Option Strategies

Generally, an Option Strategy involves the simultaneous purchase and/or sale of different option contracts, also known as an Option Combination. I say generally because there are such a wide variety of option strategies that use multiple legs as their structure, however, even a one legged Long Call Option can be viewed as an option strategy. Under the Options101 link, you may have noticed that the option examples provided have only looked at taking one option trade at a time. That is, if a trader thought that Coca Cola's share price was going to increase over the next month a simple way to profit from this move while limiting his/her risk is to buy a call option. Of course, s/he could also sell a put option. But what if s/he bought a call and a put option at the same strike price in the same expiry month? How could a trader profit from such a scenario? Let's take a look at this option combination;

I In this example, imagine you bought (long) 1 $65 July call option and also bought 1 $65 July put option. With the underlying trading at $65, the call costs you $2.88 and the put costs $2.88 also.

Now, when you're the option buyer (or going long) you can't lose more than your initial investment. So, you've outlaid a total of $5.76, which is you're maximum loss if all else goes wrong. But what happens if the market rallies? The put option becomes less valuable as the market trades higher because you bought an option that gives you the right to sell the asset - meaning for a long put you want the market to go down. You can look at a long put diagram here. However, the call option becomes infinitely valuable as the market trades higher. So, after you break away from your break even point your position has unlimited profit potential. The same situation occurs if the market sells off. The call becomes worthless as trades below $67.88 (strike of $65 minus what you paid for it $2.88), however, the put option becomes increasingly profitable. If the market trades down 10%, and at expiry, closes at $58.50, then your option position is worth $0.74. You lose the total value of the call, which cost $2.88, however, the put option has expired in the money and is worth $6.5. Subtract from this to total amount paid for the position, $5.76 and now the position is worth 0.74. This means that you will exercise your right and take possession of the underlying asset at the strike price. This means that you will effectively be short the underlying shares at $65. With the current price in the market trading at $58.50, you can buy back the shares and make an instant $6.50 per share for a total net profit of $0.74 per share. That might not sound like much, but consider what your return on investment is. You outlaid a total $5.76 and made $0.74 in a two month period. That's a 12.85% return in a two month period with a known maximum risk and unlimited profit potential. This is just one example of an option combination. There are many different ways that you can combine option contracts together, and also with the underlying asset, to customize your risk/reward profile. You've probably realized by now that buying and selling options requires more than just a view on the market direction of the underlying asset. You also need to understand and make a decision on what you think will

happen to the underlying asset's volatility. Or more importantly, what will happen to the implied volatility of the options themselves. If the market price of an option contract implies that it is 50% more expensive than the historical prices for the same characteristics, then you may decide against buying into this option and hence make a move to sell it instead. But how can you tell if an options implied volatility is historically high? Well, the only tool that I know of that does this well is the Volcone Analyzer . It analyzes any option contract and compares it against the historical averages, while providing a graphical representation of the price movements through time - know as the Volatility Cone. A great tool to use for price comparisons. Anyway, for further ideas on option combinations, take a look at the list to the right and see what strategy is right for you.

Long Call

Components A long call is simply the purchase of one call option. Risk / Reward Maximum Loss: Limited to the premium paid up front for the option. Maximum Gain: Unlimited as the market rallies. Characteristics When to use: When you are bullish on market direction and also bullish on market volatility. A long call option is the simplest way to benefit if you believe that the market will make an upward move and is the most common choice among first time investors. Being long a call option means that you will benefit if the stock/future rallies, however, you risk is limited on the downside if the market makes a correction. From the above graph you can see that if the stock/future is below the strike price at expiration, your only loss will be the premium paid for the option. Even if the stock goes into liquidation, you will never lose more than the option premium that you paid initially at the trade date. Not only will your losses be limited on the downside, you will still benefit infinitely if the market stages a strong rally. A long call has unlimited profit potential on the upside.

Short Put

Components A short put is simply the sale of a put option. Risk / Reward Maximum Loss: Unlimited in a falling market. Maximum Gain: Limited to the premium received for selling the put option. Characteristics When to use: When you are bullish on market direction and bearish on market volatility. Like the Short Call Option, selling naked puts can be a very risky strategy as your losses are unlimited in a falling market. Although selling puts carries the potential for unlimited losses on the downside they are a great way to position yourself to buy stock when it becomes "cheap". Selling a put option is another way of saying "I would buy this stock for [strike] price if it were to trade there by [expiration] date."

