Option Strategies:
The following narrative should give you an idea of which option strategies are appropriate for the particular stock/index and market conditions that you wish to trade in. This is only a brief list and is not intended to teach you how to trade options. Read until you fully understand the concepts. The principle concept to remember is buy options when the 5 day volatility is abnormally low (compared to 100 day) while the options are inexpensive and sell options when 5 day volatility is abnormally high (compared to 100 day) while options are very expensive and you can take advantage of the time decay. Option time premium rapidly decays in the last 3 - 4 weeks prior to when the options expire. As a result, it has been stated that 95% of all options expire worthless. This indicates that there is a significant built-in bias to favor selling options over purchasing options. Also remember that in general, stock/index prices are like a pendulum - they swing too far in each direction, but they always come back to the middle (norm).
Long call
You are decidedly bullish on the stock/index and the overall market is in an uptrend. You purchase a Near-The-Money or At-The-Money call to put on this trade. The stock/index 5 day volatility should be low to neutral when compared to its 100 day volatility. You profit if the stock goes up beyond your breakeven price. Probability of profit should always be greater than 50%.
Long put
You are decidedly bearish on the stock/index and the overall market is in a downtrend. You purchase a Near-The-Money or At-The-Money put to put on this trade. The stock/index 5 day volatility should be low to neutral when compared to its 100 day volatility. You profit if the stock goes down beyond your breakeven price. Probability of profit should always be greater than 50%.
Short/Covered Call
You believe the market will trend down or sideways for a period of 30 days or so. The outlook for the stock/index should be similar. You sell (short) a far Out-of-the-Money call to put on this trade. The strike price should be above the expected range of the stock during that time period. The stock/index 5 day volatility should be generally high or at least neutral when compared to its 100 day volatility. The probability of profit should be greater than 80%. You profit if the stock does not go above the strike price of the call you sold. You can also use this feature if you already own the underlying stock and you feel it will not move significantly for a period of time and want to earn some extra money by selling a covered call.
Short Put
You believe the market will trend up or sideways for a period of 30 days or so. The outlook for the stock/index should be similar. You sell a far Out-of-The-Money put to put on this trade. The strike price should be below the expected range of the stock price during that time period. The stock/index 5 day volatility should be generally high or at least neutral when compared to its 100 day volatility. The probability of profit should be greater than 80%. You profit if the stock does not go below the strike price of the put you sold.
Bear Call Credit Spread
This spread is used under the same conditions as the Short Call. You sell the lower strike call and buy the higher strike call. This spread greatly reduces the risk involved and the margin requirements over the short call. This allows you to trade with a much smaller account, but with less profits per trade. Your risk is the difference between the two strike prices plus the credit received from the spread. The lower strike should be equal to or higher than the expected range for the stock during that period. The probability of profit should be greater than 80%. The credit received should be 10% or more of the difference in strike prices.
Bull Put Credit Spread
This spread is used under the same conditions as the Short Put. You sell the higher strike put and buy the lower strike put. This spread greatly reduces the risk involved and the margin requirements over the short put. This allows you to trade with a much smaller account, but with less profits per trade. Your risk is the difference between the two strike prices plus the credit received from the spread. The higher strike should be equal to or lower than the expected range for the stock during that period. The probability of profit should be greater than 80%. The credit received should be 10% or more of the difference in strike prices.
Bull Call Debit Spread
This spread is used under the same conditions as a Long Call. You buy the lower strike call option that is closest to the current price and sell another call at a higher strike price. This spread reduces the cost of just purchasing a call, but it also reduces the maximum profit. The probability of profit should be near 50% and rarely will exceed 50%. Make sure the potential profit is in line with the maximum risk on this spread as your profit is limited.
Bear Put Debit Spread
This spread is used under the same conditions as a Long Put. You buy the higher strike put option that is closest to the current price and sell another put at a lower strike price. This spread reduces the cost of just purchasing a put, but it also reduces the maximum profit. The probability of profit should be near 50% and rarely will exceed 50%. Make sure the potential profit is in line with the maximum risk on this spread as your profit is limited.
Bull Call Ratio BackSpread
This spread is used under the same conditions as a Long Call or the Bull Call Debit Spread. You should be very bullish on the stock/index and the expected range of the stock during the particular time period should extend significantly beyond the breakeven points of the position. You buy 2 of the higher strike call options that are near the current price and sell 1call at a lower strike price than those purchased. This ratio (buy 2 ;sell 1) reduces the cost of the 2 calls purchased often to the point or a free trade or credit to put on the spread and has unlimited profit potential, but the risk can be higher since you will be responsible for the difference in strike prices plus any premium paid or less any credit received. As a result your breakeven has 2 different points and you will lose money if the options expire at any point between the 2 breakeven prices. You can aslo use a 3:2 ratio (buy 3; sell 2) which will reduce the cost further or increase the credit received, but the breakeven points will be extended even further requiring an even greater move in the stock price for a profit. The probability of profit should be greater than 40% and rarely will exceed 60%. These are excellent trades but they require a significant up move in price to be profitable.
