Derivatives Trading Basics
by 5paisa Research Team Last Updated: 2022-09-14T10:58:17+05:30

Options Trading Strategies

An asset class that investors and traders widely utilise is Derivatives which are of two types: Options and Futures. An Options contract is a financial instrument that gives buyers the right but not the obligation to buy the underlying assets such as stocks, ETFs, Bonds, Commodities etc., at a predetermined price in the future. Investors use various options trading strategies to ensure their decisions are informed and profitable. 

Options trading strategies combine various tactics such as the current market trend, underlying asset volatility, risk metrics such as options greeks etc., to create a tried and true process for every market condition. Since options trading requires the investors to decide whether to exercise the contract or not, options strategies help immensely in successful decision-making. Hence, it is vital for any investor or trader wanting to trade in options to have a deep understanding of options trading strategies. 
 

Types of Options Trading Strategies

Options are divided into call options and put options. A call option gives the contract holder the right but not the obligation to buy the attached underlying asset at the strike price before or on the expiry date. On the other hand, a put option gives the contract holder the right but not the obligation to sell the attached underlying asset at the strike price before or on the expiry date. 

These options differ in their aim, as call options are generally used by investors when they feel the market is bullish and put options when they feel the market trend is bearish. 

Based on the market trend, options trading strategies are also divided into three types; Bullish, Bearish, and Neutral Options Strategies. Investors use bullish options trading strategies when they feel that the underlying asset’s price will increase in the future. They turn to bearish options trading strategies when they feel that the underlying asset’s price will decrease. When they have no idea about the market trend, they utilise neutral trading strategies. 
 

Bullish Options Strategies

While trading in options, if investors feel that the market is bullish, they use the following bullish options trading strategies to make profits while mitigating the loss potential: 

Bull Call Spread 

A Bull-Call Spread utilises two call options with different strike prices to create a range. Both options have the same underlying asset and expiration date. However, the investor and traders buy one call option that is At-The-Money while simultaneously selling one call option that is Out-Of-The-Money. 
A bull call spread is profitable for the investor if the price of the underlying asset, such as stocks, increases in its price. In this strategy, the profit is limited to the spread minus net debit, while a loss is incurred if the stock price falls. 

Bull Put Spread

A Bull-Put spread is a part of the options trading strategies similar to the Bull-Call spread. In this strategy, the investors utilise two put options with different strike prices and the same expiration date to create a range. However, the investor and traders buy one put option that is Out-Of-The-Money while simultaneously selling one put option that is In-The-Money. 

Here too, the investors profit if the underlying asset’s price, such as stocks, increases on or before the expiration date. This strategy is formed for a net credit, or the net amount received while loss is incurred if the underlying asset’s price falls below the strike price of the long put option. 

Call Ratio Back Spread

This strategy is one of the three-legged options strategies where the investors and traders buy two Out-Of-The-Money call options while simultaneously selling one In-The-Money call option. The profit potential is unlimited, while loss is incurred if the underlying asset's price stays within a specific range. 

Synthetic Call

Investors use a synthetic call when they have a bullish long-term view of the underlying asset but at the same time are worried about the downside risks. The strategy involves buying put options of the same underlying asset, such as stocks bought through direct investment after having a bullish view. The profit potential is unlimited if the stock prices rise, while the loss potential is limited to the premium amount. 

Bearish Options Strategies

The financial market is dynamic and contains volatility derived from various external market factors and can force the market to enter a bearish trend. In such a case, the options investors use the following bearish options trading strategies: 

Bear Call Spread 

This strategy involves buying one Out-Of-The-Money call option with a higher strike price and simultaneously selling one In-The-Money call option with a lower strike price with the same underlying asset and the expiration date. The strategy is created for a net credit, and the investors make a profit if the underlying asset’s price falls. The loss is limited to the difference between the spread and the net credit. 

Bear Put Spread 

Like a bear call spread, investors implement the strategy when they feel that the underlying asset’s price will moderately fall but not by a high margin. In this strategy, the investors purchase one In-The-Money put option while simultaneously selling one Out-Of-The-Money put option. The profit potential is limited to the difference between the spread and the net debit, while the net debit is the difference between the premium paid and the premium received. 

Strip

The Strip is a three-legged strategy that is bearish to neutral in which the investors buy one call option and two put options with the same underlying asset, strike price and expiry date that are At-The-Money. In this strategy, traders earn profits if the underlying asset’s price falls significantly at the time of expiration date. The maximum profit potential is unlimited, while the loss potential is limited to the premium amount. 

Synthetic Put

Investors utilise the synthetic put strategy when they feel that the market is in a bearish trend and the underlying asset can lose strength in the near term. The strategy is also known as synthetic long put, as investors profit from the decline in the underlying asset’s price. The profit potential is unlimited and is similar to the long put, while the loss potential is the difference between the short sale price and the long call strike price. 
 

Neutral Options Strategies

Neutral options strategies are implemented by investors who have no idea where the underlying asset’s price will go. Hence, they opt for the following neutral options trading strategies: 

Long and Short Straddles

The long straddle is a simple market-neutral strategy that involves buying In-The-Money call and put options with the same underlying asset, strike price and expiration date. In this strategy, the profit potential is unlimited while the loss potential is limited. 

The short straddle comprises selling At-The-Money call and put options with the same underlying asset, strike price and expiration date. In this strategy, the profit is equal to the received premium while the loss potential is unlimited. 

