Best options trading strategies and tips
An options trading strategy not only defines how you will enter and exit trades, but can help you manage risk and volatility. There are a range to choose from, so we’ve looked at five of the most popular options strategies.
Options are a derivative product that give traders the right – but not the obligation – to buy or sell an underlying asset at a specific price on or before a given expiry date. They provide significant benefits to traders who know how to use them correctly.
Top 5 options trading strategies
The best options trading strategy for you will very much depend on why you are trading options – for example, a strategy for hedging will vary from one that is purely speculative. This makes it important to understand the benefits that each strategy provides.
Five of the most popular options strategies are:
Covered call options strategy
A covered call is an options trading strategy that involves writing (selling) a call option against the same asset that you currently have a long position on. Your existing position ‘covers’ the options trade, as it means that you can deliver the underlying shares if the buyer of the call option decides to exercise their right to buy them.
The goal behind the strategy is to increase the amount of profit that you can make from the long position alone by receiving the premium from selling an options contract.
Covered calls are used by traders who are bullish on the underlying market, believing that it will increase in value over the long term, but that in the short term there will be little price movement. This is what is known as a ‘neutral strategy’ as it is implemented when there is little movement in the underlying market expected.
The benefit of using a covered call strategy is that it can be used as a short-term hedge against loss to your existing position. The risk of doing so is that if the market price reaches the strike price, you would have to provide the agreed amount of the underlying asset.
The maximum profit that a covered call can make is calculated as follows:
(The call option’s strike price – the purchase price of the underlying stock) + the premium received for writing the call = covered call profit
The maximum loss that a covered call could make is the purchase price of the underlying stock. Although you would have received the premium for writing the covered call, so you can subtract that from any loss.
Example of a covered call strategy
Let’s say that you own 100 shares of company ABC. Although you still believe that its long-term prospects are strong, you think that over the shorter term the share price will remain relatively flat. You expect that it will only fluctuate within a couple of pounds of the current market price of 20.
So, you decide to sell a call option on ABC with a strike price of 22. This means that you’d earn the premium from the option sale, but you’d have to sell the stock at £22 per share if the option holder decided to exercise on expiry, no matter how much the stock was actually worth. For the sake of this example, we’ll assume that the premium you receive for writing a three-month call option is £80 (80p x 100 shares in a contract).
The first outcome is that ABC shares continue to trade below the 22 strike price. The option would expire worthless, so you’d keep your shares and the premium from the option. In this case, by using a covered call strategy, you have outperformed the stock – earning £80 more than you would’ve with just the shares alone.
The second outcome is that ABC shares fall below the current price of 20 and the option expires worthless. You’d still keep the shares, and the premium which would go some way to offsetting the decline in the stock price.
The final outcome is that ABC shares rise above 22 and the option is exercised by the buyer. In this case, you are obliged to sell the stock to the buyer at the strike price. If market price keeps on rising, and passes 22.80 (strike price plus premium), you’d have been better off holding the stock.
Ready to start trading options? You can open a live account to trade options via CFDs today. Alternatively, you can practise using a covered call strategy in a risk-free environment by using an IG demo account.
Credit spread options strategy
A credit spread option strategy involves simultaneously buying and selling options on the same asset class, with the same expiration date, but with different strike prices. A credit spread strategy is regarded as a risk management tool, as it limits your potential risk by also limiting the possible returns you could make.
You would be hoping to receive a net premium once the trade is opened, as the premium received for writing one option should be greater than the premium paid for holding the other. This usually happens when the option you seek to buy is ‘out of the money’ – meaning that it has no intrinsic value, ie would be worthless if exercised today – while the option you sell is ‘at the money’ or ‘in the money’.
There are two broad types of credit spreads: credit put spreads (or ‘bull put spreads’) and credit call spreads (or ‘bear call spreads’). You’d undertake a credit put spread strategy if you were bullish on the underlying market and a credit call spread if you were bearish on the underlying.
It’s important to note that for both of these strategies, the potential downside can be more than the potential upside. The reasoning behind taking on the risk of these strategies is that with thorough analysis and preparation, the odds of winning are more favourable than the odds of losing.
Credit put spread
With a credit put spread, you’d be expecting the underlying market to rise moderately. You would use two put options, selling one with a higher strike price and buying one with a lower strike price. Once the position is opened, you would be paid a net premium.
