- Option Strategies
- Short Strangle
- Option Spreads
- Strangle vs. Straddle Option Trading Strategies
- Short strangle
- Example — Bullish Money Spread
- Ratio Spreads
- Options Guy's Tip
- Limited Risk
- Covered Call
- Example—Covered Call
- Protective Put
- The Strategy
- Example—Protective Put
- Combination option trades: straddle, strangle, strip/strap (FRM T3-39)
- Option Spreads
- Straddles and Strangles
- Option Strangle (Long Strangle)
- Strangle option strategy diagram
- Example—Long and Short Strangle
- Option Strategies
- Mutual Funds and Mutual Fund Investing - Fidelity Investments
Because options prices are dependent upon the prices of their underlying securities, options can be used in various combinations to earn profits with reduced risk, even in directionless markets.
Below is a list of the most common strategies, but there are many more—infinitely more. But this list will give you an idea of the possibilities.
Any investor contemplating these strategies should keep in mind the risks, which are more complex than with simple stock options, and the tax consequences, the margin requirements, and the commissions that must be paid to effect these strategies.
One particular risk to remember is that American-style options — which are most options where the exercise must be settled by delivering the underlying asset rather than by paying cash — that you write can be exercised at any time; thus, the consequences of being assigned an exercise before expiration must be considered.
(Note: The examples in this article ignore transaction costs.)
An option spread is established by buying or selling various combinations of calls and puts, at different strike prices and/or different expiration dates on the same underlying security. There are many possibilities of spreads, but they can be classified based on a few parameters.
The money earned writing options lowers the cost of buying options, and may even be profitable.
A credit spread results from buying a long position that costs less than the premium received selling the short position of the spread; a debit spread results when the long position costs more than the premium received for the short position — nonetheless, the debit spread still lowers the cost of the position. A combination is defined as any strategy that uses both puts and calls.
Strangle vs. Straddle Option Trading Strategies
A covered combination is a combination where the underlying asset is owned.
A money spread, or vertical spread, involves the buying of options and the writing of other options with different strike prices, but with the same expiration dates.
A time spread, or calendar spread, involves buying and writing options with different expiration dates.
A horizontal spread is a time spread with the same strike prices. A diagonal spread has different strike prices and different expiration dates.
A bullish spread increases in value as the stock price increases, whereas a bearish spread increases in value as the stock price decreases.
Important Note: I strive to keep all the articles on my website up to date, but I continue to use older examples if they continue to illustrate current principles or law.
Using newer dates in these examples will not improve their illustrative value, but it would increase the amount of work that I would continually have to do.
I update everything that is important, but these option examples are based on timeless principles, so no pedagogical value would be added by using newer dates.
Example — Bullish Money Spread
On October 6, 2006, you buy, for $850, 10 calls for Microsoft, with a strike price of $30 that expires in April, 2007, and you write 10 calls for Microsoft with a strike price of $32.50 that expires in April, 2007, for which you receive $200. At expiration, if the stock price stays below $30 per share, then both calls expire worthless, which results in a net loss, excluding commissions, of $650 ($850 paid for long calls - $200 received for written short calls).
If the stock rises to $32.50, then the 10 calls that you purchased are worth $2,500, and your written calls expire worthless. This results in a net $1,850 ($2,500 long call value + $200 premium for short call - $850 premium for the long call).
If the price of Microsoft rises above $32.50, then you exercise your long call to cover your short call, netting you the difference of $2,500 plus the premium of your short call minus the premium of your long call minus commissions.
There are many types of option spreads: covered calls, straddles and strangles, butterflies and condors, calendar spreads, and so on.
Most options spreads are usually undertaken to earn a limited profit in exchange for limited risk.
Options Guy's Tip
Usually, this is accomplished by equalizing the number of short and long positions. Unbalanced option spreads, also known as ratio spreads, have an unequal number of long and short contracts based on the same underlying asset. They may consist of all calls, all puts, or a combination of both. Unlike other, better-defined, spreads, unbalanced spreads have many more possibilities; thus, it is difficult to generalize about their characteristics, such as reward/risk profiles.
However, if long contracts exceed short contracts, then the spread will have unlimited profit potential on the excess long contracts and with limited risk. An unbalanced spread with an excess of short contracts will have limited profit potential and with unlimited risk on the excess short contracts. As with other spreads, the only reason to accept unlimited risk for a limited profit potential is that the spread is more likely to be profitable. Margin must be maintained on the short options that are not balanced by long positions.
