5 Option Trading Strategies

“The goal of a successful trader is to make the best trades. Money is secondary.” This quote by one of the best teachers for traders, Alexander Elder, conveys that the initial focus should be on getting the trading strategy right. At the same time, money is only the reward for a carefully judged trade work.

What an insight, isn’t it? This is true for derivative trades as well.

Options Trading in India is enormous and the most sophisticated one. To use this instrument for maximum advantage, a trader can surely turn to the Strategies. The best part about these strategies is they can be molded, innovated, redesigned & restructured according to one’s risk appetite. 

So let’s take a look at what options trading strategies are.

What are Options Trading Strategies?

Firstly Options are derivative contracts allowing traders a right to buy & sell a security at specified date & price. While options trading strategies are the set of ideas that can be followed for maximum gain or for hedging a position in the market. Before moving forward, if you are entirely new to the world of options then these are explanations of some common terms we will continuously use in our lesson today.

Terms of Option Trading Strategies 

Underlying: The entity from which derivatives contracts derive their value.

Call Option: A contract between buyer & seller of underlying where the viewpoint of the call buyer is bullish. On the contrary, the perspective of the call seller is bearish. 

Put Option: Opposite of call, in a simple sense the put buyer is bearish about the underlying while the put seller is bullish about the same.

Long: A trading position, Long implies buying and owning the underlying. You might have often heard the term ‘going long’ which means the buyer expects a further price rise.

Short: A trading position, Short implies selling the underlying. While going short the opinion is that the price is expected to fall.

Strike price: The strike price is an agreed-upon price at which specific security can be brought or sold by the option holder. 

Spot price: The current price of the underlying in the cash market.

Option Premium: It is the current price of the option contract.

Expiration date: Options are short-term contracts. The expiration date is the last date on which the option contracts are valid. Before its expiration, the owner can choose to exercise it or not.

Moneyness: The relationship between the price of an underlying asset with the option contract. It is further classified into these categories.

In the Money

Call: A call option is In-the-Money when the spot price is above the strike price.

Put: When the spot price is below the strike price, it is the In-The-money put option.

At the Money

The situation in which the strike price is equal to the spot price is an At-the-money contract.

Out of the Money

Call: The strike price is more than the spot price. It is an Out-the-money call option.

Put: Out-the-money put option is when the spot price is above the strike price.

Without waiting any further, Let’s learn more about these Exotic products, Shall we? Below are some of the most commonly used strategies which YOU can surely consider in your next Options trade. Diving in!

The top-most Option Trading Strategies

Spread

The building block of many strategies, Options spread, is a position made by buying & selling an equal number of options of the same class & underlying for either call or put followed by different strike prices.

The strategy is divided into 3 categories:

• Horizontal spread- Also known as calendar spreads or time spreads are created using options of the same underlying & strike price but different expiry.

• Vertical Spread- These are also known as money spreads are created while working with the same underlying & expiry date but different strike price.

• Diagonal Spread- This position is made when entering into long & short positions simultaneously. The contracts of the same underlying are entered with different strike prices and expiry. 

Straddle

This strategy involves buying calls & puts together of the same strike price & expiration on the same underlying. Straddle can be used while going Long or Short. This is used when the price movement is not clear. Thus, things to remember are: 

• Buying/selling of call or put option.

• Same underlying & Strike price is a must.

• A trader is expected to enter an At-the-money contract.

• View: High volatility OR Low volatility

It works in the neutral view that price can move in either direction. 

Let’s understand this with an example

Suppose the stock of ITC is trading at Rs. 200 in the spot market, While the premium of call & put option of the strike of 170 is trading at Rs. 15 & 10.60 respectively, the cost incurred by the trader at this point is Rs. 25.60 which is also the maximum loss which the trader will incur. If ITC reaches 250 at the time of expiry the Put option will turn out of money while the call option remains in the money with the payout of 50 (250-200) and after deducting the premium paid of 25.60, the final value is of 24.40 before deducting the taxes.

Strangle

A strategy similar to straddle but with a little twist! In this, the positions are held in both calls & puts with the same expiration date and the underlying asset but with a different strike price. In a way, we know that the underlying will give huge movement but in which direction? That’s unknown.

To summarise:

• Buying/selling call or put option

• Similar underlying & expiration date

• Different strike price

• Usually carried out in out the money contracts

• View: High volatility OR Low volatility

The risk in this strategy is also limited to the premium paid.

Long Strangle: The trader has to buy out the money call & put contracts of different strikes. The thing to remember is that the strike for call option should be higher than the underlying asset on the flip side the strike of the put option should be lower than the underlying asset. One of the strikes out of two is expected to give huge movements and the risk will be limited to the premium paid.

Short Strangle: In short strangle the trader has to “sell” out the money call & put. In this, maximum profit is limited to the premium paid while the potential loss remains unlimited if the stock goes up.

Covered Call

This is a risk management strategy where the trader holds a long position of the underlying asset while sells a call option of the same underlying. The strategy is applied as a hedging instrument to safeguard the underlying against price fluctuations. Thus the risk and profit is capped.

Covered call: Long underlying asset + Short call option

Protective put

Also known as a synthetic call, the protective put strategy is closely related to the covered call and is also a hedging strategy. Holding a long position in the underlying asset and buying a put option with the same or a nearby strike price.

Protective put: Long underlying asset + Long put option

The Bottom Line

Options are risky, it’s said that 95% of traders lose money while trading but here we are with the set of ideas to make our options trading simpler. With these strategies, we try to protect our open positions & minimize the losses.

Share this blog with your friends & colleagues who are thinking of entering the world of options trading!

Do let us know in the comment section, what you think about the strategies?