In this article we will explain 10 of the most common options trading strategies, and provide diagrams for their payoffs functions. Options are a widely traded financial instrument that allow an individual to take a price in an asset without actually owning it.
This is part of my current series on option trading with Python, for those interested in the subject you can view the full series here.
Options involves high risk and therefore we do not advocate trading them! This article is for educational purposes only.
Bull Call Spread
A bull call spread is a strategy in which a trader buys one call option and sells (writes) another. This strategy should be used when the trader believes the stock will increase in value.
This strategy has a cap on the potential profit, the maximum profit is as follows.
Let’s take a quick example.
Option 1 C1: This option has a strike price of $130 and is currently selling at $5
Option 2 C2: This option has a strike price of $90 and is currently selling for $20
Notice on the diagram below that for higher future stock prices on the expiration date the position shows a profit up to a maximum of $25 and for lower ST values the position loses money to a maximum loss of $15.
Bear Call Spread
A bear call spread is the opposite of a bull spread, in this strategy we sell a call option with a lower strike and buy another with a higher strike. This strategy is useful when a trader expects the price of the stock to go down.
Let’s take a specific example to put a bear call spread into context.
Option 1: Call option selling for $2.50 at a strike price of $30.
Option 2: Call option selling for $0.5 at a strike price of $35.
The green section is limited to a maximum of $2 and the red section is limited to a maximum loss of $3.00 as we seen above.
Bull Put Spread
A bull spread using puts can also be constructed. Again this is a strategy we would implement if we took the view that the price of the stock will go up, whilst also limiting our downside. Since we expect the price to go up, we will sell a put option with a higher strike (more valuable at time T_0) and buy another with a lower strike price, the lower strike we buy acts as a way to limit our losses should the stock move against us.
Let’s take an example to put this into context.
Option 1: There is an option selling for $15 with a strike of $110, assume that the stock is currently trading at $100
Option 2: There is an option selling for $4 with a strike of $90.
As we see from the diagram below, the strategy returns a profit up to a maximum of $11 on higher values of the stock price and limits our losses to a maximum of $9.
Bear Put Spread
A bear put spread can be implemented if the trader wants to take a position on the stock decreasing in value. In order to take this position we need to sell one put option with a lower strike price and buy another with a higher strike price. This is a good way to bet against a stock whilst also having limited downside.
Let’s take an example to put a bear spread into context.
Option 1: There is a put option selling for $3 with a strike of $90 for a stock that is currently priced at $100.
Option 2: There is another put option selling for $1 with a strike of $80.
Straddle Strategy
A straddle is a strategy in which a trader buys both a call option and a put option at the same strike price. The idea here is that the trader will benefit from a large move in the price of the underlying stock regardless of the direction of the move. This is an especially useful strategy when a trader predicts a large increase in the uncertainty of an asset price, and the likelihood of a large move, but he is unsure about the direction of the move. For example, say XYZ company earnings are going to be released in the next week, a trader could buy a straddle expecting the company to blow past earnings estimates or dramatically under perform, since we aren’t sure about which of the two scenarios will happen, we can buy both a put and a call.
Since we are buying a call option, the potential profit from entering this strategy is potentially unlimited, however, since we are also buying a put option the cost of entering a strategy such as this is higher than just buying one or the other.
Let’s take an example of a straddle strategy. Say XYZ companies earnings are coming out next week, you observe a call and a put option in the market selling for $5 each at a strike price of $100 and the stock is currently trading at $100 also.
We can also implement a short straddle position if we believe the stock will stay around the area it is currently. Going back to the example of XYZ company, perhaps we take the view that the earnings will be exactly as expected and therefore the news is already priced into the stock, we could sell both a call and a put option to collect the premiums with the view that the stock will be around its current level this time next week.
Clearly there is much more downside risk associated with a short straddle strategy. Below we will examine another possible strategy if we take the view that the stock will stay approximately at its current levels.
Butterfly Strategy
As we mentioned for the reverse straddle strategy, the downside is potentially unlimited for entering this position. Say a trader wants to target the same area of the curve, but wants to limit his downside, a butterfly spread strategy is a good option in this case.
The strategy makes money if the underlying stock price stays around its current level. To enter into a butterfly strategy we should buy one deep in-the-money call and one out of the money call, to balance the long call positions, we would sell 2 options at the same strike.
Recall the discussion on a short straddle, where the trader takes the view that the underlying price will be approximately at the same level it is is now, the butterfly strategy is perhaps a better option as the payoff is realized should the trader’s view is correct, with a limited downside should the stock move strongly in either direction.
Lets take an example to show how butterfly strategies can be implemented.
A stock is selling at $100 currently and a trader want to take a position on the price of the stock in 1 month will be approximately where it is now ($100).
Option 1: BUY a call option with strike price $94 for $8
Option 2: BUY a call option with a strike price $106 for $2
Option 3: SELL TWO call options with a strike price of $100 for $4 each for a total of $8.
Reverse Butterfly Strategy
Of course we can also take a short butterfly position. This position can be taken if we wanted to take the view that the stock is likely to move away from its current level but we also want to have reduced downside. This simply involves doing the opposite from the long Butterfly position
Strangle Strategy
A strangle strategy is similar to a straddle in that the trader wants to take a position that will profit from a large change in the underlying stock price. The difference between a strangle and a straddle is that with a strangle the strike prices of the two options are different whereas in a straddle they are the same. To enter a strangle is cheaper than a straddle, but the stock will need to move further in order for the trader to realize a profit.
Consider a stock that is currently trading at $100 per share, you observe two options in the market.
Option 1: A call option for $4 with a strike at $130
Option 2: A put option for $5 with a strike at $70
To enter into a strangle you would buy both these options. For this strategy to make money the stock must be less than $61 or greater than $139. This is due to the fact that the cost of entering the strategy is $9 and to make money we need to be above/below either strike at expiration plus the cost of entry.
An Iron Condor strategy involves buying both a bull put spread and a bear call spread simultaneously, this is similar to a butterfly strategy except the returns are more spread out and the maximum profit is realized at a range of stock prices at expiration. There is also limited downside should the stock make a large move in either direction.
An example of an Iron Condor is given below. Assume that stock is currently trading at $100
Bull Put Spread.
Option 1: SELL a put with a strike of $90 for $4.
Option 2: BUY a put with a strike of $80 for $2
Bear Call Spread
Option 3: SELL a call with a strike price of $110 for $4.
Option 4: BUY a call with a strike price of $120 for $2.
Notice that we max a profit as long as the stock stays within a range around the current stock price. With limited downside if the stock experiences a large move in either direction.
Custom Strategy
Of course traders are not limited to these set strategies and they can create their own to target different ranges of stock prices at expiration. Below we give an example of buying and selling both calls and puts and show the resulting payoff diagram.
You can use this Python script to generate your own strategies and observe the resulting potential payoffs in a Diagram.
