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Stock Option Trading


Option Trading Strategies

Stock Option Trading Strategies - picture of an animated stock trader checking a chart for trading options as the market trends higher over time with increasing prices

Various market participants use options for a variety of reasons. These market participants can be broadly split into two distinct groups.

Market participants use options:

  • The first group consists of those market participants who exclusively trade options and they are referred to as Options Traders. These market participants typically utilize their entire account for the sole purpose of trading options.
  • The second group are those market participants who only use options as a supplementary tactic for their primary stock investing, trading or speculative strategies. These market participants only occasionally utilize options and any option tactics only utilize a small portion of their account. Their primary focus is on stocks.

The purpose of this article is to provide stock traders, investors and speculators with an overview of the option strategies most commonly used by options traders. These strategies may at first seem quite different from the usual buy a stock and sell a stock tactics with which most market participants are familiar with.

Strategies utilized by option traders typically incorporate the principle of the spread. The spread is a financial concept where a strategy profits from the difference between the price movements of two or more financial instruments. In the case of options trading, the financial instruments are options.

Stock Option Trading Strategies - picture of sign saying trader in large font dark blue capital letters on a light blue glass background

Option traders also usually incorporate the time decay into their strategies by including short sold options. Generally option trading strategies involve two to four different option contracts for the stock and may use combinations of call and/or put options along with long and/or short options.

While option traders are solely interested in the price moves of the options, they are still dependant on the price moves of the stock. The strategies utilized still require the option trader to have a view on the stock's price movement. The three basic views are that the stock price will rise, that stock price will decline or that the stock price will not move much and essentially trade in a trading range.

The strategies used by options traders are designed to provide different profit and loss characteristics. Some strategies are designed to limit the loss which also generally limits the profit potential. Other strategies are designed to profit when the stock price does not move much, while other strategies profit when the stock price moves either up or down or both.

Some common two option strategies are:

Two option strategies:

  • Call Spread: This strategy has a limited profit when the stock price rises and has a limited loss when the stock price declines.
  • Put Spread: This strategy has a limited profit when the stock price declines and has a limited loss when the stock price rises.
  • Long Call and Put: This strategy has a unlimited profit when the stock price rises or declines and has a limited loss when the stock price does not move much.
  • Short Call and Put: This strategy has a limited profit when the stock price does not move much and has an unlimited loss when the stock price rises or declines.

Some common three option strategies are:

Three option strategies:

  • Long Butterfly: This strategy has a limited profit when the stock price does not move much and has a limited loss when the stock price rises or declines.
  • Short Butterfly Call: This strategy has a limited profit when the stock price does not move much and has a limited loss when the stock price rises or declines.
  • Short Butterfly Put: This strategy has a limited profit when the stock price rises or declines and has a limited loss when the stock price does not move much.

Some common four option strategies are:

Four option strategies:

  • Iron Condor: This strategy has a limited profit when the stock price does not move much and has a limited loss when the stock price rises or declines.
  • Reverse Iron Condor: This strategy has a limited profit when the stock price rises or declines and has a limited loss when the stock price does not more much.
  • Iron Butterfly: This strategy has a limited profit when the stock price does not move much and has a limited loss when the stock price rises or declines.

While there are many more strategies which option traders use the above are the more commonly used strategies.

As a general rule option traders are not interested in exercising options or in being assigned on short sold options. Their sole interest is in profiting from the options directly.

Options traders do face an increased risk due to the complexity of their strategies.

The Options Clearing Corporation (OCC) has published a document called "The Characteristics and Risks of Standardized Options" which is available from the Chicago Board Options Exchange (CBOE) in a PDF format. A detailed summary of the risks is provided in the article Risk Considerations with Options.

Most of the risks outlined in the OCC document are common sense but beginner option traders are mostly caught out by these risks.

Strategies using Two Options

Stock Option Trading - picture of an option trader looking at a stock chart as it goes higher with a strong uptrend deciding the best strategy to use

Options strategies which use two options are the simplest strategies to establish as options trader only needs to deal with two options.

