Covered Calls, Strangles, Naked Options, Vertical Spreads and Iron Condors! We are discussing the basic options trading strategies commonly used. We break them down in an easy to understand way with real trading examples. The approach and management of the trades is covered as well as when to put the trades on and when to take them off.
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Covered Call
A Covered Call is a common strategy that is used to enhance a long stock position. The position limits the profit potential of a long stock position by selling a call option against the shares. This adds no risk to the position and reduces the cost basis of the shares over time.
Directional Assumption: Bullish
Setup:
– Buy 100 shares of stock
– Sell 1 call for every 100 shares. The short call is usually At-The-Money (ATM) or Out-Of-The-Money (OTM)
Ideal Implied Volatility Environment : High
Max Profit: Distance between stock price & short call + premium received from selling the call
How to Calculate Breakeven(s): Stock price – credit from short call
Approach:
We almost always prefer covered calls to naked stock because it allows us to profit when the stock doesn’t move at all, and it also reduces our max loss if the stock goes down. It’s important to consider the credit received from the call when deploying this strategy.
We look to deploy this bullish strategy in low priced stocks with high volatility. Based on our studies, entering this trade with roughly 45 days to expiration is ideal. We typically sell the call that has the most liquidity near the 30-delta level, as that gives us a high probability trade while also giving us profitability to the upside if the stock moves in our favor.
Management:
When do we close Covered Calls?
We close covered calls when the stock price has gone well past our short call, as that usually yields close to max profit. We may also consider closing a covered call if the stock price drops significantly and our assumption changes.
When do we manage Covered Calls?
We roll a covered call when our assumption remains the same (that the price of the stock will continue to rise). We look to roll the short call when there is little to no extrinsic value left. For instance, if the stock price remains roughly the same as when we executed the trade, we can roll the short call by buying back our short option and selling another call on the same strike in a further out expiration.
We will also roll our call down if the stock price drops. This allows us to collect more premium and reduce our max loss & breakeven point. We are always cognizant of our current breakeven point, and we do not roll our call down further than that. Doing so can lock in a loss if the stock price actually comes back up and leaves our call ITM.
Strangle
A short strangle is a position that is a neutral strategy that profits when the stock stays between the short strikes as time passes, as well as any decreases in implied volatility. The short strangle is an undefined risk option strategy.
Directional Assumption: Neutral
Setup:
– Sell OTM Call
– Sell OTM Put
Ideal Implied Volatility Environment : High
Max Profit: Credit received from opening trade
How to Calculate Breakeven(s):
– Downside: Subtract total credit from short put
– Upside: Add total credit to short call
Approach:
With strangles, it is important to remember that we are working with truly undefined risk in selling a naked call. We focus on probabilities at trade entry, and make sure to keep our risk / reward relationship at a reasonable level.
Implied volatility (IV) plays a huge role in our strike selection with strangles. The higher the IV, the wider our strangle can be while still collecting similar credit to a strangle with closer strikes that is sold in a lower IV environment. If we choose to keep our strikes closer to the stock price, a higher IV environment will yield a much larger credit, as IV is essentially a reflection of the option prices.
Our target timeframe for selling strangles is around 45 days to expiration. Studies show this is a great balance between shorter and longer timeframes.
Management:
When do we close strangles?
The first profit target is generally 50% of the maximum profit. This is done by buying the strangle back for 50% of the credit received at order entry.
When do we defend strangles?
With premium selling strategies, defensive tactics revolve around collecting more premium to improve our break-even price, and further reduce our cost basis. With short strangles specifically, rolling the untested side (non-losing side) closer to the stock price when the tested side (losing side) is breached is optimal.
Naked Options
Short “naked” options are calls or puts that are sold that have nothing to limit their risk (shares of stock, long options). It is a bullish strategy when selling a put option and a bearish strategy when selling a call option.
Short Naked Put
A Short Naked Put is a bullish strategy that is executed by simply selling a put option. It is a common strategy that can be used to buy shares of stock at a lower price, while keeping the premium collected if the stock price does not decrease.
Directional Assumption: Bullish
Setup: Sell OTM Put
Ideal Implied Volatility Environment: High
Max Profit: Credit received from opening trade
How to Calculate Breakeven(s): Strike price – credit received
Short Naked Call
A Short Naked Call is a bearish strategy that is executed by selling a call option without being “covered” by long stock or a long call option. Selling naked calls is an undefined risk strategy.
Directional Assumption: Bearish
Setup: Sell OTM Call
Ideal Implied Volatility Environment: High
Max Profit: Credit received from opening trade
How to Calculate Breakeven(s): Strike price + credit received
Approach:
Short “naked” options are calls or puts that are sold that have nothing to limit their risk (shares of stock, long options).
