This lesson will teach you how to build option trading strategies. If you are not familiar with the process of buying an option, please refer to the lesson ‘Call and Put options’.
The Advanced trading mode of the platform allows you to build strategies. You can enter this mode by clicking on a link ‘go advanced’.
A strategy is when you execute more than one option at the same time; buying and selling Calls and Puts in different combinations to take advantage of market moves in many different ways. Note: The Advanced mode of the platform does not allow you to trade ‘Naked Options’ when selling. For more information on selling options, please refer to lesson ‘Selling options.
Below, we teach you some of the most popular strategies, but there are endless possibilities and always more to learn. Go to the option strategies page or the platform’s strategies marketplace to view more.
The Long Straddle
The long straddle is commonly used over news announcements and major economic events to trade an increase in volatility. To execute this strategy, you buy a Put and Call at the same time with the same strike, expiry, and amount. This results in a profit if the market moves in either direction; the Put option will bring a profit if the market falls and the Call option will bring a profit if the market rises.
AUD/USD Long Straddle example:
The above image is an at-the-money straddle where both the Call and Put are set with strike rates equal to the underlying market (0%) at execution. The strike rates do not have to be at 0%, but they do have to be the same.
The chart below shows the strategies’ profit or loss at expiry over a range of market rates. The dotted grey line highlights when profit/loss equals zero (the break-even point). Anything above the grey line is a profit and anything below it is a loss. The letter indicates the strike rate. If the market moves far enough in either direction past the break-even points, the strategy is profitable. But if the market rate does not break-out in either direction, the strategy creates a loss. This ‘V’ shaped chart is a classic Long Straddle strategy.
Advantage:
- You can profit from a move in either direction.
- Your maximum loss is limited to the premium paid at open
- You will not get stopped-out
Disadvantages:
- It involves a higher premium cost compared with trading in one direction.
- As time passes and the options get closer to expiry, time value is highly against you since both legs are decaying.
Strategy trade walk-through:
The example below gives you a step-by-step guide to setting up a strategy in Advanced mode.
1. You build your strategy one line at a time. Set-up the first line as you wish. For example, you set-up a EUR/USD Call option, then tick buy.
2. You click on the button ‘turn into strategy’ to add a new line and set this line as you wish. For example, if you want a Long Straddle strategy, you set this second line as a EUR/USD Put option, then tick buy.
3. You alter the strike, expiry, and amount on all lines, and then assess the total amount ‘to pay’ (or amount ‘to receive’) of the strategy. If you have evaluated your risk and profit potential using the Scenario and Sensitivity trading tool and are happy, then click ‘trade now’ to enter the trade.
4. If you want to publish your strategy in the strategies marketplaceTM so other traders may view and trade your strategy, click the ‘publish’ button.
The Long Strangle
You would also use this strategy to trade an increase in volatility. It is very similar to the Long Straddle but the Call and Put have different strike rates.
EUR/USD Long Strangle example:
In the example above, the Call and Put have strike rates out-of-the-money, thus making both options cheaper to buy compared with at-the-money options. However, compared with a Long Straddle strategy, the underlying market needs to move further before one of the options is in-the-money.
The chart below shows a Long Strangle strategies’ profit or loss at expiry over a range of market rates. The letter A is the strike rate of the Put option and the letter B is the strike rate of the Call option. If the market moves far enough in either direction past the break-even points, the strategy is profitable. But if the market rate does not break out the strategy, it creates a loss.
Advantages:
- Can profit from a move in either direction
- It is cheaper to buy compared with a Long Straddle
- You will not get stopped-out and your maximum loss is limited to the premium paid at open
Disadvantages:
- Break-even points, at expiry, are further away compared with a Long Straddle (as observed in the chart)
- Time value is highly against you
Click here to learn more about the Long Straddle.
The Bull Spread
This strategy allows you to trade an expected rise in the underlying market and, at the same time, limits the loss and profit potential. To execute this strategy, you buy a Call and sell a Call, at the same time, with matching expiries and amounts but different strike rates. The strike rate of the sell Call option must be higher than the buy Call option.
It costs less than buying a Call option by itself because you pay a premium when you buy an option and you receive a premium when you sell. In this case, you are receiving some premium back through selling. However, the strike price of the sell option limits the profit.
EUR/USD Bull Spread example:
Step 1. Set-up a EUR/USD Call with strike rate at-the-money. It costs $785 USD as seen in the example below.
Step 2. Click ‘turn into strategy’ to add a line and sell an equivalent option with a higher strike. Since you are selling, you will receive a premium from this line. In this case, we placed the strike at +1% and received $168.81 back, hence the net premium to pay has been reduced to $592.65. This reduction also includes a discount on the spread charged, which is given when you simultaneously buy and sell an option of identical type.
The effect of adding a sell option has reduced the total premium to pay, but has also limited the profit potential. The profit is limited at the strike of the sell option no matter how high the market rate moves. In this example, if the market moves above 1% of its value at the time of opening the strategy, then the profit from the option will remain the same. You may treat this higher strike as your profit target.
The chart below shows a Bull Spread strategies’ profit or loss at expiry over a range of market rates. The letter A is the strike rate of the buy Call option and the letter B is the strike of the sell Call option. If the underlying market moves up past the break-even point, the strategy is profitable to a limit. But if the market rate moves down, then the strategy creates a limited loss.
A Bull Spread strategy can also be created through selling a Put and, at the same time, buying a Put with a lower strike price. The buy Put limits the loss of the sell Put. The lesson ‘Selling Options’ explains this in further detail.
The Bear Spread
This strategy is a similar concept to the Bull Spread, but you are trading an expected down trend through buying a Put and, simultaneously, selling a Put with a lower strike. Your total premium to pay is reduced through the sell Put option, but the strike rate of the sell option limits the profit potential.
EUR/USD Bear Spread example:
Buy a Put with a strike of 0% (at-the-money) and a sell Put with a strike of -1% (out-the-money). The total premium to pay is around $522. I.e., through the sell option, the maximum loss has been reduced by $225.
As the market rate falls, the strategy will return a profit. However, the profit is limited by -1% of the market’s value at the time of opening the strategy. No matter how far the market falls past this level, it will still return the same profit.
The chart below shows a Bear Spread strategies’ profit or loss at expiry over a range of market rates. The letter B is the strike rate of the buy Put option and the letter A is the strike rate of the sell Put option. If the underlying market moves down past the break-even point, the strategy is profitable to a limit. But if the market rate moves up, then the strategy creates a limited loss.
A Bear Spread strategy can also be created through selling a Call and, simultaneously, buying a Call with a higher strike price. The buy Call limits the loss of the sell Call. The lesson ‘Selling Options’ explains this in further detail.
Bull and Bear Spread Strategies
Advantages:
- You can reduce the premium, thus reducing your maximum risk in the market.
- The loss from time decay is less since you will receive decay from the sell option as you get closer to the expiry date.
Disadvantage:
- Potential profit is limited
