6 Common Options Trading Strategies

Last Updated on February 21, 2022

You-all ever heard about derivative options. Professional traders and investors use their knowledge to devise a trading strategy that will help to generate profits. Derivative options are of two categories i.e. Call option and Put option. Options traders perform in-depth analysis and prepare options trading strategies for the successful execution of a trade.

There are no fixed options trading strategies. Both Call and Put options can be traded in many ways and the possibilities are endless. One can create its own tailor-made trading strategy according to his/her choice and skills.

Before discussing various options trading strategies, first, understand the following terms:

  1. In the money
  2. At the money
  3. Out of the money

1. In the Money

It means the strike price (S) of the underlying assets of the Call option is less than the spot price (K) of the underlying assets of the Call option at the expiry. (S<K)

For the Put option, the strike price (S) of the underlying assets of the, Put option is more than the spot price (K) of the underlying assets of the Put option at the expiry. (S>K)

2. At the Money

It means the strike price (S) of the underlying assets of the Call/Put option is equal to the spot price (K) of the Underlying assets of the Call/Put option at the expiry. (S=K)

3. Out of the Money

It means the strike price (S) of the underlying assets of the Call option is more than the spot price (K) of the underlying assets at the expiry. (S>K)

For the Put option strike price (S) of the underlying assets of the, Put option is less than the spot price (K) of the underlying assets at the expiry. (S<K)

Example: Let’s say the stock price of Amazon Inc at the current market spot price is $3300. A 3 months Call option is available at a strike price of underlying stocks at $3350.

Mr. M buys the 3 months expiry Call option at a strike price of underlying stocks at $3350. It is expected that the price of Amazon Inc may rise to $3360 or fall to $3340 after 3 months.

The strike price (S)The stock price at expiry i.e. 3 months (K)Call optionPut option
$3350$3360In the MoneyOut of the Money
$3350$3350At the MoneyAt the Money
$3350$3340Out of the MoneyIn the Money

If the stock price of Amazon Inc rises to $3360 at expiry, the Call option is In the money. Mr. M will exercise his right and buy the Call option with the strike price of $3350. He will earn a profit of $10 per stock.

If the stock price of Amazon Inc will be at $3340 or remain $3350 at expiry. Mr. M will not exercise his right and terminate the Call option by paying a premium amount.

In the case of a Put option, if the stock price rises to $3360 or $3350. Mr. M will not exercise his right and terminate the options contract by paying a premium amount, and if the stock price falls to $3340, then he will exercise his right and buy the Put option at a strike price of $3350 and earn a profit of $10 per stock.

Call/Put Options can be confusing understand it from here.

Options Trading Strategies

There are some common options trading strategies that are widely used by traders in the stock markets. Let us understand these major strategies:-

1. Strip

In this option strategy, a long (buy) position with one Call option and two Put options with the same strike price and same expiry date is taken.

In strip, the investor is expecting a downward trend (Bearish market) in the underlying stock price in the future period but is not sure about the probability of the direction of stock price fluctuation, i.e. the stock price may rise or fall.

Example: Mr. M an investor takes a long (buy) position of a 3 months expiry Call option with a premium price of $8 and two 3 months expiry Put options with a premium price of $6. Both options have a strike price of the underlying stock of $100. So, the cost of the options is $8+($6*2)=$20.

To recover the amount of cost incurred i.e. $20. Mr. M has to achieve Break-Even Point (BEP).

Strip table
Strip

In the above example, the BEP is achieved faster in case, if the price of the underlying stock falls and slower in case the price of the underlying stock rises. So, if the underlying stock price goes beyond the BEP point, Mr. M starts earning profits.

2. Strap

In this options trading strategy, a long (buy) position with one Put option and two Call options with the same strike price and expiry date is taken.

In strap the investor is expecting an upward trend (Bullish market) in the underlying stock price in the future period but is not sure about the probability of the direction of stock price fluctuation, i.e. the stock price might rise or fall in the future.

Example: Ms. A an investor takes a long (buy) position of a 3 months expiry Put option with a premium price of $8 and two 3 months expiry Call options with a premium price of $6. Both options have a strike price of the underlying stock of $100. So, the cost of the options is $8+$6*2=$20.

To recover the amount of cost incurred i.e. $20. Ms. A has to achieve Break-Even Point (BEP).

Strap table
Strap

In the above example, the BEP is achieved faster in case, if the price of the underlying stock rises and slower in case the price of the underlying stock falls. So, if the underlying stock price goes beyond the BEP point, Ms. A starts earning profits.

3. Straddles

A. Long Straddle

In this options trading strategy, a long (buy) position with one call option and one put option with the same strike price and expiry date is taken.

The Investor is expecting a significant fluctuation in the price of the underlying stocks. But, he/she did not know either in which direction i.e. upward or downward the stock price will move.

This strategy will be profitable if the price of the underlying stocks moves significantly in either direction. If the stock price falls the Put option will be exercised, and if the stock price rises the Call option will be exercised.

Example: Mr. M an investor takes a long (buy) position of one 3 months expiry Call option with a premium price of $20 and one 3 months expiry Put option with a premium price of $15. Both options have a strike price of the underlying stock of $100. So, the cost of the options is $15+$20=$35.

Long Stradle Table

To recover the amount of cost incurred i.e. $35. Mr. M has to achieve Break-Even Point (BEP) and beyond that point the probability of profit is unlimited and loss is limited to the amount of premium paid for not exercising either of the Call or Put options.

Long Straddle

B. Short Straddle

In this options trading strategy, a short (sell) position with one call option and one put option with the same strike price and expiry date is taken.

The investor takes a short straddle position only when he/she expects that the underlying stock price would be stable and not change much.

Example: Ms. A an investor takes a short (sell) position of one 3 months expiry Call option with a premium price of $20 and one 3 months expiry Put option with a premium price of $15. Both options have a strike price of the underlying stock $100. So, the cost of the options is $15+$20=$35.

Pay-off Table Short Straddle
Short Straddle

In this case, the investor is the option writer (seller). so if the underlying stock price in the future remains the same as the strike price both the Call and Put options will expire unproductively. Hence, the investor will retain the total premium as profit i.e. $35 from selling both Call and Put options.

4. Strangles

A. Long Strangle

In this options trading strategy, a long (buy) position with one call option and one put option with the same expiry date but with different strike prices is taken. The Investor is expecting that the volatility will be high in the future.

Example: Let’s say, both Call and Put options with a different strike price are available in the stock market with a different amount of premium.

Mr. M, an investor takes a long (buy) position of one 3 months expiry Call option with the lowest premium price of $25 and one 3 months expiry Put option with the lowest premium price of $25. Both options have different strike prices i.e. for the Call option $1200 and for the Put option $1000.

Strangle example

The cost of both the options is Call $25 + Put $25 = $50. So, BEP is achieved in the Call option when the price of the underlying stock reaches $1250. Similarly, for the Put option, BEP is achieved when the price of the underlying stock reaches $950.

Long Strangle Table
Long Strangle

In the above example, the cost of premium in both the options is recovering fast but the probability of having loss is higher as the gap between the strike price from Call to Put is large.

B. Short Strangle

In this options trading strategy, a short (sell) position with one call option and one put option with the same expiry date but with different strike prices is taken. The Investor is expecting that the volatility will be low in the future.

From the above same example let’s understand the strategy.

Ms. A, an investor takes a short (sell) position of one 3 months expiry Call option with the lowest premium price of $25 and one 3 months expiry Put option with the lowest premium price of $25. Both options have different strike prices i.e. for the Call option $1200 and for the Put option $1000.

Short Strangle Table

Here Ms. A is an option writer (seller) so, the maximum profit she can earn is the amount of premium of both the Call and Put option. BEP is achieved when the price of the underlying stock for the Call option reaches $1250 and the Put option reaches $950.

Short Strangle

Here at expiry, if the price of the underlying stock is trading between the strike price of both the Call and Put option so the Call and Put both options will expire unproductively. The profit is limited to the amount of premium and the probability of the loss is unlimited. Hence, it is a risky strategy.

5. Horizontal/Time/Calendar Spread

In this options trading strategy, a short (sell) position with one call option with near period expiry date and long (buy) another Call option with far period expiry date with same strike prices are taken. The Investor is expecting that the price of the underlying stocks will be stable in the future.

The investor is setting up the Horizontal or Time spread strategy as an attempt to make a profit from the declining time value of the Option. The longer the maturity of the option the more expensive the cost of it.

There are two main factors to be considered here.

  1. Implied volatility
  2. Time value

Example: Mr. X an investor takes a long (buy) position of one 6 months expiry Call option with a premium price of $60, and a short (sell) position of one 3 months expiry Call option with a premium price of $25. Both options have a strike price of the underlying stock of $100. So, the cost of the options is $60-$20=$40.

As Mr. X takes both long and short at the money position. If, the price of the underlying stock does not move or is stable in the future time. For a long position, he has to pay a $60 premium and for the short position, he will receive a $20 premium. So, the net debit is +$20-$60=-$40.

1. At 3 months expiry, if both Call option at maturity is At or Out of the Money.

Calendar spread Chart

In this case, both the Call expires unproductive. So, the maximum loss value is the Spread i.e. $40. But as Mr. X takes a long Call position of 6 months he has more time to correct his position. The intrinsic value of the long Call option may be an increase or decrease with time or will have no change at all.

If the intrinsic long Call value Increase Mr. X will make a profit, and if decreases he will terminate the long Call option by paying a premium i.e $60.

If there is no change in the intrinsic value of the long Call yet it is worth a certain value and the future implied volatility is uncertain. He can write (sell) that long Call option let’s say $30. He can benefit from writing that long Call option.

2. At 3 months expiry, if both Call option at maturity is In the Money.

Calendar Spread Chart

In this case, the increase in the intrinsic gain value of the long Call will be set off against the intrinsic Loss value of the short Call. The value of the calendar spread becomes zero.

6. Butterfly Spread

A. Call Option

In this options trading strategy, the main focus is upon premium spread. A long (buy) position with one call option with a relatively low strike price and long (buy) another Call option with a relatively high strike price. Also, a short (sell) position with 2 Call options with strike prices between low and high strike prices is taken.

Generally, the short (sell) Call option strike price is near to the current underlying stock price.

A butterfly Call option spread will incur profit if the underlying stock price will be stable and near to the short (sell) call option’s strike price.

It will incur a small loss if there is a significant movement in the underlying stock price in either direction i.e upward or downward.

Example: Mr. T an investor takes a long (buy) position of one 3 months expiry Call option A with a strike price of $80, and another long (buy) position of one 3 months expiry Call option C with a strike price of $120. He also takes 2 short (sell) positions of 3 months expiry Call option B with a strike price of $100.

Suppose, the premium for both long Call options A & C is $30 and the premium for a short Call option B is $20. So the total cost of the strategy is $30*2-$20*2 = $20.

Here Mr. T is Writing (sell) 2 Call option B, so he will receive a premium if the buyer will not exercise these Call options.

Call Butterfly Table
Call Butterfly Chart
Call Butterfly Spread

In the above example, Mr. T will earn a profit of $30 if the underlying stock price at maturity will be stable or near Call B‘s strike price. He will incur a loss of $20 if the underlying stock price decreases near Call A‘s strike price or a loss of $30 if the underlying stock price increase near Call C‘s strike price.

B. Put Option

In this options trading strategy, a long (buy) position of a Put option with a low strike price and another Put option with a high strike price is taken along with a short (sell) position with 2 Put options in between low and high strike prices.

Generally, the short (sell) Put option strike price is near to the current underlying stock price, which an investor will gain from the strategy.

Example: Ms. S an investor takes a long (buy) position of one 3 months expiry Put option X with a strike price of $80, and another long (buy) position of one 3 months expiry Call option Z with a strike price of $120. She also takes 2 short (sell) positions of 3 months expiry Put option Y with a strike price of $100.

Suppose, the premium for both long Put options X & Z is $30 and the premium for short Put option Y is $25. So the total cost of the strategy is $30*2-$25*2 = $10.

Here, Ms. S is writing (sell) 2 Put option Y, so she will receive a premium if the buyer will not exercise these Put options.

Put Butterfly Table
Put Butterfly Chart
Put Butterfly Spread

In the above example, Ms. S will earn a profit of $40 if the underlying stock price at the maturity will be stable or near Put Y‘s strike price. She will incur a loss of $30 if the underlying stock price decreases near Put X‘s strike price or a loss of $10 if the underlying stock price increase near Put Z‘s strike price.

Conclusion

The above-mentioned options trading strategies are the most widely used by professional traders. Though there are boundless ways to create a strategy that can work out for you to gain profit from trading in derivative options. All you need is in-depth knowledge, the experience that you gain from trading, patience, and discipline which are the key factors in every trade.

What’s your options trading strategy?

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