Options Trading Strategies

Options are complex derivatives. However, this complexity introduces the possibility for a vast array of trading strategies.

A skilled options trader is able to trade any direction that a market is moving, whether it is trending upwards, downwards or moving sideways.

Combining the skills learnt in previous modules with a sound knowledge of trading strategies can make your trading very profitable.

Strategy 1: Directional Trades

Using the technical signals presented in previous modules can indicate that a directional trade should be entered. The most used strategies to implement for trading directions are bought calls or puts. These are high-risk, but also offer the greatest possible return.

Strategy 2: Covered Calls/Buy And Write

One of the most effective income generation strategies, in a neutral or moderately bullish market, is the Covered Call/Buy and Write. This involves buying or holding stock and selling a call option over this holding, generating income in the form of the option premium, as well as allowing capital gain to the point of the strike price of the sold option.

Strategy 3: Covered Calls/Buy Write Variations

These strategies are similar to covered calls but can also include protected strategies or leveraged exposure.

If a put option is purchased when holding a covered call strategy, the downside risk of the strategy is capped.

If a client is to take out a margin loan to enter a covered call, then the client is said to be in a leveraged position, and subsequently will receive more attractive profit percentages.

This module also outlines the possible changes that could be made to position as the trading environment changes, and also which option is the best to sell, given different outlooks in the market.

Strategy 4: Spreads

Spread trading is a very attractive way to trade the market while managing risk. There are endless possibilities to trading spreads, although the majority involve the simultaneous buying and selling of either call or put options.

Credit spreads

With credit spreads, the options trader receives funds when entering the trade. Credit spreads are either a bull put spread, which benefits from an upward movement in price, or a bear call spread which benefits from a downward movement in price.

Credit spreads benefit from a reduction in volatility and from time decay. For a credit spread if the price stays stationary, moves as anticipated, or even moves a small amount against the trader’s anticipations, then the strategy will still remain in profit.

The main disadvantage of credit spreads is that they will involve a margin. This strategy is comparable to naked selling of an option, although having the bought leg reduces risk significantly.

Debit spreads

Debit spreads are entered into at a debit, meaning that the options trader pays to enter a trade.

Debit spreads are either a bull call spread, which benefits from an upward movement in price, or a bear put spread which benefits from a downward movement in price.

Debit spreads benefit from an increase in volatility and are negatively affected by time decay, if the price does not move as anticipated.

Debit spreads will only see a profit if the price moves as expected, but the main advantage as compared to credit spreads is that they do not involve a margin. Debit spreads are somewhat similar to buying an option, although having the sold leg reduces entry cost significantly.

Ratio spreads

A ratio spread involves the simultaneous purchase of a call option and the sale of two (or more) call options with a higher strike price.

Ratio call spreads benefit from an upward movement in price but have limited losses if the price falls. A similar strategy can be implemented using puts if the trader has a view that the price will fall, whereby the trader buys a higher strike put and sells two or more lower strike puts.

Ratio spreads usually have margin requirements regardless of whether they are entered into at a debit or a credit.

Calendar spread

Calendar spreads benefit from a difference in rates of time decay and generally set up as a market neutral strategy.

The trader buys a longer dated call (or put) option and sells a shorter dated call (or put) option.

The shorter dated option has a higher rate of time decay and hence if the share price does not move significantly then will expire worthless. The trader could then sell to close the bought options, which would not have lost as much value as the initially sold leg, meaning the trader would realize a profit. This process can be repeated until the expiry of the longer dated option.

Butterfly spreads

The butterfly spread is a market neutral spread whereby two at the money options are sold, one out of the money options is bought and one in the money option is bought.

This strategy has limited risk, and is entered for a debit. The strategy has a high probability of making a small profit.

Straddle

The straddle is a non-directional strategy whereby the trader buys an at the money put and call option. This strategy is profitable if the stock price experiences a large move in either direction.

The sold straddle involves selling the two options, and benefits from the stock price not moving significantly.

Strangle

This is a similar strategy to the straddle, although the two options purchased (or sold) have different strike prices. This means that for a bought strangle the price to enter the trade will be less than for a straddle, although the price will have to move by a larger amount before any profits are seen.

Similarly for the sold strangle, the initial credit received will be smaller than that received for the straddle, although a larger movement in stock price needs to take place before any loss is experienced.

Naked selling

Involves selling a call or put option without owning the underlying. This strategy has limited profit potential, unlimited loss and significant margin requirements. If the position is exercised then the trader that sold the option must deliver the stock, by either buying the stock from the option holder for a put option or selling the stock to the option holder for a call option, after buying it in the current market.

This means that the trader must have enough capital available to purchase the stock at either the market rate or the strike price, which is usually a lot more that the amount received from the option premium.

Also the possibility of a margin call is very likely. This strategy can involve significant losses and is generally not advisable for many traders.

Stock repair

This is a strategy to help a stock position regain ground that it may have lost from the time it was entered. A stock repair strategy involves buying a lower strike call option and selling two (or more) higher strike call option.

This effectively doubles the leverage that the stock will experience if it rallies, but limits the upside potential to the upper strike price of the sold options.

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