Options strategies
Options strategies involve combining different options contracts to achieve specific investment goals, such as maximizing returns or minimizing risk. Common strategies include covered calls, where an investor holds a stock and sells call options to generate income, and protective puts, where an investor buys put options to safeguard against a decline in the stock’s price. More advanced strategies include straddles and strangles, which profit from significant price movements in either direction, and spreads, which involve buying and selling multiple options to limit potential losses. These strategies allow traders to tailor their risk and reward profiles according to their market outlook and investment objectives.
In a bullish market we can either buy a call option or selling a put. In a bearish market we should either buy a put or sell a call. Now let’s look at some complex scenarios. In general, the idea is for one option to work in tandem with the other until it becomes necessary for it to offset it. This way, we manage our risk and hedge our profits.
A vertical bull call spread is used for a bull market. We buy a call and sell another call at a strike price that’s higher than the first. We’re aiming for the market price to be above the strike price of the call we bought. Above a certain level, our counterpart will ALSO exercise his option, however, capping our profit. However, beneath the strike price, neither of us will exercise our option and we lose our premium but gain our counterparty’s. Since our counterparty’s strike is higher, his premium is lower, so we’ll be losing a bit less on the premium we paid.
The vertical bear call spread is used in a bear market and it’s almost identical to the vertical bull call spread, but here our second call – the shorted one – has a LOWER strike price. Again, below a certain price neither call is exercised but we PROFIT from the differential in premiums. We NEED that profit to cover this area where the counterparty exercises HIS option but we don’t, since it’s still below OUR strike price. This causes us those losses we covered with the premium. Above OUR strike price, both of us exercise our options, cancelling each other out.
The vertical bear put spread is the mirror image of the vertical bull call spread. We exercise our option below our strike price but we need to make more than what we paid as a premium to be profitable. Again, our profit is capped as soon as we hit the counterparty’s strike price, but our losses are capped at the premium differential between what we go and what we paid.
And finally, the vertical bull put spread strategy – a mirror of the vertical bull put spread. Once again, our maximum profit comes from the premium differential between the options we bought and sold. We short a put and long another put at a lower strike price. Once maturity comes along, the counterparty will exercise his option but we’ll be covered by our premium profit. Below the put we bought strikes, we too will exercise our option, cancelling out any profit the counterparty continues to make on HIS option. Again, above the put we sold, neither of us will be exercising our options and we’re up on the premiums’ differential.
Clearly, there are a host of a lot more possible strategies to show you, and some of them are REALLY complex. The best way to see how they work is by playing around on a demo account. Make sure you don’t venture forth into live trading until you know which strategy to use.