Neutral Market Option Trading Strategies

This is an introduction to various option trading strategies from basic trades to complex, multi-leg trades for a stagnant market, or a market that you believe will move, but are unsure of the direction. The profits and losses in these examples do not consider commissions, interest, or taxes.

Reversals - (Risk: Low / Reward: Low) Reversals are arbitrage strategies primarily executed by floor traders. The reversal seeks to take advantage in minor discrepancies between exchanges by buying something in one market and simultaneously selling it in another. Traders do reversals when options are relatively underpriced as compared to the underlying stock. The position is established by selling stock in the open market and simultaneously creating a synthetic long position in the options market. The synthetic long position is created by simultaneously buying a call and selling a put with the same strike price and expiration. Since reversals make their profits as soon as the trade is placed, it is a low risk strategy. The profits are typically quite small, but the trades can be placed as often as the market will allow. Reversals are a reverse trade of a conversion

Conversions - (Risk: Low / Reward: Low) A conversion is an opposite trade of a reversal. It is also an arbitrage trade, except with a conversion, you are buying a stock and simultaneously establishing a synthetic short position by selling a call and buying a put with the same strike price and expiration. Traders use conversions when option prices are relatively high compared to the underlying stock.

Collars - (Risk: Limited - Reward: Limited) Collars are primarily used to hedge an existing position. A collar is a combination of writing (selling) a covered call and buying a protective put for your existing position. Collars are a conservative strategy that can manage risk, offer a moderate rate of return and can provide tax advantages. Many investors will roll their collars on a month to month basis. If done appropriately, this can create a moderate rate of return and allow the collar to adjust with the movement in the underlying stock. A collar is sometimes referred to as a fence.

Straddles - (Risk: Medium / Reward: High) Straddles can be placed as either a short position or a long position. A long straddle is used when you expect a big movement in a stock price, but are not sure of which direction the stock will move. Examples of a good time to place a straddle would be before an earnings report is released, or an FDA decision is due to be handed down. With a long straddle you buy equal amounts of calls and puts at the same strike and expiration. The hope is that the stock will run far from the strike price in either direction. A Short straddle is the opposite. Short straddles are created by selling an equal number of calls and puts with the same strike and expiration in hopes that the stock price will not move and you make money on the time decay of the the two options.

Strangles - (Risk: Medium / Reward: High) Strangles are similar to straddles except instead of the two options having the same strike price, they have different prices. The spread between the strike prices lowers the risk of the trade as compared to a straddle because it lowers the cost of initiating the trade.

Butterflies - (Risk: Limited / Reward: Limited) A Long butterfly is a three legged trade that consists of four total options and three strike prices. The first leg is a long call at the lowest strike price. The second leg is a long call at the highest strike price. The third leg is short two calls at a strike price midway between the first two legs. Butterfly spreads make maximum profit when the price of the underlying is equal to the middle strike price at expiration. They make maximum loss when the price of the underlying stock is either below the lowest strike, or above the highest strike at expiration.

Ratio Spreads - (Risk: Medium / Reward: High) A ratio put spread is created by buying a put and then selling a greater number of puts at a lower strike price. Ideally, the premiums paid and received for the two trades would come close to offsetting each other. Maximum profit on a put ratio spread is achieved when the underlying trades at the lower strike price at expiration.

Condors - (Risk: Limited / Reward: Limited) The long condor is a long butterfly where the two short contracts that make up the body of the butterfly are spread between two different strike prices. Therefore, this trade consists of four options over four strike prices. For a long condor, the highest and lowest strikes are long positions and the two middle strikes are short. A long condor could also be viewed as a combination of a bull call spread and a bear call spread. Maximum profit on a long condor is achieved when the underlying trades between the two middle strike prices.

Calendar Spreads - (Risk: Medium / Reward: High) Calendar spreads, which are also known as horizontal spreads, consist of options with different expiration months. A long calendar spread is initiated by buying a call with a longer expiration and selling a call with the same strike price, but a shorter expiration. Money is made with the decay of the short, shorter expiration option. Therefore, this trade works best if the price of the underlying remains relatively stable.

To learn about option trading strategies for other market conditions and situations, visit our option strategy overview page.

The Clark Financial Group can help you implement all of your option trading strategies. We provide our clients with discount commissions, online trading convenience, and the support of an experienced broker at no additional cost. For more information, call us at 1-800-797-1979 or compare our combination of low fees and extensive services to see if we're right for your option trading needs.

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