Traders often jump into trading options with little understanding of options strategies. There are many strategies available that limit risk and maximize return. With a little effort, traders can learn how to take advantage of the flexibility and power options offer. With this in mind, we've put together this primer, which should shorten the learning curve and point you in the right direction.
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 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.
In this example we are using a call option on a stock, which represents 100 shares of stock per call option. For every 100 shares of stock you buy, you simultaneously sell 1 call option against it. It is referred to as a covered call because in the event that a stock rockets higher in price, your short call is covered by the long stock position. Investors might 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 P&L graph above, notice how as the stock price increases, the negative P&L from the call is offset by the long shares position. Because you receive premium from selling the call, as the stock moves through the strike price to the upside, the premium you received allows you to effectively sell your stock at a higher level than the strike price (strike + 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 (in this example, 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. Each contract is worth 100 shares. The reason an investor would use this strategy is simply to protect their downside risk when holding a stock. This strategy functions just like an insurance policy, and establishes a price floor should the stock's price fall sharply.
An example of a married put would be if an investor buys 100 shares of stock and buys one put option simultaneously. This strategy is appealing because an investor is protected to the downside should a negative event occur. At the same time, the investor would participate in all of the upside if the stock gains in value. The only downside to this strategy occurs if the stock does not fall, in which case the investor loses 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. Yet, the stock participates in upside above the premium spent on the put. The 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 will simultaneously buy calls at a specific strike price and sell the same number of calls at a higher strike price. Both call options will have the same expiration and underlying asset. This type of vertical spread strategy is often used when an investor is bullish on the underlying and expects a moderate rise in the price of the asset. The investor limits his/her upside on the trade, but reduces the net premium spent compared to buying a naked call option outright.
In the P&L graph above, you can see that this is a bullish strategy, so the trader needs the stock to increase in price in order to make a profit on the trade. The trade-off when putting on a bull call spread is that your upside is limited, while your premium spent is reduced. If 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 will simultaneously purchase put options at a specific strike price and sell the same number of puts at a lower strike price. Both options would be for the same underlying asset and have the same expiration date. This strategy is used when the trader is bearish and expects the underlying asset's price to decline. It offers both limited losses and limited gains.
In the P&L graph above, you can see that this is a bearish strategy, so you need the stock to fall in order to profit. The trade-off when employing a bear put spread is that 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 for the same underlying asset and expiration. This strategy is often used by investors after a long position in a stock has experienced substantial gains. This options combination allows investors to have downside protection (long puts to lock in profits), while having the trade-off of potentially being obligated to sell shares at a higher price (selling higher = more profit than at current stock levels).
A simple example would be if an investor is long 100 shares of IBM at $50 and IBM has risen to $100 as of January 1st. The investor could construct a protective collar by selling one IBM March 15th 105 call and simultaneously buying one IBM March 95 put. The trader is protected below $95 until March 15th, with the trade-off of potentially having the obligation to sell his/her shares at $105.
In the P&L graph above, you can see that the protective collar is a mix of a covered call and a long put. This is a neutral trade set-up, meaning that you are protected in the event of falling stock, but with the trade-off of having the potential obligation to sell your long stock at the short call strike. Again, though, the investor should be happy to do so, as they have already experienced gains in the underlying shares.
What is a Protective Collar?
6. Long Straddle
A long straddle options strategy is 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 he or she believes the price of the underlying asset will move significantly out of a range, but is unsure of which direction the move will take. This strategy allows the investor to have the opportunity for theoretically unlimited gains, while the maximum loss is limited only 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 and 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.
This could, for example, be a wager on an earnings release for a company or an FDA event for a health care stock. Losses are limited to the costs (or premium spent) for both options. Strangles will almost always be less expensive than straddles because the options purchased are out of the money.
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
All of the strategies up to this point 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, and 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 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 results in a net debit. An investor would enter into a long butterfly call spread when they think the stock will not move much by expiration.
In the P&L graph above, notice how the maximum gain is made when the stock remains unchanged up until expiration (right at the ATM strike). The further away the stock moves from the ATM strikes, the greater the negative change in P&L. 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
An even more interesting strategy is the iron condor. In this 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 (bull put spread), and selling one out-of-the-money call and buying one out-of-the-money call of a higher strike (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 like this trade 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, which would 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, higher for the call), the greater the loss up to the maximum loss. Maximum loss is usually significantly higher than the maximum gain, which intuitively makes sense given that there is a higher probability of the structure finishing with a small gain.
10. Iron Butterfly
The final options strategy we will demonstrate is the iron butterfly. In this strategy, an investor will sell an at-the-money put and buy an out-of-the-money put, while also selling an at-the-money call and buying an out-of-the-money call. All options have the same expiration date and are on the same underlying asset. Although similar to a butterfly spread, this strategy differs because 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 how the maximum gain is made when the stock remains at the at-the-money strikes of the call and put 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. (For related reading, see "Best Online Stock Brokers for Options Trading 2019")