Options Plays... How They Work, and Which Is The Right Choice?

From Greg M

Lions and friends…

I get an ENORMOUS amount of questions about trading… going long, going short, etc.

If you are looking to trade derivatives/options, there are essentially two basic ways to to it, there are also MANY advanced strategies as well.

Lets first talk about the two basic strategies regarding options/calls and puts.

The first is the purchase of an option, be it a call or put. By far, the purchasing of a call and or put is the most common way to trade derivatives, it also carries with it a lot of risk.

Here is an example of BUYING options.

Lets say you believe that asset XYZ is going to make a big move higher- you could buy a call. Purchasing a call is a bet that asset XYZ will gain in value.

Lets say you believe that asset XYZ is going to make a big move lower- you could buy a put. Purchasing a put is a bet that asset XYZ will fall in value.

In order for a purchased call or put to work, the underlying asset MUST move in the expected direction and do it quickly. Bought calls and puts decay in value FASTER the longer they are held.

A much safer way to play either an expected higher, or lower move of an asset is to SELL calls and or puts. When you sell a call or put, time decay works FOR YOU, not against you. Moreover, as long as the call or put you sold remains OUT OF THE MONEY, you get to keep the entire premium! EVEN IF THE ASSET moves against the direction you believed it would go.

Here below, I have put together for you several advanced options plays using calls and puts.

1.      The Iron Butterfly

If you are a trader who is somewhat risk-averse, consider the Iron Butterfly strategy. This options structure is less risky but still potentially profitable. This approach to trading is good for generating steady returns on investment with low risk. This strategy helps caps risk, but still offers the ability for a good return on investment.

With the iron butterfly strategy, an investor/trader will sell an at-the-money put and simultaneously buy an out-of-the-money put. To complete this strategy, the trader/investor will also sell an at-the-money call and buy an out-of-the-money call. All options MUST have the same expiration date on the same underlying asset.

2.      Long Strangle

The long options strangle is an unlimited profit, limited risk strategy. This strategy is utilized when the trader/investor believes that the underlying stock will encounter high volatility in the near term. Significant gains are attainable when the underlying asset price makes an especially strong move either upwards or downwards.

To set up a long strangle strategy, the trader/investor will purchase an out-of-the-money call option and an out-of-the-money put option simultaneously, on the same underlying asset with the same expiration date.

3.      Long Straddle

The long straddle options strategy offers unlimited profit, while limiting risk. This strategy is used when the trader/investor believes that the underlying asset will experience considerable volatility in the near term.

A long straddle strategy can be set up as follows. The investor/trader simultaneously purchases a call and put option on the same underlying asset with the same strike price and expiration date.

4.      Bear Put Spread

A bear put spread is a strategy executed by a bearish investor/trader who wants to maximize profit while minimizing potential losses.

The bear put spread strategy is set up by concurrently purchasing put options at a specific strike price and then selling the same number of puts at a lower strike price. Both options positions are purchased on the same underlying asset and have the same expiration date.

5.      Bull Call Spread

A bull call spread is used by a trader/investor when he/she believes the underlying asset price will increase in value.

To set this up, an investor will simultaneously buy calls on an underlying asset while also selling the same number of calls at a higher strike price. Here, both options will have the same expiration date and be on the same underlying asset.

6.      Long Call Butterfly Spread

Long butterfly spreads are utilized by an investor/trader when he/she believes that the underlying asset will not rise or fall much by expiration. This is a limited risk strategy.

With a long butterfly spread using call options, the investor/trader will combine both a bull spread strategy and a bear spread strategy. Here the investor will be using three different strike prices with all the options having the same underlying asset and expiration date.

You set up a long butterfly spread by purchasing one in the money call option at a lower strike price, while selling two at the money call options. Then buying one out-of-the-money call option.

7.      Iron Condor

The iron condor options strategy allows traders to profit in a market that is trading sideways.

To set up the iron condor strategy, an investor/trader simultaneously holds a bull put spread, and a bear call spread. An iron condor is created by selling one out-of-the-money put and buying one out-of-the-money put at a lower strike. To complete this trade, the investor/trader will then sell one out-of-the-money call and buying one out-of-the-money call of a higher strike. All the options positions used to set up this trade must have the same expiration date and are on the same underlying asset.

TRADING INVOLVES RISK! AND IT IS POSSIBLE TO LOSE YOUR ENTIRE INVESTMENT.