Options trading is indeed complex due to the large number of possible trade types that open up to you. Despite its initial complexity, options trading is worth learning exactly because it makes available trading strategies impossible with just stock trading. Options markets actually came before stock markets (Japanese farmers used to buy options on rice yields) and thus options are not a meme trading vehicles invented by get-rich schemers (I’m looking at you, dogecoin and binary options); nor are they overly complex financial instruments created by Wall Street fat-cats (e.g., 2008’s mortgage bundles).
Historically, options were used to speculate on a commodity without buying it outright. The options we are talking about today are those used to speculate on stocks or exchange-traded products (ETPs). Quite simply, options can be used to speculate on a stock or fund without having to directly buy said stock or fund.
Two option types exist: Calls, which allow you to speculate on an upward movement in a stock; and puts, which allow you to speculate on a downward movement in a stock. The cost of an option is much lower than buying or shorting the targeted stock (we call this stock the “underlying”) but buying a call or put comes with disadvantages. For example, an option’s price decays over time and decreases when volatility in the underlying decreases.
However, good option traders are not always affected by these disadvantages because they rarely only buy calls or buy puts. Good option traders use combinations of calls and puts, both long and short (long = buying; short = selling), to create a strategy suitable for a given situation. They also choose their options’ strike prices and expiration dates carefully.
Let’s take a look at some example option strategies. But first, some important terminology:
- ATM: At the money (the option’s strike price is roughly the same as the underlying’s price)
- ITM: In the money (for a call: the option’s strike price is below the underlying’s price; for a put: the option’s strike price is above the underlying’s price)
- OTM: Out of the money (for a call: the option’s strike price is above the underlying’s price; for a put: the option’s strike price is below the underlying’s price)
Short Put Ladder
The short put ladder is a spread (an options strategy that uses different options of different strike prices) with three strike prices:
- Buy far OTM put
- Buy near OTM put
- Sell ATM put
If you have ever wanted to short stock but are afraid of the risk of doing so, a short put ladder can completely cap your risk while still giving you a short position. What’s more, if you are wrong about the stock falling – which happens often with short speculations – you can still profit on the upside with a short put ladder. To see how this works, imagine QQQ (the ETF that tracks the NASDAQ) is trading at $207.
You can open a short put ladder via:
- Buy $202 QQQ put
- Buy $205 QQQ put
- Sell $207 QQQ put
I’m looking at the options data right now, and such a play would actually come at a net credit. The two long puts would cost you $100 in total, while the short put is sold at $120. Thus, you open this strategy at a net credit (you get paid to open the position) of $20.
The strategy pays off to a great degree if QQQ drops significantly, as you hold more puts long than short. But the main reason I like this spread is the probability of profit, which is roughly 80% of the time, due to being opened at a net credit. You get all of the potential profit of shorting a stock without the risk; indeed, if QQQ moves upward or trends sideways, you still profit, as you opened the position at a net credit.
Call Diagonal Spread
This is a spread, like above, but involves choosing different expiration dates in addition to different strike prices:
- Buy long-dated ATM call
- Sell short-dated OTM call
Example:
- Buy QQQ Jan $207 call
- Sell QQQ Dec $208 call
If you have ever thought a stock is going to rise but have not been entirely sure, the call diagonal spread is for you. This option allows you to profit whether the underlying rises or stays trending sideways. The fact that your ATM call is long-dated means that you can hold this strategy for a long period of time, after the short-dated OTM call has expired, and still be long on the stock, allowing you to capture future breakouts.
Compared to buying a long call by itself, the call diagonal spread is cheaper, as the short call helps finance the long call (in the example above, the strategy costs $60 total, $95 cheaper than the long ATM calls alone). The strategy still loses should the underlying fall or rally too quickly. But in general, the only risk is on the downside, as the long ATM call tends to gain in value more quickly than the short OTM call when the underlying rallies.
Deep ITM Call Credit Spread
This is a vertical spread and the simplest of the above strategies in construction. However, it is complex in its use. Let’s look at the design first:
- Buy ITM call
- Sell far ITM call
People often say options are risky. They must be unfamiliar with the deep ITM call credit spread. This strategy has perhaps the best risk/reward option strategy of all trading strategies overall.
Usually, call credit spreads are bearish speculative strategies that use ITM and ATM calls. However, by using only ITM calls, our maximum loss often becomes mere dollars, while the potential profit is usually in the hundreds of dollars. We are still positioned to profit from a downward move in the underlying, as long as it moves under the higher of the strike prices. Here is an example:
- Buy QQQ $206 call
- Sell QQQ $200 call
Calculate your max loss by multiplying the difference in strike prices by 100 and subtracting from that the net credit you received from opening the position. Currently, QQQ $206 calls cost $220, and $200 calls cost $750.
Thus, the maximum loss for this strategy is 6x100 - (750 - 220) = $70. The max profit, however, is the credit received for open the play: $750 - $220 = $530. This gives a risk/reward of 530/70, which is crazy good.
Trading Options in 2020
In the past, brokerages charged both commissions and per-option fees to trade options. Now, most brokerages (but not all; see below) have done away with commissions, making options trading more profitable for the average trader. But be aware that most popular brokerages still charge per-option fees.
The exception is Webull (affiliate link), on which you can trade options for free:
| Brokerage | Options Commission |
| Webull | $0 Commission + $0 Contract Fees |
| TD Ameritrade | $0 Commission + $0.65 Contract Fee |
| Fidelity | $0 Commission + $0.65 Contract Fee |
| Schwab | $0 Commission + $0.65 Contract Fee |
| Merrill Edge | $6.95 Commission + $0.75 Contract Fee |
In addition, you get 1 or 2 free stocks when you sign up with Webull. The only downside is that their options trading platform is new, meaning educational material specifically for their platform is virtually non-existent. However, Webull has reached out to me to provide Webull users with option-trading education specifically for their platform.
So, going forward, I’ll be walking you guys through trading options with Webull. Send me any questions or requests you might have.
Sign up for Webull here:
https://act.webull.com/k/15vZV5FdphnG/main
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