Trading options is one of the best ways for stock traders to limit their risk. There're many different strategies that can be used, and these can range from simple strategies to very complex ones. While there isn't a single best options investing strategy, traders should have a comprehensive understanding of the best option trading strategies to maximize their returns in a certain type of market. Ultimately, the best way to trade options is to use a strategy that fits your personality. To help you out, we've come up with a list of stock option strategies with examples.
Before we get started, you should know the differences between calls and puts; You may want to revisit our beginner's guide to options and our puts and calls guide to the different types of options here: https://www.personalincome.org/types-of-options/
Type of market environment
Low Volatility Market
Covered Call Writing
Mild Bull / Neutral Market
Limited to Premium
Bull Call Spread
Bear Put Spread
High Volatility Market
Low Volatility Market
Here’s the Top 7 Stock Option Trading Strategies
1. Covered Call Writing
A Call gives the owner of the option the right to purchase a certain number of shares at a certain price. Writing a covered call is to sell someone a call option, which is the right to purchase a stock that you own at a specified price. The buyer of the call would pay you a cash premium for it.
The maximum profit is earned when the price of the share rises above the strike price and the call is exercised. In this situation, your profit would be the premium.
The maximum loss you can incur is if the price of the share drops drastically. In such a scenario, your loss would be offset a little by the cash premium.
Covered Call Writing is an effective strategy in almost every kind of market – A bullish market, bearish market, or range bound market. However, it is most effective in either a mild bull market or a quiet one. This strategy is typically used by traders to generate short term income at low risk, or to increase their returns in slow markets.
Here's a more detailed guide on how to write covered calls: https://www.ally.com/do-it-right/investing/4-tips-for-writing-covered-calls/
2. Bull Call Spread
In the bull call spread, the options trader simultaneously buys calls at a lower strike price and sells an equal volume of calls at a higher strike price. The trader receives the cash premium for the sold calls and pays the cash premium for the calls at the lower strike price. As the call with the lower strike price has a higher value, an initial capital outlay is necessary.
Purchasing calls at a lower strike price is also known as a long call leg, while the calls sold at the higher strike prices are known as the short call leg. The bull call spread can be hard to understand, so we’ve put together some examples to illustrate it better.
An Example: Stock PPP
Let’s say that stock PPP is trading at $50.00 currently. The trader expects the price of PPP to trade between $50.50 and $51.50 in one month. To capitalize on this, the trader purchases 10 contracts for a strike price of $50.50 which is trading at $1. He simultaneously sells 10 contracts for a strike price of $51.50, which is trading at $0.50. Both of these call options will expire in one month.
The trader’s initial capital outlay will be calculated as such:
($1x100x10) – ($0.50x100x10) = $1000-$500 = $500
Each contract represents a 100 shares, so we have 1000 shares worth of calls purchased at $1000, and 1000 shares worth of calls at a higher strike price sold at $500.
PPP rises to $53 after a month.
The profit on the long call leg of the trade will be: ($53-50.50) x 1000 = $2500
The loss on the short call leg of the trade will be: ($51.50-53) x 1000 = -$1500
The trader’s gain on the spread will therefore be: $2500 - $1500 - $500 (The initial difference in cash premiums) = $500.
PPP rises to $51 after a month.
The profit on the long call leg will be:
($51-50.50) x 1000 = $500
The $51.50 Call Option will be worthless as it is out of the money.
The total profit will be $500 - $500 = $0
PPP drops to $49.50
Both call options are out of the money and therefore worthless.
The trader’s return will be $-500, which is a loss.
Why Do Traders Use the Bull Call Spread?
- When using a bull call spread, traders are able to limit their downside risk to just the net premium paid.
- Traders can use leverage to trade the bull call spread, as the bull call spread has a clearly defined risk-reward profile.
The maximum return from a bull call spread is when the price of the underlying stock or asset rises to a value that’s at equal to or above that of the strike price of the call sold. The upside is limited to the difference between the strike prices of the call options, minus the net premium outlay and commissions paid to brokers.
In the Bull Call Spread, the maximum loss is limited to the net premium outlay.
