Options trading: 9 option strategies and their risks

By roma, 16 August, 2020

Very often people start trading options with little understanding of how many different strategies can be used to limit risks and maximize profits. However, traders must first learn how to utilize options. With this in mind, this article aims to speed up the learning process.

 

1.    Covered call option

Covered call option

In addition to simply buying an option, the trader can also implement strategy “Covered Call”. In this strategy,
1) the underlying asset is bought at the same time as
2) a call option is sold on the same asset.

The volume of the purchased asset must be equivalent to the number of call options sold on the same asset. Traders often use this strategy when they have a neutral view of the assets and seek additional profit (through a premium on the sale of options) or protect against a possible decline in the value of the underlying asset.

 

2.   Married put

Married put

In this strategy, the investor
1) buys (or may already own) a specific asset (e.g., shares) and
2) simultaneously acquires a put option for an equivalent number of shares.

Investors use this strategy when they have an optimistic view on the long-term price prospects of an asset, but want to protect their portfolio from possible short-term losses and volatility. This strategy mainly functions as an insurance policy.

 

3.   Buying bull call spread

Buying bull call spread

The “bullish call spread” strategy implies simultaneous
1) buying a call option at a certain strike price T1 and
2) selling a similar number of call options at a higher strike price T2.

Both options have the same expiry date and the underlying asset. This vertical strategy is often used when the investor is optimistic about the price of the asset, but expects only a moderate price increase.

 

4.   Buying bear put spread

Buying bear put spread

A bearish put spread strategy is another vertical strategy similar to a call spread. In this strategy, the investor simultaneously
1) buys put options at a specific strike price of T1 and
2) sells the same amount of put options at a lower strike price of T2.

Both options are based on the same asset and have the same expiry date. This strategy is implemented when trader expects the price of the underlying asset to fall. The Put spread offers both limited profits and limited losses, as opposed to simply buying/selling a put option.

 

5.   Long strangle

Long strangle

Option strategy long strangle implies simultaneous
1) purchase of a out of the money call option and
2) purchase of a out of the money put option with the same expiry and underlying asset but with different strike prices.

A trader can implement this strategy with in-the-money options, but the premium will be high and the risk profile is the same. An investor who uses this strategy believes that the price of the underlying asset will change significantly, but does not know in which direction. The risk profile of the strangle is similar to straddle, only the size of the vega and the gamma is much lower. The losses of the trader are limited by the cost of buying options.

 

6.   Long straddle

Long straddle

Long Straddle - an investor usually
1) Buys ATM call option (at-the-money) and
2) Buys ATM put option.

Call and put options have the same strike price, underlying asset and expiry date. Traders use this strategy when they believe that the price of the underlying asset will change significantly, but do not know in which direction. Buying at the money call and put options means that the position has a very high gamma, high vega (for later expiries) and a zero delta. Buying a Straddle is an aggressive option strategy because the premium on options (i.e. Their time value) is very high. Therefore, a trader can make a lot of money on the gamma, in case of huge volatility of the price of the underlying asset, or fix a large loss if the price of the asset does not move.

Read Straddle and strangle trading: opportunities and risks.

 

7.    Risk reversal

Risk reversal

The risk reversal strategy is realized by
1) Buying out-of-the-money put option (strike T1) and
2) Simultaneously selling an out-of-the-money call option (strike T2) for the same underlying asset (e.g. Shares).

This is one of the most difficult strategies for professional traders, as its main function is to trade the slope of volatility (skew), i.e. The difference between implied volatility at different strikes. Professional option traders do not profit from the delta, but from the gamma, vega and volatility skew. Therefore, the delta of risk reversal is immediately hedged. Read Risk reversal: trade volatility skew.

In case of a fall in the price of an asset to strike T1:
1) delta of put option grows (becomes more negative)
2) implied volatility of the lower strikes increases
3) the vega of the whole position increases
4) the gamma of the whole position becomes more positive
5) volatility skew increases.

If the price of the underlying asset rises to strike T2:
1) Delta of short call option becomes more negative
2) the implied volatility on all strikes drops
3) the gamma of the whole position becomes more negative
4) the volatility skew drops
5) vega - unknown (can both grow and fall)

 

8.   Butterfly spread purchase

Butterfly spread purchase

All previous strategies implied a combination of two different positions or contracts. An option strategy “butterfly” can be built in several ways:

1. Buy call options with external strikes T1 and T3
Sell call options with internal strike T2

2. Purchase put options with external strikes T1 and T3
Sell put option with internal strikes T2

3 buy a bull call spread with T1 and T2 strikes
Buy a bear put spread with strikes T2 and T3

4 sell Straddle with strike T2
Buy strangle with T1 and T3

 

9.   Iron condor

Iron condor

Iron condor is an even more interesting strategy. In this strategy, the investor simultaneously takes
1) a long position with external strikes T1 and T4 and
2) a short position with internal strikes T2 and T3.

 

Conclusions

Combining options with different strikes and different expiry dates allows you to build an interesting position. Not only first order derivatives such as delta, vega, theta and rho, but also higher order derivatives such as Weezu, Charm, dDelta/dTime play an important role here. It is also necessary for the trader to observe the term structure of volatility and volatility skew.