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D. Option Strategies

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Buying Options

The most basic of options strategies is to simply buy call or put options. When you buy options, you are said to have a long position in that option. You have a long call position when you buy calls or a long put position if you buy puts.

Generally, when you are bullish on the underlying asset, you can buy call options to implement the long call strategy and when bearish, you buy put options to implement the long put strategy.

In both cases, you hope that the underlying stock price move far enough to cover the premiums paid for the options and land you a profit.

Cost Considerations When Buying Options

Moneyness

Out-of-the-money options are cheaper to buy than in-the-money options but they are also more likely to expire worthless.

For call options, this means that the higher the strike price, the cheaper the option. Similarly, put options with lower strike prices are therefore less expensive to purchase.

However, the size of the premium alone does not tell us the whole story. In fact, at-the-money options can be considered the most expensive even though their premiums are lower than in-the-money options. This is because their time value is highest and time value is the part of the premium that will waste away as the expiration date approaches.

Time to Expiration

Obviously, the longer the time to expiration, the more chance the option buyer have for the underlying price to move in the right direction and therefore the more expensive the option.

Implied Volatility (IV)


Watch out for the implied volatility (IV) when buying options. Options are more expensive when the IV is high and less expensive when it is low.

Selecting the Right Option to Buy

Which strike price and expiration you choose all depends on your outlook of the underlying. For instance, if you believe that the underlying will make an explosive move upwards very soon, then it makes sense to buy an at-the-money call option expiring in the nearest expiration month.

Buying Options for the Purpose of Hedging

Other than speculation, options can also be bought as a means to insure potential losses for an existing position in the underlying. To hedge a long underlying position, a protective put can be purchased. Similarly, to protect a short underlying position, a protective call strategy can be used.

 

Selling Options

Selling options is another way to profit from option trading. The basic idea behind the option selling strategy is to hope that the options you sold expire worthless so that you can pocket the premiums as profits.

Things to Consider When Buying Options

Covered or Uncovered (Naked)

When it comes to selling options, one can be covered or naked. You are covered when selling options if you have a corresponding position in the underlying asset. Being covered or naked can have a big impact on the risk/reward profile of the strategy you wish to implement.

Implied Volatility

When selling options, one should take note of the implied volatility (IV) of the underlying asset. Generally, when the IV is high, premiums go up and when implied volatility is low, premiums go down. So you would want to sell options when IV is high.

Selling Call Options

Writing Covered Calls

The covered call is probably the most well-known option selling strategy. A call is covered when you also own a long position in the underlying. If you are mildly bullish on the underlying, you will sell an out-of-the-money covered call. Otherwise, if you are neutral to mildly bearish on the underlying, then the in-the-money covered call strategy will be more appropriate.

Writing Naked Calls

Selling naked calls is a high risk strategy that can be used when the option trader is very bearish on the underlying. Note that your broker will not permit you to start selling naked calls until you have been deemed to possess sufficient knowledge, trading experience and financial resources.

Ratio Call Write

Using a combination of covered calls and naked calls, one can also implement what is known as the ratio call write. The trader implementing the ratio call write is neither bullish nor bearish on the underlying.

Selling Put Options

Writing Covered Puts

A written put is covered when you also have a short position in the underlying. The covered put has the same payoff as the naked call and is seldom employed because the naked call write is a much better strategy for a number of reasons. Firstly, if the underlying asset is a stock, the covered put writer has to pay dividends on the short stock while the naked call writer need not. Secondly, call options generally sell for higher premiums than put options. Lastly, having to short the underlying and the option at the same time also increases the commission costs for the covered put writing strategy.

Selling Naked Puts
Writing uncovered puts is a high risk strategy that can be used when the option trader is very bullish on the underlying. Selling naked puts can also be a great way to purchase stocks at a discount. Again, like all naked option writing strategies, your trading account must be assigned a sufficiently high trading level by your broker before you are allowed to trade naked puts.

Ratio Put Write

Using a combination of covered and uncovered puts, one can also implement what is known as the ratio put write. This strategy has the same risk/reward profile as the ratio call write but for the same reasons that the naked call strategy is preferred over the covered put write, the ratio put write is considered inferior and rarely used.

 

Option Spreads

In options trading, an option spread is created by the simultaneous purchase and sale of options of the same class on the same underlying security but with different strike prices and/or expiration dates.
Any spread that is constructed using calls can be referred to as a call spread. Similarly, put spreads are spreads created using put options.

