There Are Other Options Than Calls and Puts

Many new and some more experienced options traders think that strategies come down to one simple idea: Buy calls for a bullish outlook and buy puts for a bearish outlook. Now don’t get me wrong, I still buy calls and puts and use them successfully for my options trading but there are alternatives too. Long calls and long puts are without a doubt the most basic options positions, but they may not always be the most suitable. 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 multi-faceted that even adding another short position to a long position can lower a trader's risk. 

An Example

Take this, for example: An option trader believes that XYZ stock will rally over the next month or so. The stock is currently trading at $39.50. He could buy the February 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.

An Alternative

Instead of just buying a call, a bull call spread could be implemented by selling a higher strike call against the long call. A February 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 lowers the positions exposure to implied volatility changes because the spreads 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.

In addition, options are a decaying asset measured by theta. Theta measures the rate of decline of an option due to the passing of time. A long call or put will have a higher theta than a spread because an option is bought and sold. This offsets some and in some cases depending how the spread is initiated, all of the theta decay.
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.

The Greeks

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 too.

Final Thoughts

As most of us know, being successful at trading takes more than just applying the correct strategy based on the outlook. But let’s face it: If just buying call and puts was the answer to successful options trading, there would probably be more successful options traders out there. Understanding the "greeks" and various spreads can greatly improve the odds for success.

John Kmiecik, Market Taker Mentoring

Trader Education