Options Trading Strategies
How to Profit in Up, Down and Sideways Markets
Options provide sophisticated strategies for speculative trading, hedging, and generating income. But their complexity scares many investors away. This guide aims to demystify options trading strategies, when to use them, and real examples of putting them into practice.
Follow these best practices for navigating options profitably and minimizing risks.
What Are Options?
Options are financial derivatives that give the buyer the right, but not the obligation, to buy or sell an underlying asset at a set “strike” price on or before a specified expiration date.
The underlying asset could be a stock, ETF, futures contract, commodity, or index. Options come it two main varieties:
Calls – The right to buy the underlying asset
Puts – The right to sell the underlying asset
Options enable trading strategies unavailable to just holding the asset itself. The ability to benefit from price moves in either direction or stagnation presents unique opportunities.
Why Trade Options?
Optionality opens up many strategic possibilities:
- Profit on declines – Puts gain value when underlying securities fall.
- Leverage gains – Small amounts of capital can control much larger positions.
- Generate income – Selling options collects premiums from decay or assignment.
- Hedge portfolios – Hedge against losses by purchasing protective puts.
- Speculate on volatility – Profit from increasing or decreasing volatility.
- Enhance yields – Holding assets with overlays of covered calls or cash-secured puts boosts income.
- Access for small accounts – Options allow taking positions with less capital than buying the asset outright.
Used prudently, options offer advantages unavailable to traditional buy and hold investors. But improper use also brings heightened risks of losses from speculation.
Types of Options Trading Strategies
Below are some of the most common options trading strategies deployed by traders:
Long Calls and Puts
Buying call or put options with the hope the underlying security moves favorably to profit on the movement. Simple speculation on a directional move higher or lower.
If you own shares of a stock, you can sell (write) call options on that stock to collect premiums and hedge downside. If called away, you gain the option premium in exchange for selling shares at the strike price.
Cash Secured Puts
Selling puts on a stock you want to own obligates you to buy shares if assigned. Premiums collected lower the effective purchase cost.
Credit and Debit Spreads
Buying one option while selling a similar one at a different strike creates a spread reducing cost but also capping profits with defined risk. Vertical and calendar spreads are common strategies.
Combines a bull put spread with a bear call spread using four different strikes to profit from rangebound sideways trading in the underlying.
Straddles and Strangles
Utilize long calls and puts on both sides of current price to profit from substantial moves either way. Strangles use out-of-the-money strikes for less cost.
Combine bull and bear spreads using three strikes in a symmetrical range to profit from non-movement. Maximizes theta decay benefits.
When to Use Certain Option Strategies
Matching the strategy to market conditions improves results. Consider:
Bullish – Buy calls or run covered calls in rising markets.
Bearish – Buy puts or sell covered puts when dropping.
Neutral – Use credit spreads, iron condors, butterflies when rangebound.
Volatile – Straddles, strangles to benefit from volatile swings.
Sideways – Butterflies, iron condors capitalize on non-movement.
Income – Covered calls and cash secured puts generate income from owned assets.
Tailor your option trade choices to the type of market environment expected.
Managing Risk With Options
While inherently risky, smart risk management improves odds of success:
- Trade small – Limit position size so no single trade creates make or break consequences.
- Use stops – Set stop orders below support levels to limit losses if trades go the wrong way.
- Balance positions – Consider pairing risky directional trades with contrarian hedges to offset potential downside.
- Stick to underlyings you want to own – Selling puts only on stocks you are happy to buy reduces fallout from assignments.
- Go longer-term – Give trades time to work out with expirations at least 2-3 months out.
- Take profits early – Consider closing positions at 50-75% of max profit instead of holding to expiration.
- Avoid overtrading – Stay patient for quality setups meeting your criteria. Overtrading dilutes results through excess commissions and slippage.
Options offer great ways to speculate, hedge, and generate income IF applied prudently.
Real World Examples of Options Trading Strategies
To better visualize implementing common options strategies, consider these real scenario examples:
Covered Calls Example
You own 100 shares of XYZ stock trading at $50 per share. To generate income, you sell 1 call option contract with a $55 strike price that expires in 60 days for a premium of $2 per share ($200 total).
If XYZ closes below $55 by expiration, the calls expire worthless and you keep the $200 premium. But if XYZ rises above $55, the calls may get exercised, forcing you to sell your shares at $55. This caps upside but provides downside protection.
Cash Secured Puts Example
You would like to buy QQQ shares trading at $300 but hope to pay less. You sell a QQQ put option with a $285 strike that expires in 3 months for a $4 premium per share ($400 total premium).
If QQQ stays above $285, the puts expire worthless and you keep the $400 premium. But if QQQ drops below $285, you are obligated to buy 100 shares at $285, less the $400 premium received upfront. This lowers your effective entry cost below current market price.
Iron Condor Example
XYZ stock trades at $50 per share. You think it will trade rangebound between $45 and $55 in the coming month. To capitalize, you construct an iron condor using the following four option legs:
- Sell 1 XYZ call option at $55 strike
- Buy 1 XYZ call option at $60 strike
- Sell 1 XYZ put option at $45 strike
- Buy 1 XYZ put option at $40 strike
You structure the position to collect a net credit of $150 at the outset. If XYZ closes between $45 and $55 at expiration, all the options expire worthless and you keep the $150 credit. Maximum risk is $350 if XYZ closes outside the $40 to $60 range.
Bull Call Spread Example
You believe HYG ETF will rise over the next 2 months from its current price of $75. You buy 1 call option with a $80 strike for $2.00 and simultaneously sell a call at a $90 strike for $0.50.
Your net debit is $1.50 per share ($150 total). If HYG closes above $90 at expiration, the calls max out at a $10 spread value, or $1,000, for a $850 profit after the net debit. Risk is limited to the $150 paid upfront.
These examples demonstrate applying common options strategies in real trading scenarios.
Common Options Trading Mistakes
Some key pitfalls to avoid when options trading:
- Trading options without understanding them – Know how they work before using them.
- Failure to match strategy with market conditions – Applying directional trades in rangebound markets tends to lose.
- Holding to expiration – Close positions early atreasonable profits instead of insisting on maximum payout.
- Suboptimal strike/expiration selection – Strike prices too optimistic and expirations too short are common mistakes.
- Overleveraging account – Don’t risk full account on a single trade. Sizing positions appropriately manages risk.
- Overtrading – Burning through capital with excessive commissions from overtrading kills returns.
- Mispricing wings on credit spreads – Errors like mispricing buy/sell deltas leads to unwanted early assignments.
- Neglecting tax implications – Failing to account for impact of short-term vs long-term gains creates tax headaches.
Avoid these missteps and options can powerfully augment investment returns when applied prudently.
Key Options Takeaways
Options offer dynamic strategies to profit, protect, and generate yield:
- Match strategy to market conditions
- Utilize stops and prudent position sizing
- Stick to high probability setups
- Close winners early
- Accept small losses when trades go against you
- Avoid overtrading and overleveraging
Options provide advantages for seasoned investors comfortable managing risks. But use them carefully as their inherent leverage can accelerate both gains as well as losses.