Everything you’ve ever wanted to know about professional options trading strategies—all in one exclusive complete guide.
Option volumes have exploded year-over-year. In January 2020, 22 million equity options contracts were traded on a daily basis, according to the Options Clearing Corporation. In January 2021, that number reached an average of more than 41.5 million contracts a day.
This incredible volume is driven in part by new interest in options trading from those who traditionally trade the underlying equities. However, unlike stock trading, options trading is multi-dimensional. It’s not just, “I think it’s going up, so I’m going to buy.” There are strategies to take advantage of the passage of time, an increase or decrease in volatility, and upwards, downwards, and sideways price movement. If you don’t pair your trading outlook with the proper strategy, it is possible to be right about what happens in the market and still lose money.
The opposite is also true. If you employ the right options trading strategy, you can minimize your losses when you are wrong and maximize your gains when you are right.
Understanding specific options trading strategies is at the core of building a successful long-term portfolio. So let’s get started.
Everything you’ve ever wanted to know about professional options trading strategies—in one convenient guide.
Ultimately, you are going to have to find a risk management strategy that marries your personality, capital, and trading style. That’s because the most important thing with any risk management system is that you stick to it as much as possible. (We say “as much as possible” because even the best traders violate their own risk management rules. It’s why large hedge funds and banks have specific departments to measure firm-wide risk.)
Risk management rules have to be particular to you because if you try to fit your trading into too small of a risk management box, then you will struggle to stick with it.
For instance, if you read any of Jack Schwager’s Market Wizards series, you will find a lot of professional traders have a 1% or 2% rule for their trading account. That is, they will not risk more on a single trade than 1% to 2% of their overall trading equity. While this makes sense if you are managing seven-figure accounts, if you have a starter $10,000 trading account, you are probably not going to sell out of a position because it lost $100.
That said, understanding these risk management rules of thumb can be helpful in developing your own risk management strategy.
The key to risk management rules is that they have to be hard and fast rules—no ifs, ands, or buts. But yes, you will violate them. There is not a trader in the world that hasn’t violated (or changed) one of their risk management or trading rules. It’s almost a certainty. We’re human.
The key to weathering these times is ensuring that you never have on unlimited risk trades. You have to structure your trades such that even if the worst case scenario happens, you have a defined loss. That happens at the point that you put on the trade, not when your emotions are tied up in the position.
While it might not seem like it, the worst thing that could happen is you violate a rule and make a lot of money. For instance, that option that you didn’t sell when it was down 50% rallied back to give you profits. That might encourage you to do the same thing the next time. And then again. And again. And one of those times, it’s not going to come back… and you’re going to risk suffering a catastrophic loss.
Options are priced using three main components: the relationship of the strike price to the current market price, the amount of time until the option’s expiration, and the volatility of the stock. (We can ignore for now the impact of interest rates on equity options’ pricing. The likelihood of a sudden change in interest rate expectations is very low, particularly as it relates to U.S. markets.)
In order to choose the right options trading strategy, you must first understand how options are priced. Why?
Let’s take a hypothetical scenario. Company A has their quarterly earnings report today. You buy a call option expecting the price of the stock to rise over the next week to a level that is $5 out of the money (that is, $5 higher than the current stock price).
The earnings report happens and tomorrow, the stock is up $2. That should mean that your option has now increased in price, right? After all… just one day has passed and the stock price has moved 40% closer to your strike price. The stock is going higher, just as you expected.
However, you should remember that option prices also incorporate volatility. And given that the earnings report is a highly volatile time, odds are that after the report, the volatility component of the options price shrunk rapidly. That “vol crush” could have easily offset the gains you may have been expecting as a result of the price movement in the stock. In fact, even with the stock trading closer to your call price, the price of the option could have gone down.
If you are only trading stock, then your decisions are relatively limited. If you are bullish the stock, you buy; if you are bearish the stock, you sell; and if you are neutral on the stock, you wouldn’t buy or sell it. Options trading strategies, however, can make money in bullish, bearish, and sideways markets. This makes options trading dynamic. But because options trading is dynamic, there are a number of different trading strategies that you could employ for each of those market types.
In addition to just buying, selling, or staying in cash, options require traders to make two major decisions that can determine the difference between a profitable and unprofitable trade. The first is the strike price (or prices) that you trade. The second is the expiration date (or dates) that you select. The choice of strike price and expiration date makes the difference between a trade that is well constructed and one that more closely resembles a lotto ticket.
In addition to forecasting where a stock might move, options traders have to forecast when it may happen. That’s because option contracts expire. If you own a $100 call and the stock closes at $99 on the day the contract expires, your option has no value… even if the stock opens the next day at $110. You can’t retroactively decide to exercise the option because the stock finally moved in the direction you wanted.If, however, you owned the same option that expired the next week, your option now has a lot of value.
As a result, you will want to make sure to know when a stock has its quarterly earnings report when trading options. Choosing one that expires the week before earnings or week after can cause drastic differences in the success of your trade. If you are playing a sideways trade, you might want to choose the week before earnings. If you are playing directional, you may want to go the week after.
Additionally, traders can look at prior trends to determine how long they took to play out. For example, if it took a stock five weeks to move from a trend low to trend high in the last move, then you have a model for how long it might take the current move to play out. It would be an aggressive play to buy calls that expire in three or four weeks.
Overview: Directional play that benefits if the stock price moves higher (long calls) or lower (long puts).
Construction: Buy an in-the-money call or at-the-money put option. Our preferred strategy would be to buy an 80-85 Delta call or a 50-60 Delta put.
