In a recent series of articles on stockinvestor.com, I discussed some basics of option spread strategies. I described the main benefits and few drawbacks to keep in mind.
Now, I will explain specific steps for several basic option spread strategies. I also will mention briefly a few of the more complex option spread strategies for your consideration.
The basics strategies are usually enough to generate a steady profit. However, I want to give you the choice to decide which options to use.
1) Butterfly Spread
I use the butterfly spread as a neutral strategy when I am unsure of the market direction.
I buy one in-the-money call. I also sell two at-the-money calls and I buy one out-of-the-money call.
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BUY Advertisement.
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SELL |
| 1 in-the-money CALL |
2 at-the-money CALLS |
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1 out-of-the-money CALL |
Long-call butterfly is a variation of the butterfly spread. I use this option when I believe that the price of the underlying security will not move much before the options expire.
I buy one lower in-the-money call. I also write two at-the-money calls and I buy an out-of-the-money call at a higher strike price.
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BUY Advertisement.
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SELL |
| 1 lower in-the-money CALL |
2 at-the-money CALLS |
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1 out-of-the-money CALL at a higher strike price |
I maximize my profit when the underlying stock price doesn’t move much before expiring. Therefore, the lower strike calls expire in the money. I pocket the premium.
This is a limited risk strategy. I limit my loss to the option contract cost plus any commissions.
2) Calendar Straddle
General option straddle
A general option straddle is a neutral strategy as well. It involves buying a put and a call at the same time for the same security. Both options have the same strike price and expiration date. This type of option is also referred to as a long straddle.
A long straddle offers almost unlimited profit potential and limited risk. I use straddle strategies when I expect significant stock price changes in the short term.
I buy one at-the-money call. I buy one at-the-money put.
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BUY |
SELL |
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1 at-the-money CALL |
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1 at-the-money PUT |
The best part about a straddle is the unlimited profit potential when the price moves quickly — downward or upward. The only downside is that I will lose my entire investment – price of the option contract and commission — if the underlying security does not move much in either direction. As long as the underlying security moves considerably, I have unlimited profit potential. It does not matter whether the price of the security goes up or down.
Calendar straddle
A calendar straddle is just a variation of the general option straddle. For this strategy, I sell a near-term straddle and buy a long-term straddle.
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BUY |
SELL |
| long-term straddle |
near-term straddle |
With a calendar straddle, I am expecting very little price movement. I use the time decay of the near-term options to generate the bulk of my profit.
The calendar straddle strategy works best when the underlying security trades at the strike price of the options I sold on expiration date. At that price, both options I wrote will expire worthless. I will keep the money for selling those options as profit. The longer-term straddle that I hold suffers a small loss because of the time decay.
Calendar straddle is a limited profit and limited loss or limited risk strategy.
3) Condor
Condor is considered one of the more advanced option trading strategies. In my opinion, you do not need to use this strategy. But, I will explain it briefly.
I sell one in-the-money call. I buy one in-the-money call at a lower strike price but also buy one out-of-the-money call at a higher strike price. In addition, I sell one out-of-the-money call at a lower strike price. All options expire in the same month.
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BUY |
SELL |
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1 in-the-money CALL at a lower strike price |
1 in-the-money CALL |
| 1 out-of-the-money CALL
at a higher strike price |
1 out-of-the-money CALL at a lower strike price |
I maximize my profit if the security price ends up between the two middle strike prices on the expiration date. However, I lose money if the underlying security happens to go below the lowest strike price or above the highest strike price. I use the condor strategy when I anticipate very little or no price change of the underlying security. A lot of price volatility will result in a loss. But, the most I can lose with a condor is what I paid in premiums and commissions.
Part 3 of this series will provide option spread trading strategies 4-8.
Billy Williams is a 25-year veteran trader and author. For a free strategy guide, “Fundamentals for the Aspiring Trader”, and to learn more about profitable trading, go to www.stockoptionsystem.com.
