Options trading is a dynamic field that stretches far and wide, and is full of opportunities to help you secure your financial independence – but most investors won’t even take a look in its general direction, let alone step into that field.
Now, obviously, you are not a part of that group – if that were the case, you wouldn’t be here. But there are still trials and tribulations up ahead – but having the courage to step up to the plate alone is still quite a few steps removed from winning.
But, like someone wise once said, where there is a will, there is a way – and today, we will be dealing with the “way”.
To be a bit more precise, today we will be aiming high – while simple, basic options trading strategies are a dime a dozen, advanced options strategies are more like diamonds in the rough – tougher to find, even tougher to refine, but immensely well-worth the effort.
These strategies require a decent amount of knowledge and experience. However, if you have the basics down pat, you are ready for the next step – we’ll explain everything both in detail and in simple language.
We’ve narrowed the list down to five accessible, effective strategies. All of them are multi-leg strategies, with different risk-reward ratios, but the one thing they have in common is how applicable they are. Remember, advanced doesn’t mean specialized – these strategies make use of common occurrences, and might even end up as your “bread and butter” approach. So – let’s get to work.
Bear Put Spread
The first strategy we will cover in this guide is the bear put spread, also called the debit put spread or the long put spread, which is a subtype of a vertical spread. Vertical spreads, as you may well know, are executed by buying or selling multiple options contracts of the same type, with the same maturity, but at different strike prices.
In the case of the bear put, a trader will simultaneously go long and short – buying a put option at a higher strike price, and selling another put option at a lower strike price. That sounds simple enough – so let’s go into a bit more detail on how and why this approach works, and why traders would use it.
Being a bearish strategy, the bear put spread is used when traders expect a decline in the price of the underlying. Overall, it is a moderately bearish strategy and works best when moderate price drops occur – which tends to happen quite regularly, and can easily be spotted by options trading alerts.
So – why would anyone complicate things like this, instead of simply buying a single put? There are two simple but incredibly potent reasons – for one, this approach is actually cheaper than an outright put or a simple directional play – and number two, bear put spreads put traders in a position where potential gains and losses are both limited.
Let’s say there is a guy called trader Tom, and let’s say he wants to trade Amazon (NASDAQ: AMZN) stock, which is worth $100 at the moment. Tom is bearish—he thinks that the stock will go down so he buys a put option with a strike price of $100 for a total premium of $1,000. But Tom wants to protect himself so he sells another put option with a strike price of $90 and the same expiry date. The options contract he sold is less likely to be ITM at expiry, so he gets $700 for it.
|Stock Price at Expiry||$100 Long Put Profit||$90 Short Put Profit||Total Profit|
Potential Upsides and Downsides
If John loses his bet, in every case, his losses will be limited to $300. However, his winnings will always be limited to $700. This is the tradeoff—if Tom just bought a put option and won, his potential profits would have been huge (if the stock crashed horribly). But on the other hand, by selling a short put for $700, this offsets all his losses.
Using a bear put spread is, therefore, a safer strategy than simply buying a put option and hoping for the best. Moreover, trader Tom can tighten or widen the spread between the two options as he sees fit, which gives him the ability to manage his risk a bit more precisely.
Bull Call Spread
Another variant of the vertical spread, the bull call spread is the opposite of the previous strategy we’ve covered. Where bear put spreads are bearish and use puts, bull call spreads…well, you get the idea.
Bull call spreads also consist of going both long and short at the same time – but in this case, the trader buys calls at a specific strike price, while selling calls at a lower price at the same time. As before, the expiry date on both legs of the trade must be the same.
As a bullish strategy, the bull call spread is put into play when a trader expects a moderate increase in the price of the underlying. Just like the bear put spread, this strategy is cheaper to execute and has limited potential gains and losses.
The following day, Amazon (NASDAQ: AMZN) is trading at $100 again, and trader Tom is suddenly bullish on Amazon stock because Jim Cramer passionately advocated for this on his show. Without second-guessing himself, Tom buys a long call option with a strike price of $100. The premium costs him $1,000.