3. Bear Put Spread
The Bear Put Spread is frequently used as an alternative to shorting shares. A bear put spread has limited risk and limited upside, while a short selling shares will have unlimited risk. A bear put spread trade strategy enables the trader to easily manage his risk/reward profile.
What exactly is a Bear Put Spread
A bear put spread is the opposite of a bull call spread, where the trader buys a put with a higher strike price and simultaneously sells a put with a lower strike price. Both of these options will have the same volume and the same expiry date.
Bear Put Spread: An Example
We won’t go into a detailed example as this strategy is similar to that of the bull call. spread. Let’s say that stock PPP is trading at $50. If a trader expects PPP to trade between $46 and $49 in 2 months’ time, the trader will buy puts with a strike price of $49, and sell puts with a strike price of $46. This means that when the price of the stock goes below $49, the put option will be in the money.
However, note that a profit is only realized when the earnings from the put option covers the initial capital outlay.
Why Use the Bear Put Spread
Traders use the bear put spread when they expect a modest decline in the price of the underlying asset in the short term. Instead of buying just a put option, the trader attempts to earn more by selling the puts with a lower strike price.
The maximum profit is realized when the price of the underlying asset falls to a value that is lower or equal to the lower strike price. However, the maximum profit will be the difference between the strike prices multiplied by the number of shares, minus the initial premium outlay and any commissions charged by the broker.
The risk of the bear put spread trading strategy is limited to the initial premium outlay. The options will expire worthless when prices rise above the higher strike price.
4. Protective Collar
The protective collar is a great option trading strategy that helps an investor to lock in gains after their asset has appreciated significantly. Using a protective collar can also help to reduce capital gains tax.
There are two aspects to a protective collar trading strategy. The first part of its implementation is to lock in your gains or minimize the potential of a loss from a particular stock. Assuming that your stock has the ticker AAA.
The trader will first purchase a put on ticker AAA, which gives him the right, but not the obligation to sell AAA at the specified price before the expiration date. With this put option, the trader is effectively securing profits at that strike price.
However, the purchase of this put option isn’t free of charge either. The trader will have to find a way to pay for the put bought on ticker AAA. Here comes the second part of the protective collar trading strategy.
The second aspect of the protective collar strategy calls for the trader to sell (or write) a call option on AAA. This gives the buyer of the option the right, but not the obligation, to purchase shares of AAA the specified share price before the expiry date of the contract.
Let’s say that you own 1000 shares of AAA, which is priced at $100 per share. You bought AAA at $50 per share, which means that you currently have paper profits of $50,000.
Wanting to lock in your gains, you purchase a put with a strike price of $90, which costs roughly $10. This means that you will have an initial outlay of $10,000. You would also lock in a profit of $90,000-$50,000 = $40,000
However, this also comes at a price of the $10,000 cash premium on the put option that you would have to fork out.
Let’s say that writing a call option on AAA for a strike price of $130 can net you $11 a share. This will get you $11,000 for selling the call, and you actually profit from $1 a share, or the $1000 difference between the call and put options.
Minimal Downside Risk, Significant Upside Potential
In this case, having the protective collar has limited your downside risk to almost nothing, while keeping your upside potential to ($130-100) x 1000. This upside potential will be realized when prices rise above $130 and the call option is exercised.
The maximum profit from the protective collar strategy is realized when the price of the underlying asset rises to a value above the strike price of the written call option.
The maximum loss, or the minimum profit in this case, will be when stock prices drop below the strike price of the purchased puts. In this case, the premiums from the call options will still be there, but you will have to either exercise the put option, or sell the put option for its market value which would have increased in value.
Should you foresee a market downturn, selling a stock when it has appreciated significantly would require you to fork out a significant bit of capital gains tax on your profit.
By using the protective collar strategy, you can protect yourself against a market downturn without having to pay the capital gains tax. If the price doesn’t drop below the put option strike price, you won’t have to sell the stock. However, if it does and you are forced to exercise the put option or sell the put option, you’ll still have to pay tax.
Here's another explanation: http://www.investopedia.com/articles/optioninvestor/07/protective_collar.asp
5. The Long Straddle
A straddle is achieved when the trader holds an equal volume of puts and calls, with the same strike price and expiration dates. A straddle is usually a play on the volatility of the market.
