Top Option Trading Strategies For Beginners

Lets understand top strategies that would help you immensely in your derivatives trading. From simple 2 legged strategies such as Bull call spread, to complex strategies such as Iron condor, straddle etc., this post has it all!

There are a number of options strategies that one can choose from. Every option strategy comes with a certain level of risk. Yet, they are popular, and traders choose these strategies in the hope of winning a jackpot. 

For a beginner, though, the term itself can seem baffling, let alone the fact that one has to pick one so as to reap the maximum benefit from one’s investment portfolio. But don’t worry – we have it sorted for you. Read on to learn about the top options strategies you can choose from as you step into the world of stock trading. 

Option trading strategies mean the buying and selling of call and put options. It could mean either a buy, sell, or both simultaneously. 

Bull Call Spread

There exist various options strategies that can be employed when options are bullish. One of the most popular ones among these is a bull call spread. Sometimes it is also called a long call spread or debit call spread.

It involves the buying of an at-the-money call option and the selling of an out-of-money call option. Both these options, though, need to have the same underlying stock and the same expiry date.

This is a viable strategy option to choose when the prices fall, and the profit amount is also limited. If an investor is not aggressively bullish on a stock, then it is a much better option than simply just buying a call option.

Profit and Loss

If this strategy is used, then a profit occurs when the price of the underlying stock increases. That is:

Profit = Spread – Net debit

Spread = Higher strike price – Lower strike price

Net debit = Premium paid for a lower strike – Premium received for a higher strike

This maximum profit happens when the stock price is at or above the strike price of the short call during expiry. When the stock price is above the strike price, a short call is usually assigned at expiration. 

On the other hand, a loss occurs when the stock price falls below the strike price of the long call. 

Risk (maximum) =  Cost of the spread (including commissions) 

If the stock price at expiration is below the strike price of the long call, then both the calls expire worthless. When this happens, a loss of the aforementioned amount accrues to the investor. 

When a break-even is reached, that is, when no profit or loss is garnered, what the investor gets is the strike price of the long call/lower strike) plus the net premium paid.

When to Choose this Strategy 

In general, this strategy comes with limited profit potential. However, traders choose this option as they are less expensive than just buying the lower strike call. Also, in practice, as price changes are generally small, the chances of making a larger percentage profit are more than if one were to buy only the lower strike call. 

All said, choosing a bull call spread is a personal choice. Its main benefit lies in a rising stock price and the short option’s time decay. If the strike price of the short call is rising gradually, a bull call spread is a strategy that should be opted for.  

How a Stock Price Change Affects the Bull Call Spread

• When a stock price rises/falls, a bull call spread also rises/falls. Delta estimates how much an option price changes when there is a change in the stock price. In the case of a bull call spread, it is a net positive delta. 
• Moreover, since a bull call spread consists of a long call and a short call, changes in the net delta are small.
• Volatility measures how a stock price fluctuates in percentage terms. If there is a rise in the volatility, the option prices tend to rise, too, provided other factors remain unchanged. Since a bull call spread consists of a long and a short call, the price of a bull call spread doesn’t change much, even when there are volatility changes. 
• Time erosion is the decrease in the time value portion of an option’s total price when it is near expiration. For a bull call spread, the sensitivity to time erosion is based on the relationship between the stock and the strike prices of the spread. For example, if the stock price is near/below the strike price of the long call, the result is that, with time, there is a decrease in the price of the bull call spread.

What Happens at Expiration?

Three outcomes are at expiration. 

• Stock price is at/below the lower strike price – In this situation, both calls in a bull call spread expire worthless
• Stock price is above the lower strike price but not above the higher strike price – In this situation, the long call is exercised 
• Stock price is above the higher strike price – In this situation, the long call is exercised, and the short call is assigned such that the purchase of the stock happens at the lower strike price, and it gets sold at the higher strike price, and no stock position is created.

Bear Put Spread

A bear put spread is an option that consists of a single long put with a higher strike price and one short put with a lower strike price. Both these need to have the same underlying stock and the same ending date. Sometimes it is also known as a debit put spread or a long put spread.

When the underlying stock’s price falls, a bear put spread is set up for a net debit and profits. 