Option buyers can consider using spreads to reduce the net cost of entering a trade. Naked option sellers can use spreads instead to lower margin requirements so as to free up buying power while simultaneously putting a cap on the maximum loss potential.

Vertical, Horizontal & Diagonal Spreads


The three basic classes of spreads are the vertical spread, the horizontal spread and the diagonal spread. They are categorized by the relationships between the strike price and expiration dates of the options involved.

Vertical spreads are constructed using options of the same class, same underlying security, same expiration month, but at different strike prices.

Horizontal or calendar spreads are constructed using options of the same underlying security, same strike prices but with different expiration dates.

Diagonal spreads are created using options of the same underlying security but different strike prices and expiration dates.

Bull & Bear Spreads

If an option spread is designed to profit from a rise in the price of the underlying security, it is a bull spread. Conversely, a bear spread is a spread where favorable outcome is attained when the price of the underlying security goes down.

Credit & Debit Spreads


Option spreads can be entered on a net credit or a net debit. If the premiums of the options sold is higher than the premiums of the options purchased, then a net credit is received when entering the spread. If the opposite is true, then a debit is taken. Spreads that are entered on a debit are known as debit spreads while those entered on a credit are known as credit spreads.

More Options Strategies


Altogether, there are quite a number of options trading strategies available to the investor and many of them come with exotic names. Here in this website, we have tutorials covering all known strategies and we have classified them under bullish strategies, bearish strategies and neutral (non-directional) strategies.

 

Option Combinations

A combination is an option trading strategy that involves the purchase and/or sale of both call and put options on the same underlying asset.

Call & Put Buying Combinations

Straddle

The straddle is an unlimited profit, limited risk option trading strategy that is employed when the options trader believes that the price of the underlying asset will make a strong move in either direction in the near future. It can be constructed by buying an equal number of at-the-money call and put options with the same expiration date.

Strangle

Like the straddle, the strangle is also a strategy that has limited risk and unlimited profit potential. The difference between the two strategies is that out-of-the-money options are purchased to construct the strangle, lowering the cost to establish the position but at the same time, a much larger move in the price of the underlying is required for the strategy to be profitable.

Strip

The strip is a modified, more bearish version of the common straddle. Construction is similar to the straddle except that the ratio of puts to calls purchased is 2 to 1.

Strap

The strap is a more bullish variant of the straddle. Twice the number of call options are purchased to modify the straddle into a strap.

Synthetic Underlying

Combinations can be used to create options positions that have the same payoff pattern as the underlying. These positions are known as synthetic underlying positions. Using equity options as an example, a synthetic long stock position can be created by buying at-the-money call and selling an equal number of at-the-money put options.

 

Bullish Trading Strategies

Bullish strategies in options trading are employed when the options trader expects the underlying stock price to move upwards. It is necessary to assess how high the stock price can go and the timeframe in which the rally will occur in order to select the optimum trading strategy.

Very Bullish

The most bullish of options trading strategies is the simple call buying strategy used by most novice options traders.

Moderately Bullish

In most cases, stocks seldom go up by leaps and bounds. Moderately bullish options trader usually set a target price for the bull run and utilize bull spreads to reduce risk. While maximum profit is capped for these strategies, they usually cost less to employ.

Mildly Bullish

Mildly bullish trading strategies are options strategies that make money as long as the underlying stock price do not go down on options expiration date. These strategies usually provide a small downside protection as well. Writing out-of-the-money covered calls is one example of such a strategy.

 

Bearish Trading Strategies

Bearish strategies in options trading are employed when the options trader expects the underlying stock price to move downwards. It is necessary to assess how low the stock price can go and the timeframe in which the decline will happen in order to select the optimum trading strategy.
 
Very Bearish

The most bearish of options trading strategies is the simple put buying strategy utilized by most novice options traders.

Moderately Bearish

In most cases, stock price seldom make steep downward moves. Moderately bearish options traders usually set a target price for the expected decline and utilise bear spreads to reduce risk. While maximum profit is capped for these strategies, they usually cost less to employ.

Mildly Bearish

Mildly bearish trading strategies are options strategies that make money as long as the underlying stock price do not go up on options expiration date. These strategies usually provide a small upside protection as well. A good example of such a strategy is to write of out-of-the-money naked calls.

