October 11, 2024

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10 Options Strategies Every Investor Should Know

10 Options Strategies Every Investor Should Know

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, you 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.

Key Takeaways

  • Options trading might sound complex, but there are basic strategies that most investors can use to improve returns, bet on the market’s movement, or hedge existing positions.
  • Covered calls, collars, and married puts are used when you already have an existing position in the underlying shares.
  • Spreads involve buying one (or more) options and simultaneously selling another option (or options).
  • Long straddles and strangles profit when the market moves either up or down.

4 Options Strategies To Know

1. Covered Call

Beyond simply buying call options, the most popular option strategy is to structure a covered call or buy-write transaction. This is a very popular approach 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 buy the underlying stock as usual and simultaneously write—or sell—a call option on those same shares.

For example, suppose you are using a call option on a stock that represents 100 shares of stock per call option. For every 100 shares of stock you buy, you would simultaneously sell one call option against it. This strategy is called a covered call because if a stock price increases rapidly, the short call is covered by the long stock position.

Investors can 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 by selling the call premium or protect against a potential decline in the underlying stock’s value.

In the profit and loss (P&L) chart above, note that as the stock price increases, the negative P&L from the call is offset by the long shares. Because you get a premium from selling the call, as the stock moves through the strike price to the upside, your premium allows you to effectively sell your stock at a higher level than the strike price: strike price plus the premium received.

2. Married Put

In a married put strategy, you buy an asset—such as shares of stock—and simultaneously purchase put options for the same 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.

Investors can use this strategy to protect their downside risk when holding a stock. This acts like an insurance policy; it establishes a price floor if the stock’s price falls sharply. Hence, it’s also known as a protective put.

For example, suppose an investor buys 100 shares of stock and buys one put option simultaneously. This strategy is appealing since investors are protected from the downside if the stock price drops. Meanwhile, investors can profit from all the gains of the pricing going up. The only disadvantage of this strategy is that if the stock doesn’t fall in value, the investor loses the amount of the premium paid for the put option.

In the P&L graph above, with the long put and long stock positions combined, you can see that as the stock price falls, the losses are limited. However, the investor profits above the premium spent on the 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 accepts a limit to their potential profit. They benefit from using up less cash to make the trade than other strategies, such as buying calls or initiating a covered call trade. This creates a trade with a large reward-to-risk ratio when the underlying stock price moves only a bit higher.

The P&L graph above shows that this is a bullish strategy. The stock price has to increase for these trades to go off successfully. 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.

4. Bear Put Spread

The bear put spread strategy is another vertical spread. In this strategy, you simultaneously buy put options at a specific strike price and sell 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 limits both your potential losses and gains.

In the P&L graph above, you can see that this is a bearish approach. For this strategy to be successful, the stock price needs to fall. When employing a bear put spread, your upside is limited, but the premium spent is lower. If outright puts are expensive, one way to offset the high premium is by selling lower strike puts against them.

5. Protective Collar

A protective collar is done by purchasing an out-of-the-money (OTM) put option and simultaneously writing an OTM call option (of the same expiration) when you already own the underlying asset. This approach is often used by investors after a long position in a stock has had substantial gains. This allows you to have downside protection since the long put helps lock in the potential sale price. However, the trade-off is that you may be obligated to sell shares at a higher price, forgoing the potential for further profits.

For example, let’s say you are long on 100 shares of IBM at $100 as of Jan. 1. You could could construct a protective collar by selling one IBM March 105 call and simultaneously buying one IBM March 95 put. You are protected below $95 until the expiration date. The trade-off is that you may be obligated to sell your shares at $105 if IBM trades at that price before expiry.

The P&L graph above shows that the protective collar is a mix of a covered call and a long put. This is a neutral trade setup, meaning that you’re protected should the price of the stock fall. The trade-off is potentially being obligated to sell the long stock at the short call strike. However, you’ll likely be happy to do this because you have already profited from the underlying shares.

6. Long Straddle

A long straddle options strategy involves simultaneously buying a call and put option on the same underlying asset with the same strike price and expiration date. Investors often use this approach when they believe the underlying asset’s price will move significantly out of a specific range, but they are unsure of which direction it will go.

Theoretically, this gives you a chance at unlimited gains. Meanwhile, the maximum loss is limited to the cost of both options contracts.

In the P&L graph below, notice how there are two break-even points. This strategy becomes profitable when the stock significantly shifts in one direction or another. It doesn’t matter which direction the stock moves; it is enough to compensate for the premiums you paid for the options.

7. Long Strangle

In a long strangle options strategy, you buy a call and a put option with a different strike price: an OTM call option and an OTM put option simultaneously on the same underlying asset with the same expiration date. Investors using this approach believe the underlying asset’s price will move significantly but are unsure of which direction.

For example, let’s say you’ve bought Starbucks stock, trading at $50 per share, and want to employ a long strangle strategy by entering into two long options positions: one call and one put, with the same expiration date. You buy a Starbucks call option with a strike price of $52, paying a premium of $3 per share for a total cost of $300 (since each option contract represents 100 shares). Meanwhile, you buy a Starbucks put option with a strike price of $48, paying a premium of $2.85 per share for a total cost of $285. The combined cost of both options is $585.

This strategy is designed to profit from an increase above the call strike price of $52 or a decrease below the put strike price of $48. The trade has a maximum loss of $585 if the stock price remains between $48 and $52 at expiration—so the worst result for you is if the price stays stable.

If the stock price drops to $38 at expiration, the call option will expire worthless, but the put option will gain value. The put will be worth $1,000 (100 shares × $10), and after deducting the initial $285 cost for the put, the trader will have a net gain of $715 on the put option. When the $300 loss from the expired call option is subtracted, the trader’s total profit from the strangle strategy will be $415 ($715 – $300).

