Chapter 6: Advanced Options Strategies

Objective

In this chapter we will some of the advanced options trading strategies which are little complex for the beginners. We will see options spreads which are of two types, vertical and horizontal. We will also see straddle and strangle strategies. Lastly, we will see Iron Condor, Iron Butterfly and Butterfly Spread strategies.

Section 6.1

Introduction to Advanced Options Strategies

Advanced options strategies typically involve a combination of buying and selling multiple options contracts simultaneously, enabling traders to manage risk, hedge positions, or profit from different market conditions. These strategies can range from risk-averse strategies like spreads and covered calls to more complex strategies like straddles, strangles, and iron condors.

Section 6.2

Options Spreads

An options spread involves buying and selling options of the same type (either calls or puts) on the same underlying asset but with different strike prices or expiration dates. The primary goal of a spread is to limit the potential risk while capping the potential reward.

2.1 Vertical Spread

A vertical spread involves buying and selling options with the same expiration date but different strike prices. This strategy is typically used when a trader expects a moderate move in the price of the underlying asset.

Bull Call Spread:
- Strategy: Buy a call option at a lower strike price and sell a call option at a higher strike price.
- Market View: Bullish, but with limited upside potential.
- Max Profit: Difference between strike prices minus the net premium paid.
- Max Loss: The net premium paid for the spread.
- Example: Buy a call at ₹100 and sell a call at ₹110, with a net premium of ₹5.
Bear Put Spread:
- Strategy: Buy a put option at a higher strike price and sell a put option at a lower strike price.
- Market View: Bearish, but with limited downside potential.
- Max Profit: Difference between strike prices minus the net premium paid.
- Max Loss: The net premium paid for the spread.
- Example: Buy a put at ₹100 and sell a put at ₹90, with a net premium of ₹5.

2.2 Horizontal (Calendar) Spread

A horizontal spread involves buying and selling options with the same strike price but different expiration dates. This strategy profits from differences in time decay and volatility.

Strategy: Buy a longer-term option and sell a shorter-term option at the same strike price.
Market View: Neutral to slightly bullish/bearish. Traders expect volatility to increase or price to stay relatively flat.
Max Profit: Occurs if the price of the underlying asset is near the strike price at the expiration of the short option.
Max Loss: The net premium paid for the spread.

Section 6.3

Straddle and Strangle

Straddles and strangles are strategies used when traders expect high volatility in the underlying asset but are uncertain about the direction of the price movement.

3.1 Long Straddle

A long straddle involves buying both a call and a put option with the same strike price and expiration date. The strategy profits from large price movements in either direction.

Strategy: Buy a call and a put option with the same strike price and expiration date.
Market View: Expecting large volatility, but uncertain about direction (price movement could be up or down).
Max Profit: Unlimited (if the price moves significantly in either direction).
Max Loss: The total premium paid for both options.
Example: Buy a call and a put on stock XYZ, both at ₹100 strike price, paying a total premium of ₹15 for both options. The underlying stock needs to move significantly away from ₹100 to make a profit.

3.2 Long Strangle

A long strangle is similar to a long straddle but uses different strike prices for the call and put options. It is slightly cheaper than a straddle, but requires a more significant move in the underlying asset to break even.

Strategy: Buy a call and a put option with different strike prices (both out-of-the-money) and the same expiration date.
Market View: Expecting significant volatility in the underlying asset, but uncertain whether the price will go up or down.
Max Profit: Unlimited, if the price moves significantly in either direction.
Max Loss: The total premium paid for both options (cheaper than a straddle).
Example: Buy a call at ₹110 and a put at ₹90, both expiring in a month. The underlying stock needs to move beyond ₹115 or below ₹85 to break even or make a profit.

Section 6.4

Iron Condor

An iron condor is a neutral strategy that combines a bear call spread and a bull put spread. The goal is to profit from low volatility in the underlying asset, with the price staying within a specific range.

4.1 Iron Condor Structure

Strategy: Sell a lower strike put, buy an even lower strike put, sell a higher strike call, and buy an even higher strike call — all with the same expiration date.
Market View: Neutral. The trader expects the underlying asset to stay within a defined range.
Max Profit: The premium received from the sold options (the maximum profit occurs when the asset’s price stays between the strike prices of the short puts and calls).
Max Loss: The difference between the strike prices of the puts or calls, minus the premium received.
Example: Sell a put at ₹90, buy a put at ₹85, sell a call at ₹110, and buy a call at ₹115. If the stock stays between ₹90 and ₹110 at expiration, the options expire worthless, and the trader keeps the premium received.

4.2 Adjusting the Iron Condor

If the stock price moves outside the expected range, the trader can adjust the position by rolling up/down the short strikes (selling different strikes) or by closing the entire position to cut losses.

Section 6.5

Iron Butterfly

The iron butterfly is a variation of the iron condor but with a narrower range of profitability. It involves selling a call and a put at the same strike price (at-the-money) while buying a call and a put at higher and lower strikes, respectively.

5.1 Iron Butterfly Structure

Strategy: Sell a put and a call at the same strike price, while buying a put at a lower strike price and a call at a higher strike price.
Market View: Extremely neutral. The trader expects the price to stay near the strike price of the short options.
Max Profit: The premium received for selling the call and put options, which occurs when the underlying asset’s price is exactly at the strike price of the short options at expiration.
Max Loss: The difference between the strike prices of the long and short options minus the premium received.
Example: Sell a put and a call at ₹100, buy a put at ₹95, and buy a call at ₹105. The maximum profit is realized when the stock price is exactly ₹100 at expiration.

Section 6.6

Butterfly Spread

A butterfly spread is a non-directional strategy that profits when the price of the underlying asset remains near a specific level. It involves buying and selling multiple options with the same expiration but different strike prices.

6.1 Long Butterfly Spread

Strategy: Buy one option at a lower strike price, sell two options at the middle strike price (the body of the butterfly), and buy one option at a higher strike price.
Market View: Neutral. The trader expects the underlying asset’s price to stay near the middle strike price.
Max Profit: The difference between the middle strike price and the lower strike price, minus the net premium paid.
Max Loss: The net premium paid for the spread.
Example: Buy one call at ₹95, sell two calls at ₹100, and buy one call at ₹105. The strategy profits if the underlying asset is close to ₹100 at expiration.

6.2 Risk/Reward

The butterfly spread offers limited risk and limited reward. The maximum reward occurs when the price of the underlying asset is at the middle strike price at expiration, and the maximum loss occurs if the price moves far away from the middle strike price.

Final Takes

Conclusion

Advanced options strategies allow traders to manage risk, capitalize on volatility, and profit in various market conditions. Whether through spreads, straddles, condors, or synthetic positions, these strategies provide flexibility and creativity in how you approach trading. As these strategies can become complex, it’s crucial to understand the risk-reward profiles and ensure that each strategy fits your market outlook and risk tolerance.

In the next chapters, we’ll explore more about managing these positions, calculating Greeks for optimal adjustments, and understanding the nuances of each strategy in real-market scenarios.