Options Strategies Every Trader Should Know
During volatile markets, traders are often looking for an edge. Options have proven to be valuable tools for traders navigating a volatile market. Learning specific option strategies for differing market conditions can help traders to be more profitable and hedge against potential losses.
In this article, we’re going to discuss the following:
- Long Calls
- Long Puts
- Option Spread Positions
- Option Straddle Positions
- Option Strangle Positions
- Iron Condors
- Covered Calls
In volatile markets, options can be a trader’s best friend. Trading Options can allow traders to take advantage of the volatility instead of fearing it. Options contracts are leveraged, meaning one options contract controls the movement of 100 underlying shares.
These types of positions allow traders to enter trades using less capital. Options contracts are also one of the best ways to hedge against adverse market movements, making them an excellent tool for managing risk.
One of the most advantageous characteristics of options trading is that traders can profit in any market – bullish, bearish, or sideways.
For example, during earnings, one of the most vulnerable times for trading, an earnings announcement can propel a stock higher or lower.
Options trading volumes tend to increase around these events as traders look to position themselves for these potential moves in either direction.
Trading Options During Earnings Season
Let’s be clear; options trading isn’t for everyone, especially during earnings season. The increased volatility keeps most traders out of a position until they know which direction the earning report will push the stock in question. However, options trading affords traders the unique ability to take advantage of the volatility associated with an earnings report.
While some stock traders and investors may live in fear of earning announcements, it is often a time of joy for many options traders as they position themselves to benefit from earnings volatility.
What is an “earnings play”?
For example, NVDA expects a substantial earnings report that might push the stock higher. This often results in an increased premium cost for the option. A trader may sell a credit spread to take advantage of the increased premiums, putting theta decay in their favor. A credit spread limits the risk of taking the trade and caps the potential profit. It also requires less capital than taking a directional play because it involves selling an options contract.
The specific types of trades detailed in the rest of this article will help traders understand the different types of option strategies and the best time to use them.
Long Call and Long Put Options
Traders use two types of long options – long calls and long puts.
A long call option gives a trader the right, but not the obligation, to buy shares of a stock for a predetermined price and time.
The optimal time to use a long call is when the market outlook is bullish, and a stock price is expected to rise.
A long put option does the opposite. The long put option gives traders the right to sell shares of that stock in the future for a preset price.
One advantage of buying a put option contract is that it requires less capital than the cost associated with selling 100 shares of the underlying asset.
The downside risk is limited to the price of the options contract.
The long put is a bearish position in the market. Traders use long put options if they think a security’s price will fall.
Investors may use long put options to speculate or hedge as downside risk is limited when using a long put options strategy.
Put options are often more expensive than call options because investors typically use these contracts to hedge against downward moves in the market. Market makers know investors are willing to pay a higher premium for this protection, driving the price of put options higher.
We will discuss how options traders can benefit from selling put options contracts later in this article.
Working With Options Spreads
When working with options spreads, three key things to keep in mind are:
- All options are trading the same underlying asset.
- All options use the same type– either a call or a put.
- An options spread always has the same number of purchased and sold options (such as five short and five long).
An options spread only differs in the strike price and expiration date. Creating a wide assortment of vertical, horizontal, diagonal, credit, debit, and bull spreads is still possible. They are all different types of options spreads.
Bull Call Spread Options Strategy
A bull call spread (debit), also known as a call vertical spread, is an options trading strategy designed to benefit from a modest increase in a stock price. This strategy uses two call options to create a range consisting of a lower strike price and an upper strike price. Two scenarios can play out using this strategy:
- Bull Vertical Call Spread (Debit) is a strategy employed when traders presume the asset price will go up before the call option expires, using a bull call vertical spread.
- Bear Vertical Call Spread (Credit) On the flip side, if a trader anticipates the asset’s price will fall before the expiry date, they use a bear call vertical spread.
On a positive note, the bullish call spread helps to limit losses of trading a stock, but it also limits gains. Options spreads are created by buying and selling options on the same underlying asset but at different strike prices. The options may have the same – or even further – expiration dates.
Remember, an options spread consists of only one type of option. This means they are either a call or put, but not both. An option spread has the same number of long and short options.
Bear Put Spread Options Strategy
A bear put spread (debit) consists of buying a put and selling a put at a lower strike price. The “spread,” or difference between strike prices earns a profit if the stock price moves lower. The potential profit and risk are both limited.
A bear put spread, or vertical spread, consists of buying one put in hopes of profiting from a decline in the underlying stock, then writing another put with the same expiration but with a lower strike price to offset the cost. This strategy requires a net debit.
Should the underlying asset move lower toward the lower strike price, the bear put spread performs similarly to a long put by itself. The possibility of increased profit stops there. A lower short put strike results in a higher potential profit, although a smaller amount of the premium is received. This strategy profits from a near-term decline in the stock.
The profit/loss payoff profiles are the same compared to the bear call spread. The primary difference is the timing of the cash flows. The bear put spread requires a known debit for an unknown return.
A vertical put spread can be used as a bullish or bearish strategy. This depends on how the strike prices are selected for the long and short positions.
Maximum loss on a vertical put spread: The underlying stock trades above the higher put’s strike price at expiration. This would result in both options in the spread expires worthless.
