Options Trading Strategies
Options trading is a form of financial market activity that involves buying and selling contracts that give the right, but not the obligation, to buy or sell an underlying asset at a specified price and time. Options can be used for various purposes, such as hedging, income generation, or portfolio diversification. Options trading can also offer more flexibility and leverage than trading stocks or other securities.
There are many options trading strategies that can help investors to achieve their goals and manage their risks. Some of the most common options strategies are covered calls, married puts, bull call spreads, bear put spreads, protective collars, straddles, and strangles. Each of these strategies has its own advantages, disadvantages, and suitability for different market scenarios. In this article, we will explain the basics of each strategy, how they work, and when to use them. We will also provide some examples and tips for successful options trading.
Top options trading strategies
In this article, we will discuss 17 options trading strategies that every investor should know. These strategies are ranked from most profitable to least, based on their average returns and risk levels. However, keep in mind that the profitability and risk of any strategy may vary depending on the market conditions, the strike prices, the expiration dates, and the implied volatility of the options involved. Therefore, traders should always do their own research and analysis before entering any options trade.
1. Covered call
A covered call is a strategy where you own the underlying stock and sell a call option on the same stock with a higher strike price and the same expiration date. This strategy allows you to earn income from the premium received by selling the call option, while also retaining some upside potential if the stock price rises. However, the downside risk is that you may have to sell your stock at the strike price if the option is exercised or lose money if the stock price falls below your purchase price.
2. Married put
A married put is a strategy where you buy the underlying stock and a put option on the same stock with the same expiration date and a lower strike price. This strategy protects you from a large drop in the stock price, as you can exercise the put option and sell the stock at the strike price if the market price falls below it. However, the cost of buying the put option reduces your profit potential if the stock price rises.
3. Bull call spread
A bull call spread is a strategy where you buy a call option and sell another call option on the same stock with the same expiration date and a higher strike price. This strategy allows you to profit from a moderate increase in the stock price, as the difference between the premiums received and paid will be your maximum profit. However, the profit potential is limited by the higher strike price, and the risk is limited by the lower strike price.
4. Bear put spread
A bear put spread is a strategy where you buy a put option and sell another put option on the same stock with the same expiration date and a lower strike price. This strategy allows you to profit from a moderate decrease in the stock price, as the difference between the premiums paid and received will be your maximum profit. However, the profit potential is limited by the lower strike price, and the risk is limited by the higher strike price.
5. Protective collar
A protective collar is a strategy where you own the underlying stock and simultaneously sell a call option and buy a put option on the same stock with the same expiration date and different strike prices. This strategy protects you from a large drop in the stock price, as you can exercise the put option and sell the stock at the strike price if the market price falls below it. However, the upside potential is capped by the call option, as you may have to sell your stock at the strike price if the option is exercised. The cost of buying the put option is offset by the premium received from selling the call option.
6. Long straddle
A long straddle is a strategy where you buy a call option and a put option on the same stock with the same expiration date and strike price. This strategy allows you to profit from a significant price movement in either direction, as you can exercise the option that is in the money and let the other one expire worthless. However, the cost of buying both options is high, and the stock price has to move beyond the breakeven points to make a profit.
7. Long strangle
A long strangle is a strategy where you buy a call option and a put option on the same stock with the same expiration date and different strike prices. The call option has a higher strike price and the put option has a lower strike price. This strategy allows you to profit from a significant price movement in either direction, as you can exercise the option that is in the money and let the other one expire worthless. However, the cost of buying both options is high, and the stock price must move beyond the breakeven points to make a profit. The difference between a long straddle and a long strangle is that the latter has a lower cost but also a lower probability of success.
8. Long call butterfly spread
A long call butterfly spread is a strategy where you buy a call option, sell two call options, and buy another call option on the same stock with the same expiration date and different strike prices. The strike prices are arranged in an ascending order, such as A < B < C < D. The call options with the middle strike price (B and C) are sold, and the call options with the lowest (A) and highest (D) strike prices are bought. This strategy allows you to profit from a narrow range of stock price movement around the middle strike price, as the difference between the premiums paid and received will be your maximum profit. However, the profit potential is limited by the lowest and highest strike prices, and the risk is limited by the net cost of the trade.
9. Iron condor
An iron condor is a strategy where you sell a call option and a put option and buy another call option and another put option on the same stock with the same expiration date and different strike prices. The strike prices are arranged in an ascending order, such as A < B < C < D. The call options with the lower strike price (B) and the put options with the higher strike price (C) are sold, and the call options with the highest strike price (D) and the put options with the lowest strike price (A) are bought. This strategy allows you to profit from a stable stock price movement within the range of the sold options, as the difference between the premiums received and paid will be your maximum profit. However, the profit potential is limited by the difference between the adjacent strike prices, and the risk is limited by the difference between the non-adjacent strike prices
10. Iron butterfly
An iron butterfly is a strategy where you sell a call option and a put option and buy another call option and another put option on the same stock with the same expiration date and different strike prices. The strike prices are arranged in an ascending order, such as A < B < C < D. The call options and the put options with the same middle strike price (B and C) are sold, and the call options with the highest strike price (D) and the put options with the lowest strike price (A) are bought. This strategy allows you to profit from a narrow range of stock price movement around the middle strike price, as the difference between the premiums received and paid will be your maximum profit. However, the profit potential is limited by the difference between the adjacent strike prices, and the risk is limited by the difference between the non-adjacent strike prices.
