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Best Options Trading Strategies: Every Beginner Should Know

Best Options Trading Strategies: Every Beginner Should Know

Understanding options trading strategies is crucial, no matter how much experience you have. This is because the market can change, showing different situations like when it’s going up (bullish), going down (bearish), or staying stable (neutral). This proficiency not only enhances your returns but also reduces potential losses. In this blog, we will discuss some of the top trading strategies modified for different market situations.

Table of Contents:

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What Option Trading is and How It Works?

What Option Trading is and How It Works?

Option trading is a financial strategy that involves the buying and selling of financial contracts known as options. Options grant the holder the right, but not the obligation, to buy or sell an underlying asset at a predetermined price within a specified timeframe. In option trading, there are two alternatives: a call option, granting the privilege to buy, and a put option, offering the right to sell. Market participants enter into option trading with the goals of anticipating price shifts, hedge against potential losses, or generate income. 

Understanding the workings of options trading is essential for investors seeking to manage financial markets with agility. It permit individuals to use various strategies, from speculation to risk management, allowing them to capitalize on market opportunities and protect against potential losses. 

Here’s a breakdown of how option trading operates:

  • Select Underlying Asset: Choose the underlying asset, such as stocks, on which you want to trade options.
  • Decide Option Type: Determine whether you want to buy a call option if you anticipate the asset’s price rising or a put option if you expect a decline.
  • Specify Contract Details: Define the option contract details, including the expiration date and strike price.
  • Execute the Trade: Purchase the selected option, either a call or a put, to initiate the trade.
  • Manage Position: As the option nears expiration, decide whether to exercise the option, sell it before expiration, or let it expire based on market conditions and your trading strategy.

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Option Trading Strategies for Bull Market

Option trading strategies for bulls involve employing call options to benefit from expected upward price shifts. In options trading within a bull market, various strategies come into play.

Here, we highlight the top 5 strategies for bulls in option trading:

Bull Call Spread

Bull Call Spread

A Bull Call Spread is a strategy in options trading where you expect a stock’s price to go up. It involves buying a call option with a lower price and selling a call option with a higher price, both expiring on the same date. This helps manage costs and limits both potential profit and risk, making it a strategy suitable for those anticipating moderate price increases in a bullish market.

Example: Consider a Bull Call Spread for 100 shares of Company XYZ. Buy a call option at $50 per share (costing $5000) and simultaneously sell a call option at $60 per share, earning $1000. If the stock rises to $55, you profit $500. Maximum profit is capped at $1000, providing a controlled approach to benefit from a bullish market with limited risk and upfront cost.

Call Back Ratio Spread

Call Back Ratio Spread

In this approach, investors purchase a specific quantity of call options with a lower strike price and concurrently sell a larger quantity of call options at a higher strike price. This creates a net debit position with the goal of making a profit if the price of the underlying asset goes up gradually. The strategy allows participation in a bullish market while offsetting initial costs through the sale of extra call options.

Example: Imagine you expect XYZ stock to rise modestly. In a Bull Call Back Ratio Spread, you buy 2 call options at $50 for $200 each, spending $400. Simultaneously, you sell 3 call options at $55 for $150 each, earning $450. The net result is a $50 debit position. If XYZ stock rises gradually, the purchased call options’ value may increase, potentially leading to a profit.

Synthetic Call

Synthetic Call

This approach involves buying a stock while concurrently selling a put option with an identical strike price and expiration date. The objective is to replicate the potential price appreciation associated with a call option, all the while reducing the initial cost through the receipt of premium income from the put option sale.

Example: let’s consider a synthetic call strategy where  you purchase 100 shares of Company XYZ at $50 per share, investing $5,000. Simultaneously, you sell a put option with a $50 strike price, fetching a premium of $200. If XYZ’s stock climbs to $60, you gain $1,000, but even if it drops, your risk is managed by the premium earned. This synthetic call mirrors the profit potential of a traditional call option while strategically managing both costs and risks.

Bull Call Butterfly Spread

Bull Call Butterfly Spread

The Bull Call Butterfly Spread is an options strategy used for moderate bullish expectations. It involves buying one lower strike call, selling two middle strike calls, and buying one higher strike call, all with the same expiration date. This creates a net debit position. Maximum profit is achieved if the stock ends at the middle strike at expiration. 

