Investors frequently enter the options market without familiarity with the various options methods. Multiple options trading strategies exist that do an excellent job of minimizing loss while maximizing gain. Investors can gain the benefits of stock options’ versatility and leverage with a bit of practice.
Every investor should be familiar with these ten options trading strategies.
List of Contents
Strategy 1: Covered Call
To profit on calls, another options trading strategy is to use the “naked call” options strategy. A simple covered call or buy-write arrangement can likewise be created. Being long a company’s stock is risky, but hedging your bets with options is a popular approach because it creates revenue and mitigates some of that risk. The catch is that you must be willing to sell your shares at a predetermined price, known as the short strike price. The method entails buying the stock and simultaneously selling a call option on the same shares (writing or selling a call option).
To illustrate, let’s say that a stock investor is trading 100 shares per call option. The investor would acquire 100 shares of stock and concurrently sell one call option against it. This method is known as a covered call since the long stock position protects the investor from the short call should the stock’s price swiftly rise.
This technique may be appropriate when holding a short-term investment in stock and maintaining a neutral outlook. Potential motivations for doing so include profiting from selling the call premium and hedging against a drop in the value of the underlying stock.
In the above P&L chart, the negative P&L from the call is canceled out by the positive P&L from the long share position as the stock price rises. With the premium obtained from selling the call, the investor can effectively sell shares at a price more significant than the strike price. It is the lowest price at which the stock can be bought or sold. The profit and loss chart for a covered call trade is similar to that for a short naked put trade.
Strategy 2: Married Put
An investor using the married put options trading strategies would first acquire the underlying asset, e.g. shares of stock, and then buy put options for the same number of shares. A put option gives the holder the right to sell 100 shares of stock at the strike price.
If a trader is concerned about losing money on a stock they own, this method could be helpful. This tactic works like an insurance policy, setting a floor for the stock’s price if it drops significantly. Because of this, a protective put is yet another name for it.
A hypothetical investor purchases 100 shares of stock and a single put option. As a result of this strategy’s ability to mitigate losses caused by a decline in the stock price, it may be appealing to this investor. In addition, the investor would share the stock’s profits to the full extent allowed by law. The sole risk associated with this method is that the investor will lose the premium paid for the put option if the stock’s value does not decline.
The above profit and loss statement represents a long stock position with a dashed line. If the stock price drops, combining a long put and long stock position will minimize the loss. Despite this, the stock still shares in any gains above the put’s premium. The profit and loss chart for a married put is very similar to the chart for a long call.
Strategy 3: Bull Call Spread
In a bull call spread, the investor purchases call at one strike price and sell calls at a higher strike price. The two call options will be identical regarding their expired date and underlying asset.
Investors who are positive on the underlying asset and anticipate a gradual increase in the asset’s price typically employ this type of vertical spread approach. Investors can reduce their net premium outlay compared to purchasing a naked call option by capping their maximum gain on the trade using this approach.
Profit and loss charts like the above indicate this is a profitable course of action. Successful execution of these options trading strategies requires an increase in the stock price so the trader can pocket a profit. A bull call spread might minimize your premium costs while limiting your potential profit. When buying an outright call can be costly, you can reduce the additional cost by selling calls with a higher strike price. A bull call spread is built in the following manner.
Strategy 4: Bear Put Spread
Vertical spreads can also be implemented using the bear-put spread approach. For this method, the investor will buy a certain number of put options at a specific strike price and then sell the same number of puts at a lower strike price. Both options were purchased with the same underlying asset, and both will expire on the same date. When a trader has a pessimistic outlook on the underlying asset and believes its price will fall, they may employ these options trading strategies. It’s a risky method with a small potential payoff.
Looking at the profit and loss chart up top, you can tell this is a bearish strategy. The stock price needs to drop for this method to be effective. Using a bear put spread restricts your potential profit but lowers your premium outlay. If the premium on selling an outright put is too big, you can reduce the cost by offsetting it by selling lower strike puts. The bear put spread built in this way.
Strategy 5: Protective Collar
When you own the underlying asset, you can use a protective collar approach by acquiring an out-of-the-money (OTM) put option and writing a similar call option (with the same expiration). Investors sometimes employ this options trading strategy after seeing significant gains from holding a stock position for an extended period. Because the long put helps lock in the potential sale price, investors are protected from a drop in value. Nonetheless, the cost could be having to sell shares at a more excellent price than they’d like to and missing out on potential gains.
Assume an investor buys 100 shares of IBM on January 1 at $100 per share and immediately goes “long.” The investor can create a protective collar by selling one IBM March 105 call and simultaneously purchasing one IBM March 95 put. The investor will be protected from a drop in price below $95 until the option’s expiration date. However, if IBM stock is trading at $105 ahead of expiration, they will be forced to sell their shares at that price.
The protective collar, as seen in the profit and loss statement above, combines a covered call and a long put. Simply put, the investor is not exposed to any gains or losses in the case of a decline in the stock price due to the neutral nature of this trade setup. The cost of this leverage is that the long stock may have to be sold at the short call strike. Since the underlying shares have already increased in value, the investor will likely be pleased with this decision.