 

Neutral Trading Strategies

Neutral options trading strategies are employed when the options trader does not know whether the underlying stock price will rise or fall. Also known as non-directional strategies, they are so named because the potential to profit does not depend on whether the underlying stock price will go upwards or downwards. Rather, the correct neutral strategy to employ depends on the expected volatility of the underlying stock price.
 
Bullish on Volatility

Neutral trading strategies that profit when the underlying stock price experience big moves upwards or downwards include the long straddle, long strangle, short condors and short butterflies.

Bearish on Volatility


Neutral trading strategies that profit when the underlying stock price experience little or no movement include the short straddle, short strangle, ratio spreads, long condors and long butterflies.

 

Long Call

Definition

The long call option strategy is the most basic option trading strategy whereby the options trader buy call options with the belief that the price of the underlying security will rise significantly beyond the strike price before the option expiration

Leverage

Compared to buying the underlying shares outright, the call option buyer is able to gain leverage since the lower priced calls appreciate in value faster percentagewise for every point rise in the price of the underlying stock
However, call options have a limited lifespan. If the underlying stock price does not move above the strike price before the option expiration date, the call option will expire worthless.



Unlimited Profit Potential

Since they can be no limit as to how high the stock price can be at expiration date, there is no limit to the maximum profit possible when implementing the long call option strategy.

The formula for calculating profit is given below:

     • Maximum Profit = Unlimited
     • Profit Achieved When Price of Underlying >= Strike Price of Long Call + Premium Paid + Commissions Paid
     • Profit = Price of Underlying - Strike Price of Long Call - Premium Paid - Commissions Paid


Limited Risk

Risk for the long call options strategy is limited to the price paid for the call option no matter how low the stock price is trading on expiration date.

The formula for calculating maximum loss is given below:

     • Max Loss = Premium Paid + Commissions Paid
     • Max Loss Occurs When Price of Underlying <= Strike Price of Long Call


Breakeven Point

The underlier price at which break-even is achieved for the long call position can be calculated using the following formula.

     • Breakeven Point = Strike Price of Long Call + Premium Paid

Example

Suppose the stock of XYZ company is trading at $40. A call option contract with a strike price of $40 expiring in a month's time is being priced at $2. You believe that XYZ stock will rise sharply in the coming weeks and so you paid $200 to purchase a single $40 XYZ call option covering 100 shares.

Say you were proven right and the price of XYZ stock rallies to $50 on option expiration date. With underlying stock price at $50, if you were to exercise your call option, you invoke your right to buy 100 shares of XYZ stock at $40 each and can sell them immediately in the open market for $50 a share. This gives you a profit of $10 per share. As each call option contract covers 100 shares, the total amount you will receive from the exercise is $1000. Since you had paid $200 to purchase the call option, your net profit for the entire trade is therefore $800.

However, if you were wrong in your assessment and the stock price had instead dived to $30, your call option will expire worthless and your total loss will be the $200 that you paid to purchase the option.

Out-of-the-money Calls

Going long on out-of-the-money calls maybe cheaper but the call options have higher risk of expiring worthless.

In-the-money Calls

In-the-money calls are more expensive than out-of-the-money calls but less amount is paid for the option's time value.

 

Short Call

Definition

The short call option strategy is one of the most basic option trading strategy whereby the options trader Sell call options with the belief that the price of the underlying security will not rise significantly beyond the strike price before the option expiration.



Limited Profit Potential

Profit for the short call options strategy is limited to the price received for the call option no matter how low the stock price is trading on expiration date.

The formula for calculating maximum profit is given below:

     • Max Profit = Premium Received - Commissions Paid
     • Max Profit Occurs When Price of Underlying <= Strike Price of Long Call

Unlimited Risk

Since they can be no limit as to how high the stock price can be at expiration date, there is no limit to the maximum profit possible when implementing the short call option strategy.

The formula for calculating loss is given below:

     • Maximum Loss = Unlimited
     • Loss When Price of Underlying >= Strike Price of Long Call + Premium Received + Commissions Paid
     • Loss = Price of Underlying - Strike Price of Long Call + Premium Received - Commissions Paid

Breakeven Point

The underlier price at which break-even is achieved for the long call position can be calculated using the following formula.

     • Breakeven Point = Strike Price of Short Call + Premium Received

Example

Suppose the stock of XYZ company is trading at $50. A call option contract with a strike price of $50 expiring in a month's time is being priced at $3. You believe that XYZ stock will not rise sharply in the coming weeks and so you received  $300 to sell a single $50 XYZ call option covering 100 shares.

