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Options Trading Strategies

More complex than trading stocks, options trading can be a whole new ball game for non-seasoned traders. That’s why it’s imperative to educate yourself. Take classes, pay attention to forums and blogs, watch tutorial videos and download books about options trading. Track the news and know what’s going on in the world economy, and finally, track down a real trader and ask him/her for some real-time advice.

What are options?

Options are contracts between two parties where one party sells the other party a right to buy or sell an asset at a given price (known as the strike price) up until a given expiration date.  The amount paid for this right is known as the premium.

Check out Benzinga for more information about options trading.

Options contracts

Although most people think of stocks when they consider options, there are a wide variety of instruments that include options contracts:

  • Stocks
  • Bonds
  • ETFs
  • Indexes
  • Commodities
  • Currencies
  • Futures
  • Other derivatives

1. Best strategies

Most people start with some easier options strategies:

Long call

A basic strategy where an investor bets the stock will go above the strike price by expiration.

  • Position: Purchase of one or more call options
  • Bias: Bullish
  • Risk: Premium paid
  • Profit potential: Unlimited
  • Break-even price: Strike price + premium paid
  • Accounts eligible: Basic margin, including self-directed investment accounts
  • Key insights: Call options will be less expensive when the implied volatility index (IV Index) is lower.
Source: https://upload.wikimedia.org/wikipedia/commons/thumb/e/ec/Long_call_option.svg/200px-Long_call_option.svg.png

Long put

A basic strategy where an investor bets the stock will go below the strike price by expiration.

  • Position: Purchase of one or more put options
  • Bias: Bearish
  • Risk: Premium paid
  • Profit potential: Unlimited
  • Break-even price: Strike price – premium paid
  • Accounts eligible: Basic margin, including self-directed investment accounts
  • Key insights: Put options will almost always be more expensive than corresponding call options.
Source: https://upload.wikimedia.org/wikipedia/commons/thumb/e/e5/Long_put_option.svg/200px-Long_put_option.svg.png

2. Protection strategies

Investors use protection strategies as a way to hedge or protect current positions within their portfolio.

Collar

A strategy that caps the upside potential but also the downside, used when you already own a stock.

  • Position: Sale of one call option and purchase of one put option
  • Bias: Neutral
  • Risk: Distance between the current price and the put strike price
  • Profit potential: Distance between the current price and the call strike price
  • Break-even price: Anywhere between the call and put strike prices
  • Accounts eligible: Basic margin, including self-directed investment accounts
  • Key insights: The collar works well with high-paying dividend stocks. Because the position is neutral and both upside and downside are capped, investors can continue to collect dividends while being protected.
Source: http://www.cboe.com/publish/histogram-charts/1025-Collar-PandL.png

Protective put

Use of a put to protect a current long position.

  • Position: Purchase of one put option while you are long the stock
  • Bias: Bearish
  • Risk: Premium paid
  • Profit potential: Stock capital appreciation – premium paid
  • Break-even price: Current stock price + premium paid
  • Accounts eligible: Basic margin, including self-directed investment accounts
  • Key insights: When purchasing protective puts, it’s best to do so before the markets start to turn down significantly and while the IV index is lower.

 

Source: http://torontoexchange.com/wp-content/uploads/2012/06/protective-put.png

3. Enhancement strategies

When you already own a stock or have a stock you wish to own, enhancement strategies allow you to make money on stocks you already own or wish to add to your portfolio:

Cash-covered put

Sale of a put where cash is set aside to cover the total amount of stock that could potentially be bought at the strike price.

  • Position: Sale of one or more put contracts with enough cash equal to 100 shares multiplied by the strike price for each contract.
  • Bias: Bullish
  • Risk: Stock price anywhere below the put strike price – premium paid
  • Profit potential: Premium paid
  • Break-even price: Strike price – premium paid
  • Accounts eligible: Basic margin, including self-directed investment accounts with additional approvals
  • Key insights: Most investors use cash-covered puts as a way to collect some additional premium on a stock they already wish to purchase. You can also use this strategy when a stock is already in-the-money as a bullish bet.
Source: http://www.cboe.com/publish/histogram-charts/1095-cs-PutWrite-PandL.png

Covered call

Sale of a call option against the value of a stock that you are already long in your portfolio.