Then, Tom stops to think for a minute and concludes that maybe he shouldn’t take everything he hears on the TV at face value—he decides to hedge his position. Tom sells a short call option with a strike price of $110, and this makes him a profit of $700 right away.
|Stock Price at Expiry||$100 Long Call Profit||$110 Short Call Profit||Total Profit|
Potential Upsides and Downsides
The bull call spread limits maximum winnings as well as maximum losses on bullish bets. Like the bear put spread, traders use this strategy when they think that a stock will go up, but don’t want to leave themselves exposed in case of a reversal.
Whereas the two previous strategies that we’ve covered are variants of vertical spreads, the married put is most similar to a covered call. The most glaring similarity is that both strategies require traders to actually purchase the underlying asset, along with an options contract.
Married puts consist of going long or purchasing a stock (or another underlying asset) and simultaneously purchasing an at-the-money put option for that asset. Unlike the other strategies discussed in this guide, the married put is a defensive play – its purpose is to limit downside. Rather than an approach for making money, think of this strategy as an insurance policy.
The rationale behind the strategy is simple – by going long and holding a stock, a trader ensures a potential upside – while purchasing puts protects them from the downside. It is a simple formula – it is simple because it works, but there are a few significant caveats to mention.
The cost of at-the-money puts can often be prohibitively expensive – executing this strategy will usually require a decent amount of money. On top of that, going long on a stock is no less expensive – so the capital requirements that have to be met to execute this strategy are high overall.
Let’s use an example. Our trusty trader Tom owns stock in Dutch Bros. Coffee (NYSE: BROS) currently trading at $35. To add some extra insurance to his position, he purchases an at-the-money put that costs him $3 in premiums.
|Underlying Stock Price||Profit From Stock||Put Profit||Total Profit (Stock Profit + Put Profit – $3 Put Premium)|
Although the built-in $3 options premium makes it harder for the trade to become profitable, the put option effectively ensures that there is a “floor” underneath the trade, limiting potential downside.
Potential Upsides and Downsides
The Potential upside – in this case, the strategy becomes profitable once the price of the underlying asset increases enough to cover the price of premiums – any further increase in the price of the underlying is profit. The strategy is also unexpectedly beginner-friendly – if one can stomach the initial cost, an approach with a limited downside offers a great way to dip your toes into advanced strategies.
Potential downside and risk are minimized by the married put. While this approach does serve as an “insurance policy” in case the underlying experiences depreciation, simply going long on stock will always be more profitable because of options premiums. Married puts don’t mesh well with long-term strategies, and are too expensive to use regularly.
The Iron Butterfly is a credit spread that takes advantage of sideways trading and drops in implied volatility. Although the strategy is complex to pull off (requiring 4 options contracts to do so) and has limited application when successfully pulled off it represents one of the best ways to take advantage of lulls in the market.
Since this approach is so complex, we’re going to have to start off with a chart right off the bat.
Let’s take things step by step – since this is a credit spread strategy that benefits from underlying assets that trade in a range, the first step is to identify the target price that the trader expects an asset to close at on a certain day.
The first step is to go short or sell both a call option and a put option using the identified target price. The trader will receive premiums for this, and the largest possible profit from this strategy is keeping the entire premium.
Once the “body” of the butterfly is in place, it is time to construct the wings. On the right-hand side, this is done by going long or purchasing a call option with a strike price above the target price – which protects the trade from unlimited losses in the event of an unexpected upswing.
On the left-hand side, a trader will likewise go long on a put option with a strike price below the target price, which is used to protect the trade from unexpected drops in price.
As the expiry date of the trade approaches, the closer the price is to the target price, the greater the profit. The farther away from that point the price is, the less profitable the trade – with maximum losses occurring should the price move below the left wing or above the right wing.
One morning, trader Tom feels very inspired and wants to try out a more complex strategy on a stock that seems like it won’t move much over the next few months, like Helen of Troy LTD (NASDAQ: HELE)—it has been sitting at $100 per share. Tom wants to profit off of this stock’s passivity but without taking on too much risk personally. He does the following:
- Tom sells a call option with a strike price of $100 and gets $700 for it.
- He sells a put option with a strike price of $100 and with the same expiry date—he gets $550 in profit.
- Tom buys a long call option with a strike of $110 for $250.
- He also buys a put option with a strike of $90, which costs him $200.
