Options strategy guide

Most people pick a strategy from a list of names and then work out what it does. That is backwards, and it is why so many positions end up expressing a view their owner never held. A better order is to state your view precisely, then find the structure that pays when that view is right.

A precise view has three parts: direction, size and timing. “I think it goes up” is not enough to choose between a long call, a call spread and a cash-secured put — those three want the stock to go up by very different amounts on very different schedules, and two of them make money if it goes nowhere.

Before any strategy makes sense, answer these.

1. What has to happen for this to make money? If you cannot state it in one sentence with a price and a date in it, you do not understand the position yet.
2. What is the worst case, and can you take it? Not the likely case. If the answer is unlimited, that is a different kind of question requiring a different kind of answer.
3. What are you being paid for? Options are priced by people who do this professionally. If a structure looks like free money, you are being paid to take a risk you have not identified yet — usually a rare, large loss.

The naive answer is buy a call if bullish, buy a put if bearish. It works, and it is the hardest way to make money, because you are paying for time value that decays every day and you need a move large enough and fast enough to beat it.

The alternatives trade upside for a better probability of any profit at all:

• A vertical spread — buy one option and sell a further-out one against it. Costs less, decays less, caps your profit. If you expect a move to a specific level rather than an open-ended run, you were never going to collect the tail anyway.
• A cash-secured put, if you are bullish and would happily own the shares. You are paid to wait, and if the stock falls you buy it cheaper than today. The risk is that it falls a great deal further than the premium compensates for.
• A diagonal or calendar spread, if you have a view on timing as well as direction. These are the most demanding structures on the list, and the ones most often entered without understanding.

Range-bound views are what options are uniquely good at expressing — there is no way to bet on a stock staying still with shares alone. Iron condors, butterflies and short strangles all profit from time passing and nothing happening.

They share a characteristic worth being blunt about: they win often and lose big. A strategy that profits 80% of the time can still be unprofitable, because the 20% costs more than four wins combined. Check the maximum loss against the maximum profit on the calculator before you are seduced by the probability figure.

Straddles and strangles pay when the stock moves substantially in either direction. The catch is that everyone can see the same catalyst you can, and it is already in the price. Buying a straddle before earnings means paying for elevated implied volatility that will collapse the moment the announcement lands.

This is where the volatility slider earns its place. Set up the position, then drop implied volatility by 10 or 15 points to simulate the crush, and see how large a move you need just to break even. The answer is usually bigger than expected.

The covered call is the most common first options trade, and it is genuinely straightforward: you own 100 shares, you sell a call against them, you keep the premium. If the stock stays below the strike you keep the shares too.

What is less often said is what you gave up. You sold your upside above the strike. In the scenario where your stock finally makes the move you have been waiting for, you get the premium and a fixed exit price instead. That is a fine trade if you were going to sell there anyway, and a painful one if you were not.

Three structures on this site can lose more than the account behind them. They are marked with an Undefined risk badge everywhere they appear, and the calculator reports their maximum loss as Unlimited rather than a number.

• Naked short calls. The stock can rise without limit, and your loss rises with it. This is the single most dangerous position an ordinary account can hold.
• Short strangles and short straddles. A naked call on one side, so the same unbounded exposure, plus a large defined loss on the other.
• Short puts in size. The loss is bounded only by the stock reaching zero, which is not much comfort when the strike was $200.

Every one of these has a defined-risk equivalent that gives up a little premium in exchange for a floor: a call spread instead of a naked call, an iron condor instead of a strangle. The premium you give up is what the floor costs, and it is almost always worth it.

All of these run through the same calculation engine, so a custom eight-leg position gets the same exact breakevens and the same unlimited-risk detection as a long call.