  • Position: Sale of one or more call contracts that do not exceed the total number of shares the investor is long in their portfolio.
  • Bias: Bearish
  • Risk: Normal downside risk of owning a stock, as well as the opportunity cost should the stock go above the call strike price.
  • Profit potential: Premium paid
  • Break-even price: Strike price + premium paid
  • Accounts eligible: Basic margin, including self-directed investment accounts
  • Key insights: Covered calls are a common tool for investors who believe a stock will likely stall out or consolidate for a while and wish to collect premium while they wait for the next leg higher. The real risk with this strategy is the stock taking off to the upside without you on board.
Source: http://www.cboe.com/publish/histogram-charts/1135-ATM-Buywrite-PandL.png

4. Vertical strategies

If you’re the type of investor who likes to place small bets and work with probabilities, vertical strategies are right up your alley. If you sell a put at $45 and buy a put at $50 and receive $2.50 in premium, your break-even is $47.50. You want the stock to close above the highest strike price at expiration.  

Long call/short put spread:

  • A bullish bet that requires only enough margin to cover the total risk and can be adjusted by changing the distance between strike prices.
  • Position: Purchase one call and sell one call at a higher strike price with the same expiration, or sale of a put and purchase of a put at the next lower strike price of the same expiration.
  • Bias: Bullish
  • Risk: Difference between the two strike prices less any premium received
  • Profit potential: Premium received
  • Break-even price: For a put spread, the closer strike price less the premium, for a call spread the closer strike price plus any premium.
  • Accounts eligible: Basic margin, including self-directed investment accounts with additional approvals.
  • Key insights: These two strategies act the same, just with slightly different executions. If you take the closest strike prices to one another, generally you will have to wait until expiration for profits. If the strikes are further apart, or if the stock moves far enough away in the right direction, you can close the position early and still profit.
Source: http://www.cboe.com/lib-images/default-source/default-cboe-library/2018-05-dk-1-5-27-png.png

Long put/short call spread

These are bearish bets that work exactly the opposite of their bullish cousins above.

  • Additional insights: The closer the stock is to the strike prices, or the higher the IV index is, the larger the premium will be.
Source: http://www.cboe.com/lib-images/default-source/default-cboe-library/2018-05-dk-2-5-27-15-png.png

5. Calendar Strategies

When you think that a stock isn’t likely to go anywhere, calendar spreads, or time spreads, work really well. This is a strategy that needs to be monitored and closed out manually.

Long/short calendar spread

Strategy utilizes the fact that premium decays much faster on closer expiration dates than on further-out dates.

  • Position: Sale of a call or put at a strike price and purchase of a call or put at the same strike price but further-out expiration date.
  • Bias: Neutral
  • Risk: Difference between the back month premium and the front month premium
  • Profit potential: Premium for the back month less the premium for the front month
  • Break-even price: Difficult to calculate given a wide variety of variables
  • Accounts eligible: Basic margin, including self-directed investment accounts with additional approvals
  • Key insights: This strategy is very tricky because it relies on a stock not moving and getting the timing right. You’ll have to manually close out the trade at the expiration of the front month.
Source: https://www.fidelity.com/bin-public/060_www_fidelity_com/images/LC/LongCalendarSpreadsPuts600x330.png

Final thoughts

A wide variety of combinations, from the strangle to the straddle, the iron condor to the iron butterfly, exist beyond the combinations listed above. Regardless of how you set up your strategy, it’s important to understand the basics of how to execute your trades, where you break even, how much you can profit, how much you stand to lose, and whether your account is eligible for that type of trading.

Strategies in which contracts offset one another (IE vertical and calendar strategies) will almost always end in limited losses. On the flip side, if you sell anything that isn’t paired off, it’ll be considered a “naked” position, which leaves you open to substantial, if not infinite, loss. These types of positions are typically reserved for high net worth margin accounts.