Option Trading Strategies

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Option trading strategies are trading methods to help an investor reach their investment goals for their portfolio. The best option trading strategy for one individual may not be the best for someone else. After making an educated decision about investment goals, the investor should focus their efforts on the best option trading strategies tailored to deliver those results.

A common goal for options trading is to make a profit. There are two basic ways investors profit from options trading. An investor can make money solely by trading options. Profit can also be made by exercising a stock option and buying or selling the stock.

For example, if someone buys call options and the price of the stock goes up, the investor can buy that stock at the strike price specified in the call option. That person can sell those stocks immediately to make a profit.

If someone has the option trading goal of owning a stock at a good price, that investor would use a different option trading strategy. An investor wanting to own stock may choose to sell a put option to give the buyer of the put the opportunity to sell the investor the stocks they want at the strike price.

Some stock investors use option strategies to protect their stock investments. A protective put is such a protective measure. The investor might buy a put to limit any loss in the value of the stock by giving the investor the right to sell the stock at the strike price. A protective put is also called a synthetic long call or put hedge.

Another protection strategy is an equity collar. The equity collar is used to protect stock the investor owns. An investor using an equity collar purchases one put option and sells or writes one call option per one hundred shares of the stock that the investor owns.

The state of the market can affect which option strategies are used. For example, if the stock is bullish meaning it is rising in value, the investor might want to use a option trading method called the bull call spread. A bull call spread is when the investor purchases an at-the-money call option and sells an out-of-the-money call with a higher strike price.

Similarly, a bear put spread is an options trading method that can be used if the investor expects the price of the stock to drop. To use the bear put spread strategy, the investor buys a put option on a stock and sells a put option for the same stock at a lower strike price.

Investors need to learn how to implement option strategies that will yield the results they want based on their investment goals. Details about various strategies for options trading can be researched online. The investor may want to consult an experienced investor.

What Strategy to Trade?

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Bull Call Spread
The primary reason for buying a bull call spread is an expected increase in share price. This is a directional trade and the aim should be a high percentage return. The reason for placing a bull call spread is that the calls are expensive so sell an out-of-the-money call will reduce the cost of the trade. This strategy is suited for break out trades and trading trends.

Bear Put Spread
The main reason for buying a bear put spread is an expected decrease in share price. The aim of the directional is to have a high risk vs. reward ratio. The bear put spread can be traded when buying puts is too expensive due to high volatility and selling an options against the bought puts reduces cost, breakeven, volatility effect and time decay effect. The trade is suited to a share price in a downtrend. This strategy is suited for break out trades and trading trends.

Bear Call Spread
A bear call is traded when you are expecting a sideways share price movement to a slight decrease in share price. The bear call spread is a credit spread and can be traded as a type for income. The risk vs. reward can be set up depending on the aim of the trader whether to have high probability small profits or low probability high returns. This trade is suitable when volatility is high and expected to decrease. The bear call spread is traded to take advantage of time decay.

Bull Put Spread
A bull put spread is best suited for a sideways to upward trending share price. The bull put spread is a credit spread and can be used as an income generating strategy. The bull put spread is best implemented when there is high volatility in the puts your outlook is volatility to decrease. This may be because the share price is just above a major level of support or at the bottom end of a trading range. The bull put strategy is traded to take advantage of time decay.


To receive ASX Option Recommendations or to learn more about Bull Call Spread, Bull Put Spread, Bear Call Spread, Bear Put Spread Strategies please request the Option Spreads eBook by contacting us on 1300 368 316 or info@totaloptions.com.au

Bull Put Spread vs. Sold Put

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A number of advantages are evident when trading bull put spreads compared to selling puts (naked puts). A bull put spread has considerable lower risk than just selling a put which has a much larger risk. The bull put spread has a much better risk vs. reward than selling naked puts. Selling puts can have benefits when combined with portfolios that can help produce income and purchase stock below market value. This strategy is detailed in the Income Strategy E-Book and will be available later in the course.


To receive ASX Option Recommendations or to learn more about Bull Call Spread, Bull Put Spread, Bear Call Spread, Bear Put Spread Strategies please request the Option Spreads eBook by contacting us on 1300 368 316 or info@totaloptions.com.au

Bull Put Spread: Trade Analysis – Risk vs. Reward

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Trade Analysis

Analysing your trade is essential before placing the trade. You need to make sure you have the necessary detail and go through the following checklist:

  1. Stock Selection: Double check your analysis on the stock and make sure your outlook on the share price reflects the bull put spread.
  2. Determine max loss and check that that is suits your risk profile and how much of your trading account you are risking.
  3. Determine premium received when entering trade, most important as it is also your maximum profit.
  4. Make sure you risk vs. reward suits the trading strategy.