Some of the following option strategies require At-The-Money options. In reality it is difficult to establish an options position when the stock price is exactly at a strike price and so options traders simply use an option strike with is closest to the current stock price.

Options traders simply refer to short selling options as selling. Also the terms Long and Short are used to describe a bought option and a short sold option.

Call Spread

The Call Spread consists of the following options:

  • Buy At-The-Money call option
  • Sell Out-The-Money call option

Both call options are over the same stock and have the same expiry date.

options call spread profit

Referring to the Profit & Loss graph, the Call Spread is a strategy used by options traders when their view is that the stock's price will increase. The Call Spread has a limited profit potential when the stock price rises and has a limited loss should the stock price decline.

The Call Spread reduces the cost outlay required compared to simply buying a call option as the option trader receives the premium from short selling a second call option. The premium received also helps offset the time decay from the bought call option.

When the stock price rises, the long call option increases in value faster than the loss in the short call option resulting in a net profit.

When the stock price declines, the loss in the value of the long call option is greater than the increase in value of the short call option resulting in a net loss.

A variation to the Call Spread is to buy an Out-The-Money call option instead of At-The-Money and to sell a call option which is even more Out-The-Money.

The Out-The-Money Call Spread consists of the following options:

  • Buy Out-The-Money call option
  • Sell more Out-The-Money call option

Using Out-The-Money call options reduces the cost outlay for implementing the strategy but also reduces the profit potential.

Put Spread

The Put Spread consists of the following options:

  • Buy At-The-Money put option
  • Sell Out-The-Money put option

Both put options are over the same stock and have the same expiry date.

options put spread profit

Referring to the Profit & Loss graph, the Put Spread is the reverse of the Call Spread and is a strategy used by options traders when their view is that the stock's price will decline. The Put Spread has a limited profit potential when the stock price declines and has a limited loss should the stock price rise.

The Put Spread reduces the cost outlay required compared to simply buying a put option as the option trader receives the premium from short selling a second put option. The premium received also helps offset the time decay from the bought put option.

When the stock price declines, the long put option increases in value faster than the loss in the short put option resulting in a net profit.

When the stock price rises, the loss in the value of the long put option is greater than the increase in value of the short put option resulting in a net loss.

A variation to the Put Spread is to buy an Out-The-Money put option instead of At-The-Money and to sell a put option which is even more Out-The-Money.

The Out-The-Money Put Spread consists of the following options:

  • Buy Out-The-Money put option
  • Sell more Out-The-Money put option

Using Out-The-Money put options reduces the cost outlay for implementing the strategy but also reduces the profit potential.

Long Call and Put

The Long Call and Put strategy consists of the following options:

  • Buy At-The-Money call option
  • Buy At-The-Money put option

Both options are over the same stock and can have different expiry dates.

options long call put profit

Referring to the Profit & Loss graph, the Long Call and Put strategy is used by options traders when their view is that the stock's price will move significantly either up or down. The Long Call and Put strategy has a unlimited profit when the stock price rises or declines and has a limited loss when the stock price does not move much.

The Long Call and Put strategy involves buying two options and does not benefit from any premiums from short positions and thus the cost outlay required is higher than other strategies.

If the stock price does not move, the option trader losses the premium paid for both options. If the stock rallies the call option profits but is hindered by the loss of the put option. Similarly if the stock declines then the put option profits but is hindered by the loss of the call option.

A variation to the Long Call and Put strategy is to buy Out-The-Money options instead of At-The-Money options.

Yet another variant for the Long Call and Put strategy is buy In-The-Money options instead of At-The-Money options.

Basically any combination of call options and put options can be used with this strategy.

Short Call and Put

The Short Call and Put strategy consists of the following options:

  • Sell At-The-Money call option
  • Sell At-The-Money put option

Both options are over the same stock and have the same expiry dates.

options short call put profit

Referring to the Profit & Loss graph, the Short Call and Put strategy is used by options traders when their view is that the stock's price will move not move much. The Short Call and Put strategy has a limited profit when the stock price does not move much and has an unlimited loss when the stock price rises or declines.

