According to a report by the World Federation of Exchanges, the global market size for options trading in 2020 was approximately $1.5 trillion. Additionally, options trading is widely used by institutional investors, hedge funds, and individual traders as a way to manage risk, generate income, and speculate on market movements.
Option trading is a financial instrument that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a predetermined price within a specified time frame. The buyer of the option pays a premium to the seller for the right to take advantage of favorable market conditions. Options can be used as a hedge against potential losses or as a way to speculate on market movements.
Option trading is popular due to its versatility, allowing traders to potentially profit in any market condition, whether the market is going up, down, or sideways. It also offers limited risk and leverage, allowing traders to potentially make large gains with relatively small investments.
We’ll cover 5 popular option trading strategies: Cash-secured put, Jade lizards, Put ratio spreads, Covered calls, and Covered strangles. By the end of this post, you will have a better understanding of how these strategies work, and how to use them in real life.
What’s Ahead
Cash-secured Put
A cash-secured put is a type of options trading strategy that involves selling a put option and simultaneously holding enough cash to purchase the underlying stock at the strike price. This strategy is considered low risk and can generate income from the premium received from the put option.
– Example
Suppose you believes that the price of Stock X will stay above $50 for the next few months. You can sell a put option with a strike price of $45 for a premium of $2. At the same time, you should have $45 x 100 = $4,500 available in your account to buy the stock, if necessary. If Stock X stays above $50, then you keep the premium of $2 x 100 = $200 as profit. If Stock X falls below $45 and the option buyer exercised the option, you are obligated to purchase the stock at $45. But since you already have $4500 available, you will purchase the stock and take ownership of it.
In the case of stock price continue to decrease below $45, the price difference can be partially offset with the premium received.
Jade Lizards
A Jade Lizard is a type of neutral to bullish options trading strategy that taking 3 different positions at the same time. This strategy is designed to generate income from the premiums received from the call and put options.
– Example
Suppose you are bullish about XYZ stock that are currently trading at $100. You may setup Jade Lizards strategy as below:
- Sell a $95 strike put for $4
- Sell a $105 strike call for $3
- Buy a $110 strike call for $1
The key is to make sure the net premium received per share match with the spread between the call option you bought and sold. In this case, the net premium received will be $6 ($4 + $3 – $1) which is higher than the difference between $110 and $105 ($5).
We will achieve max profit if the option expired in between $95 and $105, in which we will earn the full premium. If the price is between $105 and $110, we will still make partial gain with the premium. Once the price is above $110, the premium plus the gain from the call option bought will offset with the loss from call option sold. In short, there will be no upside risk.
However, the risk lies on the downside where the price dropped below the put option strike price. Although part of the price difference can be offset by the premium received.
Put Ratio Spreads
A put ratio spread is a type of options trading strategy that involves selling a put option and simultaneously buying more than one put option with a lower strike price. This strategy is designed to generate income from the difference between the premiums received from the sold put and the bought put options.
– Example
Assume the stock price of XYZ is currently trading at $100. You believe that the stock will continue to trade above $95. To implement the put ratio spread strategy, you sell 1 put option with a strike price of $95 for a premium of $3. Additionally, you buy 2 put options with a strike price of $90 for a premium of $1 each. So, you receive $3 in premium from selling the $95 strike put option and pay $2 in premium to buy the 2 $90 strike put options.
At expiration, if the stock price is above $95, both the sold and bought put options expire worthless and you keep the premium of $3-$2 = $1 as profit. However, if the stock price falls below $95, the sold $95 strike put option will increase in value while the bought $90 strike put options will increase even more in value, offsetting the loss from the sold put option. For example, if the stock price falls to $90, the $95 strike put option would be worth $5 and the 2 $90 strike put options would be worth $10 each, for a total worth of $20. The premium received from the sold put option would be $3, so your net loss would be $5 – $3 = $2.
Covered Calls
Covered calls are a type of options trading strategy where you simultaneously hold a long position in an underlying asset and sell a call option for the same asset. This strategy works well in a flat or slightly bullish market as the underlying asset is unlikely to increase in value dramatically.
– Example
Suppose you own 100 shares of ABC stock, which is currently trading at $50. You believe the stock won’t move much in the near future, so you sell a call option with a strike price of $55, which is a few dollars above the current price. You receive a premium of $2 per share, or $2 x 200 = $200 in total, for selling the option.
If the price of ABC stock stays the same or rises slightly, you can keep the premium as profit. If the stock price rises above $55, the option buyer will exercise their right to buy the stock from you at the agreed-upon price. In this case, you would sell your shares for $55 each, still making a profit from the option premium as well as the capital gains on the stock.
Nevertheless, if the price dropped, you will experience capital loss on the 100 share you own.
Covered Strangles
Covered strangles are a similar options trading strategy to covered calls, with the difference being that instead of selling just one call option, you sell both a call option and a put option. This allows you to earn income from the premiums of both options and minimize your risk, but it also increases the amount of capital you need to put up to secure the options positions.
– Example
Suppose you own 100 shares of XYZ stock, which is currently trading at $50. You sell a call option with a strike price of $55 and a put option with a strike price of $45. You receive a premium of $2 per share for the call option and $1 per share for the put option, for a total of $1 + $2 = $3 x 100 = $300.
Hopefully, if the price of XYZ stock stays within the range of $45 to $55, you keep the premiums as profit. If the stock price rises above $55, the call option buyer will exercise their right to buy the stock from you at the agreed-upon price. If the stock price falls below $45, the put option buyer will exercise their right to sell the stock to you at the agreed-upon price. In either case, you would still make a profit from the option premiums. In addition, where price increase, you will also make a capital gain upon selling to the call option buyer.
On the other hand, in the case of stock price continue to decrease below $45, the price difference can be partially offset with the premium received. However, you will also experiencing capital loss of the the initial 100 share you own.
Takeaway
These are the options trading strategies that yo can consider for your next trade. It’s important to keep in mind that every strategy come with risks. Please do your own research, consult with a financial advisor, and carefully consider your own financial situation before making any investment decisions.
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