Top options trading strategies
In this article, we will discuss 17 options trading strategies that every investor should know. These strategies are ranked from most profitable to least, based on their average returns and risk levels. However, keep in mind that the profitability and risk of any strategy may vary depending on the market conditions, the strike prices, the expiration dates, and the implied volatility of the options involved. Therefore, traders should always do their own research and analysis before entering any options trade.
1. Covered call
A covered call is a popular options strategy where you own a stock and simultaneously sell a call option on the same stock. This strategy offers a balance of income generation and risk management.
How it works:
- Owning the stock: You purchase shares of a stock you believe has potential.
- Selling a call option: You sell a call option on the same stock, giving the buyer the right to purchase your shares at a specific price (strike price) within a certain timeframe.
Benefits of a covered call strategy:
- Income generation: Selling the call option generates income in the form of a premium.
- Limited downside risk: If the stock price declines, your losses are limited to the initial investment in the stock.
- Potential for upside: If the stock price rises moderately, you can still benefit from the price appreciation.
Risks of a covered call strategy:
- Limited upside: If the stock price rises significantly, you may be obligated to sell your shares at the strike price, capping your potential gains.
- Early assignment: The option holder may exercise the option early, forcing you to sell your shares before you're ready.
By understanding the mechanics and risks associated with a covered call strategy, investors can make informed decisions about its suitability for their investment goals.
2. Married put
A married put strategy involves buying an asset (like a stock) and simultaneously purchasing put options for the same number of shares. This strategy acts as an insurance policy, limiting potential losses if the stock price declines.
How it works:
- Put option: A put option gives the holder the right to sell the underlying asset at a specified price (strike price) on or before a specific date (expiration date).
- Married put: By combining a long stock position with a long put option, an investor creates a floor price for their investment. If the stock price falls below the strike price, the investor can exercise the put option, selling the stock at the higher strike price.
When to use:
- Risk management: To protect against significant downside risk in a stock holding.
Risk and reward:
- Limited loss: The maximum loss is the premium paid for the put option, plus any potential decline in the stock price up to the strike price.
- Reduced upside: The strategy limits potential gains compared to a simple long position.
3. Bull call spread
A bull call spread is a strategy where you buy a call option and sell another call option on the same stock with the same expiration date and a higher strike price. This strategy allows you to profit from a moderate increase in the stock price, as the difference between the premiums received and paid will be your maximum profit. However, the profit potential is limited by the higher strike price, and the risk is limited by the lower strike price.
4. Bear put spread
A bear put spread is a strategy where you buy a put option and sell another put option on the same stock with the same expiration date and a lower strike price. This strategy allows you to profit from a moderate decrease in the stock price, as the difference between the premiums paid and received will be your maximum profit. However, the profit potential is limited by the lower strike price, and the risk is limited by the higher strike price.
5. Protective collar
A protective collar is a strategy where you own the underlying stock and simultaneously sell a call option and buy a put option on the same stock with the same expiration date and different strike prices. This strategy protects you from a large drop in the stock price, as you can exercise the put option and sell the stock at the strike price if the market price falls below it. However, the upside potential is capped by the call option, as you may have to sell your stock at the strike price if the option is exercised. The cost of buying the put option is offset by the premium received from selling the call option.
6. Long straddle
A long straddle is a high-risk, high-reward options strategy that involves purchasing both a call option and a put option on the same underlying asset with the same strike price and expiration date. This strategy profits from significant price movements in either direction of the underlying asset.
7. Long strangle
A long strangle strategy is an options trading strategy that involves buying both a call option and a put option on the same underlying asset with different strike prices and the same expiration date. Both options are out-of-the-money (OTM), meaning their strike prices are above the current market price for the call option and below the current market price for the put option.
How it works:
- Long call option: A call option gives the holder the right to buy the underlying asset at a specific price (strike price) on or before a specific date (expiration date).
- Long put option: A put option gives the holder the right to sell the underlying asset at a specific price (strike price) on or before a specific date (expiration date).
By purchasing both a call and a put option, the investor positions themselves to profit from significant price movements in either direction. If the stock price moves significantly above the strike price of the call option or significantly below the strike price of the put option, one of the options will become profitable, offsetting the cost of both options.
When to use a long strangle:
- High volatility: A long strangle is particularly attractive in periods of high market volatility, as significant price movements are more likely.
- Event-driven situations: When there are upcoming events that could significantly impact the stock price (e.g., earnings announcements, product launches, or regulatory changes), a long strangle can be a speculative play.
Risk and reward:
- Limited loss: The maximum loss is the premium paid for both options.
- Unlimited profit potential: If the underlying asset's price moves significantly in either direction, the potential profit is theoretically unlimited.
