Navigating Option Trading Strategies

Call Buying

Involves purchasing a call option.

When to consider:

• When you are bullish.
• To take advantage of diversification (with index options).
• For leverage and limited dollar risk. Many feel it is easier to predict general market direction than individual stocks, making index options attractive.
• For shorter-term strategies, options with a higher delta should be used.
• For very long-term strategies, consider slightly out-of-the-money or long-term at-the-money options, or LEAPS.
• For aggressive purchases, consider short-term out-of-the-money calls.
• For conservative purchases, consider longer-term in-the-money calls.
• Consider buying calls when options are cheap and the market is expected to be volatile (as part of straddle/strangle buys).
• You should not write against an underlying stock if you are bearish on it.

Follow-up actions after an unrealized profit on a long call:

• "Do nothing" (continue holding).
• "Liquidate" (sell the call).
• "Roll up" (sell the call, pocket initial investment, buy more out-of-the-money calls).
• "Spread" (create a bull spread by selling an out-of-the-money call against the profitable call, preferably taking in at least the original cost). While each tactic can be best in certain scenarios, the spread tactic is never the worst one.

Put Buying

Involves purchasing a put option.

When to consider:

• When you are bearish. It represents a more attractive way to take advantage of a bearish attitude with options.
• Buying a put is equivalent in profit potential to a "protected short sale" (shorting stock and buying a call).
• Consider buying puts when options are cheap and the market is expected to be volatile (as part of straddle/strangle buys).

Follow-up actions after an unrealized gain on a long put: (Very similar to call buying tactics)

• "Liquidate" (sell the put).
• "Do nothing" (continue holding).
• "Roll down" (sell the put, pocket initial investment, buy out-of-the-money puts at a lower strike).
• "Spread" (create a spread by selling an out-of-the-money put against the held put).
• "Combine" (buy a call at a lower strike while holding the put). Each tactic can be best under different circumstances, but the spread tactic is never the worst.

Covered Call Writing

Involves selling a call option against shares of the underlying stock that you own.

When to consider:

• It is one of the most widely used option strategies by the investing public.
• Suitable for those willing to accept little or no risk other than that of owning stock.
• It is generally a relatively conservative position.
• The writer should be slightly bullish, or at least neutral, on the underlying stock.
• One goal is to look for minimum returns (e.g., 1% per month if unchanged) with sufficient downside protection (e.g., at least 10%).
• You can choose to write in-the-money calls for more downside cushion or out-of-the-money calls for higher returns if exercised. A combination can balance return and protection.
• Candidates can be ranked by annualized return (with minimum downside protection) or percentage downside protection (with minimum acceptable return).
• The mathematical expectation of covered call writing ranks behind ratio strategies and limited risk/large profit strategies.
• A strategist using the incremental return concept with a higher target price for selling stock may find LEAPS call writing attractive for larger premiums.
• Covered write products are also a type of listed structured product.

Collar

Involves the purchase of a put and simultaneous sale of a call against an underlying instrument (implicitly, stock owned).

When to consider:

• It is a strategy that receives expanded treatment. (The source mentions it but does not explicitly state specific conditions for its use beyond its structure).

Ratio Writing (against stock)

Involves selling options (typically calls) in a ratio against owned stock, often selling more calls than stock shares or in a higher ratio against the shares.

When to consider:

• It is a more sophisticated call strategy.
• It involves selling naked options, meaning there is potentially large risk.
• Ratio writing has high mathematical expectations due to taking in large time value premium.
• To be mathematically optimum, it should be operated according to a delta-neutral ratio.
• However, it is not for everyone and requires a substantial amount of money (or collateral).
• It is a neutral strategy that should perform well if the market net change is small.

Naked Option Writing

Involves selling options without owning the underlying security or having a hedging position.

When to consider:

• This strategy involves potentially large risk, either upside, downside, or both.
• It is generally not recommended because options are wrong (skewed) when there is skewing at all strikes, and there is a greater than normal chance of a large move by the underlying, especially stock.
• It requires expertise and a substantial amount of money (or collateral).
• Generally, high-risk naked option writing (selling for fractional prices) is to be avoided by most investors.
• Naked Call Writing (when rolling for credits follow-up is used) has high mathematical expectation.
• The premium dollars from selling uncovered options can be used to buy fixed-income securities.

Covered or Ratio Put Writing

Involves writing put options against owned stock (Covered Put Writing, implicitly) or in a ratio (Ratio Put Writing, implicitly).

