What Are Options Strategies?
Options strategies are combinations of one or more types of option contracts designed to help you gain profits or limit losses in different situations in the stock market.
If you want to recap what the options are, you can refer to this article here.
The combinations in each of the options trading strategies differ from each other based on:
- Strike price, i.e. the price at which the option contract is to be executed, regardless of the spot price of the underlying asset.
- ITM, OTM, and ATM, i.e. whether the option is in-the-money, out-of-the-money or at-the-money.
- Expiry date, i.e. the day when the option can be executed in the stock market in case of European options.
- Nature of the option, i.e., whether the option is a call or put and whether you are the buyer or seller.
In the following sections, we will list the different option strategies that you can use in order to exploit a bullish scenario, a bearish scenario and a neutral scenario. We will also go over how to adopt various momentum-based options strategies.
Bullish Option Strategies
Bullish option trading strategies are used when you are confident that the underlying asset will increase in price by the expiry date. You can use the following strategies to handle a bullish scenario:
1. Long Call
This is the simple strategy of buying a call option at a strike price, which you expect to be lower than the spot price on the expiry date. For example, if you expect the spot price to be ₹1,000 on the expiry date, buy a call option at a strike price lower than ₹1,000, such as ₹900. If the spot price on the expiry date is ₹1,000, then you can buy the underlying asset at ₹900, based on the call option, and sell it for ₹1,000 in the spot market.
2. Bull Call Spread
Buy an ATM call option and sell an OTM call option at a higher strike price. This will limit both your losses and your gains. This strategy is used when the trader expects a moderate increase in the spot price. For example, if you expect the spot price to be around ₹1,550 or more on expiry day, then you can buy a call at ₹1,400 and sell a call at 1,700 to deploy this strategy.
3. Bull Put Spread
Sell a put option and then buy a put option at a lower strike price. Do this if you are expecting a moderate price rise. For example, if you are expecting the price to be around ₹1,000-1,200, then you can sell a put at ₹1,200 and buy a put at ₹800 to implement this strategy.
4. Short put
This involves simply selling a put option at a strike price that you expect to be lower than the spot price on the expiry date. For example, if you expect the price to be ₹1,000, then sell the put at ₹900. If the spot price is actually ₹1,000 on the expiry date, then the person holding the put option would rather sell the asset on the spot market and thus not exercise the put option that you had sold.
Bearish Option Strategies
Bearish option trading strategies are used when you are confident that the underlying asset is going to decrease in price by the expiry date. You can use the following strategies to handle a bearish scenario:
1. Long Put
This involves simply buying a put option at a strike price that you expect to be higher than the spot price on the expiry date. For example, if you expect the spot price to be ₹1,000 on the expiry date, then buy a put option at a strike price higher than ₹1,000, such as ₹1,100.
2. Bear Put Spread
Buy an ITM put option and sell an OTM put option at a lower strike price when you expect a moderate price fall. This will limit both your losses and your gains. For example, if you are expecting the price to be around ₹1,550 or less, then sell a put at a strike price of ₹1,400 and buy a put at around ₹1,700 to implement this strategy.
3. Bear Call Spread
This strategy involves selling a call and then buying an OTM call at a cheaper premium. For example, if you expect the spot price to be ₹1,500 or lower, then you can sell a call at ₹1,400 and buy a call at ₹1,600. This will give limited gains when the price falls below ₹1,500 but it will also limit your losses if the price is higher than ₹1,500.
4. Short Call
This involves simply selling a call option at a strike price that you expect to be lower than the spot price on the expiry date.
Neutral Stance Option Strategies
Neutral option trading strategies are usually option selling strategies used when you are confident that the underlying asset’s price will stay within a particular range until the expiry date and will not see much volatility. You can use the following strategies to handle a neutral scenario:
1. Short Straddle
This strategy involves selling a call and a put option at the same strike price. You gain profits, specifically the total premium received from selling the options, as long as the spot price remains within a particular range.
2. Short Strangle
The short strangle option strategy involves selling a put option and then selling a call option at a higher price. Similar to short straddle, you gain the premium earned and retain that profit as long as the spot price remains range-bound. However, the range in this case is wider than in the case of a short straddle, the exact width depending upon the difference in the strike prices of the call and put options.
3. Short Iron Butterfly
A short straddle has the potential for unlimited losses, depending upon how volatile the spot price is. In such cases, a short iron butterfly option strategy can instead be used to limit the losses in case of volatility. You can do so by setting up a short strangle at a particular strike price and then buying a put option at a lower strike price and buying a call option at a higher strike price.
4. Short Iron Condor
Similar to a short iron butterfly, a short iron condor option strategy also tries to limit the losses that can come from the spot price moving beyond the profitable range of a neutral stance trading strategy. However, instead of basing it on a short straddle, you first set up a short strangle. Then, simply buy a put option at a lower strike price and buy a call option at a higher strike price than the strike prices of the initial short strangle.
Breakout Trading Strategies
These are option strategies that expect a breakout of the spot price from a particular range. It could be both a bullish or bearish breakout. In either case, these strategies can give you profits.
