Education

Option Trading Strategies article

Using options in your trading/investing is basically adding an additional dimension to your risk trading. Being long or short is a two dimensional game, while using option gives it a third dimension. Professional volatility trading is an area best suited for hedge funds and prop desks as it requires sophisticated systems/risk management tools and is capital intensive, but there are various strategies involving the use of options to enhance portfolio payoffs even for the less sophisticated user.

Options spreads where you own the underlying is a way to enhance portfolio value by using options. Below are a few strategies worth looking at:

Covered call

The covered call is created by selling a call against a long underlying position. The purpose is to enhance portfolio performance by cutting profit opportunities to the upside as you receive premium for the sold call. You need to be prepared to sell the underlying should the stock close above the strike price you decide to sell. Preferably this strategy is done when volatility is high as the premium you receive will be bigger.

The covered call strategy is best suited for the investor who believes in a relatively boring or slightly falling market.

Covered Strangle

Covered strangle is created by selling a call and a put against a long underlying. The strategy enhances portfolio performance if the stock stays between the strikes. The trader needs to be prepared to sell the underlying if exercised on upside and must be prepared to buy more underlying if exercised on downside. Since the trader sells premium the strategy is best done if volatility levels are high!

Fairly boring market with falling volatility is best suited for the covered strangle strategy.

Covered Ratio Spread

The covered ratio spread is established by buying a call on one strike and selling the double amount of call options on a higher strike. You also need to be long/buy the underlying.

The covered ratio spread benefits if the underlying stays in a specific price interval at expiry.

There are many options strategies to use in order to enhance portfolio performance. Investors are many times not viewing their portfolio in a dynamic way and focus on being either long or short.

Most investors have views of a stock reaching a specific level, but they fail to use options in order to dynamically adjust their risk according to their views.

What do you do if you want to take profit but stay long? You can sell your stock, and use a small portion of the profit to buy calls. Should the stock go down you will only lose the premium you paid for the calls. Should the stock continue higher the long calls position will start to produce leverage and the investor will once again be long the underlying.

Another example of staying long but using options is; assume the investor is long 2000 shares and the stock reaches the price target (the investor doesn’t want to sell all stocks here). The trader can sell 1000 shares, buy 10 upside calls and sell (short) 10 downside puts. The buying of the call is financed by selling of the put (depending on preference you will need to choose the strikes yourself).

If the stock goes lower you will get to buy the 1000 shares you sold at the strike price of the put you sold short. You will in this case get to buy the stock lower than where you sold it. Note, you will lose the call premium as the stock goes lower, but you are still much better of than having not done anything.

If the stock goes higher you will become long again as the call leverage will start kicking in. Note the call premium paid will be financed by the selling of the put. The above simple example is a much more dynamic way of thinking about your portfolio than simply just holding your stocks and not adjusting the risk in accordance to your views.

There are various options strategies that don’t involve being long the underlying. Below are a few examples;

Bull Spread

The bull spread is constructed by buying one call option and selling a higher strike option of the same type. It always has limited risk and usually the premium paid for the spread is the cost for the strategy. The profit is limited to a maximum profit = strike difference – premium paid.

The bull spread benefits from a rising market.

Pay off with a bull spread.

The inverse to the bull spread above is the bear spread. It has similar characteristics but with the preference of a view of a falling market.

Pay off with a bear spread.

Ratio spread

Ratio spreads involve buying the option of one strike and selling twice or more options of another strike. The strategy can be conducted in calls or puts and can be constructed for a view of the market moving up or down. Note that the risk is unlimited as you will end up net short options.

Below is an example of a ratio spread.

  • Buy 90-call @ 4 and sell the twice the amount of the 95-call @ 2. Premium paid is 0!
  • Max pay off is 5
  • Note the unlimited risk on the upside

 

Source: Orc software

The above strategy as an image with payoffs and risks involved.

In a back spread the trader sells one option and buys two options (of the same type) on another strike. It can be done using calls or puts and can be constructed for up/downside preference. It is a relatively cheap way to get exposure for big market moves.