Option Strategies are an integral part of a trader’s routine. Learn about common option strategies utilized by traders that express their view of market direction and expected volatility. Some option strategies are designed to mitigate risk while others are designed to profit by accepting risk. Whether you are hedging a position or speculating on market outcomes, these common option strategies should be understood.

Straddle
Have you ever heard the saying “straddle the fence?” It means that you support both sides of an issue. Similarly, a common options strategy is referred to as a straddle because a straddle is used when you think the underlying futures market is going to make a move, but you are not sure which way.

Buying a Straddle
If you are buying a straddle, it is referred to as being long the straddle. A trader buys the call and the put of the same strike, same expiration and same underlying product.

For example, if you want to straddle E-mini Sep 2425, you would buy the E-mini 2425 Sep call and buy the 2425 Sep put. The cost of the straddle in this example would be 103.75.


Traders will buy the straddle if they expect the market to start moving but are not sure which way. In our example, the E-mini futures contract would be at 2420 and we expect the future to move up or down but we are not quite sure which way.

The profit potential is much larger than the cost of the straddle in either direction. At expiration, the break-even points are 2525 and 2315. These are the strike plus the straddle cost and the strike minus the straddle cost.


Loss is limited to the cost of spread. Maximum loss occurs if the market is at the strike at expiration. Because the straddle is composed of only long options, it loses option premium due to time decay. Time decay is most costly if the market is near the strike.

Selling a Straddle
Traders will sell a straddle, or short the straddle, when they expect the market is going to stagnate. Because the traders are short the straddle, they profit as the options decay, provided the market does not move far from the strike.

Like the long straddle the straddle’s break-even points are at the strike plus the cost of straddle on the call side and the strike minus the cost of the straddle on the put side at expiration. These break-even points are the same regardless if you are long or short the straddle.

For a short straddle, profit is maximized if the market is at the strike price at expiration.

Loss potential is open-ended in either direction. Dramatic movements above the strike will make the call much more valuable. Conversely, movements below the strike will make the put more valuable. Because you are short both the call and the put, either case is potentially costly.

Because being short the straddle is essentially short options, you pick up time-value decay at an increasing rate as expiration approaches. You profit from the time decay that the long straddle holder loses. Again, time decay is most profitable if the market is near the strike.

Strangles
Long Strangle
In a long strangle, the trader buys a call and put of different strikes, the same expiration and the same underlying product. You may note the similarity to a straddle, but the difference is that with a strangle, the call and the put are different strikes versus the same strike used in a straddle.

For example, if we bought a 2395 put and a 2445 call, this would be referred to as the 95-45 strangle. The cost of the strangle in this example would be 82.00. Traders will buy the strangle if they expect the market to start moving but are not sure which way.

In our example, the E-mini futures contract would be around 2420, we expect the future to move up or down but we are not sure which way. This is almost like a straddle, but the market must move further in either direction for the options to finish in the money. The profit potential is much larger than the cost of the strangle in either direction. But since the overall potential profit is still lower than a straddle, strangles will cost less than straddles.

For our example, at expiration, the break-even points are 2313 and 2527. These are the call strike plus the strangle cost and the put strike minus the strangle cost. Loss is limited to the cost of spread. Maximum loss occurs if the market is anywhere between the two strikes at expiration. Because the strangle is composed of only long options, it loses option premium due to time decay. Time decay is most costly if the market is between the two strikes.

Short Strangle
Traders will sell a strangle when they expect the market is going to stagnate. Because the traders are short the strangle, they profit as the options decay, provided the market does not move too far beyond either strike. As previously discussed, the break-even points are 2313 and 2527. The break-even points are the same regardless if you are long or short the strangle. For a short strangle, profit is maximized if the market is between the two strikes at expiration.

Loss potential is open-ended in either direction. Dramatic movements above the strike will make the call much more valuable. Conversely, movements below the strike will make the put more valuable. Because you are short both the call and the put, either case is applicable. Because being short the strangle is essentially short options, you pick up time-value decay at an increasing rate as expiration approaches. You profit from the time decay that the long strangle holder loses. Again, time decay is most profitable if the market is between the strikes.

When it comes to options strategies, strangles are a potential tool for managing your position.

Option Butterfly
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We have learned about both the similarities and differences between a straddle and strangle. Now we will look at a commonly traded strategy, referred to as a butterfly. Going long a butterfly, the trader buys a call of a low strike, sells two calls of a middle strike, and buys a call of a high strike. The three strikes are equidistant. The options have the same expiration and the same underlying product.

For example, if we bought a 2395 call, sold two of the 2420 calls and bought a 2445 call, this would be referred to as the 95, 20, 45 fly. The cost of the butterfly in this example would be 1.75. The 2395 and 2445 strikes are referred to as the wings, while the 2420 is known as the body of the butterfly.

Trading a Butterfly
Traders will buy the butterfly if they expect the market to stagnate. In our example, we are expecting the market to be around 2420.

You might be asking, if I expect the market to stagnate - why wouldn’t I just sell the 2420 straddle? As we learned, selling the straddle is a possible way to profit from a stagnating market, but the straddle’s loss potential is unlimited. That could be very costly for a trader.