Say you were proven right wrong and the price of XYZ stock rallies to $60 on option expiration date. With underlying stock price at $50, if the option holder were to exercise your call option, you have to sell 100 shares of XYZ stock at $50 each and can buy them immediately in the open market for $60 a share. This gives you a loss of $10 per share. As each call option contract covers 100 shares, the total amount you will suffer from the exercise is $1000. Since you had received $300 when selling the call option, your net loss for the entire trade is therefore $700.

However, if you were right in your assessment and the stock price had instead dived to $40, the call option you sold will expire worthless and your total profit will be the $300 that you received at the sale of  the option.

Out-of-the-money Calls

Going long on out-of-the-money calls maybe cheaper but the call options have higher risk of expiring worthless.

In-the-money Calls

In-the-money calls are more expensive than out-of-the-money calls but less amount is paid for the option's time value.

 

Long Put

Definition

The long put option strategy is a basic strategy in options trading where the investor buy put options with the belief that the price of the underlying security will go significantly below the striking price before the expiration date.

Put Buying vs. Short Selling

Compared to short selling the stock, it is more convenient to bet against a stock by purchasing put options as the investor does not have to borrow the stock to short. Additionally, the risk is capped to the premium paid for the put options, as opposed to unlimited risk when short selling the underlying stock outright.

However, put options have a limited lifespan. If the underlying stock price does not move below the strike price before the option expiration date, the put option will expire worthless.



Unlimited Profit Potential

Since stock price in theory can reach zero at expiration date, the maximum profit possible when using the long put strategy is only limited to the striking price of the purchased put less the price paid for the option.

The formula for calculating profit is given below:

     • Maximum Profit = Strike Price of Long Put - Premium Paid - Commissions Paid
     • Profit Achieved When Price of Underlying < Strike Price of Long Put - Premium Paid - Commissions Paid
     • Profit = Strike Price of Long Put - Price of Underlying - Premium Paid - Commissions Paid

Limited Risk

Risk for implementing the long put strategy is limited to the price paid for the put option no matter how high the stock price is trading on expiration date.

The formula for calculating maximum loss is given below:

     • Max Loss = Premium Paid + Commissions Paid
     • Max Loss Occurs When Price of Underlying >= Strike Price of Long Put

Breakeven Point

The underlier price at which break-even is achieved for the long put position can be calculated using the following formula.

     • Breakeven Point = Strike Price of Long Put - Premium Paid - Commissions Paid

Example

Suppose the stock of XYZ company is trading at $40. A put option contract with a strike price of $40 expiring in a month's time is being priced at $2. You believe that XYZ stock will fall sharply in the coming weeks and so you paid $200 to purchase a single $40 XYZ put option covering 100 shares.

Say you were proven right and the price of XYZ stock crashes to $30 at option expiration date. With underlying stock price now at $30, your put option will now be in-the-money with an intrinsic value of $1000 and you can sell it for that much. Since you had paid $200 to purchase the put option, your net profit for the entire trade is therefore $800.

However, if you were wrong in your assessment and the stock price had instead rallied to $50, your put option will expire worthless and your total loss will be the $200 that you paid to purchase the option.

Out-of-the-money Puts

Going long on out-of-the-money puts maybe cheaper but the put options have higher risk of expiring worthless.

In-the-money Puts

In-the-money puts are more expensive than out-of-the-money puts but the amount paid for the time value of the option is also lower.

 

Short Put

Definition

Shorting puts is an options trading strategy involving the selling of put options without shorting the obligated shares of the underlying stock. Also known as naked put write or cash secured put, this is a bullish options strategy that is executed to earn a consistent profits by ongoing collection of premiums.



Limited profits with no upside risk

Profit for the uncovered put write is limited to the premiums received for the options sold and unlike the covered put write, since the uncovered put writer is not short on the underlying stock, he does not have to bear any loss should the price of the security go up at expiration. The naked put writer sells slightly out-of-the-money puts month after month, collecting premiums as long as the stock price of the underlying remains above the put strike price at expiration.

The formula for calculating maximum profit is given below:

     • Max Profit = Premium Received - Commissions Paid
     • Max Profit Achieved When Price of Underlying >= Strike Price of Short Put

Unlimited Downside risk with Little downside protection

While the premium collected can cushion a slight drop in stock price, loss resulting from a catastrophic drop in stock price of the underlying can be huge when implementing the uncovered put write strategy.

