Guide to Options Trading Part Three: Three Simple Strategies

In the previous article in the beginner's options trading series, we went over the purposes that options serve in financial markets, and the different ways we can construct positions that allow us to profit from diverse scenarios.

In this article, we’re going over three simple options trading strategies that every beginner should know: the vertical spread, covered call, and short strangle.

Vertical Spread

Covered Call

Short Strangle

What is a Covered Call?

Covered calls are the most long-term investors’ introduction to the options market. The strategy involves writing call options in a stock that you own. You’d write a call for every 100 shares you own. The primary objective of the covered call is to hedge against short-term price consolidation and to generate income through the premium collected for writing the option.

The covered call is a market-neutral strategy, meaning you don’t have a directional bias, and the risk and reward profile is defined. Our upside is limited because we’re shorting a call, usually above the current market price, and our downside is limited because our stock and call options are inversely related, so they’ll offset each other’s losses. If your stock goes to zero, your maximum loss is the value of your shares minus the premium you received on the covered call.

Example:

You own 100 shares of XYZ stock, which is currently trading at $50. You plan to hold the shares for the long-term but you don’t expect the price to appreciate in the short-term. This is a perfect opportunity to write a covered call.

You will write (sell) one call option for a strike price above the stock’s strike price, $55 for example. This will cap your upside (until the call’s expiration)  in the stock to $55 because the losses from your written call will offset the shares’ gains.

What is a Vertical Spread?

The vertical spread is a simple strategy for use when you have a directional bias in stock, but want to cap your downside a bit, as opposed to simply going long a put or call. This is a strategy with a defined risk and reward profile, meaning you’ll know your maximum gain and loss from the outset.

The strategy involves using two contracts in the same expiration date, but with different strike prices. There are several types of vertical spreads, some are only made of written options, others are only buying options. Here are the different types of vertical spreads you can construct:

Bull Put Spread: short and long put, with the short put being at the lower strike

Bull Call Spread: short and long call, with the long call being at the lower strike.

Bear Put Spread: short and long put, with the long put being at the lower strike

Bear Call Spread: short and long call, with the short call being at the lower strike.

In this example, we’re going to use a bull call spread. This requires both writing and buying a call option. Let’s assume we expect SPY to break out from its current trading range and steadily increase in price over the coming weeks.

Suppose we choose a spread that looks like the image below, buying a $300 call, and writing a $315 call.

Below is what the payoff of our trade looks like. As you can see, we are profiting so long as the price of SPY stays above $304.33

What is a Short Strangle?

The short strangle is market-neutral, so it’s to be used when you don’t expect the market to move that much. This isn’t a strategy you want to use in high-flying, volatile stocks, it’s best to be used in stocks that you expect to stay in a tight trading range for the duration of your trade. You can determine that through analysis of historical and implied volatility, and technical analysis.

This strategy is much riskier than the previous two strategies, being that its risk is undefined, but its reward is defined. It’s a relatively high probability strategy, but when short strangles go bad, they can go really bad if not managed quickly. Trade them with caution.

Remember, when writing naked options (writing options without buying options to cap the losses), the losses can be unlimited, much like short selling stock, except the leverage provided by options can magnify those unlimited losses.

You can construct a short strangle by writing an out of the money call and put in the same expiration.

Perhaps we expect SPY to stay within its recent trading range of between roughly $305 and $280 for the next few weeks.

We’ll pick an expiration, we’ll go for 35 days in this case, and short a $305 put and a $280 call.

Below is what the payoff of this trade looks like. You can see that when the price of SPY stays between $305 and $280, we are profiting at expiration. As price deviates from this range, our losses increase.

Final Thoughts

So we ran through three vital options strategies for beginners: the covered call, vertical spread, and short strangle, with each covering their own purpose. The covered call is a very conservative strategy that works great for those with a long-term portfolio. The vertical spread is a great alternative to buying a call or put outright, and the short strangle is a simple market-neutral strategy for those times when the market is just moving sideways.

Guide to Options Trading: Part One
Guide to Options Trading: Part Two