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When it comes down to it, the best strategy for Ms. Robinson may not be the best strategy for Mr. Jeremy, as each has their own set of goals, personality, risk tolerances, time available to watch trades, and capital characteristics. To make a blanket statement that applied to everyone would not only be unhelpful, but could be considered irresponsible.

The best way to determine which strategy is best for any trader requires a thorough understanding of the different strategies' strengths, weaknesses, advantages and limitations and determine that is best suited for their own needs. Once you have this information digested, you can narrow down the list to one or two strategies that you think will most likely be suitable for your situation. Most will not have a good understanding of which of the narrowed down strategies is best until they test drive them a little to see which best conforms to their needs.

The following will help give a more objective and clinical view of the strategies that most beginning traders have to choose from. This also applies to those who are considered intermediate but are having difficulties and wish to go back to the basics and regroup. Keep in mind that when discussing the greeks portion below, I am focusing on the major greeks, though often ancillary greeks will also be involved.

Long Call/Put Spread

Max Risk: The cost of the spread.
Max Reward: Distance between the strike bought and strike sold minus the cost of the spread.
Best Uses: Good strategy for a strong trending market. Dangerous/risky under other scenarios even though the risk is limited.
Greeks: Money is made by delta/ market direction.
Time Frame: Month-to-month/short term.
Perspective: These spreads are excellent for trending markets and are easy to understand for new traders.

Collars

Max Risk: The difference between the price of the stock purchased and the put strike, plus/minus the credit from the call sale.
Max Reward: Call strike minus stock price, plus/minus the credit/debit of the options portion of he trade.

Best Uses: This is an excellent strategy for those wishing to trade stock conservatively. Thought the upside may appear limited this can be adjusted all the time you are protecting the downside.

Greeks: Delta and Ratcheting (not a greek)

Time Frame: Long term - Losses can occur from time to time over a period of a quarter or two, but over the long run this strategy usually beats the overall market.

Perspective: This can be one of the best long term strategies for new traders provided they understand that this is designed to beat the market over the long term. At times the market as a whole may be going up and the collar will lose, or vice versa. The key to this strategy is patience and waiting for the times when the stock glides up for a few months,or blows through the put strike by a few strikes. Sitting at the low end of the collar will cause losses, but this only happens a couple times a year if you are lucky.

Short Call/Put Spreads

Max Risk: The difference between the strike prices minus the premiums received from the sale.

Max Reward: The premium received from the sale.

Best Uses: Can be used to make money if the market moves in the correct direction, sits still or even goes a little against you.

Greeks: Delta and to a lesser extent theta.

Time Frame: Month-to-month/short term.

Perspective: These are decent trades where they spread sold often goes out worthless, but then once in a while go dramatically against you as the risk v. reward ratios are often inverted, but you are banking on probabilities of the spread expiring worthless. In a trending market they can be good trades, but stomach clenchers for new traders and certainly not the most assured winner.

Long Time Spreads (a.k.a Horizontals)

Max Risk: Cost of the spread.

Max Reward: Different for each stock and volatility.

Best Uses: Can be used for either stable markets (ATM spreads) or directional trades (OTM spreads).

Greeks: Theta (time decay) is primary unless you are doing a directional an then delta plays a part.

Time Frame: Though I have heard of individuals doing these far out in time, I do not recommend this as it defeats the purpose, which is to capture theta. Long term time spreads will also then bring other variables into the mix not intended such as Vega.

Perspective: These are excellent trades for novices. They are slow paced, easy to understand, low risk, but only moderate return. They do not require as much attention as a vertical spread to maintain but they do have to be watched a little more than a collar.

Butterflies and Broken-Winged-Butterflies

Max Risk: The max risk for a butterfly is the cost of the spread. The maximum risk of a BWB is designed specifically for each trade.

Max Reward: For butterfly spreads the maximum reward is the distance between the strikes minus what the spread costs. The BWB is slightly different and is usually maxed out when the stock closes at the center strike. The BWB usually has a maximum profit in the distance between the closer to ATM strike purchased and the center strike that was sold, minus/plus any debit/credit.

Best Uses: These are good to ideal strategies for the novice trader in that they have a high risk-reward ratio, low cost of entry, low maintenance, and not too terribly complicated to understand.

Greeks: The collapse of the normal distribution curve is how these trades make their money as they all start out relatively delta, gamma, theta and vega neutral.

Perspective: Though more complicated to understand than a call spread or time spread, the effort to learn these trades is usually well worth it, and also acts as a good conduit to learning advanced strategies. Traditional butterflies are easier to understand and place correctly than the BWB the downside is that they cost more and take longer to become profitable than the BWB. In addition, I often see BWBs become slightly profitable even if the stock stays flat or moves slightly in the wrong direction as desired, but that bonus comes at the expense of more difficulty in understanding. I prefer the BWB and there is reason why so many very successful floor traders relied on them as their bread-and-butter technique.

Long Straddles/Strangles

Max Risk: The premium paid for the spread.

Max Reward: Great to the downside and unlimited to the upside.

Best Uses: Ideal for very low range of the stock's option volatility where an increase in movement is likely to occur (such as earnings coming out or record high prices).

Greeks: Gamma in your favor and theta working against you.

Time Frame: Longer term straddles do nothing for gamma, but rather are vega plays. Shorter term positions are ideal for gamma profits but theta will eat away at profits.

Perspective: These are high risk-high reward mentality trades suited for the more aggressive traders. An advanced strategy known as gamma scalping can be employed to help reduce the theta risk, but not recommended for those who do not understand the dynamics of the strategy.

Conclusion

In order to give yourself the best chance of success when starting out a good understanding of the basic option strategies is needed so one can select the one that best suits their personality, time constraints, goals and objectives. To box yourself in and make a claim that one strategy is the must learn for new traders would be irresponsible and naive. When I first started trading I too asked the same question(s) about strategy selection, but only after learning more did I realize why I never got a good answer.

If you find yourself in a quandary as to what strategy to focus on when first trading options, it is my hope that the above material may help you narrow your choices and time down. Also, keep in mind what every self-help mentor (which is an oxymoron as someone else is helping you) advocates. Find someone who has trekked the path you want to navigate and use them as a guide. Get a mentor who you trust and is a proven success, and do what it takes to have him/her assist you. This is the biggest short cut to learning how to trade and one of the reasons why you never want to skimp on your education. A good mentor, no matter the cost, can save time and money over the long run.


Scott Kramer
Staff Writer and Trading Strategist
Optionetics.com ~ Your Options Education Site

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