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Stock Market

Best Options Trading Strategies


Neither CashBlog nor its writers are financial advisors.  Nothing published on our website is financial advice.  Our articles are strictly educational.


Options trading can be exciting. An option is an investment vehicle that gives you leverage, which means they have the potential to generate explosive returns.

That leverage also means that options carry risk. You can’t expect to buy any old option and ride it to the moon. That’s why you might benefit financially by only using the most profitable strategies.

That’s where we come in. We’ve done our own proprietary research to put together this guide of the best options trading strategies.

We’re going to focus on strategies where bonafide statistical research evidences their historical profitability.

If any of the strategies we feature in this guide appeal to you, but you still want the guidance of an options expert, then you can check out our list of the best options alert services.  

It’s important to note that we are not financial advisors, so you should not consider anything here to be financial advice. The sole purpose of this article is to educate readers about potentially profitable options trading strategies.

Before we get into strategies, let’s first make sure you understand the basics about buying and selling options.

Buying and Selling Options

If you’re not familiar with the basics of options, you can check out our guide on options trading for beginners.

Understanding the mechanics of buying and selling options is essential because every options trading strategy involves some variation of buying and selling options.

Buying Options

When you buy an option, sometimes referred to as a stock option, cash goes out of your account in exchange for the option.

If you buy a call option and the underlying stock increases in price noticeably, the option will typically go up in price. Buying call options is similar to buying stocks because you’re buying an asset, and you usually benefit if the stock price increases.

If you buy a put option, you typically benefit if the stock price decreases.  

If you buy an option, it’s considered a “long” position.  

Selling Options

It’s also possible to sell options before you even own them. When you sell an option, cash comes into your account in exchange for the option. It is referred to as collecting option premium.

You maximize profit from selling an option if, at expiration, the underlying stock price is out of the money.  

That means that if you sell a call option, you maximize your profit if the stock price is below the strike price at the option’s expiration.

And conversely, if you sell a put option, you maximize your profit if, at the option’s expiration, the stock price is above the strike price.

So, for example, if you sell an Apple call option with a $100 strike price for $3.00, and at the expiration of the option, the price of Apple stock is $100 or less, then you walk away with a full profit (in this example, $3.00 per contract).  

Using that same example, if the price of Apple stock at expiration is $103, you break even on your options trade since the value of the option you sold would be $3. That’s the same as you sold it for, making it a wash.

And as you can imagine, if the price of Apple stock at expiration is above $103, say at $110, then you take a loss on your option trade. The value of the option at expiration, in this case, would be $10, and since you sold it for $3, to begin with, it means you have to pay $10 to buy it back, a loss of $7 per contract.

If you sell an option, it’s considered a “short” position.

Now that you know the basics of buying and selling options, we can go into detail about the best options trading strategies we know.

Profitable Options Trading Strategies According to Research

Option prices often move in correlation with the underlying stock they represent. For example, if Apple stock increases noticeably, the value of most Apple call options will likely go up.

With that in mind, the key to finding a profitable options trading strategy can depend primarily on finding a good stock trading strategy.  

So let’s start with that. We did back tests on many different stock trading strategies. Back tests are when you take a particular trading strategy and look back at history to see how it may have performed historically on any given stock.

There is one stock trading strategy that performed well relative to others. It’s referred to as a pullback. The idea is that if a stock’s price is driving upward and then “pulls back,” that would be a basis for entering a trade.

Back tests suggest that historically, the odds favor the stock price going up from that point.

With that knowledge in hand, the question is then which options trading strategy is best for capitalizing on it. There is no perfect answer since each strategy has tradeoffs.  

So we looked at all the possible options trading strategies and came up with this list of the ones we like best, along with their pros and cons.

Buying Simple Call Options

Buying simple call options is like hitting the “Easy” button. If you expect the stock price to be going up, then buying a simple call option is a simple and effective way to benefit from that.

But how do you choose which call option to buy? Our pro tip is that you might improve your profitability odds by minimizing the extrinsic value of the option you buy.

Option values have two components: intrinsic value and extrinsic value.  

You can calculate the intrinsic value by taking the current stock price and subtracting the option’s strike price. For example, if Apple stock is selling for $105 and the strike price of the option is $100, then the option’s intrinsic value is $5.

The extrinsic value is the difference between the option’s actual price and the intrinsic value. It represents things like time until expiration and the price volatility of the underlying stock.  

Using the same example above, if the option sells for $7, the extrinsic value would be $2 since the intrinsic value is $5.

We like call options where the extrinsic value is close to zero.

The reason is that we’re looking for an options vehicle that moves in near lockstep with the underlying stock. Extrinsic value is like the premium you pay to control the option; we want to minimize that.

Options with low extrinsic value typically have these characteristics:

Close to Expiration

In the world of options, time is money. The further from expiration, the higher the extrinsic value is likely to be.

Deep In The Money

Extrinsic value is typically highest on options that are at the money. You usually need to go deep in the money to get options whose valuations will move in lockstep with the underlying stock. That means choosing a strike price that is a fair distance below the current stock price.

There are pros and cons to using simple call options as the vehicle for this trading strategy:

Pros

  • Your trade performance can closely match that of the stock, except amplified due to the leverage options offer.
  • Back tests suggest some periods may have offered significant returns.
  • There is no profit ceiling. The sky’s the limit on your profit potential from a simple call option.

Cons

  • Despite overall profitability in back tests, the win percentage was just above 50%. It is lower than many other options trading strategies and might be harder to live with psychologically.
  • Despite long-term success in back tests, there are periods of drawdown that could be substantial.
  • Buying deep-in-the-money simple options requires more capital than buying call spreads or other simple options.