Bear Put Ratio BackSpread
This spread is used under the same conditions as a Long Put or the Bear Put Debit Spread. You should be very bearish on the stock/index and the expected range of the stock during the particular time period should extend significantly beyond the breakeven points of the position. You buy 2 of the higher strike put options that are near the current price and sell 1put at a lower strike price than those purchased. This ratio (buy 2 ;sell 1) reduces the cost of the 2 puts purchased often to the point or a free trade or credit to put on the spread and has unlimited profit potential, but the risk can be higher since you will be responsible for the difference in strike prices plus any premium paid or less any credit received. As a result your breakeven has 2 different points and you will lose money if the options expire at any point between the 2 breakeven prices. You can aslo use a 3:2 ratio (buy 3; sell 2) which will reduce the cost further or increase the credit received, but the breakeven points will be extended even further requiring an even greater move in the stock price for a profit. The probability of profit should be greater than 40% and rarely will exceed 60%. These are excellent trades but they require a significant down move in price to be profitable.
Long Straddle
This spread is used when you believe that the stock/index will make a big move in the near future, but you have no idea which direction the move will be. You purchase both an At-The-Money (very close to the current price of the stock) call and put to put on this trade. The stock/index 5 day volatility should be low to neutral when compared to its 100 day volatility. You profit if the stock goes up or down beyond your breakeven price; however, long straddles can often be very expensive requiring a major move in the stock to be profitable. You should not use this strategy if the time to expiration of the options is short. Expiration should not be within 60 days of when the trade is placed. Probability of profit will always be near 50%, if not there is an error in the prices.
Short Straddle
This spread is used when you believe that the stock/index will stay essentially unchanged with minimal price movement up or down in the near future. You sell both an At-The-Money call and put of the same strike price to put on this trade. Your risk is unlimited and margin requirements will be relatively high. You profit if the price movement over the specified time period is less than the premium received from the sale of the call and put. The rapid time decay in the last month prior to expiration is your friend in this trade. The 5 day volatility should be higher than the 100 day volatility. Expiration should generally be less than 30 days of when the trade is placed. Probability of profit is generally less than 50%. However, high margin requirements generally require having a larger trading account.
Long Strangle
This spread is used under the same conditions as the Long Straddle. You believe that the stock/index will make a big move in the near future, but you have no idea which direction the move will be. You purchase both an Out-of-The-Money (at least 1 strike price above and below the current price of the stock) call and put to put on this trade. Buying the Out-Of-The-Money options results in lower option premiums with less cost and time risk than straddles. The stock/index 5 day volatility should be low to neutral when compared to its 100 day volatility. You profit if the stock goes up or down beyond your breakeven price; however, similar to long straddles, long strangles can often be very expensive requiring a major move in the stock to be profitable. You should not use this strategy if the time to expiration of the options is short. Expiration should not be within 60 days of when the trade is placed. Probability of profit will always be less than 50%, if not there is an error in the prices.
Short Strangle
This spread is used when you believe that the price of the stock/index will stay within a specific range in the near future. You sell both an Out-of-The-Money call and put of different strike prices to put on this trade. Your risk is unlimited and margin requirements will be relatively high. You profit if the price movement over the specified time period stays within the range between the two strike prices or does not extend beyond either strike price more than the premium received from the sale of the call and put. The rapid time decay in the last month prior to expiration is your friend in this trade. The 5 day volatility generally should be higher than the 100 day volatility. Expiration should generally be less than 30 days of when the trade is placed. Probability of profit is generally greater than 50%. This is a very high probability trade to profit if entered correctly. However, high margin requirements generally require having a larger trading account.
Call Time Spread
This spread is used when you are bullish on the stock/index over the next several months. You purchase a far Out-of-The-Money call that has several months or more than a year to expiration, then sell a closer Out-of-The-Money call with a very near expiration date. You profit in two ways; 1) the premium received for the sale of the call with near expiration and 2) from the upward movement of the stock price over the specified longer expiration. Initially the sale of the call reduces the cost of the spread, but each month you sell another call generating monthly income until the price of the stock gets close to the stike of the purchased call. Once the stock price has reached near the strike price of the long term purchased call you continue to profit from the stock/index's price increase without the need of selling more calls. Your potential profit is unlimited, but your risk is limited and will vary during the time the spread is in effect. Since the spread is continually adjusted over time an accurate probability of profit cannot be determined prior to placing the trade. Margin requirements vary depending on the distance between strike prices. The rapid time decay of the closer expiration call sold and the slower time decay of the farther expiration call are your friend with this trade.
Put Time Spread
This spread is used when you are bearish on the stock/index over the next several months. You purchase a far Out-of-The-Money put that has several months or more than a year to expiration, then sell a closer Out-of-The-Money put with a very near expiration date. You profit in two ways; 1) the premium received for the sale of the put with near expiration and 2) from the downward movement of the stock price over the specified longer expiration. Initially the sale of the put reduces the cost of the spread, but each month you sell another put generating monthly income until the price of the stock gets close to the stike of the purchased put. Once the stock price has reached near the strike price of the long term purchased put you continue to profit from the stock/index's price decrease without the need of selling more puts. Your potential profit is unlimited, but your risk is limited and will vary during the time the spread is in effect. Since the spread is continually adjusted over time an accurate probability of profit cannot be determined prior to placing the trade. Margin requirements vary depending on the distance between strike prices. The rapid time decay of the closer expiration put sold and the slower time decay of the farther expiration put are your friend with this trade.
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