During the past few weeks, we’ve been looking at how investors can harness trading techniques to boost their longer-term performance in the near to intermediate term.
I’ve received several notes from readers, thanking me for this series. And I’ve lost count of how many people have asked me, "Which is the best options strategy?"
The thing is, using options is a lot easier than trying to pick a favorite strategy.
In fact, this very question can start an argument between experienced and even professional traders!
- One trader might argue that selling covered calls against your long stock positions is the best strategy because it reduces your risk but still allows for a profit.
- Another might argue that "selling to open" put options is a better strategy because you can essentially get paid to buy stock.
- Sometimes, when volatility is very high, and the market is swinging up and down, "straddling" an equity at or between strike prices can allow you to make money on a really big moves in either direction.
In the straddle strategy, you would buy a call option (as an upside bet) and buy a put option (as a downside bet) at the same strike price, in the same expiration month. Generally you look to make more on the winning "leg" of the trade than you would lose on the other side of it.
When you hear comments like these, all you’re hearing is one trader’s preference for a particular risk-reward profile.
To succeed in option trading, you must understand that all option strategies come with their own set of risks and rewards, and that the market will price them accordingly.
It’s OK for an investor, or even a professional trader, to have a favorite strategy or be more comfortable with one strategy than another.
Be careful when anyone tells you that a particular strategy is always superior to another. They either don’t understand options or want to sell you something.
Traders who tout superior option strategies focus on one aspect of the strategy — either risk or reward — and completely neglect the counterpart.
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They make comments such as, "Buying calls is superior to owning stock because the return on investment is much higher."
It’s easy to make them consider the risk side. Just reply, "Sure, but lottery tickets are superior to calls because the return on investment is even higher!"
The best option strategy is the one that directly matches your set of risk and reward tolerances on any given trade. You should learn to dissect a position into its component parts and see if you are willing to accept the associated risks.
Don’t spend your time looking for the superior option strategy. It doesn’t exist.
Understanding Risk and Reward
To understand the relationship between risk and reward with options, we need to look at profit and loss diagrams.
If you compare the profit and loss diagrams of any two strategies, there will always be a part of the diagram where each strategy dominates.
For example, let’s revisit the earlier comment. Are call options superior to stock? Assume one investor buys stock for $50 and another buys the $50 call for $5.
We can plot the profit and loss at expiration for each position, and we will get the following diagram:
For example, a trader who buys stock at $50 will make $5 profit if the stock is trading for $55. If you look at the above chart, you can see that the profit and loss line (red) crosses the $5 profit line for a stock price of $55. Likewise, if the stock is trading for $45, the trader will incur a $5 loss.
The diagram also shows that the long $50 call buyer (blue) will lose $5 if the stock is $50 or below and will break even if the stock is $55. At a stock price of $60, the $50 call buyer will make $5 profit (the call option will be worth $10 but the trader paid $5)
Notice the profit and loss diagram for stock (red). It is superior to (lies above) the profit and loss line for the long call (blue) for all stock prices above $45. This is because the call option buyer is effectively paying $55 for the stock ($50 strike for a cost of $5).
- If the stock stays above $45, the long stock position is the better strategy (the red line is above the blue line).
- If the stock price falls below $45, the call option becomes the better strategy (the blue line is above the red line), as the long call can’t lose more than the $5 premium. Niether strategy is always "better" than the other. The answer depends on your outlook of the stock and the amount of risk you are willing to accept.
An investor who believes the stock will stay above $50 is better off buying stock. Of course, there is a trade-off of accepting a potential $50 maximum loss.
Conversely, an investor who believes the stock is heading higher but doesn’t want the exposure to the downside is better off buying the call.
The trade-off is that he will pay $55 for the stock instead of $50, but in return, can’t lose more than the $5 option premium.
- When traders grow concerned with downside risk, they will bid up the price of the call.
- If they feel the price of the call is too high relative to the stock, they will sell the call (either naked or covered).
These actions will price the call fairly with respect to investors’ opinions, and neither strategy will be superior to the other.
What about naked puts? This strategy must be better than buying stock outright since you are actually paid to buy the stock, right?
Let’s look at the profit and loss diagram between stock purchased for $50 and a naked $50 put sold for $5:
Again, in some areas of the chart, the long stock position dominates, and not in others. The long stock position is better when stock prices are above $55. With the stock above $55, the long stock investor will realize unlimited profits, while the naked put writer profits only by the premium received from the sale of the put.
However, if the stock goes below $55, the naked put is the better strategy. Below a $50 stock price, both investors lose but the naked put seller is ahead because he received the cash premium.
Maybe a long call is better than a naked put? Some may reason that the long call position makes more money if the stock rises and loses less if it falls, and so is a better strategy. Let’s assume a long $50 call and short $50 put each trade at $5:
Looking at the above chart, we see that the long call position (red) does dominate for all stock prices above $60 and below $40. If the stock stays between these prices, the naked put is clearly the better choice. Your outlook on the stock and tolerance for risk will determine which strategy is best for you.
Pick any two strategies and look at their profit and loss diagrams. You will always see that each strategy dominates over a given range of stock prices. Try switching one position from long to short. Try changing strike prices. You will soon see that it does not matter; no single strategy can dominate another at all price levels.
Option strategies come in all shapes and sizes. Now you should have a better understanding why. Different strategies alter the risk-reward relationships and it is up to you, the trader, to decide which is best.
Don’t be afraid to alter a strategy to meet your taste — that is what option trading is all about. If you accept somebody’s strategy as the "best," you are, by default, accepting his or her risk tolerances too.
If those tolerances are different from yours, you will eventually learn (the expensive way) that no strategy is always superior to another.
P.S. To learn about my favorite ways to trade options to boost your investing returns, click on one of these links: