Option Strategies

Long Straddles

For aggressive investors who expect short-term volatility yet have no bias up or down (i.e., a neutral bias), the long straddle is an excellent strategy. This position involves buying both a put and a call with the same strike price, expiration, and underlying. The potential loss is limited to the initial investment. The potential profit is unlimited as the stock moves up or down.

Example Increase in Volatility Time Erosion
Buy Call
Buy Put
Helps position Hurts position

Although long and short straddles differ in their response to market movement, we have chosen to list both as neutral strategies. In a pure sense, the short straddle is a neutral strategy because it achieves maximum profit in a market that moves sideways. In contrast, the long straddle benefits from market movement in either direction. However, since a $10 move in either direction will have the same impact on profit, the trader doesn't necessarily have a preference which way the market moves. In this sense, the trader is neutral about market direction--as long as movement occurs.

Have you ever had the feeling that a stock was about to make a big move, but you weren't sure which way? For stockholders, this is exactly the kind of scenario that creates ulcers. For option traders, these feelings in the stomach are the butterflies of opportunity. By simultaneously buying the same number of puts and calls at the current stock price, option traders can capitalize on large moves in either direction.

Here's how this works. Let's imagine a stock is trading around $80 per share. To prepare for a big move in either direction, you would buy both the 80 calls and the 80 puts. If the stock drops to $50 by expiration, the puts will be worth $30 and the calls will be worth $0. If the stock gaps up to $110, the calls will be worth $30 and the puts will be worth $0. The greatest risk in this case is that the stock remains at $80 where both options expire worthless.

Short Straddles

For aggressive investors who don't expect much short-term volatility, the short strangle can be a risky, but profitable strategy. This strategy typically involves selling out-of-the-money puts and calls with the same strike price, expiration, and underlying. The profit is limited to the credit received by selling options. The potential loss is unlimited as the market moves up or down.

Example Increase in Volatility Time Erosion
Sell Call
Sell Put
Hurts position Helps position

The short straddle, as the name implies, is the opposite of the long straddle. By establishing this position, you would have to be fairly certain the stock wasn't going to move in either direction because the risk on either side if you're wrong is unlimited. Fortunately, there is another position known as the long butterfly that meets the same objectives with much less risk.

Long Strangles

For aggressive investors who expect short-term volatility yet have no bias up or down, the long strange is another excellent strategy. This strategy typically involves buying out-of-the-money calls and puts with the same strike price, expiration and underlying. The potential loss is limited to the initial investment while the potential profit is unlimited as the underlying security moves in either direction.

Example Increase in Volatility Time Erosion
Buy Call (Higher Strike)
Buy Put (Lower Strike)
Helps position Hurts position

Although long and short strangles differ in their response to market movement, we have chosen to list both as neutral strategies. In a pure sense, the short strangle is a neutral strategy because it achieves maximum profit in a market that moves sideways. In contrast, the long strangle benefits from market movement in either direction. However, since a $10 move in either direction will have the same impact on profit, the trader doesn't necessarily have a preference which way the market moves. In this sense, the trader is neutral about market direction--as long as movement occurs.

Long strangles are comparable to long straddles in that they profit from market movement in either direction. From a cash outlay standpoint, strangles are less risky than straddles because they are usually initiated with less expensive, near-the-money rather than at-the-money options. Like long straddles, they have unlimited profit potential on both the upside and downside.

Short Strangles

For aggressive investors who don't expect much short-term volatility, the short strangle can be a risky, but profitable strategy. This strategy typically involves selling out-of-the-money puts and calls with different strike price but the same expiration and underlying. The profit is limited to the credit received by selling options. The potential loss is unlimited as the market moves up or down.

Example Increase in Volatility Time Erosion
Sell Call (Higher Strike)
Sell Put (Lower Strike)
Hurts position Helps position

Short Strangles are comparable to short straddles in that they profit in stagnant markets with little price change. Like short straddles, they have unlimited loss potential on both the upside and downside. Strangles are slightly less risky than straddles, but the position is far from risk-free. In fact, the strangle got its name in 1978 when a number of IBM option traders holding this position lost everything as a result of wide, unexpected price swings.

The Butterfly

Ideal for investors who prefer limited risk, limited reward strategies. When investors expect stable prices, they can buy the butterfly by selling two options at the middle strike and buying one option at the higher and lower strikes. The options, which must be all calls or all puts, must also have the same expiration and underlying.

Example Increase in Volatility Time Erosion
Sell 2 Calls (Middle Strike)
Buy 1 Call (Lower Strike)
Buy 1 Call (Higher Strike)
Hurts position Helps position

When your feeling on a stock is generally neutral because it's been trading in a narrow range, the long butterfly can be a great strategy to use. Like many spreads, the long butterfly is a limited risk, limited reward strategy. What makes the position interesting is its ability to profit in stagnant markets.

Imagine that a stock trading at $75 has been relatively flat for some time. If you think the situation is unlikely to change, you can sell two 75 calls. At the same time, you'd buy one 70 call and one 80 call as a hedge in case the market moved against you. This combination of options creates the long butterfly. The position is considered "long" because it requires a net cash outlay to initiate.

Long Condors

Ideal for investors who prefer limited risk, limited reward strategies. The condor takes the body of the butterfly - two options at the middle strike - and splits between two middle strikes. In this sense, the condor is basically a butterfly stretched over four strike prices instead of three.

Example Increase in Volatility Time Erosion
Buy 1 Call (In-the-Money)
Sell 2 Calls (Consecutive Strikes Near Money)
Buy 1 Call (Out-of-the-Money)
Hurts position Helps position

The condor takes the body of the butterfly - two options at the middle strike - and splits it between two middle strikes rather than just one. In this sense, the condor is basically a butterfly stretched over four strike prices instead of three.

Example:
Long (Buy) 70 Call
Short (Sell) 75 Call
Short (Sell) 80 Call
Long (Buy) 85 Call

You can also view a condor as a combination of a bull and bear call spread:
Long (buy) 70 call, short (sell) 75 call (bull call spread)
Short (sell) 80 call, long (buy) 85 call (bear call spread)

The long condor can be a great strategy to use when your feeling on a stock is generally neutral because it's been trading in a narrow range. Like the butterfly, the condor is a limited risk, limited reward strategy that profits in stagnant markets.

Short Condors

Ideal for investors who prefer limited risk, limited reward strategies. The condor takes the body of the butterfly - two options at the middle strike - and splits between two middle strikes. In this sense, the condor is basically a butterfly stretched over four strike prices instead of three.

Example Increase in Volatility Time Erosion
Sell 1 Call (In-the-Money)
Buy 2 Calls (Consecutive Strikes Near Money)
Sell 1 Call (Out-of-the-Money)
Helps position Hurts position

When your feeling on a stock is that it's about to move one way or the other, but you're not sure which way, the short condor can be an effective strategy. Like the long condor and long butterfly, the short condor is a limited risk, limited reward strategy. In this case, you would buy one 75 call and one 80 call. At the same time, you'd sell one 70 call and one 85 call as a hedge in case the market moved against you. This combination of options creates the short condor. The position is considered "short" because you will collect a credit for making the trade.

The Collar

For bullish investors who want a nice low risk, limited return strategies to use in conjunction with a long stock position, collars are a great alternative. In this case, the collar is created by combining covered calls and protective puts.

Example Increase in Volatility Time Erosion
Buy Stock
Sell Call
Buy Put
Minimal Impact Hurts position

When the stock position is long, the collar is created by combining covered calls and protective puts. From a profitability standpoint, the collar behaves just like a bull spread. The upside potential is limited beyond the strike price of the short call while the downside is protected by the long put.

Calendar Spreads

Calendar spreads are also known as time or horizontal spreads because they involve options with different expiration months. Because they are not exceptionally profitable on their own, calendar spreads are often used by traders who maintain large positions. Typically, a long calendar spread involves buying an option with a long-term expiration and selling an option with the same strike price and short-term expiration.

Example Increase in Volatility Time Erosion
Sell Near Term Position
Buy Far Term Position
Hurts position Helps position

Calendar spreads are also known as time or horizontal spreads because they involve options with different expiration months. In this case, "horizontal" refers to the fact that option months were originally listed on the board at the exchange from left to right. At the same time, strike prices were listed from top to bottom. For this reason, options with different strike prices and the same expiration are often referred to as vertical spreads.

In simplest terms, a long calendar spread involves buying an option with a longer expiration and selling an option with the same strike price and a shorter expiration. For example, imagine that Bubba Gump's (XYZ) is trading for $45 per share. To initiate a calendar spread, you might sell the Bubba Gump June 45 calls and buy the July 45 calls.

Ratio Spreads

For aggressive investors who don't expect much short-term volatility, ratio spreads are a limited reward, unlimited risk strategy. Put ratio spreads, which involve buying puts at a higher strike price and selling a greater number of puts at a lower strike, are neutral in the sense that they are hurt by market movement.

Example Increase in Volatility Time Erosion
Buy 1 Put (Lower Strike)
Sell 2 Puts (Higher Strike)
Hurts position Helps position

Ratio spreads are neutral in the sense that you don't want the market to move much either way once you make the trade.

While call and put ratio spreads can be effective strategies when you are expecting relatively stable prices over the short term, they are not without risk. By definition, a ratio spread involves more short than long options. If the trade moves against you, the extra short option(s) expose you to unlimited risk.

Put Ratio Spreads
To create a put ratio spread, you would buy puts at a higher strike and sell a greater number of puts at a lower strike. Ideally, this trade will be initiated for a minimal debit or, if possible, a small credit. This way, if the stock jumps, you won't suffer much because all of the puts will expire worthless. However, if the stock plummets, you have unlimited risk to the downside because you will have sold more options than you bought. For maximum profitability, you want the stock price to stay at the strike price where you are short options.

Call Ratio Spreads
Like the put ratio spread, call ratio spreads are great strategies when you are expecting relatively stable prices over the short term. To create this position, you would buy calls at a lower strike price and sell a greater number of calls at a higher strike price. Here again, do your best to initiate the trade for a minimal debit or even a small credit. This way, if the stock drops, you won't suffer much because all of the calls will expire worthless. However, if the stock takes off, you will have unlimited risk to the upside because you will have sold more options than you bought.