Trading strategies with options

Often times, traders or investors will combine options using a spread strategy , buying one or more options to sell one or more different options. Spreading will offset the premium paid because the sold option premium will net against the options premium purchased. Moreover, the risk and return profiles of a spread will cap out the potential profit or loss. Spreads can be created to take advantage of nearly any anticipated price action, and can range from the simple to the complex.

As with individual options, any spread strategy can be either bought or sold. Investors and traders undertake option trading either to hedge open positions for example, buying puts to hedge a long position , or buying calls to hedge a short position or to speculate on likely price movements of an underlying asset. The biggest benefit of using options is that of leverage. The investor is bullish in the short term on XYZ Inc. Our investor can buy a maximum of 10 shares of XYZ. Now, instead of buying the shares, the investor buys three call option contracts.

When the broker's cost to place the trade is also added to the equation, to be profitable, the stock would need to trade even higher. These scenarios assume that the trader held till expiration. That is not required with American options. At any time before expiry, the trader could have sold the option to lock in a profit. Or, if it looked the stock was not going to move above the strike price, they could sell the option for its remaining time value in order to reduce the loss. Here are some broad guidelines that should help you decide which types of options to trade.

Are you bullish or bearish on the stock, sector, or the broad market that you wish to trade? Making this determination will help you decide which option strategy to use, what strike price to use and what expiration to go for. Is the market calm or quite volatile? How about Stock ZYX? As you are rampantly bullish on ZYX, you should be comfortable with buying out of the money calls. You decide to go with the latter since you believe the slightly higher strike price is more than offset by the extra month to expiration. In this case, you could consider writing near-term puts to capture premium income, rather than buying calls as in the earlier instance.

As an option buyer, your objective should be to purchase options with the longest possible expiration, in order to give your trade time to work out. Conversely, when you are writing options, go for the shortest possible expiration in order to limit your liability. Trying to balance the point above, when buying options, purchasing the cheapest possible ones may improve your chances of a profitable trade.

Implied volatility of such cheap options is likely to be quite low, and while this suggests that the odds of a successful trade are minimal, it is possible that implied volatility and hence the option are under-priced. So, if the trade does work out, the potential profit can be huge. Buying options with a lower level of implied volatility may be preferable to buying those with a very high level of implied volatility, because of the risk of a higher loss higher premium paid if the trade does not work out.

There is a trade-off between strike prices and options expirations , as the earlier example demonstrated.

What is Options Trading?

An analysis of support and resistance levels, as well as key upcoming events such as an earnings release , is useful in determining which strike price and expiration to use. Understand the sector to which the stock belongs. For example, biotech stocks often trade with binary outcomes when clinical trial results of a major drug are announced. Deeply out of the money calls or puts can be purchased to trade on these outcomes, depending on whether one is bullish or bearish on the stock. Obviously, it would be extremely risky to write calls or puts on biotech stocks around such events, unless the level of implied volatility is so high that the premium income earned compensates for this risk.

By the same token, it makes little sense to buy deeply out of the money calls or puts on low-volatility sectors like utilities and telecoms. Use options to trade one-off events such as corporate restructurings and spin-offs, and recurring events like earnings releases.

Stocks can exhibit very volatile behavior around such events, giving the savvy options trader an opportunity to cash in. For instance, buying cheap out of the money calls prior to the earnings report on a stock that has been in a pronounced slump , can be a profitable strategy if it manages to beat lowered expectations and subsequently surges. Investors with a lower risk appetite should stick to basic strategies like call or put buying, while more advanced strategies like put writing and call writing should only be used by sophisticated investors with adequate risk tolerance.

Buyers: Who Wins? Trading Techniques. Your Privacy Rights. To change or withdraw your consent choices for Investopedia. This is how a bear put spread is constructed. 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. 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. 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.

This strategy becomes profitable when the stock makes a large move in one direction or the other. 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. This strategy becomes profitable when the stock makes a very large move in one direction or the other. 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. An investor would enter into a long butterfly call spread when they think the stock will not move much before expiration. 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.

Options in today's market

This strategy has both limited upside and limited downside. 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. 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. 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 buy an out-of-the-money call. Although this strategy is similar to a butterfly spread , it uses both calls and puts as opposed to one or the other. It is common to have the same width for both spreads. Google Play is a trademark of Google Inc. Amazon Appstore is a trademark of Amazon.

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