In my series on options spread strategy, you have learned by now how to identify the market, chose the investment vehicle and pick the direction that you want to trade. With that information in hand, now pick the strategy that will maximize your profit potential while minimizing risk exposure.
Before selecting a specific strategy, you must determine what level of bullishness, bearishness, or neutrality you want to take. If you found clear indications that the trend is up for the sector and the specific vehicle, you could just buy a call option for a simple 100% bull trade. The same reasoning applies to put options.
However, since markets are rarely purely bullish or purely bearish, we have smarter ways to approach trades. The function of option spread trading is to avoid the strictly defined bullish or bearish side almost entirely.
In a series of articles, I have outlined dozens of different options spread strategies and I have indicated for each whether they apply to bullish, bearish or neutral markets. Here is a brief summary of some of those strategies listed by the type of market to which they apply.
Neutral market strategies
- Ratio Spread
- Calendar Straddle
- The Condor
- The straddle
- The Iron Butterfly
- The Iron Condor
- The Strangle
Bull market strategies
- Covered Straddle
- Bull Calendar Spread
- Call Back Spread
- Bull Call Spread
- The Collar
- Covered Calls
- Naked Puts
Bear market strategies
- Naked Calls
- Covered Puts
- Bear Put Spread
- Put Back Spread
These strategies and the trend line direction defined from the technical analysis will help determine the type of trade to enter. After you determine the trend of the sector you wish to trade, sometimes you might go back and forth to decide whether you want to find a sector that is in a bullish or bearish direction. After you settle on the sector, you chose the vehicle for the trade.
All the strategies defined under each of the categories are not equal. Some strategies are clearly superior than others, so use the best ones most often. If you are new to option spread trading, you should use these superior strategies exclusively until you get some experience.
I clearly indicated which strategies to avoid when I described each in previous articles. Some of the strategies are too risky or do not offer enough return on investment potential relative to the level of risk exposure.
Neutral markets are generally most complicated. There are so many neutral strategies, referring to the situation when a trader is unsure whether the market is headed up or down or would simply rather trade for low volatility. This uncertainty of neutral markets creates a bigger challenge to figuring out which strategies to choose than either the bullish or the bearish markets.
Recommended strategies
Following the rule that simple is better, you should focus on mastering few of the strategies for each type of market. That way, you will be able to start trading spread options right away and start generating profit. As you gain experience, you can add additional strategies to your toolbox, but you will see that you can be a successful options spread trader even with just a few basic strategies.
Here are the strategies that I recommend for neutral markets.
- Neutral Calendar Spread
- Butterfly Spread and its variations
- Condor and its variations
The bullish spread trades I recommend also include some trades that others may consider to be neutral-oriented trades. The reason I recommend them as bullish trades as well is that they are oriented toward greater profit if the trend continues to be bullish, though they will also profit if there is low volatility prior to the options expiring.
My recommended bullish-oriented option spread trades include:
- Bull Calendar Spread
- Bull Call Spread
- Diagonal Bull Call
- Bull Put Spread
- Call Back Spread
There are many other bullish strategies, with names like married put and uncovered put write. However, those strategies present major complications and do not offer significant advantages over the ones I have chosen.
The recommended bearish-oriented option spread trades will be essentially the same as the bullish ones but in reverse:
- Put Back Spread
- Diagonal Bear Put Spread
- Bear Call Spread
- Bear Put Spread
While there are many other bearish and bullish option spread strategies, the ones above limit the risk and present reasonable profit opportunities.
In a future article, I will put all of these pieces together and explain how to form a trading plan that will minimize your risk and maximize the probability of profitable trades.
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.
