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From zero to hero: options strategies
Summary: In our "From zero to hero" series, we explore options strategies, designed to clarify the mechanics of combining options for various market scenarios. The article outlines how to manage risks and enhance potential rewards by using defined risk strategies like vertical spreads and undefined risk strategies such as strangles. It offers insight into choosing between debit and credit spreads and explains the terms commonly used in options trading. The piece serves as a guide for investors and traders seeking to better understand and utilize options strategies in their portfolio management.
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From zero to hero: options strategies
In our earlier discussions, we walked through the basics of buying and selling options. While they can be more cost-effective compared to trading stocks directly, they come with certain risks. Now, let’s delve into option strategies to better manage these risks and aim for more favorable outcomes.Understanding option strategies
Option strategies are akin to combining different options together, much like putting together the pieces of a puzzle. For instance, if you buy a call and a put at the same time, that's a strategy known as a straddle.
Some of these strategies have unique names like butterfly spread, which gets its name because its profit and loss graph looks like a butterfly. These strategies are designed to help manage our risks and potentially improve our rewards in varying market conditions.
Defined and undefined risk strategies: a calculated approach
Defined risk strategies allow us to know the maximum amount we could lose right from the get-go. It’s a way of having a clear picture of the risks involved before making a decision.
Undefined risk strategies: A more open-ended approach. On the other hand, undefined risk strategies don’t have a cap on how much we could lose. The potential for higher rewards comes with a higher level of risk.
Exploring vertical spreads: The cornerstone of options strategies
Vertical spreads are a basic yet powerful strategy in options trading, forming the foundation for many other strategies. Spreads can either need a debit to be paid or a credit to receive when opening a position like this. Below are 2 examples showing just that, both with the same outlook on the underlying stock (slightly bullish):
Debit vertical spread (Bullish): Suppose you think stock XYZ, currently at $50, will go up slightly. You:
• Buy a $50 call for $3 (hoping the stock will go up).
• Sell a $55 call for $1 (offsetting some of the cost).
Your total cost is $2 per share, which is the most you could lose. The most you could earn is $3 per share if stock XYZ goes up.
Credit vertical spread (Bullish): Now, let's assume you think stock XYZ, currently at $50, again, will go up slightly. Rather than working with calls, we'll use puts. You:
• Sell a $50 put for $3 (earning a premium).
• Buy a $45 put for $1 (spending some to limit the risk).
You earn $2 per share upfront, which is the most you could earn. The most you could lose is $3 per share if stock XYZ goes down.
Debit vs Credit Vertical Spreads: Weighing Your Options
The choice between debit and credit spreads hinges on multiple factors including your market outlook, risk tolerance, and the premium costs involved.
- Debit spread: In a debit spread like the one illustrated earlier, you're paying an upfront cost to enter the trade. This is suitable when you have a strong conviction about the direction the stock will move, and you're willing to pay for the potential to earn a higher profit. However, the money spent upfront is at risk if the stock doesn’t move as anticipated.
- Credit spread: On the flip side, in a credit spread, you receive a premium upfront. This could be more appealing if you prefer to have a cushion against small adverse moves in the stock price. The premium received upfront is yours to keep, providing a buffer that could potentially offset losses should the stock move against your position. However, the potential earnings are capped at the premium received.
Nomenclature: Decoding the terminology
In the realm of options trading, the terminology often reflects the anticipated market direction or the tools (options) used in crafting the strategy. A bull spread indicates an outlook where the trader expects the market price to rise, while a bear spread represents a perspective where the market price is anticipated to fall. The terms call and put in the naming convention point to the type of options utilized. A call spread involves call options and is often used in a bullish scenario, while a put spread involves put options, typically used in a bearish scenario.
Now, intertwining these terms, a bear credit vertical spread could also be termed a call credit spread as selling a call at a lower strike and buying a call at a higher strike is a strategy anticipating a bearish movement, hence “bear,” and it generates a credit upfront, hence “credit.”
