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What are options trading strategies?
Many traders use some kind of strategy when trading options, we detail some of them below.
Options trading allows you the right to purchase stocks when they hit a specific price (called the strike price). Often options are traded with some kind of strategy in mind. These are some of the strategies and how they work.
Options trading isn’t for the beginner investor though. If you’ve somehow found your way here while looking for some beginner investing guides try heading to our investing homepage and save yourself the headache of getting your head around these.
Before we begin
Before we can get into these options strategies, it is important to understand some of the key terms you come across when trading options, such as “call”, “put”, “in the money”, “at the money” and “out of the money”. The table below describes exactly what these terms mean.| Call – the right to buy | Put – the right to sell | |
|---|---|---|
| In the money | Strike price is lower than the market price of the asset | Strike price is higher than the market price of the asset |
| At the money | Strike price is the same as the market price of the asset | Strike price is the same as the market price of the asset |
| Out of the money | Strike price is higher than the market price of the asset | Strike price is lower than the market price of the asset |
Covered call strategy
This strategy is designed for when you think a stock will maintain its value.
How to use the covered call strategy
- Purchase the stock as you normally might. Traders usually go for one that they don’t think will move much in the future. For example, let’s say you purchase 100 Apple shares at $425 each.
- At the same time, write a call option on those shares at a slightly higher price to another trader for a premium. The other trader now has the right to purchase your shares from you for, say, $450 each.
How a covered call strategy works
Say the price was to rise to $500 USD then your shares are now worth $50,000 USD. But, it’s likely that the other trader will purchase them from you for the agreed price of $450 USD each.
If they go ahead with this, then you have made a profit of the premium amount, but you’ve lost out on a potential gain on your shares.
If the share price was to go down to $400 per share, it’s unlikely that the other trader will purchase from you, as they can get them cheaper elsewhere. This way, you’ve made a profit with the premium and you still hold the shares.
Married put
This strategy tends to give you protection both ways but can limit your gains.
How to use a married put strategy
- Purchase the stock as you normally might. Such as purchasing 100 Apple shares at $425 each.
- At the same time, purchase a put option.
- If the stock price goes up then do nothing (or sell the shares). You make a profit of the total amount that the stock increased in value by, less the premium you paid.
- If the stock price goes down, make use of your put option before the expiration date. You can sell your stock for the price you paid for them. This way, you lose the premium you paid.
How a married put strategy works
So you’ve got 100 Apple shares which you bought for $425 each, totalled at $42,500.
You also have a put option for those 100 shares to sell them for $425 each, meaning that you have the option to sell them for $42,500 if the price goes down.
This means that you’ve got protection both ways. If the stock price suddenly jumps to $500 per share then your shares are now worth $50,000 USD and you can choose not to use your call option. If the price plummets to $400 USD per share then you can exercise your right to sell the stocks for the price agreed, which is now higher than the going rate for the shares.
Bull call spread strategy
This type of trade is usually used by investors who believe that the company will outperform against the market.
How to use a bull call spread strategy
- Choose an asset that you think will rise in value.
- Buy call options at one strike price.
- At the same time, sell the same number of call options at a higher strike price.
How bull call spreads work
You need the value of the stock to increase in price in order to make any money from this trade.
You pay a premium when you buy call options, but you’ll receive a premium from the other investors when they buy call options from you, so it is partially offset.
So, let’s say the market price for a stock is £50. You’ve got a call option for this stock with a strike price of £55 and you’ve sold another call option for this stock at a strike price of £70.
As the stock price rises, several things happen:
- Once it gets to £55 per stock, you purchase the stocks for the agreed price of £55 each.
- If it then goes on to reach £70, then the other trader has the right to purchase the stocks from you for this price, so you sell them.
- The profit you make is the higher strike price of £70 minus the price you paid for them (£50) and the net cost of the original put option and sale of the put option.
This graph can help you visualise this:
Bear put spread strategy
The bear put spread is exactly the same as the bull call spread, except you choose an asset that you expect to decrease in value.
How to use a bear put spread strategy
- Choose an asset that you think will decrease in value
- Buy put options at one strike price
- At the same time, sell the same number of put options at a lower strike price.
How bear put options work
To make money from this, you need the value of the stock to decrease. As with the bull call spread, you pay a premium when you purchase put options, which is then partially offset by the premium you receive from the other traders that purchase put options from you.
Now, using the same example from earlier, say the market price for a stock is £50. You’ve got a put option with a strike price of, say, £45 and you’ve sold a put option for this stock at a strike price of £30.
Say this went your way, and the value of the stock did indeed decrease in value.
Between £50 and £40, nothing happens, but once the stock price reaches £45, you have the option to sell the stocks for this price. Once the stocks reach £30, the other trader has the option to sell the stocks to you for £30.
Here’s another chart to help you visualise this:
Protective collar
This strategy is similar to the bear put strategy and bull call strategy with a key difference which we detail below.
How to use a protective collar strategy
To use a protective collar strategy, you simultaneously purchase a call option and a put option, pretty similar to the bear put strategy and bull call strategy. These have to be “out of the money”, which means, in the case of a call option, the strike price is higher than the market price of the asset and in the case of a put option, the strike price is lower than the market price of the asset.
The asset and expiration dates of both options are exactly the same.
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