Investing > Options Trading Strategies

Options Trading Strategies

In this guide, we explain the most common options strategies — how they function and which situations they're best for — with plenty of examples.

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Interested in trading options? You’ll need to know which strategies are out there — and which are most suited to your investment style.

Options trading strategies are blueprints to help investors both protect their investments and maximize their chances of success. They provide investors with lots of flexibility to enable them to configure investments in a way and manner that will benefit them the most. 

There are a variety of option trading strategies available, some built on simple, “one-legged” trades, to more complex, multipronged instruments. 

Puts and calls are the foundational building blocks upon which all option trading strategies are constructed. They represent the most basic, straightforward strategies for selling or buying options and we have already discussed them in previous posts.  

These two option choices, along with creative use of strike prices and expiration dates, provides an investor with immense opportunity to both control risk and increase profits simultaneously.

However, more complex combinations of options and spread strategies have arisen to address a wider range of market scenarios and investor needs based on market outlook, volatility, capital gains, and income imperatives.

The breadth of the subject matter is significant, however, this article hopes to provide a more than a cursory glance beyond the fundamentals of options trading.

1. Our options trading categorization

Options trading strategies exist in various permutations and combinations, and this section and the next attempts to tie them together with a neat, coherent ribbon.

Broadly speaking, option trading strategies can be categorized into one or more of the following frameworks:

  1. The basic strategies which include the long and short variations of call and put options.
  2. Protective strategies such as protective puts and collar strategies
  3. Strategies to enhance option trades such as covered calls and cash-covered puts
  4. Vertical strategies such as spreads such as long put/short call spreads, and long call/short put spreads.
  5. Calendar strategies

While the preceding paints option strategies in broad strokes, a more hierarchical framework is often more practical in depicting how traders use these techniques:

  • Proficiency level: Certain trading strategies are only appropriate for certain type of traders because of their levels of complexity and sophistication:
    1. Novices
    2. Intermediates
    3. Advanced traders
    4. Expert traders
  • Market outlook: certain strategies are dictated by the direction of the market
    1. Bullish market conditions
    2. Bearish market conditions
    3. Sideways market conditions
  • Volatility
    1. High volatile markets
    2. Low volatile markets
  • Risk
    1. Capped risk
    2. Uncapped risk
  • Reward
    1. Capped reward
    2. Uncapped reward
  • Strategy type
    1. Income strategies
    2. Capital gain strategies
  • Strategy legs
    1. Long call
    2. Short call
    3. Long put
    4. Short put

Option strategies aren’t mutually exclusive; in fact most traders either knowingly or inadvertently deploy them in overlapping fashion to attain more than just a specific set of goals and objectives.

Due to obvious time and space constraints, we’ll focus only on options trading strategies that fall within the categorization of strategy legs and market outlook.

At least one example from the market outlook strategy which indicates the direction of the market as either bullish, bearish, volatile, and sideways is included. 

Next, we’ll look at the strategy legs upon which the basic option strategies rest upon. 

2. The four basic options strategies

Though they come in a variety of flavors, all options trading, no matter how complex, is ultimately based on just two fundamental trading instruments: calls and puts.

Just like complex mathematical formulas and sophisticated algorithms are built upon the basic arithmetic, investors use puts and calls to create a range of trading strategies to suit their financial objectives. The basic option strategies traders use are still based on calls and puts, though a more extensive categorization is preferred by delving deeper into their roles, namely: long call, short call, long put, and the short put.

If you’re confused by the long and short prefix, just remember the following as an elementary rule in trading: long means to buy; short means to sell. 

Most of the time it helps to provide readers a snapshot of information in one place so that comparisons and contrasts can be seen up close by virtue of proximity.

  • Long call: a long call indicates the trader is buying a call option, betting for a rise in prices because they want to buy below market value and make a profit.
  • Short call: this occurs when an investor is selling a call option. This seller (or writer) writes call options and is betting that prices will fall because she wants to sell the underlying stock above market value. This seller has the obligation to provide the corresponding long position (call buyer) with the underlying shares in the event they choose to exercise their contract.
  • Long put: The trader has bought an option which gives her the right to sell the underlying asset at the strike price before expiration. The trader wants stock prices to fall because she wants to sell the stock at above market price, and thereby earning a profit.
  • Short put: this put writer is bullish on the market and wants the stock prices to rise beyond the strike price by expiration. It is a means of generating income or achieving a more attractive buy price because she wants to purchase the stock below market value. This seller has the obligation to provide the corresponding long position (put buyer) with the commensurate cash (by purchasing the stock) in the event they choose to exercise their contract.

