Trading options has exploded in popularity over the last couple of decades, and option trading in particular has become a major force in contemporary finance.
The ability to create sophisticated and nuanced trading positions using options and other derivatives is incomparable when contrasted with traditional securities trading.
Out of the many advanced trading techniques used by option traders, there are 7 strategies that stand out above the rest:
- Long Call and Puts
- Bull Call Spread
- Bear Put Spread
- Covered Call
These top 7 option strategies should be a mainstay of every option trader’s playbook, and they should understand their application intimately.
Long Call and Long Put Option Strategies
A long call uses call options to bet on an increase in the price of the underlying security, while a long put uses put options to bet on a decrease in the price of the underlying security.
Option traders use these simple strategies when they are confident in the direction and intensity of an upcoming price change.
Because options cost only a small premium compared to the potential increase in their value as a result of large changes in the price of the underlying security, the long calls and puts are the best technique for maximizing profits in the relatively rare cases where a trader has such confidence in forecasting upcoming price changes.
The risk of long calls and long puts is that the price fails to move far enough in the right direction, and the options expire worthless or fail to cover the full cost of the premiums, resulting in a trading loss on the position.
Bull Call Spread
A bull call spread involves the purchase of call options at one strike price and the writing of the same number of call options with the same expiration date but a moderately higher strike price.
The profit from a bull call spread is maximized when the price of the security reaches slightly under the strike price of the written options, so that the written options expire worthless while the purchased options can be exercised for the maximum value within the window of the written options expiring worthless.
The downside in a bull call spread is protected when both options expire worthless, but the premium gained from the written options helps to reduce the loss from the premium paid for the purchased options.
Bull call spreads are used when a trader has confidence in the direction of an upcoming price change, but not in its intensity.
If a trader foresees only a small increase in the price of a security, then they can capitalize on that small increase by purchasing call options while also limiting any potential downside and reducing the cost of the premiums paid by writing options at a higher strike price that is unlikely to be reached.
The downside to the bull call spread is, of course, that any potential upside beyond the projected price increase is limited due to the corresponding increase in the cost to cover the written call options.
Bear Put Spread
A bear put spread is the exact opposite of a bull call spread, where the trader purchases put options and also sells the same number of put options with the same expiry date but a moderately lower strike price.
The profit from a bear put spread is maximized when the price of the underlying security reaches slightly above the strike price of the written put options, which means that the written options expire worthless while the value of the purchased options is maximized within the window of the written options expiring without value.
The downside to a bear put spread is limited to the premium paid for the purchased options less the premium gained from the written options, which occurs when both of the options expire worthless.
Traders use the bear put spread when they want to bet on a moderate decline in the price of a security.
The premiums gained from the written options help to offset any potential losses if the security fails to fall in price significantly, and they are added to the profits if the price falls within the window of the written options expiring without value.
However, the upside to a bear put spread is limited by the cost of the written options increasing as the security continues to fall in value past the written put options’ strike price.
Option Strategies Straddle
A straddle option strategies involves the purchase of call options and put options at the same strike price, usually the current price of the security, and the same expiration date.
A straddle option trade will profit when the price of the security changes enough in either direction to compensate for the cost of both the call options’ and put options’ premiums.
Option traders use the straddle options strategy when they are unsure about the direction of an upcoming price change, but are confident in the intensity of the price change.
While this kind of situation can arise for a variety of reasons, straddles are most often used when there is a significant event that is set to occur on or around a specific date.
Press conferences and news releases are common events where traders expect significant price changes, but are not confident about the direction of the price change.
Straddles can offer relatively low cost access to substantial profits with little downside risk, which is merely that the price change is not significant enough to cover the cost of both premiums.
A strangle options strategy is similar to a straddle, but it uses the simultaneous purchase of call options and put options at different strike prices.
This spread in the strike prices means that the underlying security needs to move more substantially for one of the options to be in the money, but the premium cost for purchasing the options is lower in the case of a strangle because the options are purchased out of the money.
An option trader will use the strangle options strategy when they believe that the upcoming price change will be significant, but they are unsure of the direction.
This situation occurs in the same sort of events as are popular for the straddle strategy, but the trader is more confident that the change in price will be extreme.
The strangle can expire worthless, unlike a straddle, but the lower initial outlay on premiums means that a strangle may actually cost loss in the event of a loss than a straddle will with only a small change in price.
The strangle also has a much stronger upside potential due to the lower initial premium cost and the greater potential value increase for options that were purchased out of the money.
The butterfly options strategy involves the sale of call or put options at a given strike price, usually at the current price, matched by an equal number of purchased call or put options equidistant from the strike price.
For example, if a trader sold 2 call options at $40, they would buy one call option at $45 and another at $35 to match the 2 written options sold.
In this example, the loss from the trade would be maximized at either $35 or $45, while the trade would be profitable somewhere between the $35 to $45 range. The profit from the butterfly position would be maximized at $40.
Options traders use the butterfly option strategy when they wish to bet on little or no upcoming price change. The purchased options act as a form of insurance against major price changes, putting a ceiling on the potential losses from the trade.
A covered call uses the actual underlying security to cover the potential losses of writing call options on the security.
For example, if the option trader owns shares of company A, they can write call options at a higher strike price for a matching number of shares.
If the price of the shares goes above the strike price, then the losses are capped by simply trading the shares that the option writer already owns when the options are exercised.
If the price of the shares rise yet fail to reach the strike price, then the option trader gains both from the increase in the underlying shares and the premium gained from the written calls expiring worthless.
If the price of the shares fall, then the loss in the value of the underlying shares is somewhat offset by the premium from the written options that expired worthless.
Option traders use covered calls when they like the long term prospects of a security they own, but feel that the price is unlikely to increase in the short term or may even fall.
In this case they are able to gain the premium from writing the call options with the security of owning the shares in case that the options expire in the money.