Risk vs. Reward

The risk vs. reward will be different for every strategy. Credit spreads have a lower risk reward meaning the maximum profit (reward) is quite low relative to the maximum loss (risk). This trade can be positioned to risk $0.50 to make a $0.50 this is when the bull put spread is traded at-the-money. The trade can be more cautious by selling out-of the money options where you risk $0.80 to make $0.20. Both trades work well at the right time but the first example only requires a 50% success rate to break even while the second example requires an 80% success rate to break even.

Author: Matthew Gartrell

To receive ASX Option Recommendations or to learn more about Bull Call Spread, Bull Put Spread, Bear Call Spread, Bear Put Spread Strategies please request the Option Spreads eBook by contacting us on 1300 368 316 or info@totaloptions.com.au

Bull Put Spread: Technical and Fundamental Analysis

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Technical Analysis

Identifying bull put spread can be assisted through technical analysis. Technical analysis allows identification of expected price movement through indentifying trends through momentum indicators and trend lines. The types of chart patterns you are looking to identify a bull put trade are:

  • Strong support levels
  • Uptrend
  • Lower end of trading range
  • Oversold indicators – MACD and Stochastic.

Fundamental Analysis

Fundamental analysis can determine if the bull put outlook is aligned with the company news and research. There are a number of fundamental factors that influence the option prices of a stock. When identifying a bull put spread you have a bullish to neutral outlook on the share. Therefore you are looking for positive news in the company or sector. As this trade also makes money if the share price does not move, if there is no news coming out of the company for the next month this can also be a positive for this particular strategy.

To receive ASX Option Recommendations or to learn more about Bull Call Spread, Bull Put Spread, Bear Call Spread, Bear Put Spread Strategies please request the Option Spreads eBook by contacting us on 1300 368 316 or info@totaloptions.com.au

Bull Put Spread: Advantages and Disadvantages

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Advantages of Bear Put Spread

  • The loss is limited if the underlying share price falls instead of rises.
  • If the share price fails to stay above the strike price of the sold put option, the profit yield will be greater than just buying call options.
  • Able to profit even when the share price remains completely still.
  • Lower risk than simply writing naked put options as maximum downside is limited by bought put option.

Disadvantages of Bull Put Spread

  • There will be no more profits possible if the underlying asset rises beyond the strike price of the sold put option.
  • Because it is a credit spread, there is a margin requirement in order to place the trade.
  • As long as the sold put options remain in-the-money, there is a possibility of it being assigned. You may then have to purchase the underlying stock to meet the sold put obligation.


To receive ASX Option Recommendations or to learn more about Bull Call Spread, Bull Put Spread, Bear Call Spread, Bear Put Spread Strategies please request the Option Spreads eBook by contacting us on 1300 368 316 or info@totaloptions.com.au

Bull Put Spread: The Strategy

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A bull put spread is a moderately bullish option strategy that profits when the underlying share price stays still or increases. A bull put spread is similar to a bull call spread. The bull put spread involves simultaneously selling of a put option at a strike price while also buying the same number of put options of the same asset but at a lower strike. A bull put spread is also a technique to selling naked puts but buying lower puts to reduce the maximum loss. Because the bull put spread is a credit spread, you also make money if the underlying asset does not move through time decay. The bull call spread, on the other hand, would not be able to profit if the stock did not move upward beyond its breakeven point.

Maximum Profit

To achieve maximum profit the share price must be above the sold put strike price at expiry. The maximum profit for a bull put spread is the net credit received.

Maximum Loss

If the stock price decreases below the bought put at the expiration date, then the investor has a maximum loss. The maximum loss is the difference between the sold put and bought put strike price less the net credit received.

Break Even

The breakeven is higher than just selling a put; however the maximum loss is reduced significantly. The break even point is the strike price of the sold put minus the net credit received.


