Options Trading Strategies

If you are wanting to trade options, an understanding of some common options trading strategies that are utilized by active traders.

In this guide, I will cover a selection of options trading strategies that are suitable for various experience levels.

Ready to start trading? Consider reading my guide to the best options trading platforms May 2023

Key Takeaways

The key takeaways from my guide on options trading strategies are as follows:

Best option strategies for beginners

Options are best suited for experienced traders. But if you are looking to get into this trading scene, then a great starting point is to learn some basic strategies.

Purchasing calls or puts

If you believe that the underlying stock or asset will rise in value you will purchase a call option and in some cases a long call option. You will make money on the position if the options contracts expire higher than the strike price minus the premium paid.

If you believe that the underlying asset will decline in value, you will instead purchase puts. This will result in a profit if the options close lower than the strike price.

• The strike price is essentially your target to land in the money (ITM).
• The difference when the option is trading in the opposite direction to your trade is know as being out of the money (OOTM)
• For instance, let’s say you purchase put options on Netflix stock at a strike price of $290.
• If the contracts expire at $270, you make a gross profit of $20 per option.

You would then need to factor in the premium, which is the fee you pay to enter the trade. Nonetheless, this beginner-friendly strategy does not require you to enter multiple positions. Instead, you simply need to speculate on the future direction of the underlying stock. The premium paid will depend on the stock’s price.

Most importantly, this strategy will only see you lose the premium on an unsuccessful trade. As I cover in more detail shortly, most other options strategies require multiple trades at any given time.

Long straddle

Both the calls and puts will be purchased simultaneously with the same strike price and expiration date.

Although this sounds like a classic hedging strategy, there is an alternative motive. Put simply, this options strategy is used when the trader expects a rapid price movement in the coming days, but they are not sure whether this will be to the upside or downside.

• Once the support or resistance line has been broken convincingly, the trader can offload either the calls or puts.
• If the asset moves to the downside, then the calls will be sold.
• The puts will be sold if the asset moves to the upside.

The trader will then keep the options trade open for as long as the identified trend remains in place. In order to benefit from this options strategy, you will need to have an understanding of technical analysis.

The reason for this is that you will first need to identify a pricing range that you believe is about to break out. A common technical indicator for this purpose is the RSI.

The short put

The short put is a strategy that is best utilized by experienced options traders. But even as a beginner, it is wise to understand how this strategy works. As you become more proficient with options trading, the short put can yield notable results.

You will deploy this strategy if you believe the value of an asset is likely to rise. For this strategy to generate a profit, the asset must not close below the strike price of the position.

If the asset closes above the strike price, then you will collect the premium that was paid by investors on the other side of the trade.

• For example, let’s say that you believe that Tesla stock is likely to rise in the coming months.
• As a seller, you offer a strike price of $210 with a premium of $17.
• You decide to underwrite 1 contract, which amounts to 100 Tesla stocks.
• Therefore, you collect $1,700 in premiums.

From this moment on, one of two things can happen.

• Let’s say that you speculated correctly, with Tesla stock closing at $200 when the options contracts expire.
• In this instance, you keep the premiums that you collected – worth $1,700

However, if Tesla stock closed above the $210 strike price that you offered, you could be liable for losses. The extent of the losses will depend on the price that Tesla stock closed at.

For example, if Tesla stock closes at $227, this is $17 above the strike price. This means that you simply need to return the premium that you collect, which was $17 per stock option.

However, if Tesla stock closed at $237, then you would also be liable for an additional $10 per stock. You underwrote 1 contract (100 Tesla stocks), so that would amount to a liability of $1,000 in addition to the premium that you would need to return.

Married put

• For instance, let’s suppose that you hold 100 Ford stocks in your portfolio.
• You want to protect yourself from a potential price decline, so you purchase one put options contract on Ford stock.
• One options contract covers 100 Ford stocks, so this counters the original investment.

At this stage, if Ford stock declines in value, you will make money on the put options contract that you purchased. At the other end of the trade, your original Ford stock investment will decline in value.

A married put strategy enables you to profit from declining stock prices with minimal risk. The reason for this is that should Ford stock increase in value, the most you can lose from the put option purchase is the premium.

On the other hand, let’s suppose that Ford stock continues to rise. While you might lose the premium on the options trade, you effectively have unlimited upside on the original stock investment.

Covered call

This is where you would hedge existing positions to offset any loses you may make either way/

In fact, covered calls can also be used even if you believe that the value of the stock will rise, but by a limited amount.

• For example, let’s suppose that you are holding a solid dividend stock like Johnson & Johnson.
• You determine that the likelihood of Johnson & Johnson making a dividend cut is highly unlikely, considering that the firm has increased the size of its payments for 60 consecutive years.
• With that said, you are less convinced about the upside potential of Johnson & Johnson’s stock price.
• In this scenario, you decide to deploy a covered call options strategy.
• In order to achieve this, you would need to sell call options on Johnson & Johnson stock.

I should note that as an options seller, your risk exceeds that of the premium. This is because you are the underwriter of the options contract.

In other words, you are a market maker. However, because you already have an open position on Johnson & Johnson stock, much of this risk is alleviated.

This is because your profit and loss from the original stock investment and the call options will counter each other out. But in the meantime, you will continue to receive dividend payments from Johnson & Johnson every quarter as you normally would.

This strategy should, in theory, keep the value of the stock investment neutral. The main drawback with this strategy is that should Johnson & Johnson stock increase over the course of the covered call position, you have opportunity costs to bear.

