The ability to manage risk vs. reward precisely is one of the reasons traders continue to flock to options. While an understanding of simple calls and puts is enough to get started, adding simple strategies such as spreads, butterflies, condors, straddles and strangles can help you better define risk and even open up trading opportunities you didn’t have access to previously.
Although it may seem daunting at first to put on these strategies, it’s important to remember most are just a combination of calls and puts, says Marty Kearney, senior instructor at CBOE Options Institute. “These names came about so that people who were phoning in orders to trading desks could convey very quickly what they wanted to do. These are all pretty basic strategies, just taking things up a notch.”
A call gives the buyer the right, but not the obligation, to buy the underlying asset at the purchased strike price. A put gives the buyer the right, but not the obligation to sell the underlying asset at the purchased strike price.
An options spread is any combination of multiple positions. This can include buying a call and selling a call, buying a put and selling a put, or buying stock and selling the call (which would be a covered write). For our purposes, we are going to look more closely at a vertical call bull spread, which is used if we expect the price of the underlying stock to rise, although these same principles can be applied to bull put spreads, bear call spreads and bear put spreads.
Fundamentally, vertical spreads are a directional play, says Joseph Burgoyne, director of institutional and retail marketing for the Options Industry Council, which means the investor needs to have an opinion whether the underlying is going to go up or down. Additionally, while they have limited risk, they also have limited reward.
Kearney explains, “What I’m looking at is I want to control the stock, and I think we’re going to a certain dollar amount. I’m willing to give up anything above that,” he says. For our example of a vertical call bull spread, he uses a stock trading at $63 that he believes will go at least to $70.
You simply could buy either the stock or a single call, but by purchasing the bull call spread you are able to better limit your risk. In Kearney’s example, we put on the 60-70 vertical call spread, which consists of buying one in-the-money 60 call and selling one out-of-the-money 70 call. Because we sold the 70 call, we limit the maximum value of our spread to $10 (minus commissions), but we lower our breakeven for the trade because of the credit we earned selling the 70 call. Additionally, our loss is limited to the cost of the spread.
Where vertical spreads require you to have an opinion just on direction, a butterfly requires more precision because, not only do you have to have an opinion on direction, but also a target price. Essentially, a butterfly is a combination of a vertical bull spread with a vertical bear spread using either all calls or all puts. “The way a butterfly is formed is by buying an in-the-money and an out-of-the-money call or put, and then selling two calls or puts at the middle strike,” which is your price target, Burgoyne says.
One reason a trader may use a butterfly over a vertical spread is because it is usually cheaper, Kearney says, because you are selling two options. This changes the risk/reward ratio.
Looking again at Kearney’s $63 stock, if we think it will be at $70 at expiration, a butterfly could make a lot of sense. To put it on, we again buy the 60-70 vertical bull call spread by buying an in-the-money 60 call and selling an out-of-the-money 70 call, but we then add a 70-80 vertical bear call spread by selling a second out-of-the-money 70 call and buying an out-of-the-money 80 call.
In this example, our reward is maximized if the stock settles at $70 on expiration, in which case our 60 call is 10 points in-the-money and the other three calls all expire worthless. Even if it doesn’t settle at $70, as long as the stock increased in value, our butterfly still could be profitable within a range of prices. If the stock either stagnates or only rises a little, or if it takes off and completely overshoots our $70 target, our loss is limited to the cost of the butterfly because of the wings on either side. “The risk/reward on a butterfly usually is very good,” Kearney says. “Once again, though, we have four commissions entering the trade and two to four on the way out, so it is commission-intensive.”
Condors, like butterflies, require you to have an opinion on direction and a price target. Unlike butterflies, you can target a range in which you think the stock will be at expiration. Where a butterfly requires you to sell two options at a central strike price (which also is your price target), a condor could be profitable if the stock expires along a range of prices because it involves selling at two different strike prices. “Butterflies are very pretty and symmetrical; [condors] can be big and gawky. They look like they have trouble even getting up in the air,” Kearney says.
