While options can be traded by themselves, investors often use them in conjunction with other securities. So before going further, let’s consider the four basic ways that options trades are structured.
You Can Trade Options by Themselves
As we learned in a previous lesson, long calls gain value when stocks rise and long puts gain value when stocks fall. Traders looking for a rally can buy calls and traders looking for a drop can buy puts.
Simplicity is the main benefit of this approach. However, buying and selling single options can be more expensive because you have to pay the entire premium. That higher cost increases your potential loss.
In general these are the cases when the single-option, or single-leg, strategy makes sense:
- Short-term trading: Buying and selling from one day to the next.
- You see an extended move: If you think a stock has the potential to keep running, then an individual call or put offers the most potential profit.
- The stock is less liquid: Because you can never avoid paying the bid/ask spread, it makes sense to trade less-liquid underliers less often. That’s when a single, longer-dated contract can make sense.
Spreads are one of the most common techniques in the options market. This is when you buy one contract and sell another on the same underlier to create a single position.
Cost management is the first reason for this. Selling, or writing, an option, generates a credit. That reduces the cost of buying another option. However, transaction costs can be higher because each leg of the spread has its own bid/ask spread. (These are two completely different meanings of the word “spread.”)
Traders often position for a move in a specific direction with “vertical” spreads:
- Buy a call or put near the money
- Sell a call or put further out of the money
- Profit from a move between the two
There are also “calendar,” or “horizontal,” spreads. These make money from time decay, with a directional bias:
- Buy a longer-term call or put out of the money.
- Sell a short-term call or put out of the money.
- Both contracts must have the same strike price, but different expirations.
- Profit from the shorter-term options losing value (time decay) faster.
Future lessons will cover “calendars” and “verticals” in more detail.
Another common strategy is the “covered call.” This is when you own a stock and sell calls against it.
Say you have 100 shares of Company X worth $50 each in your portfolio, for a $5,000 value. Say the 55 calls expiring next month have a bid / ask of $1 / $1.10. You could write a call for $1.
That would give you $100 in cash, raising your account’s value to $5,100.
If Company X stays under $55 through expiration the calls become worthless. You keep the $100 — a classic example of shorting something you expect to lose value.
If Company X rallies above $55 by expiration, you will have to deliver your shares for $55. Because you sold the calls for $1, your effective exit would be $56.
- The drawback is limited upside. If Company X goes to $100, you still only get $56.
- The benefit is income. If Company X drifts to $53, you still keep $1 per share of extra money.
- The main risk is significant downside in the underlying stock, which you must hold as long as the short calls are open.
Generally investors sell covered calls on stocks they expect to trend higher over time. They’re willing to give up some gains in return for an income stream. Those premiums can also offset losses if the shares fall.
We’ll explore more on covered calls in a future post.
Straddles and Strangles
The three strategies outlined above either profit from a directional move, or at least have a directional bias. Straddles and strangles are a fourth kind of strategy that approach the market differently.
- A straddle consists of buying calls and puts in the same underlier at the same strike near the stock’s current price. The result is that the trader will profit from a big move either up or down.
- A strangle is similar. It consists of buying calls and puts on either side of the current price. For example if a stock’s at $80, you could create a strangle by purchasing the 75 puts and the 85 calls.
Both of these strategies profit from volatility increasing. (We’ll discuss volatility in future posts.) However, they’re both expensive because you have to pay for two contracts — unlike a spread. You also know that one of the two contracts will lose value if the other gains. A rally in the stock will inflate the calls and hurt the puts and vice versa.
It’s also worth knowing the two related strategies combine straddles and strangles with vertical spreads.
- Iron butterflies are “straddles with wings.” They consist of buying calls and puts the same price and then selling contracts further from the money. For example, if a stock is at $80, the trader would:
- Buy 80 call
- Sell 85 call
- Buy 80 put
- Sell 75 put
- Iron condors are “strangles with wings.” They consist of buying calls and puts near the money and then selling contracts further from the money. For example, if a stock is at $80, the trader would:
- Buy 85 call
- Sell 90 call
- Buy 75 put
- Sell 70 put