This article describes five option spread strategies and is part 6 of an eight-part series.
This write-up follows a previous article about different option spread strategies to help explain the unique circumstances that are suitable for each. The articles also are intended to explain the potential risks and rewards of the various option spread strategies.
The following strategies are 17-21 of the 29 total option spread combinations featured in the series.
17) Short (Naked) Straddle
The short straddle is another strategy with limited profit potential and unlimited loss exposure. The risk is unlimited because it involves selling at-the-money options. In such an instance, I expect that the price of the underlying security will not move. Otherwise, I must make up for one of the trades becoming an in-the-money option.
To execute a short straddle strategy, I engage in two trades. I sell one at-the-money call and I sell one at-the-money put. Both trades are for the same security at the same strike price and with the same expiration date.
| BUY Advertisement. | SELL |
| 1 at-the-money CALL | |
| 1 at-the-money PUT |
The most profit I can expect are the premiums for selling the options, less any commissions. However, if the underlying security is above or below the two strike prices, I am on the hook for the difference.
18) Short Strangle
The short strangle strategy is sometimes called a sell strangle. I sell one out-of-the-money call and I sell one out-of-the-money put.
| BUY Advertisement. | SELL |
| 1 out-of-the-money CALL | |
| 1 out-of-the-money PUT |
Any time I sell a call or a put, I expose myself to unlimited risk. My risk is unlimited even if the options I sell are out of the money. Conversely, my profit is limited to the net of premiums collected and commissions paid for the trade.
19) Variable Ratio Write
The variable ratio write is similar to the ratio write strategy. For this strategy, I sell more calls than the number of shares I own. Limited profit and unlimited risk make this strategy almost always a bad idea.
This strategy is applicable in a neutral market. I expect very little movement from the underlying security in the near term. For this strategy, I could go long on 100 shares of a stock. Then, I might sell one in-the-money call and one out-of-the-money call. It is called a variable ratio write because I am writing one out-of-the-money call and one in-the-money call.
| BUY | SELL |
| 1 in-the-money CALL | |
| 1 out-of-the-money CALL |
If the underlying security’s price is between the strike prices of the two options I sold, I will earn maximum profit. The profit potential with this strategy is low. However, the difference between the in-the-money and out-of-the-money calls increase the overall likelihood of earning a profit.
I lose money with this strategy if the underlying security’s price moves outside the bounds of the two calls I sold.
20) Reverse Iron Condor
Here is a strategy worth considering. Unlike some of the trades I recently described, the reverse iron condor does not have unlimited risk potential. However, it does limit profit.
The reverse iron condor has a reasonable balance between risk and profit. I buy one out-of-the-money put and I buy one out-of-the-money call. I sell one out-of-the-money put at a lower strike price, and sell one out-of-the-money call at a higher strike price.
| BUY | SELL |
| 1 out-of-the-money PUT | 1 out-of-the-money PUT at a lower strike price |
| 1 out-of-the-money CALL | 1 out-of-the-money CALL at a higher strike price |
Even though I am selling a put and a call, the cost to enter this trade is generally a net debit. Maximum profit with a reverse iron condor is limited. I make money when the price of the underlying security goes below the strike price of the short put or if the price is equal to the higher strike price of the short call.
The reverse iron condor has a net debit to enter the trade. I expect to make up for that debit by exercising the trade at a profit.
21) Reverse Iron Butterfly
I use the reverse iron butterfly strategy when I expect volatility. I maximize my profit when the price of the underlying security makes a very fast move either up or down.
To create a reverse iron butterfly, I execute four trades. I sell one out-of-the-money put and I buy one at-the-money put. I also buy one at-the-money call and I sell one out-of-the-money call.
| BUY | SELL |
| 1 at-the-money PUT | 1 out-of-the-money PUT |
| 1 at-the-money CALL | 1 out-of-the-money CALL |
I will have a net debit when I enter this trade. Premiums for buying the at-the-money options will be higher than the premiums for selling the out-of-the-money options.
I realize maximum profit if one of two instances occur. One instance is if the price of the security drops below the strike price of the short put option. The other instance is if the price of the security is equal or higher than the strike price of the short call option. In either of those instances, my profit is the difference between the calls and the puts minus the debit I took on to enter the trade.
My loss is highest if the price of the underlying security does absolutely nothing. However, my loss is limited to the net debit for entering the trade.
The next article in the series will be part 7, which features options spread strategies 22-27.
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.
