Options Trading Strategies
Options trading carries quite a bit of risk; many options trades have the potential for unlimited losses. For this reason, it is important to employ options trading strategies that help protect you from large losses.
Here is a quick refresher on the four basic ways to trade options:
Buying Calls: This type of options trade allows you to purchase the right to buy shares of the underlying asset at the strike price before the expiration date. This type of option is sometimes called a "long call". If the price is not moving in a favorable direction, you can choose to let the options contract expire without buying any shares of the underlying asset. In this scenario, your loss is limited to the premium you paid for the options contract.
Buying Puts: This type of options trade allows you to purchase the right to sell shares of the underlying asset at the strike price before the expiration date. This type of option is sometimes called a "long put". If the price is not moving in a favorable direction, you can choose to let the options contract expire without selling any shares of the underlying asset. In this scenario, your loss is limited to the premium you paid for the options contract.
Selling Calls: This type of options trade allows you to sell the right for someone else to buy shares of the underlying asset from you at the strike price if they exercise their option. This is sometimes called a "short call". This type of options trade comes with a relatively small reward (the premium you collect from the buyer), and a potentially unlimited risk if the underlying asset's price move is unfavorable. Selling a call without taking other measures to protect, or cover, yourself against this risk is why these are also sometimes called "naked calls".
Selling Puts: This type of options trade allows you to sell the right for someone else to sell you shares of the underlying asset at the strike price if they exercise their option. This is sometimes called a "short put", and just like with selling calls, it comes with a small reward (the premium you collect), and potentially unlimited risk. Selling puts without protecting yourself against this risk has earned this type of options trade the nickname of "naked puts".
Selling calls and puts is especially risky, but even buying calls and puts carries some risk. So, how can you mitigate that risk? In this article, we'll go over six types of options trading strategies that can reduce the potential for big losses in your options trades.
Caution: This is a high-level overview of options trading strategies, and does not go into detail about the premiums and other fees involved in making options trades. For example, if you buy a call option and the underlying stock price goes up by $4/share, but you paid a $5/share premium for the options contract, you are not yet making a profit. Be sure to factor in premiums and other fees when calculating your breakeven point on options trades.
Collateralized Strategies
One way to reduce the risk that comes with naked calls and puts is to "cover" that nakedness. Typically, you provide that cover either by already owning shares of the underlying asset, or setting aside cash to purchase the underlying asset if needed. The shares or the cash provide collateral for the trade. Let's look at a few popular collateralized strategies.
Covered Calls
A covered call strategy involves selling a call option on stock (or another asset) that you already own. Covered calls can be an excellent strategy when you are already planning to (or at least are willing to) sell 100 shares of an asset that you own.
In a covered call strategy, you already own 100 shares of the stock, then you sell a call option on the stock. The strike price on the option should be higher than what you paid for the underlying shares.
If the underlying asset's price stays the same or drops, the options contract will likely expire worthless, and you will collect the premium from the buyer. You will still own the underlying shares.
If the underlying asset's price rises above the strike price, then the buyer may exercise their option. In that case, you will supply the shares you own in order to fulfill the contract. You keep the premium, plus any profit you made on the sale of the underlying shares.
While this strategy requires a larger upfront investment (to pay for the 100 shares), it is a relatively low-risk options trade, and is popular with beginner options traders.
Protective Puts
A protective put strategy involves buying a put option on stock (or another asset) that you already own. Protective puts can act as insurance against a large drop in the underlying asset's price.
In a protective put strategy, you already own 100 shares of the stock, then you buy a put option on the stock.
If the underlying asset's price stays the same or rises, you can let the option expire worthless and keep the underlying shares. Your loss will be the cost of the premium for the options contract, which may even be offset by gains in the underlying asset's price.
If the underlying asset's price drops significantly before the options contract's expiration date, you can exercise the option and sell your underlying shares at the higher strike price, minimizing your losses on the sale of that stock.
With this strategy, the goal is to protect yourself from losses if you expect the underlying asset's price to drop.
Cash-Secured Puts
A cash-secured put strategy is when you sell a put option on stock (or another asset) that you do not own. Instead, you set aside enough money in your brokerage account to buy 100 shares of the underlying asset at the strike price, in the event that you need to purchase shares to fulfill the contract.