1. Long Straddle
This straddle option strategy involves buying a call and a put option at the same strike price. You gain profits as long as the spot price moves outside a particular range.
2. Long Strangle
This strategy involves buying a put option and then buying a call option at a higher strike price. Similar to long straddle, you may gain unlimited profits as long as the spot price remains range-bound. However, the range in this case is wider than in the case of a long straddle, the exact width depending upon the difference in the strike prices of the call and put options.
3. Long Iron Butterfly
To reduce the amount of money committed to a long straddle, a long iron butterfly can instead be used to gain some money by additionally selling a put option at a lower strike price and selling a call option at a higher strike price.
4. Long Iron Condor
Similar to a long iron butterfly, to reduce the amount of money committed to a long strangle, a long iron condor can instead be used to gain some money by additionally selling a put option at a lower strike price and selling a call option at a higher strike price.
Other Strategies
1. Covered Call
Simply buy a stock and then also sell a call option on that stock. This strategy can be used when you have a neutral position on a stock however, even if the stock price increases or decreases, the premium received can help you make a profit.
2. Married Put
This involves buying a stock and also buying a put option on that stock. The put option then acts like a stop loss as you can sell at the strike price even if the stock loses value.
There can be many more option strategies, such as synthetic call and put, call ratio back spread, etc. You can also create multi-legged option strategies, i.e. option strategies involving multiple types of option contracts, by yourself, based on your own predictions of risk and market trends.
Risk vs Reward in Option Strategies
The primary risk of any of the option trading strategies is the risk of the underlying asset’s price moving in the opposite direction than was expected. This includes the scenario of the price not moving at all, even when a strategy expecting volatility had been set up. This is why many traders prefer a downside protection options strategy, like the covered call, to protect their bases.
The best option trading strategy for you is the one that accommodates:
- Your prediction of the market trend.
- A balance between the amount of reward that you can get and the amount of money you are putting at risk.
- Your trading balance available at the moment, including the amount that you can get under the margin trading facility.
Advantages of Trading Options
- Leverage: Options allow you to control a bigger position in the market for a relatively smaller investment. Leverage can help you amplify your gains if the trade goes in your direction.
- Hedging: Options can be used effectively as a risk management tool against potential losses. For example, you can use a put option to safeguard against a decline in the value of your holdings.
- Versatile: You can work out different option strategies according to market conditions, making it a versatile tool to apply. Whether the market condition is bullish, bearish, or neutral, you can use options to capitalise on your market outlook.
- Income generation: You can generate income by selling options. When options expire worthless, you can earn income from the premium collected.
Disadvantages of Trading Options
- Complexities: Options trading is more complex than trading stocks. It involved decisions regarding the underlying asset’s time, direction, and price. Options trading is not suitable for new or beginner traders.
- Time decay: Options are time-bound contracts, meaning their value erodes quickly if the asset price doesn’t move in the direction of the trade within the time frame of the options contract.
- Uncertainty of gains: Options strategies are based on future expectations of the price movement. You can earn a profit only when the trade moves in the predicted direction.
- Agreement signing: Options trading in India requires traders to sign an agreement with the broker. It is a requirement asked for by SEBI. The agreement contains a disclosure of the risks involved in options trading.
- High volatility risk: Volatility is the reason for changing options’ values. When volatility rises, it makes options more valuable. Conversely, the options can lose value even if the underlying asset price doesn’t move significantly.
Final Words
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What is the best strategy for options buying?
There are several strategies that traders use when buying options in India. One common strategy is the “covered call,” where traders buy shares of a stock and sell call options on those shares to generate income. It’s important to note that the best strategy for options buying will depend on the individual trader’s goals, risk tolerance, and market outlook. It’s always a good idea to thoroughly research and test any strategy before putting it into practice.
Which strategy is best for options trading?
There is no one-size-fits-all strategy for options trading. The best strategy depends on the trader’s goals, risk tolerance, and market conditions. Some commonly used options trading strategies include:
Covered Call Bull Call Spread Bear Put Spread Iron Condor
What is the safest options strategy?
No options strategy can be considered the safest, as the risks and potential rewards of any given strategy will depend on a variety of factors, including market conditions, the specific options being traded, and the investor’s individual risk tolerance and investment goals.
What is the riskiest option strategy?
The riskiest option strategy can vary depending on market conditions and individual circumstances. However, naked call writing, short straddles/strangles, and directional bets using out-of-the-money options are considered to be highly risky. It’s important to understand the risks involved with any option strategy and use proper risk management techniques, such as limiting position size and using stop-loss orders.
How do I start trading options for beginners?
Here are some basic steps for beginners in India to start trading options:
Learn the basics Choose a broker Open an account Fund your account Start trading Monitor your trades Practice good risk management
Which strategy is best for option selling?
Option selling can be a complex and risky strategy that requires a thorough understanding of market dynamics and risk management techniques to imply any strategy that can work. Therefore, there is no one best strategy.
