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Option Strategies

Option Strategies

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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

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

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

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 naked puts can be a very risky strategy as your losses are unlimited in a falling market. Risk / Reward Maximum Loss: Unlimited in a falling market.Short Put Components A short put is simply the sale of a put option." . Characteristics When to use: When you are bullish on market direction and bearish on market volatility. Like the Short Call Option. Maximum Gain: Limited to the premium received for selling the put option. 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.

Risk / Reward Maximum Loss:Unlimited.A short put locks in the purchase price of a stock at the strike price. For example. say AAPL is trading at $98. You want to buy this stock buy think it could come off a bit in the next couple of weeks. .37." At the time of writing this the $90 November put option (Nov 21) is trading at $2.25. Long Synthetic Components Buy one call option and sell one put option at the same strike price. You say to yourself "if AAPL sells off to $90 in two weeks I will buy. Plus you will keep any premium received as a result of the trade. Plus you get to keep the $237 no matter what. 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.

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. Risk / Reward Maximum Loss: Limited to the difference between the two strikes plus the net premium (which should be a credit). Characteristics When to use: When you are bullish on market direction. A Backspread is also called a Ratio Spread. Maximum Gain: Unlimited on the upside and limited on the downside.Maximum Gain: Unlimited. . Long Synthetic behaves exactly the same as being long the underlying security. Components Short one ITM call option and long two OTM call options.

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

But the downside to this is that you will end up paying more for the spread. Maximum Gain: Limited to the difference between the two strike prices minus the net premium paid for the spread. Like I mentioned. Risk / Reward Maximum Loss: Limited to premium paid for the long option minus the premium received for the short option. Put Bull Spread . 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 cost of the bought call option will be partially offset by the premium received by the sold call option. when putting on a bull spread remember that the wider the strikes the more you can make. if the trader sees a short term move in an underlying but doesn't see the market going past $X. 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. however. 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. 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. The sold call acts as a profit target for the position. a call bull spread is a very cost effective way to take a position when you are bullish on market direction. Characteristics When to use: When you are mildly bullish on market price and/or volatility. This does.Long one call option with a low strike price and short one call option with a higher strike price. then a bull spread is ideal. limit your potential gain if the market does rally but also reduces the cost of entering into this position. So. So.

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

This strategy is used by many investors who hold stock. Risk / Reward Maximum Loss: Unlimited on the downside. 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.Components Long the underlying asset and short call options. It is also used by many large funds as a method of generating consistent income from the sold options. you must remember that many investors implementing this type of strategy . Characteristics When to use: When you own the underlying stock (or futures contract) and wish to lock in profits. Maximum Gain: Limited to the premium received from the sold call option.

plan and manage covered call trades for consistent monthly cash flow. say you bought IBM last year at $25 and today it is trading at $40. the call option expires worthless and you pocket the premium received from the spread. 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". Call Writer promotes this strategy as a Super Put. Sell Call Option and Buy Put Option.e: Buy Stock. Meanwhile. Their method shows you how to limit your risk to a small percentage of your total account. Protective Put . Protected Covered Call A "protected" covered call involves buying a downside (out-of-the-money) put together with the covered call i. 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. Services like Call Writerwill provide you with real time lists and a trade management calculator where you will learn how to select.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. 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. For example.

You maximum loss is limited to the premium paid for the option and you have an unlimited profit potential. . A Protective Put strategy has a very similar pay off profile to the Long Call. 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. Risk / Reward Maximum Loss: Limited to the premium paid for the put option.Components Long the underlying asset and long put options.

Collor \ Components . 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. So. the loss of the put position is limited.Protective Puts are ideal for investors whom are very risk averse. But. if the market rises substantially past the exercise price of the put options. So. i. then the puts will expire worthless while the stock position increases. However. they hold stock and are concerned about a stock market correction. 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. if the market does sell off rapidly. while the profits gained from the increase in the stock position are unlimited.e.

a collar behaves just like a long call spread. then your maximum gain is the difference between the strikes plus this amount (and then plus the profit from the stock leg). the investor keeps the premium.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. 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.e. . you received money for the option legs. If the stock doesn't trade above this level. The problem with covered calls is that they have unlimited downside risk. i. Maximum Gain: Limited to the difference between the two strikes plus the net premium paid or received plus the gain on the stock leg. This increases the cost as you will have to outlay more to purchase the put and hence lowers your overall return. The solution to this is to protect the downside by buying an out-of-themoney put. If the net premium is a credit. Characteristics As you can see from the above payoff chart. 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. If the net premium was a payment then it is subtracted from the strike differential.

Short Call Components A short call is simply the sale of one call option. Risk / Reward Maximum Loss: Unlimited as the market rises. Selling options is also known as "writing" an option. . 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. Long Put Components A long put is simply the purchase of one put option. Naked calls are considered very risky positions because your risk is unlimited. Maximum Gain: Unlimited as the market sells off. Risk / Reward Maximum Loss: Limited to the net premium paid for the option. Characteristics .

buying put options can do this with limited risk. Risk / Reward . Short Synthetic Components Short one call option and long one put option at the same strike price. Like the long call a long put is a nice simple way to take a position on market direction without risking everything.When to use: When you are bearish on market direction and bullish on market volatility. 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.

So.Maximum Loss:Unlimited.e. 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. Maximum Gain: Unlimited. this option combination behaves exactly the same way as being short the underlying security. Characteristics When to use: When you are bearish on market direction. Put Backspread Components Long two OTM put options and short one ITM put option. . A Short Synthetic is just the reverse of the Long Synthetic i.

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

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

the premium paid for the long position less the premium received for the short position.e. Characteristics When to use: When you are bearish on market direction.i. 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. . Same idea as the Call Bull Spread but reversed .e. I. Risk / Reward Maximum Loss: Limited to the net amount paid for the spread. Maximum Gain: Limited to the difference between the two strike prices minus the net paid for the position.This type of spread is used when you are mildly 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. . A good tip is to compare the market prices of both spreads to determine which has the better payoff for you. however. Risk / Reward Maximum Loss: Limited to the total premium paid for the call and put options. comes down to risk/reward. Neutral Long Straddle Components Buy one call option and buy one put option at the same strike price. The choice as to which spread to use.

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 . A long straddle is like placing an each-way bet on price action: you make money if the market goes up or down.for example.Maximum Gain: Unlimited as the market moves in either direction. before an earnings announcement Short Straddle . But. A long straddle is an excellent strategy to use when you think the market is going to move but don't know which way. Characteristics When to use: When you are bullish on volatility but are unsure of market direction.

Components Short one call option and short one put option at the same strike price. 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. Risk / Reward Maximum Loss: Unlimited as the market moves in either direction.html . http://www. Maximum Gain: Limited to the net premium received for selling the options.optiontradingtips.com/strategies/longstrangle. Characteristics When to use: When you are bearish on volatility and think market prices will remain stable.

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