In a cash-secured put strategy, you set aside the cash to buy 100 shares at a certain price, then you sell a put option on the stock with the strike price set to the same amount you set aside.
If the underlying asset's price rises, the options contract will likely expire worthless, and you will collect the premium from the buyer.
If the underlying asset's price stays the same or drops, the buyer may exercise their option. In that case, you will purchase shares of the underlying asset from the buyer for the strike price, using the cash you set aside earlier. You keep the premium from the buyer.
Cash-secured puts can earn a little extra money in premiums on a share purchase that you were already planning to (or at least were willing to) make.
Volatility Strategies
High volatility can come with high risk. These two options trading strategies attempt to take advantage of big price moves, regardless of the direction of those moves, while reducing the risk that comes with a price move in the wrong direction.
Straddles
A straddle is an options strategy in which you buy (or sell) both a call and a put at the same strike price and expiration date. This way, you're prepared to take advantage of a big price move in the underlying asset, regardless of whether that move is upward or downward.
In a long straddle, you buy both a call option and a put option on the same stock, with the same expiration date. The strike price is the same for both contracts, and is typically at the money (close to the price of the underlying asset at the time the contracts are purchased).
If the underlying asset's price rises dramatically, you exercise the call option (buying shares at the lower strike price), and let the put option expire worthless.
If the underlying asset's price drops dramatically, you exercise the put option (selling shares at the higher strike price), and let the call option expire worthless.
Remember that you will be paying two premiums (one for the put and one for the call), so the underlying asset must make a big enough move to offset the combined price of the two premiums. If the security's price swing is not big enough, then you will let both options expire worthless, and you only lose the cost of the two premiums.
The example above is for a long straddle. There is also a short straddle strategy, where you sell both a call and a put on the same security, with the same expiration date and strike price. In this strategy, you are expecting the underlying asset to not make a big move, allowing both options to expire worthless and netting you both premiums.
Strangles
A strangle is an options strategy in which you buy (or sell) both a call and a put at the same expiration date but different strike prices. This strategy is helpful when you expect the underlying asset to make a big price move before the expiration date, but you are unsure of the direction.
In a long strangle, you buy a call option at a strike price higher than the current price of the underlying asset, and a put option at a lower strike price than the underlying asset's current price. The expiration date is the same for both contracts.
If the underlying asset's price rises dramatically, you exercise the call option (buying shares at the strike price which is now lower than the current price of the underlying asset), and let the put option expire worthless.
If the underlying asset's price drops dramatically, you exercise the put option (selling shares at the strike price which is now higher than the current price of the underlying asset), and let the call option expire worthless.
Remember that you will be paying two premiums (one for the put and one for the call), so the underlying asset must make a big enough move to offset the combined price of the two premiums. If the security's price swing is not big enough, then you will let both options expire worthless, and you only lose the cost of the two premiums.
The example above is for a long strangle. There is also a short strangle strategy, where you sell a call at a higher strike price and sell a put at a lower strike price, with both options having the same expiration date. In this strategy, you are expecting the underlying asset to not make a big move, allowing both options to expire worthless and netting you both premiums.
Note: The strategy behind a strangle is very similar to the strategy behind a straddle. The primary difference is that in strangles, both the call and the put options are typically out of the money, so they usually have lower premiums than the options purchased in a straddle. With this lower cost comes higher risk, however. The underlying asset's price typically has to make a much larger move to profit from a long strangle than from a long straddle. Similarly, the premiums collected with a short strangle are typically smaller than those collected from a short straddle.
Spread Strategies
Spread strategies involve buying one options contract and selling one options contract (either both calls or both puts). The two contracts usually differ in the expiration date (calendar spreads) or in the strike price (vertical spreads). If the two contracts differ in both expiration date and strike price, that is called a diagonal spread.
Calendar spreads and diagonal spreads can be complex for beginners, but vertical spreads are fairly straightforward strategies that can reduce risk for those new to options trading.