Alternatively, if the stock price rises to $57 at expiration, the put option will expire worthless, resulting in a loss of $285. However, the call option will have a value of $500 (100 shares × $5), and after subtracting the $300 cost of the call option, the net gain from the call option is $200. When the loss from the expired put option is factored in, the trader incurs a slight loss of $85 ($200 – $285) because the price increase wasn’t large enough to cover the total cost of the options.

For this strategy to be profitable, Starbucks’ stock price must move significantly below the break-even point of $42.15 or above $57.85 at expiration, covering the total cost of $5.85 per share for both options. As such, the long strangle strategy is best for high-volatility environments, where the stock experiences large price swings in either direction.

An excellent use of this strategy would be a wager on news from an earnings release for a company or an event related to a Food and Drug Administration approval for a pharmaceutical company’s new treatment. These are times when you can expect volatility. Losses are limited to the costs–the premium spent–for both options. Strangles will almost always be less expensive than straddles because the options bought are OTM options.

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, you 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, selling two at-the-money (ATM) call options, and buying one OTM call option. A balanced butterfly spread will have the same wing widths. This example is called a “call fly, ” resulting in a net debit. Investors enter into a long butterfly call spread when they think the stock will not move much before expiration.

In the P&L graph below, notice how the maximum gain is when the stock remains unchanged until expiration–at the point of the ATM strike. The further 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 a limited upside and downside.

9. Iron Condor

The iron condor is a neutral strategy designed to profit from low volatility. The investor simultaneously holds a bull put spread and a bear call spread, and the iron condor is constructed by selling one OTM put, buying one OTM put of a lower strike, selling one OTM call, and buying one OTM 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 approach earns a net premium on the structure and is designed to take advantage of low volatility.

For example, say you collect $4 per iron condor ($400 for each 100-share contract) by selling OTM puts and calls while protecting against large movements with further OTM options. The maximum profit of $4,000 occurs if the stock price stays between $95 and $110 at expiration, allowing all options to expire worthless. However, if the stock price falls below $91 or rises above $114, the strategy begins to incur losses. The maximum loss of $6,000 occurs if the stock price is below $85 or above $120 at expiration.

This strategy is best when you’re not expecting big price moves in the underlying stock since the most profitable outcome occurs within the range of the strike prices for the options sold.

10. Iron Butterfly

In the iron butterfly strategy, you sell an ATM put and buy an OTM put. Meanwhile, you also sell an ATM call and buy an OTM call. All options have the same expiration date and are on the same underlying asset. Although this strategy is like a butterfly spread, it uses both calls and puts (instead of one or the other).

This approach essentially combines selling an ATM straddle and buying protective “wings.” You can also think of the construction as two spreads. It’s common to have the same width for both spreads. The long OTM call protects against unlimited upside. The long OTM put protects against the downside (from the short put strike to zero). Profit and loss are 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 nonvolatile stock.

Let’s use an example. Suppose you expect IBM’s stock to rise slightly after a good earnings report, with implied volatility declining in the coming two weeks. Thus, IBM’s stock should remain near $160 over the next two weeks. By selling an ATM straddle (selling both the 160 call and 160 put) and buying further OTM options (the 165 call and 155 put), you collect a net credit of $550.

The maximum profit occurs if IBM’s stock price stays at $160, allowing both sold options to expire worthless. Your risk is capped by the OTM options you bought, which limits losses if the stock price moves sharply beyond $154.50 or $165.50.

You start the trade with an initial net credit of $550 ($5.50 per share) and will profit as long as IBM’s stock price stays between $154.50 and $165.50 at expiration. You enter the following trades:

  • Sell one IBM 160 call
  • Sell one IBM 160 put (creating the ATM straddle)
  • Buy one IBM 165 call (to limit upside risk)
  • Buy one IBM 155 put (to limit downside risk)

The maximum loss is limited to the width of the spread minus the premium collected. The distance between the strikes of the short call/put and the long call/put is $5 per share (or $500 per contract).

Which Options Strategies Can Make Money in a Sideways Market?

A sideways market is one where prices don’t change much over time, making it a low-volatility environment. Short straddles, short strangles, and long butterflies all profit in such cases, where the premiums received from writing the options will be maximized if the options expire worthless (e.g., at the strike price of the straddle).

Are Protective Puts a Waste of Money?

Protective puts are insurance against losses in your portfolio. Like all other types of insurance, you pay a regular premium to the insurer and hope that you never need to file a claim. The same is true for portfolio protection: you pay for the insurance, and if the market does crash, you’ll be better off than if you didn’t own the puts.

What Is a Calendar Spread?

A calendar spread involves buying (selling) options with one expiration and simultaneously selling (buying) options on the same underlying in a different expiration. Calendar spreads are often used to bet on changes in the volatility term structure of the underlying.

What Is a Box Spread?

A box is an options strategy that creates a synthetic loan by going long a bull call spread along with a matching bear put spread using the same strike prices. The result will be a position that always pays off the distance between the strikes at expiration. So if you put on a 20-strike, 40-strike box, it will always expire worth $20. Before expiration, it will be worth less than $20, making it like a zero-coupon bond. Traders use boxes to borrow or lend funds for money management purposes depending on the implied interest rate of the box.

The Bottom Line

While options trading can seem intimidating to new market participants, there are many strategies that can help limit risk and increase return. Some strategies use several offsetting options. Covered calls, collars, and married puts are among the options for those who are already invested in the underlying asset, while straddles and strangles can be used to establish a position when the market is on the move.

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