These four option strategies are the foundational basis on which their other more complex cousins are built. 

Option strategies are used by investors to gain exposure to a specific type of opportunity while reducing risk. One of the defining features of option strategies is how they allow investors to profit from movements in their underlying assets usually based on market sentiment, market direction, and time decay.

2.1 Price movement (volatility) and time decay

They say death and taxes are the only constant features of life. With options, time decay happens to be their Krytonite.

Option contracts are a wasting or depreciating asset. Due to this factor, investors typically prefer to own options with expiration dates that are far out into the future, so that their stock has a chance to increase in value. 

However, options are affected by time decay in different ways. For instance, if time decay hurts investors when they buy options, it helps them when they sell options. Since time value decreases (time decay increases) rapidly during the last month to expiration of the contract, investors usually don’t like to own options for that last month. 

3. Bullish Strategies

3.1 Long Calls

  • Investor outlook: Bullish on the underlying stock or index
  • Risk: Limited to only the premium paid (though it is 100% of the amount invested by the investor)
  • Reward: Unlimited, albeit potentially,  to the upside of the underlying stock
  • Position: Considered a net debit trade since the investor pays the premium for the trade
  • Break Even point: Strike price plus premium paid

In this strategy, the investor is betting that the market will make an upward move, and the underlying stock will rise higher than the strike price. 

This is the most common strategic option choice among option traders, and the easiest to learn. 

Assuming a certain fictitious company, ABC’s stock currently trades at $90 per share and an investor is feeling bullish about its prospects. A call option contract at $100 strike is available for $2, expiring in six months.

ABC eventually expires at $110, leaving the investor with a profit of $8: $110 – ($100 + $2). A contract is worth 100 shares, so the net profit is $800; or $1,600 if two option contracts were purchased.

Conversely, if the stock fell below the strike price at expiry, the investor would lose $2 for each share; therefore, the net loss is $2 x 100 ($200) shares. 

The graph below approximates the long call:

The Long Call
The graph above approximates the long call.

Advantages

  • Limited risks, yet yields unlimited potential
  • Provides more leverage than simply owning stock
  • Requires a less amount of capital to pull off than buying the stock outright

Disadvantages

  • Time decay is often more perilous for bullish strategies
  • Loss of 100% of investment income if the trade goes awry, especially if the underlying stock, strike price, and expiration dates are badly chosen.

Exiting strategies

  • If the contract is in-the-money (ITM), then the investor can shut down the position at a profit
  • The investor can sell the in-the-money call and thereafter utilize the proceeds to buy an out-of-the money call.
  • The investor can innovatively create a spread (the difference between the ask price and bid price) by disposing of an out-of-money (OTM) call by selling it against the long position.

3.1 Covered Calls

  • Investor outlook: Bullish to neutral on the underlying stock or index
  • Risk: Potentially Unlimited to the decline of the stock, halted at zero
  • Reward: Limited. This occurs at the option expiry when the stock is the same as the strike price or above it, and the option is exercised. Profit = [Call Strike – Stock Price Paid] + Call Premium Collected
  • Breakeven: Strike price paid — premium collected
  • Position: Considered a net debit trade since the investor is paying the full price for the stock, although it is offset by the comparatively small premium collected.

Investors have two strategies to pursue with regards to writing call options: naked calls or covered calls. Naked calls involve an investor writing call options without actually owning the underlying security. 

In contrast with a naked call, an investor with a covered call owns the underlying stock or assets on which the call option contract is written. As a result, the long position in the underlying stock provides a “cover” since the shares can be delivered to the buyer in case they decide to exercise their option.

Covered calls serve the category of investors who are expecting only a slight increase or not much change from the underlying price position. It is a tradeoff for those willing to limit upside potential or profit in exchange for downside protection.

It is also one of the simplest, most basic option strategies used by beginners and experts alike.