The wings of the butterfly protect the trader from the unlimited risk of the straddle. Buying a butterfly limits the risk of being wrong to the cost of the butterfly.

If we sold the straddle by selling the 2420 call and put, we receive 105 from the buyer. Therefore, the maximum profit is 105 if the market is at 2420 at expiration.

The cost breakdown of the butterfly is:

Buy 2395 call at 69.75
Sell 2420 call twice for 53.25 each
Buy 2445 call at 38.50
For a cost of 1.75
In that same scenario, we can calculate the maximum profit from our butterfly.

The 2395 expires 25 points in-the-money. The short 2420 calls expire worthless. The long 2445 call also expires worthless. Less our initial cost of 1.75, we will make a profit of 23.25.

Butterfly versus Straddle
Compare the breakeven points between a straddle and a butterfly. The breakeven points are where the payoff equals the original premium for each strategy. For the straddle, they are the strike plus or minus the premium received. For the butterfly, the breakeven points are the lower strike plus the premium paid and the upper strike minus the premium paid.

In our example, we bought the butterfly for 1.75. The low strike of the fly is 2395. Adding 1.75 to that strike gives us our first breakeven point of 2396.75. Our high strike of the fly is 2445. If we subtract the butterfly’s premium of 1.75 from that our high breakeven point is 2443.25. Recall that the maximum profit for the butterfly is 23.25 and the maximum profit for the straddle is 105.

Time Decay
The time decay of a butterfly is greatly dependent upon the current level of the market. Near the short strikes, time decay is in your favor. Near the wings, time decay works against you.

Utilizing the butterfly allows traders to profit on their view that the market will be at a certain point at expiration; and the wings limit the loss if they are incorrect.

Bull Spread
A bull spread consists of a buy leg and a sell leg of different strikes for the same expiration and same underlying contract.

This strategy will pay off in a rising market, also known as a bull market, that is why it is referred to as a bull spread.

Bull spreads can be constructed from either going long a call spread or going short a put spread.

Call Bull Spreads
A trader believes that the market will have a moderate rise before the options expire.

If the underlying market was trading at 100, he would buy a 105 call for $3 and sell the 110 call for $2. By selling the 110 call, he receives a premium, which offsets the cost of the 105 leg. The total cost of the spread is $1. The breakeven point for the spread is 106. This is the cost of the spread plus the 105 strike.


The best-case scenario is if the market finishes at or above 110 because the 105-110 call spread will pay off $5. This is the maximum payoff for the spread, regardless of where the underlying finishes. If we subtract the $1 cost of the spread, the total profit for the trade will be $4.

Assume the underlying finished at 113. The 105 call will pay the trader $8, but he will need to payout $3 on the 110 call. Another example, if the market finishes at 130, the 105 call will pay the trader $25, but he will need to payout $20 on the 110 call.

The worst-case scenario is if the market finishes at or below 105. Because both the 105 and 110 call expire out-of-the-money and are therefore worthless. The trader loses the full cost of the spread, $1.

If the trader had purchased only the 105 call at $3, his loss would be $3 versus $1.

If the underlying finishes at 107.5, the long 105 call will be worth $2.50 and the short 110 call expires worthless. The trader’s payout of $2.50 minus the $1 cost of the spread gives him $1.50 profit.

If the trader had bought only the 105 call, his payout would still be $2.50, but that is less than the $3 he would have paid for the 105 call alone.

Put Bull Spreads
Bull spreads can also be constructed from selling a put spread.

Selling a put allows you to collect a premium that you can keep if the underlying futures contract finishes at or above the strike price.

Instead of buying the 105-110 call spread, we can sell the 110-105 put spread. This would entail selling the 110 puts and buying the 105 puts which would result in a $4 credit with the underlying future trading at 100

The breakeven point for the spread is 106, the 110 strike minus the spread credit of $4. This is the same breakeven point as the call bull spread.

If the market finishes above 110, the puts expire worthless. Therefore, the trader keeps the $4 he received by selling the put.

If the market finishes at 103, the 110 put is worth $7 and the 105 put is worth $2. Therefore, the put spread is worth $5 dollars. The trader received $4, and must now payout $5, resulting in a $1 loss.

If the market finishes at 107.5, the 110 put is worth $2.50 and the 105 put expires worthless. The trader must pay out $2.50 from his $4 credit. Resulting in a $1.50 profit.

We can see in this chart, that these three scenarios have the same outcome whether we buy a call spread or sell a put spread to create a bullish position. Traders still want the market to finish above the high strike of the spread.

Bull spreads are a commonly used and valuable options strategy.

Bear Spread
A bear spread consists of a buy leg and a sell leg of different strikes for the same expiration and same underlying contract. This strategy will pay off in a falling market, also known as a bear market, that is why it is referred to as a bear spread.

Bear spreads can be constructed from either going long a put spread or short a call spread.

Put Bear Spreads
A trader believes that the market will have a moderate drop before the options expire. If the underlying market was trading at 100, he would buy a 95 put for $3 and sell the 90 put for $2.