The maximum profit is limited to the net premium you’d receive, less any fees for the position – you’d receive this profit if the stock price is at or above the higher strike price at the time of expiry.
The maximum overall loss for a credit put option strategy would be equal to the difference between the options’ strike prices, less the premium and any additional costs and charges. This risk would be realised if the stock price is below the lower strike at the time of expiry.
Credit call spread
With a credit call spread, you’d be expecting a decline in the overall price of the underlying market. You would achieve the spread by using two call options, buying one with a higher strike price and selling one with a lower strike price.
The potential profit is capped at the premium received, less any charges – you’d receive this profit if the stock price is at or below the lower strike price at the time of expiry.
The maximum loss of this trade would be calculated in the same way as a credit put spread: the difference between the options’ strike prices, less the premium and any additional costs and charges. You’d realise the maximum risk if the option is trading above the higher strike price at expiry.
This options strategy is regarded by some as a safer way to short a stock, as you will know the risk and reward before entering the trade.
To find a credit spread breakeven point, you’d add the net premium received to the lower strike price for call options and subtract the net premium from the higher strike price for put options.
Example of a credit spread options strategy
As the mechanics of both trades are virtually the same, we’re just going to look at an example of a credit call spread strategy. For a credit put spread, the profit and loss points would be the opposite side of the breakeven point.
Let’s suppose that shares of Company XYZ were trading at 192, and you thought that the underlying market price was going to remain below this figure for the next ten days. To execute a credit call strategy, you decide to sell an in-the-money XYZ call option with a strike price of 190, which is being sold for 105p per share – this means you would earn a premium of £105, as one contract equals 100 underlying shares (1.05 x 100).
You then buy an out-of-the-money 195 XYZ call option, which costs you a premium of £55 (55p x 100). This means that your total net credit upon opening the trade is £50 (105-55).
If the underlying market price did fall below 192 within ten days, your maximum profit would be £50 – although this doesn’t sound like a lot, if you had bought more than one contract, you would be looking at significantly more. Credit options ensure that you have a fixed income for a fixed risk.
And that fixed risk is this: if the stock price rose above 192, you’d start to lose money. If it increased above the 195 strike before the expiry, you would incur the maximum loss of £300 ([195-192] x 100).
The difference between a £50 gain and a £300 loss is substantial, which is why many traders decide not to take on the risk. As mentioned, the theory behind the strategy is that if you’ve done your technical analysis correctly, you are far more likely to win than you are to lose. This is because your area for profit, which is anywhere below 192, is far larger than your area for loss, which is between 192 and 195.
Ready to start trading options? You can open a live account to trade options via CFDs today. Alternatively, you can practise using a credit spread strategy in a risk-free environment by using an IG demo account.
Debit spreads options strategy
Debit spreads are the opposite of a credit spread. Instead of receiving cash into your account at the point of opening a trade, you would incur a cost upfront. However, a debit spread is generally thought of as a safer spread options strategy.
You’d create a debit spread by buying and selling two options contracts on the same underlying security but with different strike prices. The assumption with debit spreads is that the cost of purchasing the option is higher than the premium you’d receive for selling it – as such, your account would be debited for opening the positions.
This usually happens when the option you seek to buy is already at the money or in the money at the time of purchase, while the option you are selling is out of the money. It wouldn’t necessarily matter where each strike price was, as long as the options you write (sell) were cheaper than the ones you’d bought.
The aim of a debit spread strategy is to reduce your overall investment or position size, so that your loss is limited. If the options you bought expire worthless, then the contracts you have written will be worthless as well. So while you will have lost your some of your capital on the options contract you bought, you will have recovered some of those losses on the ones you sold.
There are two types of debit options strategy: debit call spreads (or ‘bull call spreads’) and debit put spreads (or ‘bear put spreads’). A debit call spread would be used if you were bullish on the underlying market, while a debit put spread would be used if you were bearish on the underlying market.
Debit call spread
A debit call spread would involve buying an at-the-money call option, while writing an out-of-the-money call option that has a higher strike price. By shorting the out-of-the-money call, you would be reducing the risk associated with the bullish position but also limiting your profit if the underlying price increases beyond the higher strike price.