To receive ASX Option Recommendations or to learn more about Bull Call Spread, Bull Put Spread, Bear Call Spread, Bear Put Spread Strategies please request the Option Spreads eBook by contacting us on 1300 368 316 or info@totaloptions.com.au

Bear Call Spread: Trade Analysis – Risk vs. Reward

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Trade Analysis

Analysing your trade is essential before placing the trade. You need to make sure you have the necessary detail and go through the following checklist:

1. Stock Selection: Double check your analysis on the stock and make sure your outlook on the share price reflects the bear call spread.

2. Determine premium received when entering trade, most important as it is also your maximum profit.

3. Determine max loss and check that that is suits your risk profile and how much of your trading account you are risking.

4. Make sure you risk vs. reward suits the trading strategy.

Risk vs. Reward

The risk vs. reward will be different for every strategy. Credit spreads have a lower risk vs. reward meaning the maximum profit (reward) is quite low relative to the maximum loss (risk). Bear call spreads can be positioned to risk $0.50 to make a $0.50 this is when the bear call spread is traded at the money (Risk vs. reward 1:1). The trade can be more cautious by selling out-of-the-money options where you risk $0.80 to make $0.20 (Risk vs. reward 4:1). Both trades work well at the right time but the first example only requires a 50% success rate to break even while the second example requires an 80% success rate to break even.


To receive ASX Option Recommendations or to learn more about Bull Call Spread, Bull Put Spread, Bear Call Spread, Bear Put Spread Strategies please request the Option Spreads eBook by contacting us on 1300 368 316 or info@totaloptions.com.au

Bear Call Spread: Technical and Fundamental Analysis

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Technical Analysis

Identifying bear call spreads can be assisted through technical analysis. Technical analysis allows identification of expected price movement through indentifying trends through momentum indicators and trend lines. The types of chart patterns you are looking to identify a bear call trade are:

  • Strong resistance levels
  • Down trends
  • Trading ranges

Fundamental Analysis

Fundamental analysis can determine if a trade is viable or not. There are a number of fundamental factors that influence the option prices of a stock. When identifying a bear call spread you have a bearish outlook on the share. Therefore you are looking for negative news in the company or sector. As this trade also makes money if the share price does not move it if there is no news coming out of the company for the next month this can also be a positive for this particular strategy.


To receive ASX Option Recommendations or to learn more about Bull Call Spread, Bull Put Spread, Bear Call Spread, Bear Put Spread Strategies please request the Option Spreads eBook by contacting us on 1300 368 316 or info@totaloptions.com.au

Bear Put Spread: Woolworths Limited (WOW) Past Recommendation

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This is a past recommendation that demonstrates how a bear put spread is implemented in real life.

Trade:

Bear Put Spread

Sell 2 WOWB7 Sep 08 2200 Puts @ 55

Buy 2 WOWW3 Sep 08 2550 Puts @ 175

Net Cost = 120 cents

This trade requires no margin requirements.

Maximum Profit

The ideal result is for the share price to fall below the lower strike price of $22.00.

= Difference between strike prices less net premium received

= 3.50 – 1.20

= 2.30 x 2 contracts

= $4,600

Maximum Loss

This will occur if the share price is above the bought at expiry

= Net Premium Paid

= 1.20 * 2 contracts

= $2,400

Breakeven

Higher strike minus net premium received

= 25.50 – 1.20

= $24.30

Main Benefits of Strategy

1. Provides leveraged exposure to a decrease in the share price

2. The ideal result is for the share price to fall below the lower strike price of $22.00.

Risk:

The main risk is for the share price to increase above profitable range ($25.50) and stay there until expiry. If the position expires above the high strike, the position will expire worthless and there will be no exit cost to the trade. If it is below, we will have to exit the trade to avoid being exercised. A change in volatility levels can also have an effect on the profitability before expiry, however the max loss and profit is known at expiry. Contact your adviser for more information.

Technical Analysis

WOW has a large bearish head and shoulders pattern which has taken about a year and a half to develop. These patterns are usually very reliable and the stock has broken below the neck line this morning. The head and shoulders give a price target of $17.00. We are trading a bear put spread out to September which will return around 200% if the stock falls to $22.00 which is realistic considering the price target for this pattern is $17.00. The September position gives just over 3 months for the stock to fall. Due to the break today, the volatility on the out of the money puts options are very high, so this trade is actually been filled for below fair value which of course is in our favour.


To receive ASX Option Recommendations or to learn more about Bull Call Spread, Bull Put Spread, Bear Call Spread, Bear Put Spread Strategies please request the Option Spreads eBook by contacting us on 1300 368 316 or info@totaloptions.com.au