10 Options Strategies Every Investor Should Know

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10 Options Strategies Every Investor Should Know

Traders often enter the options market with minimal knowledge of the options methods accessible to them. There are several ways available to reduce risk while maximizing reward. Traders may learn how to take advantage of the flexibility and power that stock options can give with a little effort.

Here are ten options strategies that every investor should be familiar with.

Key Takeaways

  • Options trading may seem complicated, but there are many fundamental tactics that ordinary investors may employ to boost profits, wager on market movement, or hedge current holdings.
  • When you already have a stake in the underlying shares, you may employ covered calls, collars, and married puts.
  • Spreads include purchasing one (or more) options while concurrently selling another (or options).
  • Long straddles and strangles make money when the market goes up or down.

4 Options Strategies To Know

1. Covered Call

One method for calls is to just purchase a naked calloption. A simple covered callorbuy-write may also be constructed. This is a popular technique since it creates revenue while reducing the danger of being long only on the stock. The downside is that you must be willing to sell your shares at a predetermined price—the short strike price. To implement the method, you buy the underlying stock as usual and concurrently write (or sell) a call option on those identical shares.

Assume an investor purchases a call option on a stock that represents 100 shares of stock per call option. For every 100 shares of stock purchased, the investor would sell one call option against it. This method is known as a covered call because if the stock price rises quickly, the investor’s short call is covered by the long stock position.

This approach may be used by investors who have a short-term holding in the stock and a neutral judgment on its direction. They may be aiming to make money from the selling of the callpremium or to protect against a possible drop in the value of the underlying stock.

Image by Julie Bang © Investopedia 2019

In the profit and loss (P&L) graph above, notice how the negative P&L from the call is compensated by the long shares position as the stock price rises. Because the investor obtains a premium for selling the call, when the stock rises over the strike price, they may effectively sell their shares at a greater level than the strike price: strike price plus the premium earned. The P&L graph of a covered call is similar to that of a short, naked put.

2. Married Put

Amarried putstrategy involves an investor purchasing an asset (such as stock) and concurrently purchasing put options for an equal number of shares. A put option gives the holder the right to sell stock at the strike price, and each contract is worth 100 shares.

When owning a stock, an investor may opt to employ this method to mitigate downside risk. This method works similarly to an insurance policy in that it sets a price floor in the event that the stock’s price falls dramatically. This is why it is sometimes referred to as a protective put.

Assume an investor purchases 100 shares of stock and one put option at the same time. This method may appeal to this investor since it protects them against the downside in the case of a negative change in the stock price. Simultaneously, the investor would be able to partake in any upside possibility if the stock increased in value. The sole downside of this technique is that the investor loses the premium paid for the put option if the stock does not decline in value.

Image by Julie Bang © Investopedia 2019

The dashed line in the P&L graph above represents the long stock position. When the long put and long stock bets are combined, the losses are restricted as the stock price declines. However, the stock may share in the upside beyond the price paid for the put. The P&L graph of a married put is comparable to that of a long call.

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3. Bull Call Spread

A bull call spread strategy involves an investor buying calls at a given strike price while concurrently selling the same number of calls at a higher strike price. The expiry date and underlying asset for both call options will be the same.

This form of vertical spread technique is often utilized when an investor is optimistic on the underlying asset and anticipates a slight increase in the asset’s price. Using this method, the investor may restrict the trade’s upside while simultaneously lowering the net premium paid (compared to buying a naked call option outright).

Image by Julie Bang © Investopedia 2019

This is a bullish approach, as seen by the P&L graph above. To execute this technique effectively, the trader must see the stock price rise in order to earn from the deal. The downside of a bull call spread is that your upside potential is restricted (even though the amount spent on the premium is reduced).When outright calls are costly, one strategy is to sell higher strike calls against them to offset the increased premium. This is how a bull call spread is built.

How To Manage A Bull Call Spread

4. Bear Put Spread

Another kind of vertical spread is the bear put spread method. In this technique, the investor buys put options at a specified strike price while concurrently selling the same amount of puts at a lower strike price. Both options are acquired for the same underlying asset and expire on the same date. This approach is utilized when the trader has a pessimistic attitude toward the underlying asset and anticipates its price to fall. The method allows for both restricted losses and benefits.

Image by Julie Bang © Investopedia 2019

The P&L graph above shows that this is a negative approach. The stock price must decline in order for this method to be effective. The downside is restricted when using a bear put spread, but the premium invested is minimized. If outright puts are costly, one approach to compensate is to sell lower strike puts against them. This is how a bear put spread is built.

5. Protective Collar

A protectivecollarstrategy is performed by purchasing anout-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 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.

As an example, suppose an investor is long on 100 shares of IBM at $100 on January 1. By selling one IBM March 105 call and concurrently purchasing one IBM March 95 put, the investor might create a protective collar. The trader is protected if the price falls below $95 till the expiry date. The trade-off is that they may be required to sell their shares at $105 if IBM trades at that price before expiration.

Image by Julie Bang © Investopedia 2019

The protective collar in the P&L graph above is a hybrid of a covered call and a long put. This is a neutral trade setup, which implies the investor is protected if the stock falls. The trade-off is that you may be forced to sell the long stock at the short call strike. However, the investor is likely to be pleased since they have already seen increases in the underlying equities.

What is a Protective Collar?

6. Long Straddle

A straddleoptions strategy happens when an investor purchases a call and put option on the same underlying asset with the same strike price and expiry date at the same time. This approach is often used by investors who anticipate the price of the underlying asset will move dramatically outside of a specified range but are unclear which direction the move will take.