The Short Call and Put strategy involves selling both a call option and a put option and thus receives the premiums from both options but this strategy does have a margin requirement and as such the cost outlay required is similar to many other strategies.

If the stock price does not move, the option trader effectively keeps the premium received from both options. If the stock rallies then the call option increases in value and the loss incurred exceeds the premiums received and results in a net loss. Similarly if the stock declines then the put option increases in value and the loss incurred exceeds the premiums received and results in a net loss.

A variation to the Short Call and Put strategy is to sell Out-The-Money options instead of At-The-Money options.

Yet another variant for the Short Call and Put strategy is sell In-The-Money options instead of At-The-Money options.

While any combination of selling call options and put options can be used, the Short Call and Put strategy has the greatest profit potential with options At-The-Money since the time value is the greatest.

Summary

While there are many more strategies which option traders use the above are the more commonly used strategies which utilize two options.

As a general rule option traders are not interested in exercising options or in being assigned on short sold options. Their sole interest is in profiting from the options directly.

Options traders do face an increased risk due to the complexity of their strategies.

The Options Clearing Corporation (OCC) has published a document called "The Characteristics and Risks of Standardized Options" which is available from the Chicago Board Options Exchange (CBOE) in a PDF format. A detailed summary of the risks is provided in the article on Option Trading Risks.

Most of the risks outlined in the OCC document are common sense but beginner option traders are mostly caught out by these risks.

Strategies using Three Options

Stock Option Trading - picture three option traders standing in front of a large wall computer screen with a stock increasing in price deciding on the strategy to use

Options strategies which use three options are more complex than simpler two option strategies. The options trader now needs to establish three separate positions. Some options traders will leg into their positions by entering one option at a time when the option prices are favorable for a particular option.

Some of the following option strategies require At-The-Money options. In reality it is difficult to establish an options position when the stock price is exactly at a strike price and so options traders simply use an option strike with is closest to the current stock price.

Options traders simply refer to short selling options as selling. Also the terms Long and Short are used to describe a bought option and a short sold option.

Long Butterfly

The Long Butterfly strategy consists of the following options:

  • Buy Out-The-Money call option
  • Sell 2 At-The-Money call options
  • Buy In-The-Money call option

All options are over the same stock and usually have the same expiry dates. However the long call options can also have expiry dates after the short call options.

options long butterfly profit

Referring to the Profit & Loss graph, the Long Butterfly strategy is used by options traders when their view is that the stock's price will not move much. The Long Butterfly strategy has a limited profit potential when the stock price does not more much and has a limited loss should the stock price rise or decline.

The Long Butterfly strategy involves selling two call options which balance the In-The-Money and Out-The-Money call options. This strategy receives the premiums from two short options and as such the cost outlay required is quite small.

If the stock price does not move, the option trader effectively keeps the premium received from both short options. If the stock rallies then the two short options increases in value and the loss incurred exceeds the premiums received and the profit from the long call options. If the stock declines then the two short options decrease in value but the profit is less than the loss incurred from the long options.

When the stock prices is not at a strike price, rather than selling two call options at the same strike, a variation to the Long Butterfly strategy is to sell one just Out-The-Money call option and sell one just In-The-Money call option.

Another variation with the Long Butterfly is to buy the Out-The-Money and In-The-Money call options with an expiry date with is longer than that of the short call options. This reduces the time decay loss with the Long options.

Short Butterfly Call

The Short Butterfly Call strategy consists of the following options:

  • Sell Out-The-Money call option
  • Buy 2 At-The-Money call options
  • Sell In-The-Money call option

All options are over the same stock and usually have the same expiry dates. However the long call options can also have expiry dates after the short call options.

options short butterfly call profit

Referring to the Profit & Loss graph, the Short Butterfly Call strategy is used by options traders when their view is that the stock's price will move significantly either up or down. The Short Butterfly Call has a limited profit potential when the stock price rises or falls and has a limited loss should the stock price not more much.

