The Top 10 Option Trading Strategies Every Trader Should Know

Option trading offers savvy investors an opportunity to hedge their portfolio risk and earn income on existing Stock positions. While options seem complex at first, most option trading dtrategies boil down to a combination of buying or selling calls and puts. Mastering a few basic strategies can help you profit in bull and bear markets alike. This comprehensive guide will overview the 10 most popular option trading strategies to boost your investing IQ.

What Are Options Trading Strategies and How Do They Work?

Before diving into strategies, let’s review the basics of what options are and how they work.

Options give you the right, but not the obligation, to buy or sell an underlying asset at a set “strike” price on or before the option expiration date. There are two main types:

• Calls – Give you the right to buy the underlying stock. Traders buy calls when bullish on a stock.
• Puts – Give you the right to sell the underlying stock. Traders buy puts when bearish on a stock.

The main parts of an option contract are:

• Underlying stock or ETF
• Strike price – Fixed price to buy or sell
• Expiration date
• Premium – Cost to purchase the option contract
• Contract size – Usually 100 shares per contract

Options have defined risk, meaning your maximum loss is limited to the premium paid. They also provide leveraged exposure to the underlying for a fraction of the stock’s price.

Now let’s explore 10 winning option trade setups.

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1. Covered Call

The covered call, also known as a “buy-write”, is one of the most popular income generating options strategies. It involves buying 100 shares of the underlying stock and selling 1 call option against it.

Here are the covered call details:

• You buy 100 shares of the underlying stock
• You sell 1 call option against your long stock position

This options strategy caps the upside on the stock position. However, you collect income from selling the call to offset a portion of the purchase cost.

You profit if the stock stays below the strike price. The call expires worthless allowing you to keep the entire premium. If the stock rallies above the strike at expiration, the shares are called away at the higher price.

Covered calls work best in sideways or downward drifting markets. They allow you to generate income from an idle long stock position.

2. Long Call

The long call strategy is a basic options trade to profit from bullish price action. It simply involves buying a call option on a stock you expect to increase in value.

Here are the long call details:

• You buy 1 call option
• You expect the stock to rise above the call strike price before expiration

The long call strategy offers unlimited profit potential with limited downside risk. The most you can lose is the initial premium paid for the call option.

You profit if the stock rises above the strike price by an amount greater than the premium paid. At expiration, if the stock is above the strike, you can exercise the call to acquire shares at the lower strike price.

Long calls benefit from high implied volatility and upward trending markets. They offer leveraged upside exposure with minimal capital outlay.

3. Long Put

The long put is a basic options strategy to profit from bearish price action. It involves buying one put option on a stock you expect to decrease in value.

Here are the details on long puts:

• You buy 1 put option
• You expect the stock to fall below the put strike price before expiration

Long puts have limited risk and unlimited profit potential. The most you can lose is the premium paid to purchase the put.

You profit if the stock falls below the strike price by an amount greater than the premium paid. At expiration, if the stock is below the strike, you can exercise the put to sell shares at the higher strike price.

Puts benefit from high implied volatility and downward trending markets. They provide leveraged downside exposure while limiting capital at risk.

4. Short Put

The short put, also known as a “naked put”, is a neutral to bullish option trading strategy often used to generate income. It involves selling cash secured put options against cash reserves.

Here are the short put details:

• You sell 1 put option
• You must set aside cash to potentially buy 100 shares per contract

If the stock stays above the short put strike at expiration, the option expires worthless allowing you to keep the premium. If the stock drops below the strike price, you may be assigned and obligated to buy shares at the higher strike price.

The short put strategy works best in neutral to bullish markets. The main objective is to collect income from option premium decay.

5. Call Spread

The call Spread is an options strategy constructed by buying and selling call options at different strike prices. It allows you to profit from a stock’s upside potential while reducing the upfront cost.

Here are the two main call spread variations:

Bull Call Spread

• Buy 1 lower strike call
• Sell 1 higher strike call
• Max profit is the spread between strikes minus net debit

Bear Call Spread

• Sell 1 lower strike call
• Buy 1 higher strike call
• Max profit is net credit received between strikes

Call spreads limit upside but have defined and limited risk. They benefit from time decay and modest upside moves in the stock.

6. Put Spread

Like call spreads, put spreads involve the purchase and sale of put options at different strikes. They allow you to profit from a stock’s downside move at reduced cost.