Profit and Loss

In a bear put spread, if the stock price goes below the strike price of the short put, then the profit is limited. On the other hand, the potential loss is limited if the stock price goes above the strike price of the long put.

Potential profit = Strike price – Net cost of the spread (including commissions). 

In this type of option, the stock price is at/below the strike price of the short put when the expiry happens then the maximum profit occurs. Although early assignments are possible, usually short puts are assigned during expiration when the strike price is above the stock price.

The maximum risk that is associated with this option strategy is the total cost of the spread, which includes commissions. If both puts expire worthless, which happens when the stock price at expiration is above the strike price of the long put, then the loss that is incurred is equal to this maximum risk amount. 

For the breakeven stock price at expiration, the amount that the investor gets is the strike price of the long put less the net premium paid.

When to Choose this Strategy 

This strategy works best when the price of the underlying stock goes below the strike price of the short put at expiration. This is, the forecast of this option strategy is referred to as being moderately bearish.

How a Stock Price Change Affects the Bear Put Spread

• Even though bear put spreads have limited profit potential, the advantage lies in the fact that it costs less than if one were to just buy the higher strike put. In theory, bear put spreads have the probability of making a larger percentage profit than if one was buying only the higher strike put. This is because the changes in most stock processes are small. In practice, though, whether this option strategy will be chosen or not is a personal choice. 
• Bear put spreads benefit arises from two factors – one is the falling stock price and the second is the time decay of the short option. When the forecast is that the strike price of the short put will reduce gradually, the bear put spread is usually chosen.
• When the stock price falls the bear put spread rises and vice versa. Hence, this position has a net negative delta. 
• The net delta change is minimal because it consists of one long put and one short put.
• A bear put spread, consisting of one long put and one short put, changes very little when there is a change in volatility. 
• How sensitive a bear put spread will be to time erosion is based on the relationship between the stock and the strike prices of the spread. For example, if the price of the bear put spread decreases over time then it means that the stock price is near/above the strike price of the long put. On the other hand, if the stock price is in the middle of the strike prices, then the bear put spread is not affected by time erosion.

What Happens at Expiration?

Three outcomes are at expiration. 

• Stock price is at or above the higher strike price – In this situation, both puts in a bear put spread expire worthless
• Stock price is below the higher strike price but not below the lower strike price – In this situation, the long put is exercised 
• Stock price is below the lower strike price – In this situation, the long put is exercised and the short put is assigned such that selling of the stock happens at the higher strike price and it gets bought at the lower strike price and no stock position is created.

Straddle Strategy

A straddle strategy is a neutral options strategy. In this, the investor buys and sells a put option and a call option simultaneously, wherein both options have the same underlying security, the same strike price, and the same expiration date. 

The straddle strategy is most useful when the investments being considered are very volatile but are without strong price movements. It helps, hence, in situations when there are chances of the premiums that are paid for multiple options outweighing the existence of any potential profit.

A straddle can be of two types – a long and a short straddle. The investor benefits from the former when the security’s price goes above or below the strike price by an amount that is more than the total amount that was paid for the premium. In a long straddle, the potential of profits is unlimited provided that there are sharp movements of the price of the underlying security.

The benefit of a straddle lies in the fact that the investor will know what volatility of the stock is expected in the market and what the expected trading range of the stock will be by the expiration date.

Long Straddle

A long straddle, consisting of one long call and one long put with the same strike price and the same expiration date, benefits the trader if there is a big price change in the underlying stock – the movement can be in either direction. 

Profit/Loss

This option strategy brings in profit if the underlying stock goes above the upper break-even point or falls below the lower break-even point. 

The profit potential can be unlimited (this is so on the upside since there can be an indefinite rise of the stock price) or substantial (this is so on the downside since the price of the stock price can fall to zero).

The potential loss is, at most, the straddle’s total cost (including the commissions). This happens when the position is held to expiration, and both options expire worthless because the stock and the strike prices are exactly the same at expiration.

When to Choose This Strategy?