When to consider:

• These strategies are generally to be avoided by most investors.

General Spread Concepts

• Spreads involve buying and selling options simultaneously.
• They can be structured as credit spreads (cash inflow) or debit spreads (cash outflow).
• Placing an order as a spread order can facilitate better price execution.
• They can combine basic types like bull, bear, and calendar spreads.
• Put spread strategies employ similar tactics to call spread strategies, although there are technical differences.

Bull Spreads

Involves buying a call at one strike and selling a call at a higher strike, or buying a put at a lower strike and selling a put at a higher strike.

When to consider:

• When you are bullish.
• They are one of the simpler types of spreads.
• They have limited downside risk and limited upside profit potential.
• A bull spread can sometimes be constructed to have little or no risk by selling a call against a currently profitable long call.
• The profit graph has the same shape as a covered write protected by a put purchase, making them equivalent in profit and loss potential.
• Bull spreads can be considered a "substitute" for covered writing by investing a small portion in the spread and the rest in fixed-income.
• They can be ranked by reward/risk ratio or return if unchanged.
• Ranking should not solely rely on maximum potential profits at expiration, especially for deeply out-of-the-money spreads.
• For a conservative purchase, consider in-the-money (large debit) bull spreads.
• A call bull spread can be used to benefit from a forward (positive) volatility skew.

Bear Spreads

Involves selling a call at one strike and buying a call at a higher strike (implicitly, bear call spread), or selling a put at one strike and buying a put at a lower strike (implicitly, bear put spread).

When to consider:

• When you are bearish.
• They are one of the simpler types of spreads.
• For a conservative purchase, consider in-the-money (large debit) bear spreads.
• A bear put spread can be used for a market with a reverse (negative) volatility skew (OEX example).

Calendar Spreads

Typically involves selling a near-term option and buying a longer-term option with the same striking price.

When to consider:

• They are one of the simpler types of spreads.
• A neutral calendar spread is established when the stock is relatively close to the striking price.
• The object is to capture the time decay differential between the two options.
• They are normally closed when the near-term option expires.
• Pricing models can aid in determining the profit potential and break-even points.
• Spreads can be ranked by their return if unchanged.
• Calendar spreads with futures options are less popular and more complicated than stock or index counterparts but may offer pricing inefficiencies.
• They are a neutral strategy that should perform well if the market net change is small.
• A bullish or bearish calendar spread only assumes its directional bias after the near-term option expires.
• Mathematically, they rank behind ratio strategies and limited risk/large profit strategies.

Ratio Spreads (Call or Put)

Involves buying and selling options on the same underlying, typically with the same expiration or different expirations, but in a ratio other than 1:1.

When to consider:

• They are more sophisticated option strategies.
• They often involve selling naked options, presenting potentially large risk.
• Differing philosophies: one simulates ratio writing by buying an in-the-money call (potentially large debit), another focuses on establishing the spread for a credit (no downside loss), and the "Delta Spread" aims for initial neutrality using option deltas.
• They have high mathematical expectations, particularly when operated as a delta-neutral ratio spread.
• They require substantial capital/collateral and are not for everyone due to the naked option component.
• They are a neutral strategy that should perform well if the market net change is small.
• They can be used when identifying situations with discrepancies in implied volatilities.
• For a market with a reverse (negative) volatility skew, strategies include ratio write of puts (buy puts/sell more OTM puts) or backspread of calls (sell calls/buy more OTM calls).
• For a market with a forward (positive) volatility skew, a call ratio spread can be used.
• A ratio spread strategy is generally used if the current level of implied volatility is in a high percentile.

Butterfly Spread

A neutral position involving three striking prices, utilizing a bull spread between the lower two strikes and a bear spread between the higher two strikes.

When to consider:

• It is a neutral position.
• It has limited risk as well as limited profits.
• Maximum profit is realized at the middle strike at expiration.
• It is a neutral strategy that should perform well if the market net change is small.
• Mathematically, it ranks behind ratio strategies and limited risk/large profit strategies.

Diagonal Spreads

Combine options with different striking prices and different expiration dates.

When to consider:

• They are more advanced strategies.
• Diagonalizing a spread can often be very attractive.
• Similar to calendar strategies, their aim is to generate profits on the sale of shorter-term options to offset the cost of longer-term options.
• A diagonal credit spread can sometimes allow the strategist to own a call free.
• They rank high on an expected profit basis.

