Options strategies: building the hand.

01Four building blocks

Every strategy, however exotic its name, is built from four pieces:

• Buy a call: gains if the stock rises; the most you lose is the premium.
• Sell a call: collects the premium; loses if the stock rises, without limit.
• Buy a put: gains if the stock falls; the most you lose is the premium.
• Sell a put: collects the premium; loses if the stock falls, down to a stock price of zero.

Add the pieces' payoffs together at every stock price and you have the strategy's payoff. That's all a strategy is. The usual reason to combine them: buy the piece you want, and sell another to pay for part of it, giving up some upside you didn't expect to need.

02Three dials: direction, movement, time

Every options position is a bet on three things at once, and the Greeks measure each:

• Direction, measured by delta: will the stock rise or fall? A delta of +30 shares means the position gains about $30 for each $1 rise.
• Movement: how much the stock actually moves, and how much the market expects it to. The second is measured by vega: positive vega gains when the volatility priced into options rises. The two usually go together, but not always, as the calendar spread below shows.
• Time, measured by theta: positive theta collects a little each calendar day nothing happens; negative theta pays it. That daily payment is the price of carrying the risk that something does happen.

The useful habit: before choosing a strategy, decide your view on all three. "I think it rises, but not by much, and not soon" points to a different shape than "something big is coming, I don't know which way." Each strategy below ends with its reading on the three dials.

The dials are readings for today's price and today's date, not settings. Move the stock and all three change; traders call the speed at which delta changes gamma. For anyone selling options that is the catch: the theta collected each day is pay for a delta that turns against you as the stock nears a short strike, and the theta shrinks as it gets there.

03Vertical spreads

A vertical spread buys one option and sells another of the same type and expiry at a different strike. (Vertical, because the two strikes sit one above the other on an option chain.) It caps both the gain and the loss. A debit spread costs money up front; a credit spread pays you up front, and you keep the payment if the stock behaves.

• Bull call spread: buy the $100 call, sell the $110 call. Costs about $3.55 instead of $5.43, makes at most $6.45 if the stock ends at $110 or above, and breaks even at $103.55. A cheaper bet on a rise, with the upside capped.
• Bear put spread: buy the $100 put, sell the $90 put. Costs $3.33, makes at most $6.67 at $90 or below. The mirror image, on a fall.
• Bull put spread (a credit spread): sell the $100 put, buy the $90 put. You collect $3.33 up front and keep it if the stock stays above $100; the most you can lose is $6.67, if it ends at or below $90.
• Bear call spread (a credit spread): sell the $100 call, buy the $110 call. Collect $3.55; keep it if the stock stays below $100.

On the same two strikes, a debit spread and a credit spread are nearly the same bet. A bull put spread on $100 and $110 (sell the $110 put, buy the $100 put) collects $6.36 and risks $3.64: the bull call spread's $3.55 cost and $6.45 gain, turned around, give or take ten cents of interest. That is put-call parity at work.

The bull put spread in the list sits lower, on $90 and $100, and that changes the bet. It wins anywhere above $96.67, so it is a bet that the stock doesn't fall much, not that it rises. It wins more often than it loses, and the price says so: $3.33 to risk $6.67. A debit spread needs the move to happen; a credit spread needs it not to happen against you.

So the real choice is the strikes. A debit spread further from today's price costs less and pays off less often; a credit spread further out collects less and keeps it more often. The premium is the market's price for that trade-off.

The dials: a vertical is mostly a bet on direction, with a delta of about 30 shares either way at these strikes. Time works against the debit spreads and for the credit spreads; their exposure to volatility is a fraction of a straddle's.

04Straddles and strangles

• Long straddle: buy the $100 call and the $100 put for $9.88. Wins if the stock moves far either way, past $90.12 or $109.88. A bet on movement, not direction.
• Long strangle: buy the $90 put and the $110 call for $3.00. Cheaper, but the stock has to move further: past $87.00 or $113.00.
• Short straddle and strangle: sell them instead. You collect the premium and win if the stock stays quiet; the loss on a big move has no limit on the upside.

The market knows when news is coming, and prices it in. At 25% volatility one standard deviation of the 90-day move is about $12.40. The average move, up or down, is about $9.90, and the $9.88 straddle costs almost exactly that. Held to expiry, a long straddle pays only if the move beats what was already priced; a short one is a bet that it won't.