Common strategies stemming from vertical spreads
Vertical spreads serve as the foundational blocks for many other common strategies in options trading. Here are some of them:
- Iron condor:
An iron condor is essentially two vertical spreads (one call spread and one put spread) positioned on either side of the market. It's utilized when you expect the underlying asset to remain within a specific price range. - Butterfly spread:
A butterfly spread is a combination of a bull spread and a bear spread, both of which are extensions of the vertical spread. It's used when you expect the price of the underlying asset to either rise or fall to a particular level. - Calendar spread:
While a calendar spread involves options with different expiration dates rather than different strike prices, the concept of buying and selling options simultaneously, as seen in vertical spreads, remains central to this strategy. - Diagonal spread:
A diagonal spread is a mix of a vertical spread and a calendar spread, involving options with different expiration dates and strike prices. It allows for more flexibility in managing price expectations over time. - Double diagonal spread:
A double diagonal spread is a calendar spread and an iron condor rolled into one. It is used when you expect the price of the underlying asset to remain within a certain range, but with the flexibility offered by different expiration dates.
Each of these strategies can be tailored to suit varying market conditions and individual risk appetites, offering a rich toolkit for navigating the options market.
Common undefined risk strategies
After delving into vertical spreads, which form the basis of most defined risk strategies, it's time to step into the realm of undefined risk strategies, should your risk appetite permit. These strategies often come with the potential for higher rewards, but also carry the risk of potentially unlimited losses. A classic example of an undefined risk strategy is the strangle.
Strangle: A common undefined risk strategy
Suppose stock XYZ is trading at $50 and you expect it to stay within a range for a while, but you believe there’s a chance it could make a significant move in either direction. To capitalize on this, you:
- Sell a $45 put for $1 (earning a premium, but taking on the risk if the stock drops significantly).
- Sell a $55 call for $1 (earning another premium, but taking on the risk if the stock rises significantly).
You earn $2 per share upfront, which is the most you could earn. However, your losses could be substantial if the stock makes a large move in either direction, and there's no cap on how much you could lose.
For those with a higher risk appetite, undefined risk strategies offer the potential for greater rewards, and easier adjusting of positions when the market demands, since we don't need to manage the long-legs (the 'insurance' options). Here's a brief look at some:
- Naked call and put:
Selling a call or a put without owning the underlying stock or a protective option is known as selling naked options. This strategy has unlimited risk as the stock price can theoretically rise or fall indefinitely. - Short straddle:
This strategy involves selling a call and a put at the same strike price and expiration date, expecting the stock to stay close to the strike price. It comes with the risk of unlimited losses if the stock makes a significant move in either direction. - Short strangle:
Similar to a straddle but with different strike prices, selling a call and a put on the same stock with the same expiration but at different strikes. This also has potentially unlimited risk if the stock moves significantly. - Short ratio spread:
This involves selling more options than you buy, expecting the stock to stay within a certain range. The potential for loss is unlimited if the stock moves significantly in either direction. - Uncovered calendar spread:
Selling a short-term option and buying a long-term option at the same strike price without covering the position with the underlying stock. The risk is unlimited due to the short-term option.
In Conclusion
Through the journey from understanding the basic tenets of buying and selling options to exploring the myriad strategies possible with combining options, we have enriched our toolkit for navigating the options market. The understanding of defined and undefined risk strategies, along with the comprehension of vertical spreads, serves as a stepping stone to exploring more complex strategies.
By mastering these basics, we open the doors to a more nuanced and potentially rewarding engagement with options trading, while being cognizant of the risks involved. Each strategy comes with its own set of potentials and risks, and it's crucial to align them with our risk tolerance and market outlook. As we continue on this path of learning, the realm of options trading unfolds with a promise of more strategies to explore and master, each with its unique character and potential to enhance our trading experience.
By mastering these basics, we open the doors to a more nuanced and potentially rewarding engagement with options trading, while being cognizant of the risks involved. Each strategy comes with its own set of potentials and risks, and it's crucial to align them with our risk tolerance and market outlook. As we continue on this path of learning, the realm of options trading unfolds with a promise of more strategies to explore and master, each with its unique character and potential to enhance our trading experience.
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Options are complex, high-risk products and require knowledge, investment experience and, in many applications, high risk acceptance. We recommend that before you invest in options, you inform yourself well about the operation and risks. In Saxo Bank's Terms of Use you will find more information on this in the Important Information Options, Futures, Margin and Deficit Procedure. You can also consult the Essential Information Document of the option you want to invest in on Saxo Bank's website.