Basic Understanding of Option Strategies

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. Call options, simply known as calls, give the buyer a right to buy a particular stock at that option’s strike price. Conversely, put options, simply known as puts, give the buyer the right to sell a particular stock at the option’s strike price. 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 straightforward 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 traders to profit from movements in the underlying assets based on market sentiment (i.e., bullish, bearish or neutral). In the case of neutral strategies, they can be further classified into those that are bullish on volatility, measured by the lowercase Greek letter sigma (σ), and those that are bearish on volatility. Traders can also profit off time decay, measured by the uppercase Greek letter theta (Θ), when the stock market has low volatility. The option positions used can be long and/or short positions in calls and puts.

Bullish strategies

Bullish options strategies are employed when the options trader expects the underlying stock price to move upwards. They can also use Theta (time decay) with a bullish/bearish combo called a Calendar Spread, when sideways movement is expected. The trader may also forecast how high the stock price may go and the time frame in which the rally may occur in order to select the optimum trading strategy for buying a bullish option.

The most bullish of options trading strategies, used by most options traders, is simply buying a call option.

The market is always moving. It’s up to the trader to figure out what strategy fits the markets for that time period. Moderately bullish options traders usually set a target price for the bull run and utilize bull spreads to reduce cost or eliminate risk altogether. There is limited risk trading options by using the appropriate strategy. While maximum profit is capped for some of these strategies, they usually cost less to employ for a given nominal amount of exposure. There are options that have unlimited potential to the up or down side with limited risk if done correctly. The bull call spread and the bull put spread are common examples of moderately bullish strategies.

Mildly bullish trading strategies are options that make money as long as the underlying asset price does not decrease to the strike price by the option’s expiration date. These strategies may provide downside protection as well. Writing out-of-the-money covered calls is a good example of such a strategy. The purchaser of the covered call is paying a premium for the option to purchase, at the strike price (rather than the market price), the assets you already own. This is how traders hedge a stock that they own when it has gone against them for a period of time.

Bearish strategies

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. Selling a Bearish option is also another type of strategy that gives the trader a “credit”. This does require a margin account.

The most bearish of options trading strategies is the simple put buying or selling strategy utilized by most options traders.

The market can make steep downward moves. Moderately bearish options traders usually set a target price for the expected decline and utilize bear spreads to reduce cost. This strategy has limited profit potential, but significantly reduces risk when done correctly. 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 asset does not rise to the strike price by the options expiration date. However, you can add more options to the current position and move to a more advanced position that relies on Time Decay “Theta”. These strategies may provide a small upside protection as well. In general, bearish strategies yield 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 asset’s 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 price will increase or decrease. Rather, the correct neutral strategy to employ depends on the expected volatility of the underlying stock price.

Examples of neutral strategies are:

• Guts: Buy (long gut) or sell (short gut) a pair of ITM (in the money) put and call (compared to a strangle where OTM puts and calls are traded);
• Butterfly: A neutral option strategy combining bull and bear spreads. Long butterfly spreads use four option contracts with the same expiration but three different strike prices to create a range of prices the strategy can profit from.
• Straddle: An options strategy in which the investor holds a position in both a call and put with the same strike price and expiration date, paying both premiums (long straddle)
• Strangle: Where you buy a put below the stock and a call above the stock, with profit if the stock moves outside of either strike price (long strangle).
• Risk reverse: 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;
• Calendar spread: The purchase of an option in one month and the simultaneous sale of an option at the same strike price (and underlying) in an earlier month, for a debit

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, long condor (Iron Condor), long butterfly, and long Calendar.

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, short condor, short butterfly, and short calendar.

Option strategy profit / loss chart

A typical option strategy involves the purchase / selling of at least 2-3 different options (with different strikes and / or time to expiry), and the value of such portfolio may change in a very complex way.

One very useful way to analyze and understand the behavior of a certain option strategy is by drawing its Profit / Loss graph.

An option strategy profit / loss graph shows the dependence of the profit / loss on an option strategy at different base asset price levels and at different moments in time.

Option Strategies

1. Orientation

Setting the context Before we start this module on Option Strategy.

2. Bull Call Spread

Background The spread strategies are some of the simplest option strategies that a trader can implement. Spreads are multi leg strategies involving 2 or more options.

3. Bull Put Spread

Why Bull Put Spread? Similar to the Bull Call Spread, the Bull Put Spread is a two leg option strategy invoked when the view on the market is ‘moderately bullish’.

4. Call Ratio Back Spread

Background The Call Ratio Back Spread is an interesting options strategy. I call this interesting keeping in mind the simplicity of implementation and the kind of pay off it offers the trader.

5. Bear Call Ladder

Background The ‘Bear’ in the “Bear Call Ladder” should not deceive you to believe that this is a bearish strategy. The Bear Call Ladder is an improvisation over the Call ratio back spr.

6. Synthetic Long & Arbitrage

Background Imagine a situation where you would be required to simultaneously establish a long and short position on Nifty Futures, expiring in the same series.

7. Bear Put Spread

Spreads versus naked positions Over the last five chapters we’ve discussed various multi leg bullish strategies. These strategies ranged to suit an assortment of market outlook – from.

8. Bear Call Spread

Choosing Calls over Puts Similar to the Bear Put Spread, the Bear Call Spread is a two-leg option strategy invoked when the view on the market is ‘moderately bearish’. The Bear Call Spread.

9. Put Ratio Back spread

Background We discussed the “Call Ratio Back spread” strategy extensively in chapter 4 of this module. The Put ratio back spread is similar except that the trader invokes this when he is b ..

10. The Long Straddle

The directional dilemma How many times have you been in a situation wherein you take a trade after much conviction, either long or short and right after you initiate the trade the market move.

11. The Short Straddle

Context In the previous chapter we understood that for the long straddle to be profitable, we need a set of things to work in our favor, reposting the same for your quick reference – The vo ..

12. The Long & Short Strangle

Background If you have understood the straddle, then understanding the ‘Strangle’ is quite straightforward. For all practical purposes, the thought process behind the straddle and strangl ..

13. Max Pain & PCR Ratio

My experience with Option Pain theory in the never ending list of controversial market theories, the theory of ‘Option Pain’ certainly finds a spot. Option Pain, or sometimes referred to.

14. Iron Condor

New margin framework These are fascinating times we are living in, especially if you are an options trader in India Starting 1st June 2020, NSE’s new margin framework is live.