Option Strategies

What strategy you choose depends on what the market is doing. If the market is flat and not moving much is makes sense to do certain types of trades more, and if the market is flying in one direction either up or down, you should concentrate more on other types of trades.

Volatility is an option trader’s friend and nemesis. High volatility is great because it raises the prices of all options. As sellers, this means options are pricier and the seller gets paid more when he sells them than under normal conditions. But high volatility can also hurt us because the market can move quickly.

Credit Spread Option Trading Strategy

The credit spread is one of our favorite option strategies. This is a trade which results in a credit (money given to you at the beginning of the trade). It consists of two different options (legs).

You buy an out of the money option at a certain strike price and then you sell an out of the money option at a different strike price of the same month.

For example, if ABC stock is selling at $50. You sell the $75 January Call option for $2. Then you buy the $80 January Call option for $1.50. You get a credit of 50 cents. As long as ABC stays below $75 at expiration you get to keep the credit. As time goes on the options will decay in value. This strategy allows you to win if ABC goes down, stays where it is, or goes up until $75.50. You start to lose money above $75.50.

Since each option is for 100 shares, the maximum potential gain on the above trade would be $50. (50 cents x 100 shares). The maximum loss would be $450.(Difference in strikes minus the credit: 80-75-.5) The return on investment would be 11.11% I like to place credit spread close to expiration so this return for would for a one or two month time frame.

Buying the second option does two things:

  • If protects you from a large loss if ABC shoots above $75.
  • It allows you to do the trade with less margin.

So even though you have to pay for the second option it is a conservative strategy to employ it. You can also do credit spreads with Put options if you think a stock is going up.

Which option strike you decide to sell depends on how aggressive you want to be. Our style is conservative so we choose options that have a very low probability of expiring with any value. If you use this strategy with At the Money or In the Money options you can make a lot more money, but have a higher risk of loss.

Iron Condor Option Trading Strategy

Another of our favorite option strategies is the Iron Condor.

An Iron Condor is simply two credit spreads, calls and puts, used together. This way you get a larger credit. Most stocks stay within a range. And using statistics we can tell with a high degree of confidence exactly what that range will be. We then sell options above and below this range. As long as the stock stays in the range, we win.

If the stock threatens to break our range, we have to adjust our range by adjusting the trade to account for the movement.

If you subscribe to my Free Options Course, I will show you exactly how we put on an Iron Condor trade, a real trade that we did, and the adjustments that we made to the trade when it got into trouble.

Butterfly Spread Option Trading Strategy

The butterfly is a neutral position that is a combination of a bull spread and a bear spread.

Let’s look at an example using calls.

ABC price: 60

July 50 Call: 12

July 60 Call: 6

July 70 Call: 3

Butterfly:

Buy 1 July 50 Call $1,200 Debit

Sell 2 July 60 Call $1,200 Credit

Buy 1 July 70 Call $300 Debit

$300 Debit to place the trade

  • Our maximum loss is our debit of $300.
  • The Maximum potential gain is the difference between strikes minus the debit(10-3=7)
  • So our Max gain is $700.

Results of butterfly spread at expiration:

Price at Expiration July 50 Profit July 60 Profit July 70 profit Total Profit
40 -1200 1200 -300 -300
50 -1200 1200 -300 -300
53 -900 1200 -300 0
56 -600 1200 -300 300
60 -200 1200 -300 700
64 200 400 -300 300
67 500 -200 -300 0
70 800 -800 -300 -300
80 1800 -2800 700 -300

As you can see our breakeven points are 53 and 67. As long as ABC stays between those strikes the trade will be a winner.

Covered Call Option Trading Strategy

While the covered call is considered a conservative option strategy it can be very risky. Basically you buy 100 shares of stock and you write a call against that stock.

So for example, you buy 100 shares of ABC at 100 and you sell the 100 Call for 2.00. At expiration if ABC is above 100, your call will be exercised and they will take your 100 shares. But you get to keep the 2.00.

Writing calls against stock you already own and want to keep long term is a neat way to make some extra money for holding the stock.

Where you can get into trouble is when the stock drops in price. If you want to hold it, do so. But if you were in for a quick trade, you are in trouble. If that is a risk, you can do a covered call that is already in the money. So buy ABC at 100 and sell the 90 Call.

We do not use this technique much. But it comes in handy in times of very high volatility. When volatility is high, options are more expensive and so the premiums we get by selling options are larger than normal. We can use covered calls to take advantage of this volatility.

Here’s a real trade that we did on November 26, 2008.

Stock Symbol: C

Buy 200 shares at 7.00

Sell 2 Dec 5 Calls at 2.31 for a Debit of 4.69

I chose to illustrate the trade with 200 shares, but members are free to trade as much or as little as they want.

In this trade we paid $7 each for 200 shares = $1,400. We then got a credit of $462 for selling 2 calls that were set to expire in 25 days on December 20. Notice that we sold In the Money Calls. So if C is above $5 on expiration day we will get called and our stock will be taken away from us which results in a maximum gain. We stand to make 31 cents per share or $62 max. That is a 6.6% return in only 25 days . If you use margin the return is 13.2%. On expiration day C was at 7.02. Our stock got called away and we made the max on the trade.

Calendar Spread Option Trading Strategy

The Calendar (AKA: Time Spread) is a spread that is a relatively cheap trade but has a large profit potential. It is created by selling one option and buying a more distant option with the same strike price. When we use it as a neutral trade, we benefit from the time decay because the near term option will decay and lose value faster than the farther out option that we bought. When enough decay has occurred we exit the trade.

The risk in a Calendar is the debit required to put on the trade.

Check out this link for more on Calendar Spreads

Check out this link for more on Calendar Spread

Double Diagonal Option Trading Strategy

Double Diagonal is two diagonals, put together. First, let’s discuss the regular

diagonal trade. The diagonal spread is created by buying a longer term call at a higher strike price and selling a near term call at a lower strike price.

So if ABC was at 100, we would sell the January 110 Call and Buy the February 120 Call. In this case we want ABC to stay below 100 at expiration in January. To make it a Double, you do the same on the Put side. So we would sell the January 90 Put and buy the February 80 Put.

This gives us a range of 110-90 that ABC can play in. If it stays in that range we make our max profit. If it gets out, we need to make adjustments. The Double Diagonal is a good trade because with adjustments you can still win even if the stock goes well out of the range.

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