Different Strategies to Trade in Options

Options strategies are combinations. We shall look at various types of options strategies along the way and also now apply such option trading strategies along the way. The main idea to understand is that option trading strategies are combinations of two or more options positions or futures and options positions to be able to define a risk-reward ratio.

Strategies for options trading can be aggressive, defensive, or even submissive at times. Some of the options strategies are very basic and you can almost call them option trading strategies for beginners. Let us look at such option trading strategies for beginners and also look in detail at the different option trading strategies available to the trader.

What is Different Strategies to Trade in Options?

Option trading strategies are possible due to the very unique nature of options; being asymmetric. That means; the buyer has unlimited benefits and the seller has unlimited liability. Broadly, option trading strategies can be divided into 6 categories viz:

  • Bullish strategies
  • Bearish strategies
  • Moderately bullish strategies
  • Moderately bearish strategies
  • Volatile strategies
  • Range bound strategies

In option trading strategies the third and the fourth are not exactly unique but are part of the first two. But since they are quite a popular option trading strategy, we have included them separately. We will now take a look at various option trading strategies for greater clarity. We will also bucket them into some key segments for a better understanding of option trading strategies.

These are the 3 most basic strategies for option trading that are used regularly. Within the gamut of strategies for option trading, we start with 3 strategies easy to understand and simple to execute.

Protective Put strategy

This is one of the very common strategies for option trading and is also widely used and deployed by professional and rookie traders. What do you do if you bought a stock to hold from a long-term perspective? Unfortunately, after you buy the stock, the sector goes into a downturn and you expect the stock to be weak in the short run. What do you do? Are there any strategies for option trading that you can apply?

You can exit the stock but it has a cost in terms of loss of opportunity, transaction costs, and tax implications. A good strategy for options trading to be applied here is the “Protective Put” strategy. In a protective put, you hold the cash market positions but simultaneously buy a lower put option, which is nothing but a right to sell the stock. How does the payoff work? Let us look at the nuances of this strategy for options trading.

On the upside, you have unlimited profits once put option premium cost is covered. On the downside, the risk is limited to the difference between (purchase price – put option strike price) + option premium. That is your maximum loss. Quite often traders book profits in the put and hold the stock. You can do that knowing the risks.

Covered Call strategy

Another interesting strategy for options trading is the covered call but it is not exactly a limited risk strategy. The covered call as a strategy for options trading can be effectively used to reduce the cost of holding a stock when it does not move for a long time. In this strategy, you sell higher call options, earn the premium and reduce the cost of holding the stock. Over a longer period, this strategy for options trading makes a lot of sense.

While you are covered on the upside, your downside is open. So, you must be careful to only do this in stocks you intend to hold for a long time. However, on the upsides, you don’t have much to worry about in this strategy for options trading. That is because if the price shoots above the strike price, then the losses on the sold call can be unlimited but it would be fully covered by your long stock position.

Collar strategy

A slightly more defensive strategy for options trading compared to covered call is the collar strategy. In a collar, there are 3 phases to the strategy. First, you are long on the stock. Secondly, you buy a lower put option. Thirdly, you sell a higher call option. As a result, your loss or risk is protected on both sides. The beauty of the collar strategy is that it is a limited loss and limited profit strategy. Such strategies are called closed option strategies but they entail a higher cost due to multiple legs, so you must factor that in while using these kinds of strategies for option trading.

Long and Short Strangle strategy

The strangle strategy involves buying two options of different strike prices and the same maturity. A long strangle position is created by buying a higher strike call and a lower strike put option of the same expiry whereas a short strangle is created by selling a higher strike call and a lower strike put option of the same expiry. A long strangle is a volatile strategy that will be profitable when the stock is highly volatile and exhibits a sharp movement on the upside or the downside. The short strangle works in a range-bound market where you can play for profits in a range.

Different Strategies to Trade in Options

These are smart strategies for making the best of pricing and price differentials. This may sound a tad complicated but actually, it is quite simple. In a nutshell, spread trades are about limited profit and limited loss positions. Spreads fall in one of the below categories.

  1. Vertical Spreads are created by using options having the same expiry but different strike prices. Vertical spread can be bullish vertical spreads or bearish vertical spreads. Bull call spreads and bears put spreads are two of the most popular vertical spreads and we shall dwell on these two strategies in detail.
  2. In a bull call spread, you buy a lower strike call and sell a higher strike call. Hence your net cost is the difference between the two premiums and that is also the maximum loss in the strategy irrespective of where the price goes. Profits are limited to the upper call writing limit. Just as a bull call spread is a moderately bullish strategy, the bear put spread is a moderately bearish strategy.
  3. Horizontal spreads are popularly called calendar spreads where you buy and sell the same contract and strike but across different strikes. For example, buying a Nifty 15,500 July call and selling a Nifty 15,500 August call is an example of horizontal spread.
  4. Diagonal spreads are normally referred to as pairs and are more based on statistical relationships and are not exactly limited risk models. They are a tad more aggressive. Normally, such diagonal spreads are common in the OTC markets.

Different types of options

There are different ways to classify options.

  • Based on the view of the traders, it can be a right to buy (call option) or a right to sell (put option).
  • In terms of moneyness, it can be an ITM option, ATM option, or OTM option.
  • Finally, in terms of structure, options can be American or European.

What is a put-call ratio?

It is the ratio of puts to calls and can be seen as the put/call ratio of volumes or the put/call ratio of open interest.

Frequently Asked Questions Expand All

There is nothing like the best strategy and one needs to devise the strategy based on the situation and risk-reward as well as risk appetite.

Start with trading small quantities of index options, buy under-priced options and keep stop losses to tame risk.