Many people that trade options will use either puts or calls to define a position because they believe that the underlying security will either go up or down, and they choose the option to pay off if their assumption is correct. However, I generally don’t have a strong assumption about what the market will do, so I usually make trades that allow for some movement up or down- basically playing both sides of a potential move. Doing this usually involves the use of both puts and calls in the same trade. We’ll walk through these strategies to make sure you are familiar with them. For whatever reason, the naming of these kinds of trades gets a little wonky, not really obvious at first. When I first started trading options, I thought all of these were overkill, but in time I’ve come to rely on one of these strategies extensively. One key advantage of these kinds of trades is that the cash that covers the risk can cover both sides of the trade, because only one side of the trade can ever lose.
These trades use an equal amount of puts and calls. Some strategies use one call and one put, and others use two calls and two puts, selling one each and buying one each. We’ll start with those that use one of each.
The Strangle
A strangle is a position of one naked short put and one naked short call, both out of the money. The goal is for the underlying security price to stay between the strike price and have both options expire worthless. Since both positions are naked this is an undefined risk position that requires a cash margin because a large move either direction could mean a big loss. Approvals for these types of trades generally are the same as single naked short options, the highest approval for advanced traders.
The Straddle
A straddle is similar to the strangle, with one naked short put and one naked short call, but at the same strike price. Typically, these are sold at the money for a fairly large premium. The goal is for the underlying to move a small enough amount that the value of the position ends up less than it was sold for. Again, this strategy is an undefined risk position that requires the same high level of approval.
You may have noticed that I’ve portrayed both the Strangle and Straddle as short strategies. It is possible to buy long Strangles or Straddles, but these are very expensive and low probability trades that require a very large move one way or the other to pay off. At least one side of the trade will be a total loss, if not both. However, since they involve a long call and a long put, the risk is only what is paid to buy the position.
Synthetic Long Stock
For traders that want to have the same risk and return as shares of stock but at the price of an option, they can buy a call and sell a put at the same strike price. The cost is minimal. The profit and loss is the same as buying shares of stock. Since this trade involves selling a naked put, the put must be secured either by cash or margin. If by cash, then the trade is really the same risk and return as buying shares of the security.
Synthetic Short Stock
This is just the opposite of the synthetic long stock. With the purchase of a put and the sale of a call, this position is just like being short shares of the underlying security. Since there is a naked short call, the call needs to be secured with margin or stock.
Why would someone use this strategy? One possibility would be when an investor has a security with a large profit but a lot of uncertainty. The investor doesn’t want to sell the security because of the capital gain. So, by creating a synthetic short, the investor can cancel out any future move of the existing shares for almost no cost.
The Iron Condor
The iron condor uses four different options, two calls and two puts. A put is sold out of the money and another put is bought further out of the money for a net credit. At the same time, a call is sold out of the money and another call is bought further out of the money also for a net credit. Essentially, this is a combination of two credit spreads. The idea for profit is the same as the Strangle, the trader wants the underlying price to stay out of the money of all the options, and have all options expire worthless. The difference from the strangle is that the long options limit the risk to the distance between the long and short strike.
Why call it an iron condor? If you look at a graph of the profit and loss of an iron condor at expiration, it kind of looks like a big bird in flight, a condor. Additionally, bird terms are used to describe how far apart each of the strike prices are from each other. The difference between the short call and short put is called the body width. The difference between the two puts or the two calls is called the wing width. The wings don’t have to be the same width, although traditionally they are. Each width is in dollars, so you may describe a iron condor as $10 body width and $5 wide wings. Adjusting these widths impacts potential risk as well as the premium collected. We’ll discuss this strategy extensively later in the book because this is my top go to option only strategy.
The Iron Fly or Iron Butterfly
Depending on your broker, the name of this strategy may vary, but either way the strategy is the same. The Iron Fly is the same as an Iron Condor, but with the same strike price for both the short call and short put. Essentially this is an Iron Condor with a zero width body.
The profit/loss graph for the Iron Fly sort of resembles a butterfly. As just mentioned this strategy has no body width like the Iron Condor, just a wing width for the difference beween the calls and between the puts.
Like the straddle and strangle, iron condors and iron flies can be bought instead of sold, in this case as a pair of debit spreads instead of credit spreads. Going long in either is very expensive and low probability, and I can’t think of a good reason to do it.