Strategy 6: Long Straddle
When investors buy a call option and a put option on the same underlying asset at the same strike price and expiration date, they are said to have employed long straddle options trading strategies. Assuming the underlying asset’s price will break out of a narrow range but without conviction as to the direction of the break, this approach is used by investors who lack confidence as to the direction of the break.
This plan offers the potential for endless profits for the investor. While the investor stands to gain unlimitedly, their maximum loss is capped at the total amount invested in the options contracts.
Observe how the accompanying P&L chart has two distinct “break-even” positions. Stocks with significant price swings are ideal candidates for this technique. To the investor, it makes little difference which way the stock goes as long as the total gain exceeds the premium paid for the structure.
Strategy 7: Long Strangle
An investor employing the long strangle options trading strategies simultaneously buys a call and a put option on the same underlying asset and expiration date. However, it will be done with different strike prices. Traders that employ this options trading strategy typically anticipate a considerable price swing for the underlying asset, but they are unsure about the direction of the swing.
This tactic could involve, for instance, a wager on the outcome of a company’s earnings report or an event involving a drug stock receiving FDA clearance. Both choices have a maximum loss that is equal to the premium paid. Because a strangle involves purchasing out-of-the-money options, it will typically be cheaper than a straddle.
Take note of the orange line depicting the two break-even positions in the P&L graph above. This technique can be successful when there is a significant change in the stock price direction, either up or down. The only thing that matters to the investor is that the stock price shifts far enough to put one of the options in the money, regardless of which way the stock goes. The amount must be more significant than the investor’s entire premium for the building.
Strategy 8: Long Call Butterfly Spread
In the past, successful options trading strategies have necessitated taking two different positions or entering into two separate contracts. An investor utilizing call options for a long butterfly spread will employ a combination of a bull spread and bear spread strategies. There will be three different strike prices used. The options all have the same expiration date and underlying asset.
A long butterfly spread, for instance, might consist of buying one in-the-money call option at a lower strike price, selling two at-the-money call options, and buying one out-of-the-money call option. The wing spans of a well-balanced butterfly will be identical. This scenario, known as a “call fly,” leads to a negative net payment. When an investor expects little to no movement in the stock price before the options’ expiration date, they may decide to enter a long butterfly call spread.
Notably, the highest profit is realized when the stock price does not fluctuate between now and expiration when the at-the-money (ATM) strike is reached. The more the stock deviates from the ATM strikes, the more the P&L will suffer. Maximum loss happens when stock settles at or below the lower strike or at or above a higher strike call. The potential rewards and losses from these options trading strategies are both small.
Strategy 9: Iron Condor
For the iron condor, the trader will hold a bull put spread and a bear call spread. Constructing an iron condor involves selling an OTM put, buying a lower strike OTM put (a bull put spread), selling an OTM call, and buying a higher strike OTM call (a bear call spread).
There is a uniform time limit and underlying asset for all choices. The spread between the put and call sides is usually the same. This trading approach is meant to profit from a stock’s low volatility and generates a net premium on the structure. Since many traders believe that even a modest premium can significantly increase their profits, this options trading strategy sees widespread adoption.
Looking at the profit and loss statement, it is clear that the best results are achieved when the stock maintains a pretty stable trading range. As a result, the investor can end up with a profit equal to the trade’s total net credit. The maximum loss accrues as the stock price goes away from the short strikes, which are lower for the put and higher for the call.
The worst-case scenario is almost always worse than the best-case scenario. This makes sense if the structure has a higher chance of ending with a tiny gain.
Strategy 10: Iron Butterfly
Selling an in-the-money put and purchasing an out-of-the-money put is what an iron butterfly trader does. They will sell an in-the-money call option and buy an out-of-the-money call simultaneously. All options are for the same asset and expire on the same date. These options trading strategies are comparable to the butterfly spread but employ calls and puts instead of only puts.
Said, this approach involves selling an at-the-money straddle and simultaneously purchasing protective “wings,” or spreads, to hedge against potential losses. The two spreads typically have the same width. The long out-of-the-money call protects the limitless loss. Out-of-the-money extended put limits losses between short put strike and zero. The strike prices of the options used set a ceiling on the profit or loss that can be incurred. Investors prefer this approach due to the stable income it provides and the increased likelihood of a minor gain when employing a stock that is not very volatile.
Keeping the stock at the at-the-money strikes of the sold call and put results in the highest profit, as seen in the profit and loss statement above. The sum of all premiums collected constitutes the maximum gain. When the stock price goes above the long call strike or below the long put strike, the investor suffers maximum loss.
Conclusion
Profits can be made whether prices are moving up, down, or staying about the same with the help of options trading strategies. Investing in the stock market is not for everyone due to the high complexity and inherent risk involved. Nevertheless, as mentioned earlier, this article lays out various trading tactics that traders of varying skill levels may implement.
FAQs
Straddle, strangle, butterfly, and iron condor options trading strategies are common advanced options trading strategies.
When selecting options trading strategies, traders should consider a variety of factors, including market conditions, risk tolerance, capital allocation, time horizon, and liquidity.
The best options trading strategy for beginners is contingent upon their risk tolerance and investment goals. Buying call or put options is a straightforward strategy that can generate excellent returns. The covered call strategy is also a popular option for beginning investors.
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Read more: Stocks
Source: Investopedia