5 Strategies for Advanced Options Trading

Strategies for options trading range from the simple to the complex — from basic one-legged trades to the four-legged monsters — but all strategies are based on just two basic option types: calls and puts. Each has its own upsides and downsides, and you might want to refresh your understanding of what a call option is and what a put option is.

The bull call spread

The bull call spread pairs a long lower-strike call with a short higher-strike call, each with the same expiration. It's a wager that the underlying stock will rise, but perhaps not above the strike of the short call. This trade caps the potential upside in exchange for higher percentage gains than just buying a call. The long call protects the portfolio from the potential dangers of the short call.

Example: XYZ stock trades at $50 per share, and a call at a $50 strike is available for $5 with an expiration in six months. A $60 call with the same expiration can be sold for $2. Here’s the payoff profile of one bull call spread.

Potential upside and downside: The short call caps the potential upside of this strategy at $700, which occurs at any stock price above $60 per share. That profit comprises the $500 profit on the long call and the $200 premium from the short call. The net cost of the trade is $300, which is the potential total downside if the stock stays below $50 per share.

Why use it: The bull call spread is an attractive way to wager on a stock’s modest price rise. The bull call spread offers many advantages over just a long call:

• It costs less to set up (in this example, $300 versus $500)

• It lowers the breakeven point (from $55 to $53)

• It lowers potential downside (from -$500 to -$300)

• It provides a better return up to the short strike (a potential 233% return versus 100%)

» Want to take a step back? Check out five beginning options trading strategies

The bear put spread

The bear put spread looks much like the bull call spread, but it’s a wager on the modest decline of a stock instead of a rise. The bear put spread pairs a long higher-strike put with a short lower-strike put. The strategy bets that the stock will fall, though maybe not much below the lower strike price. This trade caps the potential upside in exchange for higher percentage gains than just buying a put.

Example: XYZ stock trades at $50 per share, and a put at a $50 strike is available for $5 with an expiration in six months. A $40 put with the same expiration can be sold for $2. Here’s the payoff profile of one bear put spread.

Potential upside and downside: The short put caps this spread’s potential upside at $700, which happens at any stock price below $40 per share. That profit is made up of the $500 profit on the long put and the $200 premium from selling the $40 call. The net cost of the trade is $300, which is the potential total downside, if the stock stays above $50 at expiration.

Why use it: The bear put spread is an attractive way to bet on a stock price falling modestly. The bear put spread offers many advantages over just a long put:

• It costs less to set up (in this example, $300 versus $500)

• It raises the breakeven point (from $45 to $47)

• It lowers potential downside (from -$500 to -$300)

• It provides a better return up to the short strike (a potential 233% return versus 100%)

The long straddle

The long straddle pairs an at-the-money long call and an at-the-money long put at the same expiration and same strike price. The long straddle wagers that a stock will move significantly higher or lower, but the investor is unsure in which direction.

Example: XYZ stock trades at $50 per share, and a call and a put at a $50 strike are each available for $5 with an expiration in six months. Here’s the payoff profile of one long straddle.

Potential upside and downside: If the stock rises, the potential upside of the long straddle is infinite, less the cost of the $1,000 in premiums. If the stock falls, the potential upside of the put option is full value of the underlying stock minus the cost of the options’ premium (so $5,000 minus $1,000, or $4,000).

The potential downside of the long straddle is when the stock does not move much, in the range from $40 to $60 per share. The maximum downside occurs at $50 per share, with both options expiring completely worthless.

Why use it: Given the sizable cost of setting up a long straddle, investors use the strategy only when they expect a big price movement but don’t know which way the stock might run. In this example, the breakeven is 20% above or below the starting stock price. That’s a significant hurdle for establishing a long straddle, but that kind of move might occur in an industry such as biotechnology, where the release of crucial research results could whiplash a stock 50% or more in a day.

The long strangle

The long strangle looks like the long straddle, pairing a long call and a long put with the same expiration, but it uses out-of-the-money options instead of at-the-money options. Like the long straddle, the long strangle wagers that a stock will move significantly higher or lower, but the investor is unsure in which direction. It’s cheaper to set up a long strangle than a straddle because the strangle uses out-of-the-money options, but it takes more price movement in either direction to make the strangle profitable.

Example: XYZ stock trades at $50 per share. A call at a $60 strike is available for $2, and a put at a $40 strike is available for $2, each with an expiration in six months. Here’s the payoff profile of one long strangle.

Potential upside and downside: Like the long straddle, the upside on the long strangle’s call is potentially infinite, minus the cost of $400 in premiums. On the put, the strangle’s potential upside is the total value of the underlying stock from the put’s strike price less the premiums (so $4,000 minus $400, or $3,600).

The potential downside on the long straddle occurs when the stock does not move much, in the range of $36 to $64 per share at expiration. Anywhere in this range results in both the call and put expiring worthless, leading to the maximum loss of $400.

Why use it: This strategy is another bet that the stock will move a huge amount, though the investor doesn't know in which direction. The long strangle is more aggressive than the long straddle but cheaper. The wider spread of strike prices means the underlying stock has to move even more substantially for the strangle to break even. However, once it does, the percentage gains rack up even quicker than the straddle’s. While the strangle’s out-of-the-money options make it cheaper to set up, the chance of losing it all is higher.

The synthetic long

The synthetic long strategy pairs a long call with a short put at the same expiration and strike price. The intent is to mimic the upside performance of actually owning the underlying stock.

For a synthetic long, the proceeds from selling the put help offset the cost of the call, and sometimes investors have to put up little or no net investment. More aggressive synthetic longs can be set up at a strike price higher than the current stock price, while more conservative synthetic longs are set up below the stock price.

Example: XYZ stock trades at $50 per share, and a call and a put at a $50 strike are available for $5 with an expiration in six months. Here’s the payoff profile of one synthetic long.

Potential upside and downside: This payoff profile looks like it would if the investor had owned the stock directly. For example, at a stock price of $80, the investor receives a net benefit of $3,000 with the stock as well as the synthetic long. So like the stock, the potential upside is uncapped, but only until the option’s expiration.

The downside of the synthetic long occurs if the underlying stock goes to $0. Then just like the short put strategy, the investor would be forced to buy the stock at the strike price and realize a total loss. The maximum downside is the total value of the underlying stock, here $5,000.

Why use it: The synthetic long can be a useful strategy to achieve the performance of a stock without investing any net capital. (That really is infinite potential returns.) In exchange, the investor must be willing — and, importantly, able — to buy the stock if it declines below the strike price at expiration. More aggressive synthetic longs at a strike above the stock price can even result in a net cash benefit to the account. That’s even more appealing for bullish investors.