Options strategies trading

10 Options Strategies to Know.

10 Options Strategies To Know.

Too often, traders jump into the options game with little or no understanding of how many options strategies are available to limit their risk and maximize return. With a little bit of effort, however, traders can learn how to take advantage of the flexibility and full power of options as a trading vehicle. With this in mind, we've put together this slide show, which we hope will shorten the learning curve and point you in the right direction.

10 Options Strategies To Know.

Too often, traders jump into the options game with little or no understanding of how many options strategies are available to limit their risk and maximize return. With a little bit of effort, however, traders can learn how to take advantage of the flexibility and full power of options as a trading vehicle. With this in mind, we've put together this slide show, which we hope will shorten the learning curve and point you in the right direction.

1. Covered Call.

Aside from purchasing a naked call option, you can also engage in a basic covered call or buy-write strategy. In this strategy, you would purchase the assets outright, and simultaneously write (or sell) a call option on those same assets. Your volume of assets owned should be equivalent to the number of assets underlying the call option. Investors will often use this position when they have a short-term position and a neutral opinion on the assets, and are looking to generate additional profits (through receipt of the call premium), or protect against a potential decline in the underlying asset's value. (For more insight, read Covered Call Strategies For A Falling Market.)

2. Married Put.

In a married put strategy, an investor who purchases (or currently owns) a particular asset (such as shares), simultaneously purchases a put option for an equivalent number of shares. Investors will use this strategy when they are bullish on the asset's price and wish to protect themselves against potential short-term losses. This strategy essentially functions like an insurance policy, and establishes a floor should the asset's price plunge dramatically. (For more on using this strategy, see Married Puts: A Protective Relationship . )

3. Bull Call Spread.

In a bull call spread strategy, an investor will simultaneously buy call options at a specific strike price and sell the same number of calls at a higher strike price. Both call options will have the same expiration month and underlying asset. This type of vertical spread strategy is often used when an investor is bullish and expects a moderate rise in the price of the underlying asset. (To learn more, read Vertical Bull and Bear Credit Spreads.)

4. Bear Put Spread.

The bear put spread strategy is another form of vertical spread​ like the bull call spread. In this strategy, the investor will simultaneously purchase put options at a specific strike price and sell the same number of puts at a lower strike price. Both options would be for the same underlying asset and have the same expiration date. This method is used when the trader is bearish and expects the underlying asset's price to decline. It offers both limited gains and limited losses. (For more on this strategy, read Bear Put Spreads: A Roaring Alternative To Short Selling.)

Investopedia Academy "Options for Beginners"

Now that you've learned a few different options strategies, if you're ready to take the next step and learn to:

Improve flexibility in your portfolio by adding options Approach Calls as down-payments, and Puts as insurance Interpret expiration dates, and distinguish intrinsic value from time value Calculate breakevens and risk management Explore advanced concepts such as spreads, straddles, and strangles.

5. Protective Collar.

A protective collar strategy is performed by purchasing an out-of-the-money put option and writing an out-of-the-money call option at the same time, for the same underlying asset (such as shares). This strategy is often used by investors after a long position in a stock has experienced substantial gains. In this way, investors can lock in profits without selling their shares. (For more on these types of strategies, see Don't Forget Your Protective Collar and How a Protective Collar Works.)

6. Long Straddle.

A long straddle options strategy is when an investor purchases both a call and put option with the same strike price, underlying asset and expiration date simultaneously. An investor will often use this strategy when he or she believes the price of the underlying asset will move significantly, but is unsure of which direction the move will take. This strategy allows the investor to maintain unlimited gains, while the loss is limited to the cost of both options contracts. (For more, read Straddle Strategy A Simple Approach To Market Neutral . )

7. Long Strangle.

In a long strangle options strategy, the investor purchases a call and put option with the same maturity and underlying asset, but with different strike prices. The put strike price will typically be below the strike price of the call option, and both options will be out of the money. An investor who uses this strategy believes the underlying asset's price will experience a large movement, but is unsure of which direction the move will take. Losses are limited to the costs of both options; strangles will typically be less expensive than straddles because the options are purchased out of the money. (For more, see Get A Strong Hold On Profit With Strangles.)

8. Butterfly Spread.

All the strategies up to this point have required a combination of two different positions or contracts. In a butterfly spread options strategy, an investor will combine both a bull spread strategy and a bear spread strategy, and use three different strike prices. For example, one type of butterfly spread involves purchasing one call (put) option at the lowest (highest) strike price, while selling two call (put) options at a higher (lower) strike price, and then one last call (put) option at an even higher (lower) strike price. (For more on this strategy, read Setting Profit Traps With Butterfly Spreads . )

9. Iron Condor.

An even more interesting strategy is the iron condor. In this strategy, the investor simultaneously holds a long and short position in two different strangle strategies. The iron condor is a fairly complex strategy that definitely requires time to learn, and practice to master. (We recommend reading more about this strategy in Take Flight With An Iron Condor, Should You Flock To Iron Condors? and try the strategy for yourself (risk-free!) using the Investopedia Simulator.)

