Option Strategies
Introduction to Directional and Non-Directional Strategies
Introduction
There two types of options – calls and puts. With calls and puts, you can either enter into the position as a long (buy) or short (sell). So, you can buy calls, sell calls, buy puts, and sell puts. When you buy options, it will cost you a premium to enter into the trade and when you sell options, you will receive a premium up front. Options have incredible flexibility and by combining these four types of options – long call, long put, short call, short put – in various ways, you can potentially profit not just if the underlying stock or index goes up or down but if it goes sideways or becomes more volatile. In addition, you can combine options to adjust your risk / reward ratios by capping losses or reducing the cost to enter a trade through hedges.
What are directional option strategies?
Option strategies that require the underlying to either move up or down in order to be profitable are directional option strategies. The most basic directional option strategies are long call and long put. When you buy or go long a call option, the favorable direction is for the stock or index to go up in price. If the underlying stock or index rises enough to cover the cost to purchase the call options, then you will be profitable. Likewise, the favorable direction for a long put is for the stock or index to go down in price. These are the directional option strategies that you are most likely familiar with as you start this course.
Illustration 1
| Strategy | Construction | Intent | Type |
|---|---|---|---|
| Long Call | Buy Call | Bullish | Debit |
| Long Put | Buy Put | Bearish | Debit |
| Short Call | Sell Call | Slightly Bearish | Credit |
| Short Put | Sell Put | Slightly Bullish | Credit |
This course will also introduce you to several more directional option strategies. These option strategies are “multi-legged” strategies or ones that involve the purchase or selling of more than one type of option. For example, a bull call spread is the simultaneous purchase of a call option and selling of a corresponding call option at a higher strike price. This is the list of directional strategies that we will cover in-depth in this course. There are many others, but those strategies are more advanced to manage as they could require various ratios of contracts or using different expiration dates.
Illustration 2
| Strategy | Construction | Intent | Type |
|---|---|---|---|
| Long Bull Call Spread | Buy Call, Sell Call at Higher Strike | Slightly Bullish | Debit |
| Long Bull Put Spread | Buy Put, Sell Put at Higher Strike | Slightly Bullish | Credit |
| Long Bear Put Spread | Buy Put, Sell Put at Lower Strike | Slightly Bearish | Debit |
| Long Bear Call Spread | Buy Call, Sell Call at Lower Strike | Slightly Bearish | Credit |
| Long Combo | Buy Call, Sell Put at Same or Lower Strike | Bullish | Debit or Credit |
| Short Combo | Buy Put, Sell Call at Same or Higher Strike | Bearish | Debit or Credit |
| Covered Call | Own Stock, Sell Call at ATM or OTM Strike | Slightly Bullish | Credit |
| Protective Put | Own Stock, Buy Put at ATM or OTM Strike | Slightly Bearish | Debit |
| Equity Collar | Own Stock, Sell Call, Buy Put | Slightly Bullish | Debit or Credit |
What are non-directional option strategies?
There are also option strategies that are known as “non-directional” strategies. These option strategies are used when you believe the underlying stock or index will move significantly or not move. This is different than having a trading hypothesis where you think the price of the underlying stock or index will rise or fall. For example, what if a stock has been hitting new highs day after day? After this run-up in price, you believe that there will be a few days of sideways price action. There isn’t a simple way to profit by trading stocks when stocks move sideways or have little price movement. However, by combining call and put options, you can do this. Alternatively, you can also take advantage of volatile markets – when prices rise or fall dramatically. What if you believe that a stock will move significantly in the near future but you aren’t certain about the direction? Again, you can turn to non-directional option strategies to help position you for an opportunity to profit. The table below is the list of non-directional option strategies that we will cover in this course.
Illustration 3
| Strategy | Construction | Intent | Type |
|---|---|---|---|
| Long Straddle | Buy Call ATM, Buy Put ATM | High Volatility | Debit |
| Long Strangle | Buy Call OTM, Buy Put OTM | High Volatility | Debit |
| Reverse Iron Butterfly | Long Straddle, Sell Put OTM, Sell Call OTM | High Volatility | Debit |
| Reverse Iron Condor | Long Strangle, Sell Put OTM, Sell Call OTM | High Volatility | Debit |
| Short Straddle | Sell Call ATM, Sell Put ATM | Low Volatility | Credit |
| Short Strangle | Sell Call OTM, Sell Put OTM | Low Volatility | Credit |
| Iron Butterfly | Short Straddle, Buy Put OTM, Buy Call OTM | Low Volatility | Credit |
| Iron Condor | Short Strangle, Buy Put OTM, Buy Call OTM | Low Volatility | Credit |
Summary
- Directional option strategies allow traders to potentially profit when the underlying’s price moves in a specific direction – either up or down – by expiration.
- Non-directional option strategies allow traders to potentially profit when the underlying’s price either moves significantly or stays in place.
- There are two types of directional strategies: bullish and bearish.
- There are two types of non-directional strategies: volatile (high movement) and neutral (low movement).
- Non-directional strategies require multiple types of options to be traded including combinations of long call, long put, short call, and short put.
- Directional strategies could be constructed using multiple option contracts but they don’t need to be. The most basic option strategies – long call, long put, short call, and short put – are inherently directional strategies.
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