• When the price of the underlying stock goes above the upper breakeven point/falls below the lower breakeven point, then there are profits in a long straddle. This means that in cases of high volatility, a long straddle benefits traders. 
• The price change can be in either direction. Thus, when the investor is not sure of the direction of change, he chooses this strategy. For example, usually buying of straddles happens before the announcements of earnings reports, the introduction of new products, and before FDA announcements. The risk of this is that if the price does not change significantly post the announcement, then there is a fall in the price of both the call and put option as the traders sell both. 
• Long straddles consist of two long options. Therefore, its sensitivity to time erosion is more than for single-option positions. Thus, it tends to lose money quickly with time if the stock price does not change.

What Happens at Expiration?

Three outcomes are at expiration. 

• Stock price is at the strike price – Both the call and the put expire worthless
• Stock price is above the strike price – Put expires worthless, the long call is exercised, the stock is purchased at the strike price 
• Stock price is below the strike price – Call expires worthless, the long put is exercised, the stock is sold at the strike price 

Short Straddle

A short straddle, consisting of a short call and a short put, both with the same underlying stock, the same strike price, and the same expiration date, brings in profit when there the movement of the price of the underlying stock is either little or none at all. 

Profit/Loss

The profit that one can earn from this option strategy is:

Profit = Total premiums – commissions 

The maximum profit is earned when, at expiration, the short straddle is held and it closes exactly at the strike price.

The loss, though, can be unlimited (when the stock price rises) or substantial (when the stock price falls). On the upside, the loss potential is unlimited because the stock price can rise indefinitely.

When to Choose This Strategy?

• This strategy will benefit the trader if the stock prices remain within a narrow range near the strike price. 
• When there is an increase in volatility, the prices of options go up. This makes the price of a short straddle ride, thus making it lose money.
• Its sensitivity to time erosion is higher than for single-option positions. 

What Happens at Expiration?

Three outcomes are at expiration. 

• Stock price is at the strike price – Both the call and the put expire worthless 
• Stock price is above the strike price – Put expires worthless, the short call is assigned, and stock is sold at the strike price 
• Stock price is below the strike price – Call expires worthless, the short put is assigned, the stock is purchased at the strike price 

Strangle Strategy

A strangle is an options strategy with a call and a put option with different strike prices. However, these two options have the same expiration date and underlying asset. If a trader feels that there will be a large price movement in the days to come, but is not sure of which direction it will move in, then this is a good strategy to opt for. Similar to a straddle, its difference lies in the fact that it uses options at different strike prices.

Long Strangle

A long strangle will benefit an investor if the price change of the underlying stock experiences a big change, whatever the direction of it may be. 

Profit/Loss

The profit potential of a strangle is unlimited (if it is on the upside because then the stock price can rise indefinitely) or substantial (if it is on the downside because then the stock price reaches the zero level). 

The potential loss that may be experienced, though, is limited to the total cost of the strangle (including the commissions). This happens when the position is held to expiration and the stock price is equal to/ between the strike prices at expiration, thus making them worthless.

When to Choose This Strategy?

• When the price of the underlying stock goes above the upper breakeven point or if it goes below the lower breakeven point, then the long strangle will show profits. 
• The risk associated with this strategy is that if the stock price does not change considerably, then the call and put prices both decrease, and then traders then sell both options.
• When the chances of volatility increase, it means that higher prices have to be paid for buying options. This, for strangles, means that the breakeven points are farther apart. Hence, the movement of the underlying stock price will be more so as to reach the breakeven point. 
• As long strangles have two long options, it is more sensitive to time erosions. Thus, it tends to make losses quickly over time.

What Happens at Expiration?

Three outcomes are at expiration. 

• The stock price is at/between the strike prices – Both the call and the put expire worthless 
• The stock price is above the strike price of the call – Put expires worthless, the long call is exercises, the stock is purchased at the strike price 
• The stock price is below the strike price of the put – Call expires worthless, the long put is exercised, the stock is sold at the strike price 

Short Strangle

An investor can profit from a short strangle if the underlying stock experiences little or no price movement. It consists of a short call and a short put. The former has a higher strike price and the latter has a lower strike price. Both, though, have the same underlying stock and the same expiration date. 

Profit/Loss

The profit that one can earn is the total premium that is received less the expense of commissions. The short strangle earns maximum profit if it is held to expiration and if the stock price closes at/between the strike prices, thus making both options worthless.