There are two kinds of straddles – The long straddle and the short straddle.
The long straddle is an options strategy where the trader purchases an equal volume of put and call options at the same strike price and expiration date. The purpose of this is to allow the trader to make a profit when the market moves in either direction.
Profiting From Increased Volatility
The long straddle aims to profit from increased market volatility. When the market breaks to either side, the trader will earn a profit. If the market price of the underlying asset increases beyond the strike price of the call option, the trader can exercise the call option, or sell the call option for a significant profit. The put option will either be held till the market swings in the other direction, or expire worthless. The long straddle can be played when such events that cause market volatility occur:
- Important upcoming news or earnings predictions
- Uncertain market conditions
An Expensive Play
However, the long straddle can be a rather expensive play. Options that are in-the-money and at-the-money are more costly than out-of-the-money options. This means that the trader will have to pay a significant premium to do a long straddle.
The value of the options also decrease closer to the expiration date. This means that if the market does not experience much volatility, the trader might be losing value on his options as time passes.
6. The Short Straddle
The short straddle, like the name implies, is an options strategy where the trader sells an equal volume of put and call options at the same strike price and expiration date. By selling the options, the trader also earns from collecting the cash premiums from the sale of the options.
In the short straddle, the trader hopes that the market does not move in any direction. The trader would collect the cash premiums for selling the put and call options, and this can generate a significant amount of steady returns. However, the downside of this strategy is that it exposes the trader to an unlimited amount of risk.
Profiting from Low Volatility
The best case scenario for a short straddle is for the price of the underlying asset to not move in either direction. In such a case, the options will expire, and the trader makes a good profit from the premiums collected. However, if the market does move heavily in either direction, the trader would be exposed to an indefinite loss. The only way for the trader to limit his loss is to buy back the options.
7. The Iron Condor
The Iron Condor is a rather complicated strategy that many beginners find hard to understand and execute well. It has become a rather popular option trading strategy, and it is a good way for traders to make consistent profits when the price of the underlying asset isn’t moving much.
The Wings of the Iron Condor
The whole idea of an Iron Condor is to create two credit spreads. If you visualize the credit spreads and the options, the Iron Condor consists of two “wings”, which is the call credit spread and the put credit spread. The call credit spread requires the trader to create a credit spread above the market price, while the put credit spread requires the trader to create a credit spread below it. As long as the price of the asset falls within these 2 ranges, the trader would keep the profits generated from the credit spreads.
Call Credit Spread
Let’s say that the price of asset ZZZ is 1500. The call credit spread is created by buying a call option with strike price 1600, and selling the more expensive, closer call option with strike price 1550. This will create credit from the difference in cash premiums.
Put Credit Spread
The other side of the Iron Condor, the put credit spread, requires the trader to sell a put option for strike price 1400, and buy the less valuable put option for strike price 1450. Again, positive credit will be generated from this credit spread.
Profiting from the Iron Condor
As long as the price of the asset doesn’t cross the boundaries of both credit spreads, the trader would be able to profit from the positive cash premium differences in both credit spreads. In ZZZ’s case, as long as the price falls between 1450 and 1550, the strategy would produce the maximum profit.
Preventing Huge Losses
As you would probably have noticed, such a strategy means that the trader would need to have a significant amount of capital to maintain the margin. In the case of the price of the asset moving strongly in one direction, the trader would need to manage his risk, which can either be to get out of the entire Iron Condor, or sell that particular credit spread and hold the other side. The trader can also roll the losing side and create a further credit spread.
Pros and Cons
The Iron Condor is a good strategy for traders to make use of options to generate returns even when the price of the underlying asset doesn’t move much. However, it can be challenging to manage the risk when the “wings” of the Iron Condor are breached.
For more detailed information on exactly how to execute the Iron Condor Options Strategy, here's a link: http://www.investopedia.com/articles/optioninvestor/08/iron-condors-risk-reward.asp
If you've found this explanation a little hard to follow, this video will illustrate it more clearly!
If you liked these strategies, we've also put together a list of Bearish Options Strategies, as well as Bullish Options Strategies, for you to use in different circumstances.
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