- Trading Options For Dummies, 2nd Edition
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- Options Trading Strategies: A Guide for Beginners
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Trading Options For Dummies, 2nd Edition
Unlike most other markets, the options market continues to expand with Miami International Securities Exchange filing to become the 11th U.S. options exchange. For the uninitiated, though, getting started in options can be daunting.
To give you a head-start, here are 10 option strategies. These range from simple puts and calls to more complex strategies, such as condors and strangles.
Referred to as “locked trades,” a box allows you to profit from differences in the value at expiration and the price of the underlying instrument.
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Ignoring commission costs, you will make a profit if you can buy them for less than the value or sell them for more.
Additionally, this can be an alternative to closing out positions at possibly unfavorable prices.
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Because there are so many legs, the cost of commissions can make it unfeasible, though.
Long Box: Long call A, short call B, long put B, short put A.
Value = B – A.
Short Box: Long call B, short call A, Long put A, short put B. Value = A – B.
Buying or selling a single call option is one of the two ways of expressing a pure directional bias in the underlying instrument.
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A call gives the buyer the right, but not the obligation, to buy the underlying instrument at the exercise price. As almost every other type of strategy will use either short or long calls, it is important to understand this basic strategy.
Long Call: Gives you unlimited profit potential with limited downside risk.
Profits rise as the market rises and will remain profitable as long as price remains above your option exercise price.
Loss is limited to the premium paid for the option if it expires below A. An at-the-money call should move in value close to the underlying, however, an out-of-the-money call, though less expensive, will not increase in value on par with the underlying.
Short Call: Also known as a “naked short,” a short call allows you to collect the premium for selling a call option.
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Because you are selling at just one exercise price, you potentially face unlimited risk if the market moves against you.
Buying or selling a put is the second way of expressing a pure directional bias.
A put gives the buyer the right, but not the obligation, to sell the underlying instrument at the exercise price. Long or short puts are the second type of basic option legs most other strategies will make use of.
Long Put: Used when you are very bearish the market.
Just as a long call gives you unlimited upside profit potential, a long put gives you nearly unlimited downside profit potential (limited of course by the underlying hitting $0). Loss is limited to the premium paid if it expires above A.
Just as with calls, less expensive out-of-the-money puts will not appreciate in value at the same rate as the underlying.
Short Put: If you are very bullish the market, rather than buying a call, you can short a put whereby you agree to buy the underlying if price falls below the exercise price of the option.
Maximum profit is the premium you received for selling the put, whereas loss is open-ended if the market moves against you.
Spread trades allow you to put on a directional trade, but with a little protection. This means that if you think a market move is likely in one direction, you can put on a spread to take advantage of it if it moves your way, but limits your risk if it does not.
Bull Spread: Long call A, Short call B; Long put A, Short put B
Put on a Bull Spread if you think the market will go up or at least is more likely to than to fall.
Maximum profit is reached if the market ends at or above B at expiration, whereas loss is capped if the market ends at or below A at expiration.
Bear Spread: Short call A, Long call B; Short put A, Long put B
Put on a bear spread if you think the market will go down, or at least is more likely to than to rise.
Maximum profit is reached if the market ends at or below A at expiration, whereas loss is capped if the market ends at or above B at expiration.
Butterfly spreads allow you to take a position as to where exactly you expect the market to be at expiration.
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If correct, the reward is great; if partly right, the reward is very good; and if barely right, you still get even money. If wrong, you know exactly what your risk is and the exact amount you will lose.
A butterfly essentially is two spreads — one you buy and one you sell.
Long Butterfly: Long call A, Short 2 calls B, Long call C; Long put A, Short 2 puts B, Long put C
A very conservative trade, maximum profit occurs if the market is at B at expiration (B – A – cost of doing spread).
Conversely, because of the wings on either side, maximum loss in either direction is the cost of the spread.
