What are Option Strategies?


The Market is always moving. Options Market is an exciting trading platform as it holds huge gain potential. It’s up to the trader to analyze and choose the strategy he wants to implement in order to protect against the losses. Traders often try to trade options without understanding the various strategies available to Options traders and these are all based on fundamental options: Calls and Puts. These basics are a base for investors to create a range of strategies that maximize the payout from a stock’s movement and savvy investors pick the strategy that’s best for how they expect the stock to perform. Options strategies help traders to make effective use of their capital.


Why do traders use Options Strategies ?

Options strategies can help traders protect against losses by holding buying and selling positions simultaneously of one or more options. Options strategies allow traders to generate profit from movements in the prices of the securities based on market behavior; namely Bullish, Bearish, and neutral.


Which Options Strategies ?

There is a wide range of strategies available to Options traders. The strategies vary according to market situations. The market could be Bearish, Bullish, Range-Bound, and Neutral. Consequently, the strategies differ as per the market situation. These not only limit the risk but also maximize returns effectively. We are here discussing the 5 most popular and useful strategies among successful traders.


COVERED CALL

A covered call is an options strategy involving trades in both the underlying stock and options contract. This strategy helps you make extra income on the securities you already hold in the cash market. The trader buys an underlying asset and plans to hold on to the security to earn profits on that security without selling it. He may sell a call contract for the same stock and earn income on that security by collecting option premiums.


How do you create a covered call trade?

You purchase stock in the cash market and further sell a call contract in the options market in lots of 100 shares. You need not sell a call contract for all the shares purchased in the cash market.

  • A covered call that is sold is typically out of the money (OTM), (underlying asset is below the option’s strike price). In an OTM call, you can make a profit on both the stock and sale of the contract as you maintain your stock position by not exercising the contract and also collect the premium by selling call options.

  • If you believe the stock price is going to drop, but you still want to maintain your stock position, you can sell an in the money (ITM) call option, where the strike price of the underlying asset is lower than the market value. When selling an ITM call option, you will receive a higher premium from the buyer of your call option.

  • You may then let the contract expire or exercise the option, whatever suits your investment goal the best.

  • If you want to sell the stock while making additional profit by selling the calls, then you want the stock to rise above the strike price and stay there at expiration. That way, the calls will be assigned.

  • When the call is first sold, potential profit is limited to the strike price minus the current stock price plus the premium received for selling the call.

  • Whereas, the maximum loss could be when the prices exponentially rise, you might miss out on those gains.

Recommendation

Covered calls are a great way to generate additional income from owning stock and suitable for investors with all skill levels


BULL CALL SPREAD

A bull call spread consists of one long call with a lower strike price and one short call with a higher strike price, both expiring at the same time. The strike price of the short call is higher than the strike of the long call, therefore this strategy will always require the investor to pay for the trade.

  • The short call’s primary purpose is to help pay for the long call’s upfront cost.

  • The max profit in a bull call spread is calculated by taking the difference between the two strike prices minus the premium paid. This maximum profit is realized if the stock price is at or above the strike price of the short call at expiration.

  • Max loss is the cost of the trade. This is reached when the stock trades below the lower strike price at expiration.

  • The breakeven for a bull call spread is the lower strike price plus the cost of the trade.

  • Breakeven = long call strike + net debit paid.

Example

A 550-650 call spread costing Rs.70 would consist of buying a 550-strike price call and selling a 650 strike price call, have an Rs.100 wide strike width (650 -550), which is the most the investor could make on the trade, minus the premium paid to get into the trade, in our example Rs.70, leaving the investor with a max profit of Rs.30.


Recommendation

This is not a strategy that should be executed very often unless there is evidence of an expected upward movement. Without that, it’s a lower probability of success trade that relies on stock to trade higher


BEAR PUT SPREAD

A bull call spread consists of one long call with a higher strike price and one short call with a lower strike price, both expiring in the same month. The short strike price is lower than the strike of the long put which is why this strategy demands the investor to pay for the trade. The short put’s primary purpose is to help pay for the long put’s upfront cost.


  • The max profit of a bear put spread is calculated by taking the difference between the two strike prices minus the premium paid. This is reached when the strike trades below the lower strike price at expiration.