Spreads Combining Puts and Calls

When to consider:

• These can offer potentially large profits.
• Three specific complex strategies are designed to limit risk while allowing for large potential profits if correct market conditions develop.
• They are combinations of calendar spreads and/or straddles involving varying expiration dates.
• Although complex, they can provide attractive risk/reward opportunities and are not strictly for professionals.

Calendar Combination

One of three complex strategies combining calendar spreads on puts and calls. Involves selling a near-term combination (put and call) and simultaneously buying a longer-term combination (implicitly, with the same strikes).

When to consider:

• It is a reasonable strategy if operated over a period encompassing several market cycles.
• Selection criteria include: stock nearly halfway between two striking prices (at least 10 points apart), relatively volatile underlying, optimum time 2-3 months before near-term expiry, and sum of near-term prices at least one-half the cost of longer-term.
• It offers the largest probability of capturing the entire near-term premium because both near-term options are initially out-of-the-money.
• It has limited risk and large potential profits.
• It is not to be attempted by a novice investor.

Calendar Straddle

Another strategy combining calendar spreads on both puts and call options by selling a near-term straddle and simultaneously purchasing a longer-term straddle.

When to consider:

• Profits are sought from the fact that the time value premium of the near-term straddle decreases more rapidly than the longer-term one.
• It is a neutral strategy, established with the stock near the striking price.
• It is generally best to close it out at near-term expiration if the stock is near the striking price, as a profit will generally result.
• It offers the largest potential profits at near-term expiration if the stock is relatively unchanged.
• It has limited risk and large potential profits.
• It is not to be attempted by a novice investor.

Diagonal Butterfly Spread

A strategy involving both put and call options that uses differing expiration dates and strikes, which can give the opportunity to own a "free" combination. It is a combination of a diagonal bearish call spread and a diagonal bullish put spread.

When to consider:

• It is designed to limit risk while allowing for large potential profits.
• It offers the possibility of owning free options (if near-term profits equal or exceed the cost of long-term options).
• The risk is limited and occurs prior to the expiration of the near-term options.
• It is an attractive strategy that should produce large profits over a period of market cycles.
• It is not to be attempted by a novice investor.

Straddles and Combinations (General)

Strategies that involve the use of both puts and calls together.

When to consider:

• They can present reasonably high levels of profit potential.
• They allow attractive positions established with either puts or calls to be combined into one.

Straddle Writing

Involves selling both a put and a call with the same striking price and expiration date.

When to consider:

• It is a neutral strategy.
• It involves selling naked options, which means potentially large risk.
• Straddle writing has high mathematical expectations due to taking in large time value premium.
• It requires a substantial amount of money (or collateral) and is not for everyone due to the naked option component.
• Premium dollars received can be used to buy fixed-income securities.
• Technical analysis can help, ideally seeking support at or above the lower break-even and resistance at or below the upper break-even.
• It is a neutral strategy that should perform well if the market net change is small.

Strangle Writing

Involves selling both a put and a call with the same expiration date but different striking prices (typically out-of-the-money).

When to consider:

• It is a neutral strategy.
• It involves selling naked options and thus potentially large risk.
• It has high mathematical expectations due to taking in large time value premium.
• It requires a substantial amount of money (or collateral) and is not for everyone due to the naked option component.
• Premium dollars received can be used to buy fixed-income securities.
• It is a neutral strategy that should perform well if the market net change is small.

Treasury Bill/Option Strategy

Involves putting a large portion of money (e.g., 90%) in risk-free investments like short-term Treasury bills and buying options with the remaining portion (e.g., 10%).

When to consider:

• This strategy consists of small levels of risk with the potential for large profits.
• It typically has a high frequency of small losses but a small probability of large gains, where a few large profits can outweigh the small losses.
• It is considered superior to convertible bonds or synthetic convertible bonds as the largest portion of investment has no price fluctuation risk.
• It is fairly easy to operate, though it requires work when buying new options and periodic adjustments to manage risk levels.
• It ranks high on an expected profit basis.

Backspreads

Generally involve selling fewer options than are bought, potentially structured as buying out-of-the-money puts and selling at-the-money puts, or buying at-the-money calls and selling out-of-the-money calls, usually with a ratio.

