If you’re new to the stock market or investing, terms like “Option Strategies” or “Option Trading Strategies” might sound unfamiliar, but don’t worry, I can explain!
Option strategies are trading strategies that use options contracts( Call, Put) to achieve specific outcomes, such as hedging risk, generating income, or speculating on market movements. These strategies can be complex and involve multiple options contracts with different strike prices and expiration dates.
Options can provide leverage, allowing traders to control a larger position in the underlying asset (like Stock) with a relatively small amount of capital. Options offer a high degree of flexibility in terms of trading strategies. Traders can use options to construct a wide range of strategies, from simple to complex, depending on their market outlook and risk tolerance.
Best Option Strategy that every trader should know
Here are five common options trading strategies, along with their potential rewards and risks, and when a trader might use them for their next investment. While these strategies are easy to understand, they can help traders make a lot of money — but they do involve risks.
1. Covered Call
The covered call option strategy is a popular strategy used by investors who own the underlying stock and want to generate additional income from their holdings. In a covered call strategy, an investor owns shares of a stock and sells call options on those shares. By selling call options, the investor collects a premium, which is the price paid by the buyer of the option.
You decide to sell one call option contract on your 100 shares of XYZ stock. Each option contract typically represents 100 shares of the underlying stock. As the seller of the call option, you receive a premium from the buyer. Regardless of whether the option buyer exercises the option or not, you get to keep the premium you received from selling the call option.
Example:
Let’s say you own 100 shares of XYZ company, currently trading at $50 per share. You decide to sell a call option with a strike price of $55 and an expiration date in one month. The premium you receive for selling this option is $2 per share, or $200 total (since one option contract represents 100 shares).
Reward/risk: If the stock price remains below the strike price of $55 per share at expiration, the call option will expire worthless, and you keep the premium as profit. You also continue to hold onto your shares of XYZ stock. If the stock price rises above the strike price of $55 per share at expiration, the option buyer may choose to exercise their right to buy the stock from you at $55 per share. In this case, you would sell your shares at the strike price, but you still get to keep the premium you received from selling the call option. While you would miss out on any potential gains above $55 per share, you still keep the $200 premium, which helps offset the loss.
2. Long Call or Put
The long call and long put option strategies are basic option trading strategies that involve buying call or put options to profit from price movements in the underlying asset.
Long Call:
In this option trading strategy, the trader purchases a call option, which is also known as “going long” a call. The long call strategy aims to profit from an expected increase in the price of the underlying asset.
Example: Suppose a stock is trading at $50 per share, and an investor expects the price to rise. They buy one call option contract with a strike price of $55 and an expiration date one month from now. The investor pays a premium of $2 per share for the option (total cost = $200 for one contract, each contract representing 100 shares).
Reward/risk: The risk is limited to the premium paid for the option. If the stock price does not rise above the strike price before expiration, the option will expire worthless, and the investor will lose the premium paid. The potential profit is unlimited. If the stock price rises significantly above the strike price, the investor can exercise the option and buy the stock at the strike price, then sell it at the higher market price.
Long Put:
The long put strategy aims to profit from an expected decrease in the price of the underlying asset.
Example: Using the same stock trading at $50 per share, suppose an investor expects the price to fall. They buy one put option contract with a strike price of $45 and an expiration date one month from now. The investor pays a premium of $1.50 per share for the option (total cost = $150 for one contract, each contract representing 100 shares)
Reward/risk: The risk is limited to the premium paid for the option. If the stock price does not fall below the strike price before expiration, the option will expire worthless, and the investor will lose the premium paid. The potential profit is limited to the difference between the strike price and the stock price, minus the premium paid. If the stock price falls significantly below the strike price, the investor can exercise the option and sell the stock at the strike price, then buy it back at the lower market price.
3. Straddle
The straddle strategy is an options trading strategy where an investor holds a position in both a call option and a put option with the same strike price and expiration date. This strategy is used when the investor expects a significant price movement in the underlying asset but is unsure of the direction of the movement.
