Choosing An Appropriate Strategy

Introduction to option trading

Your goal is to make money when using options and to do that, you must make some trades.  The trades cannot be made randomly, and obviously, some thought must be given to which specific options to buy and/or sell.

That's where choosing a specific option strategy comes into play.  It's important to choose one or two option strategies that suit your style.  Some traders are aggressive and want to make a pile of money in a hurry. The only way to accomplish that goal is to take lots of risk.  I strongly discourage that approach, but if you insist, then risk will be your constant companion.

I prefer to adopt methods that have a higher probability of success and which entail much less risk.  When you adopt a strategy with those attributes, then potential profits are limited.  Less risk and less reward go together like:

Horse_Cart

As mentioned, you want to learn various strategies so you can find some that you not only understand, but which you can adopt and remain within your personal comfort zone.  There is nothing to be gained by trading strategies that make you too afraid of taking a loss.

When you adopt a strategy and make some trades, then you have an investment portfolio and are playing the game.  Note:  the purpose of the strategy is to allow you to play.  It's your point of entry.  And strategy selection is important.  But too many traders and investors never grasp this fact: the most important factor that will ultimately determine your success as a trader is your ability to manage risk.  It's not your choice of strategy.

Below I list my favorite methods – the only methods I use when trading my own money.  There are other strategies, and if they appeal to you, by all means, use them,  But learning how these specific strategies work is just the first step.  Managing risk should always be on your mind.  Please remember my #1 rule for traders/investors:  DON'T GO BROKE. That means refusing to take more risk than your experience and pocketbook dictate.

Favorite strategies – with brief descriptions and links to previous posts on these topics.

1) Covered call writing is a good method for rookies to learn how options work.  It's a bullish strategy and is not designed for bearish markets.

2) Collar.  Considered by many to be the most conservative strategy available.  Both gains and losses are limited.

3) Writing naked put, secured with cash.  Good strategy for learning about options, but it's equivalent to writing covered calls and should be used only by investors who prefer to accumulate stocks over time.

4) Credit spread.  Buy one option and sell another with the same expiration.  Both are puts or both are calls.  If you sell the more expensive option, it's a credit spread.  If you buy the more expensive option, it's a debit spread.

5) Iron condor.  A market neutral strategy in which you sell one call spread and one put spread.

6) Diagonal (or double diagonal) spread.  Similar to a credit spread (or iron condor), but the option(s) you buy expires later than the option you sell.

I'll be posting some discussion on each of these methods.  Or you can take a look at previous posts or The Rookie's Guide to Options.

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2 Responses to Choosing An Appropriate Strategy

  1. lynx 02/27/2009 at 10:27 AM #

    Mark,
    At some point, would you mind discussing “skews.” I see this concept mentioned from time to time, but have never read a reasonable explanation.
    Thanks in advance.

  2. Mark Wolfinger 02/27/2009 at 10:33 AM #

    I’ll see if I can write something that is understandable.
    My guess is that this is too mathematical, but I’ll look into it.