Right off the bat, trader Tom makes $1,250 and loses $450. It would be ideal for Tom if the stock remained at $100 after his options expire because then, the options he sold would become worthless. If the stock goes up or down too much, Tom will be at a loss, but the options he bought will protect him against any significant losses. Here is how this works:
|Stock Price at Expiry||$100 Short Call Profit||$100 Short Put Profit||$110 Long Call Profit||$90 Long Put Profit||Total Profit|
Potential Upsides and Downsides
The iron butterfly is used when traders think that the underlying stock’s value won’t change significantly. If the trade plays out like this, the trader gets paid the most. However, if the underlying stock’s price changes, even if it is a huge and sudden movement, the trader’s losses are contained.
Potential upside – the potential upside is limited and is equal to the total premium received for selling the “body” of the butterfly.
Potential downside and risk – the potential downside is also limited and occurs when the strike price at expiration is either above the call used in the right wing, or below the put used in the left wing.
The synthetic long is an advanced bullish strategy that seeks to replicate the performance of owning an underlying asset – without actually owning it. This is accomplished by going long or purchasing a call and going short on or selling a put – both with the same expiration date and strike price.
Replicating the performance of an asset might seem like too much hassle for too little gain – but unlike actually owning the asset, executing a synthetic long requires a lot less money. In fact, the premiums collected from selling puts go a long way in covering the costs of the calls. Depending on the trader’s forecasts, the strike price can be at the money, or out of the money in either direction in relation to current asset price.
Rio Tinto’s NYSE-issued shares are trading at $70 (NYSE: RIO), with calls and puts with a $70 strike price available for $5.
|Price of Underlying at Expiration||$70 Call Profit||$70 Put Profit||Overall Profit of Strategy|
Keep in mind that, should the price of the underlying asset be below the strike price at expiration, you will have to purchase the stock. However, most traders who use the synthetic long strategy do not intend to keep the position open long enough to reach expiration – closing the position a bit before expiration is usually the most rational approach.
Potential Upsides and Downsides
Potential upside – the potential upside of a synthetic long is equal to the upside of the underlying stock, minus premiums and fees. If a strike price that is out of the money is chosen, traders can even see a net increase in account value once the strategy is put into play – although this should only be reserved for the most bullish of occasions.
Potential downside and risk – just as the case would be if a trader were to own the underlying asset, the potential downside is equal to the total value of the underlying asset.
And so we come to the conclusion of today’s guide – thank you for your attention and for sticking with us. With options trading, there is a lot of specific terminology – and this was a dense, information-heavy guide – so don’t worry if everything hasn’t settled into place instantly – remember, repetition is the mother of learning.
The truth is simply that basic options trading strategies have to be mastered – but advanced strategies such as these give traders an incomparable level of versatility. By applying oneself and mastering these strategies, a trader can spot (and execute) a lot of good plays – no matter what the market might be doing.
Sophisticated Options Trading Strategies: FAQs
What Are Some Good Indicators to Follow When Trading Options Contracts?
As far as technical indicators for trading options go, taking into account the relative strength index (RSI), Bollinger Bands, the Intraday Momentum Index (IMI), as well as the Put/Call Ratio is a good way to gain an overlook of both general and specific market sentiments.
What Are the Different Levels of Options Trading?
In the world of options trading, levels refer to a set of permissions that a brokerage provides to a client. Levels usually range from 1 to 5 and influence how large a position a client can open, as well as what strategies the client can use. Levels are usually decided by account size.
What’s the ‘rule of 16’ in Options Trading?
The rule of 16 is a simple method of converting annualized implied volatility into daily volatility, which consists of taking annualized volatility and dividing it by 16 to get a percentage value.
What’s a Good Timeframe for Options?
Although there is no one-size-fits-all solution here, we here are The Trading Analyst focus on swing trading – which entails a timeframe that usually lasts between a couple of weeks and a couple of months.
Can You Lose More than 100% of Your Invested Capital When Trading Options?
Yes – in certain conditions, losing more than 100% of your initial investment via options trading is possible – although these so-called “uncovered” strategies are never recommended.
How Does Put Call Ratio (PCR) Work in Options?
The put call ratio is a metric that measures the ratio of puts to calls and is used to gauge current market sentiment when trading options. If more puts are purchased, the market is bearish – if more calls are purchased, the market is bullish.