Here are the two main put spread variations:

Bull Put Spread

• Sell 1 higher strike put
• Buy 1 lower strike put
• Max profit is net credit between strike prices

Bear Put Spread

• Buy 1 higher strike put
• Sell 1 lower strike put
• Max profit is difference between strike prices minus debit

Put spreads limit downside risk but cap the profit potential. They benefit from time decay and modest downside moves in the underlying stock.

7. Iron Condor

The iron condor combines a bull put spread and a bear call spread. It provides a way to profit from sideways trading markets with minimal directional risk.

Here are the iron condor details:

• Sell 1 OTM put
• Buy 1 further OTM put
• Sell 1 OTM call
• Buy 1 further OTM call

The iron condor produces a net credit through option premiums received. The maximum gain is the initial credit. The maximum loss is the difference between strike prices minus the credit.

You profit if the stock price remains between the short strikes at expiration. If the price stays within the range defined by the long and short strikes, both spreads expire worthless allowing you to keep the full credit received.

Iron condors are ideal for range-bound stocks and low volatility environments. They benefit from time decay as long as the stock holds steady.

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8. Long Straddle

The long straddle involves buying both a call and put option on the same stock with the same strikes and expiration date. This strategy offers a way to profit from a large move in either direction.

Here are the details on long straddles:

• Buy 1 ATM call option
• Buy 1 ATM put option
• Expiration is the same for both options

The long straddle has unlimited profit potential but limited risk defined by the total premium paid. You profit if the stock makes a large move up or down past the break-even points.

Straddles are ideal around events like earnings when volatility expands. They benefit from an increase in implied volatility.

9. Long Strangle

The long strangle is similar to the straddle but uses OTM call and put options instead of ATM options. This further reduces cost but requires a larger stock move to profit.

Here are the key points on long strangles:

• Buy 1 OTM call option
• Buy 1 OTM put option
• Expiration is the same for both options

Like the straddle, the long strangle has unlimited profit potential but limited risk. The position benefits from a substantial move in either direction by the underlying stock.

Strangles are lower cost than straddles and ideal for stocks expected to make a larger directional move.

10. Ratio Spread

Ratio spreads involve buying and selling multiple options contracts with different strike prices or expirations. They allow advanced traders to profit from specialized outlooks on volatility and direction.

Some examples of ratio spread strategies are:

• Call ratio backspread
• Put ratio backspread
• Ratio call spread
• Ratio put spread

Ratio spreads have defined risk-reward profiles. They can be tailored to profit from specialized option pricing anomalies. These advanced strategies require experience to implement successfully.

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Frequently Asked Question

Q: What is a covered call?

A: A covered call is an option trading strategy where an investor sells a call option on an underlying asset that they already own.

Q: What is a long call?

A: A long call is an option trading strategy where an investor buys a call option, giving them the right to buy the underlying asset at a specified price before the expiration date.

Q: What is a long put?

A: A long put is an option trading strategy where an investor buys a put option, giving them the right to sell the underlying asset at a specified price before the expiration date.

Q: What is a short put?

A: A short put is an option trading strategy where an investor sells a put option, obligating them to buy the underlying asset at a specified price if the option is exercised.

Q: What is a call spread?

A: A call spread is an option trading strategy where an investor simultaneously buys a call option with a lower strike price and sells a call option with a higher strike price, limiting both the potential profit and loss.

Q: What is an iron condor?

A: An iron condor is an option trading strategy where an investor combines a call spread with a put spread, creating a range of profit between the two spread’s strike prices.

Q: What is a put spread?

A: A put spread is an option trading strategy where an investor simultaneously buys a put option with a higher strike price and sells a put option with a lower strike price, limiting both the potential profit and loss.

Q: What is a long straddle?

A: A long straddle is an option trading strategy where an investor simultaneously buys a call option and a put option with the same strike price and expiration date, speculating on a significant price movement in either direction.

Q: What is a long strangle?

A: A long strangle is an option trading strategy where an investor simultaneously buys a call option with a higher strike price and a put option with a lower strike price, speculating on a significant price movement in either direction.

Q: What is a bull call spread?

A: A bull call spread is an option trading strategy where an investor buys a call option with a lower strike price and sells a call option with a higher strike price, aiming to profit from a bullish market outlook.

In Summary

This overview covers 10 of the most widely used option trading strategies from basic to advanced. New traders should start with basic long calls and puts. As you gain experience, experiment with vertical spreads, neutral strategies like iron condors, and directional trades like straddles. Mastering even a few key option trading strategies can boost returns and hedge risk in your overall portfolio.

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