How to use options to improve your stock trading results
Options can be a powerful tool in any stock trader’s portfolio. They provide the opportunity to hedge against losses, increase returns and generate income while managing risk levels. In this article, we will discuss how you can use options to improve your stock trading results by outlining distinct strategies traders should consider utilising when using options as part of their investment approach. You can try these strategies with Saxo Bank.
Protecting your portfolio
Options are commonly utilised as hedging instruments which help to protect trading portfolios against downside exposures. By investing in put options on the underlying stocks or indexes you own, you can hedge against potential losses if market conditions suddenly turn sour. It helps to reduce your overall portfolio volatility and mitigate some of the risks associated with trading stocks.
Traders can also use options to generate income by selling call options. By selling calls on stocks you already own in your portfolio, you can capture premiums and generate additional returns over and above that, which you may achieve by simply holding the stock.
Traders can employ options to speculate on the price movement of a given stock or index without actually buying any shares. They can do this by purchasing call options if they expect the underlying security to rise in value or put options if they expect it to fall. By using options, traders can limit their risk exposure while still having the potential for significant gains should their forecast prove accurate.
Taking advantage of implied volatility
Implied volatility (IV) is the estimated future variability in an underlying security’s price and is used to compute option prices. Traders can take advantage of IV by buying options when IV is low, as these will typically cost less than when IV is high. It can be beneficial when one expects a significant move in an underlying stock or index but wishes to limit risk exposure by using options.
Options allow traders to employ leverage, which means they can control more shares for less capital outlay than if they were purchasing the stocks outright. It allows traders to amplify returns should their predictions prove accurate and make profits on smaller market movements, which would be impossible if trading the stock itself.
Traders can use options to adjust existing positions to limit risk or generate additional income by closing out a portion of an existing position and replacing it with a new options contract with the same net delta (i.e. the net directional exposure of the combined position remains unchanged). It allows traders to better manage their risk exposure while maintaining upside potential for profits should market conditions move in their favour.
Combining options and stocks
Traders can combine options with stocks to create synthetic positions, allowing traders to benefit from stock and option-based strategies. For example, a trader may wish to hold a long position in a given underlying security but wishes to limit risk exposure should market conditions suddenly turn sour. In such cases, they could purchase the underlying security while simultaneously selling put options against it, creating a synthetic long position with lower risk than simply buying the stock itself.
Spreads are another strategy traders can use when trading options. It involves simultaneously buying and selling two or more different options contracts on the same underlying security to capture profits from price discrepancies between them. Traders should do this when they expect the underlying security to move in a specific direction but wishes to limit potential losses should their forecast prove incorrect.
Options traders may also utilise straddles to capture profits when they expect a significant move in underlying security but are still determining its direction. A straddle involves simultaneously buying both a call option and a put option on the same stock with identical strike prices, allowing traders to benefit from upward or downward moves in the share price.
Options can also be used as a means of managing risk. By selling puts and calls on stocks you already own, you can effectively create a “collar” around your position, limiting losses should market conditions suddenly turn sour. It can be an effective way of protecting gains without having to completely close out a position.