in the short term but that will move in either direction in the longer term, the following strategies are recommended:
Key Advantage - Potential losses are limited.
Key Disadvantage – Multiple transactions mean more paid in commission charges.
Key Advantage – Flexible position that can easily be adjusted if your outlook changes.
Key Disadvantage – Higher commission charges due to number of transactions involved.
Stable in Short Term with a Rise in Long Term
In circumstances where you expect the price of an underlying security to be fairly stagnant in the short term but then rise in the longer term, the following strategy is worthy of consideration:
Key Advantage – Potential losses are limited.
Key Disadvantage – There is a risk of your call options being assigned.
Stable in Short Term with a Fall in Long Term
If you believe the price of an underlying security won't move much in the short term but start to fall in the long term, the following strategy is recommended:
Key Advantage – Limit to potential losses.
Key Disadvantages – Your put options can be assigned if the price falls sooner than expected.
Stable but a Possible Rise
When you believe that the price of an underlying security is unlikely to move but may possibly rise and want to cover both outcomes, then the following strategy is recommended:
Key Advantage – Can profit from a price remaining stable and a rising price.
Key Disadvantage – Potential profits are limited.
Stable but a Possible Fall
The following strategy is suitable if you expect the underlying security to remain stable but think it may possibly fall in price:
Key Advantage – Can profit from a price remaining stable and a falling price.
Key Disadvantage – Limited profits to be made.
Significant Move in Either Direction
If you believe that an underlying security is volatile and likely to move significantly in price but you are unsure in which direction, then the following strategies are suitable to use:
Key Advantage – Profits are potentially unlimited.
Key Disadvantage – Will incur losses if the underlying security fails to move significantly.
Key Advantage – Cheaper than the Long Straddle.
Key Disadvantage- Requires a larger price move than the Long Straddle.
Key Advantage – Maximum potential losses are lower than the Long Straddle or Long Strangle.
Key Disadvantage – Higher upfront costs than the Long Straddle or Long Strangle.
Key Advantage – Can profit from smaller price movements than the Long Straddle or Long Strangle.
Key Disadvantage – Potential profits are limited.
Significant Move in Either Direction but Rise More Likely
The following strategies are good choices when you believe the price of an underlying security is volatile and think that a significant rise is more likely than a significant fall:
Key Advantage – Greater profits than the Long Straddle if the underlying security rises in price.
Key Disadvantage – Higher potential losses than the Long Straddle.
Key Advantage – Lower upfront costs than the Strap Straddle.
Key Disadvantage – Requires a greater price movement than the Strap Straddle to be profitable.
Key Advantage – No upfront costs required.
Key Disadvantages – May need a high trading level with your options broker.
Significant Move in Either Direction but Fall More Likely
If you believe the price of an underlying security is volatile think that a significant fall is more likely than a significant rise, then the following strategies are recommended:
Key Advantage – Bigger returns than the Long Straddle if the underlying security falls in price.
Key Disadvantage – Potential losses are higher than the Long Straddle.
Key Advantage – Upfront costs are lower than the Strip Straddle.
Key Disadvantage – Greater price movement required for a return compared to the Strip Straddle.
Key Advantage – No upfront costs required.
Key Disadvantage – Your broker may require you have a high trading level for this strategy.