Options trading strategies: What they are, and their different types

Summary:

Options strategies are combinations of options positions that traders use to make profits and keep losses in check. In this article, we'll explain some of the most popular option trading strategies with examples.

Options trading might seem complex, but here's a simple take: you invest a small amount and get to control a large volume of assets like stocks, currencies, or indices. This approach can lead to higher profits, but also potential losses. Today, many traders prefer options because they use tried and tested option strategies to predict market movements. In this article, we'll explain some of these strategies in detail with examples. Let's get started.

What are options strategies? 

Option trading strategies are sets of rules or guidelines that traders follow when dealing with options. These strategies help traders decide when, how, and which options to buy or sell, aiming to make profits or protect their investments based on expected market movements and price changes.

Types of option strategies

The following are some of the most common option strategies:

Bull call spread

In a bull call spread, you buy a call option at a lower strike and sell another at a higher strike on the same asset, like NIFTY. For example, if stock 'ABC' is at INR 100 and you expect it to rise to INR 120, you buy a call at INR 100 and sell one at INR 120 with the same expiration. Profits are made if the price rises as predicted, but losses occur if it doesn't or drops.

Bull put spread

You sell a put option (expecting the price not to drop) at a higher strike price and buy another put option at a lower strike price on the same index or share, like SENSEX. You earn when the price stays above the higher strike price. For a stock at INR 100, expecting no drop below INR 80, sell a put option at INR 90 and buy one at INR 80. Profit if above INR 90. If below INR 80, face losses, softened by the sold option's premium.

Bear put spread

In this strategy, you buy a put option (expecting the price to drop) at a higher strike price and sell another put option at a lower strike price on a stock, index or commodity. You’ll profit when the price drops but not drastically. Let’s say, you expect 'ABC' stock, currently priced at INR 100, to drop, but not below INR 80. So, you buy a put option at INR 100 and sell another put option at INR 80. If the stock falls between these prices, you'll make a profit. On the flip side, if the stock price rises above INR 100, you'll lose the premium paid for the put option you bought. However, the premium from the sold put option will provide some cushion.

Bear call spread

Here, you sell a call option at a lower strike price and buy another call option at a higher strike price on the same share. It's profitable when the price falls or rises slightly. For instance, if you predict the stock ‘ABC’ won't rise above INR 110, then in this strategy you’ll sell a call option at INR 100 and buy another at INR 110. If the stock stays below INR 110, you keep the premium from the sold option. If the stock price happens to rise above INR 110, you might face losses. However, the premium from the call option you sold will help cover some of that loss.

The long straddle

This option strategy involves buying both a call and a put option at the same strike price and expiration date on an index like NIFTY. This is done when you expect big price fluctuations but are uncertain about the direction. In this case, you’ll buy both a call and a put option of stock ‘ABC’ at INR 100. If the stock price shoots up or falls, one of your options will turn profitable. However, if the stock price stays close to INR 100 without much change, you'll lose the money you spent on the premiums for both options.

The short straddle

You sell both a call and a put option at the same strike price and expiration date on a share. It's profitable when the price remains stable with little fluctuation. Suppose you expect little movement in the stock 'ABC'. You decide to sell both a call and a put option at INR 100. If the stock remains close to INR 100, you can keep the premiums from both sold options. However, if the stock price moves significantly in either direction away from INR 100, you could face losses, especially if the movement exceeds the premiums you received from the sold options.

Iron condor

You create a bull put spread and a bear call spread on the same asset. It's used when you expect the price to move within a specific range without any drastic jumps or drops. You would use this strategy when you believe that the stock 'ABC' will stay between INR 90 and INR 110. You set up a bull put spread at INR 90 and INR 80 and a bear call spread at INR 110 and INR 120. If the stock price remains within this range, you'll profit from the premiums. However, if the stock price moves outside the INR 80 to INR 120 range, you could face potential losses. The premiums from the options would provide some buffer against those losses.

Wrapping up: Point to remember 

• It's wise to diversify your investments with different strategies. That way, you're not taking on too much risk in one go.
• Stay calm during market fluctuations. Emotional decisions can lead to hasty actions that might not align with your initial strategy. Stick to your plan and adjust only after careful consideration.