11. Bull put spread
A bull put spread is a strategy where you sell a put option and buy another put option on the same stock with the same expiration date and a lower strike price. This strategy allows you to profit from a moderate increase in the stock price, as the difference between the premiums received and paid will be your maximum profit. However, the profit potential is limited by the higher strike price, and the risk is limited by the lower strike price.
12. Bull call ratio backspread
A bull call ratio backspread is a strategy where you buy more call options than you sell on the same stock with the same expiration date and a higher strike price. For example, you can buy two call options and sell one call option on the same stock. This strategy allows you to profit from a large increase in the stock price, as the difference between the number of options bought and sold will be your profit multiplier. However, the risk is that you may lose money if the stock price falls below the breakeven point or stays within a narrow range.
13. Synthetic call
A synthetic call is a strategy where you buy the underlying stock and a put option on the same stock with the same expiration date and strike price. This strategy mimics the payoff of a call option, as you can exercise the put option and sell the stock at the strike price if the market price falls below it or keep the stock and let the put option expire worthless if the market price rises above it. The cost of buying the put option is equivalent to the premium paid for a call option.
14. Synthetic put
A synthetic put is a strategy where you sell the underlying stock and a call option on the same stock with the same expiration date and strike price. This strategy mimics the payoff of a put option, as you can buy back the stock and exercise the call option at the strike price if the market price rises above it or keep the short position and let the call option expire worthless if the market price falls below it. The premium received from selling the call option is equivalent to the premium paid for a put option ²⁷²⁸.
15. Bear call spread
A bear call spread is a strategy where you sell a call option and buy another call option on the same stock with the same expiration date and a higher strike price. This strategy allows you to profit from a moderate decrease in the stock price, as the difference between the premiums received and paid will be your maximum profit. However, the profit potential is limited by the lower strike price, and the risk is limited by the higher strike price.
16. Strip
A strip is an options strategy used when an investor anticipates a significant price decline in an asset. It involves buying two put options for every call option sold. This strategy profits from a sharp decline in the asset's price and has limited profit potential but also limited risk.
17. Short straddles
A short straddle is a neutral strategy used when investors expect minimal price volatility in an asset. It involves selling both a call option and a put option with the same strike price and expiration date. The investor collects the premiums from both options but faces unlimited potential losses if the asset's price makes a substantial move in either direction.
Please note that this is not a comprehensive list and there may be other strategies that are not covered here. Also, this is not a financial advice, and you should do your own research before investing in any options.
Each of these options trading strategies has its own unique characteristics, risk-reward profiles, and suitability for different market conditions. Traders and investors should carefully consider their market outlook and risk tolerance when selecting the most appropriate strategy for their specific goals. Additionally, it is essential to stay informed about market developments and adjust strategies as needed to adapt to changing conditions.
What are the levels of options trading?
There are four levels of options trading, which determine the types of strategies that traders can use based on their experience and resources. The levels are:
- Level 1: This level allows traders to write covered calls and cash-secured puts. These are conservative strategies that involve selling options against an existing stock position or cash balance.
- Level 2: This level allows traders to buy calls or puts and open long straddles and strangles. These are bullish or bearish strategies that involve buying options to profit from a directional move or volatility in the underlying asset.
- Level 3: This level allows traders to open long spreads and long-side ratio spreads. These are strategies that involve buying and selling options of the same type and expiration, but with different strike prices. They can be used to reduce the cost and risk of buying options, or to create asymmetric payoffs.
- Level 4: This level allows traders to write naked calls and puts. These are aggressive strategies that involve selling options without owning the underlying asset or having enough cash to cover the potential loss. They can generate high income, but also expose traders to unlimited risk.
Advantages and disadvantages of trading options
Advantages of trading options
Some of the advantages of trading options are:
- Risk hedging: Options can be used to protect a stock position or portfolio from adverse price movements. For example, buying a put option can limit the downside risk of owning a stock, while selling a call option can reduce the opportunity cost of holding a stock.
- Cost efficiency: Options can be cheaper than buying or selling the underlying asset, especially for expensive, or illiquid stocks. For example, buying a call option can give the same exposure as buying 100 shares of a stock, but at a fraction of the cost.
- Amplified returns: Options can magnify the returns from a favourable price movement in the underlying asset, due to the leverage effect. For example, buying a call option can result in a higher percentage gain than buying the stock, if the stock price rises above the strike price.
- Flexibility and versatility: Options can be used to create a variety of trading strategies that suit different market conditions, outlooks, and risk preferences. For example, options can be combined to create spreads, straddles, strangles, butterflies, condors, and more.
Disadvantages of trading options
Some of the disadvantages of trading options are:
- Price fluctuations: Options prices can change significantly from day to day, due to factors such as time decay, implied volatility, interest rates, dividends, and market sentiment. This can result in large losses or missed opportunities for option buyers, especially for short-term or out-of-the-money options.
- Higher risk for sellers: Option sellers have limited profit potential and unlimited loss potential, as they are obligated to fulfil the contract if the option is exercised by the buyer. This can expose them to margin calls, forced liquidation, especially for naked options.
- Educational investment: Educational investment: Options trading requires a certain level of knowledge, skill, and experience to trade effectively and safely. Traders need to learn the terminology, concepts, and strategies of options trading, as well as the risks and rewards involved. Traders also need to keep up with the market trends, news, and events that affect the options prices.
Conclusion
Options trading strategies can be complex and involve significant risks, especially for beginners. Therefore, it is important to understand the basics of options, the factors that affect their prices, and the potential outcomes of each strategy before entering any trade. Moreover, it is advisable to consult a financial adviser or a broker who can guide you through the process and help you choose the best strategy for your goals and risk tolerance.