The ratio in a ratio spread designates the number of long contracts over short contracts, which can vary widely, but, in most cases, neither the numerator nor the denominator will be greater than 5.
A front spread is a spread where the short contracts exceed the long contracts; a back spread has more long contracts than short contracts. A front spread is also sometimes referred to as a ratio spread, but front spread is a more specific term, so I will continue to use front spread only for front spreads and ratio spreads for unbalanced spreads.
Whether a spread results in a credit or a debit depends on the strike prices of the options, expiration dates, and the ratio of long and short contracts.
Ratio spreads may also have more than one breakeven point, since different options will go into the money at different price points.
|Type of Spread||Strategy Description||Reward/Risk||Profit Direction|
|Call Ratio Spread||buy lower strike call, sell more higher strikes||limited profit, unlimited risk||moderately bullish|
|Put Ratio Spread||buy higher strike put, sell more lower strikes||limited profit, substantial risk||moderately bearish|
|Call Back Spread||sell lower strike call, buy more higher strikes||unlimited profit, limited risk||bullish|
|Put Back Spread||sell higher strike put, buy more lower strikes||substantial profit, limited risk||bearish|
The simplest option strategy is the covered call, which simply involves writing a call for stock already owned.
If the call is unexercised, then the call writer keeps the premium, but retains the stock, for which he can still receive any dividends. If the call is exercised, then the call writer gets the exercise price for his stock in addition to the premium, but he foregoes the stock profit above the strike price.
If the call is unexercised, then more calls can be written for later expiration months, earning more money while holding the stock. A more complete discussion can be found at Covered Calls.
On October 6, 2006, you own 1,000 shares of Microsoft stock, which is currently trading at $27.87 per share.
You write 10 call contracts for Microsoft with a strike price of $30 per share that expire in January, 2007. You receive .35 per share for your calls, which equals $35.00 per contract for a total of $350.00. If Microsoft doesn't rise above $30, you get to keep the premium as well as the stock.
If Microsoft is above $30 per share at expiration, then you still get $30,000 for your stock, and you still get to keep the $350 premium.
A stockholder buys protective puts for stock already owned to protect his position by minimizing any loss. If the stock rises, then the put expires worthless, but the stockholder benefits from the rise in the stock price.
If the stock price drops below the strike price of the put, then the put's value increases 1 dollar for each dollar drop in the stock price, thus, minimizing losses.
The net payoff for the protective put position is the value of the stock plus the put, minus the premium paid for the put.
Protective Put Payoff = Stock Value + Put Value – Put Premium
Using the same example above for the covered call, you instead buy 10 put contracts at $0.25 per share, or $25.00 per contract for a total of $250 for the 10 puts with a strike of $25 that expires in January, 2007.
If Microsoft drops to $20 a share, your puts are worth $5,000 and your stock is worth $20,000 for a total of $25,000. No matter how far Microsoft drops, the value of your puts will increase proportionately, so your position will not be worth less than $25,000 before the expiration of the puts—thus, the puts protect your position.
A collar is the use of a protective put and covered call to collar the value of a security position between 2 bounds.
A protective put is bought to protect the lower bound, while a call is sold at a strike price for the upper bound, which helps pay for the protective put. This position limits an investor's potential loss, but allows a reasonable profit. However, as with the covered call, the upside potential is limited to the strike price of the written call.
Collars are one of the most effective ways of earning a reasonable profit while also protecting the downside.
Combination option trades: straddle, strangle, strip/strap (FRM T3-39)
Indeed, portfolio managers often use collars to protect their position, since it is difficult to sell so many securities in a short time without moving the market, especially when the market is expected to decline. However, this tends to make puts more expensive to buy, especially for options on the major market indexes, such as the S&P 500, while decreasing the amount received for the sold calls.
In this case, the implied volatility for the puts is greater than that for the calls.
On October 6, 2006, you own 1,000 shares of Microsoft stock, which is currently trading at $27.87 per share.
You want to hang onto the stock until next year to delay paying taxes on your profit, and to pay only the lower long-term capital gains tax. To protect your position, you buy 10 protective puts with a strike price of $25 that expires in January, 2007, and sell 10 calls with a strike price of $30 that also expires in January, 2007. You get $350.00 for the 10 call contracts, and you pay $250 for the 10 put contracts for a net of $100.
If Microsoft rises above $30 per share, then you get $30,000 for your 1,000 shares of Microsoft. If Microsoft should drop to $23 per share, then your Microsoft stock is worth $23,000, and your puts are worth a total of $2,000.