The formula for calculating loss is given below:

     • Maximum Loss = Unlimited
     • Loss Occurs When Price of Underlying < Strike Price of Short Put - Premium Received
     • Loss = Strike Price of Short Put - Price of Underlying - Premium Received + Commissions Paid

Breakeven Point

The underlier price at which break-even is achieved for the uncovered put write position can be calculated using the following formula.

     • Breakeven Point = Strike Price of Short Put - Premium Received

Example

Suppose XYZ stock is trading at $45 in June. An options trader writes an uncovered JUL 45 put for $200.

If XYZ stock rallies to $50 on expiration, the JUL 45 put expires worthless and the trader gets to keep the $200 in premium as profit. This is also his maximum profit and is achieved as long as XYZ stock trades above $45 on options expiration date.

If instead XYZ stock drops to $40 on expiration, then the JUL 45 put expires in the money with $500 in intrinsic value. The JUL 45 put needs to be bought back for $500 and subtracting the initial credit of $200 taken, the resulting net loss is $300.

Writing Naked Puts to Purchase Stocks

The biggest risk facing the uncovered put writer is that should the price of the underlying drops below the put strike price, he is forced to buy the shares at the put strike price. However, for a long-term investor looking to go long on the stock at a discount, writing naked puts can be a great way to buy stock. He can do that by writing uncovered puts with a strike price at or near his target entry price. If the stock price drops below the put strike and the puts gets assigned, he gets to make the stock purchase at the desired price.

Additionally, he gets a further discount in the form of the premium earned from selling the puts. Even if the put strike price was not reached and the stock not acquired, he still gets to keep the premiums!

 

Long Straddle

Definition

The long straddle, also known as buy straddle or simply "straddle", is a neutral strategy in options trading that involve the simultaneously buying of a put and a call of the same underlying stock, striking price and expiration date.


Unlimited Profit Potential

By having long positions in both call and put options, straddles can achieve large profits no matter which way the underlying stock price heads, provided the move is strong enough.

The formula for calculating profit is given below:

     • Maximum Profit = Unlimited
     • Profit Achieved When Price of Underlying > Strike Price of Long Call + Net Premium Paid OR Price of Underlying < Strike Price of Long Put - Net Premium Paid
     • Profit = Price of Underlying - Strike Price of Long Call - Net Premium Paid OR Strike Price of Long Put - Price of Underlying - Net Premium Paid

Limited Risk

Maximum loss for long straddles occurs when the underlying stock price on expiration date is trading at the strike price of the options bought. At this price, both options expire worthless and the options trader loses the entire initial debit taken to enter the trade.

The formula for calculating maximum loss is given below:

     • Max Loss = Net Premium Paid + Commissions Paid
     • Max Loss Occurs When Price of Underlying = Strike Price of Long Call/Put

Breakeven Points


There are 2 break-even points for the long straddle position. The breakeven points can be calculated using the following formula.

     • Upper Breakeven Point = Strike Price of Long Call + Net Premium Paid
     • Lower Breakeven Point = Strike Price of Long Put - Net Premium Paid

Example

Suppose XYZ stock is trading at $40 in June. An options trader enters a long straddle by buying a JUL 40 put for $200 and a JUL 40 call for $200. The net debit taken to enter the trade is $400, which is also his maximum possible loss.

If XYZ stock is trading at $50 on expiration in July, the JUL 40 put will expire worthless but the JUL 40 call expires in the money and has an intrinsic value of $1000. Subtracting the initial debit of $400, the long straddle trader's profit comes to $600.

On expiration in July, if XYZ stock is still trading at $40, both the JUL 40 put and the JUL 40 call expire worthless and the long straddle trader suffers a maximum loss which is equal to the initial debit of $400 taken to enter the trade.

 

Short Straddle

Definition

The short straddle - a.k.a. sell straddle or naked straddle sale - is a neutral options strategy that involve the simultaneous selling of a put and a call of the same underlying stock, striking price and expiration date.

Short straddles are limited profit, unlimited risk options trading strategies that are used when the options trader thinks that the underlying securities will experience little volatility in the near term.


Limited Profit

Maximum profit for the short straddle is achieved when the underlying stock price on expiration date is trading at the strike price of the options sold. At this price, both options expire worthless and the options trader gets to keep the entire initial credit taken as profit.

