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What's the Best Option Strategy?
by Bill Johnson, Options Strategist
21st Century Investors
You may have asked the same question and gathered many opinions. Have you heard that covered calls are best because they reduce the risk but still allow for a profit? Are naked puts best because you're getting paid to buy stock? Or are straddles best because they make money whether the market is going up or down?
Unfortunately, looking for the "best" strategy is the wrong approach to options trading. Strategies are tools. It is impossible to say which is best just as one cannot say that a hammer is better than a wrench. All strategies work, but it is up to the trader to decide which tool is right for the job. Each strategy carries a unique set of risks and rewards, which is why it is impossible to say that one is better than another.
The best way to understand this is through profit and loss diagrams, which are crucial for understanding options. If you compare any two strategies, there will always be a part of the diagram that shows each strategy's strength.
For example, let's compare call options to stock. Assume one investor buys stock for $50 and another buys a $50 call for $5. When we plot the profit and loss, at expiration, for each position, we get the following diagram:
 The trader who buys stock (broken line) will make $5 profit if the stock is trading for $55. The option trader (solid line), however, will only break even.
But if the stock falls below $45, the stock trader continues to incur dollar-for-dollar losses all the way down to a stock price of zero. The options trader only loses $5.
We can see that owning stock is more advantageous if the stock price is above $45 at expiration (the broken line is above the solid line) and is less desirable if the stock is below $45 (the broken line is below the solid line). Which strategy is best? It depends on your outlook and the risks you are willing to take.
An investor who believes the stock will stay above $45 is better off buying stock -- but accepts a potential $50 maximum loss. Conversely, a trader who believes the stock is heading higher but doesn't want the exposure to the downside is better off buying the call. The tradeoff is that the trader will effectively pay $55, not the current $50 price, for the stock.
Let's try another example. Is a long call better than a naked put? Some rationalize that the long call makes more money if the stock rises and loses less if it falls so it must be a better strategy. Assume a long $50 call (solid line) and short $50 put (broken) are each traded for $5.
 Look at the chart. We see that the long call does dominate for all stock prices above $60 and below $40. But if the stock stays between these prices, the naked put is clearly the better choice.
Pick any two strategies and look at their profit and loss diagrams. You will always see that each strategy will dominate given a particular range of stock prices.
Strategies come in all shapes and sizes and each alters the risk-reward relationship. Do not be afraid to alter a strategy to meet your taste -- that is what option trading is all about. If you accept somebody's strategy as the "best," you are, by default, also accepting his or her risk tolerances. If those tolerances are not in line with yours, you will eventually learn, the expensive way, that no strategy is superior to another.
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