Closed early, which is how most are, a straddle is also a bet on the volatility priced in. Buy one before earnings and the drop in that volatility once the news is out can take back the gain even when the stock moves.

The dials: no direction; long volatility (a long straddle gains about $39 a contract for each point the volatility priced in rises); time hurts, by about $5.46 a day. The short versions read the other way.

05Butterflies and iron condors

These are bets that the stock ends in a range, with the loss capped on both sides.

• Call butterfly: buy the $90 call, sell two $100 calls, buy the $110 call. Costs about $3.02; makes at most $6.98 if the stock ends exactly at $100, and wins anywhere between $93.02 and $106.98. Cheap, with a sharp peak: a bet on a pin, the stock closing right on a strike.
• Iron condor: sell the $95 put and the $105 call, buy the $85 put and the $115 call as protection. Collect $4.28; keep it all if the stock ends between $95 and $105, lose at most $5.72 beyond the wings (the outer options bought as protection). Wins between $90.72 and $109.28.
• Iron butterfly: the same idea with both short options at $100 and wings at $90 and $110. Collect about $6.88, lose at most $3.12, and win between $93.12 and $106.88.

The dials: no direction; short volatility; time helps. The iron condor collects about $2.35 a calendar day per contract while nothing happens, and loses about $17 for each point the volatility priced in rises. It is a short volatility position with a seat belt. The butterfly reads the same way, more gently.

06Calendar spreads

A calendar spread uses the same strike and different expiries. Sell the 30-day $100 call for $3.02 and buy the 90-day $100 call for $5.43: a cost of $2.41. The short-dated option loses value faster, so if the stock is still near $100 when it expires, the long one is worth about $4.36 and the spread has made $1.95. Move far either way and it loses. A calendar is a bet on time and on the stock staying near the strike. It has one twist: it gains if the volatility priced into options rises, because the longer-dated option it owns is more sensitive to that than the one it sold. Quiet stock, nervous market: that is the calendar's ideal.

The dials: no direction; long volatility; time helps while the stock stays near the strike.

07Collars

A collar protects a stock you already own: buy a $90 put as insurance, and pay for it by selling a $110 call. Here the call brings in a little more than the put costs, a net credit of $0.77, and the stock plus the options is worth no less than $90 and no more than $110 a share at expiry. Your result runs from a loss of $9.23 to a gain of $10.77 a share. People use collars to hold a large position through a risky stretch without selling it.

The dials: still a bet on the stock rising, but with about 57 shares of exposure per 100 owned instead of 100; little exposure to volatility.

08Try it: the strategy builder

Pick a strategy and the builder prices it, draws its payoff and reads its three dials back to you in words on the "A bet on" line. The gold line is profit at expiry (for a calendar, at the near expiry); the dashed line is what you would get closing today. Most spreads are closed, not held to expiry.

Four things to try:

1. The strike is the trade-off. Bull call spread: move Strike 2 from $110 to $120. The cost rises from $355 to $492 a contract and the best case from $645 to $1,508, but the breakeven moves up to $104.92.
2. The dials move. Iron condor: set the stock to $105, right on the short call. Delta goes from −2 to −14 shares, so the position now loses as the stock rises, and the daily theta drops from $2.35 to $1.86.
3. The volatility crush. Long straddle: drop volatility from 25% to 15%. The price falls from $988 to $596 a contract; a straddle you already owned would lose about that much the moment the market calmed down.
4. The calendar's twist. Calendar spread (it opens at 30 days, with the long call 60 days later): raise volatility from 25% to 35%. Its value rises from $241 to $323 a contract.

09Which shape for which view

10What can go wrong

• "Defined risk" isn't low risk. A credit spread that collects $3.33 to risk $6.67 can lose twice what it earns, and a run of small wins can be erased by one loss.
• Costs multiply with legs. Four options means four commissions and four bid-ask spreads, which can eat a large share of a small credit.
• Early assignment. Short options on individual US stocks can be exercised at any time, which can break a spread apart, especially just before a dividend.
• Expiry surprises. A stock that closes right at a short strike leaves you unsure whether you'll be assigned until the notice arrives the next business day, and the stock can move after hours in between.
• The model isn't the market. Real option prices include a volatility skew and a bid-ask spread; the builder's Black-Scholes prices are a guide, not a quote.