Example: Let’s consider trading XYZ stock at $100. Expecting a moderate rise, you execute the strategy: buy 1 call at a $95 strike for $7 premium, sell 2 calls at a $100 strike for $4 premium each, and buy 1 call at a $105 strike for $2 premium. This results in a net cost of $1 ($7 – 2x$4 + $2) as your maximum risk. If the stock closes at $100 at expiration, the two middle calls expire worthless, and the $95 call is worth $5, yielding a $4 profit. This strategy thrives if the stock closes at the middle strike, $100, but loses potential profit with significant stock movement.

Bull Iron Condor Spread

Bull Iron Condor Spread

The Bull Iron Condor Spread is an options strategy for stable or slightly bullish markets. It involves four separate options contracts, combining elements of both the Bull Put Spread and Bear Call Spread. It involves selling an OTM put and buying a further OTM put for protection, while also selling an OTM call and buying a further OTM call as a hedge. This aims to generate a net credit while capping potential gains and losses within a defined range.

Example: In the Bull Iron Condor Spread for stock XYZ, you receive a premium of $200 from selling 1 XYZ 95 Put, and you pay a premium of $100 to buy 1 XYZ 90 Put. Similarly, you receive a premium of $200 from selling 1 XYZ 105 Call, and you pay a premium of $100 to buy 1 XYZ 110 Call. This results in a net premium received of $200 – $100 + $200 – $100 = $200, representing your maximum potential gain. The strategy’s profit is capped at this amount. The range for maximum profitability lies between the sold put strike ($95) and the sold call strike ($105). If the stock stays within this range at expiration, you keep the entire premium received. 

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Option Trading Strategies for Bear Market

Understanding option trading strategies for bears is crucial for investors anticipating a decline in stock prices. These strategies offer opportunities for gains or protection against downward market trends. Here are the top strategies for bears in options trading:

Below are the top strategies for bears in options trading:

Bear Put Spread

It is an options trading strategy used when an investor expects a moderate decrease in the price of an underlying asset. It involves buying a put option with a lower strike price and simultaneously selling a put option with a higher strike price. This creates a net debit, limiting both potential gains and losses. The strategy profits if the stock’s price falls below the higher strike price but above the lower strike price. It’s an effective way to hedge against downside risk while still maintaining a limited-cost position.

Example: Let’s say you expect a moderate drop in a stock’s price. You buy a put option with a $50 strike price for $2 per share ($200 total cost) and sell a $45 strike put for $1 per share ($100 total credit). This creates a net debit of $100. If the stock falls below $45, the sold put offsets losses on the bought put, limiting potential losses. The maximum gain is achieved if the stock drops to or below $45 at expiration.

Strip Strategy

Strip Strategy

The strip strategy is a bearish options strategy involving the purchase of two at-the-money call options and the sale of a higher strike out-of-the-money call option. It profits from a significant decline in the underlying stock’s price. Maximum profit occurs if the stock falls below the lower strike, while maximum loss happens if it rises above the higher strike. This strategy is suitable for strongly bearish market perspectives.

Example:  Consider stock XYZ at $100.  By using the strip strategy you are buying 2 XYZ 100 Call options for $3 each, costing $600 in total, and selling 1 XYZ 105 Call option for $2, resulting in a credit of $200. This leads to a net expenditure of $400. If the stock falls below $100, profit begins to accumulate; maximum profit of $200 is achieved if the stock stays at or below $100 at expiration. However, if the stock exceeds $105, the maximum loss of $400 is incurred. This strategy is suitable for strongly bearish market expectations, capitalizing on substantial price declines.

Synthetic Put

Synthetic Put

The Synthetic Put strategy combines owning a stock with buying a put option. This creates a synthetic position that replicate the payoff of a traditional put option, providing downside protection. This strategy is used by investors who are bearish on a stock or market, allowing them to benefit from potential price declines while still holding the underlying stock.

Example: An investor owns 100 shares of ABC at $50 each. They buy a put option with a $50 strike price for $3 (expires in a month). If the stock drops, the put option’s value rises, offsetting losses. If the stock rises, they’re only out the $3 premium, still benefiting from gains. This strategy offers downside protection without selling the stock.

Bear Iron Condor Spread

Bear Iron Condor Spread

The Bear Iron Condor Spread is an options strategy for sideways or slightly bearish markets. It involves selling out-of-the-money put and call options while buying further out-of-the-money options for protection. This creates a net credit, representing the maximum profit if the underlying asset stays within a specific range.

