In Pursuit of the Best Options Trading Strategy
Posted on Mar 2 2012 at 11:44:39 AM in Finance & Investment
Author: Nelly Naneva, LL.M, MBF, Markets Weekly
You have probably heard many attempts to define the best strategy for options trading: Covered call options are the best, because of the reduced risk and still retained possibility of realizing profit. According to others, put options are the best because you are paid to buy the underlying asset. Straddle (one of the types of Hedges) is the best strategy, because it gives you the opportunity to win regardless of whether the market prices rally or fell.
If you have even a small experience in options trading, undoubtedly you have heard many other definitions. Each of them expresses the opinion of an individual investor for particular situation. Most importantly, what you need to know when trading options is that every strategy involves a certain risk and adequate profit, determined by market fluctuations. Do not trust someone who claims one strategy for options trading surpasses another. This means that he does not fully understand the nature of this derivative financial instrument or tries to sell you something. The investors, who praise too much one strategy, focus only on one side of risk or profit equation and largely ignore the other.
In view of the particular situation, the best options trading strategy directly combines risk hedging and potential profit.
Let us assume a Great Britain company expects to receive $ 420,000 after three months and must exchange the US Dollars to Pounds (USD/GBP). The current exchange rate is £ 1 = $ 1.50; the company anticipates revenue of £ 280,000 (420,000¸1.50), but the conversion rate of US Dollar to Pound Sterling may move up or down at maturity. The firm is exposed to an adverse movement of exchange rates during the three-month period, unless it decides to take some measures to hedge the currency risk.
• If the exchange rate at maturity of the obligation is £ 1 = $ 1.60, the revenue in GBP will be only £ 262,500, £ 17,500 fewer than initially expected and the financial result will be a loss as a result of exchange rate impact. If the company finds the risk acceptable, it may do nothing. In case it decides to hedge the potential currency risk, the firm may buy a put option to sell $ 420,000 against GBP at executive price of £ 1 = $ 1.50. This means the seller of the option will need to buy the dollars for £ 280,000.
• If the exchange rate in three months is £ 1 = $ 1.40, the revenue of the company in Pound Sterling will be £ 300,000 (420,000¸1.40), i.e. with £ 20,000 more than expected. This way the company profits as a result of foreign exchange rate movements. In such a situation, the option will expire worthless and the company will lose only the premium paid for the purchase of the option.
To understand accurately the relationship among risk, profit, and the options, you must analyze the components of each item and decide whether you are willing to accept the potential risk. Become familiar with the different strategies, learn how to use them to meet your needs, and do not lose your time in search of the best options trading strategy because it simply does not exist.
Look at the profit and loss charts in different situations, analyze the potential trading strategies and explore their gains and losses as reflected on charts. Obviously, there is no single strategy, which is the best.