Options are an increasingly popular way for traders to play the market, and it’s no surprise why. Options let you make some big money if you’re right, potentially multiplying your money, perhaps in days or weeks. But advanced traders like the ability of options to fine-tune their risk exposure, letting them take the exact risks they want and avoid the risks they don’t.
But whether you’re a beginner or an advanced trader, you’re always constructing your trades from just two types of options: calls or puts. So you’ll need to fully understand how those work before you build up to advanced multi-leg option strategies. But from there, you can construct more calibrated option strategies that fit your expectations about how a stock will perform.
Here are five option strategies for advanced investors and how they work.
5 options trades for advanced traders
1. Bull call spread
In a bull call spread, a trader buys a call and sells a call at a higher strike price, both with the same expiration. If the stock closes expiration above the higher strike, the strategy will maximize its value, which is capped at the difference in the two strike prices.
When to use it: A bull call spread is an appropriate strategy when the stock is expected to rise by the options’ expiration. It can work well for a stock that rises a lot but also one that gains a more modest amount. This hedged strategy allows the trader to break even at a lower price and multiplies the net premium faster up to the higher strike price compared to a long call. A bull call spread may work well on some of the best long-term investments, which should rise over time.
Example: Stock ABC trades for $20, and a $20 call is available for $1, while a $24 call trades for $0.50. The long call costs $100 ($1 per contract * 100 shares per contract * 1) offset by $50 from the short call ($0.50 per contract * 100 shares per contract * 1), or a net debit of $50.
Here’s the profit at expiration on the bull call spread at a range of stock prices.
Upside/downside: The maximum value on this spread is $4, or the difference between the two strike prices. Subtract the cost of $0.50 per spread, and the total potential profit is $3.50 per share, or $350 in total. So if the stock closes expiration above $24, the spread would be worth $4 — or a gain of eight times the net premium investment. The downside on this trade is limited to the net premium, or the $0.50 paid to set up the trade.
This trade can be an attractive alternative to a long call if the stock is expected to make a more modest gain. The bull call spread lowers the breakeven price on the trade, which would have been $21 with a long call alone, but is now just $20.50 with the spread strategy, or the net premium plus the long call’s strike price.
The spread also allows the trader to multiply the premium faster up to the short strike. At the short strike of $24, the bull call spread is worth $4, a gain of eight times. In contrast, a long call would be worth $4 if the stock closed expiration at $24, good for only a gain of four times. To get the same 8x return with the long call alone, the stock would need to rise to $28.
The best brokers for options trading can help you identify attractive options trades.
2. Bear put spread
What the bull call spread does for rising stocks, the bear put spread does for falling stocks. In a bear put spread, a trader buys a put and sells a put at a lower strike price, both with the same expiration. If the stock closes expiration below the lower strike, the strategy will maximize its profit, which is limited to the difference in the two strike prices.
When to use it: A bear put spread is an effective strategy when the stock is anticipated to fall by the options’ expiration. It can work if the stock is expected to fall significantly but can also work well if the stock falls more moderately. This spread strategy lets the trader break even faster and multiplies the net premium faster down to the lower strike price compared to a long put.
Example: Stock ABC trades for $20, and a $20 put is available for $1, while a $16 put trades for $0.50. The long put costs $100 ($1 per contract * 100 shares per contract * 1) offset by $50 from the short call ($0.50 per contract * 100 shares per contract * 1), or a net debit of $50.
Here’s the profit at expiration on the bear put spread at a range of stock prices.
Upside/downside: This spread will be worth $4 at most, or the difference between the $16 and $20 strike prices. Deduct the cost of $0.50 per spread, and the maximum profit is $3.50 per share, or $350 in total. If the stock closes expiration below $16, the spread would be worth $4, or a gain of eight times the net investment. The downside on this strategy is capped to the net premium, or the $0.50 paid to make the trade.
This strategy can be a good alternative to a long put if the stock is projected to make a more moderate decline. The bear put spread improves the breakeven price, which would be $19 with a long put alone, but is now only $19.50 with the spread strategy, or the long put’s strike price minus the net premium.
The bear put spread lets the trader multiply the premium faster down to the short strike. At the short strike of $16, the spread is worth $4, a gain of eight times the premium. In contrast, a long put would be worth $4 if the stock closed expiration at $16, a gain of only four times. To get the same return of eight times with the long put alone, the stock would need to fall to $12.
3. Long diagonal spread with calls
In a long diagonal spread with calls, a trader buys a long-dated call at or near the money and sells a near-term higher-strike call. If the stock finishes at the higher strike price at the first expiration, the strategy hits its maximum profit, and the trader can sell another near-term call to generate more income. This strategy is sometimes called a “poor man’s covered call” because setting it up requires less capital than a covered call but it can generate the same amount of income.
When to use it: A long diagonal spread with calls can be a useful strategy for a stock that’s expected to rise over time but that may not rise immediately. This spread allows the trader to repeatedly sell calls to generate income, and the long call may also appreciate significantly if the stock rises over time, leading to the potential to multiply money.
