Options Trading Strategies: How to Use Spreads, Collars and Butterflies

Options Trading Strategies: How to Use Spreads, Collars and Butterflies

If you are interested in trading options, you may have heard of some common strategies such as spreads, collars and butterflies. These are ways of combining different options contracts to create a specific risk-reward profile that suits your trading goals. In this blog post, we will explain what these strategies are, how they work and when to use them.

Spreads

A spread is a strategy that involves buying and selling options of the same type (calls or puts) with different strike prices and/or expiration dates. The idea is to reduce the cost of the trade and limit the potential loss, while still profiting from a favorable move in the underlying asset.

There are two main types of spreads: vertical and horizontal. A vertical spread involves options with the same expiration date but different strike prices. For example, you can buy a call option with a strike price of $50 and sell a call option with a strike price of $55, both expiring in one month. This is called a bull call spread, because it profits from a rise in the underlying asset above $50. The maximum profit is the difference between the strike prices minus the net premium paid ($55 - $50 - net premium), and the maximum loss is the net premium paid.

A horizontal spread involves options with the same strike price but different expiration dates. For example, you can buy a call option with a strike price of $50 and expiration date in two months, and sell a call option with the same strike price but expiration date in one month. This is called a calendar spread, because it profits from a difference in time decay between the two options. The maximum profit is the difference between the premiums received and paid, and the maximum loss is the net premium paid.

Collars

A collar is a strategy that involves buying an asset and simultaneously buying a put option and selling a call option on it. The idea is to protect the asset from a large downside move, while giving up some upside potential. This is useful for investors who want to hedge their long positions or lock in some profits.

For example, you can buy 100 shares of XYZ stock at $50 per share, and buy a put option with a strike price of $45 and sell a call option with a strike price of $55, both expiring in one month. This is called a zero-cost collar, because the premium received from selling the call option offsets the premium paid for buying the put option. The maximum profit is the difference between the strike price of the call option and the purchase price of the stock ($55 - $50), and the maximum loss is the difference between the purchase price of the stock and the strike price of the put option ($50 - $45).

Butterflies

A butterfly is a strategy that involves buying and selling four options of the same type (calls or puts) with three different strike prices. The idea is to profit from a narrow range of movement in the underlying asset, while limiting the risk on both sides.

For example, you can buy one call option with a strike price of $45, sell two call options with a strike price of $50, and buy one call option with a strike price of $55, all expiring in one month. This is called a long call butterfly, because it profits from a rise in the underlying asset near $50. The maximum profit is the difference between the middle strike price and the lower strike price minus the net premium paid ($50 - $45 - net premium), and the maximum loss is the net premium paid.

Conclusion

These are some of the most popular options trading strategies that you can use to take advantage of different market scenarios. However, they are not without risks and require careful analysis and execution. If you want to learn more about options trading and how to apply these strategies in practice, you can join Forex Academy, a leading financial markets trading academy located in Port Harcourt, Nigeria. We offer courses, coaching and mentoring for traders of all levels, from beginners to professionals. Contact us today and start your journey to financial freedom!