Bias: Bullish (calls) or bearish (puts)
Breakeven: Buying the option will create a debit to the trader. The breakeven would be the strike price of the trade plus the price paid for the call or minus the price paid for the put.
Max gain: The max gain for a call would be unlimited. The max gain for a put would be the breakeven price times the number of shares underwritten by the options contract.
Max loss: The max loss is the total price paid for the option.
Key concepts: A stock replacement strategy is a cost-efficient, safe alternative to owning or shorting stock. It offers a limited loss scenario where a trader can only lose the money that they spent to buy the option. In addition, a trader has the option to roll the position in the event that the trade starts to make money, locking in profits in the trade. Because you own an option, you do have Theta decay eroding the value of your option.
Overview: Can be used to express bullish, bearish, or neutral trading outlooks.
Construction: Simultaneously enter a position in options with two separate strike prices but one expiration date. For a bullish spread, a trader can either buy a call and sell one at a higher strike or sell a put and buy a put at a lower strike. The first would result in a debit from the trading account, while the second would result in a credit to the account. For a bearish spread, a trader can either sell a call and buy one at a higher strike or buy a put and sell a put at a lower strike. In these trades, the first would result in a credit, while the second would result in a debit. By taking in a credit, the trader also would add the opportunity to make money in a sideways or neutral market.
Bias: Depends on the construction of the trade. Can be bullish, bearish, or neutral.
Breakeven: The breakeven would be the cost of the spread plus the strike price of the lower call or the strike price of the higher put minus the cost of the spread.
Max gain: In a debit spread (trader pays money), the max gain is the width of the spread minus the cost of the spread. For instance, if the trader paid $2 for a $5 wide spread, the max gain would be $3 per share. In a credit spread (trader receives money), the max gain is the amount of premium that the trader collected.
Max loss: In a debit spread, the max loss is the amount of premium that the trader paid. In a credit spread, the max loss is the width of the spread minus the amount of premium collected. In the same $5 wide spread, a trader that sold that spread for $2 would have a max loss of $3 per share.
Key concepts: This is a defined risk strategy trade where the gains and losses are limited. However, at expiration, the trader could find themselves in a precarious position if the stock is trading between the two strikes. That could cause one of the trades to be exercised, while the other trade is not, resulting in the trader having a net position short or long stock.
Overview: A premium collection strategy that benefits from Theta decay, which is higher for near-term at-the-money options.
Construction: Long a call or put at one strike price in one month, while being short a call or put at the same strike price with a shorter expiration date. (Since we don’t go naked short options, Market Rebellion would never be long the shorter expiration while being short the longer expiration. That would set up an unlimited risk scenario.)
Bias: Neutral—at least in the short term.
Breakeven: Difficult to determine at order entry. When the short-term option expires, the long-dated option will still have Theta value.
Max gain: If the stock moves sideways, the position will profit by the nearer month option decaying at a faster rate than the longer-dated option. This will cause the spread to widen and create a profit. The position will also profit if implied volatility rises.
Max loss: The maximum loss is the amount paid for the time spread, no matter where the stock price rises to, so long as the position is closed as a single trade (as it should be).
Key concepts: The strategy is best done by going short at-the-money near-term options, where the extrinsic value is the highest. The strategy works because of Theta decay that results from the passage of time.
Overview: A premium collection strategy that benefits in sideways markets, with both defined risk and profit potential. Since both sides of the trade are defined, traders can go either long or short butterfly spreads.
Construction: Uses either all calls or all puts. For a long butterfly using calls, you would buy one in-the-money call, sell two calls at-the-money, and buy one additional call out-of-the-money—all with the same expiration date and equidistant apart. The trade results in a debit.
Breakeven: There are two breakeven points. The first is found by adding the debit to the lowest strike call. The upper breakeven is found by subtracting the debit from the highest price strike.
Max gain: The max gain is found by subtracting the debit from the difference between the long and short strikes. The maximum gain is only realized if the stock price closes at exactly the short strike at expiration.
Max loss: The max loss is typically limited to the debit of the trade. This occurs if the stock price closes above the highest strike or below the lowest strike.
Key concepts: This is a powerful premium collection strategy, even though the trade results in a debit. That’s because it benefits if the stock moves sideways and profits occur from Theta decay. The trade is fully hedged and normally delta neutral.
Overview: A premium collection strategy that benefits if the stock price moves sideways between now and expiration.
Construction: The iron condor is the simultaneous entry of a credit put spread along with a credit call spread, typically some ways out of the money. The strike prices should be equidistant from the current price and equidistant from each other.
Breakeven: There are two breakeven prices. The breakevens are the premium collected plus the closest call price or minus the closest put price.
Max gain: The max gain is the amount of premium collected.
Max loss: The max loss is the width of the spread between the two strikes minus the amount of premium collected.
Key concepts: A premium collection strategy where a trader collects a credit instead of paying a debit for the trade. The trader makes a maximum profit if the stock closes between the two short strikes.
The key to trading options like a pro is finding the opportunity and then employing the strategy that is best for that opportunity. Because options can make money in bullish, bearish, and neutral markets, the strategy is critical. Not only can it make the difference between making money and losing money, but it can make the difference between minimizing losses when you are wrong and maximizing profits when you are right.
If you are interested in learning about all the strategies that we teach here at Market Rebellion, download Jon and Pete Najarian’s free Key Options Strategy Guide
Everything you’ve ever wanted to know about Unusual Options Activity—in one convenient insider’s guide.