In this strategy, the potential loss is unlimited (if the stock price rises because then it can rise indefinitely) or substantial (if the stock price falls because then, at most, it can fall to zero).

When to Choose This Strategy?

• When the underlying stock’s price fluctuates in a narrow range between the breakeven points then an investor will benefit from holding a short strangle.
• When volatility increases, so do the price of the options. Thus, when this happens the price of short strangles goes up and there is financial loss. 
• Short strangles are sensitive to time. This means that one can make quick money with time. 

What Happens at Expiration?

Three outcomes are at expiration. 

• Stock price is at/between the strike prices – Both the call and the put expire worthless 
• Stock price is above the strike price of the call – Put expires worthless, the short call is assigned, and stock is sold at the strike price 
• Stock price is below the strike price of the put – Call expires worthless, the short put is assigned, the stock is purchased at the strike price 

Short Strangle Adjustments

The aim of a short strangle is to bring down the risk by selling off two options – when the underlying stock moves in one direction, while one option loses, the other goes on to gain. However, while selling a short strangle can generate income, it comes with risks. If not managed correctly, it can lead to significant financial losses. Hence, the need for adjustments. 

Adjustments are generally made slowly with this strategy. With this in mind, if a trader finds that the stock is quickly moving towards one end of the strategy, then he will make adjustments on the side that the stock is moving away from. This is done by moving that option closer to the money. Doing the reverse, which is moving up the side that the stock is moving towards, only increases the chances of compounding losses (this will happen if the movement continues to stay in this direction).

The question that arises is how much adjustment is correct. 

• The correction should be such that the probability on the side where adjustments are being made is reset to what it was when the strategy came into play. 
• The adjustments should be made so that the number of call and put options on either side should remain the same as it was in the beginning. 

Other Strategie

‍

Iron Condor

​​An iron condor consists of a long and a short put and a long and a short call. It has four strike prices, and all have the same expiration date. Its aim is to earn profit from the low volatility of the underlying asset. This strategy is able to earn the maximum profit when, at expiration, the underlying asset closes between the middle strike prices. 

Unlike a regular condor spread, it uses both calls and puts instead of just calls/puts. However, like a regular condor spread, the iron condor has a similar payoff. 

The risk of this strategy, both on the upside and the downside, is limited because the high and low strike options protect it against any considerable movement in either direction. This limited risk, though, makes the profit that can also be earned limited in nature. 

In this, all options will expire worthlessly if the closure of the underlying asset is at the middle two strike prices during closure. If this happens, there is likely to be a closure fee. If not, then too, the loss will be only limited. 

In this strategy, the commission can be an important factor as it is a combination of four options. Since four different strike prices are to operate, the strategy can be made lean bullish or bearish. 

Profit/Loss

The maximum profit for this strategy is the premium amount or the credit that is obtained for the creation of the four-options position. This happens when the closing price of the underlying asset is between the middle strike prices at expiration

The maximum loss for this is the long call less the short call strikes or the long put less the short put strikes. If the loss is reduced by net credits received and the commissions are added, then the total loss is obtained. 

Put Ratio Spread

A put ratio spread is a neutral options strategy where options are bought at a higher strike price, and more options are sold at a lower strike price of the same underlying stock. It is called a put ratio front spread when more out-of-the-money puts are sold and are referred to as the put ratio back spread when more out-of-the-money puts are bought.

This options strategy’s aim is to bring down the premium’s upfront costs, also, sometimes, an upfront credit can also be received. It is used when an investor feels that there will be a moderate fall in the price of the underlying asset in the near time period. This fall, at most, will be only till the sold strike. 

The put ratio spread has unlimited risk potential. This occurs if the underlying asset breaks lower breakeven. This is why traders should be very careful when using this strategy. 

The best time to use this strategy is when the trader is moderately bearish, as then he will be able to maximise his profit – the maximum profit will be when the price of the stock expires at the lower strike. 

Summary

If chosen and done correctly, then options trading can be one of the most efficient methods to earn profits and, hence, accumulate money over a long period of time. There exists a number of strategies so that profits may be maximised – each comes with its risks. Hence, if an investor carefully analyses the market as well as is aware of his trading style, he will be able to choose wisely, thereby gaining more wealth.