By selling the 90 put, he receives a premium which offsets the cost of the 95 leg. The total cost of the spread is $1. The breakeven point for the spread is 94: the 95 strike minus the cost of the spread.

The best-case scenario is if the market finishes at or below 90. Because the 95-90 put spread will pay off $5. This is the maximum payoff for the spread, regardless where the underlying finishes. If we subtract the $1 cost of the spread, the total profit for the trade will be $4


Assume the underlying finished at 87. The 95 put will pay the trader $8, but he will need to payout $3 on the 90 put. If the market finishes at 70, the 95 put will pay the trader $25, but he will need to payout $20 on the 90 put.

The worst-case scenario is if the market finishes at or above 95. Because both the 95 and 90 put expire out-of-the-money and are therefore worthless. So, the trader loses the full cost of the spread, $1. If the trader purchased only the 95 put at $3, his loss would be $3 versus $1.

If the underlying finishes at 92.5, the long 95 put will be worth $2.50 and the short 90 put expires worthless. The trader’s payout of $2.50 minus the $1 cost of the spread gives him $1.50 profit.

If the trader bought only the 95 put, his payout would still be $2.50, but that is less than the $3 he would have paid for the 95 put alone.

Call Bear Spreads
Selling a call is another way to be bearish on the market by allowing you to collect a premium that you keep if the underlying futures finish at or below the strike price.

Instead of buying the 95-90 put spread, we can sell the 90-95 call spread. This would entail selling the 90 call and buying the 95 call, which would result in a $4 credit with the underlying future trading at 100.

The breakeven point for this spread is 94: the 90 strike plus the spread credit of $4. This is the same breakeven point as the put bear spread.


If the market finishes below 90, the calls expire worthless. Therefore, the trader keeps the $4 he received by selling the call spread.

If the market finishes at 97, the 90 call is worth $7 and the 95 call is worth $2 . Therefore, the call spread is worth $5 dollars. The trader received $4 and must now payout $5, resulting in a $1 loss.

If the market finishes at 92.5, the 90 call is worth $2.50. The 95 call expires worthless. So, the trader must pay out $2.50 from his $4 credit. Resulting in a $1.50 profit.

These scenarios have the same outcome whether we sell a call spread or buy a put spread to create a bearish position. Traders still want the market to below the high strike of the spread.

Covered Calls
Understanding Covered Calls
Before we look at the covered call strategy, remember that the writer, or seller, of an option is obligated to deliver the underlying futures contract to the buyer of the option when it is exercised. To cover the risk of a short call position, at any time prior to the options expiration, a trader can buy a futures contract to deliver to the call owner if the short call is exercised.

Owning the futures contract to deliver into the call means that the assignment risk is covered; hence the phrase covered call.

Selling a naked call, which means selling the call without owning the underlying instrument, exposes the option writer to unlimited losses if the market moves up. The maximum profit potential is the premium received for the call.

For example, if a trader sold the 100 call for $5, the breakeven point for the call would be the strike plus the premium. In this case 105.

Between 105 (the breakeven point) and 100 (the strike), the profit increases from zero to $5. At or below 100, the profit is the full amount of the premium, namely $5.

Covered Call Strategy.
The covered call strategy consists of a long futures contract and a short call on that futures contract. The call can be in-, at- or out-of-the-money. Generally, traders choose a call that is at-the-money to maximize the premium that is received from the sale of the call.

Covered calls are executed as an income-generating strategy when the futures contract holder expects the market to remain stable.

The trader foregoes some of the up-side potential of the futures position in return for the premium received from the sale of the call.

Example
It is the end of June and our trader is long a September futures contract. He believes that the market will be quiet and stable through July, after which he believes that the market will rally tremendously.

He could hold his September futures position until expiration. But instead, he attempts to generate income by selling a call option that expires before August. He sells the July 100 call for $5.

Since he already owns the underlying futures contract, his positions will be aggregated. This is the payoff profile for the long September futures contract.

He received $5 from the sale of the 100 call. So, the futures contract breakeven point is lowered by $5 dollars, to 95.

But because he sold the call, his up-side potential is capped. He forgoes profit if the underlying market is above 105.

The long September futures contract and short July call combined have a payoff profile as shown. His profit is capped at $5, from the sale of the call, through July expiration. This is because he needs to deliver the futures contract into the short call.

Scenarios
At July option expiration, if the September futures contract is at 93, his loss on this strategy would be two. The $7 of futures contract loss was mitigated by the $5 of premium from the call.

At July option expiration, with the September futures at 100, his profit will be $5 due to the futures PNL being zero and the call expiring worthless. This allows him to keep the full $5 of premium.

If the September futures contract was at 103, his profit would again be $5, $3 from the futures contract gain and $2 from the 100 call.

If the market had a tremendous rally earlier than he had anticipated, and the September futures rose to 120, his profit will remain $5, $20 from the futures contract minus $15 from the short call.

Conclusion
Covered calls are a commonly used and valuable options strategy providing income while lessening the sting of a downward market movement.