10 Options Strategies

 Option strategies should limit risk and maximize return.

 Enhance 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.

1. Covered Call

With calls, one strategy is simply to buy a naked call option. You can also
structure a basic covered call or buy-write. This is a very popular strategy
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 purchase the
underlying stock as you normally would, and simultaneously write—or sell—
a call option on those same shares.

Example: Suppose an investor is using a call option on a stock that

represents 100 shares of stock per call option. For every 100 shares of stock
that the investor buys, they would simultaneously sell one call option against
it. This strategy is referred to as a covered call because, in the event that a
stock price increases rapidly, this investor's short call is covered by the long
stock position.

Investors may choose to 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 through the sale of the call premium or protect
against a potential decline in the underlying stock’s value.
In the profit and loss (P&L) graph above, observe that as the stock price
increases, the negative P&L from the call is offset by the long shares
position. Because the investor receives a premium from selling the call, as
the stock moves through the strike price to the upside, the premium that they
received allows them to effectively sell their stock at a higher level than the
strike price: strike price plus the premium received. The covered call’s P&L
graph looks a lot like a short, naked put’s P&L graph.

2. Married Put

In a married put strategy, an investor purchases an asset—such as shares of

stock—and simultaneously purchases put options for an equivalent number
of shares.2 The holder of a put option has the right to sell stock at the strike
price, and each contract is worth 100 shares.

An investor may choose to use this strategy as a way of protecting their

downside risk when holding a stock. This strategy functions similarly to an
insurance policy; it establishes a price floor in the event the stock's price
falls sharply. This is why it's also known as a protective put.

Example, suppose an investor buys 100 shares of stock and buys one put
option simultaneously. This strategy may be appealing for this investor
because they are protected to the downside, in the event that a negative
change in the stock price occurs. At the same time, the investor would be
able to participate in every upside opportunity if the stock gains in value.
The only disadvantage of this strategy is that if the stock does not fall in
value, the investor loses the amount of the premium paid for the put option.

In the P&L graph above, the dashed line is the long stock position. With the
long put and long stock positions combined, you can see that as the stock
price falls, the losses are limited. However, the stock is able to participate in
the upside above the premium spent on the put. A married put's P&L graph
looks similar to a long call’s P&L graph.

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 is able to limit their upside on the
trade while also reducing the net premium spent (compared to buying a
naked call option outright).
From the P&L graph above, you can observe that this is a bullish strategy.
For this strategy to be executed properly, the trader needs the stock to
increase in price in order to make a profit on the trade. 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. This
is how a bull call spread is constructed.

4. Bear Put Spread

The bear put spread strategy is another form of vertical spread. In this strategy,
the investor simultaneously purchases put options at a specific strike price
and also sells 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 offers
both limited losses and limited gains.
In the P&L graph above, you can observe that this is a bearish strategy. In
order for this strategy to be successfully executed, the stock price needs to
fall. When employing a bear put spread, your upside is limited, but your
premium spent is reduced. If outright puts are expensive, one way to offset
the high premium is by selling lower strike puts against them. This is how a
bear put spread is constructed.

5. Protective Collar

A protective collar strategy is performed 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 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 of further profits.

An example of this strategy is if an investor is long on 100 shares of IBM at

$100 as of January 1. The investor could construct a protective collar by
selling one IBM March 105 call and simultaneously buying one IBM March
95 put. The trader is protected below $95 until the expiration date. The trade-
off is that they may potentially be obligated to sell their shares at $105 if IBM
trades at that rate prior to expiry.
In the P&L graph above, you can observe that the protective collar is a mix
of a covered call and a long put. 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.

6. Long Straddle

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.
In the P&L graph above, notice how there are two breakeven points. This
strategy becomes profitable when the stock makes a large move in one
direction or the other. The investor doesn’t care which direction the stock
moves, only that it is a greater move than the total premium the investor paid
for the structure.

7. Long Strangle

In a long strangle options strategy, the investor purchases a call and a put
option with a different strike price: 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.
In the P&L graph above, notice how the orange line illustrates the two break-
even points. This strategy becomes profitable when the price of the stock,
either up or down, has significant movement. The investor doesn't care
which direction the stock moves, only it moves enough to place one option
or the other in-the-money. It needs to be more than the total premium the
investor paid for the structure.

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, 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 (ATM) call options and buying one out-of-the-money call option. A
balanced butterfly spread will have the same wing widths. This example is
called a “call fly” and it results in a net debit. An investor would enter into a
long butterfly call spread when they think the stock will not move much
before expiration.
In the P&L graph above, notice how the maximum gain is made when the
stock remains unchanged up until expiration–at the point of the ATM strike.
The further away 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 both limited upside and limited
downside.

9. Iron Condor

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 OTM
put and buying one OTM put of a lower strike–a bull put spread–and 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
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.
In the P&L graph above, notice how the maximum gain is made when the
stock remains in a relatively wide trading range. 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.

10. Iron Butterfly

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. All options have the same
expiration date and are on the same underlying asset

Although this strategy is similar to a butterfly spread, it uses both calls and
puts (as opposed to one or the other).

This strategy essentially combines selling an at-the-money straddle and

buying protective “wings.” You can also think of the construction as two
spreads. It is common to have the same width for both spreads. The long,
out-of-the-money call protects against unlimited upside. The long, out-of-
the-money put protects against downside (from the short put strike to zero).
Profit and loss are both 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 non-volatile
stock.

In the P&L graph above, notice that the maximum amount of gain is made
when the stock remains at the at-the-money strikes of both the call and put
that are sold. The maximum gain is the total net premium received.
Maximum loss occurs when the stock moves above the long call strike or
below the long put strike.

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).

Protective Puts

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.

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.

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. Prior to expiration, it will be worth less than
$20, making it function 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.

Key Points To Remember

While options trading can seem intimidating to new market participants,

there are a number of strategies that can help limit risk and increase return.
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.