The maximum gain on a vertical put spread: The best case scenario for this spread is that the stock price is below both strike prices at expiration.
The maximum profit on this spread is the difference between the two strike prices, less the debit paid to establish the spread.
Break-even on a vertical put spread: This spread will break even if, at expiration, the stock price is below the upper put’s strike, a price equal to the debit paid to establish the position.
Straddle Options Strategy
A straddle options strategy involves the purchase of both a put and call option with the same expiration date and strike price. This strategy is profitable when the stock rises or falls from the strike price by more than the total premium paid.
To execute a long straddle, the investor buys an at-the-money call, and an at-the-money put with the same expiration date and strike price.
Traders favor using a straddle option when they anticipate a significant move in the stock price but aren’t sure which direction the stock will move.
Strangle Options Strategy
A strangle options strategy is a position with both a call and a put contract with different strike prices and the same date of expiration.
A strangle is a good strategy should you expect the security will experience a significant price movement.
The straddle and strangle options approaches involve purchasing an equal number of calls and put options with the same expiration date. However, the strangle strategy has two different strike prices, while the straddle has a common strike price.
A long strangle is a strategy where both a long call and long put with different strike prices – but the same expiration date – are purchased simultaneously. This options strategy has an unlimited profit potential on either side of the market.
Profits are earned when the underlying asset moves past a break-even point in either direction.
A short strangle involves simultaneously selling call and put options at different market prices but with the same maturity date.
This strategy benefits traders because a premium is collected from the sale of both options, but only if the asset’s price stays between the two strike prices while the options contract is at expiration.
Traders use the short strangle position with the expectation that the underlying asset’s price will trade within a specific range, resulting in time or Theta decay of both options.
Butterfly Options Strategy
The butterfly options strategy is a neutral, multi-leg setup that combines bullish and bearish spreads. Butterflies are one of our favorite strategies. Why? Because they typically require less premium to initiate. A typical butterfly spread can cost less than half of a long call option on the same stock.
Butterfly spreads can use both puts and calls. Traditionally, traders can make earn credit when they sell calls or puts and are debited when they buy calls or puts. To take on a more risk-defined trade, traders can sell & buy a put at a lower strike. Creating a put vertical spread.
Also, traders can sell and buy a call together to create a call vertical spread. To achieve a butterfly spread, you’re just combining two vertical spreads.
For maximum profit, traders look for the stock to be near the middle strike close to the expiration date of the trade. Butterfly prices fluctuate wildly while in the trade because there are three legs to the trade. When traders buy a butterfly, the maximum loss is what was paid for the trade.
Butterfly options trades gain most of their value the closer to expiration they get. When trading butterflies, you want to project price and timing to determine the strike prices and expiration date you choose.
Iron Condor Options Strategy
An iron condor is an options strategy containing two puts (one long and one short), and two calls (one long and one short), all with different strike prices – but the date of expiration.
The iron condor setup earns a maximum profit when the asset closes between the middle strike prices at expiration. This strategy attempts to profit from low volatility.
The condor strategy and the iron condor are extensions of the butterfly spread and iron butterfly, respectively.
As a delta-neutral options strategy that profits the most when the underlying asset does not move much, the strategy can be modified with a bullish or bearish bias. Like an iron butterfly, an iron condor is composed of four options with the same date of expiration: a long put further out of the money (OTM) and a short put closer to the money, a long call further OTM, and a short call closer to the money.
Profit is limited to the credit received, while potential loss is limited to the difference between the bought and sold call strikes and the bought and sold put strikes—less the net premium received.
A covered call is a popular strategy to generate income from options premiums. When traders only anticipate little movement in the stock (or asset) price, they can execute a covered call.
To execute a covered call, a trader holding a long stock position then writes (sells) call options on that asset. Covered calls are often used by traders who plan on holding underlying stock for an extended period of time but do not expect any considerable price change in the short term (hence it is not considered one of the short-term options strategies).
The covered call position can serve as a hedge on a long stock position, allowing investors to generate income, or premium, by selling calls against that stock. This strategy can work well if the stock price stays below the option strike price. If the stock price moves above the strike price of the option, the investor will forfeit gains in the underlying stock. The investor is also obligated to sell 100 shares of stock per every contract written if the buyer exercises the options contract.
A covered call strategy isn’t helpful during bullish or bearish market environments. Bullish investors are typically better off holding the stock. If an investor has a bearish sentiment, they may consider selling their position, as the premium generated from the covered call will probably not offset the potential loss of a significant move downwards.
A: In a long trade, traders purchase an asset to sell when the price goes up. The terms “buy” and “long” are used interchangeably. A short trade is made in anticipation that the stock price will move lower. With a short trade, traders borrow an asset, sell it, and hope to buy it back when the price goes down.
A: Short-selling stock is not available for all investors as this requires a margin account. Short selling has unlimited risk as the asset has unlimited upside potential. The long put option gives the buyer the right, but no obligation, to sell shares of the underlying stock at the strike price on or before expiration.
A: All options and their related spreads are trading the same underlying asset or stock. An options spread only differs in the strike price and/or expiration date. It is possible to create a wide assortment of spreads such as vertical, horizontal, diagonal, credit, debit, and bull spreads.