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Option Strategies

Generally, an Option Strategy involves the simultaneous purchase and/or sale of different option contracts, also known as an Option Combination. I say generally because there are such a wide variety of option strategies that use multiple legs as their structure, however, even a one legged Long Call Option can be viewed as an option strategy.

Under the Options101 link, you may have noticed that the option examples provided have only looked at taking one option trade at a time. That is, if a trader thought that Coca Cola's share price was going to increase over the next month a simple way to profit from this move while limiting his/her risk is to buy a call option. Of course, s/he could also sell a put option.

But what if s/he bought a call and a put option at the same strike price in the same expiry month? How could a trader profit from such a scenario? Let's take a look at this option combination;

Option Strategy Example - Long Straddle

In this example, imagine you bought (long) 1 $65 July call option and also bought 1 $65 July put option. With the underlying trading at $65, the call costs you $2.88 and the put costs $2.88 also.

Now, when you're the option buyer (or going long) you can't lose more than your initial investment. So, you've outlaid a total of $5.76, which is you're maximum loss if all else goes wrong.

But what happens if the market rallies? The put option becomes less valuable as the market trades higher because you bought an option that gives you the right to sell the asset - meaning for a long put you want the market to go down. You can look at a long put diagram here.

However, the call option becomes infinitely valuable as the market trades higher. So, after you break away from your break even point your position has unlimited profit potential.

The same situation occurs if the market sells off. The call becomes worthless as trades below $67.88 (strike of $65 minus what you paid for it - $2.88), however, the put option becomes increasingly profitable.

If the market trades down 10%, and at expiry, closes at $58.50, then your option position is worth $0.74. You lose the total value of the call, which cost $2.88, however, the put option has expired in the money and is worth $6.5. Subtract from this to total amount paid for the position, $5.76 and now the position is worth 0.74. This means that you will exercise your right and take possession of the underlying asset at the strike price.

This means that you will effectively be short the underlying shares at $65. With the current price in the market trading at $58.50, you can buy back the shares and make an instant $6.50 per share for a total net profit of $0.74 per share.

That might not sound like much, but consider what your return on investment is. You outlaid a total $5.76 and made $0.74 in a two month period. That's a 12.85% return in a two month period with a known maximum risk and unlimited profit potential.

This is just one example of an option combination. There are many different ways that you can combine option contracts together, and also with the underlying asset, to customize your risk/reward profile.

You've probably realized by now that buying and selling options requires more than just a view on the market direction of the underlying asset. You also need to understand and make a decision on what you think will happen to the underlying asset's volatility. Or more importantly, what will happen to the implied volatility of the options themselves.

If the market price of an option contract implies that it is 50% more expensive than the historical prices for the same characteristics, then you may decide against buying into this option and hence make a move to sell it instead.

But how can you tell if an options implied volatility is historically high?

Well, the only tool that I know of that does this well is the Volcone Analyzer. It analyzes any option contract and compares it against the historical averages, while providing a graphical representation of the price movements through time - know as the Volatility Cone. A great tool to use for price comparisons.

Anyway, for further ideas on option combinations, take a look at the list to the right and see what strategy is right for you.

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