Traders often jump into trading options with little understanding of the options strategies that are available to them. There are many options strategies that both limit risk and maximize return. With a little effort, traders can learn how to take advantage of the flexibility and power that stock options can provide. Here are 10 options strategies that every investor should know.
4 Options Strategies To Know
1. Covered Call
With calls, one strategy is simply to buy a naked call option. You can also structure a basic covered call or buy-write. This is a very popular strategy because it generates income and reduces some risk of being long on the stock alone. The trade-off is that you must be willing to sell your shares at a set price– the short strike price. To execute the strategy, you purchase the underlying stock as you normally would, and simultaneously write–or sell–a call option on those same shares.
For example, suppose an investor is using a call option on a stock that represents 100 shares of stock per call option. For every 100 shares of stock that the investor buys, they would simultaneously sell one call option against it. This strategy is referred to as a covered call because, in the event that a stock price increases rapidly, this investor's short call is covered by the long stock position.
Investors may choose to use this strategy when they have a short-term position in the stock and a neutral opinion on its direction. They might be looking to generate income through the sale of the call premium or protect against a potential decline in the underlying stock’s value.
In the profit and loss (P&L) graph above, observe that as the stock price increases, the negative P&L from the call is offset by the long shares position. Because the investor receives a premium from selling the call, as the stock moves through the strike price to the upside, the premium that they received allows them to effectively sell their stock at a higher level than the strike price: strike price plus the premium received. The covered call’s P&L graph looks a lot like a short, naked put’s P&L graph.
2. Married Put
In a married put strategy, an investor purchases an asset–such as shares of stock–and simultaneously purchases put options for an equivalent number of shares. The holder of a put option has the right to sell stock at the strike price, and each contract is worth 100 shares.
An investor may choose to use this strategy as a way of protecting their downside risk when holding a stock. This strategy functions similarly to an insurance policy; it establishes a price floor in the event the stock's price falls sharply.
For example, suppose an investor buys 100 shares of stock and buys one put option simultaneously. This strategy may be appealing for this investor because they are protected to the downside, in the event that a negative change in the stock price occurs. At the same time, the investor would be able to participate in every upside opportunity if the stock gains in value. The only disadvantage of this strategy is that if the stock does not fall in value, the investor loses the amount of the premium paid for the put option.
In the P&L graph above, the dashed line is the long stock position. With the long put and long stock positions combined, you can see that as the stock price falls, the losses are limited. However, the stock is able to participate in the upside above the premium spent on the put. A married put's P&L graph looks similar to a long call’s P&L graph.
What's a Married Put?
3. Bull Call Spread
In a bull call spread strategy, an investor simultaneously buys calls at a specific strike price while also selling the same number of calls at a higher strike price. Both call options will have the same expiration date and underlying asset. This type of vertical spread strategy is often used when an investor is bullish on the underlying asset and expects a moderate rise in the price of the asset. Using this strategy, the investor is able to limit their upside on the trade while also reducing the net premium spent (compared to buying a naked call option outright).
From the P&L graph above, you can observe that this is a bullish strategy. For this strategy to be executed properly, the trader needs the stock to increase in price in order to make a profit on the trade. The trade-off of a bull call spread is that your upside is limited (even though the amount spent on the premium is reduced). When outright calls are expensive, one way to offset the higher premium is by selling higher strike calls against them. This is how a bull call spread is constructed.
How To Manage A Bull Call Spread
4. Bear Put Spread
The bear put spread strategy is another form of vertical spread. In this strategy, the investor simultaneously purchases put options at a specific strike price and also sells the same number of puts at a lower strike price. Both options are purchased for the same underlying asset and have the same expiration date. This strategy is used when the trader has a bearish sentiment about the underlying asset and expects the asset's price to decline. The strategy offers both limited losses and limited gains.
In the P&L graph above, you can observe that this is a bearish strategy. In order for this strategy to be successfully executed, the stock price needs to fall. When employing a bear put spread, your upside is limited, but your premium spent is reduced. If outright puts are expensive, one way to offset the high premium is by selling lower strike puts against them. This is how a bear put spread is constructed.
5. Protective Collar
A protective collar strategy is performed by purchasing an out-of-the-money put option and simultaneously writing an out-of-the-money call option. The underlying asset and the expiration date must be the same. This strategy is often used by investors after a long position in a stock has experienced substantial gains. This allows investors to have downside protection as the long put helps lock in the potential sale price. However, the trade-off is that they may be obligated to sell shares at a higher price, thereby forgoing the possibility for further profits.
An example of this strategy is if an investor is long on 100 shares of IBM at $50 and suppose that IBM rises to $100 as of January 1. The investor could construct a protective collar by selling one IBM March 105 call and simultaneously buying one IBM March 95 put. The trader is protected below $95 until the expiration date. The trade-off is that they may potentially be obligated to sell their shares at $105 if IBM trades at that rate prior to expiry.
