Options Trading Strategies

When it comes to options trading, there are many different strategies that a trader can apply, depending on his level of expertise, his view of the market and his risk appetite. The following is an introduction to the most prominent options trading strategies.

Beginners, start here: Understanding the Basics of the Options Market

Naked options

Option contracts are ultimately leveraging instruments. They can help a trader amplify a certain market view he wants to exercise in the market. A most basic options strategy is to buy naked options. If a trader is bullish on an underlying asset and expects its price to go up, he can buy a naked call that will give him the opportunity to buy the underlying at a lower price, in case the asset price does indeed rally upwards. By buying a naked call option, a trader is leveraging his positive outlook on the option’s underlying asset.

Traders that are bearish on a particular asset and expect its price to fall can buy naked put options. By doing this, a trader can take a leveraged position to speculate on falling prices, while being exposed to less downside risk than if he were to execute a short-selling strategy.

By buying either a call or a put option a trader can either go long or short an underlying asset. Traders that want to take the opposite side to such a trade are the ones that sell, i.e. write option contracts. Selling a call option if a trader is bearish on the option’s underlying asset, as well as selling a put option if a trader is bullish on the underlying asset, are both strategies for traders willing to earn a premium as a potential “passive income”. At the same time, calls and puts can also be sold if a seller is thinking that the market will move sideways for a while.

Covered call

If traders expect rather flat or only slight upwards volatility in an asset’s price over a defined period of time, they can choose the strategy of a covered call. In this scenario, the trader buys the underlying asset on the spot market, while simultaneously selling a call option against the same asset. Because this sort of trader expects the underlying asset to remain flat and therefore close to the strike price, i.e. out of the money, he is betting on getting a cash-flow in the form of the option premium for the time the option is running. 

If the price of the underlying asset falls, the trader might lose on the spot purchases for the underlying asset. Because he has sold a covered call, the premium collected will act as a limited downside protection as the trader is compensated for selling the covered call option. If the underlying asset price would skyrocket past the strike price of the covered call, which would be against the trader’s expectations, he would need to sell the underlying to the call option buyer at the strike price, but still having earned his premium 

Protective Put or Married Put

Another risk-mitigating strategy works with buying protective puts, also referred to as married puts. They are used by traders with a positive long-term outlook for an asset. Because of this bullish outlook, the trader is  invested in the respective asset. If for some reason the short-term forecast for this very asset is bearish though, the trader can go into the markets and buy protective puts for this asset. 

By holding the asset as well as protective put options for this asset the trader is able to get  insurance against downside volatility. If the price of the underlying asset goes up, he profits since he’s holding the asset and he won’t need to follow through on his put option. His profits come from the price increase of the underlying asset minus the cost for the put option. Note that this kind of protection is only available to the trader as long as the put options have not expired yet.

However, if the asset’s price does indeed fall below the strike price of his put option, he is able to exercise his put option rights and sell the asset at the pre-defined strike price. Because the asset has now fallen in price, he can repurchase the asset at a lower price. The trader’s profit is the difference between the put option’s strike price and the asset’s current price minus the premium he paid for having the put option.

Vertical Option Spread

Spread strategies are so-called multi-leg strategies as they involve two or more options at the same time. By applying this strategy, a trader buys one option and simultaneously sells another one with a different strike price. Both of these options have the same expiry date as well as the same underlying asset. In a vertical option spread a trader either uses both calls or both puts. The reason for putting this strategy into action is simple: By having two legs, the trader can cap potential losses, while still having a limited upside potential.  

In a bull call strategy, a call is bought, and the corresponding call is sold at a higher strike price. This strategy is applied if a trader feels bullish towards the market and believes an asset will rise modestly in price. When it comes to a bear call strategy, a call is sold while another call option with a higher strike price is bought simultaneously. The trader choosing this strategy expects the market to go down modestly, he is bearish.

A bull put strategy is the mirror image of a bull call strategy. A put option is sold and another put option is bought at a lower strike price. If the premium of puts are cheaper than calls, it makes more sense to opt for the bull put spread instead as the bull call spread. A bear put strategy on the other hand is used if a trader is modestly bearish on an asset’s price. He therefore buys a put option and sells another put option with the same expiration date but a lower strike price. This way, the trader can generate a premium and offset part of the cost for the put option that he bought. At the same time, he also limits his potential profits.

Straddle

This is a strategy where a trader buys a call option as well as a put option at the same strike price. By following this strategy, a trader goes long volatility as he expects the underlying asset to be volatile but is unsure about which direction the asset will go. If the asset breaks out to the upside and will be above its strike price at expiry, he will be able to execute the call option and buy the asset for the lower price he locked in with his call option. 

If on the other hand the asset’s price tanks and will be way below the option’s strike price at expiry date, the trader will execute his second option, i.e. his put option. This means that the trader can sell the underlying asset at a higher price than the asset is currently trading at.

In either case, if volatility kicks in and the asset’s price diverges significantly from the options’ strike price, the investor will be able to pocket the difference of the price divergence. His profit will come from the difference between the market price and the better price he can sell or buy the underlying asset at minus the option premiums he paid for having bought the call as well as the put option. So ultimately, by engaging in this strategy, a trader is betting that an underlying asset’s price will move further away from the strike price on expiration than the trader paid in option premiums.

What we just described is a strategy when a trader is long a straddle and expects great volatility in the underlying asset. Conversely, this strategy can also be taken by an opposite trader, who believes that the underlying asset won’t move as much because of low volatility. In this case, the trader is short the straddle by selling a call as well as a put option at the same strike price.

As an option seller, a trader profits from the premium paid to him by the option buyer. In this specific case of being short a straddle, the trader’s maximum profit is realized, when the price of the underlying has barely moved and stays close to the strike price. The trader is able to collect the entire premium that he sold his options for. The further away the underlying asset’s price moves away from the strike price, the more of his collected premiums the trader is losing.

Strangle

This strategy resembles that of a straddle with the difference that a trader buys a call and a put option but with different strike prices. The put strike price should be below the call strike price.

Similarly to the straddle situation, this strategy is applied if a trader expects an underlying asset to sharply move in price, but he is unsure about the direction of the movement. In a long strangle, the call option bought has a strike price that is higher than the underlying asset’s current price. If the asset moves past the strike price, the option buyer will be able to follow through on his right to buy the asset below the current market price. At the same time, the trader also holds a put option, whose strike price is lower than the asset’s price. If the asset were to indeed fall below the strike price, the trader again is able to take advantage of his put option right and sell the asset at the pre-defined strike price which is higher than the asset’s current price. In both instances, the trader’s profits equal the gains made on the strangle minus the cost of purchasing  both options.Usually a strangle is considered less expensive than a straddle because two different strike prices are used. With a straddle, the trader needs only small price jumps in either direction to offset the premium paid. In case of the strangle, the underlying asset’s price needs to move to a greater extent for the strategy to be profitable. This makes it less expensive but also riskier to really generate a profit after all.

Things to keep in mind

The strategies we described can be considered the most prominent once. As a matter of fact, there are more strategies that consist of various different legs such as for example butterfly spreads. The more sophisticated the strategy carried out using options becomes, the more the trader really needs to know what he is doing. 

Especially if you sell call options losses can theoretically be infinite. This is why setting up some protection by using another option might be important. But this is also when it gets more complicated and a proper understanding of what is being done is needed.

After all, options are a way to take up leverage. Whenever leverage is involved, things can get rough quickly, which is why options, especially complicated options strategies, should be used by advanced traders only.

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RELATED CATEGORIES: Investing, Options