Options are an excellent vehicle to leverage small amounts of capital to control large blocks of stocks. The potential gains and low cost prompt retail investors and hedge funds alike trade options. In order to minimize the significant risks of options, you can employ spread strategies, which effectively limit the maximum amount of money you can lose.
Naked options can be very dangerous. Naked calls or puts are written and sold without controlling the underlying stock. Naked options have an indefinite potential risk of loss, whereas purchased calls and puts limit the investor’s potential loss to the cost of the option.
However, you can invest in an options spread, which significantly minimizes your risk. Before you even engage in a spread, you can dictate your maximum risk tolerance for the trade. With trading spreads, you are exposed to several factors of risk: price changes in the underlying stock, exposure to market volatility, and time decay.
With an options spread strategy, you hedge your trade against the buying and selling sides of the market. Thus, regardless of market direction, you protect yourself from these changes. Purchasing an option spread means that you simultaneously buy and sell contracts within one trade. You will buy and sell the exact number of options on the same underlying stock, but the difference exists in the expiration date and/or the strike price.
The most basic, fundamental strategies for options spreads are:
Limitation of spreads
With every financial strategy, the risk-to-reward ratio applies. With options spreads, the risk-to-reward ratio is no different. With your risks mitigated, regardless if the stock or market rises, falls, or does nothing at all - your rewards are also limited in comparison to naked options.
Nonetheless, option spread strategies can be a very lucrative financial tool. In comparison to equities, option spreads can gain significantly more in returns. Potentially garnering 10% - 40% per trade in profits, option spreads offer the investor great returns at limited risk.