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How options can lower traders’ risk

Trading

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Options are a form of derivatives that traders can use to lower their risk when investing in the UK. An option is a contract between two parties that gives the buyer the entitlement, but not the duty, to buy or sell an asset at a specific price on or before a particular date. Over time, options have evolved from an exotic financial instrument to a well-established part of the investor’s toolkit. While options can be used in many different ways, they can also be used to reduce risk.Check the Saxo website to get started trading listed options. Read on to learn about some options trading strategies.

Options spreads

Spreads involve purchasing and selling different options (typically calls or puts) with different strike prices, expiration dates, and underlying assets. This strategy reduces risk by limiting potential losses and maximising potential gains. For example, a call spread might involve buying a call option at a higher strike price and simultaneously selling a call option at a lower strike price. If the underlying asset moves in the trader’s favour, they could profit from the higher strike call option while limiting losses from the lower strike call option.

Buying protective puts

Buying protective puts is another popular options strategy for limiting risk. When a trader buys a put option, they acquire the right to sell their underlying asset at the strike price on or before the expiration date. By buying protective puts, traders essentially put an insurance policy on their investments in case of unexpected market movements. It can limit potential losses if the underlying asset’s price falls significantly. Additionally, traders who buy protective puts can still profit from any gains in the asset’s price, while their downside is limited by their purchased put.

Writing covered calls

Writing covered calls is a popular option strategy for traders looking to reduce risk. When writing a covered call, the trader simultaneously sells an equivalent amount of call options and holds an equal number of shares in the underlying security. It reduces risk by allowing the trader to benefit from any uptrend in the underlying asset while at the same time protecting against a downtrend. The trader can also benefit from any short-term dips as they will be obliged to sell the underlying asset at a higher price than what it was initially purchased for, thus resulting in a profit.

Writing cash-secured puts

Writing cash-secured puts is another options strategy that can be used to lower risk. It involves writing a put option and having enough cash in the account to purchase the underlying asset if it is exercised. This strategy reduces risk by allowing the trader to benefit from any uptrend in the underlying asset while at the same time protecting against a downtrend. Additionally, writing cash-secured puts can result in additional income as traders may receive premiums for selling a put option.

Long-call butterflies

Long call butterflies involve purchasing two calls with a lower strike price and one with a higher strike price. This strategy reduces risk by limiting potential losses and maximising potential gains, depending on the underlying asset’s movement. For example, if the underlying asset moves in the trader’s favour, they could benefit from the higher strike call option while limiting losses from the lower strike call options.

Other advantages of using options

Options can be an effective tool for traders to limit risk and increase potential profits. There are additional advantages of using options that make them popular among traders. Below, we explore some of the main ones:

Flexibility

Options can provide traders with greater flexibility when it comes to trading. Traders can tailor an options strategy to match their particular objectives, making them highly suitable for market conditions.

Leverage

Options can also provide traders with a way to leverage their investments. As options require less capital than owning the underlying asset, they can amplify potential gains while limiting losses due to unexpected market movements.

Low cost

Options are a relatively low-cost way for traders to access the markets. By using options, traders can limit their capital requirements and open positions with less initial capital than if they were taking outright positions in the underlying asset.

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