Option Stock Strategy Trade Trading

An option strategy is implemented by combining one or more option positions and possibly an underlying stock position. Options are financial instruments that give the buyer the right to buy (for a call option) or sell (for a put option) the underlying security at some specific point of time in the future (European Option) or until some specific point of time in the future (American Option) for a price (strike price), which is fixed in advance (when the option is bought).

Calls increase in value as the underlying stock increases in value. Likewise puts increase in value as the underlying stock decreases in value. Buying both a call and a put means that if the underlying stock moves up the call increases in value and likewise if the underlying stock moves down the put increases in value. The combined position can increase in value if the stock moves significantly in either direction. (The position loses money if the stock stays at the same price or within a range of the price when the position was established.) This strategy is called a straddle . It is one of many options strategies that investors can employ.

Options strategies can favor movements in the underlying stock that are bullish, bearish or neutral. In the case of neutral strategies, they can be further classified into those that are bullish on volatility and those that are bearish on volatility. The option positions used can be long and/or short positions in calls and/or puts at various strikes.

Bullish strategies

Bullish options strategies are employed when the options trader expects the underlying stock price to move upwards. It is necessary to assess how high the stock price can go and the time frame in which the rally will occur in order to select the optimum trading strategy.

The most bullish of options trading strategies is the simple call buying strategy used by most novice options traders.

Stocks seldom go up by leaps and bounds. Moderately bullish options traders usually set a target price for the bull run and utilize bull spreads to reduce cost. (It does not reduce risk because the options can still expire worthless.) While maximum profit is capped for these strategies, they usually cost less to employ for a given nominal amount of exposure. The bull call spread and the bull put spread are common examples of moderately bullish strategies.

Mildly bullish trading strategies are options strategies that make money as long as the underlying stock price does not go down by the option's expiration date. These strategies may provide a small downside protection as well. Writing out-of-the-money covered calls is a good example of such a strategy.

Bearish strategies

Bearish options strategies are the mirror image of bullish strategies. They are employed when the options trader expects the underlying stock price to move downwards. It is necessary to assess how low the stock price can go and the time frame in which the decline will happen in order to select the optimum trading strategy.

The most bearish of options trading strategies is the simple put buying strategy utilised by most novice options traders.

Stock prices only occasionally make steep downward moves. Moderately bearish options traders usually set a target price for the expected decline and utilise bear spreads to reduce cost. While maximum profit is capped for these strategies, they usually cost less to employ. The bear call spread and the bear put spread are common examples of moderately bearish strategies.

Mildly bearish trading strategies are options strategies that make money as long as the underlying stock price does not go up by the options expiration date. These strategies may provide a small upside protection as well.

Neutral or non-directional strategies

Neutral strategies in options trading are employed when the options trader does not know whether the underlying stock price will rise or fall. Also known as non-directional strategies, they are so named because the potential to profit does not depend on whether the underlying stock price will go upwards or downwards. Rather, the correct neutral strategy to employ depends on the expected volatility of the underlying stock price.

Examples of neutral strategies are:

1. Guts - sell in the money put and call
2. Butterfly - buy at the money and out of the money call, sell two in the money calls, or vice versa
3. Condor - sell out of the money call and buy call with higher strike price, while simultaneously selling out of the money put and buying put with lower strike price
4. Straddle - holding a position in both a call and put with the same strike price and expiration. The position is profitable (to the buyer) if the underlying stock changes value in a significant way, either higher or lower. If the options have been bought, the holder has a long straddle. If the options were sold, the holder has a short straddle.
5. Strangle - the simultaneous buying or selling of out-of-the-money put and an out-of-the-money call, with the same expirations. Similar to the straddle, but with different strike prices.
6. Risk Reversal

Bullish on volatility

Neutral trading strategies that are bullish on volatility profit when the underlying stock price experiences big moves upwards or downwards. They include the long straddle, long strangle, short condor and short butterfly.

Bearish on volatility

Neutral trading strategies that are bearish on volatility profit when the underlying stock price experiences little or no movement. Such strategies include the short straddle, short strangle, ratio spreads, long condor and long butterfly.

See also

• Options spread
• Synthetic options position
• Options arbitrage

References

• McMillan, Lawrence G. (2002). Options as a Strategic Investment (4th ed. ed.). Prentice Hall. ISBN 0-7352-0197-8.  

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