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In theory, this technique provides the investor with the chance for endless returns. At the same time, this investor’s maximum loss is restricted to the cost of both options contracts combined.

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Take note of the two breakeven marks in the P&L graph above. When the stock makes a huge move in one way or the other, this method becomes lucrative. The investor doesn’t care which way the stock goes; all that matters is that it moves more than the whole premium paid for the arrangement.

7. Long Strangle

A longstrangleoptions strategy involves the investor purchasing a call option and a put option with separate strike prices: an out-of-the-money call option and an out-of-the-money put option on the same underlying asset with the same expiry date. An investor who employs this approach thinks the underlying asset’s price will suffer a significant fluctuation but is unclear about the direction of the movement.

This technique may, for example, be a bet on news from a company’s earnings release or an event connected to a Food and Drug Administration (FDA) clearance for a pharmaceutical stock. Losses are restricted to the price paid on both options. Because the options bought are out-of-the-money, strangles are usually always less costly than straddles.

Image by Julie Bang © Investopedia 2019

Notice how the orange line in the P&L graph above depicts the two break-even positions. This technique gets lucrative when the stock price moves significantly, either up or down. The investor doesn’t care which way the stock swings; all that matters is that it moves enough to put one option or the other in the money. It must be more than the whole premium paid for the structure by the investor.

8. Long Call Butterfly Spread

Previous techniques required the merger of two distinct roles or contracts. An investor will use both a bull spread strategy and a bear spread technique in a longbutterfly spread employing call options. They will also use three distinct strike pricing. The underlying asset and expiry date are the same for all options.

A long butterfly spread, for example, may be formed by acquiring one in-the-money call option at a lower strike price, selling two at-the-money call options, and purchasing one out-of-the-money call option. The wing widths of a balanced butterfly spread will be the same. This is known as a “call fly,” because it results in a net debit. When an investor believes the stock will not move much before expiry, he or she will purchase a long butterfly call spread.

Image by Julie Bang © Investopedia 2019

Notice how the largest gain is generated in the P&L graph above when the stock stays stable until expiration—at the moment of the at-the-money (ATM) strike. The higher the negative shift in the P&L, the farther the stock moves away from the ATM strikes. When the stock closes at the lower strike or below, the maximum loss happens (or if the stock settles at or above the higher strike call).This method offers a limited reward as well as a restricted drawback.

9. Iron Condor

In the iron condor strategy, the investor owns both a bull put spread and a bear call spread at the same time. The iron condor is built by selling one out-of-the-money (OTM) put and purchasing one OTM put with a lower strike—a bull put spread—and selling one OTM call and buying one OTM call with a higher strike—a bear call spread.

All options expire on the same day and are based on the same underlying asset. Typically, the spread widths on the put and call sides are the identical. This trading method generates a net premium on the structure and is intended to profit from a stock with minimal volatility. Many traders use this approach due to the perceived high likelihood of making a little premium.

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Image by Julie Bang © Investopedia 2019

Notice how the biggest profit is produced in the P&L graph above when the stock continues in a rather broad trading range. As a consequence, the investor may profit from the entire net credit earned while structuring the deal. The larger the loss up to the maximum loss, the farther away the stock travels via the short strikes—lower for the put and higher for the call.

The greatest loss is frequently far greater than the maximum gain. This makes obvious sense, given that the structure is more likely to end with a tiny benefit.

10. Iron Butterfly

An investor will use the iron butterfly method to sell an at-the-money put and purchase an out-of-the-money put. Simultaneously, they will sell an at-the-money call and purchase an out-of-the-money call. All options expire on the same day and are based on the same underlying asset. Although similar to the abutterfly spread, this technique employs both calls and puts (as opposed to one or the other).

This approach combines selling an at-the-money straddle with purchasing protection “wings.” The structure may alternatively be thought of as two spreads. It is typical for both spreads to have the same width. The out-of-the-money call is long and protects against limitless downside. The long, out-of-the-money put hedges against potential losses (from the short put strike to zero).Profit and loss are both restricted to a certain range, based on the strike prices of the options employed. Investors appreciate this technique because it provides income and has a greater chance of making a tiny profit with a non-volatile stock.

Image by Julie Bang © Investopedia 2019

Notice in the P&L graph above that the largest amount of profit is realized when the stock stays at the at-the-money strikes of both the sold call and put options. The entire net premium received is the maximum gain. When the stock rises above the long call strike or below the long put strike, the maximum loss occurs.

Which Options Strategies Can Make Money in a Sideways Market?

A sideways market is one in which prices do not vary much over time, resulting in a low-volatility situation. In such instances, short straddles, short strangles, and long butterflies all benefit since the premiums gained from writing the options are 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 portfolio losses. You pay a monthly payment to the insurer and hope that you never need to submit a claim, just as with any other form of insurance. The same is true for portfolio protection: you pay for the insurance, and if the market crashes, you’ll be better off than if you hadn’t purchased the puts.

What Is a Calendar Spread?

A calendar spread includes purchasing (selling) options with one expiry and concurrently selling (buying) options with a different expiration on the same underlying. Calendar spreads are often utilized to speculate on changes in the underlying’s volatility term structure.

What Is a Box Spread?

A box is an options strategy that generates a synthetic loan by buying a bull call spread and a bear put spread with the identical strike prices. As a consequence, after expiry, the position will always pay off the distance between the strikes. As a result, putting up a 20-strike, 40-strike box will always expire for $20. It will be valued less than $20 before expiry, making it a zero-coupon bond. Traders use boxes to borrow or lend cash for money management reasons, based on the box’s indicated interest rate.

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