A short put locks in the purchase price of a stock at the strike price. Plus you will keep any premium received as a result of the trade. For example, say AAPL is trading at $98.25. You want to buy this stock buy think it could come off a bit in the next couple of weeks. You say to yourself "if AAPL sells off to $90 in two weeks I will buy." At the time of writing this the $90 November put option (Nov 21) is trading at $2.37. You sell the put option and receive $237 for the trade and have now locked in a purchase price of $90 if AAPL trades that low in the 10 or so days until expiration. Plus you get to keep the $237 no matter what.

Long Synthetic

Components Buy one call option and sell one put option at the same strike price. Risk / Reward Maximum Loss:Unlimited.

Maximum Gain: Unlimited. Characteristics When to use: When you are bullish on market direction. Long Synthetic behaves exactly the same as being long the underlying security. You can use long synthetic's when you want the same payoff characteristics as holding a stock or futures contract. It has the benefit of being much cheaper than buying stock outright.

A Backspread is also called a Ratio Spread.

Components Short one ITM call option and long two OTM call options. Risk / Reward Maximum Loss: Limited to the difference between the two strikes plus the net premium (which should be a credit). Maximum Gain: Unlimited on the upside and limited on the downside.

Characteristics Similar to a Short Straddle except the loss on the downside is limited. When to use: When you are bullish on volatility and bullish on market price. Note though, that you profit when prices fall, although the gains are greater if the market rallies. A Backspread looks a lot like a Long Straddle except the payoff flattens out on the downside. The other key difference is that Backspreads are usually done at a credit. That is, the net difference for both legs means that you receive money into your account up front instead of paying (debit) for the spread. Even though the payoff looks like a "long" type position, it is often referred to as a "short" strategy. Generally it is like this: if you receive money for the position up front it is called a "Short" position and when you pay for a position it is called being "Long".

Call Bull Spread

Components

Long one call option with a low strike price and short one call option with a higher strike price. Risk / Reward Maximum Loss: Limited to premium paid for the long option minus the premium received for the short option. Maximum Gain: Limited to the difference between the two strike prices minus the net premium paid for the spread. Characteristics When to use: When you are mildly bullish on market price and/or volatility. You can see from the above graph that a call bull spread can only be worth as much as the difference between the two strike prices. So, when putting on a bull spread remember that the wider the strikes the more you can make. But the downside to this is that you will end up paying more for the spread. So, the deeper in the money calls you buy relative to the call options that you sell means a greater maximum loss if the market sells off. Like I mentioned, a call bull spread is a very cost effective way to take a position when you are bullish on market direction. The cost of the bought call option will be partially offset by the premium received by the sold call option. This does, however, limit your potential gain if the market does rally but also reduces the cost of entering into this position. This type of strategy is suited to investors who want to go long on market direction and also have an upside target in mind. The sold call acts as a profit target for the position. So, if the trader sees a short term move in an underlying but doesn't see the market going past $X, then a bull spread is ideal. With a bull spread he can easily go long without the added expenditure of an outright long stock and can even reduce the cost by selling the additional call option.

Put Bull Spread

Components Long one put option and short another put option with a higher strike price. Risk / Reward Maximum Loss: Limited to the difference between the two strike prices minus the net premium received for the position. Maximum Gain: Limited to the net credit received for the spread. I.e. the premium receieved for the short option less the premium paid for the long option. Characteristics When to use: When you are bullish on market direction. A Put Bull Spread has the same payoff as the Call Bull Spread except the contracts used are put options instead of call options. Even though bullish, a trader may decide to place a put spread instead of a call spread because the risk/reward profile may be more favourable. This may be the if the ITM call options have a higher implied volatility than the OTM put options. In this case, a call spread would be more expensive to initiate and hence the trader might prefer the lower cost option of a put spread.

