When traders first start using options, they often employ them either as a way to take a directional view on an asset (buying a call if they expect it to rise or a put if they expect it to fall) or as a way to hedge their portfolio against market volatility. However, experienced traders can also go on to consider more complex strategies that involve buying or selling combinations of options.
It is important to have a strong grasp of options trading principles before attempting this and to understand the risks involved in each position. Broadly speaking, bought options and long option strategies carry limited risk. The buyer pays the seller a premium that equals the maximum loss on any position expiring out of the money. Granted options and short options strategies (also known as sold options and written options) have the potential for unlimited maximum losses in some cases if the position expires in the money, and so very careful risk management is needed when employing some of these strategies.
Trading spreads
Traders seeking leveraged exposure to an underlying equity might consider trading cheaper call and put spreads. These benefit from lower initial outlays in exchange for a capped maximum profit or loss.
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A long call spread, also known as a debit call spread or a bull call spread, is used to express a moderately bullish view on an underlying asset. It is constructed by purchasing a call option with a lower strike price while selling a call option with a higher strike price. Both options have the same expiration date.
This profits from a moderate rise in the price of the underlying asset. Purchasing a call with a lower strike and selling a call with a higher strike – creating a spread – lowers the initial net premium in exchange for a capped maximum profit, which is reached if the underlying asset’s price is at or above the higher strike price at expiration. The profit is the difference between the strike prices minus the net premium paid. The maximum loss is limited to the net premium paid for the spread and occurs if the underlying asset’s price is at or below the lower strike price at expiration.
For example, if XYZ Inc stock is trading at $400, a trader might buy an out-of-the-money XYZ $420 20-Sep-2024 call option for $17 and sell an out-of-the-money XYZ $460 20-Sep-2024 call option for $6. The net premium paid for the spread and hence the maximum loss is $17 - $6 = $11. If the stock price rises to $460 or above, the trader’s maximum profit is $460 - $420 - $11 = $29.
A short call spread, also known as a credit call spread or a bear call spread, expresses a moderately bearish outlook on an asset. It entails selling a call option with a lower strike price while buying a call option with a higher strike price. Again, both options have the same expiration date.
This strategy profits from a moderate decline or neutral movement in the price of the underlying asset. The trader receives a net premium since the sold call option (lower strike) is more expensive than the purchased call option (higher strike). The maximum profit is the net premium and is achieved if the asset’s price is at or below the lower strike price at expiration. The maximum loss is limited to the difference between the strike prices minus the net premium received.
For example, a trader may sell an out of the money XYZ $420 20-Sep-2024 call option for $17 and buy an out of the money XYZ $460 20-Sep-2024 call option for $6. The net premium received for the spread is $17 - $6 = $11. If the stock price remains below $420, the trader’s maximum profit is $11 (the premium received). If the underlying asset’s price is at or above the higher strike price at expiration, the maximum loss is $460 - $420 - $11 = $29.
Similar strategies can be employed with put options. A short put spread (bull put spread or credit put spread) is another way to take a moderately bullish view. It involves selling a put option with a higher strike price and buying a put option with a lower strike price. A long put spread (bear put spread or debit put spread) expresses a moderately bearish view, by buying a put option with a higher strike price and selling a put option with a lower strike price. As with call spreads, these strategies have a maximum potential loss that can be calculated before entering the trade.
Getting to grips with volatility
Options can also be used to construct positions that are sensitive to changes in volatility, rather than directional movements in the underlying asset. These positions allow traders to profit from sharp changes in the market without needing to predict the overall direction of the change in an asset’s price.
The CBOE Volatility index (VIX), often referred to as the “fear gauge”, is a real-time market index that represents the expectations for volatility in the US stock market. It is derived from the implied volatility embedded into the prices of S&P 500 index options traded on the Chicago Board Options Exchange.
When the VIX is high, it indicates that traders expect large price swings in the underlying assets. Both call and put options become more expensive during periods of high volatility. This is because the potential for large price movements increases the likelihood that an option will expire in-the-money. When the VIX is low, it suggests that traders expect stable prices with minimal fluctuations. Both call and put options become cheaper during periods of low volatility, because of the reduced probability that an option will expire in the money.
During times of geopolitical and macroeconomic uncertainty, opportunities to trade volatility may arise amidst the chaos. A long straddle, also known as “buying volatility”, is employed by a trader expecting a sharp rise in the volatility of an underlying asset. It is constructed by buying a call option and a put option with the same strike price and the same expiration date. It will make a profit when the underlying asset price moves by a magnitude sufficient to cover the combined cost of both options.
For example, a trader may buy an at-the-money XYZ $400 20-Sep-2024 call option for $30 and buy an at-the-money XYZ $400 20-Sep-2024 put option for $23. The net premium paid for the straddle is $30 + $23 = $53. If the price of the underlying asset goes above the strike price of the call option, the trader’s potential maximum profit is determined by how high it goes and is (theoretically) potentially unlimited. Should the price of the asset fall instead, the maximum potential gain from the put option is $400 - $53 = $347. The strategy breaks even when the underlying price at expiry is either $453 or $347, since this is equal to the strike price for each option plus or minus the total premium paid for both options. The maximum loss if both options expire out-of-the-money is the total premium of $53.
A long strangle, similar to a straddle, is also executed by investors expecting a sharp rise in the volatility of an underlying asset. It entails buying an out-of-the-money call option and an out-of-the-money put option with different strike prices and the same expiration date. A long strangle will be cheaper than a long straddle because the premiums for out of the money options will be lower than at-the-money options used for a long straddle, but the underlying asset price will have to move further to make the position profitable.
For example, if a stock is trading at $400, a trader will buy an out-of-the-money XYZ $450 20-Sep2024 call option for $6 and buy an out-of-the-money XYZ $350 20-Sep-2024 put option for $7. The net premium paid for the strangle is $6 + $7 = $13. The maximum profit to the upside from the call option is again in principle unlimited; the maximum profit to the downside from the put option is $350 - $13 = $337. The maximum loss is limited to the $13 premium paid for both options. However, the breakeven points for this strategy are $463 or $337 (the strike prices plus or minus the $13 total premium) – a greater distance than for the long straddle.
Traders who want instead to bet on volatility being lower could sell put and call options to create a short straddle or short strangle. However, unlike the long strategies we have discussed, both of these strategies can produce potentially unlimited losses if volatility spikes, so they should only ever be considered by very experienced traders with rigorous risk management.
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