This means that you would have made larger gains had you avoided selling the call options. But nonetheless, this enables you to target a solid dividend strategy with limited risk.

Bull call spread

• The bull call spread is deployed by an options trader when they believe that the upside of a stock is limited.
• This might be because the stock is approaching a pricing point that has historically acted as a level of resistance.

In order to deploy the bull call spread, there are two stages to this strategy.

First, you would look to purchase call options on a stock. This needs to be at a strike price that is higher than the current stock value.

For instance, if Disney stock is trading at $100, you might purchase calls at a strike price of $105.

• Next, you would then sell call options on Disney stock.
• This needs to have the same expiry date as the purchased calls but with a different strike price.
• The strike price needs to be higher than that of the purchased calls, which were $105.
• Therefore, you might elect to sell the Disney call options at a strike price of $110.

At this stage, you have opposing trades on the same stock. But additionally, you have different strike prices ($105 on purchased calls and $110 on sold calls).

If you speculated correctly and the stock increases in value, then you make a net profit on this position. The upside will be limited, however, as you also sold call options.

If the value of Disney stock declines, you will not exercise the purchased call options on expiry, so you simply lose the premium. Your risk is limited in this scenario, as you collected a premium when selling the call options.

Overall, this options strategy is ideal for experienced traders that wish to profit from volatile market conditions but in a risk-averse way.

Bear put spread

Just like the previously discussed bull call spread, this options strategy comes with limited upside and risk.

The first part of the strategy requires you to purchase put options. Second, you would need to sell put options on the same asset and contract expiry date.

• The put options that you sell need to be executed at a price that is lower than the initial purchase.
• For example, let’s say that you purchased put options on Microsoft stock at $250 each.
• In this instance, you might consider selling Microsoft put options at $240 each.

In order for this options strategy to yield a profit, you will need Microsoft stock to decline in value, in relation to the aforementioned strike prices.

If Microsoft stock increases in value, your risk is limited.

Protective collar

Traders will often turn to this strategy when the broader markets are volatile.

Although the overarching objective is to limit losses from a bearish market, there is still an upside on offer.

The protective collar is a three-part options trading strategy that covers the following:

• The original stock investment
• Purchased put options
• Sold call options

Let’s break the above down into layman’s terms.

So, we’ll say that you have an outstanding stock investment in Amazon. Due to increased market volatility, you want to deploy the protective collar strategy to limit the risk.

The first step is to purchase Amazon stock put options. These options will increase in value if the price of Amazon stock declines.

Second, you will need to sell Amazon call options. This means that you are underwriting the options trade. As such, you collect a premium from those that are long on Amazon. This segment of the strategy also makes money if Amazon stock declines.

The protective collar also requires you to be methodical with your chosen strike prices. In a nutshell, the calls that you sell must have a higher strike price than the puts that you purchase. For instance, you might sell Amazon calls at $90 and purchase puts at $85.

This ensures that the overall downside risk on your Amazon stock positions are limited. This also means that you have a limited upside. But this is an upside nonetheless.

As such, the protective collar strategy is not a conventional hedging move, as you can still make gains.

Making options trading adjustments: 3 things to consider

Reasons for the adjustment

There are many reasons why your options contracts might be adjusted. In the vast majority of cases, this will be the result of a corporate action.

One of the most common reasons for an adjustment is the announcement of a dividend. An adjustment will also be made if a company decides to split its stocks. This can be a conventional or a reverse split. Although the former is a lot more common.

Your options contracts can also be adjusted if a stock is involved in a merger or an acquisition.

Assess the specifics of the adjustment

You will also need to have a 360-degree overview of how the options contracts have been adjusted. The specifics of the adjustment are determined by the Options Clearing Corporation (OCC).

Nonetheless, there are one or more adjustments that can be made to the options contracts depending on the reason. This might include an adjustment of the strike price or the date of expiry.

Evaluate the consequences of the adjustment

If you are holding options contracts that are adjusted by the OCC, this can either go in your favor or against you.

If the adjustment is positive, the value of your options position will likely move to the upside. You can then decide whether to lock in your gains or allow the position to remain open.

On the other hand, if the adjustment goes against you, then you will likely see a sudden drop in value on the options position.

Crucially, the fundamentals of your original speculation likely haven’t changed. As such, it might make sense to avoid panic selling and instead give the trade time to react to the adjustment.

How much money do you need to trade options?

For instance, many options strategies require the usage of margin. Retail clients in the US are required to have at least $2,000 in a margin account.

If you are simply looking to purchase calls or puts, then you won’t be trading on margin. This is because if calls or puts expire worthless, you will only lose the premium. And hence, you are not trading with more than you have.

You should also consider the frequency that you plan to trade options. This is because of the pattern day trading rule, which applies to both stocks and options.

• The rule requires you to have $25,000 in your brokerage account if you place four or more day trades within five business days.
• This means opening and closing an options position on the same day.
• The $25,000 requirement can be avoided by limiting the number of same-day options positions that are entered.

You also need to consider the minimum requirements at your chosen brokerage. Many US brokers support fractional options trading, which means that you can limit your exposure to a few dollars.

Conclusion

Either way, most options strategies utilized by active traders require multiple positions to be opened at any given time.

This can be an intimidating undertaking for complete novices. Ultimately, I find that the best options strategy for beginners is to simply purchase calls or puts.

This requires just a single trade and the downside risk is capped to the premium.

If you are ready to start trading in options and need to know which broker to use check out our Best Options Trading Platforms