The formula for calculating maximum profit is given below:

     • Max Profit = Net Premium Received - Commissions Paid
     • Max Profit Achieved When Price of Underlying = Strike Price of Short Call/Put

Unlimited Risk

Large losses for the short straddle can be incurred when the underlying stock price makes a strong move either upwards or downwards at expiration, causing the short call or the short put to expire deep in the money.

The formula for calculating loss is given below:

     • Maximum Loss = Unlimited
     • Loss Occurs When Price of Underlying > Strike Price of Short Call + Net Premium Received OR Price of Underlying < Strike Price of Short Put - Net Premium Received
     • Loss = Price of Underlying - Strike Price of Short Call - Net Premium Received OR Strike Price of Short Put - Price of Underlying - Net Premium Received + Commissions Paid

Breakeven Points

There are 2 break-even points for the short straddle position. The breakeven points can be calculated using the following formula.

     • Upper Breakeven Point = Strike Price of Short Call + Net Premium Received
     • Lower Breakeven Point = Strike Price of Short Put - Net Premium Received

Example

Suppose XYZ stock is trading at $40 in June. An options trader enters a short straddle by selling a JUL 40 put for $200 and a JUL 40 call for $200. The net credit taken to enter the trade is $400, which is also his maximum possible profit.

If XYZ stock rallies and is trading at $50 on expiration in July, the JUL 40 put will expire worthless but the JUL 40 call expires in the money and has an intrinsic value of $1000. Subtracting the initial credit of $400, the short straddle trader's loss comes to $600.

On expiration in July, if XYZ stock is still trading at $40, both the JUL 40 put and the JUL 40 call expire worthless and the short straddle trader gets to keep the entire initial credit of $400 taken to enter the trade as profit.

 

Long Strangle

Definition

The long strangle, also known as buy strangle or simply "strangle", is a neutral strategy in options trading that involve the simultaneous buying of a slightly out-of-the-money put and a slightly out-of-the-money call of the same underlying stock and expiration date.

The long options strangle is an unlimited profit, limited risk strategy that is taken when the options trader thinks that the underlying stock will experience significant volatility in the near term. Long strangles are debit spreads as a net debit is taken to enter the trade.


Unlimited Profit Potential

Large gains for the long strangle option strategy is attainable when the underlying stock price makes a very strong move either upwards or downwards at expiration.

The formula for calculating profit is given below:

     • Maximum Profit = Unlimited
     • Profit Achieved When Price of Underlying > Strike Price of Long Call + Net Premium Paid OR Price of Underlying < Strike Price of Long Put - Net Premium Paid
     • Profit = Price of Underlying - Strike Price of Long Call - Net Premium Paid OR Strike Price of Long Put - Price of Underlying - Net Premium Paid

Limited Risk


Maximum loss for the long strangle options strategy is hit when the underlying stock price on expiration date is trading between the strike prices of the options bought. At this price, both options expire worthless and the options trader loses the entire initial debit taken to enter the trade.

The formula for calculating maximum loss is given below:

     • Max Loss = Net Premium Paid + Commissions Paid
     • Max Loss Occurs When Price of Underlying is in between Strike Price of Long Call and Strike Price of Long Put

Breakeven Points

There are 2 break-even points for the long strangle position. The breakeven points can be calculated using the following formula.
     • Upper Breakeven Point = Strike Price of Long Call + Net Premium Paid
     • Lower Breakeven Point = Strike Price of Long Put - Net Premium Paid

Example

Suppose XYZ stock is trading at $40 in June. An options trader executes a long strangle by buying a JUL 35 put for $100 and a JUL 45 call for $100. The net debit taken to enter the trade is $200, which is also his maximum possible loss.

If XYZ stock rallies and is trading at $50 on expiration in July, the JUL 35 put will expire worthless but the JUL 45 call expires in the money and has an intrinsic value of $500. Subtracting the initial debit of $200, the options trader's profit comes to $300.

On expiration in July, if XYZ stock is still trading at $40, both the JUL 35 put and the JUL 45 call expire worthless and the options trader suffers a maximum loss which is equal to the initial debit of $200 taken to enter the trade.

 

Short Strangle

Definition

The short strangle, also known as sell strangle, is a neutral strategy in options trading that involve the simultaneous selling of a slightly out-of-the-money put and a slightly out-of-the-money call of the same underlying stock and expiration date.