Covered Call

Components Long the underlying asset and short call options. Risk / Reward Maximum Loss: Unlimited on the downside. Maximum Gain: Limited to the premium received from the sold call option. Characteristics When to use: When you own the underlying stock (or futures contract) and wish to lock in profits. This strategy is used by many investors who hold stock. It is also used by many large funds as a method of generating consistent income from the sold options. The idea behind a Covered Call (also called Covered Write) is to hold stock over a long period of time and every month or so sell out-of-the-money call options. Even though the payoff diagram shows an unlimited loss potential, you must remember that many investors implementing this type of strategy

have bought the stock long ago and hence the call option's strike price may be a long way from the purchase price of the stock. For example, say you bought IBM last year at $25 and today it is trading at $40. You might decide write a $45 call option. Even if the market sells off temporarily it will have a long way to go before you start seeing losses on the underlying. Meanwhile, the call option expires worthless and you pocket the premium received from the spread. Protected Covered Call A "protected" covered call involves buying a downside (out-of-the-money) put together with the covered call i.e: Buy Stock, Sell Call Option and Buy Put Option. The profile of a protected covered call looks like call spread and has the benefit of limiting your downside risk in the event of a large sell off in the underlying stock/future. Call Writer promotes this strategy as a Super Put. Monthly Income Covered and protected covered calls are usually the strategies used by advisory services that promote option strategies for "generating monthly income" while "protecting capital". Services like Call Writerwill provide you with real time lists and a trade management calculator where you will learn how to select, plan and manage covered call trades for consistent monthly cash flow. Their method shows you how to limit your risk to a small percentage of your total account.

Protective Put

Components Long the underlying asset and long put options. Risk / Reward Maximum Loss: Limited to the premium paid for the put option. Maximum Gain: Unlimited as the market rallies. Characteristics When to use: When you are long stock and want to protect yourself against a market correction. A Protective Put strategy has a very similar pay off profile to the Long Call. You maximum loss is limited to the premium paid for the option and you have an unlimited profit potential.

Protective Puts are ideal for investors whom are very risk averse, i.e. they hold stock and are concerned about a stock market correction. So, if the market does sell off rapidly, the value of the put options that the trader holds will increase while the value of the stock will decrease. If the combined position is hedged then the profits of the put options will offset the losses of the stock and all the investor will loose will be the premium paid. However, if the market rises substantially past the exercise price of the put options, then the puts will expire worthless while the stock position increases. But, the loss of the put position is limited, while the profits gained from the increase in the stock position are unlimited. So, in this case the losses of the put option and the gains form the stock do not offset each other: the profits gained from the increase in the underlying out weight the loss sustained from the put option premium.

Collor

Components

Long underlying stock/future Short OTM call option Long OTM put option Risk / Reward Maximum Loss: Limited to the difference between the two strikes less the net premium paid or received less the loss on the stock leg. Maximum Gain: Limited to the difference between the two strikes plus the net premium paid or received plus the gain on the stock leg. If the net premium is a credit, i.e. you received money for the option legs, then your maximum gain is the difference between the strikes plus this amount (and then plus the profit from the stock leg). If the net premium was a payment then it is subtracted from the strike differential. Characteristics As you can see from the above payoff chart, a collar behaves just like a long call spread. It is suited to investors who already own the stock and are looking to:

increase their return by writing call options minimize their downside risk by buying put options

Covered calls are becoming very popular strategy for investors who already own stock. They sell out-of-the-money call options at a price that they are happy to sell the stock at in return for receiving some premium upfront. If the stock doesn't trade above this level, the investor keeps the premium. The problem with covered calls is that they have unlimited downside risk. The solution to this is to protect the downside by buying an out-of-themoney put. This increases the cost as you will have to outlay more to purchase the put and hence lowers your overall return.

Short Call

Components A short call is simply the sale of one call option. Selling options is also known as "writing" an option. Risk / Reward Maximum Loss: Unlimited as the market rises. Maximum Gain: Limited to the premium received for selling the option. Characteristics When to use: When you are bearish on market direction and also bearish on market volatility.

A short is also known as a Naked Call. Naked calls are considered very risky positions because your risk is unlimited.

