Top 3 Strategies For Options Trading
Some of the most popular strategies that option traders us include straddles, strangles, and covered calls. Read on to learn more about each.
Selling a strangle aka Short strangle
These are created when a trader purchases a high-strike call option and a low-strike put option on the same principal security with identical expiry dates.
If the market becomes volatile and moves in a any direction by a certain amount, a trader owning a strangle profits.
The profit one stands to gain is unlimited, but the maximum loss is usually known only when the trade is executed. This is equal to the total amount paid for both options.
Buying a strangle aka long strangle
Buying a strangle involves selling a high strike call option and a low strike put option on the same principal security with identical expiry dates.
Option traders love short strangles because they allow the trader to potentially profit when the market’s volatility is low.
The profit is however limited to the amount spent on the strangle and losses are unlimited.
Short strangle example
Let us assume that you:
Sell a UK 50 Dec 5000 put option at 80 for 20 per point.
Sell a UK 50 Dec 6000 call option at 50 for 10 per point.
A best case scenario would be if the UK 50 expires between 5000 and 6000 on the date of expiry because you stand to make a profit of 2,100 (80 x 20 + 50 x 10).
Break even points are attained if the UK 50 expires at 4870 (80 + 50 points below 5000) or at 6130 (80 + 50 points above 6000) on the date of expiry.
A worst case scenario would be if the UK 50 falls below 4870 or gathers well above 6130. Your loss will be 20 for every point that the UK 50 expires below 4870 or above 6130.
If for example, the UK 500 expires at 4700, your loss will be 4,700 ([5000 – 4700] x 20 per point – [80 + 50] x 10 per point).
If you are trading CFDs, then 1 CFD = 1 per point, meaning 10 CFDs = 10 per point.
The only difference between a strangle and a straddle is that the strike of a put option and a call are equal.
Selling a straddle aka short straddle
When a trader sales a call option and a put on the same primary security with identical strike prices and expiry dates, it is said he has sold a straddle.
This strategy is loved by traders because it enables them profit in markets that have low volatility. Additionally, it is possible to close positions before their expiry dates.
If the market remains in a certain range determined by the premium received from the straddle upon expiry you stand to make a profit. Profits are however limited to the amount spent on the straddle while losses are unlimited.
If an investor can sell a straddle of he does not expect current market levels to change or if he is operating in a range bound market.
Buying a straddle aka long straddle
When a put and call option are bought on the same primary security with identical strike prices and dates of expiry, a long straddle is made.
An investor would typically purchase a straddle if he expects volatility in the market.
You would therefore make a profit your trade if the original price moves up or down by more than the amount you paid when buying the straddle.
The profits of buying a straddle are potentially unlimited, but losses are limited to the amount you paid for the two options. This is why the straddle is said to have limited risk.
3. Covered call
In this strategy, you already own the primary instrument. If you believe that it its price will remain the same or you are willing to sell it should the prices go up, you could sell a call option against the instrument you own.
Should the prices of the primary instrument remain unchanged or increase, you will make a profit that is equal to the price multiplied by the stake of the call option.
Additionally, should the price of the instrument fall, you will not lose as much as you would have if you had refused to sell the call option.
Covered call example
Let us assume that you own 100 per point of BP from 300p.
You then sell a BP Mar 320p call option at a price of 30 for 100 per point.
If BP expires around 300p in March, you would make 3,000 (30 x 100)
If BP was to settle at 320p in March, you would make 5,000 (320-300 x 100 = 2,000 profit from the original BP position. 30 x 100 = 3,000 profit from the call option).
But if by the date or expiry BP has fallen, you would make a loss, but it would be 3,000 less than the amount you would have lost had you not sold the call option.
If BP was to fall by a small amount by the date of expiry, let us say to 280p, you would still make a 1,000 profit (a profit of 3,000 from the call option. 2,000 loss on the original BP position).
If you are trading CFDs, 1 CFD = 1 per point , meaning that 100 CFDs = 100 per point which is equal to 10,000 shares.