Options Trading Strategy: Meaning, How to Use & Examples

Options trading strategy is a unique form of derivative trading, offering investors the chance to participate in the trading of options contracts on a wide range of underlying assets, including stocks, indices, commodities, and currencies. Options trading may sound complex, but there are many basic strategies that you can use to limit risk as well as maximise return.

In this article, we’ll look at options trading, how it works, as well as 10 options strategies that you should know.

What is an options trading strategy?

Options trading involves investors speculating on the future direction of various assets, such as stocks, commodities, currencies, and indeks, without owning the underlying asset. Options contracts offer the opportunity, but not the obligation, to buy or sell an underlying asset at a specified price by a specified date.

Options trading is typically used by traders to hedge against risks, generate income, and profit from market movements in different directions.

Options strategies you should know 

1. Covered Call:

The covered call strategy is very popular because it generates income and reduces some risk of being long on the stock alone. However, you must be prepared to sell your shares at a set price —the short strike price. Here’s how it works: First, you buy the underlying stock. Then, at the same time, you write (or sell) a call option on those same shares.

For instance, suppose an investor is using a call option on a stock that represents 100 shares of stock per call option. For every 100 shares of stock that you buy, you would simultaneously sell one call option against it. This strategy is referred to as a covered call because if the price increases rapidly, this short call is covered by the long stock position.

You may prefer this strategy if you are holding short-term positions in the stock with a neutral outlook on its direction. You may use it to generate income by selling a call premium or to hedge against potential declines in the underlying stock’s value.

2. Married Put:

In a married put strategy, an investor buys an asset, such as shares of stock, while also buying put options for the same number of shares. Each put option is worth 100 shares and provides you with the right to sell stock at the strike price.

You may decide to use this strategy to protect your downside risk when holding a stock. This strategy is also known as a protective put as it functions like an insurance policy; it sets a price floor in the event the stock’s price falls sharply.

For instance, suppose an investor buys 100 shares of stock and buys one put option simultaneously. This strategy may be attractive because you are protected against downside risk if there is a negative change in the stock price. At the same time, you may benefit from potential upside movements if the stock rises in value. The disadvantage of this strategy is that if the stock does not fall in value, you lose the premium you paid for the put option.

3. Bull Call Spread – Options trading strategy:

In a bull call spread strategy, an investor simultaneously buys calls at a specific strike price while selling an equal number of calls at a higher strike price. Both of these will have the same expiration date and underlying assets.

You can use this type of vertical spread strategy when you are bullish on the underlying asset and expect a moderate increase in its price. Using this strategy, you can limit your upside on the trade while also lowering the net premium you paid.

4. Bear Put Spread:

The bear-put spread strategy is another type of vertical spread. In this strategy, the investor simultaneously buys put options at a specific strike price and sells the same number of puts at a lower strike price. Both options involve the same underlying asset and have the same expiration date. You may use this strategy when you have a bearish sentiment about the underlying asset and expect a decline in its price. The bear put spread strategy offers limited losses and limited gains.

5. Protective Collar – Options trading strategy:

A protective collar strategy involves buying an out-of-the-money (OTM) put option while simultaneously writing an OTM call option (both with the same expiration) when you already own the underlying asset. This strategy is commonly used by investors following substantial gains from a long position in a stock. By using this strategy, you can secure downside protection as the long put option locks in a potential sale price. However, you may be obligated to sell shares at a higher price, thus forgoing the possibility of further profits.

An example of this strategy is if an investor goes long on 100 shares of IBM at $100 as of January 1. To construct a protective collar, they could sell one IBM March 105 call while simultaneously buying one IBM March 95 put. This setup protects the trader against declines below $95 until the expiration date. However, they might have to sell their shares at $105 if IBM trades at that rate prior to expiry.

6. Long Straddle:

A long straddle strategy involves buying both a call and put option on the same underlying asset with the same strike price and expiration date. You may use this strategy when you think the price of the underlying asset will move significantly out of a specific range, but you’re unsure of which direction the move will take.

This strategy allows you to have the opportunity for unlimited gains. At the same time, the maximum loss you can experience is limited to the cost of both options contracts combined.

7. Long Strangle:

A long strangle strategy involves buying both a call and a put option with a different strike price: an out-of-the-money call option and an out-of-the-money put option simultaneously on the same underlying asset and the same expiration date. Investors use this strategy when they believe the price of the underlying asset will experience a very large movement but are not sure about the direction of the movement.

For instance, this strategy might be used to speculate on events such as an earnings release for a company or an FDA (Food and Drug Administration) approval for a pharmaceutical stock. In this strategy, potential losses are limited to the premium paid for both options. Strangles will typically be less expensive than straddles because the options purchased are out-of-the-money options.

8. Long Call Butterfly Spread – Options trading strategy:

The butterfly spread strategy combines both a bull spread strategy and a bear spread strategy. Investors will also use three different strike prices for the same underlying asset and expiration date.

For example, a long butterfly spread involves buying one in-the-money call option at a lower strike price, while also selling two at-the-money (ATM) call options and buying one out-of-the-money call option. A balanced butterfly spread, also known as a “call fly”, is characterized by equal wing widths and typically results in a net debit. Investors may opt for a long butterfly call spread when they anticipate minimal movement in the stock’s price before expiration.

9. Iron Condor:

In the iron condor strategy, investors simultaneously hold both a bull put spread and a bear call spread. This strategy is constructed by selling one OTM put and buying one OTM put of a lower strike, a bull put spread, and selling one OTM call and buying one OTM call of a higher strike (forming a bear call spread).

All options in this strategy have the same expiration date and are for the same underlying asset. Typically, both the put and call sides of the iron condor strategy have equal spread widths. This trading strategy aims to generate a net premium on the structure and is designed to capitalise on stock experiencing low volatility. Traders often use this strategy due to its perceived high probability of earning a small premium.

10. Iron Butterfly:

The iron butterfly strategy involves selling an at-the-money put and buying an out-of-the-money put. At the same time, investors will also sell an at-the-money call and buy an out-of-the-money call. All options have the same expiration date and are for the same underlying asset. This strategy is similar to a butterfly spread, but it uses both calls and puts (as opposed to one or the other).

This strategy essentially combines selling an at-the-money straddle and buying protective “wings.” You can also think of the construction as two spreads, with the spreads often having the same width. The long, out-of-the-money call protects against unlimited upside risk, while the long, out-of-the-money put protects against downside risk (from the short put strike to zero). Both profit and loss are limited within a specific range, depending upon the strike prices of the options used. Investors like this strategy for the income it generates and its potential for a small gain with a non-volatile stock.

The bottom line

Options trading may seem daunting to beginners, but several strategies can help limit risk and increase returns. Some strategies, like butterfly and Christmas tree spreads, involve using multiple offsetting options to manage risk and maximize returns. Strategies such as covering calls, collars, and marriage puts are among the options for investors already holding the underlying asset, while straddles and strangles can be used to establish a position when the market is on the move.

Disclaimer:
This information is not considered investment advice or an investment recommendation, but instead a marketing communication. IronFX is not responsible for any data or information provided by third parties referenced or hyperlinked in this communication.