The Short Butterfly Call strategy involves buying two call options which balance the In-The-Money and Out-The-Money short call options. This strategy receives the premiums from two short call options however the margin requirements can be quite high and as such the cost outlay required is generally higher than other strategies.

If the stock price rises, the two long call options increase in value faster than the short call options lose. When the stock price declines, the two short call options lose value faster than the two long call options gain. However when the stock price does not move much, the value of both long call options declines towards zero offsetting the premiums from the short call options resulting in a loss.

When the stock prices is not at a strike price, rather than buying two call options at the same strike, a variation to the Short Butterfly Call strategy is to buy one just Out-The-Money call option and buy one just In-The-Money call option.

Another variation with the Long Butterfly is to buy the two At-The-Money call options with an expiry date with is longer than that of the short call options. This reduces the time decay loss with the long call options.

Short Butterfly Put

The Short Butterfly Put strategy consists of the following options:

  • Sell Out-The-Money put option
  • Buy 2 At-The-Money put options
  • Sell In-The-Money put option

All options are over the same stock and usually have the same expiry dates. However the long put options can also have expiry dates after the short put options.

options short butterfly put profit

Referring to the Profit & Loss graph, the Short Butterfly Put strategy is a variation to the Short Butterfly Call strategy and is used by options traders when their view is that the stock's price will move significantly either up or down. The Short Butterfly Put has a limited profit potential when the stock price rises or falls and has a limited loss should the stock price not more much.

The Short Butterfly Put strategy involves buying two put options which balance the In-The-Money and Out-The-Money short put options. This strategy receives the premiums from two short put options however the margin requirements can be quite high and as such the cost outlay required is generally higher than other strategies.

If the stock price rises, the two short put options increase in value faster than the long put options lose. When the stock price declines, the two short put options lose value faster than the two long put options gain. However when the stock price does not move much, the value of both long put options declines towards zero offsetting the premiums from the short put options resulting in a loss.

When the stock prices is not at a strike price, rather than buying two put options at the same strike, a variation to the Short Butterfly Put strategy is to buy one just Out-The-Money put option and buy one just In-The-Money put option.

Another variation with the Short Butterfly Put is to buy the two At-The-Money put options with an expiry date with is longer than that of the short put options. This reduces the time decay loss with the long put options.

Summary

While there are many more strategies which option traders use the above are the more commonly used strategies which utilize three options.

As a general rule option traders are not interested in exercising options or in being assigned on short sold options. Their sole interest is in profiting from the options directly.

Options traders do face an increased risk due to the complexity of their strategies.

The Options Clearing Corporation (OCC) has published a document called "The Characteristics and Risks of Standardized Options" which is available from the Chicago Board Options Exchange (CBOE) in a PDF format. A detailed summary of the risks is provided in the article on Option Trading Risks.

Most of the risks outlined in the OCC document are common sense but beginner option traders are mostly caught out by these risks.

Strategies using Four Options

Stock Option Trading - picture of a stock trader scratching his head on what strategy to use for the stock that is in a strong uptrend shown against a light blue background panel

Options strategies which use four options are more complex than simpler two option strategies or even the three option strategies. The options trader now needs to establish four separate positions. Some options traders will leg into their positions by entering one option at a time when the option prices are favorable for a particular option.

Some of the following option strategies require At-The-Money options. In reality it is difficult to establish an options position when the stock price is exactly at a strike price and so options traders simply use an option strike with is closest to the current stock price.

Options traders simply refer to short selling options as selling. Also the terms Long and Short are used to describe a bought option and a short sold option.

