Options trading can help you potentially benefit from price movements in the stock market, whether prices go up, down, or stay flat. However, it’s important to know which strategy may be relevant for each scenario and understand the risks involved.
Table of Contents:
This guide covers different option strategies for bullish, bearish, and neutral market views. These are not recommendations and do not guarantee profit but can help you understand the wide range of strategies traders may use.
Some prior trading knowledge might be useful for you to grasp the strategies outlined in this article.
What is options trading?
An option is a financial contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset (like a stock) at a specific price within a set period. It’s used to hedge risk or speculate on price movements, with limited risk for the buyer.
There are two main types of options: call options and put options.
A call option gives you the right to buy a stock at a fixed price (called the "strike price") before a certain date. Traders typically buy a call option if they think the price of the stock is likely to go up. If the stock price rises above the strike price, you can buy the stock at the lower price and potentially make a profit.
A put option gives you the right to sell a share at a fixed price before a certain date. You might buy a put option if you think the price of the stock is going to go down. If the stock price falls below the strike price, you can sell the stock at the higher price and potentially make a profit.
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Different types of trading strategies and their role
Bullish option trading strategies
When you expect the market or a particular stock to rise, bullish option strategies allow you to participate in the upside while mitigating risk.
1. Bull-call spread
A bull-call spread is an options trading strategy you can use when you think a stock or asset will go up, but not by a large amount. You buy a call option with a lower strike price, which gives you the right to buy the stock at that price within a certain time. At the same time, you sell another call option with a higher strike price but with the same expiry date.
By selling the higher strike call, you collect some premium, which helps offset the cost of buying the lower strike call. This can make the overall strategy more affordable than solely buying a call option.
A naked call usually refers to selling a call option without owning the underlying asset. In contrast, a bull-call spread limits both potential profit and loss, making it a more controlled way to potentially benefit from a moderate rise in the stock price. This strategy is useful when you expect the stock to go up, but not make a huge jump.
2. Bull-put spread
A bull-put spread is an options strategy that can be used when you expect a stock or asset to go up slightly or stay steady, but you don’t want to take on too much risk. In this strategy, you sell a put option with a higher strike price and, at the same time, buy a put option with a lower strike price. Both options have the same expiry date.
By selling the higher strike put, you receive a premium. Part of this money is then used to buy the lower strike put. The difference between what you receive and what you pay is your net premium, which is your maximum possible potential profit from this trade.
This approach is considered suitable by some traders because the potential profit is highest if the stock stays above the higher strike price until expiry. However, if the stock falls below the lower strike price, your loss is limited because you own the lower strike put. The bull-put spread is typically used when traders expect a moderate rise or stability in the stock and want to keep their potential loss controlled.
3. Call ratio backspread
This advanced bullish strategy involves buying more out-of-the-money (OTM) calls than you sell in-the-money (ITM) calls, typically in a 2:1 ratio.
An out-of-the-money (OTM) call option is a call where the strike price is higher than the current market price of the stock. This means the option does not have any intrinsic value yet, and you would only profit if the stock’s price rose above the strike price before the option’s expiry. OTM calls are usually cheaper to buy because there is less chance of them ending up profitable unless there is a strong upward movement in the stock.
An in-the-money (ITM) call option, on the other hand, is one where the strike price is lower than the current market price. This means if you exercised the option immediately, you could buy the stock for less than it is worth on the market, giving the option some built-in value. ITM calls cost more because they are already profitable at the current price level.
The idea is to benefit from a strong upward move in the underlying asset, as the extra long calls provide unlimited profit potential if the price surges. This strategy can be suitable when you expect high volatility and significant upside.
4. Synthetic call
A synthetic call is constructed by buying the underlying stock or futures and simultaneously purchasing a put option. This combination mimics the payoff of a long call option, offering the potential for unlimited upside and limited downside (the put cushions against a fall) potential. It’s useful for investors who want to hold stocks for dividends or voting rights but also want downside protection without selling their holdings.
Bearish option trading strategies
Bearish strategies help you potentially profit from a decline in the underlying asset’s price while mitigating risk.
5. Bear call spread
A bear call spread is an options strategy you can use if you think a stock or asset might go down a little or stay flat, but you do not expect it to drop sharply. In this strategy, you sell a call option with a lower strike price and, at the same time, buy another call option with a higher strike price. Both options have the same expiry date.
When you sell the lower strike call, you receive a premium (which is the price paid to you for selling the option). You use part of this money to buy the higher strike call, which costs less. The difference between what you receive and what you pay is your net premium, and this is your maximum possible profit from the strategy.
If the stock price stays below the lower strike price until the options expire, both options will expire worthless, and you keep the net premium as your profit. This approach is often used when you expect the stock to go down a bit or remain steady, but not crash.
Strike price is the price at which you can buy (call) or sell (put) the underlying asset if you exercise the option. When you "sell a call," you give someone else the right to buy the stock from you at the strike price. When you "buy a call," you have the right to buy the stock at the strike price. The bear call spread limits both your potential profit and loss, making it relatively less risky than selling a call option alone.
6. Bear-put spread
A bear-put spread is a straightforward options strategy you can use if you expect a stock or asset to decline moderately, but not plummet. To create this spread, you buy a put option with a higher strike price and, at the same time, sell a put option with a lower strike price. Both puts have the same expiry date.
With a bear put spread, your potential profit is at its highest if the stock price falls below the lower strike price at expiry. In this case, the profit from your bought put is maximized, but the sold put limits how much more you can gain beyond that point. The most you can lose using this strategy is the net premium you paid at the start, so your risk is clearly limited. This approach may be suitable if you expect a moderate decline and want to limit potential losses.
