The 7 Strategies Every Trader Must Know
Dec 23, 2016
By: Josh Fabian
Picking the proper strategy when executing a trade is a lot like a quarterback working through a progression of receivers. A quarterback has to read the defense, see where the opportunity is, then find the right receiver. Traders need to read the market, see what opportunities exist then choose the proper strategy. There are seven strategies most commonly used when trading options.
Selling a put is a bullish strategy benefiting from a move higher in the underlying asset. To increase our probability of being profitable (POP), we look for a strike price offering a greater than 50% POP. We can make that determination by looking at an option’s delta. In exchange for selling the put, a credit is received. Short puts are managed at 50% of the initial credit received or maximum credit.
Selling calls is a bearish strategy profiting from a move down in price. Mechanically, identifying the correct strike price to sell is much like that of the short put. We want a strike price where POP is above 50%. Again, profits on short calls are managed at 50% of credit received.
A short strangle simply takes the above strategies, selling a put and selling call, and doing both trades at the same time as one unit. In a strangle, direction is not the top consideration, volatility is. The put and call which are sold have different strike prices, allowing the underlying to trade within a range. So long as that range is not breached, the trade is profitable. That is why strangles are considered “non-directional” trades. Because strangles are entered into as a single unit, they are also closed as one. Just like the short put and short call, short strangles are managed at 50%.
Much like the short strangle, a short straddle consists of selling both a put and a call. However, in a straddle, the put and call both have the same strike price and are typically sold where the asset is currently trading, also known as at-the-money (ATM). Straddles do not have directional biases, therefore, they are a strategy for times of high implied volatility which maximizes the credit received. Straddles will generate the greatest initial credit of all strategies because they are sold ATM. Because of that, straddles are managed more aggressively at 25% of max profit.
Short Put (Call) Spread
Selling a spread generates a credit while at the same time, defining maximum possible loss. This is often referred to as selling a “credit spread” and is a directionally biased trade. Selling a put (call) spread involves selling the option with a strike price near where the underlying asset is trading then buying the same type of option further out-of-the-money (OTM). For example, SPY is currently trading near $220. A call spread might involve selling the December 224 calls and buying the 227 calls for a credit of $0.40. In this trade, maximum profit is $.40. Maximum loss is equal to the difference in strike prices ($3) minus credit received ($0.40) or $2.60. This trade is risking $260 to make $40. Credit spreads are common in smaller accounts and IRAs, where undefined risk trades, such as short puts, short calls, short strangles and short straddles are not possible. Credit spreads are managed at 50%.
Long Put (Call) Spread
This strategy is commonly referred to as a “debit spread” because it involves buying a put (call) near where the underlying asset is trading then selling the same type of option further OTM. Debit spreads are often used when volatility is too low to justify selling options. Similar to the short credit spread, long debit spreads have directional bias. Debit spreads are managed at 50% (i.e., if the cost of the spread was $1, the trade would be closed when it could be sold for $1.50). Maximum loss on a debit spread is equal to the cost of entering the trade.
Iron condors are similar to strangles in that both a put and a call are sold, away from where the underlying asset currently trades. However, instead of selling just a put and a call, a put spread and call spread are each sold. Iron condors are defined risk, non-directional trades. The trade is entered as one single unit in exchange for a credit received and exited as one unit, once the trade has reached 50% of its maximum credit.
While we cannot control what the market does, we can choose which strategy is most appropriate. These are seven fundamental option trading strategies. Which strategy to use is largely dependent on the market, volatility and risk tolerance.
Josh Fabian has been trading futures and derivatives for more than 25 years.
For more on this topic see:
Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.
tastytrade content is provided solely by tastytrade, Inc. (“tastytrade”) and is for informational and educational purposes only. It is not, nor is it intended to be, trading or investment advice or a recommendation that any security, futures contract, transaction or investment strategy is suitable for any person. Trading securities can involve high risk and the loss of any funds invested. tastytrade, through its content, financial programming or otherwise, does not provide investment or financial advice or make investment recommendations. Investment information provided may not be appropriate for all investors, and is provided without respect to individual investor financial sophistication, financial situation, investing time horizon or risk tolerance. tastytrade is not in the business of transacting securities trades, nor does it direct client commodity accounts or give commodity trading advice tailored to any particular client’s situation or investment objectives. Supporting documentation for any claims (including claims made on behalf of options programs), comparison, statistics, or other technical data, if applicable, will be supplied upon request. tastytrade is not a licensed financial advisor, registered investment advisor, or a registered broker-dealer. Options, futures and futures options are not suitable for all investors. Prior to trading securities products, please read the Characteristics and Risks of Standardized Options and the Risk Disclosure for Futures and Options found on tastyworks.com.
tastyworks, Inc. ("tastyworks") is a registered broker-dealer and member of FINRA, NFA and SIPC. tastyworks offers self-directed brokerage accounts to its customers. tastyworks does not give financial or trading advice nor does it make investment recommendations. You alone are responsible for making your investment and trading decisions and for evaluating the merits and risks associated with the use of tastyworks’ systems, services or products. tastyworks is a wholly owned subsidiary of tastytrade, Inc (“tastytrade”). tastytrade is a trademark/servicemark owned by tastytrade.
Quiet Foundation, Inc. (“Quiet Foundation”) is a wholly-owned subsidiary of tastytrade The information on quietfoundation.com is intended for U.S. residents only. All investing involves the risk of loss. Past performance is not a guarantee of future results. Quiet Foundation does not make suitability determinations, nor does it make investment recommendations. You alone are responsible for making your investment and trading decisions and for evaluating the merits and risks associated with the use of Quiet Foundation’s systems, services or products.
Small Exchange, Inc. is a Designated Contract Market registered with the U.S. Commodity Futures Trading Commission. The information on this site should be considered general information and not in any case as a recommendation or advice concerning investment decisions. The reader itself is responsible for the risks associated with an investment decision based on the information stated in this material in light of his or her specific circumstances. The information on this website is for informational purposes only, and does not contend to address the financial objectives, situation, or specific needs of any individual investor. Trading in derivatives and other financial instruments involves risk, please read the Risk Disclosure Statement for Futures and Options. tastytrade is an investor in Small Exchange, Inc.