Example: Let’s say you believe that a stock, currently trading at $100, is going to experience a significant price movement in the near future due to an upcoming earnings announcement or any other reason. However, you’re not sure whether the stock will go up or down after the announcement. In this case you can apply straddle strategy, to implement you would
- Buy a call option: Buy a call option with a strike price of $100 and an expiration date after the earnings announcement.
- Buy a put option: Buy a put option with the same strike price of $100 and the same expiration date.
Reward/risk: The main risk of the straddle strategy is the potential loss of the premiums paid for both the call and put options if the stock price doesn’t move significantly. You need the stock price to move enough to cover the cost of both premiums. The potential reward of the straddle strategy is theoretically unlimited if the stock price makes a large enough move in either direction. If the stock price rises significantly, the call option will become profitable, and if it falls significantly, the put option will become profitable.
Breakeven Point: The breakeven points for a straddle strategy are the strike price plus the total premium paid for the call and put options, and the strike price minus the total premium paid. Suppose In our example, if the total premium paid for both options is $5, the breakeven points would be $105 and $95 ($100 + $5 and $100 – $5).
4. Iron Condor
An Iron Condor is an options trading strategy that involves four different contracts ( bull put spread & bear call spread). It’s used when you believe that the price of a stock or other underlying asset will stay within a certain range over a period of time.
| Sell Call Option | Buy call option | Sell put option | Buy put option |
| First, sell call option with a strike price above the current market price of the asset. | Then buy a call option with a higher strike price than the one you sold. This creates a “credit spread,” where you receive a premium for selling the first call option and pay a premium for buying the second one. | Next, you sell a put option with a strike price below the current market price of the asset. | To limit your risk on the downside, you buy a put option with a lower strike price than the one you sold. This creates another credit spread, similar to the one on the call side. |
Example: let’s say you sell a call option on XYZ stock with a strike price of $50 and receive a premium of $1. You then buy a call option with a strike price of $55 for $0.50. On the put side, you sell a put option with a strike price of $45 for $0.80 and buy a put option with a strike price of $40 for $0.30.
Reward/risk: The result is a position with limited risk and limited profit potential. Your maximum profit is the premium you receive from selling the call and put options, minus the premium you pay for buying the call and put options with higher strike prices. Your maximum loss occurs if the price of the underlying asset moves significantly beyond the strike prices of the options you bought.
In the above example, your net premium received is $1 ([$1 – $0.50] + [$0.80 – $0.30]). If the price of XYZ stock stays between $45 and $50 at expiration, all four options expire worthless, and you keep the $1 premium as your profit. If the price moves outside of this range, your losses are limited to the difference between the strike prices of the options you bought and sold, minus the premium received.
5. Vertical Spreads
Vertical spreads are option trading strategies that involve buying and selling options of the same type (both calls or both puts) on the same underlying asset, but with different strike prices. It is also called bull call spread and bear put spread. This is kind of reverse iron condor.
Bull Call Spread:
A bull call spread involves buying a call option and simultaneously selling another call option with a higher strike price. Both options have the same expiration date.
Example: Suppose stock XYZ is trading at $50. You could buy a call option with a strike price of $50 (the current price) for $3 and simultaneously sell a call option with a strike price of $55 for $1.50. This creates a bull call spread.
Reward/risk: The maximum loss is limited to the initial cost of the spread ($3 – $1.50 = $1.50 per share in this example). The maximum profit is limited to the difference in strike prices ($55 – $50 = $5) minus the cost of the spread ($1.50), which is $3.50 per share.
Bear Put Spread:
A bear put spread involves buying a put option and simultaneously selling another put option with a lower strike price. Both options have the same expiration date.
Example: Using the same stock XYZ trading at $50, you could buy a put option with a strike price of $50 for $2 and simultaneously sell a put option with a strike price of $45 for $1. This creates a bear put spread.
Reward/risk: The maximum loss is limited to the initial cost of the spread ($2 – $1 = $1 per share in this example). The maximum profit is limited to the difference in strike prices ($50 – $45 = $5) minus the cost of the spread ($1), which is $4 per share.