Example: Let’s say an investor uses a Bear Iron Condor Spread on Stock XYZ, priced at $100. They sell a $90 put and a $110 call, and to limit losses, they buy a $85 put and a $115 call. This creates a profit range of $90 to $110. If XYZ stays within, they keep the initial credit. If it moves outside, losses are capped. This strategy suits low volatility or mildly bearish markets.

Bear Butterfly Spread

Bear Butterfly Spread

The Bear Butterfly Spread is an options strategy for anticipating a moderate downward movement in an asset. Here the investor buys one lower strike put option, sells two middle strike puts, and buys one higher strike put, all with the same expiration date. This creates a net debit position and profits from a specific range of price decreases. It offers limited potential gains and caps the maximum loss, making it suitable for those with a moderately bearish perspective.

Example: Let’s say you’re bearish on stock XYZ, which is currently trading at $100. You employ a Bear Butterfly Spread by buying one put option with a strike price of $95 for $300 (lower strike), selling two put options with a strike price of $100 for $200 each ($400 total), and buying one put option with a strike price of $105 for $250 (higher strike). Your net debit for this trade is $150. If the stock closes at $100 at expiration, the spread would be worth $500, resulting in a $350 profit. This strategy benefits from a moderate decline in the stock’s price while capping potential losses.

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Option Trading Strategies for Neutral Market

Knowing about option trading strategies for neutral market conditions is important because it provides investors with tools to profit in situations where the market lacks a clear upward or downward trend.

Let’s look into some of the top option trading strategies for neutral market conditions:

Long and Short Straddles

Long and Short Straddles
  • Long Straddle is an options tactic in which an investor purchases both a call and a put option at the same strike price and expiration date. This approach is utilized when there is an expectation of significant price movement in the underlying asset, but the direction is uncertain. The goal is to profit from the volatility, as the gains from one option can potentially offset the losses from the other.
  • Short Straddle involves selling both a call and a put option with the same strike price and expiration date. This strategy is used when the trader anticipates minimal price fluctuation, aiming to profit from the time decay of the options. However, it carries unlimited risk if the price of the underlying asset makes a significant move in either direction.

Example: Imagine an investor who foresees a significant price shift in a $100 stock due to an upcoming earnings report. They use a Long Straddle strategy, buying both a call and a put option at a $100 strike price. If the stock makes a noteworthy move, they have the potential to profit. If it climbs to $120, the call option gains value, offsetting the put option’s loss. Likewise, if it falls to $80, the put option becomes profitable, compensating for the call option’s decline.This same principle applies to a Short Straddle strategy, in this case, if the stock remains stable at around $100, they profit from the options’ time decay.

Long and Short Strangles

Long and Short Strangles
  • Long Strangle is an options strategy where an investor simultaneously buys an out-of-the-money call option and an out-of-the-money put option with the same expiration date.  This approach aims to gain from substantial price shifts in either direction. 
  • Short Strangle involves selling an out-of-the-money call option and an out-of-the-money put option, typically with the expectation that the underlying asset will remain within a specific range. This strategy is used to profit on low volatility environments, as the options will ideally expire worthless. 

Both strategies involve higher risk due to the purchase or sale of two options, but they offer potentially good amounts of profit if the underlying asset makes a substantial move. Careful consideration of market conditions and thorough risk assessment are crucial when employing these strategies.

Example: Let’s assume that an investor buying a $130 call and a $70 put option for a total premium of $300, both expiring in a month. If the stock moves significantly beyond $160 or below $40, there’s potential for high profits. For instance, if it reaches $170 or drops to $30, significant gains are possible. However, if the stock remains stable, the options may expire worthless, resulting in a loss of the initial $300 premium paid. The Short Strangle is similar, with some parameters adjusted for a different strategy.

Disclaimer

The strategies for options trading discussed in this blog are intended for informational purposes exclusively and should not be considered as financial advice or recommendations. 

Conclusion

 Understanding options trading and the various strategies available can empower investors to manage financial markets effectively. Whether capitalizing on bullish, bearish, or neutral market conditions, each strategy comes with its own risk-reward profile. It’s important to carefully assess market conditions, risk tolerance, and individual financial goals before implementing any of these strategies. Additionally, seeking advice from a qualified financial advisor and conducting thorough research is recommended. 

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