In essence, to execute a covered call, an investor needs to hold a long position in an asset and then proceed to write (sell) call options on the very same asset in order to generate an income stream. The “cover” in the name of this option strategy comes from the long-position of the seller which means they can deliver the assets or shares if and when the call option buyer decides to exercise their right to purchase the security.

The covered call is based on call options and its popularity hinges on its ability to earn income in the form of option premiums.  

The investors who like employing this strategy are those who favor long-positions on the stock. But although they intend to hold the underlying stock for a long duration, they nevertheless don’t expect it to have an appreciable price increase in the short-term.

One way investors use covered calls is to run it after they’ve already earned considerable gains on the underlying stock. Or when they just expect the stock to remain flat over the life of the option contract. 

Covered Call
In the graph above you can see approximation of covered call option’s profit or loss dispostion.

Advantages 

  • An investor has three avenues or scenarios to profit from trade:
    • If the underlying stock price rises
    • The underlying stock moves sideways
    • The underlying stock drops by a relatively small amount
  • Enables the investor to generate a monthly income
  • Provides an investor with profit from three sources:
    • Premium collected
    • Dividends on the underlying stock
    • Price increase in the underlying stock

Disadvantages

  • Reward limited to the upside potential if and when the underlying stock rises
  • The investor is exposed to an unlimited downside in the event the underlying stock plunges. In that event, the premium collected is only a small consolation prize.
  • The investor is unable to earn any interest on the proceeds used to purchase the underlying stock.

Exit strategies

  • Stock price surpasses the strike price
    • An almost certain possibility the call option will be exercised and the seller will be assigned to deliver the stock. The call option writer realizes a maximum profit.
  • Stock price falls below strike price but above the initial purchase price
    • The investor can allow the option to expire worthless yet still retain the premium collected. Moreover, the cost of the underlying stock is reduced by offsetting it with the premium received. 
    • The investor can sell another call option expiring in the next month in order to earn an additional premium, working this strategy in a loop: presumably, the investor has already earned premium from the previous call sale, and therefore poised to earn extra income from the second call sale, and so on. The investor can decide to repeat this process on a monthly, quarterly, or every couple of months; this further reduces the cost of the underlying stock.
  • Stock price plunges below the initial purchase price 
    • In this instance, the investor can find ways to cut her losses by simultaneously selling the bought and buying back the options that were sold in the first place. This works out because the option premiums received helps to cushion the losses from the stocks decline, and the investor is actually better off shorting the stock. 

Confused about stocks and options? Learn about the difference between stocks vs. options.

3.3 Protective Put

  • Investor outlook: Bearish to neutral
  • Risk: Unlimited in the event that the stock price rises
  • Reward: Limited. This occurs at the option expiry when the underlying stock is the same as the strike price or below it, and the option is exercised. Profit = [Stock Price Shorted – Put Strike Price] + Put Premium Collected
  • Breakeven: Strike price shorted plus put premium received
  • Position: Considered a net credit trade since the investor credit for both shorting the put and the underlying stock

This strategy is also known as covered put or married put. 

This is akin to the long put, but instead of intending to profit from a downside move of the security, the goal of the investor is downside protection. It “marries” the long put with owning the underlying stock. 

A protective put comes in handy when an investor has a bullish outlook but nonetheless wants to protect the value of the stock in their portfolio from a decline in the short term. This strategy is like insurance, where an owner of an asset pays a premium against its decline. 

When a protective put is purchased, it gives the investor complete control over when they can exercise their option, with the price at which they can receive their stock already predetermined. 

It functions as a win-win situation for the investor. If against the inclinations of a long put, the price of the underlying stock increases and rises above the strike price at expiry, although it matures worthless, the trader loses her premium but the increase benefits the underlying price of her portfolio.

Conversely, when the price of the underlying decreases, although the investor’s stock loses value, this loss is covered by the gain from maintaining the put option position. There are other flexibilities that the protective put option provides.

To reduce the premium she has to pay, the investor can decide to set the price of the option below the current price although this will inevitably decrease the downside protection of the stock. 

Example: An investor who has purchased 1,000 shares of ABC stock at $54. She wants to protect her investment from adverse price movement over a span of time, say about three months. These are the hypothetical options available to the investor.

June 2020 OptionsPremium
$54 put $1.25
$53 put$0.45
$50 put$0.20

From the above table, it can be seen that the cost of protection increases with the premium level. 