In the P&L graph above, you can observe that the protective collar is a mix of a covered call and a long put. This is a neutral trade set-up, which means that the investor is protected in the event of a falling stock. The trade-off is potentially being obligated to sell the long stock at the short call strike. However, the investor will likely be happy to do this because they have already experienced gains in the underlying shares.
What is a Protective Collar?
6. Long Straddle
A long straddle options strategy occurs when an investor simultaneously purchases a call and put option on the same underlying asset with the same strike price and expiration date. An investor will often use this strategy when they believe the price of the underlying asset will move significantly out of a specific range, but they are unsure of which direction the move will take. Theoretically, this strategy allows the investor to have the opportunity for unlimited gains. At the same time, the maximum loss this investor can experience is limited to the cost of both options contracts combined.
In the P&L graph above, notice how there are two breakeven points. This strategy becomes profitable when the stock makes a large move in one direction or the other. The investor doesn’t care which direction the stock moves, only that it is a greater move than the total premium the investor paid for the structure.
What's a Long Straddle?
7. Long Strangle
In a long strangle options strategy, the investor purchases an out-of-the-money call option and an out-of-the-money put option simultaneously on the same underlying asset with the same expiration date. An investor who uses this strategy believes the underlying asset's price will experience a very large movement but is unsure of which direction the move will take.
For example, this strategy could be a wager on news from an earnings release for a company or an event related to a Food and Drug Administration (FDA) approval for a pharmaceutical stock. Losses are limited to the costs–the premium spent–for both options. Strangles will almost always be less expensive than straddles because the options purchased are out-of-the-money options.
In the P&L graph above, notice how there are two breakeven points. This strategy becomes profitable when the stock makes a very large move in one direction or the other. Again, the investor doesn’t care which direction the stock moves, only that it is a greater move than the total premium the investor paid for the structure.
8. Long Call Butterfly Spread
The previous strategies have required a combination of two different positions or contracts. In a long butterfly spread using call options, an investor will combine both a bull spread strategy and a bear spread strategy. They will also use three different strike prices. All options are for the same underlying asset and expiration date.
For example, a long butterfly spread can be constructed by purchasing one in-the-money call option at a lower strike price, while also selling two at-the-money call options and buying one out-of-the-money call option. A balanced butterfly spread will have the same wing widths. This example is called a “call fly” and it results in a net debit. An investor would enter into a long butterfly call spread when they think the stock will not move much before expiration.
In the P&L graph above, notice how the maximum gain is made when the stock remains unchanged up until expiration–at the point of the at-the-money (ATM) strike. The further away the stock moves from the ATM strikes, the greater the negative change in the P&L. The maximum loss occurs when the stock settles at the lower strike or below (or if the stock settles at or above the higher strike call). This strategy has both limited upside and limited downside.
9. Iron Condor
In the iron condor strategy, the investor simultaneously holds a bull put spread and a bear call spread. The iron condor is constructed by selling one out-of-the-money put and buying one out-of-the-money put of a lower strike–a bull put spread–and selling one out-of-the-money call and buying one out-of-the-money call of a higher strike–a bear call spread. All options have the same expiration date and are on the same underlying asset. Typically, the put and call sides have the same spread width. This trading strategy earns a net premium on the structure and is designed to take advantage of a stock experiencing low volatility. Many traders use this strategy for its perceived high probability of earning a small amount of premium.
In the P&L graph above, notice how the maximum gain is made when the stock remains in a relatively wide trading range. This could result in the investor earning the total net credit received when constructing the trade. The further away the stock moves through the short strikes–lower for the put and higher for the call–the greater the loss up to the maximum loss. Maximum loss is usually significantly higher than the maximum gain. This intuitively makes sense, given that there is a higher probability of the structure finishing with a small gain.
10. Iron Butterfly
In the iron butterfly strategy, an investor will sell an at-the-money put and buy an out-of-the-money put. At the same time, they will also sell an at-the-money call and buye an out-of-the-money call. All options have the same expiration date and are on the same underlying asset. Although this strategy is similar to a butterfly spread, it uses both calls and puts (as opposed to one or the other).
This strategy essentially combines selling an at-the-money straddle and buying protective “wings.” You can also think of the construction as two spreads. It is common to have the same width for both spreads. The long, out-of-the-money call protects against unlimited downside. The long, out-of-the-money put protects against downside (from the short put strike to zero). Profit and loss are both limited within a specific range, depending on the strike prices of the options used. Investors like this strategy for the income it generates and the higher probability of a small gain with a non-volatile stock.
In the P&L graph above, notice that the maximum amount of gain is made when the stock remains at the at-the-money strikes of both the call and put that are sold. The maximum gain is the total net premium received. Maximum loss occurs when the stock moves above the long call strike or below the long put strike.