The option trader’s playbook can feel like sitting through an old-time grifter movie. Bull calls, costless collars, covered straddles… they sound almost like bad fiction.
Fiction, they are not. In fact, many of these strategies are required reading for any would-be derivatives investor. (We’ve already discussed covered calls and shorting against the box!) Here are four of the most essential tricks used by the professionals, along with some lingo for sounding very cool at the bar.
First, two building block strategies:
The Put/Call Spread
A “spread” is when you both sell and buy an equal number of contracts on the same underlying instrument, changing either the expiration dates or strike prices.
For example, a call spread could look like this:
Sell 1 GameCo contract. Strike price: $10, Expiration date July 1
Buy 1 GameCo contract. Strike price: $10, Expiration date August 1
Both have a call option, both use the same underlying asset and both share either the strike price or expiration (here, the strike). They can take many different forms, but spreads are a building block of many trading strategies.
The butterfly option is a risk-mitigation tactic that, like the spread, builds to many more sophisticated strategies.
The trader sells two option contracts at a middle strike price, then buys one contract above and one contract below that price. They can be either put or call contracts, but all have to be the same. So it could look like this:
Buy 1 GameCo put contract. Strike price: $20, Expiration date: July 1
Sell 2 GameCo put contracts. Strike price: $15, Expiration date: July 1
Buy 1 GameCo put contract. Strike price: $10, Expiration date: July 1
Often you will sell contracts as close to at-the-money as possible, but this isn’t necessary. Nor is it required that the three prices be equidistant.
The Iron Condor
The iron condor is a low-risk, low-reward trading strategy targeted at low-volatility assets.
An iron condor involves four simultaneous contracts: one call spread and one put spread, all on the same underlying instrument. The goal is to profit off the premiums while providing maximum hedge against payouts.
Here’s it works:
Sell 1 GameCo call contract. Strike price: $50, Expiration date: July 1
Buy 1 GameCo call contract. Strike price: $60, Expiration date: July 1
Sell 1 GameCo put contract. Strike price: $40, Expiration date: July 1
Buy 1 GameCo put contract. Strike price: $30, Expiration date: July 1
Now you wait.
Because you sold contracts closer to the center of the range, those premiums were higher than on the contracts that you bought. So, as long as all of the options expire out of the money, you get to keep the difference and make a profit.
If one of those contracts that you sold goes into the money, you will lose by having to pay out on the contract but that loss is capped by the boundary contract you sold. So if GameCo exceeds $50, you’ll have to pay on that call contract, but once it exceeds $60 you’ll get a $1-for-$1 profit on the call contract you bought. That will offset all losses, making this a capped risk strategy.
Married puts are put options which no longer live in sin.
Okay, that’s not true… the married put is a way to secure long term investments against short term fluctuation.
Here’s how it works:
Buy 100 shares of GameCo stock at $10 per share
Buy a put option on 100 shares of GameCo. Strike price: $9, Expiration July 1
If GameCo goes up by July 1, past the per-share premium paid for the option, then the scope of profits is virtually unlimited.
If GameCo tumbles, then on July 1 you can exercise the option and sell these stocks off for $9 per share. Your losses have been capped at $1 per share plus the premium. Now you can purchase the stock back at its new, lower price, pocket the profits, and keep the stock in anticipation of long term growth.
Got all that? If not, don’t worry. Options trading is a learn-as-you-go process. Let us help you with your learning curve! Try us risk free