Buying Debit Call Spreads

A call spread (specifically a debit call spread) is a type of options strategy involving buying one call option and then selling another at a higher strike price for the same expiration.

For example, you could buy an Apple $100 strike option with a December 12 expiration and sell an Apple $105 strike option with the same expiration. Holding both those positions at the same time would constitute a call spread.

It may seem counterintuitive to buy and sell an option simultaneously, but since they are at different strike prices, it’s not a washout.

Typically, the call option with the lower strike price costs more than the one with the higher strike price. So the net effect is that money is coming out of your pocket to buy the spread. That means that as the stock price goes up, the value of your option spread will also typically go up.

Call option debit spreads like this are different from simple call options. Here’s how:

Lower Cost

When you buy a call spread, you’re incorporating the extra component of selling an option. That means you’re collecting some money that offsets the cost of the call option you’re buying.

The net result is an options vehicle that costs less than just buying just the simple call option itself.

Profit Ceiling

When you buy a simple call option, there is no limit to the profit you can earn. But with a debit call spread, there is indeed a limit. And that limit is dictated by the strike price of the short call option.

We’ll demonstrate it by using an example. Let’s say you have an Apple call spread. You buy a call option with a strike price of $100 for $3.00, and you sell a call option with a strike price of $105 for $1.00. The net price you paid for the option spread is $2.00.

Let’s explore how the value of your option position looks at expiration based on where the underlying stock price ends up:

Stock Price at expiration: $100

Value of long option: $0

Value of short option: $0

Net value of option vehicle: $0

Final profit: -$2

Stock Price at expiration: $102

Value of long option: $2

Value of short option: $0

Net value of option vehicle: $2

Final profit: $0

Stock Price at expiration: $105

Value of long option: $5

Value of short option: $0

Net value of option vehicle: $5

Final profit: $3

Stock Price at expiration: $110

Value of long option: $10

Value of short option: -$5

Net value of option vehicle: $5

Final profit: $3

Notice that at expiration, if the stock price is $105 or higher (the strike price of the short position), the final profit remains the same. That demonstrates the profit ceiling that is characteristic of debit call spreads.

Going back to the research that shows when stocks might tend to go up in value, you can see how a call spread is a type of options trading strategy that could offer a way to profit. The reason is that the value of the option spread often goes up when the underlying stock price goes up.

We like setting up a spread where the long option is at the money, and the short option is out of the money.

Here are some pros and cons of using the option spread strategy:

Pros

  • It is a more affordable options strategy since you collect option premiums from the short position.
  • Sometimes profits can be larger as a percentage of the initial investment than simple call options since their cost basis is lower.
  • Back tests suggest some periods may have offered significant returns.

Cons

  • Despite overall profitability in back tests, this strategy had a win percentage lower than 50%. That means the wins can be significant when they come, but they are less frequent.
  • Despite long-term success in back tests, there are periods of drawdown that could be substantial.
  • There is a ceiling on the profit of any given trade.

Other Popular Options Trading Strategies

Okay, now you know which options strategies are supported statistically by the research we did. Now let’s talk about other popular strategies.  

We can’t personally vouch for the long-term profitability of any of these, but that certainly doesn’t mean they won’t work well for you.

Selling Credit Spreads

Compared to a debit spread, described above, a credit spread is where the short option leg has more value than the log leg. It is, therefore, a net “short” position.

Many people who sell credit spreads are selling them out of the money. By doing this, they are often aiming for consistent returns.

So whereas debit spreads can sometimes lead to more explosive rewards, credit spreads typically offer a more muted return but much higher consistency.  

Some credit spread strategies can generate win rates above 90%. That doesn’t necessarily mean they’re profitable over the long haul every time, but they sure might be easier to live with psychologically since they can have higher win rates.

Exotic Options Strategies

There are all sorts of other options strategies out there. There are butterflies, broken-wing butterflies, iron condors, strangles, straddles, and calendar spreads.

We don’t know who came up with all these names, but they sure sound fun. Every combination and permutation of calls and puts likely has a moniker.

From our research, we have yet to identify long-term profit opportunities with these exotic types of options strategies. There might be people out there making plenty of money from them, but since we can’t personally vouch for them, we aren’t going to teach them to you here.

Sign Up With an Options Alert Service

If you want to try to make money from trading options without learning all the strategies, then you’re like many other people.  

It can take a lot of time to become effective at trading options. Many people either don’t have the time or aren’t interested in dedicating that much time to mastering the discipline.

Enter options alert services. These are services where stock market professionals do all the research for you and alert you when potential option trade opportunities arise. They pick the options, and you decide whether you want to follow along.

We’ve put together a list of the best options alert services. Our guide allows you to quickly compare them all side by side to decide who you like best.

Conclusion

To our minds, the best options trading strategies are those supported by historical data and statistical analysis.  

We have data that suggests stock prices might have historically favorable odds of going up in price after particular types of pullbacks.

Therefore, the options strategies we like the most are simple call options, and debit call spreads when those pullback opportunities arise. Those two options vehicles typically benefit when the underlying stock increases in price.

 

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James Rochester

James Rochester has decades of stock market experience. He's run his own stock market intelligence firm and is an active trader of stocks, options, and futures.

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The content on Cashblog.com is for informational and educational purposes only. It is not financial advice and we are not certified financial advisors. Cashblog.com strives to keep its information accurate and up to date, but it may differ from actual numbers. We may have financial relationships with companies listed on our site. We may receive compensation for the placement of sponsored products or services. We work hard to write authentic and accurate articles.