Introduction
Option strategies refer to specific combinations of buying and/or selling options contracts with the goal of achieving particular objectives based on an investor’s market outlook, risk tolerance, and desired outcomes. These strategies involve various combinations of call-and-put options, each designed to capitalize on different market conditions or to hedge against potential risks.
Option strategies are employed by investors and traders for various reasons, offering advantages that include risk management, income generation, speculation, and flexibility. Here are some reasons why option strategies are popular:
- Risk Management: Options can be used to hedge against potential losses in a portfolio. Strategies like protective puts or collars allow investors to limit downside risk on their holdings.
- Income Generation: Selling options (such as covered calls or cash-secured puts) can generate income through the premiums received. This strategy is appealing to investors seeking regular income in addition to potential stock appreciation.
- Leverage and Potential Returns: Options allow investors to control a larger position with a smaller amount of capital. This leverage can amplify potential returns. However, it’s essential to note that it also amplifies risk.
- Flexibility: Options provide flexibility in various market conditions. Bullish, bearish, or neutral strategies can be employed, enabling investors to profit in different market scenarios.
- Speculation and Directional Bets: Traders can use options to speculate on the direction of a stock or index without committing a significant amount of capital. This allows for more precise bets on short-term movements.
- Portfolio Diversification: Options can be used to diversify a portfolio beyond traditional stocks and bonds. They provide exposure to different asset classes and strategies, potentially reducing overall portfolio risk.
- Customization and Tailored Risk/Reward: Investors can design option strategies that match their risk tolerance and investment objectives. There’s a wide range of strategies available, from conservative to more aggressive approaches.
- Volatility Trading: Options are sensitive to changes in volatility. Volatility trading strategies, like straddles or strangles, capitalize on expected volatility changes regardless of market direction.
Options Strategies
Here are some common option strategies and why investors use them:
- Covered Call: Involves owning the underlying stock and selling call options against it. It’s used when the investor has a neutral to slightly bullish outlook on the stock and aims to generate income from the premiums received.
- Protective Put: Buying a put option to protect an existing stock position from downside risk. This strategy is employed when an investor wants to hedge against potential losses in a stock position while still participating in its potential upside.
- Straddle: Simultaneously buying a call option and a put option with the same strike price and expiration date. It’s used when investors expect significant price movement but are uncertain about the direction. The goal is to profit from a substantial move in either direction.
- Strangle: Similar to a straddle, but with different strike prices for the call and put options. It’s used when investors anticipate significant price movement but are uncertain about the direction. Strangles are less expensive than straddles but require larger price movements to be profitable.
- Iron Condor: A more complex strategy involving simultaneous selling of a call spread and a put spread. This strategy is employed when investors expect the underlying asset’s price to remain within a specific range. It aims to profit from the limited price movement while limiting potential losses.
- Butterfly Spread: Involves three strike prices and uses both calls or both puts. It’s used when investors anticipate low volatility and a specific range of movement in the underlying asset’s price. The goal is to profit from a narrow range of price movements
There exist numerous other option strategies, making it challenging to encompass them all. However, let’s focus on exploring the above-mentioned strategies to grasp the fundamental concepts that underlie various options strategies. This focused exploration will provide a solid foundation for understanding the core principles and mechanics within the realm of options trading strategies.
Covered Call
A covered call is an options strategy used by investors who own the underlying asset (such as stocks) and simultaneously sell call options on that asset. It involves two transactions:
- Owning the underlying asset – The investor holds a certain amount of the underlying asset, such as stocks.
- Selling call options against it – Simultaneously, the investor sells call options on the owned stocks. Each call option gives the buyer the right (but not the obligation) to buy the underlying asset at a specified price (strike price) within a particular time frame (expiration date).
Pros
- Income Generation: Selling call options generates premiums, providing additional income to the investor. This premium acts as a buffer against potential downside risk or enhances overall returns.
- Partial Downside Protection: The premium earned from selling the call option partially protects against small declines in the stock’s price. It reduces the effective cost basis of holding the stock.
- Profit Potential in Neutral or Slightly Bullish Markets: If the stock price remains below the strike price, the options will likely expire worthless, and the investor keeps the premium collected while retaining ownership of the stock.
- Enhanced Returns for Moderately Bullish Expectations: Investors who have a moderately bullish outlook on the stock can potentially benefit from both the stock’s appreciation and the premiums earned from selling the call options.
Cons and Risks
- Capped Upside Potential: If the stock price exceeds the strike price, the investor is obligated to sell the stock at the strike price, missing out on potential gains beyond that point.
- Unlimited Downside Risk: While the premium reduces the cost basis and provides some downside protection, the stock’s price can still decline substantially, and the investor remains exposed to potential losses in the stock’s value.
- Opportunity Cost: If the stock price increases significantly, the investor’s gains are limited to the strike price plus the premium received. They might regret not fully participating in the stock’s substantial price appreciation.
- Complexity and Market Risk: Options trading involves complexities and risks related to time decay, implied volatility, and market movements, which can impact the profitability of the strategy.
When to Use Covered Calls
Covered calls are favored by income-oriented investors who are comfortable potentially capping their upside gains in exchange for immediate income and some downside protection. However, this strategy requires a good understanding of options and careful consideration of market conditions and risk-reward trade-offs. Investors need to assess their risk tolerance and investment objectives before implementing covered call strategies.
The best time to sell covered calls is when the underlying security has neutral to optimistic long-term prospects, with little likelihood of either large gains or large losses. This allows the call writer to earn a reliable profit from the premium.
