In finance, a trading strategy is a fixed plan that is designed to achieve a profitable return by going long or short in markets. The main reasons that a properly researched trading strategy helps are its verifiability, quantifiability, consistency, and objectivity.
Some of the commonly used trading strategies are as follows:
In a covered call (also called a buy-write), you hold a long position in an underlying asset and sell a call against that underlying asset. Your market opinion would be neutral to bullish on the underlying asset. On the risk vs. reward front, your maximum profit is limited and your maximum loss is substantial. If volatility increases, it has a negative effect, and if it decreases, it has a positive effect.
In a married put strategy, an investor who purchases (or currently owns) a particular asset (such as shares), simultaneously purchases a put option for an equivalent number of shares. Investors will use this strategy when they are bullish on the asset’s price and wish to protect themselves against potential short-term losses. This strategy essentially functions like an insurance policy, and establishes a floor should the asset’s price plunge dramatically.
In a bull call spread, you buy a call on the underlying asset while simultaneously writing (selling) a call on the same underlying asset with the same expiration month at a higher strike price. You should use it when you think the market will go up somewhat, or think it’s more likely to rise than fall (in other words, you have a bullish or moderately bullish outlook). Your likelihood for profit is limited, as is your risk, because the price paid for the call with the lower strike price is partially offset by the premium received from writing the call with a higher strike price, so you have less risk of losing the entire premium paid for the call.
In a bear put spread, you buy a put on an underlying asset while writing a put on the same underlying asset with the same expiration month, but at a lower strike price. You should use this strategy when you think the market will fall somewhat or is more likely to fall than rise, as you’re capitalizing on a decrease in the price of the underlying asset.
Another strategy used in options is calendar, or time, spreads. In a calendar spread, you establish your position by entering a long and short position at the same time on the same underlying asset, but with different expiration / delivery months.
A long straddle options strategy is when an investor purchases both a call and put option with the same strike price, underlying asset and expiration date simultaneously. An investor will often use this strategy when he or she believes the price of the underlying asset will move significantly e.g. around the time of Union Budget and/or Results of General Elections etc., but is unsure of which direction the move will take. This strategy allows the investor to maintain unlimited gains, while the loss is limited to the cost of both options contracts.
In a long strangle options strategy, the investor purchases a call and put option with the same maturity and underlying asset, but with different strike prices. The put strike price will typically be below the strike price of the call option, and both options will be out of the money. An investor who uses this strategy believes the underlying asset’s price will experience a large movement, but is unsure of which direction the move will take. Losses are limited to the costs of both options; strangles will typically be less expensive than straddles because the options are purchased out of the money.
In a butterfly spread options strategy, an investor will combine both a bull spread strategy and a bear spread strategy, and use three different strike prices. For example, one type of butterfly spread involves purchasing one call (put) option at the lowest (highest) strike price, while selling two call (put) options at a higher (lower) strike price, and then one last call (put) option at an even higher (lower) strike price.
A protective collar strategy is performed by purchasing an out-of-the-money put option and writing an out-of-the-money call option at the same time, for the same underlying asset (such as shares). This strategy is often used by investors after a long position in a stock has experienced substantial gains. In this way, investors can lock in profit without selling their shares.
A trading strategy in which an investor holds a long position in a security or commodity while simultaneously holding a short position in a futures contract on the same security or commodity. In a cash-and-carry trade, the security is held until the contract delivery date, and is used to cover the short position’s obligation.
A combination of a short position in an asset such as a stock or commodity, and a long position in the futures for that asset. Reverse cash-and-carry arbitrage seeks to exploit pricing inefficiencies for the same asset in the cash (or spot) and futures markets in order to make riskless profits. The arbitrageur or trader accepts delivery of the asset against the futures contract, which is used to cover the short position. This strategy is only viable if the futures price is cheap in relation to the spot price of the asset. That is, the proceeds from the short sale should exceed the price of the futures contract and the costs associated with carrying the short position in the asset.
The box spread, or long box, is a common arbitrage strategy that involves buying a bull call spread together with the corresponding bear put spread, with both vertical spreads having the same strike prices and expiration dates. The long box is used when the spreads are underpriced in relation to their expiration values.
A conversion is an arbitrage strategy in options trading that can be performed for a riskless profit when options are overpriced relative to the underlying stock. To do a conversion, the trader buys the underlying stock and offset it with an equivalent synthetic short stock (long put + short call) position.
On the other hand, A reversal, or reverse conversion, is an arbitrage strategy in options trading. that can be performed for a riskless profit when options are underpriced relative to the underlying stock. To do a reversal, the trader short sell the underlying stock and offset it with an equivalent synthetic long stock (long call + short put) position.