The maximum profit would be calculated by finding the difference between the options’ strike prices, and subtracting the net premium paid and any additional charges. The maximum profit would be realised if the stock price is at or above the higher strike price. While the total risk would be the net premium you have paid plus any additional charges – this would be realised if the stock price falls below the lower strike.
Debit put spread
A debit put spread would involve buying an in-the-money put option with a high strike price and selling an out-of-the-money put option with a lower strike price. By shorting the out-of-the-money put, you’d reduce the risks associated with your bearish position. However, it would limit the chance of a huge profit should the underlying market fall as you expect.
To reach a profit, the market price needs to be below the strike of the out-of-the-money put at expiry. Your profit would be calculated by finding the difference between the options’ strike prices and subtracting the net premium paid and any additional costs. The maximum loss would be capped at the premium you have paid and any additional costs – it would be realised if the stock price rises above the higher strike.
Example of a debit spread options strategy
Again, as the mechanics of both trades are virtually the same, we’ll just look at one example. This time, we’ll look at a bullish strategy.
Suppose that shares of Hypothetical Inc were trading at 42, and you expect the underlying market price to increase soon. You decide to enter a debit call spread by buying an in-the-money call option with a strike price of 40 for £300 and selling an out-of-the-money call option with a strike price of 45 for just £100 – both with an expiry of one month. So to enter the position, you’d have to pay £200.
Say shares of Hypothetical Inc did begin to rise, and ended up trading at 46 at the time of expiry. Both options would expire in the money – the long option that you bought would have a value of £600 (6 x 100 shares in a contract), while the short option that you sold would have a value of £100 (1 x 100 shares in a contract). This means that your options spread is now worth £500 (600-100) but as it is a debit spread, you’d have to subtract your initial payment of £200. Your total profit would therefore be £300 (minus any additional fees).
If shares of Hypothetical Inc fell instead, say to £38, both options would expire worthless. You would lose your initial debit of £200 (plus any additional fees) as this is your maximum loss.
Ready to start trading options? You can open a live account to trade options via CFDs today. Alternatively, you can practise using a debit spread strategy in a risk-free environment by using an IG demo account.
Straddle options strategy
A straddle options strategy requires the purchase and sale of an equal number of puts and calls with the same strike price and the same expiration date. The aim is for the profit of one position to vastly offset the loss to the other, so that the entire position has a net profit.
Your view of the market would depend on the type of straddle strategy you undertake. Straddles fall into two categories: long and short.
Long straddles involve purchasing a put and a call with the same strike price and the same expiration date. This would take advantage of market volatility, as regardless of which way the market moves, you’d have one position that would profit.
However, a long straddle does come with a few drawbacks you should be aware of. Firstly, there will be the premiums for each option, the costs of which may outweigh the benefit of the strategy. There is also the risk of loss, as while one of your options will profit, the other will incur a loss – if the loss from one option is larger than the gains in the other, the trade would have a net loss. And finally, if there is no volatility, then both options will likely incur a loss as they would expire worthless and you’d have paid a premium for opening the position.
Short straddles require you to sell a call and a put with the same strike price and expiration date – in doing so, you’d be able to collect the premium for each. This takes advantage of a market with low volatility.
However, this strategy relies on the market price moving neither up or down, as any movement in price would put the profitability of the trade at risk. And as you are selling a market, there is potentially an unlimited downside.
Example of a straddle options strategy
Let’s say that shares of Imaginary Co. were trading at 40, and you believe that the share price could see significant volatility over the next month due to an upcoming earnings announcement. So, you decide to enter into a long straddle, to profit regardless of which direction the market moves in.
You buy a put option with a strike price of 40 for and an expiry in one month, which costs you a premium of £100 (100p x 100 shares per options contract). You also buy a call option with an identical strike price and expiry date, also for £100. You’d be in a net debit of £200, which would be your maximum possible loss on the trade.
If the shares were trading at 50 by the time of expiry, your put would expire worthless, but your call would have an intrinsic value of £1000 (10 x 100 shares per contract). If you subtracted your initial outlay of £200, you’d have a profit of £800.
Likewise, if the shares were trading at 35 by the time of expiry, your call would expire worthless while your put would have an intrinsic value of £500 (5 x 100 shares per contract). Subtracting your initial outlay, you’d have a profit of £300.
If both options expired worthless at the time of expiry, your maximum loss would be £200.
Ready to start trading options? You can open a live account to trade options via CFDs today. Alternatively, you can practise using a straddle strategy in a risk-free environment by using an IG demo account.
