Basic Options Trading Strategies Summarised
Options trading can be as simple or as complex as the trader wishes to make it. Those who are familiar with stock trading, where one can only make money if the price of the underlying stock goes up, tend to start off their options trading career by simply buying call options.
From there they migrate to buying puts and still later to options spreads – of which there are a multitude, some with exotic names of New World Vultures such as the Condor.
A basic bullish strategy
The most basic option strategy of them all, which even beginner traders find easy to understand, is the long call. This simply consists of buying an ATM call option. Fig. 9.12(a) below illustrates the risk/reward payoff for a typical ATM long call.
Fig. 9.12 (a)
With this trade the trader makes a profit if the price of the underlying asset goes up and his or her maximum loss is limited to the cost of the long call option. If the price remains stagnant the trader will still lose, since the breakeven point is equal to the current price of the asset plus the cost of the long call.
A basic bearish strategy: The long put
The put counterpart of the long call is the long put, which is illustrated below in Fig. 9.12(b).
This trade makes money if the price of the underlying asset goes down. The maximum loss if the price should go up instead is limited to the purchase price of the short put.
A basic neutral strategy
For the long call and long put above, the trader needs to have a directional view of the market, i.e. he or she needs to have a fairly good idea whether the price is going to go up or down. The truth is that often it is extremely difficult to make that judgement call. In that case a neutral strategy is preferable.
Probably the simplest neutral options strategy of them all is the long straddle, which involves buying both put and call options. It is therefore just a combination of the strategies outlined under long calls and long puts above. This is what a typical risk/reward diagram for a long straddle looks like:
Fig. 9.12 c
With this strategy the trader will make money whether the price of the underlying asset moves up or down. The only trouble is that this is a very expensive trade: the price has to move more than the combined cost of the long call and long put before the trade will make any profit.
A more advanced neutral strategy
What follows is included under advanced strategies by some writers, but since the trade is relatively easy to set up and the risk/reward profile is excellent it is actually a great strategy for a beginner trader who doesn’t have a lot of money to play around with and who certainly doesn’t want to lose most of it with a single trade.
The iron butterfly is a neutral strategy which will be profitable if the price of the underlying asset remains within a range between now and the expiration date. Here the trader doesn’t have to wait for the price to move up or down before making any money: it is already in the ‘profit zone’ when the trade is entered – it just has to stay there! An iron butterfly is entered into by:
- Selling x number of ATM call options
- Selling the same number of ATM put options
- Buying the same number of OTM call options
- Buying the same number of OTM put options
Below is an example of a typical iron butterfly.
Fig. 9.12 (d)
In this particular example the trade has a maximum profit of about 4 times the maximum loss. The perfect time to trade an iron butterfly is when volatility has been high and is starting to drop off.