When to consider:

• They offer the opportunity to benefit from spreading mispriced options.
• Choosing between a put backspread and a call ratio spread (both involving mispriced futures options) may be helped by examining the technical picture of the futures contract.
• A backspread strategy is generally used if implied volatility is currently in a low percentile.
• A put backspread can be used to benefit from a forward (positive) volatility skew.
• They rank high on an expected profit basis.
• Considered if options are cheap and the market is expected to be volatile.

Reverse Hedges and Spreads

When to consider:

• Considered if options are cheap and the market is expected to be volatile. (The sources describe the structure and potential outcomes but do not provide specific conditions for when to initiate these strategies beyond this general category).

Volatility Trading (General)

An approach based on the value of the option itself, distinct from picking market direction.

When to consider:

• When implied volatility is perceived as being "out of line".
• Strategies used when the market net change is small over time include ratio writing/spreading, straddle/strangle writing, neutral calendar spreading, and butterfly spreads.
• Strategies used when options are cheap and the market is expected to be volatile include straddle/strangle buys, backspreads, and reverse hedges/spreads.
• Determining when volatility is out of line can involve comparing implied volatility to its past levels (percentile), historical volatility, or interpreting volatility charts.
• Using a probability calculator to assess success chances is also necessary.

Strategies for Trading Volatility Prediction

Involves trading based on the absolute level of implied volatility being perceived as "wrong".

When to consider:

• When implied volatility is sufficiently out of line that it warrants a trade.
• A simple approach is often best, especially when buying volatility.
• Use a selection criterion (e.g., extreme implied volatility percentile, large discrepancy between implied and historical volatility, chart interpretation showing trend reversal).
• Then, use a probability calculator to estimate expected success. You can also consider past price histories.

Strategies for Trading Volatility Skew

Involves trading based on the fact that implied volatilities for different options on the same underlying have substantially different values.

When to consider:

• Opportunities arise for the neutral strategist whenever volatility skewing exists.
• Establish a neutral spread by buying options with lower implied volatilities and simultaneously selling ones with higher implied volatilities.
• The difference in implied volatilities should be significantly large.
• For a market with a reverse (negative) volatility skew (like the OEX), strategies include buying a bear put spread, using a ratio write of put options (buy puts/sell more OTM puts), or using a backspread of call options (sell calls/buy more OTM calls).
• For a market with a forward (positive) volatility skew, strategies include a call bull spread, a put backspread, and a call ratio spread.

Stock Index Hedging Strategies

Involves using futures or options to hedge the risk of an equity portfolio.

When to consider:

• These strategies are often preferable to merely buying or selling stock.
• They are used by owners of stock portfolios (individuals or institutions).
• Techniques include hedging an actual or simulated index, trading the tracking error, selling the futures instead of the entire portfolio when one turns bearish, or buying the futures when they are cheap instead of buying stocks.
• These hedges require monitoring and potential adjustments.

Index Spreads

Involves trading the price relationship between two different indices, such as inter-index or intra-index spreads.

When to consider:

• When you observe the relationship between two popular indices changing.
• Options can be used to advantage, such as using synthetic options, in-the-money options, or leveraging with delta.
• This area offers profit opportunities recognized by fewer people.

Futures Option Trading Strategies

Strategies involving options on futures contracts.

When to consider:

• Many strategies are not significantly different from stock or index option strategies. However, unique strategies exist.
• Calendar spreading with futures options is less popular than with stock options but may offer pricing inefficiencies.
• Intermarket spreads are a type of futures option strategy.
• SPAN margin is beneficial for reduced requirements.
• One can monitor exposure using deltas and adjust the position.
• Backspreads and ratio spreads can be used with futures options.

Protected Stock or Index Products

Listed structured products designed to provide upside market potential while limiting downside risk. Similar to a synthetic long call.

When to consider:

• They can be useful longer-term investments, provided the underwriter's creditworthiness is good.
• Listed options can be used with these products for adjustment strategies.

Covered Write Products

Listed structured products mentioned as a type. (The sources list them but do not provide specific details on their use cases).

Various Arbitrage Techniques

Includes Basic Put and Call Arbitrage ("Discounting"), Dividend Arbitrage, Conversions and Reversals, and More on Carrying Costs. Index Arbitrage and Riskless Arbitrage are also discussed.

When to consider:

• These involve capitalizing on mispricing.
• Index arbitrage can be used when futures on an index are mispriced relative to their fair value.
• Discounting with cash-based options is often done near the close of the day to reduce underlying index price risk.
• These techniques are generally primarily member firm, not public customer, strategies.
• Facilitation (Institutional Block Positioning) is also primarily for member firms.