The advantage of a condor compared to a butterfly is it allows you to take a directional play, but it gives you a larger range where you may do pretty well. Like a butterfly, a condor is composed of either all calls or all puts.
Again, if we take our $63 stock, but this time we think it will be somewhere between $70 and $75 at expiration, a condor can let us maximize profit while limiting risk. To do this, we can buy a 65-70 bull call spread by buying the 65 call and selling the 70 call, and then selling a 75-80 bear call spread by selling the 75 call and buying the 80 call. Profit is maximized if we expire between $70-$75 and our wings give us protection should we miss our mark. Again, our maximum loss is the cost of the condor, plus commissions.
If you think a stock is due to make a big move either to the upside or downside but don’t know which way it could break, a straddle can allow you to take advantage of that implied volatility. Typically, a long straddle involves buying an at-the-money call and an at-the-money put, thus straddling where the stock currently is trading.
Kearney uses the example of a stock trading at $50 going into an earnings report. Although he doesn’t know if it is going to do well or poorly, he expects there to be an outsized reaction to earnings, so he initiates a straddle by buying a 50 call and a 50 put. “Hopefully the stock goes to either $80 or $10. If we go to $80, then my put is worthless, but my call is $30 in-the-money; if we go to $10, then my call is worthless, but my put is $40 in-the-money,” he says.
A straddle makes the most sense if you think something exceptional is going to happen, but that implied volatility already likely is high, which would make the at-the-money call and put fairly expensive. “The market isn’t stupid,” Burgoyne says. “Especially with companies that don’t manage their expectations with the street very well, the market expects a big move so the [implied volatility] will go up in advance of earnings.”
Anything less than a 10% move can cause a loss because the position is so expensive to put on. Your maximum risk is right at the strike price. If in our example the stock only moves to $53 or $46, we may get $3 or $4 back on a position that may have cost $5 or $6 to initiate. If it works in your favor, though, the potential profit is open-ended.
A straddle would have worked very well for an investor going into Apple Inc.’s (AAPL) first quarter earnings report. The stock closed at $514 on Jan. 23, 2013, and options prices indicated investors expected the stock to trade in a $32 range the next day. AAPL opened the next morning at $460 and closed the day near $450. A straddle on the 515 strike would have done very well.
Although you also can initiate a short straddle by selling a call and a put if you think the stock is likely to stagnate, Kearney says most beginning investors may not be approved by their brokers for the strategy because it would give you unlimited loss potential on the upside or the stock “could get clobbered on the downside,” resulting in massive losses.
A strangle is the same idea as a straddle, but you purchase the call and put at different strike prices. “That’s how the butterfly and condor varied,” Burgoyne says. “Typically you’re going to be long an out-of-the-money call and an out-of-the-money put in a strangle.”
Using our $50 stock again, we buy the 45 put and the 55 call. The advantage is that by buying out-of-the-money options, our initial cost is much lower, but it also means we need to have a bigger move in the underlying for it to be profitable. If we were able to buy both the put and call for $1 each, then stock will have to reach $57 or $43 just to break even (not including commissions). “I am risking a lot less, but the chance is greater that I will lose my entire investment than with the straddle,” Kearney says.
Looking again at AAPL going into earnings, a trader could have initiated a strangle by buying the 505 put and 525 call. The move below $460 would make our put about $45 in-the-money, while our call would expire worthless.
You also are able to short a strangle, but the same issues apply as if you were to short a straddle.
With all of these strategies, you need to be aware of your positions going into expiration. If a portion of your strategy is in-the-money and you do not want to take possession, then you need to ensure you are able to exit that position before expiration.
Although these strategies allow you to balance your risk vs. reward to your liking, Burgoyne advises that traders always should consider the worst-case scenario when taking on a trade. “It all goes back to risk management. Look at that first, and proceed accordingly.”