If the stock increases above the strike price, the loss is only limited to the put option premium paid; which was basically paid as insurance in the first place. On the other hand, if the opposite occurs and the stock is below the strike price, then the investor will suffer a loss in capital, however, this will be offset by the increase in the price of the option contract.

This increase in the option’s price is the difference between the strike price and the initial stock price, obtained thus (assuming the strike price of $50) : $54 – $50 + $0.20 = $4.20 per share

Married Put Options Strategy

Advantages

  • The investor is primed to profit from three different conditions
    1. Drop in stock price of the underlying asset
    2. Earn monthly income
    3. Generate interest from proceeds received from put options and shorting the underlying stock 
  • Provides the investor with the possibility of generating a monthly income
  • The investor can collect interest from the proceeds received from put options and shorting the stock

Disadvantages

  • Premium collected is small consolation since there is unlimited downside risk presented if stock rises
  • Only a limited upside is provided when and if the stock drops

Exit Strategies

  • Underlying stock price drops below strike price
    1. Almost certain possibility the put option sold will be exercised and the investor will be assigned to buy the stock. Since the investor has already shorted the stock earlier, the resultant effect of this move will be equivalent to the “Sell High, Buy Low” mantra, with the investor realizing the maximum profit available.
  • Underlying stock price rises above strike price but falls below the initially shorted price
    1. Allow the option to expire worthless and subsequently keep the premium received
    2. The investor can sell another put option expiring in the next month in order to earn additional premium, working this strategy in a loop: presumably, the investor has already earned premium from the previous put sale, and therefore poised to earn extra income from the second put sale, and so forth. The investor can decide to repeat this process on a monthly, quarterly, or every couple of months; this further reduces the risk of the underlying stock.
  • Underlying stock price rises above initial shorted price
    1. In this instance, the investor can do this before the option expiration date: find ways to cut her losses by purchasing back the options that were sold, including those shorted initially. Therefore, the option premiums received helps to cushion the losses from the stocks increase, and the investor is actually better off shorting the stock.

Ready to start trading options? See our top brokers for options trading.

4. Bearish Strategies

4.1 Short (Naked) Calls

  • Investor outlook: Bearish or neutral on the underlying stock or index
  • Risk: This is unlimited. Restricted to the upside of the stock (requires a built-in risk management feature to avoid losing more than the premium collected)
  • Reward: Limited to only the premium received
  • Breakeven: Strike price plus premium received
  • Position: this is a net credit trade because the investor collects the premium for the trade

The short call and the long put are the bearish cousins of the basic option strategies. But this is a writer position so the short call strategy profits when the price of the underlying security falls below strike.

However, the short call writer has unlimited exposure if the price rises astronomically during the length of time the option is viable. This is called a naked option, or even worse could lead to a naked short call.  

A valid form of short selling in its basic form is to deliver borrowed shares. However, if a writer neither owns the stock nor borrows from someone, a situation arises where she owes shorted shares to the buyer but fails to deliver. This is called naked short selling and it is illegal. 

Selling options naked will give the investor an unlimited risk profile. 

In order to limit these losses, and avoid the naked call scenario, investors usually execute a short call while simultaneously owning the underlying security. This is known as a covered call and we’ll cover this later under protective option strategies.

Ideal conditions

Unlike long calls, selling calls imposes obligations to do something, especially if the investor is selling naked. Therefore, it isn’t generally considered to be a preferable position to put oneself in.

The Short Call

Advantages

  • Investor stands to profit from three scenarios: the stock price falls, the stock price rises by a relatively small amount, the stock price moves sideways
  • The investor can profit from the time erosion of option values
  • Doesn’t require as much capital as outrightly shorting the stock
  • No capital outlay required and investor can still earn interest while they trade

Disadvantages

  • Unlimited risk with regard to the upside of the stock
  • If the underlying stock, expiration date or the strike price are wrongly chosen, the investor may potentially lose more than the premium collected.

Exit strategies

  • Buying back and then closing off the call option position at a profit
  • Allow the trade to expire worthless and then profit from the premium collected
  • Purchase a lower strike call at the same expiration date and then create a Bear call spread strategy.
  • Allow time decay to do its work. The option seller will be in a position to buy back the stock at a lower value than what was paid initially, assuming all other variables remain equal. 

