What's The Best Option Strategy?

You've probably heard many opinions as to which option strategies are the best: Covered calls are best because they reduce the risk but still allow for a profit. Naked puts are the best because you're getting paid to buy stock. Straddles are the best because they allow you to make money whether the market is going up or down.

If you've been trading options for a while, you no doubt have heard many others. But, when you hear comments such as these, all you're hearing are opinions of one trader's preference for a particular risk-reward profile. In order to really understand option trading, you need to understand that all option strategies come with their own sets of risks and rewards and the market will price them accordingly. Be careful of anyone telling you that a particular strategy is superior to another; they either do not fully understand options or are trying to sell you something.

Traders who tout superior option strategies focus on one aspect of the strategy -- either the risk or reward side -- and completely neglect the counterpart. They will make comments such as, "Calls are superior to stock because the return on investment is much higher." It's easy to make them consider the risk side by replying, "Sure, but lottery tickets are superior to calls because the return on investment is even higher!"

The best option strategy is the one that directly matches your set of risk and reward tolerances for a given outlook on the underlying. This is the level of option trading you want to achieve. Learn to dissect a position into its component parts and see if you are willing to accept the associated risks. Learn the various strategies and how to further tailor them to match your needs better. Don't spend your time looking for the superior option strategy. It doesn't exist.

Understanding risk and reward
To fully understand the relationships between risk and reward with options, we need to look at profit and loss diagrams.

If you compare the profit and loss diagrams of any two strategies, there will always be a part of the diagram where each strategy dominates.

For example, let's revisit the earlier comment. Are call options superior to stock? Assume one investor buys stock for $50 and another buys the $50 call for $5.

We can plot the profit and loss at expiration for each position, and we will get the following diagram