The short strangle option strategy is a limited profit, unlimited risk options trading strategy that is taken when the options trader thinks that the underlying stock will experience little volatility in the near term. Short strangles are credit spreads as a net credit is taken to enter the trade.


Limited Profit

Maximum profit for the short strangle occurs when the underlying stock price on expiration date is trading between the strike prices of the options sold. At this price, both options expire worthless and the options trader gets to keep the entire initial credit taken as profit.

The formula for calculating maximum profit is given below:

     • Max Profit = Net Premium Received - Commissions Paid
     • Max Profit Achieved When Price of Underlying is in between the Strike Price of the Short Call and the Strike Price of the Short Put

Unlimited Risk

Large losses for the short strangle can be experienced when the underlying stock price makes a strong move either upwards or downwards at expiration.

The formula for calculating loss is given below:

     • Maximum Loss = Unlimited
     • Loss Occurs When Price of Underlying > Strike Price of Short Call + Net Premium Received OR Price of Underlying < Strike Price of Short Put - Net Premium Received
     • Loss = Price of Underlying - Strike Price of Short Call - Net Premium Received OR Strike Price of Short Put - Price of Underlying - Net Premium Received + Commissions Paid

Breakeven Points

There are 2 break-even points for the short strangle position. The breakeven points can be calculated using the following formula.

     • Upper Breakeven Point = Strike Price of Short Call + Net Premium Received
     • Lower Breakeven Point = Strike Price of Short Put - Net Premium Received

Example

Suppose XYZ stock is trading at $40 in June. An options trader executes a short strangle by selling a JUL 35 put for $100 and a JUL 45 call for $100. The net credit taken to enter the trade is $200, which is also his maximum possible profit.

If XYZ stock rallies and is trading at $50 on expiration in July, the JUL 35 put will expire worthless but the JUL 45 call expires in the money and has an intrinsic value of $500. Subtracting the initial credit of $200, the options trader's loss comes to $300.

On expiration in July, if XYZ stock is still trading at $40, both the JUL 35 put and the JUL 45 call expire worthless and the options trader gets to keep the entire initial credit of $200 taken to enter the trade as profit.

 

Synthetic Long Stock (Split Strikes)

Definition

The synthetic long stock (split strikes) is a less aggressive version of the synthetic long stock.
The synthetic long stock (split strikes) position is created by buying slightly out-of-the-money calls and selling an equal number of slightly out-of-the-money puts of the same underlying stock and expiration date.

The split strike version of the synthetic long stock strategy offers some downside protection. If the trader's outlook is wrong and the underlying stock price falls slightly, he will not suffer any loss. On the flip side, a stronger upside move is needed to produce a profit.

Profits and losses with a split strike strategy are also not as heavy as a corresponding long stock position as the strategist has traded some potential profits for downside protection.


Unlimited Profit Potential

Similar to a long stock position, there is no maximum profit for the synthetic long stock (split strikes). The options trader stands to profit as long as the underlying stock price goes up.

The formula for calculating profit is given below:

     • Maximum Profit = Unlimited
     • Profit Achieved When Price of Underlying > Strike Price of Long Call - Net Premium Received
     • Profit = Price of Underlying - Strike Price of Long Call + Net Premium Received

Unlimited Risk

Like the long stock position, heavy losses can occur for the synthetic long stock (split strikes) if the underlying stock price takes a dive.

Often, a credit is taken when establishing this position. Hence, even if the underlying stock price remains unchanged on expiration date, there will still be a profit equal to the initial credit taken.

The formula for calculating loss is given below:

     • Maximum Loss = Unlimited
     • Loss Occurs When Price of Underlying < Strike Price of Short Put - Net Premium Received
     • Loss = Strike Price of Short Put - Price of Underlying - Net Premium Received + Commissions Paid

Breakeven Points

The underlier price at which break-even is achieved for the synthetic long stock (split strikes) position can be calculated using the following formula.

     • Breakeven Point = Strike Price of Short Put - Net Premium Received
    Or

     • Breakeven Point = Strike Price of Long Call + Net Premium Paid

Example

Suppose XYZ stock is trading at $40 in June. An options trader setups a split-strikes synthetic long stock by selling a JUL 35 put for $100 and buying a JUL 45 call for $50. The net credit taken to enter the trade is $50.

