Options are a type of financial derivative where traders can potentially profit from market movements without having to own the underlying asset on which they speculate. Some other derivatives that traders may be familiar with include futures and CFDs (Contracts for Differences).
Options trading in Australia is a popular investment in Australia, with many locals finding opportunities in markets with this derivative product. With options contracts, traders can speculate on the price movements of a range of financial instruments, including but not limited to stocks, commodities, currencies, and indices.
The difference between a trading strategy and method
One very important thing that many rookie traders confuse is the concept of a trading strategy versus the concept of a trading method. They are related, but they do not describe the same thing and therefore are not interchangeable.
What is a trading strategy?
A trading strategy is a plan on how a trader plans to trade. In other words, it is an approach that guides a trader when they make decisions about buying and selling. A trading strategy outlines the criteria that the market must meet before a trader makes a move by either entering or exiting positions.
What is a trading method?
A trading method, on the other hand, refers to specific techniques and tools that traders use to implement their trading strategy. This means they may use certain chart analysis tools to identify patterns, ranges, and price points. They may also use fundamental analysis to evaluate the overall health of the economy and of a company, if they are looking to trade stock or index options.
In other words
To summarise, a trading strategy is a trader’s plan they put together that acts as a guide whilst they are on their trading journey, while a trading method is how a trader will execute their plans. This means that a trader who trade options may have multiple methods, but they will likely only have one overarching strategy they use to guide them and their decisions.
Components of an options contract
Before we dive into several options trading strategies and methods, it is vital to understand how options contracts work. Briefly, below are the components of a contract and what they mean. If you are interested in more detail, you can have an in-depth look online.
- Underlying asset
This is the asset on which you are speculating, and it can come from a wide range of markets. A concrete example would be Gold, EUR/USD, or Amazon shares.
- Contract type
Contract types include calls and puts, and they either give the contract holder the right to buy or to sell an underlying asset (respectively).
- Strike price
Some traders refer to the strike price as ‘exercise price’, and it is the predetermined price at which the contract holder agrees to buy or sell the underlying asset.
- Expiry date
The contract provider – the ‘writer’ – and the provider agree on an expiry date. This is when the contract holder must execute the contract. There is also the
- Exercise style
Contracts may follow the American or European exercise style, which means they may be executed any time before the expiry date (American style) or only on the expiry date itself (European style).
- Contract size
This is the amount of the underlying asset one option contract represents. Sometimes options contracts for certain instruments may be fixed. For example, one option contract for a certain stock may represent 100 shares. If you would like to speculate on 500 shares, you will need to purchase 5 contracts.
- Settlement style
Settlement style is how the underlying assets change hands between the contract provider and the contract buyer. Traders can settle contracts via cash or physical settlement. How you settle a contract may also depend on the exchange you trade on, and more importantly, the kind of instrument on which you speculate.
5 options trading strategies
Options trading strategies that are considerably popular in Australia are diverse and dynamic. This is because choosing a strategy depends on each person’s strengths, weaknesses, and preferences. Below are 5 options strategies that you may consider if you are looking to start trading:
Call options
One of the first types of options strategies you will encounter as a rookie trader is the call option. This strategy simply involves buying call options, which will give you the right – but not the obligation – to buy an underlying asset of your choosing at a predetermined price. The option contract will also expire at a predetermined date. Traders buy call options when they are for a bullish market.
Put options
The next type of options strategy you will encounter as a rookie trader is the put option. This strategy is the opposite of the call option, and traders buy a put option when they believe the asset that they are monitoring will depreciate, and their underlying value will fall. Put options gives you the right – but not the obligation – to sell an underlying asset of your choosing at a predetermined price. There is, as always, an expiry date for the contract.
Covered call writing
The third strategy that an option trader can employ is that of covered call writing. This involves selling call options on an underlying asset of your choosing, and it requires you to already own the asset. Many traders participate in covered call writing when they want to generate additional income by at the same time reducing the cost of owning the underlying asset.
Bull spread
A bull spread involves buying a call option at a lower strike price and selling a call option at a higher strike price. It can be a bit more complex than the previously mentioned strategies. Traders employ bull spreads when they believe the price of the underlying asset will appreciate, yet not dramatically so.
Bear spread
A bear spread involves buying a put option at a higher strike price and selling a put option at a lower strike price. In some ways, it is the ‘opposite’ of the bull spread. Traders employ bear spreads when they believe the price of the underlying asset will depreciate, yet not dramatically so.
4 options trading methods
On the flip side, below are 4 options trading methods that can help you execute your plans.
Technical Analysis
The first is technical analysis, which means looking at historical prices on charts and trying to find patterns and trends. Traders use technical indicators such as the Relative Strength Index (RSI), Moving Averages (MAs), Bollinger Bands, and more to make assessments.
Fundamental Analysis
Fundamental analysts look at the overall health of the economy and – if they are trading stock options – how companies are performing, as well as their prospects. They look at company earnings and revenue, national interest rates and GDP, as well as inflation numbers or international trade agreements if they want to speculate on commodities.
Volatility trading
Traders may also trade options based on the underlying asset’s volatility. This means looking at how often and how much the asset fluctuates over a specific period. This is a great way to estimate and make predictions about the price of an option, and in general traders use it to speculate on the future volatility direction, so they can make informed decisions on whether to buy or sell.
Options combinations
Finally, when you are ready to level up and try out more advanced trading methods, many traders favour combining options contracts. This means they will buy and sell calls and puts to create more complex strategies. A good example is the butterfly spread – an intermediate play that requires traders to buy and sell options contracts at several different strike prices.
The bottom line
Knowing the difference between a trading method and a trading strategy is essential when it comes to options trading. While one may only have one strategy they would like to execute at a time, there are different methods a trader can use to reach their goals. The most important thing when selecting a method is to make sure you understand how the financial markets work and how options trading works. Remember that all trading contains a level of risk, and you should never invest more than you can afford to lose, regardless of your speculations and your confidence in your trades.