10. Iron Butterfly.

The final options strategy we will demonstrate here is the iron butterfly. In this strategy, an investor will combine either a long or short straddle with the simultaneous purchase or sale of a strangle. Although similar to a butterfly spread, this strategy differs because it uses both calls and puts, as opposed to one or the other. Profit and loss are both limited within a specific range, depending on the strike prices of the options used. Investors will often use out-of-the-money options in an effort to cut costs while limiting risk. (To learn more, read What is an Iron Butterfly Option Strategy?)

Options Trading: How to Use Basic Options Strategies.

Key Points.

In this final installment of a two-part series, we review basic options trading strategies and how they can be used.

Discover more about long calls, short calls, long puts and short puts.

Find out how you might select the strike price for your option depending on your level of bullishness or bearishness.

In the first part of this series, Getting Started With Options, we discussed the basics of options such as terminology, rights and obligations, open interest, pricing, sentiment and expiration cycles. Now it’s time to put some of this new knowledge to work by examining some basic options trading strategies and how they can be used.

Bullish vs. bearish options trading strategies.

Source: Schwab Center for Financial Research.

Long calls.

Perhaps, the simplest option strategy to understand (though not necessarily the simplest with which to make a profit) may be the long call trade. A long call trade is often the first option strategy used by investors once they decide to venture into trading options. Unfortunately, long calls can often be difficult to trade profitably. However, it’s good to discuss the strategy because it helps to lay the foundation for more complex option strategies.

A long call option is a bullish strategy, but unlike a long stock trade, you generally have to be right about more than just the direction of the underlying stock to be profitable. As we discussed in part one of this series, the price of an option is based on many components. Three of these components are: (1) type of option (call vs. put), (2) the strike price of the option and (3) the amount of time until the option expires. To profit on a long call trade, you will need to be right about the direction of the underlying stock price movement and the number of points it moves in that direction, as well as how long it takes to make the move. Occasionally, you can be profitable if you are right on two of these three items, but direction alone is almost never enough.

Before you decide to enter into any option strategy, it is important to do some simple calculations to find the maximum gain, maximum loss and breakeven points (price of the underlying stock/index where there is neither a gain nor a loss) for the trade. The formula for these calculations on a long call trade (assuming the position is held until expiration) and a visual depiction of a profit-and-loss graph are illustrated below:

Long 1 XYZ Jan 50 Call $3.

Maximum gain = unlimited.

Maximum loss = $300 (3.00 option premium paid x 100 shares per contract)

Breakeven point = 53 (50 strike price + 3.00 option premium)

Source: Schwab Center for Financial Research.

Note: Chart depicts strategy at expiration.

As you can see, while the maximum potential loss on a long call trade is the price paid for the option, the upside profit potential is theoretically unlimited. However, keep in mind that because the option has a limited lifespan, the underlying stock will need to move up enough to cover the cost of the option and offset the erosion in time value and possibly even offset changes in volatility. These factors work against the owner of a long option, resulting in a much more difficult profit-and-loss scenario than you might think.

Short calls.

Although I don’t recommend the use of short (naked) calls, and they would be particularly inappropriate for inexperienced option traders or traders without substantial risk capital, I think it’s helpful to illustrate how selling a call creates a profit-and-loss scenario that is exactly the opposite of long call. Here’s an example:

Short 1 XYZ Jan 50 Call $3.

Maximum gain = $300 (3.00 option premium received x 100 shares per contract)

Maximum loss = unlimited.

Breakeven point = 53 (50 strike price + 3.00 option premium)

Source: Schwab Center for Financial Research.

Note: Chart depicts strategy at expiration.

Note: Chart depicts strategy at expiration. An uncovered (naked) call trade is an extremely risky position, because while the profit (if the stock drops in price) is limited to the premium received at the time the option is sold, the upside risk is unlimited. To enter an uncovered call trade, you’ll need the highest option approval level available at Schwab (level 3), and must have substantial funds to meet the higher margin requirements of this strategy.

Similar to a long call trade, a long put trade is fairly straightforward. Although long put trades can be difficult to trade profitably, it’s also worthwhile to discuss the strategy as a foundation for more complex option strategies.

A long put option is a bearish strategy, but unlike a short stock trade, you generally have to be right about more than just the direction of the underlying stock in order to be profitable. As with long calls, to be profitable, you will need to be right about the stock price movement direction and the magnitude and the time frame. You can occasionally be profitable if you are right on two of these three items, but direction alone is almost never enough.

As with long calls, before you decide to enter a long put trade, be sure to find the maximum gain, maximum loss and breakeven points. The formula for these calculations on a long put trade and a visual depiction of a profit-and-loss graph are illustrated below:

Long 1 XYZ Jan 50 Put $3.

