Options Trading Strategies

options trading strategies

What are the Popular Options Trading Strategies?

Few of the most popular options trading strategies are the following:

  • Covered call option strategy.
  • Bull put spread option strategy.
  • Bear put spread option strategy.

Primer: Quick read on Call Options and Put Options.

The Covered Call

The covered call option trading strategy is prevalent among long-term stock investors because it can reduce the loss potential on shares. It can create a stream of income on those shares so long as the stock price does not decrease too significantly, and the strategy is very easy to execute. The covered call option strategy consists of two components.

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  1. Owning 100 shares of the stock, say AAPL currently trading at $120 (Sept 4, 2020)
  2. Selling one call option against the shares, with strike price $150 expiring Jan 15, 2021 for $5 (*100 = $500)

This way, if the AAPL stock stays below $150 until Jan 15, 2021, you can keep your 100 shares, and also the $500 premium you collected by selling the call option.

However, if the AAPL stock goes above $150 before Jan 15, 2021, you would have to sell your 100 shares @ $150 each to the person who exercises their option to buy the 100 shares.

Bull Put Spread

Bull Put Spread strategy profits when the stock price increases or remains above the put spreads strike prices as time goes on. It is a limited-risk strategy, consisting of two separate put option components.

  1. Sell a put option at one strike price, e.g. $350 for $10
  2. Buy another put option at a lower strike price, e.g. $340 for $3

The bull put spread strategy is one of the four vertical option strategies. The maximum loss of this strategy is limited: {($350-$340) – ($10 – $3)}*100 = $300 i.e. the difference between the strikes, the less credit received.

On the flip side, the maximum profit is also limited. Max profit in this example would be ($10 – $3)*100 = $700

Bear Put Spread

The strategy is also called the long put spread. Bear put spread is less risky than simple short-selling. In declining markets, bear put works modestly well. Debit put spread, or a long put spread, is also known as a bear put spread.

The bear put option strategy is a strategy that profits when the stock price decreases but has a limited loss potential when the stock price increases. The bear put spread options strategy is one of the four vertical spread options strategies. Compared to short 100 shares of stock, the bear put spread has limited loss potential if the stock price increases while shorting stock shares have unlimited loss potential since there’s no limit to how much a stock can increase. This means that there is no limit to how much the loss potential can be when you simply short a stock.

The bear put spread options strategy consists of two put options transactions:

  1. Purchase a put option, e.g. $320 put for $5
  2. Sell a put option at a lower strike price. e.g. $310 for $2

The maximum loss you will bear in this example is the ($5- $2)*100 = $300.

The maximum gain you will make in this example is {($320 – $310) – ($5 – $2)}*100 = $700

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Butterfly Options Trading Strategies

The butterfly spread is an options strategy. It is a strategy with a fixed risk and capped profit. It is a combination of both bull and bear spreads. All butterfly spreads involve 4 option contracts for the same expiration date, and use three different strike prices. The strike prices of out-of-money option and in-the-money option are equidistant from the strike price at-the-money option (for example $110 and $90 are equidistant from $100).

butterfly options trading strategy

Long Call Butterfly Options, with example

The long call butterfly spread is established by purchasing one in-the-money call option, one out-of money call option, and selling two at-the-money call options. The long butterfly option strategy is a limited risk options strategy that consists of simultaneously buying the call spread and selling two at-the-money calls. Additionally, the strike prices for buying both calls should be equidistance from the at-the-money call option you’re selling.

long call butterfly option spread

For example, A stock is trading at $100 today. A Long call butterfly would look like this:

  1. Sell 2 * $100 call options (at-the-money)
  2. Buy 1 * $110 call option (out-of-money call)
  3. Buy 1 * $90 call option (in-the-money call)

To reiterate, all of the above options should have the same expiration date.

Short Call Butterfly Options, with example

A short butterfly spread is created by the sale of one call option at a lower strike price, the sale of another call option at a relatively higher strike price, and purchase of two at-the-money call options.

short call butterfly option spread

For example, a stock is trading at $100 today. A short call butterfly would look like this:

  1. Buy 2 * $100 call options (at-the-money)
  2. Sell 1 * $110 call option (out-of-money call)
  3. Sell 1 * $90 call option (in-the-money call)

Long Put Butterfly Options, with example

A long put butterfly spread is created by selling 2 at-the-money put options, and buying two put options – one in-the-money and one out-of-money.

long put butterfly option spread

For example, a stock is trading at $200 today. A long put butterfly would look like this:

  1. Sell 2 * $200 put options (at-the-money)
  2. Buy 1 * $190 put option (out-of-money put)
  3. Buy 1 * $210 put option (in-the-money put)

Short Put Butterfly, with example

A short butterfly spread is created by buying 2 at-the-money put options, and buying two put options – one in-the-money and one out-of-money.

short put butterfly option spread

For example, a stock is trading at $200 today. A short put butter fly would look like this:

  1. Buy 2 * $200 put options (at-the-money)
  2. Sell 1 * $190 put option (out-of-money put)
  3. Sell 1 * $210 put option (in-the-money)

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Summary of Butterfly Spreads Options Trading Strategies

Cases explained for a stock trading at $100

butterfly options strategy

Iron Butterfly, with example

Iron butterfly spread is created by selling one at-the-money call option, selling one at-the-money put option, buying one out-of-money call option, and buying one out-of-money put option.

For example, a stock is trading at $100 today. An iron butterfly would look like this:

  1. Sell 1 * $100 call option (at-the-money)
  2. Sell 1 * $100 put option (at-the-money)
  3. Buy 1 * $110 call option (out-of-money call)
  4. Buy 1 * $ 90 put option (out-of-money put)

The maximum profit in case of call option is the net premium received for buying and selling these options.

The maximum possible loss is the difference between call strike prices ($110 – $100), less the net premium received for buying and selling these options.

Reverse Iron Butterfly, with example

As the name suggests, a reverse iron butterfly is created by doing the opposite of what is done to create an iron butterfly spread. It involves buying one at-the-money call option, buying one at-the-money put option, selling one out-of-money call option, and selling one out-of-money put option.

For example, a stock is trading at $100 today. A reverse iron butterfly would look like this:

  1. Buy 1 * $100 call option (at-the-money)
  2. Buy 1 * $100 put option (at-the-money)
  3. Sell 1 * $110 call option (out-of-money call)
  4. Sell 1 * $90 put option (out-of-money put)

Daily Options Trading vs Long Term Investors

Day options are a high-risk, high reward strategy. We mean 10 X returns (or more) are possible if you get it right. It’s also very easy to see your money vaporize if you place trades and get it all wrong. Because of the nature of accelerated (and leveraged) returns on options, daily option traders must be very careful to not ‘fat-finger’ trade orders.

Options can be a strategic part of portfolio for long term investors also, so learning the tricks of the trade can benefit investors whether they intend to do day trading or not.