Iron Condor

The Iron Condor strategy consists of the following options:

  • Buy deep Out-The-Money call option
  • Sell Out-The-Money call options
  • Sell Out-The-Money put option
  • Buy deep Out-The-Money put option

All options are over the same stock and have the same expiry dates.

options iron condor profit

Referring to the Profit & Loss graph, the Iron Condor strategy is used by options traders when their view is that the stock's price will not move much. The Iron Condor strategy has a limited profit potential when the stock price does not move much and has a limited loss should the stock price rise or decline.

The Iron Condor strategy involves buying and selling Out-The-Money call options and also buying and selling Out-The-Money put options. The premium received from the short options is greater than costs of the long options but the short positions do have margin requirements.

If the stock price does not move much, the option trader effectively keeps the premium received from both short options. If the stock rallies then the net loss incurred from put options exceeds the net profit made on the call options. Similarly if the stock price declines the net loss made on the call options exceeds the net profit made on the put options.

The deep Out-The-Money options can simply be the next strike price level after the strike selected for the Out-The-Money options.

Reverse Iron Condor

The Reverse Iron Condor strategy consists of the following options:

  • Sell deep Out-The-Money call option
  • Buy Out-The-Money call options
  • Buy Out-The-Money put option
  • Sell deep Out-The-Money put option

All options are over the same stock and usually have the same expiry dates. However the long options can also have expiry dates after the short options.

options reverse iron condor profit

Referring to the Profit & Loss graph, the Reverse Iron Condor strategy is used by options traders when their view is that the stock's price will move significantly either up or down. The Reverse Iron Condor strategy has a limited profit potential when the stock price rises or falls and has a limited loss should the stock price not more much.

The Reverse Iron Condor strategy involves buying and selling Out-The-Money call options and also buying and selling Out-The-Money put options. The premium received from the short options is less than costs of the long options and the short positions also have margin requirements.

If the stock price rises, the long call option and the short put option increases in value. Similarly when the stock price declines, the long put option and the short call option increases in value.

However when the stock price does not move much, the value of the long options declines towards zero offsetting the premiums from the short options resulting in a loss.

The deep Out-The-Money options can simply be the next strike price level after the strike selected for the Out-The-Money options.

A variation with the Reverse Iron Condor is to buy the two long options with an expiry date with is longer than that of the short options. This reduces the time decay loss with the long call options.

Iron Butterfly

The Iron butterfly strategy consists of the following options:

  • Buy Out-The-Money call option
  • Sell At-The-Money call options
  • Sell At-The-Money put option
  • Buy Out-The-Money put option

All options are over the same stock and have the same expiry dates.

options iron butterfly profit

Referring to the Profit & Loss graph, the Iron butterfly strategy is used by options traders when their view is that the stock's price will not move much. The Iron butterfly strategy has a limited profit potential when the stock price does not move much and has a limited loss should the stock price rise or decline.

The Iron butterfly strategy involves selling At-The-Money options and also buying Out-The-Money options to cover the short options. The premium received from the short options is greater than costs of the long options but the short positions do have margin requirements.

If the stock price does not move much, the option trader effectively keeps the premium received from both short options. If the stock rallies then the net loss incurred from short options exceeds the net profit made on the long call option. Similarly if the stock price declines the net loss made on the short options exceeds the net profit made on the long put option.

All options are over the same stock and usually have the same expiry dates. However the long options can also have expiry dates after the short options.

A variation with the Iron Butterfly is to buy the two long options with an expiry date with is longer than that of the short options. This reduces the time decay loss with the long call options.

Summary

While there are many more strategies which option traders use the above are the more commonly used strategies which utilize four options.

As a general rule option traders are not interested in exercising options or in being assigned on short sold options. Their sole interest is in profiting from the options directly.

Options traders do face an increased risk due to the complexity of their strategies.

The Options Clearing Corporation (OCC) has published a document called "The Characteristics and Risks of Standardized Options" which is available from the Chicago Board Options Exchange (CBOE) in a PDF format. A detailed summary of the risks is provided in the article on Option Trading Risks.

Most of the risks outlined in the OCC document are common sense but beginner option traders are mostly caught out by these risks.

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