Option Strategies

Because options prices depend on the prices of their underlying securities, options can be used in various combinations to earn profits with reduced risk, even in directionless markets. Below is a list of the most common strategies, but there are many more — infinitely more. But this list will give you an idea of the possibilities. Any investor contemplating these strategies should keep in mind the risks, which are more complex than with simple stock options, and the tax consequences, the margin requirements, and the commissions that must be paid to effect these strategies. One particular risk to remember is that American-style options — which are most options where the exercise must be settled by delivering the underlying asset rather than by paying cash — that you write can be exercised at any time; thus, the consequences of being assigned an exercise before expiration must be considered. (Note: The examples in this article ignore transaction costs.)

Option Spreads

An option spread is established by buying or selling various combinations of calls and puts, at different strike prices and/or different expiration dates on the same underlying security. There are many possibilities of spreads, but they can be classified based on a few parameters.

The money earned writing options lowers the cost of buying options, and may even be profitable. A credit spread results from buying a long position that costs less than the premium received selling the short position of the spread; a debit spread results when the long position costs more than the premium received for the short position — nonetheless, the debit spread still lowers the cost of the position. A combination is defined as any strategy that uses both puts and calls. A covered combination is a combination where the underlying asset is owned.

A money spread, or vertical spread, involves the buying of options and the writing of other options with different strike prices, but with the same expiration dates.

A time spread, or calendar spread, involves buying and writing options with different expiration dates. A horizontal spread is a time spread with the same strike prices. A diagonal spread has different strike prices and different expiration dates.

A bullish spread increases in value as the stock price increases, whereas a bearish spread increases in value as the stock price decreases.

Ratio Spreads

Option spreads have many types: covered calls, straddles and strangles, butterflies and condors, calendar spreads, etc. Most options spreads are undertaken to earn a limited profit in exchange for limited risk. This may be accomplished by equalizing the number of short and long positions. Unbalanced option spreads, also known as ratio spreads, have an unequal number of long and short contracts based on the same underlying asset. They may consist of all calls, all puts, or a combination of both. Unlike other, better-defined, spreads, unbalanced spreads have many more possibilities; thus, it is difficult to generalize about their characteristics, such as reward/risk profiles. However, if long contracts exceed short contracts, then the spread will have unlimited profit potential on the excess long contracts and with limited risk. An unbalanced spread with an excess of short contracts will have limited profit potential and with unlimited risk on the excess short contracts. As with other spreads, the only reason to accept unlimited risk for a limited profit potential is that the spread is more likely to be profitable. Margin must be maintained on the short options that are not balanced by long positions.

The ratio in a ratio spread designates the number of long contracts over short contracts, which varies widely, but, mostly, neither the numerator nor the denominator will exceed 5. A front spread is a spread where the short contracts exceed the long contracts; a back spread has more long contracts than short contracts. A front spread is also called a ratio spread, but front spread is a more specific term, so I will continue to use front spread only for front spreads and ratio spreads for unbalanced spreads.

Whether a spread results in a credit or a debit depends on the strike prices of the options, expiration dates, and the ratio of long and short contracts. Ratio spreads may also have more than one breakeven point, since different options will go into the money at different price points.

Covered Call

The simplest option strategy is the covered call, which simply involves writing a call for stock already owned. If the call is unexercised, then the call writer keeps the premium, but retains the stock, for which he can still receive any dividends. If the call is exercised, then the call writer gets the exercise price for his stock in addition to the premium, but he foregoes the stock profit above the strike price. If the call is unexercised, then more calls can be written for later expiration months, earning more money while holding the stock. A more complete discussion can be found at Covered Calls.

Protective Put

A stockholder buys protective puts for stock already owned to protect his position by minimizing any loss. If the stock rises, then the put expires worthless, but the stockholder benefits from the rise in the stock price. If the stock price drops below the strike price of the put, then the put's value increases 1 dollar for each dollar drop in the stock price, thus, minimizing losses. The net payoff for the protective put position is the value of the stock + the put, minus the premium paid for the put.

Protective Put Payoff = Stock Value + Put Value − Put Premium

Collar

A collar is the use of a protective put and covered call to collar the value of a security position between 2 bounds. A protective put is bought to protect the lower bound, while a call is sold at a strike price for the upper bound, which helps pay for the protective put. This position limits an investor's potential loss, but allows a reasonable profit. However, as with the covered call, the upside potential is limited to the strike price of the written call.

Collars are one of the most effective ways of earning a reasonable profit while also protecting the downside. Indeed, portfolio managers often use collars to protect their position, since it is difficult to sell so many securities in a short time without moving the market, especially when the market is expected to decline. However, this tends to make puts more expensive to buy, especially for options on the major market indexes, such as the S&P 500, while decreasing the amount received for the sold calls. In this case, the implied volatility for the puts exceeds that for the calls.

Straddles and Strangles

A long straddle is established by buying both a put and call on the same security at the same strike price and with the same expiration. This investment strategy is profitable if the stock moves substantially up or down, and is often done in anticipation of a big movement in the stock price, but without knowing which way it will go. For instance, if an important court case will soon be decided that will substantially impact the stock price, but whether the price will rise or fall is not known, then the straddle would be a good investment strategy. The greatest loss for the straddle is the premiums paid for the put and call, which will expire worthless if the stock price doesn't move enough.

To be profitable, the price of the underlier must move substantially before the expiration date of the options; otherwise, they will expire either worthless or for a fraction of the premium paid. The straddle buyer can only profit if the value of either the call or the put exceeds the cost of the premiums of both options.

A short straddle is created when one writes both a put and a call with the same strike price and expiration date, which one would do if she believes that the stock will not move much before the expiration of the options. If the stock price remains flat, then both options expire worthless, allowing the straddle writer to keep both premiums.

A strap is a specific option contract consisting of 1 put and 2 calls for the same stock, strike price, and expiration date. A strip is a contract for 2 puts and 1 call for the same stock. Hence, straps and strips are ratio spreads. Because strips and straps are 1 contract for 3 options, they are also called triple options, and the premiums are less then if each option were purchased individually.

A strangle is the same as a straddle except that the put has a lower strike price than the call, both of which are usually out-of-the-money when the strangle is established. The maximum profit will be less than for an equivalent straddle. For the long position, a strangle profits when the price of the underlying is below the strike price of the put or above the strike price of the call. The maximum loss will occur if the price of the underlying is between the 2 strike prices. For the short position, the maximum profit will be earned if the price of the underlying is between the 2 strike prices. As with the short straddle, potential losses have no definite limit, but they will be less than for an equivalent short straddle, depending on the strike prices chosen. See Straddles and Strangles: Non-Directional Option Strategies for more in-depth coverage.