Traders often hear options are a versatile trading tool but it’s not always clear why that’s true. Options can be used to benefit from bull and bear markets with limited risk or they can generate income when a trader has a clear opinion on the market direction that turns out to be correct. But options can also be used to profit when you don’t have a market opinion. Straddles, strangles and spreads can be useful tools and add to the versatility of options.
Straddles allow a trader to take positions on both sides of the market (straddling the strike price) and potentially profit whether prices move up or down.
You can create a long straddle by buying both a put and call on the same stock. The options should have the same expiration date and the same strike price. The strike price is typically at the money, which means as close as possible to the market price of the stock. A long straddle is a trading strategy for a market that has been consolidating for some time.
In any market, we tend to see periods of relative calm followed by large price moves. The longer the consolidation lasts, the more likely it is to end and prices will then either rise or fall. Since we can’t know for certain in advance which way they’ll move, a straddle allows us to potentially capture the profits in either direction. If prices go up, the call will be profitable and the trader will take a small loss on the put option while still enjoying the upside gains. A decline will lead to the put delivering profits while the call suffers a small loss. The figure below shows profits grow as the size of the price move increases.
- Motley Fool’s Top 2019 Stock For The Marijuana BoomSponsored Content
We recommended this stock before the marijuana boom and while it’s grown 490% since, we have a very strong conviction this is just the beginning…
Short straddles involve selling both a call and a put to establish the initial position. This strategy would be used if you expected the market to remain range-bound, with little price movement causing both options to expire worthless. There is a great deal of risk with this strategy since shorting can lead to large losses. This strategy also has limited upside since you will never make more than the premium you earn when selling the options.
Strangles are similar to straddles, but use contracts that are out of the money when the trade is initiated. This makes the premiums of a strangle less expensive than the price of a straddle. Out of the money options are far from the market price. They are well above the market price for calls and well below the market price for puts.
To enter a long strangle position a trader purchases an out of the money call and an out of the money put option. Both the call and the put have the same expiration date and are for the same underlying instrument but they have different strike prices. Like a straddle, this strategy is used when a trader thinks that the market will make a large price move but isn’t sure on the direction. Because it uses out of the money options, it costs less to initiate than the straddle.
If a trader believes that the market is going to continue to trade with a range, bouncing between support and resistance levels, selling a straddle involving an out-of-the-money put and call, will allow the trader to pocket the premiums. Since the options have lower premiums, the profit potential of a short strangle is less than that of a straddle, while the risk remains unlimited.
Spreads involve the simultaneous purchase of one option and the sale of another option on the same underlying instrument. The concept behind this strategy is to reduce the cost of a position by selling short some options to fund the purchase of other options. This reduces the cost of the trade and limits risk.
Some strategies, like the backspread, involve buying and selling multiple contracts. This strategy requires knowing the estimated fair value of the options. If a particular option is overpriced relative to another option, you can benefit from that mispricing by selling the overvalued one. This strategy is generally used by more experienced traders.
For example, if a stock is trading at $40.00, you could sell a call at $42.50 for $3. The premium received could be used to buy two $45.00 calls at $1. If the stock makes a large move and rises to $45, this position would deliver a profit to the trader. If the stock makes a small move higher, the options are all likely to expire worthless. But the bullish trader using this strategy would have been able to establish their desired position without using any of their own trading capital.
In a backspread, the trader will end up owning more option contracts than they sold. Sometimes, it will cost more to buy the option than you receive in premiums for the contracts sold. But in all cases, the backspread will make it less expensive to open an options position.
Spreads can also be used to benefit from a market. An excellent way to hedge against potential losses is with a spread. To initiate a bull call spread, a trader purchases a call option, typically one that is at the money or slightly in the money. At the same time, the trader sells an out of the money option with a higher strike price. This strategy offers limited risk and limited reward but requires only a small amount of trading capital. Used in anticipation of a significant up move, the maximum loss is limited to the cost of the position while the maximum gain is the difference between the two strike prices.
Credit spreads result from selling options that are more expensive than the ones you’re buying. They derive their value from the time decay of the option premium and are a low risk strategy.
When establishing a credit spread, a trader simultaneously buys and sells options having two different strike prices. A bullish put spread involves selling a put below the current market price and then buying a lower priced put further below the market price. The profit is the difference between the price of the options and the risk is the difference between the strike prices of the options.
A trader who is bearish could open a credit spread by selling a call with a strike price above the market price while buying a call with price further above the market price. Again the profit and risk are limited.
More complex spread trades are also possible. Butterfly spreads are used by traders who believe a stock will not experience significant up or down moves in the near term. This strategy involves using three separate options contracts, making it a little more complex than the other spreads we’ve looked at. Using calls as an example, to initiate a butterfly spread, a trader would end up buying two separate call contracts and selling a third. You would buy one call at the lowest strike price, sell two calls at the middle strike price, and buy one call at the highest strike price. It could result in either a credit or debit spread after all those orders are executed.
Potential profits and risk are limited, but commissions can be significant. In this example, you would be opening positions in four option positions and commissions can rapidly eat away any profits.
A calendar spread or time spread is the sale of an option with a nearby expiration date and the simultaneous purchase of the same option, with the same strike price, that has an expiration date farther out in the future. The theory is that the time value of the near-term option will erode more quickly than the time value of the option that is more distant in the future. Should this occur, the spread between the prices of the two options will widen and you’ll make a profit as that occurs.
These options trading basic strategies can help you achieve income with limited risk and usually require limited trading capital. That could be their greatest appeal since small traders can generate relatively high income with straddles, strangles and spreads.