If Microsoft drops further, then the puts become more valuable — increasing in value in direct proportion to the drop in the stock price below the strike.
Thus, the most you'll get is $30,000 for your stock, but the least value of your position will be $25,000. And since you earned $100 net by selling the calls and writing the puts, your position is collared at $25,100 below and $30,100. Note, however, that your risk is that the written calls might be exercised before the end of the year, thus forcing you, anyway, to pay short-term capital gains taxes in 2007 instead of long-term capital gains taxes in 2008.
Straddles and Strangles
A long straddle is established by buying both a put and call on the same security at the same strike price and with the same expiration.
This investment strategy is profitable if the stock moves substantially up or down, and is often done in anticipation of a big movement in the stock price, but without knowing which way it will go. For instance, if an important court case is going to be decided soon that will have a substantial impact on the stock price, but whether it will favor or hurt the company is not known beforehand, then the straddle would be a good investment strategy.
The greatest loss for the straddle is the premiums paid for the put and call, which will expire worthless if the stock price doesn't move enough.
To be profitable, the price of the underlier must move substantially before the expiration date of the options; otherwise, they will expire either worthless or for a fraction of the premium paid.
The straddle buyer can only profit if the value of either the call or the put is greater than the cost of the premiums of both options.
A short straddle is created when one writes both a put and a call with the same strike price and expiration date, which one would do if she believes that the stock will not move much before the expiration of the options. If the stock price remains flat, then both options expire worthless, allowing the straddle writer to keep both premiums.
A strap is a specific option contract consisting of 1 put and 2 calls for the same stock, strike price, and expiration date.
A strip is a contract for 2 puts and 1 call for the same stock.
Option Strangle (Long Strangle)
Hence, straps and strips are ratio spreads. Because strips and straps are 1 contract for 3 options, they are also called triple options, and the premiums are less then if each option were purchased individually.
A strangle is the same as a straddle except that the put has a lower strike price than the call, both of which are usually out-of-the-money when the strangle is established.
The maximum profit will be less than for an equivalent straddle. For the long position, a strangle profits when the price of the underlying is below the strike price of the put or above the strike price of the call.
The maximum loss will occur if the price of the underlying is between the 2 strike prices. For the short position, the maximum profit will be earned if the price of the underlying is between the 2 strike prices.
Strangle option strategy diagram
As with the short straddle, potential losses have no definite limit, but they will be less than for an equivalent short straddle, depending on the strike prices chosen. See Straddles and Strangles: Non-Directional Option Strategies for more in-depth coverage.
Example—Long and Short Strangle
Merck is embroiled in potentially thousands of lawsuits concerning VIOXX, which was withdrawn from the market. On October, 31, 2006, Merck's stock was trading at $45.29, near its 52-week high.
Merck has been winning and losing the lawsuits. If the trend goes one way or the other in a definite direction, it could have a major impact on the stock price, and you think it might happen before 2008, so you buy 10 puts with a strike price of $40 and 10 calls with a strike price of $50 that expire in January, 2008.
You pay $2.30 per share for the calls, for a total of $2,300 for 10 contracts. You pay $1.75 per share for the puts, for a total of $1,750 for the 10 put contracts.
Your total cost is $4,050 plus commissions. On the other hand, your sister, Sally, decides to write the strangle, receiving the total premium of $4,050 minus commissions.
Let's say, that, by expiration, Merck is clearly losing; it's stock price drops to $30 per share. Your calls expire worthless, but your puts are now in the money by $10 per share, for a net value of $10,000.
Mutual Funds and Mutual Fund Investing - Fidelity Investments
Therefore, your total profit is almost $6,000 after subtracting the premiums for the options and the commissions to buy them, as well as the exercise commission to exercise your puts. Your sister, Sally, has lost that much. She buys the 1,000 shares of Merck for $40 per share as per the put contracts that she sold, but the stock is only worth $30 per share, for a net $30,000.
Her loss of $10,000 is offset by the $4,050 premiums that she received for writing the strangle. Your gain is her loss. (Actually, she lost a little more than you gained, because commissions have to be subtracted from your gains and added to her losses.) A similar scenario would occur if Merck wins, and the stock rises to $60 per share. However, if, by expiration, the stock is less than $50 but more than $40, then allyour options expire worthless, and you lose the entire $4,050 plus the commissions to buy those options.
For you to make any money, the stock would either have to fall a little below $36 per share or rise a little above $54 per share to compensate you for the premiums for both the calls and the puts and the commission to buy them and exercise them.