Vertical Spreads
A vertical spread is an options strategy in which you buy a call and sell a call (or buy a put and sell a put) with the same expiration date but different strike prices. The spread refers to the difference between the strike prices on the two contracts.
Vertical spreads employ competing options contracts to cap both the risk and the reward in the trade. These strategies do not have unlimited potential gains, but they also do not have unlimited potential losses, making them an attractive choice for beginners to gain experience in options trading.
In a bull call spread, you buy a call option with a lower strike price and sell a call option with a higher strike price, both with the same expiration date. This strategy is helpful when you expect a moderate increase in the underlying asset's price prior to the expiration date.
If the underlying asset's price remains in the range defined by the two options contracts' strike prices, you can either exercise the lower-priced option to buy shares, or let it expire worthless; this will depend on whether the modest price gains outweigh the costs to set up the options trade. The higher-priced option will expire worthless and you will keep the premium.
If the underlying asset's price drops below the range defined by the two options contracts' strike prices, both options expire worthless. You will keep the premium for the option you sold (but you will need to subtract the premium for the option you bought in order to calculate your profit/loss on the trade).
If the underlying asset's price rises above the range defined by the two options contracts' strike prices, then the buyer may exercise the higher-priced option. If so, you can exercise the lower-priced option to buy shares at the lower price to fulfill the other contract.
The bull call spread is the most common type of vertical spread, but there are other options for buying and selling different combinations of higher-priced and lower-priced contracts. All four options are summarized in the table below.
Strategy
Options Bought/Sold
When to Use
Strategy Risk
Bull Call Spread
Buy lower-priced call option and sell higher-priced call option
When a moderate price increase is expected
Gain capped at the difference between the two strike prices, minus the net premium (difference between premium paid and premium collected). Loss capped at the net premium.
Bull Put Spread
Buy lower-priced put option and sell higher-priced put option
When a moderate price increase is expected
Gain capped at the net premium (difference between the premium paid and premium collected). Loss capped at the difference between the two strike prices, minus the net premium.
Bear Call Spread
Sell lower-priced call option and buy higher-priced call option
When a moderate price decrease is expected
Gain capped at the net premium (difference between the premium paid and premium collected). Loss capped at the difference between the two strike prices, minus the net premium.
Bear Put Spread
Sell lower-priced put option and buy higher-priced put option
When a moderate price decrease is expected
Gain capped at the difference between the two strike prices, minus the net premium (difference between premium paid and premium collected). Loss capped at the net premium.
The Iron Condor strategy is a combination of a bull put spread strategy, set below the underlying asset's current price, and a bear call spread strategy, set above the underlying asset's current price. This strategy can be useful when you expect the price of the underlying asset to remain steady.
The lower-priced contract of the bull put spread and the higher-priced contract of the bear call spread protect you from extreme price swings in either direction. The two options contracts in the middle define the price range that you expect the underlying asset's price to remain within. While the profit potential is quite limited with this strategy, the loss potential is also limited.
The Bottom Line
There are options trading strategies for every situation, whether your primary focus is on reducing risk by providing collateral, taking advantage of high volatility, or making the most of time decay and trading ranges. When used sensibly, these long options strategies can reduce risk compared to buying a single long options contract.
Exploring Options Strategies with StockCharts and OptionsPlay
StockCharts has partnered with OptionsPlay to offer the OptionsPlay Add-On for StockCharts members. The add-on provides two tools to help subscribers explore options trading strategies and vet the strategies for specific symbols.
OptionsPlay Strategy Center
The OptionsPlay Strategy Center ranks trade ideas based on your trading preferences. This tool can be used to find trade ideas for Covered Calls, Long Calls, Long and Short Puts, and various vertical spread strategies, including the Iron Condor.
OptionsPlay Explorer
Members who have subscribed to the OptionsPlay add-on can use the OptionsPlay Explorer to research options trade ideas for a specific ticker symbol.
The OptionsPlay Explorer suggests promising options strategies for US stocks. Enter the stock you are interested in, and the OptionsPlay Explorer will suggest three potential options strategies to use, along with profit/loss graphs and other information to help assess the strategy. Users can also click the Modify button on any suggested strategy to customize the trade parameters or choose a different strategy entirely.
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