RE: Seven Professional Options Strategies Every Trader Needs to Know.

From Greg M

Lions and friends.. This is a re-post. Please feel free to share this.

Let me begin here with laying out some options basics, just as a quick review!

What Are Options?

An option is a derivative, that is an option derives its value from another underlying asset. When a trader either buys or sells an option, he or she is entering into a contract which gives its owner the right, but not the obligation, to buy or sell the underlying at a specified strike price prior to or on a specific date in the future.

Why Trade Options at All?

Options are traded for one reason, leverage! That is an investor/trader can control a large amount of the underlying asset with a much smaller investment. For example, to purchase 100 shares of a $50 stock, an investor must lay out $5,000. But, if the investor were to purchase one options contract of $10 calls, (with each contract representing 100 shares), the total cash outlay would be only $1,000. He/she is controlling the same amount of shares in this example by owning the option, but at 1/5th the cost of owning the underlying stock.

Options Can Offer Less Risk If Used Properly.

Options can be less risky for investors first and foremost because they involve a much lower financial commitment than owning the underlying asset. However, there are circumstances where options can expose the investor to unlimited risk as well. For example, if a trader sells a call- which has unlimited upside. When writing/selling naked calls, the risk is unlimited.

Options Offer Investors Higher Potential Returns.

Being that buying an option vs owning the underlying stock involves a much smaller investment, it’s easy to understand that if you spend less money and can potentially make more profit, you will have a higher percentage return on your money- this is good.

Now I am going to cover how, and why, specific options strategies are utilized and how to simply set them up!

First a few important terms. You will see several of the terms I have listed below as I outline how to set up particular strategies, these are important to know.

Options Contract. This is an agreement between two parties to facilitate a potential transaction on an underlying asset at a preset price, known as the strike price, prior to the options expiration date.

Options Expiration Time. This is defined as the exact date and time when an options contract is rendered null and void.

Put. A Put is defined as a contract giving the owner the right, but not the obligation, to sell a specified amount of an underlying security at a predetermined price within a specified time frame.

Call. A Call is defined as a financial contract that gives the option buyer the right, but not the obligation, to buy a stock/underlying asset at a specified price within a specific time-period, (the contract’s expiration date). 

Strike Price. This is defined as the price at which an option contract can be bought or sold.

ATM. This stands for AT THE MONEY which is defined as a situation where the strike price of the option is identical to the current market price of the underlying security

OTM. This stands for OUT OF THE MONEY which is defined as an option which has not yet reached its strike price.

ITM. This stands for IN THE MONEY which is defined as an option's state of *moneyness.

*Moneyness is a way to define the value of an options contract relating its strike price, and to the current price of the underlying asset. The more ITM an option is, the more its worth.

Seven Options Strategies That Every Trader Needs to Know.

Options not only offer an investor/trader leverage in the market, but they also offer potentially less risk if utilized properly. Moreover, they allow an investor/trader to make a smaller investment to control a large amount of shares in an underlying asset. When considering options, there are many ways to structure them, and I will cover what I consider to be the seven most important ones here.

Options can be either bought by a trader/investor or sold by a trader/investor. If a trader chooses to buy an option, the order is BUY TO OPEN. If a trader chooses to sell an option, the order is SELL TO OPEN. Either of these can be reversed at any time if the trader/investor wants to exit their position. If an option is bought, he/she would then SELL TO CLOSE as to exit the position. If the investor has sold an option, the order is then BUY TO CLOSE, as to exit the position.

In general, I personally like to be a net seller of options. Being a net seller of options allows me to collect a premium on my trades upfront.

Ways To Structure a Trade.

I am relatively certain that if you have already had some exposure to options trading, some of the names of the trading strategies I am going to cover here will be familiar to you, but here I am going to show you exactly how to set them up.

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.