Consider a Spread

If options traders only buy and sell options outright, they are really ignoring the benefits of using options to create more flexible positions and hedge risks. Options are so multifaceted that even adding another short position to a long position can lower a trader's risk. As always with options, there are tradeoffs too.

Take this example: An option trader believes XYZ stock will rally over the next month or so. The stock is currently trading at $39.50. He could buy the April 40 call for 3.50. But what if XYZ traded sideways or dropped in price over the next several weeks or the implied volatility of the option fell? The value or premium of the option would probably be lowered.

Instead of just buying a call, the trader could implement a bull call spread by selling a higher strike call against the long call. An April 45 call can be sold for 1.75, which not only lowers the cost and maximum risk on the trade to 1.75, it also decreases the position’s exposure to implied volatility changes because the spread’s vega is lower than just the long call by itself. Vega measures the sensitivity of an option's price to a change in implied volatility.
This spread lowers the risk, but it also limits potential gains because of the short option. Unlike a long call, whose maximum profit is unlimited no matter how much the stock rises past the short strike, maximum profit is capped.

Also, options traders should have a full understanding and be able to compare vega (option's price change given a change in volatility), theta (option's price change given a change in time decay) and delta (option's price change given a change in the underlying) when buying calls and puts outright. Being aware of these "greeks" will help eliminate buying options with inflated premiums or choosing options with too little time left to expiration and other problems.

There are a lot of components that go into becoming a successful option trader. If buying call and puts was the answer to successful options trading, there would probably be more successful options traders out there.

John Kmiecik, Market Taker Mentoring

Trader Education