Maximum gain = $4,700 (50 strike price – 3.00 option premium x 100 shares per contract)

Maximum loss = $300 (3.00 option premium paid x 100 shares per contract)

Breakeven point = 47 (50 strike price – 3.00 option premium)

Source: Schwab Center for Financial Research.

Note: Chart depicts strategy at expiration.

As you can see, while the maximum potential loss on a long put trade is the price paid for the option, the profit potential, as the stock drops in price, is significant. However, keep in mind that because the option has a limited lifespan, the underlying stock will need to move down enough to cover the cost of the option and offset the erosion in time value and possibly even changes in volatility. These factors work against the owner of a long option, resulting in a much more difficult profit-and-loss scenario than you might think.

Short puts.

Although short (naked) puts are not quite as risky as short (naked) calls, they are still not a strategy for inexperienced option traders or traders without substantial risk capital. Selling a put creates a profit-and-loss scenario that is exactly the opposite of long put. Here’s an example:

Short 1 XYZ Jan 50 Put $3.

Maximum gain = $300 (3.00 option premium received x 100 shares per contract)

Maximum loss = $4,700 (50 strike price – 3.00 option premium x 100 shares per contract)

Breakeven = 47 (50 strike price – 3.00 option premium)

Source: Schwab Center for Financial Research.

Note: Chart depicts strategy at expiration.

An uncovered (naked) put trade is an extremely risky position, because while the profit (if the stock rises in price) is limited to the premium received at the time the option is sold, the downside risk can increase until the stock reaches zero. To enter an uncovered put trade, you’ll need not only the highest option approval level available at Schwab (level 3), but also must have substantial funds to meet the high margin requirements of this strategy.

Selecting your strike price.

When first introduced to options, many traders have little trouble understanding the risk/reward characteristics of options but often have difficulty deciding which strike prices to use. Whether those strike prices are in, at, or out of the money will affect the magnitude of the underlying move needed to reach profitability and also determine whether the trade can be profitable if the underlying stock remains unchanged. The tables below illustrate how to properly structure a long or short option trade to match your level of bullishness or bearishness.

For example, if you are extremely bullish, you may want to consider out-of-the-money (OOTM) long calls or in-the-money (ITM) short puts. Keep in mind, both will generally require a bullish move in the underlying stock of extreme magnitude in order to reach profitability. By contrast, if you are only slightly bullish, you may want to consider ITM long calls or OOTM short puts, the latter of which can sometimes be profitable with no movement in the underlying stock.

Bullish options strategies.

Source: Schwab Center for Financial Research.

In the same manner, if you are extremely bearish you may want to consider out-of-the-money (OOTM) long puts or in-the-money (ITM) short calls. Keep in mind, both will generally require a bearish move of extreme magnitude in the underlying stock in order to reach profitability. By contrast, if you are only slightly bearish, you may want to consider ITM long puts, or OOTM short calls, the latter of which can sometimes be profitable with no movement in the underlying stock.

Bearish options strategies.

Source: Schwab Center for Financial Research.

As with most option strategies, the greater the underlying move needed, the higher the profit potential, but it’s also less likely that a profit will be made. In the case of OOTM short puts and OOTM short calls, because profitability is possible with no movement in the underlying stock, the potential profit will likely be very small. However, the risk on these trades is extremely high, which is why I don’t recommend uncovered calls or puts. The use of credit spreads is a much safer alternative while generally providing only slightly less profit potential.

Hopefully, by now you have learned that you can take either a bullish or bearish position on an underlying instrument (stock, exchange-traded fund [ETF] or an index) using either calls or puts. It simply depends upon whether you buy or sell them first. Another important concept to understand is that when you pair stocks and options, your sentiment on the underlying stock does not change; you are simply using the option leg of the strategy to hedge your position or help generate additional income. The table below helps to illustrate this point.

Pairing stocks and options.

Source: Schwab Center for Financial Research.

I hope this enhanced your understanding of options. I welcome your feedback—clicking on the thumbs up or thumbs down icons at the bottom of the page will allow you to contribute your thoughts.

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Options carry a high level of risk and are not suitable for all investors. Certain requirements must be met to trade options through Schwab. With long options, investors may lose 100% of funds invested. Spread trading must be done in a margin account. Multiple leg strategies will involve multiple commissions. Please read the Options Disclosure Document titled "Characteristics and Risks of Standardized Options"before considering any option transaction.

Investing involves risks, including loss of principal. Hedging and protective strategies generally involve additional costs and do not assure a profit or guarantee against loss.

Uncovered option writing and short selling are advanced trading strategies involving potentially unlimited risks, and must be done in a margin account.

For the sake of simplicity, the examples in this presentation do not take into consideration commissions and other transaction fees, tax considerations, or margin requirements, which are factors that may significantly affect the economic consequences of strategies displayed. Please contact a tax advisor for the tax implications involved in these strategies. Supporting documentation for any claims or statistical information is available upon request.

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