Trading options is a popular way for investors to make money in the market. While basic option strategies allow for big swings and big risks, more advanced multi-leg options strategies provide traders with the ability to hedge their risks, offering more precise exposure and potential payoffs.
Regardless of the complexity of the strategy, all options are based on two fundamental types: calls and puts. Below, we explore five advanced strategies, their associated risks and rewards, and when traders might consider using them. These multi-leg strategies may be more intricate than basic options, exposing traders to more nuanced risks, but they are not without risk. It’s important for traders to have a solid understanding of call and put options before delving into these advanced strategies.
1. Bull call spread
The bull call spread involves buying a call at a low strike price and selling a call at a high strike price with the same expiration date. This strategy is used when the trader anticipates the stock price to rise towards or exceed the high strike price by expiration. The profit on this trade is limited to the difference between the two strike prices. This hedged trade lowers the break-even point and accelerates potential returns compared to a standalone long call option.
Example: If Stock X is trading at $20 per share, a call with a $20 strike price is priced at $1, and a call with a $24 strike price is priced at $0.50. The cost of setting up this trade would be $50 per contract, calculated as the $100 cost of the long call minus the $50 premium received for the short call.
The profit on a bull call spread at expiration for various stock prices can be visualized in the chart below:
Reward/risk: The trade breaks even at $20.50 per share in the provided example. The maximum potential upside is capped at the difference between the two strike prices minus the cost of the strategy. However, the downside is a total loss of the initial investment if the stock price is below the long call’s strike price at expiration.
When to use it: The bull call spread is suitable when expecting moderate stock price increases. It allows for a reduced break-even point and faster multiplication of returns compared to a basic long call option. This strategy can be effective for long-term investments, enabling traders to leverage call options and generate income through short calls over time.
2. Bear put spread
Similar to the bull call spread, the bear put spread is a hedged trade involving a long put and a short put, set up to profit from a decrease in the underlying stock’s price. In a bear put spread, the trader purchases a put at a high strike price and sells a put at a low strike price with the same expiration date. The profit potential is limited to the difference between the two strike prices, and this strategy can lower the break-even point and enhance returns compared to a standalone long put option.
Example: If Stock X is trading at $20 per share, a put with a $20 strike price is priced at $1, and a put with a $16 strike price is priced at $0.50. The setup cost for this trade would be $50 per contract, calculated as the $100 cost of the long put minus the $50 premium received for the short put.
The profit on a bear put spread at expiration for various stock prices can be visualized in the chart below:
Reward/risk: The trade breaks even at $19.50 per share in the provided example. The maximum potential upside is limited to the difference between the two strike prices. However, the downside is a total loss of the initial investment if the stock price is above the long put’s strike price at expiration.
When to use it: The bear put spread is effective when anticipating moderate stock price declines. It allows for a reduced break-even point and accelerated returns compared to a basic long put option. This strategy can be suitable for investors looking to profit from downward movements in stock prices.
3. Synthetic long
The synthetic long strategy involves buying a call and selling a put at the same strike price and expiration date. This trade is designed for scenarios where the trader expects the stock price to rise moderately or significantly by expiration. The upside potential on this trade is theoretically unlimited, and it requires less upfront capital compared to a traditional long stock position.
Example: If Stock X is trading at $20 per share, a put and call with a $20 strike price are both priced at $1. Setting up this trade would have no initial cost, as the cost of the call is offset by the premium received from the put.
The profit on a synthetic long at expiration for various stock prices can be visualized in the chart below:
Reward/risk: The trade breaks even at $20 per share in the provided example. The upside potential increases as the stock price rises, while the downside risk is limited to the stock price multiplied by the number of shares.
When to use it: The synthetic long strategy is suitable for investors expecting moderate to significant stock price increases without the need for immediate capital outlay. This strategy provides exposure to potential stock gains without the upfront cost of purchasing shares, offering theoretically unlimited returns if the stock price continues to rise.
4. Long straddle
In a long straddle, the trader purchases a call and put at the same strike price and expiration date. This strategy is utilized when anticipating significant price movement in either direction by expiration, without a specified direction. The profit potential on this trade is uncapped, minus the initial cost of establishing the straddle.
Example: If Stock X is trading at $20 per share, a put and call with a $20 strike price are both priced at $1. Setting up this trade would cost $200, combining the costs of the call and put options.
The profit on a long straddle at expiration for various stock prices can be visualized in the chart below:
Reward/risk: The trade breaks even at $18 and $22 per share in the provided example. The maximum potential upside is theoretically unlimited, with profits increasing as the stock price moves in either direction. However, the downside risk is limited to the initial cost of the strategy.
When to use it: The long straddle strategy is suitable for investors expecting significant stock price movement but uncertain about the direction. While more expensive to implement due to the cost of both options, it provides the opportunity for substantial gains if the stock price moves significantly in either direction.
5. Short straddle
Conversely, the short straddle involves selling a call and put at the same strike price and expiration date. This strategy is employed when expecting the stock price to remain within a specified range until expiration. The profit potential on this trade is capped at the total premium received.
Example: If Stock X is trading at $20 per share, a put and call with a $20 strike price are both priced at $1. Implementing this trade would yield a premium of $200.
The profit on a short straddle at expiration for various stock prices can be visualized in the chart below:
Reward/risk: The trade breaks even at $18 and $22 per share in the provided example. The maximum potential upside is limited to the premium received, while the downside risk is substantial and theoretically unlimited if the stock price moves significantly in either direction.
When to use it: The short straddle strategy is suitable for investors expecting the stock price to remain range-bound. While offering the potential for income through the premium received, it carries the risk of significant losses if the stock price deviates substantially from the strike price.
Getting Started with Options Trading
Before engaging in options trading, it is essential to have a thorough understanding of how options work, including basic strategies. Finding a broker that supports options trading and obtaining permission to trade options are crucial steps. Brokers may require information about the types of strategies you intend to use, as some strategies carry higher risks than others.
For riskier trades like short calls or short puts, a margin account may be necessary. However, safer strategies such as covered calls may not require a margin account. Each broker has its own requirements for options trading, so it is important to review these requirements before initiating options trades.
Some brokers allow options trading in retirement accounts like IRAs. Even in an IRA, options can be a viable choice if employing safer, income-producing strategies. It is important to understand the risks and rewards of each options trade and assess whether the potential upside justifies the risks involved.
Conclusion
Options trading offers opportunities for investors to generate profits, with advanced strategies providing ways to hedge risks and target specific outcomes. However, it is crucial to fully comprehend the complexities of options trading and carefully evaluate the potential risks and rewards of each trade. By having a solid understanding of options and utilizing strategies that align with your investment goals, you can maximize your chances of success in the options market.
Editorial Disclaimer: Investors are advised to conduct independent research into investment strategies before making decisions. Past performance of investment products does not guarantee future price appreciation.