Covered calls are not an optimal strategy if the underlying security has a high chance of large price swings. If the price rises higher than expected, the call writer would miss out on any profits above the strike price. If the price falls, the options writer could stand to lose the entire price of the security, minus the initial premium.
Max Profit & loss and Breakeven Point
Max Profit = Strike price – stock purchase price + premium received
Max Loss = Stock purchase price – premium received
Breakeven = Stock price – premium received
Graphical Representation
Protective Puts
Protective puts are another options strategy used by investors to hedge against potential downside risk on a stock they own. This strategy involves buying put options on a stock an investor already holds.
Pros
- Downside Protection: The primary purpose of using protective puts is to limit potential losses on the stock position. If the stock price declines, the put options gain value, allowing the investor to sell the stock at the higher strike price, thereby mitigating losses.
- Flexibility: It provides downside protection while allowing the investor to still benefit from potential upside movements in the stock’s price.
- Peace of Mind: Investors who are concerned about a potential decline in a stock’s price can use protective puts to safeguard their investment.
Cons and Risks
- Cost of Protection: Buying put options requires paying a premium, which can reduce overall returns. If the stock price remains above the strike price, the put option may expire worthless, leading to a loss of the premium paid.
- Limited Timeframe: Protective puts have expiration dates. If the stock’s price doesn’t decrease within the specified timeframe, the put option may expire worthless.
- Opportunity Cost: If the stock price increases significantly, the investor’s gains are reduced by the premium paid for the put option
When to Use Protective Puts
- Market Uncertainty or Downside Risk: When an investor is concerned about potential downside risk in a stock position due to market volatility, earnings announcements, or other events.
- Long-Term Holders Seeking Protection: Investors with a long-term view who want to protect their positions against short-term declines without selling the stock.
- Risk Management: A hedging strategy to protect gains in a stock that has appreciated significantly but might be susceptible to a pullback.
Max Profit & loss and Breakeven Point
Max Profit = Unlimited
Max Loss = Stock purchase price – strike price + premium paid
Breakeven = Stock price + premium
Graphical Representation
Straddle
Long Straddle: In a long straddle, a trader simultaneously buys a call option and a put option at the same strike price and expiration. This strategy is used when the trader expects substantial price movement but is uncertain about the direction. If the price moves significantly in either direction, the trader profits, as the gain in the in-the-money option offsets the loss in the out-of-the-money option. The risk is limited to the cost of purchasing both options.
Max Profit & loss and Breakeven Point
Max Profit = Unlimited
Max Loss = Premium paid
Upside breakeven = Call Strike + premiums paid
Downside breakeven = Put Strike – premiums paid
Graphical Representation
Short Straddle: Conversely, a short straddle involves selling a call option and a put option simultaneously at the same strike price and expiration. This strategy aims to profit from minimal price movement, as the trader anticipates the underlying asset’s price to remain relatively stable. The maximum profit is the premiums collected from selling both options, but the potential losses can be significant if the price moves significantly in either direction
Max Profit & loss and Breakeven Point
Max Profit = Premium received
Max Loss = Unlimited
Upside breakeven = Call Strike + premiums received
Downside breakeven = Put Strike – premiums received
Graphical Representation
Strangle
Long Strangle: Similar to the straddle, a long strangle involves buying both a call and a put option. However, in a strangle, the options have different strike prices. The call option is typically placed above the current market price, and the put option is placed below it. Traders use a long strangle when they anticipate significant price volatility but are unsure of the direction. The risk is limited to the total cost of purchasing both options.
Max Profit & loss and Breakeven Point
Max Profit = Unlimited
Max Loss = Premium paid
Upside breakeven = Call Strike + premiums paid
Downside breakeven = Put Strike – premiums paid
Graphical Representation
Short Strangle: In a short strangle, a trader sells both a call and a put option with different strike prices. This strategy is employed when the trader expects minimal price movement in the underlying asset. The goal is to profit from time decay and a decrease in volatility. However, the risk is substantial if the price moves significantly beyond the strike prices of the options sold.
Max Profit & loss and Breakeven Point
Max Profit = Premium received
Max Loss = Unlimited
Upside breakeven = Call Strike + premiums received
Downside breakeven = Put Strike – premiums received
Graphical Representation
Iron Condor
An iron condor involves the simultaneous sale of an out-of-the-money (OTM) call spread and an OTM put spread on the same underlying asset but with different strike prices and the same expiration date.
This strategy profits from a specific range-bound movement in the underlying asset’s price. Traders benefit if the price stays within a defined range, and both the call and put options expire worthless. The maximum profit is the net premium received, and the maximum loss is limited but can be substantial if the price moves significantly beyond the spreads.
Max Profit & loss and Breakeven Point
Max Profit = Premium received
Max Loss = (High call strike – low call strike) OR (High put strike- low put strike) – net premium received
Upside breakeven = Lower Call Strike + premiums received
Downside breakeven = Upper Put Strike – premiums received
Graphical Representation
Butterfly Spread
A butterfly spread consists of three legs and can be constructed using either call options or put options.
In a call butterfly, the trader buys one call option at a lower strike price, sells two call options at a middle strike price, and buys another call option at a higher strike price, all with the same expiration.
This strategy aims to profit from a specific, narrow range in the underlying asset’s price. Maximum profit is achieved if the price expires at the middle strike price. However, the potential loss is limited to the initial cost of the options.
Long Call Butterfly
Max Profit & loss and Breakeven Point
Max Profit = High strike – middle strike – net premium paid
Max Loss = Net premium paid
Upside breakeven = Lower Strike + premiums paid
Downside breakeven = Upper Strike – premiums paid
Graphical Representation
“The Python code for the above strategies is accessible in the Python code category.“