4.2 Long Put

  • Investor view: Bearish on the underlying stock or index
  • Risk: Limited to only the premium paid
  • Reward: Potentially unlimited to the downside of the underlying stock
  • Breakeven: Strike price  —  premium paid

Buying a put option means that the investor is going “long” on the stock. She is bearish that the market is going to trend downwards in the short term and wants to earn large upside. 

Unlike a call option, a put option gives the buyer of the put option contract the right to sell the underlying stock (to the put seller) at a predetermined price, thereby limiting risk. 

With this option, an investor intends to utilize leverage by taking advantage of falling stock prices. While traders also employ short selling to take advantage and profit from falling prices, its risk position is unlimited, thereby making it untenable for most investors. 

With a put option, however, once the underlying price increases beyond the strike price, the option will immediately expire worthless. Another reason investors are advised to use long puts instead of attempting to short the stock directly is because puts provide significantly higher returns.

Moreover, shorting a stock exposes a trader to unlimited, uncapped losses; with long puts however, losses are limited to the premium paid.

Therefore, if the market rallies, going “long” on a call option indicates that if the underlying Stock/Index rallies, then the investor benefits.

Exit strategies

  • The investor can dispose of the put option by selling it and then closing off the put option position at a profit
  • The investor can sell off the in-the-money (ITM) put option contract, then subsequently use the money acquired to buy an out-of-the-money (OTM) put.
  • The investor can dispose of an out-of-the-money (OTM) put by selling it against the current long position, thereby creating a spread.
  • Allow the trade to expire worthless and then profit from the premium collected, though this isn’t recommended. 

5. Volatile Strategies

5.1 Long Straddle

  • Investor view: Directional neutral. 
  • Risk: this is limited to only the net premium paid for the at-the-money (ATM) puts and option calls
  • Reward: Unlimited to ascending or downward motion of underlying stock
  • Breakeven
    • Upside: Strike price plus the Net premium paid
    • Downside: Strike price  — the Net premium paid
  • Position: Considered a net debit trade since the investor is buying the puts and calls options at a similar expiration date and strike price.

This is one of the neutral strategies used on a highly volatile stock. The investor purchases both  at-the-money (ATM) long call and long put options on the same underlying asset with both the same strike price and expiration date. 

These both counteract and cancel each other out: an upward movement of stock benefits calls while puts are advantaged by a downward move. Therefore, both of these components cancel out little moves in either direction. 

Ideal conditions: Used when an investor is expecting an increase in the volatility of the underlying stock in either direction. The investor hopes to profit from a strong move of stock, perhaps precipitated by a big unanticipated newsworthy event in either direction of the underlying asset.

Net Effect of A Long Position

Advantages

  • Enables investors to profit from extreme volatility in stocks without having to predetermined their direction
  • Present a potentially unlimited profits beyond the breakeven point in either direction of stock movement
  • When the underlying stock so happens to be at strike price on the expiration date (both call and put options expire worthless), then it provides limited risk exposure to the net premium paid 

Disadvantages

  • This strategy can only be profitable when there’s significant movement of the underlying stocks
  • Time decay imperils long options since option contracts are a wasting asset. This has a double impact on this strategy, especially if the underlying stock, strike price, expiration date are poorly chosen. 

Exit strategies

  • In the event the underlying stock plummets, then it is advised that the investor sell the put options (profiting for the whole position) and then subsequently wait for stock retracement in order to profit from the call option. 
  • In the event the underlying stock surges upward, then it is advised that the investor dispose of the call options by selling it (profiting from the entire position) and then subsequently wait for a stock pull back in order to profit from the put option. 
  • The investor can offset the position by selling both the call and put options.

Conclusion

There are bear markets, there are bull markets, and there is the market volatility that often occurs in between. Even for the analysts who truly understand how the stock market functions, there is no exact science, oracle or crystal ball to divine the market. That is why investors usually employ option trading strategies to ensure they come out ahead regardless of its direction.

Investors approach the market with their strengths and weaknesses: their own risk tolerance, capital, time constraints, not to mention personalities. 

Choosing the right option trading strategy that aligns with the traders investing style, personality, and resources are key to maximize the chances of success with limiting losses.

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Want to continue learning about options? See our binary options guide.

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