Investors sometimes enter into trading options with little to no understanding of popular option strategies that can help limit risk and maximize potential returns. With minimal effort, investors can capitalize on the power and flexibility options can offer.
What Are Option Strategies
Option strategies are conditional derivative contracts allowing option buyers to buy or sell assets at a chosen price. Option buyers pay a fee, called a premium to the seller for this right. If the option holder finds market prices to be unfavorable, they let the option expire worthless, making sure the losses are not more than the premium. Options are divided into two categories, either being call options or put options. Here are 10 option strategies you need to know and understand:
- Covered call
- Married put
- Bull call spread
- Bear put spread
- Protective collar
- Long straddle
- Long strangle
- Long call butterfly spread
- Iron condor
- Iron butterfly
One strategy for call options is simply buying a naked call option. This popular strategy generates income while reducing some of the risks that come with being long stock alone. The flip-side is you must be willing to sell your stock at a predetermined price or the short strike price. Executing this strategy requires you to purchase the identified shares as usual while simultaneously writing a call option on the same stocks.
For example, an investor could purchase a call option on a stock that represents 150 shares of stock for each call option. For every 150 shares of stock purchased, the buyer simultaneously sells one call option against it. This is referred to as a covered call because if the stock jumps higher in price, the short call is covered by the long stock position.
Investors may use a covered call option strategy if they have a neutral opinion on the direction of a stock they have a short-term position in. They may be looking to protect against potential declines in the value of the stock or hoping to generate income by selling the call premium.
2. Married Put
With a married put option strategy, a trader buys shares of stock while simultaneously purchasing put options for the same number of stocks allowing the holder to sell stock at the strike price. For example, an investor would purchase 100 shares of stock while buying one put option at the same time. They are protected from the downside if an adverse event should occur while benefiting from any upside if the value of the stock increases. If the stock value doesn’t fall, the investor loses the premium they paid for the put option.
3. Bull Call Spread
A bull call spread option strategy allows an investor to simultaneously purchase calls at a predetermined strike price while selling an equal number of calls at a higher strike price. Each of the call options includes the same stock and expiration date. Investors anticipate a moderate price increase while limiting their upside on the trade and reducing the net premium spent compared to purchasing a naked call option.
4. Bear Put Spread
Another vertical spread strategy, the bear put spread happens when an investor simultaneously purchases put options at a set strike price and sells an equal number of puts for a lower strike price. Both put options are for the same stock and have the same date of expiration. Investors need the stock to fall for them to profit. The trade-off when investors implement a bear put spread is that their upside is limited, but their premium spent is also lower. If the cost of outright puts is expensive, investors can offset the high premium by selling a lower strike puts against them.
5. Protective Collar
A protective collar option strategy is when an investor buys an out-of-the-money put option while writing an out-of-the-money call option simultaneously for the same stock and expiration. Traders often use this strategy after a long position in an asset has experienced significant gains as it allows them to have downside protection with long puts locking in profits while potentially being forced to sell stocks at a higher price for more profits than current stock levels.
A good example is if a trader is long 100 shares of Apple at $60 and Apple has increased to $120 as of January 1. The trader could create a protective collar by selling one Apple March 15 125 call and simultaneously purchasing one Apple March 15 115 put. The investor is now protected below $115 until March 15, with the trade-off being they will potentially be obligated to sell their shares at $125.
A protective collar is a neutral trade situation, protecting investors if the stock price decreases, but perhaps obligating them to have to sell their long stock at the short call strike, although they will have already experienced increases in the underlying stocks.
6. Long Straddle
When a trader simultaneously buys a call and put option on the same stock, with the same expiration date and strike price, they are implementing a long straddle options strategy. Investors often utilize this strategy when they believe the price of a stock will significantly move out of a range but are unsure which direction it will move. The long straddle strategy provides them the theoretical opportunity for unlimited gains while knowing their maximum loss is limited to the combined costs of both options contracts.
This strategy is profitable when a stock makes a significant enough move in one direction or the other. The trader has no preference in which direction it moves, only that the movement is higher than the total premium they paid.
7. Long Strangle
Traders use the long strangle option strategy when they believe the price of the stock will have a significant movement but aren’t sure in which direction it will move. They buy an out-of-the-money call option at the same time as an out-of-the-money put option on the same stock with the same expiration date, limiting their losses to the cost of both options. This could be for an FDA event on a health care stock or an earnings release for a company. Strangles are almost always less expensive than straddles a the options purchased are out-of-the-money.
The long strangle option strategy is profitable when the stock makes a significant move one way or the other. Once again, the trader isn’t concerned with which direction the stock moves, only that it moves more than the total premium they paid.
8. Long Call Butterfly Spread
In a long call butterfly spread, traders combine the bear spread strategy and the bull spread strategy while using three different strike prices on the same stock with the same expiration date. A long butterfly spread can be created by selling two at-the-money call options while buying one in-the-money call option at a lower strike price and one out-of-the-money call option. When a butterfly spread has equal wing widths, it is considered a balanced butterfly spread. This example is referred to as a “call fly” and will result in a net debit. Investors enter into a long butterfly call spread when they aren’t anticipating much stock movement by the expiration date.
This option strategy has limited downside and limited upside with maximum losses occurring when the stock settles at or below the lower strike or at or above, the higher strike call.
9. Iron Condor
The iron condor option strategy is even more interesting. Here the trader holds a bear call spread and a bull put spread at the same time. The iron condor is established by purchasing one out-of-the-money put and selling one out-of-the-money put of a lower strike, or the bull put spread simultaneously with purchasing one out-of-the-money call and selling one out-of-the-money call of a higher strike, or the bear call spread.
All options are on the same stock and have the same expiration date with the call and put sides usually having the same spread width. This option strategy takes advantage of stocks experiencing low volatility and earns a net premium on the structure. Many investors like this for what appears to be a high probability of earning a small premium amount.
10. Iron Butterfly
The iron butterfly option strategy happens when traders sell an at-the-money put and purchase an out-of-the-money put while selling an at-the-money call and purchasing an out-of-the-money call simultaneously with all options being on the same stock and having the same expiration date. While the iron butterfly strategy has similarities to the butterfly spread, it’s different in that it uses both puts and calls as opposed to just one or the other.
This option strategy combines buying protective “wings” and selling an at-the-money straddle. You can also think of this as having two spreads with each spread usually have the same width. The long out-of-the-money call protects an unlimited downside while the long out-of-the-money put protects the downside from the short put strike to zero. Both profits and losses are limited within a set range, dependent on the strike price of the options used. Traders like this option strategy for the higher probability of a small gain on a non-volatile stock and it’s income generation.
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