Long Put

Components A long put is simply the purchase of one put option. Risk / Reward Maximum Loss: Limited to the net premium paid for the option. Maximum Gain: Unlimited as the market sells off. Characteristics

When to use: When you are bearish on market direction and bullish on market volatility. Like the long call a long put is a nice simple way to take a position on market direction without risking everything. Except with a put option you want the market to decrease in value. Buying put options is a fantastic way to profit from a down turning market without shorting stock. Even though both methods will make money if the market sells off, buying put options can do this with limited risk.

Short Synthetic

Components Short one call option and long one put option at the same strike price. Risk / Reward

Maximum Loss:Unlimited. Maximum Gain: Unlimited. Characteristics When to use: When you are bearish on market direction. A Short Synthetic is just the reverse of the Long Synthetic i.e. this option combination behaves exactly the same way as being short the underlying security. So, if you are very bearish on an asset and want the same characteristics as if you were short the asset then you might want to consider using a Short Synthetic.

Put Backspread

Components Long two OTM put options and short one ITM put option.

Risk / Reward Maximum Loss: Limited to the difference between the two strikes less the premium received for the spread. Maximum Gain: Limited on the upside to the net premium received for the spread. Unlimited on the downside.

Characteristics When to use: When you are bearish on market direction and bullish on volatility. This strategy could also be referred to as a Short Put Backspread, however, I will refer to this strategy simply as a Put Backspread. A Put Backspread should be done as a credit. This means that after you buy 2 OTM puts and sell 1 ITM put the net effect should be a credit to you. I.e. you should receive money for this spread as your are short more than you are long. Put Backspread's are a great strategy if you are bullish and bearish at the same time, however, have a bias to the downside. Looking from the payoff, you can see that if the market sells off you make unlimited profits below the break even point. If, however, you are wrong about the direction and the market stages a rally instead, you still win - though your profits are limited. You might say that this type of strategy is similar to a Long Straddle - and you would be right. The difference is that 1) the profits are limited on one side and 2) Backspread's are cheaper to put on.

Call Bear Spread

Components Short one call option with a low strike price and long one call option with a higher strike price. Risk / Reward Maximum Loss: Limited to the difference between the two strikes minus the net premium. Maximum Gain: Limited to the net premium received for the position. I.e. the premium received for the short call minus the premium paid for the long call. Characteristics When to use: When you are mildly bearish on market direction. A call bear spread is usually a credit spread. A credit spread is where the net cost of the position results in you receiving money up front for the trade. I.e. you sell one call option (receive $5) and the buy one call option ($4). The net effect is a credit of $1.

This type of spread is used when you are mildly bearish on market direction. Same idea as the Call Bull Spread but reversed - i.e. you think the market will go down but think that the cost of a short stock or long put is too expensive.

Put Bear Spread

Components Short one put option at a lower strike price and long one put option at a higher strike price. Risk / Reward Maximum Loss: Limited to the net amount paid for the spread. I.e. the premium paid for the long position less the premium received for the short position. Maximum Gain: Limited to the difference between the two strike prices minus the net paid for the position. Characteristics When to use: When you are bearish on market direction.

A Put Bear Spread has the same payoff as the Call Bear Spread as both strategies hope for a decrease in market prices. The choice as to which spread to use, however, comes down to risk/reward. A good tip is to compare the market prices of both spreads to determine which has the better payoff for you.

Neutral
Long Straddle

Components Buy one call option and buy one put option at the same strike price. Risk / Reward Maximum Loss: Limited to the total premium paid for the call and put options.

Maximum Gain: Unlimited as the market moves in either direction. Characteristics When to use: When you are bullish on volatility but are unsure of market direction. A long straddle is an excellent strategy to use when you think the market is going to move but don't know which way. A long straddle is like placing an each-way bet on price action: you make money if the market goes up or down. But, the market must move enough in either direction to cover the cost of buying both options. Buying straddles is best when implied volatility is low or you expect the market to make a substantial move before the expiration date - for example, before an earnings announcement

Short Straddle

Components Short one call option and short one put option at the same strike price. Risk / Reward Maximum Loss: Unlimited as the market moves in either direction. Maximum Gain: Limited to the net premium received for selling the options. Characteristics When to use: When you are bearish on volatility and think market prices will remain stable. Short straddles are a great way to take advantage of time decay and also if you think the market price will trade sideways over the life of the option. http://www.optiontradingtips.com/strategies/longstrangle.html