Since “naked” options have no options that are purchased against them, they benefit the most from the passage of time (theta decay) and any decreases in implied volatility (IV). As a result, the ideal environment for selling naked options in terms of the premium collected is when IV is high.
Management:
When do we close Naked Options?
Profitable Short Naked Calls and Short Naked Puts will be closed at a more favorable price than the entry price (first goal: 50% of maximum profit)
When do we manage Naked Options?
When trading short naked options, selling an option of the opposing type (i.e. selling a call against a short put that is being “tested”) can be one defense mechanism. This reduces the directional risk of the position and collects more premium, which extends the break-even point.
If the trader’s assumption on the underlying has not changed as expiration approaches, the position can be rolled to the next expiration cycle to extend the time in the trade and collect more premium.
Vertical Spread
A vertical spread is a directional strategy made up of long and short puts/calls at different strikes in the same expiration. Vertical spreads allow us to trade directionally while clearly defining our maximum profit and maximum loss on entry (known as defined risk).
Long Call Vertical Spread
A long call vertical spread is a bullish, defined risk strategy made up of a long and short call at different strikes in the same expiration.
Directional Assumption: Bullish
Setup:
– Buy ITM Call
– Sell OTM Call
Ideal Implied Volatility Environment: Low
Max Profit: Distance Between Call Strikes – Net Debit Paid
How to Calculate Breakeven(s): Long Call Strike + Net Debit Paid
Long Put Vertical Spread
A long put vertical spread is a bearish, defined risk strategy made up of a long and short put at different strikes in the same expiration.
Directional Assumption: Bearish
Setup:
– Buy ITM Put
– Sell OTM Put
Ideal Implied Volatility Environment: Low
Max Profit: Distance Between Put Strikes – Net Debit Paid
How to Calculate Breakeven(s): Long Put Strike – Debit Paid
Short Call Vertical Spread
A short call vertical spread is a bearish, defined risk strategy made up of a long and short call at different strikes in the same expiration.
Directional Assumption: Bearish
Setup:
– Sell OTM Call (closer to ATM)
– Buy OTM Call (further away from ATM)
Ideal Implied Volatility Environment: High
Max Profit: Credit received from opening trade
How to Calculate Breakeven(s): Short call strike + credit received
Short Put Vertical Spread
A short put vertical spread is a bullish, defined risk strategy made up of a long and short put at different strikes in the same expiration.
Directional Assumption: Bullish
Setup:
– Sell OTM Put (closer to ATM)
– Buy OTM Put (further away from ATM)
Ideal Implied Volatility Environment: High
Max Profit: Credit received from opening trade
How to Calculate Breakeven(s): Short Put Strike – Credit Received
Approach:
Vertical spreads allow us to trade directionally while clearly defining our maximum profit and maximum loss on entry (known as defined risk).
While implied volatility (IV) plays more of a role with naked options, it still does affect vertical spreads. We prefer to sell premium in high IV environments and buy premium in low IV environments. When IV is high, we look to sell vertical spreads hoping for an IV contraction. When IV rank is low, we look to buy vertical spreads to stay engaged and also use it as a potential hedge against our short volatility risk.
Since the maximum loss is known at order entry, losing positions are generally not defended. We always look to roll for a credit in general, and doing so with vertical spreads is usually difficult.
Management:
When do we close vertical spreads?
Profitable vertical spreads will be closed at a more favorable price than the entry price (goal: 50% of maximum profit
When do we manage vertical spreads?
Losing long vertical spreads will not be managed but can be closed any time before expiration to avoid assignment/fees.
Iron Condor
An Iron Condor is a directionally neutral, defined risk strategy that profits from a stock trading in a range through the expiration of the options. It benefits from the passage of time and any decreases in implied volatility.
Directional Assumption: Neutral
Setup:
– Sell OTM Call Vertical Spread
– Sell OTM Put Vertical Spread
Ideal Implied Volatility Environment : High
Max Profit: The maximum profit potential for an Iron Condor is the net credit received. Maximum profit is realized when the underlying settles between the short strikes of the trade at expiration.
How to Calculate Breakeven(s):
– Upside: Short Call Strike + Credit Received
– Downside: Short Put Strike – Credit Received
Approach:
We shoot for collecting 1/3rd the width of the strikes in premium upon trade entry. For example, if we have an iron condor with 3-point wide spreads, we will look to collect $1.00 for the trade. This gives us a probability of success around 67%, which is acceptable to us.
Management:
When do we close Iron Condors?
Much like other standard premium selling strategies, we close iron condors when we reach 50% of our max profit. This can increase our win rate over time, as we are taking risk off the table and locking in profits.
When do we manage Iron Condors?
We manage iron condors by adjusting the untested side, or profitable side of the spread. We look to roll the untested spread closer to the stock price to collect more premium. We can go as far as rolling our untested spread to the same short strike as our tested spread, which creates an iron fly.
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