8. Long call butterfly spread
A long call butterfly spread is a strategy where you buy a call option, sell two call options, and buy another call option on the same stock with the same expiration date and different strike prices. The strike prices are arranged in an ascending order, such as A < B < C < D. The call options with the middle strike price (B and C) are sold, and the call options with the lowest (A) and highest (D) strike prices are bought. This strategy allows you to profit from a narrow range of stock price movement around the middle strike price, as the difference between the premiums paid and received will be your maximum profit. However, the profit potential is limited by the lowest and highest strike prices, and the risk is limited by the net cost of the trade.
9. Iron condor
An iron condor is a strategy where you sell a call option and a put option and buy another call option and another put option on the same stock with the same expiration date and different strike prices. The strike prices are arranged in an ascending order, such as A < B < C < D. The call options with the lower strike price (B) and the put options with the higher strike price (C) are sold, and the call options with the highest strike price (D) and the put options with the lowest strike price (A) are bought. This strategy allows you to profit from a stable stock price movement within the range of the sold options, as the difference between the premiums received and paid will be your maximum profit. However, the profit potential is limited by the difference between the adjacent strike prices, and the risk is limited by the difference between the non-adjacent strike prices
10. Iron butterfly
An iron butterfly is a complex options strategy that involves buying and selling both call and put options on the same underlying asset with different strike prices and the same expiration date. This strategy is typically employed in low-volatility markets when the investor expects the stock price to remain relatively stable.
How it works:
- Selling an ATM straddle: The investor sells an at-the-money (ATM) call option and an ATM put option. This generates immediate income but exposes the investor to potential losses if the stock price moves significantly in either direction.
- Buying protective OTM options: To limit potential losses, the investor buys out-of-the-money (OTM) call and put options with strike prices further away from the current market price.
By combining these positions, the investor creates a defined risk profile. The maximum profit is limited to the net credit received from selling the ATM options, while the maximum loss is capped by the cost of the OTM options.
When to use an iron butterfly:
- Low volatility: This strategy is most effective in low-volatility environments when the stock price is expected to remain relatively stable.
- Income generation: The strategy can generate income from the premium received from selling the ATM options.
Risk and Reward:
- Limited profit: The maximum profit is the net credit received from selling the options.
- Limited loss: The maximum loss is the net cost of the OTM options.
Example:
Suppose you expect a stock (XYZ) to trade near $100 over the next month. You could implement an iron butterfly strategy as follows:
- Sell an ATM straddle: Sell a 100 call and a 100 put.
- Buy protective OTM options: Buy a 95 put and a 105 call.
If the stock price remains near $100 at expiration, both the sold options will expire worthless, and you'll keep the premium received. However, if the stock price moves significantly above $105 or below $95, the OTM options you bought will limit your losses.
11. Bull put spread
A bull put spread is a strategy where you sell a put option and buy another put option on the same stock with the same expiration date and a lower strike price. This strategy allows you to profit from a moderate increase in the stock price, as the difference between the premiums received and paid will be your maximum profit. However, the profit potential is limited by the higher strike price, and the risk is limited by the lower strike price.
12. Bull call ratio backspread
A bull call ratio backspread is a strategy where you buy more call options than you sell on the same stock with the same expiration date and a higher strike price. For example, you can buy two call options and sell one call option on the same stock. This strategy allows you to profit from a large increase in the stock price, as the difference between the number of options bought and sold will be your profit multiplier. However, the risk is that you may lose money if the stock price falls below the breakeven point or stays within a narrow range.
13. Synthetic call
A synthetic call is a strategy where you buy the underlying stock and a put option on the same stock with the same expiration date and strike price. This strategy mimics the payoff of a call option, as you can exercise the put option and sell the stock at the strike price if the market price falls below it or keep the stock and let the put option expire worthless if the market price rises above it. The cost of buying the put option is equivalent to the premium paid for a call option.
14. Synthetic put
A synthetic put is a strategy where you sell the underlying stock and a call option on the same stock with the same expiration date and strike price. This strategy mimics the payoff of a put option, as you can buy back the stock and exercise the call option at the strike price if the market price rises above it or keep the short position and let the call option expire worthless if the market price falls below it. The premium received from selling the call option is equivalent to the premium paid for a put option ²⁷²⁸.
15. Bear call spread
A bear call spread is a strategy where you sell a call option and buy another call option on the same stock with the same expiration date and a higher strike price. This strategy allows you to profit from a moderate decrease in the stock price, as the difference between the premiums received and paid will be your maximum profit. However, the profit potential is limited by the lower strike price, and the risk is limited by the higher strike price.
