Option Strategy refers to the combination of two or more put or call options that are designed in such a way that it helps in capping losses and gaining unlimited profits.
Let’s decode the meaning of put and call options–
Call options give the owner the right but not an obligation for buying the underlying stock at a predetermined price by a fixed expiration time.
On the other hand, put options give the owner the right, but not the obligation, for selling the underlying stock at a predetermined price by a set expiration time.
Having understood these terms, now let us discuss the option strategies:
Option Trading Strategies can be divided into bearish, bullish, or neutral option trading strategies depending on the direction of the underlying assets:
Bullish option strategies are implemented when we have a bullish view on the underlying stock, so let us first discuss some of the popular bullish option strategies:
- Bull Call Spread:
A bullish option trading strategy which involves buying one At-The-Money (ATM) call option and selling the Out Of-The-Money call option, having the same underlying asset and the same expiration date.
This strategy can act as a great alternative to just buying a call option when the traders are not that aggressively bullish on a stock.
This strategy is implemented for net debit that is equal to the Premium Paid for a lower strike minus the Premium Received for a higher strike.
The Spread is the difference between the higher and lower strike price
Profit is made in this strategy when the underlying stock’s price increases. The profit is equal to spread minus net debit.
Loss is incurred when the stock price falls and equals the net debit.
This strategy is used for protecting our capital when the prices fall and the profit amount is also limited.
From the above example from elearnoptions, it can be observed that both the profit and loss is limited.
- Bull Put Spread:
This option strategy is similar to the above option strategy, in the sense that instead of buying calls we are buying puts in the Bull Put Spread.
This strategy is implemented when the traders are a little bullish on the underlying asset’s price direction and involves buying 1 OTM Put option and selling 1 ITM Put option.
Here the profit is incurred when the stock price rises and is limited to the net credit received. The potential loss is also limited as shown above and occurs when the stock’s price falls below the strike price of the put that we had bought.
- Synthetic Call:
This is a bullish option strategy also known as the protective put strategy that is used by those traders having a bullish view of the stock for the long term but also worried that the stock might move down too.
The strategy involves buying put options of the stock whose futures we are holding. Here the profit is unlimited which is made if the price of the underlying rises whereas if the price falls, then the loss will be capped to the premium.
Having discussed the bullish option strategies, now let us discuss the bearish option strategies which are implemented when we have a bearish view on the underlying stock-
- Bear Call Spread-
The Bear Call Spread is a bearish option trading strategy that is implemented by the options traders when they have a ‘moderately bearish’ view on the market.
This strategy involves buying 1 OTM Call and selling 1 ITM Call option. Both the calls should have the same underlying stock as well as the same expiration date.
This strategy is formed for the net credit and profits are made when the stock prices fall that is limited to the net credit.
The potential loss is also limited and equals the spread minus net credit.
- Bear Put Spread-
This bearish option strategy is similar to the Bull Call Spread and is implemented when the view of the market is moderately bearish.
We buy the ITM Put option and sell the OTM Put option in this strategy that has the same underlying stock and the same expiration date.
This strategy is made for a net debit and profits are incurred as the underlying stock falls in price.
The profit is limited which is equal to the spread minus the net debit and the loss is also limited and equal to net debit.
- Synthetic Put-
Synthetic put, also known as the synthetic long put, is a bearish option strategy that is implemented when traders have a bearish view and are worried about potential strength in that stock.
In this strategy, the maximum profit is unlimited and the maximum loss is limited.
Having discussed the bearish option strategies, now let us discuss the neutral option strategy which is implemented when traders do not have clarity on any market direction in the near term.
- Long and Short Straddles:
The long straddle is a neutral option trading strategy in which the profits or losses remain unaffected by either of the directions i.e uptrend or downtrend.
This strategy involves buying the ATM Call and Put options belonging to the same underlying, same expiry and also the same strike price.
On the other hand, Short Straddle involves selling the ATM Call and Put. The profit is equal to the total premium received and loss is unlimited as shown below:
Bottomline:
The above-discussed option strategies help protect us from unlimited losses that we may incur if we trade in the cash market. Those traders who are scared of losing a large part of their capital in trading can trade with the above-discussed option strategies.
Happy Investing!