Strangle options strategy
A strangle options strategy involves holding a position on both a call and a put option, which have the same expiry date and underlying asset, but different strike prices. Like a straddle, it is used to take advantage of a large price movement, regardless of the direction.
There are two types of strangle options strategies: long and short.
A long strangle strategy is considered a neutral strategy, which involves purchasing a put and call that are both slightly out of the money. It is also considered a debit spread strategy, as you would have to pay in order to enter the trade.
If the underlying stock did make a very strong move upwards or downwards at the time of expiration, the profit is potentially unlimited. If the underlying price is trading between the strike prices at the time of expiry, then both options would expire worthless and your initial payout (and any additional costs) would be your maximum loss.
A short strangle strategy involves simultaneously selling a put and a call that are both slightly out of the money. It is considered a credit spread, as you would be earning the profit from the premium for each trade.
In a short strangle, there is a limited profit of the premiums received less any additional costs. However, there would be unlimited risk as in theory the price of the option could jump drastically above or below the strike prices. When using a short strangle trade, you’d want the market price to remain trading within the boundaries of the strike prices.
Example of a strangle options strategy
Let’s say that Company 123 was trading at 50, and you believe that the market price will remain flat within the next month. You decide to adopt a short strangle options strategy by selling a put with a strike price of 45 and an expiry of one month – from the trade you gain a £100 premium. You would also sell a call option with a strike price of 55, with the same expiry date – this also earned you £100. So, you would open your trade with a net credit of £200.
If at the time of expiry, Company 123 shares are still trading at 50, then both options would expire worthless, and you would have taken the premiums as profit.
However, let’s say the stock rallied instead, and was trading at 60 at the time of expiry. The 45 put you sold would expire worthless. However, the 55 call option would have an intrinsic value of £500 (5 x 100 shares per contract). If you subtracted your initial credit of £200, you would have an overall loss of £300.
Ready to start trading options? You can open a live account to trade options via CFDs today. Alternatively, you can practise using a strangle strategy in a risk-free environment by using an IG demo account.
Options trading tips: what you need to know before trading
Regardless of which strategy you decide to implement, there are a few key things that you should do before you start to trade:
Learn how options work
Options are divided into two categories: calls and puts. Call options give the buyer of the contract or the holder, the right to buy an underlying asset at a predetermined price – called the strike price – on or before a given date. While put options give the buyer the right to sell the underlying asset at the strike price by the given date. Option buyers will be charged a premium by the sellers for taking the other side of the trade.
Learn more about how options work
Build an options trading plan
A trading plan is the blueprint for your time on the markets, which will govern exactly what, when and how you will trade. Your plan should be unique to you, your goals and risk appetite.
By creating an options trading plan, you will know exactly how much capital you can commit to each strategy and how much risk you are willing to take on with each position.
A trading plan also eliminates many of the risks of trading psychology. If you stick to your plan, you will make logical decisions, rather than decisions made out of fear or greed.
Create a risk management strategy
Whichever options strategy you choose, it is vital to understand the risks associated with each trade and create an appropriate risk management strategy before you trade.
The most important factors that can help you measure the risk of each of your positions are called the ‘Greeks’. These are:
- Delta, which measures the sensitivity of an option to the underlying price
- Vega, which measures an option’s sensitivity to market volatility
- Theta, which measures the impact of time to expiry on an option’s value
While many options are traded via a broker, you can also trade options using contracts for difference (CFDs). These enable you to trade using leverage, which can magnify your potential profits, but it can also magnify your losses – meaning it’s even more important to be aware of the risks of each trade.
We offer a range of tools available for you to manage your risk, including stops which close your trade automatically, and limits which allow you to lock in a profit.
Learn more about risk management with IG
Start options trading
Now that you’ve chosen your strategy and followed the tips for trading options, it’s time to put what you have learnt to use.
With IG, you can trade options using CFDs. However, it is important to remember that when using CFDs, you are speculating on the underlying options price, rather than entering into a contract yourself. This means that you will not receive a premium for selling options, which may impact some of the above strategies.
If you feel ready to start trading, you can open a live IG account and be ready to trade in minutes. Alternatively, if you’d like to build your confidence up in a risk-free environment, you can create a demo account to trade with £10,000 in virtual funds.
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