Scenario #1: XYZ stock price rise moderately to $45

If the price of XYZ stock rises to $45 on expiration date, both the long JUL 45 call and the short JUL 35 put will expire worthless and the trader keeps the initial credit of $50 as profit.

Scenario #2: XYZ stock rallies explosively to $60


If XYZ stock rallies and is trading at $60 on expiration in July, the short JUL 35 put will expire worthless but the long JUL 45 call expires in the money and has an intrinsic value of $1500. Including the initial credit of $50, the options trader's profit comes to $1550. Comparatively, a corresponding long stock position would have achieved a larger profit of $2000.

Scenario #3: XYZ stock price crashes to $20

On expiration in July, if the price of XYZ stock has instead crashed to $20, the long JUL 45 call will expire worthless while the short JUL 35 put will expire in the money and be worth $1500. Buying back this short put will require $1500 and subtracting the initial $50 credit taken when entering the trade, the trader's loss comes to $1450. A heavier loss of $2000 loss would have been suffered by a corresponding long stock position.

 

Synthetic Short Stock (Split Strikes)

Definition

The synthetic short stock (split strikes) is a less aggressive version of the synthetic short stock strategy.

The synthetic short stock (split strikes) position is created by selling slightly out-of-the-money calls and buying an equal number of slightly out-of-the-money puts of the same underlying stock and expiration date.

The split strike version of the synthetic short stock strategy offers some upside protection. If the trader's outlook is wrong and the underlying stock price rises slightly, he will not suffer any loss. On the flip side, a stronger downward move is necessary to produce a profit.

Profits and losses with a split strike strategy are also not as heavy as a corresponding short stock position as the strategist has traded some potential profits for upside protection.


Unlimited Profit Potential

Similar to a short stock position, there is no limit to the maximum possible profit for the synthetic short stock (split strikes). The options trader stands to profit as long as the underlying stock price goes down.

The formula for calculating profit is given below:

     • Maximum Profit = Unlimited
     • Profit Achieved When Price of Underlying < Strike Price of Short Call + Net Premium Received OR Price of Underlying < Strike Price of Long Put - Net Premium Paid
     • Profit = Strike Price of Long Put - Price of Underlying +/- Net Premium Received/Paid

Unlimited Risk

Like the short stock position, heavy losses can occur for the synthetic short stock (split strikes) if the underlying stock price makes a sharp move upwards.

Often, a credit is usually taken when establishing this position. Hence, even if the underlying stock price remains unchanged on expiration date, there will still be a profit equal to the initial credit taken.

The formula for calculating loss is given below:

     • Maximum Loss = Unlimited
     • Loss Occurs When Price of Underlying > Strike Price of Short Call + Net Premium Received OR Price of Underlying > Strike Price of Long Put - Net Premium Paid
     • Loss = Price of Underlying - Strike Price of Short Call +/- Net Premium Paid/Received + Commissions Paid

Breakeven Points

The underlier price at which break-even is achieved for the synthetic short stock (split strikes) position can be calculated using the following formula.

     • Breakeven Point = Strike Price of Short Call + Net Premium Received
     OR
     • Breakeven Point = Strike Price of Long Put - Net Premium Paid

Example

Suppose XYZ stock is trading at $40 in June. An options trader setups a split-strikes synthetic short stock by buying a JUL 35 put for $50 and selling a JUL 45 call for $100. The net credit taken to enter the trade is $50.

Scenario #1: XYZ stock price falls slightly to $35


If the price of XYZ stock drops to $35 on expiration date, both the long JUL 35 put and the short JUL 45 call will expire worthless and the trader keeps the initial credit of $50 as profit.

Scenario #2: XYZ stock rallies explosive to $60


If XYZ stock rallies and is trading at $60 on expiration in July, the long JUL 35 put will expire worthless but the short JUL 45 call expires in the money and has an intrinsic value of $1500. Buying back this short call will require $1500 and subtracting the initial $50 credit taken when entering the trade, the trader's loss comes to $1450. A heavier loss of $2000 loss would have been suffered by a corresponding short stock position.

Scenario #3: XYZ stock price falls to $20

On expiration in July, if the price of XYZ stock has instead crashed to $20, the short JUL 45 call will expire worthless while the long JUL 35 put will expire in the money and be worth $1500. Including the initial credit of $50, the options trader's profit comes to $1550. Comparatively, a corresponding short stock position would have achieved a greater profit of $2000.