Last updated on April 27th, 2023 at 03:40 am

Do you know what option strategies are? AAMcourses is here to answer your question. In this article, we will discuss various option strategies investors can use.

Investors looking to make quick and big cash from the stock market should opt for options. The options market is a high-fluctuation market, enough knowledge of the field can help investors to earn a lot with minimum risk.

An option is a contract in which the buyer and seller agree to exchange the underlying assets for a specified price on a specified future date. But unlike future contracts, there is no obligation to exchange the underlying assets at the decided date. Due to no obligation, people opt for options trading instead of futures. It allows people from bad deals and unexpected price fluctuations.

Now, without further ado, let’s study the 4 types of option strategies.

4 Types of Option Strategies

Options Spread 

The first of the option strategies is the options spread. It is one of the most known and best option strategies used by traders.

The option spread is a strategy where the trader can purchase and sell multiple options contracts of the same type with the same underlying asset. The options are similar but have a different strike price, expiry, or both.

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Options Spread is further categorized into three types.

Vertical Spread

A vertical spread has a separate and different strike price. Whereas the expiry date and the underlying asset are the same for vertical spread. Vertical spread is also known as money spread due to its nature. 

Example : An individual purchased a January call option on scrip A with a $20 strike price and sold a different January call option on scrip A with a $22 strike price. 

A vertical spread is an option contract that is opted by traders who have a light takeaway of the stock. Vertical spread can be used for bullish as well as bearish markets. 

Bullish Vertical Spread

In the case of a bullish market, a vertical spread is a position where the trader has an optimistic view of the stock’s future, either for a long or short call. In a bullish market, the trader purchases lower strike-price options and plans to sell them at a higher strike price. 

Bullish Vertical Spread Using Calls

In this case, the trader would buy a lower strike-priced option and sell a higher strike-priced call option. This tactic is called the net debit strategy. This bullish vertical spread using calls is one of the best option strategies.

Example : The market price at scrip is $50. A trader purchases the January call option with the strike price of $50 after paying a premium of $1. Then, he sells the other January call options with a strike price of $55 by receiving a premium of 50 cents. 

• Maximum Profit = Higher Strike Price – Lower Strike Price – Net Premium Paid 
  = 55 – 50 – 0.50
  = 4.50
• Maximum Loss = Net Premium Paid = 0.50 
• Break Even Point = Lower Strike Price + Net Premium Paid 
     = 50 + 0.50 
  = 50.5

Bullish Market Using Put Option

To establish a bullish vertical spread using a put option, a trader would buy a lower strike-priced put option and sell a higher strike-priced put option. Here, there is an inflow of cash for net premium. This is called a net credit strategy. 

Example : The market price at scrip is $50. A trader purchases the January Put option with the strike price of $50 after paying a premium of $1. Then, he sells the other January Put option with a strike price of $55 by receiving a premium of 50 cents.

• Maximum Profit = Net premium received
  = $1.5
• Maximum Loss = Higher Strike Price – Lower Strike Price – Net Premium Received 
  = 55 – 50 – 1.5
  = $3.5
• Break Even Point = Higher Strike Price – Net Premium Received 
  = 55 – 1.5
  = $53.5

Bearish Vertical Spread

The next of the vertical spread option strategies is the bearish vertical spread.

In the case of a bullish market, a vertical spread is a position where the trader has an optimistic view of the stock’s future, either for a long or short call. In a bullish market, the trader purchases lower strike-price options and plans to sell them at a higher strike price.

Bearish Vertical Spread Using Call Option

To establish a bearish vertical spread using a call option, the trader must purchase a high strike-priced call option and sell a lower strike-priced call option. Here, there is an inflow of money in the case of net premium. This options strategy is called the net credit strategy.

Example : The market price at scrip is $50. A trader purchases the January call option with the strike price of $50 after paying a premium of $1. Then, he sells the other January call option with a strike price of $55 by receiving a premium of 50 cents. 

• Maximum Profit = Net Premium Received = $1.5
• Maximum Loss = Higher Strike Price – Lower Strike Price – Net Premium Received
  = 55 – 50 – 1.5
  = $3.5
• Break Even Point = Lower Strike Price – Net Premium Received 
  = 50 + 1.5
  = $51.5

Horizontal Spread

A horizontal spread is established when an option with the same underlying asset, with the same strike price and expiry date, differs.

The main difference in a horizontal spread is the maturity period; the maturity period of each option is different. Therefore, Horizontal Spread is also known as calendar or time spread. The main objective of time spread is to gain profit using the time decay of two different options with different maturity dates. Time decay refers to how much an option’s price depreciates over time.

Diagonal Spread

A diagonal spread is established when the trader simultaneously engages in both – long and short positions with similar types of options with varying strike prices and expiry. A diagonal spread is a combination of vertical and horizontal spread.

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Straddle 

Straddle is one of the option strategies which involves both – call and put options. In this strategy, both options are purchased for the same expiry date and strike price on the same underlying asset.

The straddle strategy is profitable only when the stock price increases or decreases from the strike price by more than the total premium paid.

A long position in straddle is established by buying a call and put options at the same strike price.
Whereas a short position in straddle is established by selling call and put options with the same strike price.

A straddle strategy is used by a person who believes that the option’s market price will fluctuate, but the individual is still determining which direction it will move in.

Strangle 

Next of the option strategies is the strangle strategy. The strangle strategy is quite similar to the straddle, but it has some minor changes. Strangle strategy uses options at different strike prices, whereas straddle uses a call and put at the same strike price.

In a strangle strategy, the trader holds both – the put and call option with different strike prices but with the same expiry and underlying assets. This strategy has limited risk and a potential for unlimited profits.

A strangle strategy is used when you believe that the option will gain a huge price movement in the future but are not sure of the direction of the movement.

• Break Even Point = Lower Strike Price – Total Premium Paid on the Downside 
  
• Break Even Point = Higher Strike Price + Total Premium Paid on the Upside. 
  

Butterfly Spread 

The last of the option strategies is the butterfly spread. The butterfly strategy is one of the option strategies that uses the combination of both – bull and bear spreads.

A butterfly strategy pays off the most when the underlying asset doesn’t move before its expiry date. This strategy uses four options contracts with the same expiry but three different strike prices.

The butterfly strategy uses four options and three different strike prices where the upper and lower strike prices are at an equal distance from the middle strike price.

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FAQs

Closing Statement

An option is a pre-established contract where the date and price for trading the contract are agreed on. But when we dive deeper, there are four types of option strategies that traders use. These four strategies are discussed in the above article. Each strategy offers different earning methods based on the mindset and the objective of the trader.

In this article, we have explained all 4 types of option strategies in the easiest way possible. I hope this article is informative. If you have any doubts or suggestions, trade them in the comment box.