Long and Short Strangles

The options strangle strategy is similar to the straddle options strategy but differs as it involves buying Out-Of-The money call and put options. The long strangle strategy involves purchasing one Out-Of-The-Money call option, and one Out-Of-The-Money put option. The profit potential is unlimited, while the loss potential is limited to the net premium. 
The short straddle consists of selling one Out-Of-The-money put and one Out-Of-The-Money call option. The maximum profit is equal to the premium received, while the maximum loss is unlimited.

Long and Short Butterfly 

This strategy is a combination of bull and bear spreads with limited profit and fixed risk, and the options are at the same distance from the At-The-Money options. The long butterfly call spread includes buying one In-The-Money call option while selling two At-The-Money call options and then buying one Out-Of-The-Money call option. 

The short butterfly spread includes selling one In-The-Money call option while simultaneously buying two At-The-Money call options and then selling one Out-Of-The-Money call option. 

Long and Short Iron Condor

This options strategy includes one long and one short put along with one long and one short call with different strike prices and the same expiration date. Unlike a bull put spread, the iron condor strategy is a four-legged strategy which has limited risk and allows investors, inventors and traders to benefit from the low volatility in the market. The profit potential is highest when the underlying asset’s price is between the middle strike price at the time of expiration. 

What Are The Levels of Options Trading?

Generally, there are four levels of options trading assigned by brokers, which determines the approval given by the stockbroker up to a certain level while the customers maintain a margin account. Here are the four levels of options trading: 

Level 1: The use of protective puts and covered calls when the investor or trader already owns the underlying asset. 

Level 2: The use of straddles and strangles along with long calls and puts. 

Level 3: The use of various options spreads consisting of buying multiple options while simultaneously selling multiple options with the same underlying asset and expiration date. 

Level 4: Writing (Selling) options, such as naked options, while undertaking the risk of unlimited losses. 
 

Advantages of Trading Options

Options trading can prove to be one of the most beneficial financial instruments that investors can use to make profits in the market. Its advantages include:

Higher Leverage 
Options contracts have higher leveraging power as investors can take options positions similar to stocks but at a lesser personal investment. They can buy positions through leverage provided by the stockbrokers until they maintain a minimum balance in their margin account. Furthermore, until they do not exercise the contract, they do not have to pay any amount to purchase the underlying asset. 

Limited Downside
When buying call or put options, investors have the right but not the obligation to exercise the contract. It means that if their positions have not reached their preferred price, they do not have to exercise the contract to make losses. They can decide against it and limit their losses to the premium amount depending on the type of options contract. 

Predetermined Price 
When investors buy options contracts, they can fix the stock price at a certain predetermined price to guarantee a specific amount if the contract is exercised. This helps them hedge against their direct investment and ensure they can square off the losses made in direct investment. 
 

Disadvantages of Trading Options

Although options trading can provide numerous profit-making opportunities to investors or traders, they contain a set of risks that can force investors to incur losses. Here are the disadvantages of trading options: 

Unlimited Losses
Unlike buyers, options contracts can force option sellers to incur unlimited losses as they are obligated to buy or sell. This happens because options contracts provide the right to the buyers where they can exercise to buy the underlying asset at the predetermined price. In such a case, even when the sellers may not want to sell as they will incur losses, they are obligated to sell if the buyer exercises the right to buy. 

Margin 
Investors and traders must maintain a minimum margin amount in their brokerage accounts. As most investors and traders execute options trading through leverage which the stockbroker provides, they are required to maintain a minimum margin account which works as a protection for the stockbroker in case the buyer incurs losses. If such an amount is not maintained, the buyer gets a margin call to fund the account, failing which can result in the squaring off of the positions. 

Complex
Options trading requires the study of complex terms and strategies, which may be time-consuming and complicated. Since there are numerous strategies for bullish, bearish and neutral markets, it becomes complex for investors or traders to understand all of them in detail and execute them without committing any mistakes. 

The Bottom Line

There are numerous asset classes, such as equities, bonds, ETFs, commodities etc., which investors or traders can directly invest in to make profits. However, derivatives, especially options, are one such financial instrument that allows investors and traders to create a financial contract with any underlying asset from different asset classes. 

Furthermore, options also provide flexibility to the buyers as they have the right but not the obligation to buy the underlying assets at a predetermined price. It means that if the buyers feel that the contract can force them to incur losses, they can choose not to exercise the contract, allowing them to mitigate their losses. 

Numerous options trading strategies are available to let the investors and traders profit in any market condition. They can use bullish strategies when they feel the market is bullish, and bearish strategies when they feel the market is bearish. However, if they have no idea about the market trend, they can utilise neutral strategies to mitigate losses and make profits. 

FAQs:

Q.1: Which strategy is best for options trading?
Ans: The use of strategies in options trading depends on the market trend. You can use bullish strategies amid a bull market, bearish strategies amid a bear market and neutral strategies when the market is moving sideways. 

Q.2: Which is the easiest options strategy?
Ans: Synthetic call is considered one of the most widely used and easiest options strategies. 

Q.3: Which is the riskiest options strategy?
Ans: Naked options such as covered calls and covered puts are the riskiest because of their unlimited loss potential. 

Q.4: What are the least risky options strategy?
Ans: Synthetic call is one of the least risky options strategy as it is simple with limited loss potential. 

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