Introduction to Options #4 - Trading Strategies

Choosing a strategy

There is a different level of strategy when trading options compared with shares. Not only can you buy (take) or sell (write) calls and puts, but you can combine them or even hold them while trading the underlying asset.

As an option taker, you are looking to buy options as low as possible and profit (sell) on their rise. Conversely, as an option writer, you want to sell options at the highest possible price on the notion they will decline thereafter, or expire (profit).

In this article we covered concepts like time decay, asset price movements and volatility, including their impact on an option’s premium. These aspects can be used to formulate an option trading strategy, since the favourable impact of one variable alone is not enough to guarantee profits.

Time-based strategy

Options are governed by a finite life. To profit, you require the option premium reach your expected target before it expires. Therefore, predicting the direction of the move is insufficient.

If it is a call, you need to opt for a time horizon by choosing an option allowing sufficient time, but with a low premium. This explains why options with a longer expiry have a greater premium - there is more time to reach their target. For puts, you can receive a higher premium for an option with a longer expiry, but you are exposed to more likelihood of the price defying your forecast and incurring losses.

Time decay always favours the option writer (seller). All things being equal, option premiums will decline even if the share price is stable, since they are gradually moving towards expiry. Therefore, timing selection is everything. Options with longer dates may have a premium but they safeguard the taker from time decay should their projected target not be met in time.

Price-based strategy

It is movements in the price of the underlying asset which will have the largest influence on the option premium and your strategy. Some traders opt to use fundamental analysis to establish this, whereas others prefer technical analysis, or both.

Assets with large price movements are more desirable if deciding to buy (take) calls or puts. The option type you choose depends on which direction you expect the price to move. If the asset follows your expectations, the option’s intrinsic value and premium will both rise. This allows you to profit if you sell, or if you exercise the option, you acquire/dispose of the asset at a better price.

For assets with a more neutral price outlook, writing (selling) options is one strategy. This is because the option’s intrinsic value will be fairly stable. Time decay will impact the option’s premium and afford you profits when it expires, or make it cheaper (profitable) to buy back when you close your position.

Volatility-based strategy

Because of the time value associated with options, the sensitivity in the underlying asset - considered its volatility - has a prominent strategic role. Lower volatility reduces the likelihood of an asset reaching an exercise price that is distant from its market price. In turn, this reduces the option’s premium.

To gauge the underlying asset’s volatility, you could refer to its historical volatility over the same period of time as an option you might be considering, and project that forward. As past performance is not indicative of future performance, you may prefer your own volatility outlook based on expected events.

If volatility is set to increase, buying (taking) options facilitates those major price movements and increases the option’s time value, making it an appealing strategy.

Should you expect volatility to decrease, this reduces the likelihood of the option reaching a target plus lowers its time value, making it more favourable to sell (write) options.

Volatility can work against you even if the asset price moves in the direction you anticipate - for example, falling volatility while buying options, or rising volatility when selling options, are both detrimental.

Combining time, price and volatility

The outlook and price of an underlying asset plays the most prominent role in options strategy. However, time and volatility are of notable importance if you want to execute profitable trades more consistently.

Remember, the concepts are related. An asset’s price is associated with its volatility. Should you forecast large movements in an asset’s price, you buy options as it hints of an expectation for high or increasing volatility. Furthermore, volatility can help you decide option expiry timing. Volatile assets may even be better suited to short expiry terms because they afford a buyer the chance to make profits.

Combining time, price and volatility strategies

  • Time, asset pricing and volatility are all related and should be used for options trading strategies

  • Time decay favours the option writer as premiums decline even if the asset price is stable

  • Longer dated options safeguard the timing of the taker’s target from time decay

  • Asset pricing has the largest influence on option pricing, with large movements more favourable to buy options, and neutral movements suiting those selling options

  • Increasing volatility makes it lucrative to buy options, while decreasing volatility encourages the act of selling options

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