Out of all the many option trading strategies available, how do you decide which one is the most profitable? When you read through investing forums, you will find so many different opinions that it is pretty hard to sort out the facts from all noise. Some writers take a rigid academic approach and analyse risk and profitability from that point of view, while other hands-on traders take a more flexible view. However, one fact remains – the main reason investors consider using options is because they want to achieve better returns than can be achieved through any ordinary stock trading strategy. With the wild gyrations of the stock market in the last few years, most investors have started to realise the folly of strategies such as ‘buy-and-hold’ or ‘dollar-cost-averaging’, and have been looking for more sustainable, reliably profitable trading tactics.
Is Options Trading Profitable?
Some forum contributors will have you believe that options trading is dangerous and highly risky. The truth is that for sheer magnitude of profit, options trading cannot be beaten. The potential for gain provided by the leverage employed in options is enormous. For relatively small amounts of money, you can control large blocks of stock, and can reap the profits from a move in the right direction. The flipside is that this same leverage also has the ability to wipe out your portfolio, if you are using a trading plan that does not address the risk issues of the particular strategy that you are using. So, the simple answer to the question is: yes, options trading can be profitable, but it can also be very risky in some circumstances.
Is there a consistently profitable options trading strategy?
Most new derivatives traders are introduced to the simple concepts of buying calls or puts. While these are easy to understand and all too easy to implement, the reality is that to be successful in this strategy, you must have exceptional technical analysis skills which allow you to predict both the magnitude and direction of any market moves. This strategy certainly offers the greatest potential for profit, but the reality is that this potential is not often achieved. It often takes several good trades to recover from one single large loss. So while the ‘buying calls and puts’ method has the largest potential for profit, it is quite hard to achieve that potential on a consistent basis.
Options Selling Strategies
Two academic studies (in 2006 and 2012) have shown that the most profitable options strategy on a consistent basis involve not buying options, but selling them. Selling puts, or for those with lower margin limits, selling credit spreads, was shown to be more profitable over the long term than any other approach. The absolute magnitude of the profit is less than that from other strategies, but the consistency of this profit makes it the best method available. The huge advantage is that the technical analysis requirements for selling puts or credit spreads is not nearly as stringent as that required for other strategies, and the risk profile is significantly lower at every level. In fact, with sturdy trading plan, which includes a well tested exit strategy, selling options can be more profitable and less risky that almost any stock trading strategy.