7. Strip
The strip strategy involves buying one call and two puts at the same strike and expiry. This approach is directionally bearish but can also benefit from high volatility. If the underlying asset falls sharply, the double-put position can yield significant potential gains, while a sharp rise can also provide potential profit, albeit relatively less than a comparable decline. The maximum potential loss is limited to the total premium paid for the options.
8. Synthetic put
A synthetic put is an options strategy you might use if you want to benefit from a potential drop in a stock or asset, but with limited risk. To set up a synthetic put, you take two steps: first, you sell (or short) the underlying stock or a futures contract; second, you buy a call option with the same expiry.
This combination is called “synthetic” because it closely copies the payoff you would get from simply buying a put option. If the price of the stock goes down, your short position becomes profitable, just like a put. If the price rises sharply, your losses on the short position are capped because the call option gives you the right to buy back the stock at a fixed price.
A synthetic put can be useful if you want to hedge a short position, or if you want to speculate on a fall in the asset’s price but don’t want unlimited risk. This approach allows you to define your maximum loss while still offering the chance for profit if the stock or asset declines.
Neutral option trading strategies
Neutral strategies are designed for markets where you expect little movement or simply want to profit from volatility, regardless of direction.
9. Long straddles and short straddles
- Long straddle: Buy a call and a put at the same strike and expiry. You potentially profit if the underlying asset makes a large move in either direction. The maximum potential loss is the total premium paid if the underlying asset stays near the strike price.
- Short straddle: Sell a call and a put at the same strike and expiry. You potentially profit if the underlying asset remains stable, collecting both premiums. However, risk is unlimited if the underlying asset moves sharply in either direction, so this strategy requires careful risk assessment. Moreover, outcomes can vary significantly based on market volatility and execution.
10. Long strangles and short strangles
- Long strangle: Buy a call and a put with the same expiry but different strikes (call above, put below current price). It’s cheaper than a straddle, but requires a bigger move to be potentially profitable. Maximum potential loss is the total premium paid.
- Short strangle: Sell a call and a put with different strikes. You potentially profit if the underlying asset stays within the range defined by the strikes, collecting both premiums. However, risk is unlimited if the underlying asset breaks out of this range, so strict risk controls are advised. Market volatility and execution efficiency can impact outcomes.
Read Also: Differences between Futures and Options Trading
Intraday option trading strategies
For short-term traders who watch the market closely:
11. Momentum strategy
This approach focuses on identifying stocks or indices showing strong momentum––either up or down––during the trading day. By entering trades in the direction of momentum and using position sizing, you can ride short-term trends for quick potential gains. Tools like volume analysis and price action are often used to spot momentum.
12. Breakout strategy
This strategy involves identifying key support and resistance levels. When the price breaks out of these levels with strong volume, you enter a trade in the direction of the breakout. Setting clear entry, stop-loss, and target levels is crucial for mitigating risk and optimising potential gains.
13. Reversal strategy
This strategy aims to spot potential intraday trend reversals after a strong move. By analysing patterns and using technical indicators, you can enter trades when the prevailing trend shows signs of exhaustion and reversal. Risk management is critical, as false signals can also occur.
14. Scalping strategy
Options scalping is all about making quick trades to capture small potential profits from short-term price fluctuations. Scalpers use highly liquid options and rely on rapid execution, tight stop-losses, and frequent trades. While the potential gains per trade are small, they can cumulatively add up to high potential gains if executed with discipline.
15. Moving average crossover strategy
This strategy uses short-term and long-term moving averages (e.g., 9-period and 21-period EMAs) to generate buy or sell signals. It’s popular for its simplicity and effectiveness in capturing intraday trends.
16. Gap and go strategy
The gap and go strategy aims to take advantage of price gaps at the market opening. If a stock opens significantly higher or lower than the previous close, you trade in the direction of the gap, expecting momentum to continue. Confirming the gap with volume and setting clear risk parameters is advised.
Conclusion
Understanding these option trading strategies can help traders choose tools that match their view of the market and risk appetite. Each one has its own strengths and limitations, and it’s important to study how they work before using them. However, it is important to remember that while these strategies offer different approaches to market views, none of them can guarantee returns. Market conditions, execution, and risk management all play a role in outcomes.
FAQs:
What is a bull-call spread, and when should it be used?
A bull-call spread involves buying a lower strike call and selling a higher strike call with the same expiry. It is suitable when you expect a moderate rise in the underlying asset, as it limits both potential profit and loss compared to a naked call.
How does a bull-put spread differ from a bull-call spread?
While both are bullish strategies, a bull-put spread involves selling a higher strike put and buying a lower strike put, generating potential income through net premium received. In contrast, a bull-call spread involves buying and selling calls at different strikes with a net premium outflow. The risk-reward profiles differ, but both aim to cap potential loss and gain.
What is the bull-call ratio backspread strategy, and what are its risks?
The bull-call ratio backspread involves buying more OTM calls than you sell ITM calls, typically in a 2:1 ratio. It seeks to potentially capitalise on a strong upward move but losses can occur if the underlying asset doesn’t move enough. The risk is the net premium paid, but the profit potential can be unlimited if the underlying asset surges.
What is a synthetic call, and how does it function in options trading?
A synthetic call is created by buying the underlying (stock or futures) and purchasing its put option. This setup mimics a long call’s payoff-potentially unlimited upside and limited downside, which may make it suitable for investors who want downside protection without selling their holdings.
How does a bear call spread work, and when is it appropriate to use this strategy?
A bear call spread involves selling a lower strike call and buying a higher strike call, both with the same expiry. You potentially profit if the underlying asset stays below the lower strike, with risk limited to the difference between the strikes minus the premium received. It’s suitable when you expect a moderate decline in the underlying asset.
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