16. Strip
A strip is an options strategy used when an investor anticipates a significant price decline in an asset. It involves buying two put options for every call option sold. This strategy profits from a sharp decline in the asset's price and has limited profit potential but also limited risk.
17. Short straddles
A short straddle is a neutral strategy used when investors expect minimal price volatility in an asset. It involves selling both a call option and a put option with the same strike price and expiration date. The investor collects the premiums from both options but faces unlimited potential losses if the asset's price makes a substantial move in either direction.
Please note that this is not a comprehensive list and there may be other strategies that are not covered here. Also, this is not a financial advice, and you should do your own research before investing in any options.
Each of these option trading strategies has its own unique characteristics, risk-reward profiles, and suitability for different market conditions. Traders and investors should carefully consider their market outlook and risk tolerance when selecting the most appropriate strategy for their specific goals. Additionally, it is essential to stay informed about market developments and adjust strategies as needed to adapt to changing conditions.
What are the levels of options trading?
There are four levels of options trading, which determine the types of strategies that traders can use based on their experience and resources. The levels are:
- Level 1: This level allows traders to write covered calls and cash-secured puts. These are conservative strategies that involve selling options against an existing stock position or cash balance.
- Level 2: This level allows traders to buy calls or puts and open long straddles and strangles. These are bullish or bearish strategies that involve buying options to profit from a directional move or volatility in the underlying asset.
- Level 3: This level allows traders to open long spreads and long-side ratio spreads. These are strategies that involve buying and selling options of the same type and expiration, but with different strike prices. They can be used to reduce the cost and risk of buying options, or to create asymmetric payoffs.
- Level 4: This level allows traders to write naked calls and puts. These are aggressive strategies that involve selling options without owning the underlying asset or having enough cash to cover the potential loss. They can generate high income, but also expose traders to unlimited risk.
Advantages
Some of the advantages of trading options are:
- Risk hedging: Options can be used to protect a stock position or portfolio from adverse price movements. For example, buying a put option can limit the downside risk of owning a stock, while selling a call option can reduce the opportunity cost of holding a stock.
- Cost efficiency: Options can be cheaper than buying or selling the underlying asset, especially for expensive, or illiquid stocks. For example, buying a call option can give the same exposure as buying 100 shares of a stock, but at a fraction of the cost.
- Amplified returns: Options can magnify the returns from a favourable price movement in the underlying asset, due to the leverage effect. For example, buying a call option can result in a higher percentage gain than buying the stock, if the stock price rises above the strike price.
- Flexibility and versatility: Options can be used to create a variety of trading strategies that suit different market conditions, outlooks, and risk preferences. For example, options can be combined to create spreads, straddles, strangles, butterflies, condors, and more.
Disadvantages
Some of the disadvantages of trading options are:
- Price fluctuations: Options prices can change significantly from day to day, due to factors such as time decay, implied volatility, interest rates, dividends, and market sentiment. This can result in large losses or missed opportunities for option buyers, especially for short-term or out-of-the-money options.
- Higher risk for sellers: Option sellers have limited profit potential and unlimited loss potential, as they are obligated to fulfil the contract if the option is exercised by the buyer. This can expose them to margin calls, forced liquidation, especially for naked options.
- Educational investment: Educational investment: Options trading requires a certain level of knowledge, skill, and experience to trade effectively and safely. Traders need to learn the terminology, concepts, and strategies of options trading, as well as the risks and rewards involved. Traders also need to keep up with the market trends, news, and events that affect the options prices.
Which options strategies can make money in a sideways market?
A sideways market is characterized by a lack of significant price movement, resulting in a low-volatility environment. In such market conditions, certain options strategies can be particularly effective:
- Short straddle: This strategy involves selling both a call and a put option with the same strike price and expiration date. If the underlying asset's price remains relatively stable, both options will expire worthless, and the seller will keep the premium received.
- Short strangle: Similar to a short straddle, a short strangle involves selling both a call and a put option, but with different strike prices. This strategy also profits from low volatility, as both options are likely to expire worthless.
- Long butterfly: This strategy involves buying and selling both call and put options with different strike prices and the same expiration date. In a sideways market, the long options can limit potential losses, while the short options generate income.
These strategies are particularly attractive in sideways markets because they profit from the absence of significant price movement. However, it's important to note that these strategies are also riskier than others, as a sudden, unexpected price movement can lead to significant losses.
Conclusion
Options trading strategies can be complex and involve significant risks, especially for beginners. Therefore, it is important to understand the basics of options, the factors that affect their prices, and the potential outcomes of each strategy before entering any trade. Moreover, it is advisable to consult a financial adviser or a broker who can guide you through the process and help you choose the best strategy for your goals and risk tolerance.
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