Options Trading Part 3 - Trading Strategies

There are various strategies that can be employed using options to counter different market conditions. Equity Options can be used as a hedge and also speculate on the underlying securities. For example if an investor thinks that an underlying security is getting bearish in the coming weeks. He can counter the downturn with the following moves.

1. Sell a call option
2. Buy a put option

If he is bullish on the underlying security then he may employ the following moves.

1. Buy a call option
2. Sell a put option

However there are more complex strategies that are available in trading options and it is not suitable for many investors. We shall address the strategies below.


1. Straddles
A Straddle is made up of one put and one call option on one underlying security that is having the same strike price and expiry. So in a straddle, the investor buys or sells two identical options except one is put and the other is call. The investor can either have a long or short straddle.


Long Straddle
After studying the volume accumulation of IBM and its price patterns, the investor feels that IBM is going to make a move but not sure whether up or down. What she can do is the following.

Buy 1 IBM Aug 130 Call - Premium 10
Buy 1 IBM Aug 130 Put  - Premium  7

By this, it means that she will be participating in either an upward or downward movement of IBM. Please note that the total premium she paid was 17 points, and her initial investment is $1700 (10x100 shares + 7x100 shares).

So by August, IBM shares must be at 147 (130+17) for the call or 113 (130-17) for the put options, in order for it to break even. So the beauty about this strategy is that if the IBM stock goes above 147 or below 113, then it will start generating a profit. This represents an unlimited gain versus limited loss which is the premium of $1700. However, the investor seldom lose all the premium because she can cut loss in between.


Short Straddle
A short straddle is exactly the opposite. What she can do is the following.

Sell 1 IBM Aug 130 Call - Premium 10
Sell 1 IBM Aug 130 Put  - Premium  7

Instead of paying for the premium, an investor who sells an option receives the premium. So, as long as the stock price hovers between 147 (130+17) for the call or 113 (130-17), the investor will retain some of the premium as profit. However the risk and reward for the investor who sells a straddle is different from the person who buys a straddle.  This is because the maximum profit of the person who sold the above straddle is equivalent to $1700, but she will assume unlimited risk if say the stock price goes above 130.

In other words she is selling (writing in option lingo) an uncovered call in this case. So by selling a straddle, she will be exposed to limited profits but unlimited losses. 


# If you are not familiar with options, it will better limit yourself, to buying and not selling options because the risk is too high.

2. Strip

If the investor feels that the market direction is bearish for IBM, instead of buying a straddle she can buy a strip. A strip consists of 2 puts and one call. An example will be the following.

Buy 1 IBM Aug 130 Call - Premium 10
Buy 2 IBM Aug 130 Put  - Premium  7

So if IBM were to go down, the investor will have a bigger profit. Say if IBM dropped to 110, then there will be a profit of 40 points (2 put options x 20 points). The total premium paid is 24 points (1 call x 10 + 2 puts x 7). So the net profit gained will be 40 points – 24 points premium = 16 points.

It will be a different story if the stock price rose. The investor need at least a 24 points gain in IBM stock to cover its premium so that she will be break even. In other words, IBM stock will need to rise to at least 154 so that she can exercise her call at 130 and sell the stock at 154.


3. Strap
If the investor feels that the market direction is bullish for IBM, instead of buying a straddle she can buy a strap. A strap consists of 2 calls and one put. An example will be the following.

Buy 2 IBM Aug 130 Call - Premium 10
Buy 1 IBM Aug 130 Put  - Premium  7

So if IBM were to go up, the investor will have a bigger profit. The effect will be the opposite of our strip strategy earlier. These are different forms of straddle but varying the degree of puts and calls, by capitalizing on the market condition, whether it is bullish or bearish.


4. Combination
A combination will be an event where the underlying stock is the same but the strike price or the expiration date is different. An example of a straddle with a different strike price is shown below.

Buy 1 IBM Aug 135 Call - Premium 10
Buy 1 IBM Aug 130 Put  - Premium  7

As you can see, the strike price for the call is 135, whereas the put is 130. To achieve a break even, the stock price had to be at least 152 for the call option or 113 for the put option. Anything above 152 and below 113 will represent ‘additional profits’. However if the stock price is exactly at 135 or 130 then the investor will lose all of her premium of $1700. However, this is a highly unlikely scenario.

An example of a straddle with a different expiry date is shown below.

Buy 1 IBM Aug 130 Call - Premium 10
Buy 1 IBM Sep  130 Put  - Premium  9

In this case, the strike price is the same at 130, but the expiry date is different. Call on August and Put on September. The extra month of expiry of the Put will raise the premium to 9. In this case the extra risk involved will be the extra month for the Put to expiry. If it is let uncovered, what will happen when the stock price go up to 180 in September? The investor will have to bear the losses of 50 points (180-130) x 100 shares = $5000. So the potential losses in this case will be unlimited.

5. Other Strategies

There are other more sophisticated strategies which I think should reserved for professional options traders. Some of them are dealing in more than 3 options at one time. An example will be the butterfly spreads whereby it involves buying 1 low price call option, 1 higher price call option and selling 2 call options with a price in between the buy call options.
It can be illustrated below.


Buy 1 IBM Aug 130 Call - Premium 10
Buy 1 IBM Aug 150 Call - Premium 12
Sell 2 IBM Aug 140 Call - Premium 9


In this case an investor will only make a profit if the stock price is trading in between 130 and 150. The premium paid by the investor is 10+12-(2x9) = 4 points. So if the stock price move out of this range then the maximum the investor can lose is 4 points. Other strategies includes the following.

1. Spreads which can be divided to Bull, Bear, Butterfly, Calendar and Diagonal
2. Iron Condor when an investor believes the stock will trade in a range until expiry
3. Collar is used when an investor already own a stock but looking to,
• increase return by writing call option
• minimize downside by buying put option
4. Guts used when bullish in volatility. Buy 2 calls , one with higher strike price

Alright, that basically sums up our Trading Strategies and next we will look into how Big Money and Insiders manipulate the Stock Market using Options


P/s : Part 4 will be addressing the issue of how BIG money and Insiders using Options to manipulate stock markets.