Options trading: popular strategies, charts, examples

By roma, 16 August, 2020

1. Straddle

A straddle strategy involves the simultaneous buying/selling of a call option and a put option with the same expiry date and strike price. Strike is chosen so that both options are at the money or their deltas are about 50% in absolute terms.

Straddle is the most common instrument for investors who expect significant price fluctuations in the underlying asset regardless of direction. Options traders begin to pay attention to the price of straddle (and not to implied volatility) about a week before an option expiry. As the expiry date approaches, traders shift their attention from vega (volatility) to gamma (straddle prices), as the vega decreases over time and the gamma of at-the-money options increases.

Straddle

Straddle is the most common instrument for investors who expect significant price fluctuations in the underlying asset regardless of direction. Options traders begin to pay attention to the price of straddle (and not to implied volatility) about a week before an option expiry. As the expiry date approaches, traders shift their attention from vega (volatility) to gamma (straddle prices), as the vega decreases over time and the gamma of at-the-money options increases.

 

2. Strangle

Strangle is formed by buying/selling call and put options with different strike prices but the same expiry dates. As a rule, both options are out of the money. If call and put were purchased, the investor has a long strangle position. If options have been sold, this position is called a short strangle.

Strangle

A Strangle strategy has many similarities to Straddle, as call and put options are either bought together or sold. However, the value of the strangle is lower because out of the money (OTM) options are used, but the profit and loss potential is also lower than that of the straddle. The reasons for buying a strangle are similar to buying a straddle – an expectation of increased implied volatility and/or the possibility of large price fluctuations in the underlying asset. The only difference is that the buyer expects more significant movements in the spot price of the asset.

 

3. Butterfly strategy

The strategy is formed by combining options with 3 strikes. A long butterfly position means buying one option with a relatively low strike K1 and one option with a high strike K3, and simultaneously selling two options with a strike K2. It should be noted that K2 is usually halfway between K1 and K3. In practice, traders select a strike price so that the average strike equals the forward price of the underlying asset, i.e. that options with K2 strike are in the money, and thus have the highest gamma and vega.

Butterfly strategy

A long position is profitable if the price of the underlying asset does not fluctuate significantly and remains around the mid-strike until expiry. This strategy will result in a small loss if the price of the asset is highly volatile, since selling options with medium strikes close to the forward price of the underlying asset implies a short gamma position.

A butterfly strategy can be built with either put options or call options. Consequently, the value of a butterfly generated through put options must be equivalent to the value of a butterfly from a call option. Otherwise, there is a possibility of arbitration on the market.

 

4. Calendar spread

The calendar spread (horizontal spread) is formed by buying an option with one expiry date T1 and simultaneously selling an option with another date T2. When buying a long-term option (futures) and selling a short-term option (futures), the trader takes a long position in the calendar spread.  This strategy also has the names of time spread and horizontal spread.

A trader can construct a calendar spread by selling a straddle on the S&P 500 index with an expiration in August 2015 and buying a straddle with an expiration in December 2015. If the time structure of the volatility is normal, the calendar spread will have a negative gamma and a positive vega.

Calendar spread is used by traders in several cases:
1) trading in the time structure of volatility;
2) trading the gamma with short-term options and hedging the vega by buying/selling long-term options.

 

5. Box spread

Box spread – a combination of a long call spread with strikes K1 and K2 and a long put spread with the same price and expiration date. At expiry trader gets the sum equal to the difference between two strike prices (K2 - K1). Since the trader knows in advance the value of the box spread on the expiry date, the theoretical fair value of the box spread when buying should be a discounted value from (K2 - K1). Thus, the net profit from the box spread is a risk-free interest rate.

 

Box spread

The box spread strategy is popular among algorithmic trading companies that profit from short-term divergences in option prices. The reason for such divergences may be:
1) imbalance between supply and demand for options with a certain strikes;
2) the size of the minimum bid-ask spread that is set by the exchange.

If the option market is illiquid, the profit from the box spread will be much lower than the risk-free interest rate.