  • Max loss is the cost of the trade. This is reached when the stock trades above the upper strike price at expiration.

  • Breakeven

  • The breakeven for a bear put spread is the upper strike price minus the cost of the trade. Breakeven = long put strike – debit paid

Example

A 400-500 bear put spread costing Rs.70 would consist of buying a 500-strike price call and selling a 400 strike price call, have an Rs.100 wide strike width (500-400), which is the most the investor could make on the trade, minus the premium paid to get into the trade, in our exampleRs.70, leaving the investor with a max profit of Rs.30.


Recommendation

This is not a strategy that should be executed very often unless there is evidence of an expected downward movement. Without that, it’s a lower probability of success trade that relies on the stock to trade lower before the expiration date.


THE LONG STRANGLE

The long strangle (buying the strangle) is a neutral options strategy with limited risk and unlimited profit potential. It consists of one long put option with a lower strike price and one call option with a higher strike price call. The strategy is best used in highly volatile markets where a significant price move in the stock is expected.


  • If the stock trades up, the investor can let the put option expire worthlessly and exercise the call.

  • If the stock trades down, the investor will let the call expire worthlessly and exercise the put. The profit potential is unlimited, while the risk is limited to the net premium paid in this strategy.

  • This options trading strategy has unlimited profit potential in a volatile market while minimizing the loss

  • The maximum profit for a long strangle strategy is unlimited as the position can continue to pick up gains the further the stock travels in either direction.

  • Maximum Loss = Net Premium Paid

  • Breakeven

  • A strangle has two breakeven points.

  • Lower Breakeven = Strike Price of Put – Net Premium

  • Upper Breakeven = Strike Price of Call + Net Premium


Recommendation

The long strangle strategy appears often in the world of options trading and can be beneficial to traders seeking to profit from market volatility. Long strangle is an excellent strategy for market moves based on current news and events because it is a low-cost strategy with minimal risk and limitless benefit potential.


Example

If the stock is trading at Rs.500 and one is expecting the stock to either increase or decrease in the near future, an investor can simultaneously purchase Rs.550 call and Rs.450 put for the net cost premium of Rs.40. If the stocks rise to Rs.650 upon expiration, then the Rs.550 call would be resulting in a profit of Rs.60 (call worth (Rs.100) minus the (Rs.40) premium). If the stock drops to Rs.350 upon expiration, then the Rs.450 put would similarly be worth Rs.100 resulting in the same Rs.60 after deducing the premium paid. If the stock stayed between the two strike prices, Rs.450 and Rs.550, then the trader would lose their Rs.40 premium invested.


SHORT STRANGLE

A short strangle consists of selling calls and a put option in the same underlying security, strike price, and expiration date. With a short strangle, maximum profit is reached when the stock stays within the range of the two strike prices.

  • The maximum profit of a short strangle is limited to the total premiums received. This strategy works best when the stock has little movement until the expiration.

  • The maximum loss for a short strangle strategy is unlimited as the stock can continue to move against the trader in either direction.

  • Breakeven

  • The breakeven on the top side of the strangle is calculated by adding the premium to our call strike price and on the downside subtracting the premium from the put strike price.

  • Lower Breakeven = Put Strike Price – Premium Received

  • Upper Breakeven = Call Strike Price + Premium Received


Example

If a trader executes a short strangle at the following prices:

  • Sell 1 call of 105 strike price at Rs.20

  • Sell 1 put of 95 strike price at Rs.23

  • Net credit = 3

If the stock stays within the 95 to 105 range then the trader would get to keep the full Rs.3 and achieve their maximum gain. If the stock trades up to Rs.112, then the trader would lose Rs.7 on the 105- strike price call, but because they received Rs.3 on the strangle, they would have a net loss of Rs.4.


Recommendation

this trade does have unlimited risk, it’s recommended to be very selective when executing a trade like this and to keep quantity sizing small. Traders like to sell strangles so that they receive two premiums, requiring the stock to have to move twice as far in either direction before they would start to lose.


These are just a handful of strategies listed out, whereas each type of trader has a favorable strategy in the market that they can profit from. Every option trader keeps hunting for the best options strategy. There are over 400 options strategies that you can deploy. But to spot a winning strategy that matches your investment goal is the challenge.




132 views0 comments

Recent Posts

See All