Option strategies are the simultaneous, and often mixed, buying or selling of one or more options that differ in one or more of the options’ variables. This is often done to gain exposure to a specific type of opportunity or risk while eliminating other risks as part of a trading strategy. A very straight forward strategy might simply be the buying or selling of a single option, however option strategies often refer to a combination of simultaneous buying and or selling of options.
Options strategies allow to profit from movements in the underlying that are bullish, bearish or neutral. In the case of neutral strategies, they can be further classified into those that are bullish on volatility and those that are bearish on volatility. The option positions used can be long and/or short positions in calls.
Bullish options strategies are employed when the options trader expects the underlying stock price to move upwards. It is necessary to assess how high the stock price can go and the time frame in which the rally will occur in order to select the optimum trading strategy.
The most bullish of options trading strategies is the simple call buying strategy used by most novice options traders.
Stocks seldom go up by leaps and bounds. Moderately bullish options traders usually set a target price for the bull run and utilize bull spreads to reduce cost. (It does not reduce risk because the options can still expire worthless.) While maximum profit is capped for these strategies, they usually cost less to employ for a given nominal amount of exposure. The bull call spread and the bull put spread are common examples of moderately bullish strategies.
Mildly bullish trading strategies are options strategies that make money as long as the underlying stock price does not go down by the option’s expiration date. These strategies may provide a small downside protection as well. Writing out-of-the-money covered calls is a good example of such a strategy.
Bearish options strategies are employed when the options trader expects the underlying stock price to move downwards. It is necessary to assess how low the stock price can go and the time frame in which the decline will happen in order to select the optimum trading strategy.
The most bearish of options trading strategies is the simple put buying strategy utilized by most novice options traders.
Stock prices only occasionally make steep downward moves. Moderately bearish options traders usually set a target price for the expected decline and utilize bear spreads to reduce cost. While maximum profit is capped for these strategies, they usually cost less to employ. The bear call spread and the bear put spread are common examples of moderately bearish strategies.
Mildly bearish trading strategies are options strategies that make money as long as the underlying stock price does not go up by the options expiration date. These strategies may provide a small upside protection as well. In general, bearish strategies yield less profit with less risk of loss.
Neutral or non-directional strategies
Neutral strategies in options trading are employed when the options trader does not know whether the underlying stock price will rise or fall. Also known as non-directional strategies, they are so named because the potential to profit does not depend on whether the underlying stock price will go upwards. Rather, the correct neutral strategy to employ depends on the expected volatility of the underlying stock price.
Examples of neutral strategies are:
- Guts – sell ITM (in the money) put and call
- Butterfly – buy ITM (in the money) and OTM (out of the money) call, sell two at the money calls, or vice versa
- Straddle – holding a position in both a call and put with the same strike price and expiration. If the options have been bought, the holder has a long straddle. If the options were sold, the holder has a short straddle. The long straddle is profitable if the underlying stock changes value in a significant way, either higher or lower. The short straddle is profitable when there is no such significant move.
- Strangle – the simultaneous buying or selling of out-of-the-money put and an out-of-the-money call, with the same expiration. Similar to the straddle, but with different strike prices.
- Risk reversal – simulates the motion of an underlying so sometimes these are referred as synthetic long or synthetic short positions depending on which position you are shorting.
- Collar – buy the underlying and then simultaneous buying of a put option below current price (floor) and selling a call option above the current price (cap).
- Fence – buy the underlying then simultaneous buying of options either side of the price to limit the range of possible returns.
- Iron butterfly – sell two overlapping credit vertical spreads but one of the verticals is on the call side and one is on the put side.
- Iron condor – the simultaneous buying of a put spread and a call spread with the same expiration and four different strikes. An iron condor can be thought of as selling a strangle instead of buying and also limiting your risk on both the call side and put side by building a bull put vertical spread and a bear call vertical spread.
- Jade Lizard – a bull vertical spread created using call options, with the addition of a put option sold at a strike price lower than the strike prices of the call spread in the same expiration cycle.
Bullish on volatility
Neutral trading strategies that are bullish on volatility profit when the underlying stock price experiences big moves upwards or downwards. They include the long straddle, long strangle, short condor and short butterfly.
Bearish on volatility
Neutral trading strategies that are bearish on volatility profit when the underlying stock price experiences little or no movement. Such strategies include the short straddle, short strangle, ratio spreads, long condor and long butterfly.