This is the eighth and final article in a series about option spread strategies that build upon the previous write-up. If you missed any previous articles, you can start at the beginning or pick the ones you missed from the list.
Each article in the series is designed to describe option spread combination trades that are intended to be used in specific circumstances. The goal is to help investors understand each option spread strategy, as well as when to apply it to maximize potential returns and limit losses.
The strip strategy provides unlimited profit potential and limited risk. I use this strategy when I expect a lot of volatility in the near term. However, the price of the underlying security must be more likely to go for this strategy to maximize returns.
I buy one at-the-money call and I buy two at-the-money puts.
1 at-the-money CALL
2 at-the-money PUTS
The unlimited profit potential comes when the underlying security price moves either way up or way down before expiration. I prefer if the price goes down. That way I make more money.
The only risk of the strip is that the underlying security might be trading at the strike price of the call options. At that price, all the options end up expiring worthless.
However, if you choose the expiration date and our underlying security correctly, there is a high probability you could earn significant profits with limited risk.
A strap is another trade strategy with unlimited profit potential and limited risk. Like with the strip strategy, I use this the strap when I expect a lot of volatility in the near term. However, this time the price of the underlying security must be more likely to go up.
I buy two at-the-money calls and I buy one at-the-money put.
2 at-the-money CALLS
1 at-the-money PUT
The unlimited profit potential occurs when the underlying security goes strongly either up or down. I make more money with an upward move.
I lose money when the underlying security price is equal to the strike price of the call or the put options I bought. The options expire worthless. My loss amounts to the contract premiums plus commissions for entering the trade.
The list of 29 option spread strategies I described briefly in the several recent articles are not a comprehensive list of all option spread strategies. The goal of those articles is to give you a small set of option spread strategies you can use in a variety of conditions.
Once you develop familiarity with option spread trading, you can use a variety of option combinations. These option spread strategies are built on the same principles but use different strategies for specific expected moves in the market.
These articles will not make you an option spread strategies expert. My intention is to give you a brief understanding on how to limit risk in option spread trading.
I have explained that whenever we sell the right for somebody to take delivery of shares from us, we expose ourselves to considerable risk. If we buy the option, however, we are limiting our risk. That is an important lesson.
All option trades, no matter how sophisticated, depend on two levers — the lever for increasing our risk and the lever for reducing our risk. Increasing our risk means we give somebody control over what they can demand from us. Reducing our risk means we buy the right to take delivery or demand something from the other options trader.
Reducing risk often results in reduced profit. The most important aspect of this option spread strategies list is to identify which option spread trades to avoid and which ones to embrace and use.
Surprisingly, many of the more complex and sophisticated trading strategies do not necessarily increase our profit potential. Therefore, I have identified the short and simple spread trades that give you unlimited profit potential with limited risk.
I have described many different strategies in my series of eight articles about option spread trading. I let you know which strategies I prefer and which ones I think you should avoid. It is not necessary to master and use all or most of option trade strategies I mentioned. Knowing which of the limited number of option strategies to use in which situation is what matters the most.
One aspect of almost all option trading strategies is that we must identify the type of market we are entering. Do you see the market as neutral, bullish or bearish for the underlying security? To make that determination, you need some tools to assess what the market is doing.
Therefore, in a separate series of articles on stockinvestor.com, I will explain how to evaluate what the market is doing based on technical indicators. I will focus on technical indicators and not fundamental analysis of underlying securities and options. Fundamental analysis does not play as large a role in short-term option trading.
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.