Short Butterfly: Short call A, Long 2 calls B, Short call C; Short put A, Long 2 puts B, Short put C
Use if you expect the market to move before expiration.
Maximum profit is credit earned for putting on the spread, and occurs when market at expiration is either below A or above C. Maximum loss will occur if market is at B at expiration.
Like a Butterfly, a Condor allows you to express an opinion as to where you think the market may be at expiration. Rather than choosing a single price, though, a condor is used to select a price range.
Long Condor: All calls or All Puts — Long A, Short B, Short C, Long D
Use if you expect the market to move, but you are not sure how far it may move.
The Condor allows you to choose a range that you think the market may end it. Maximum profit realized if market is between B and C at expiration, and maximum loss if market is below A or above D at expiration.
Short Condor: All Calls or All Puts — Short A, Long B, Long C, Short D
Enter if the market is between B and C, but you think it will move strongly outside of that range by expiration.
Maximum profit will occur if market is below A or above D at expiration, and maximum loss if position is held until expiration and market ends between B and C.
A straddle essentially is a play on volatility. Ultimately, a straddle allows the owner to profit based on how much the underlying moves, regardless of the direction of the move. You pick a point around which to base the straddle.
Long Straddle: Long call A, Long put A
Put on a Long Straddle if the market is near A and you expect it to start moving, but are not sure which way it will go.
Profit is open-ended in either direction, and loss is limited to the cost of the spread.
Short Straddle: Short call A, Short put A
Put on a Short Straddle if the market is near A and you expect it to stagnate through expiration.
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Because you are short, you reap profits as they decay, as long as market remains near A. Maximum profit is realized if market expires at A, but loss is open-ended in either direction.
Like a Straddle, a Strangle is a volatility play, but over a range of strike prices. A Strangle has many of the same characteristics as a Straddle, but by adding additional legs, it is able to put limits on risk.
Long Strangle: Long put A, Long call B; Long call A, Long put B
Use if a market is within or near A – B range and has been stagnant.
If market moves in either direction, you make money with open-ended profit potential. If market continues to stagnate, then loss is limited to the cost of the position.
Short Strangle: Short put A, Short call B; Short call A, Short put B
Use if market is within or near A – B range and, though active, is quieting down.
Maximum profit is found if the market stagnates and expires between A and B. Although less risky than a Straddle, potential loss still is open-ended.
The Call Ratio Spread and Put Ratio Spread are the only options trading strategies capable of making a profit in all three of the ways a market can move: Upward, downward or sideways. Ratio Spreads are similar to vanilla Spread trades, but put on more positions on one leg of the strategy, hence a ratio.
Call Ratio Spread: Long call A, Short calls B
Use when the market is near A and you expect to see a slight rise in the market, but there is potential for a selloff.
Maximum profit (B – A – cost of position) is realized if market expires at B. Loss is limited on the downside, but is open-ended if market rises.
Put Ratio Spread: Long put B, Short puts A
Use when market is near B and you expect it to fall slightly, but you see a potential for sharp rise.
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Maximum profit (B – A – cost of position) is realized if market is at A at expiration. Loss is limited on the upside, but open-ended if the market falls.
By selling an option at one strike price, traders are able to leverage that premium into more options at another strike price. Ratio Backspreads usually are used when an underlying has been stagnant but is beginning to show signs of increasing activity in one direction.
Call Ratio Backspread: Short call A, Long calls B
Normally entered when market is near B and shows signs of increasing activity and has greater probability to upside.
Profit is limited on downside, but open-ended in rallying market, whereas maximum loss is realized if the market expires at B.
Put Ratio Backspread: Short put B, Long puts A
Normally entered when market is near A and shows signs of increasing activity with greater probability to downside. Profit is limited to the upside but is open-ended in collapsing market.
Maximum loss (B – A – initial credit) is realized if market expires at A.
About the Author
Michael McFarlin joined Futures in 2010 after graduating summa cum laude from Trinity International University, where he majored in English/Communication.