Example: Stock ABC is $20, and a $22.50 call that expires in two years costs $6, while a $22.50 call that expires in three months pays $0.75. Setting up this trade costs a net debit of $5.25, or a total of $525, for every spread that’s established.
Here’s the profit at expiration on this long diagonal at a range of stock prices.
Upside/downside: This strategy hits its maximum profit on the first expiration at $22.50, where the short call expires worthless, allowing the trader to keep the premium of $0.75 and letting the long call rise in value. The maximum downside is the net investment in the trade, or $5.25. The long call hedges the trader against a short call that could rise too rapidly in the near term.
After the short call expires, the trader can set up the trade again, selling another call at the same strike price or whatever other price yields an attractive premium for the risk. So part of the appeal of the long diagonal is that it’s cheaper to purchase the long call for $6 than the stock at $20, and then the trader can still sell calls against the safety of the long call, just as in a covered call.
The extra advantage of the long diagonal, however, is that the long call may end up worth many times its initial value when it finally expires much later. This strategy can be especially effective inside an IRA, where you can avoid immediate taxes from selling the calls or the capital gains.
4. Short straddle
In a short straddle, a trader sells a put and a call at the same strike, typically at the money, and the same expiration. If the stock finishes expiration at the strike price, the strategy hits its maximum profit, which is limited to the premiums received upfront.
When to use it: A short straddle can be a good strategy when you expect the stock to stay in a narrow range until the options expire, near the strike price of the straddle, and the options can offer a lot of time value. If the stock moves significantly, one of the options could lose a lot.
Example: Stock ABC is $20, and a $20 put pays $1 and a $20 call pays $1. Creating this trade yields $2 upfront, or a total of $200 ($1 premium * 100 shares per contract * 2 contracts).
Here’s the profit at expiration on the short straddle at a range of stock prices.
Upside/downside: The short straddle will be worth at most $2, or $200, the total premium received from setting it up. The max payout occurs if the stock finishes expiration right at the strike price, meaning both the call and put expire worthless. However, it can be difficult to receive the full premium. Typically only one of the options is likely to end up in the money, and one will expire worthless. This setup means that the trader is unlikely to capture the full premium.
The downside on this strategy is theoretically unlimited, if the stock rises, and traders could lose many times the premium. For example, if the stock soars to $30 a share after the trade was set up. While the put expires worthless, the call is now worth $10. The trader loses a total of $8 — $10 on the short call, which is offset by the $2 received upfront — for a grand total of -$800. Of course, if the stock falls, the short put could lose many times its value that way, too.
5. Long butterfly spread with calls
The long butterfly spread with calls is a more complex strategy with three parts: a long call at a low strike price, two short calls at a middle strike price and a long call at a still-higher strike price. All the options have the same expiration and the strikes are equally distant from one another. The strategy maxes out its profit if the stock closes expiration right at the middle strike price.
When to use it: This strategy is a limited-risk, limited-return strategy that relies on the stock not moving too far from the middle strike price by expiration. So it’s more useful for a stock that is experiencing falling volatility and is likely to remain near the middle strike, where profit is greatest.
Example: Stock ABC trades for $20. A $17.50 call is available for $3, a $20 call pays $1 and a $22.50 call costs $0.20. The trade costs a net $1.20 to set up, or the cost of the long calls ($3 and $0.20) minus the premium from the two middle strikes ($2 total), or a total of $120.
Here’s the profit at expiration on the butterfly spread with calls at a range of stock prices.
Upside/downside: The maximum value on this spread is $2.50, or the difference between the low strike and the middle strike, earning the trader a net $1.30 per spread at most. The maximum downside on the trade is its net cost of $1.20.
The profitability of this strategy is highly sensitive to where the stock price finishes expiration. If the stock finishes below $17.50, all the calls expire worthless and the trader loses the net debit of $1.20. If the stock closes above $22.50, the strategy also is a total loser, with the short calls offsetting any increase in the long calls. The sweet spot is right at the middle strike, where both short calls expire with no value and the $17.50 call ends up worth $2.50.
If the stock finishes at $19.50, the trade is worth $2, or a net profit of $0.80. If the stock finishes at $20.50, the trade is also worth $2, or the long call worth $3 minus the two short calls worth $0.50. This strategy breaks even at $18.70 and $21.30, or the $17.50 call plus the net debit and the $22.50 call minus the net debit. In between $18.70 and $21.30, this trade is profitable, not factoring in commissions. That leaves a narrow range for the stock to finish in.
Bottom line
Proceed carefully as you’re setting up advanced options trades. With multiple legs, it can be easy to set up the wrong trade. Plus, it’s important that these strategies are the right ones based on your expectations of the underlying stock’s performance. Some traders may select advanced (but inappropriate) strategies as an ego boost when a simpler strategy would work better.
Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.
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