Options Trading Strategies: Advanced Techniques for Maximising Returns
Finding the Optimal Risk-Reward to Maximise Returns
Options trading offers unique opportunities to increase returns and profit from various market conditions. Not only can option traders benefit from directional trades in bullish and bearish markets, but they can also have opportunities in markets that are moving sideways. Combining different option positions or options with the underlying asset positions can be tailored to varying expectations of market direction, volatility and time horizon. By understanding the interactions between the market's direction, time and volatility, options traders can gain an edge in their trading.
To maximise returns, option traders need to consider the risk-reward trade-off of the option strategy before making the trade. Risk management is critical in achieving the optimal risk-to-reward in any trade. Traders look for opportunities with high returns from lower-risk investments. Option strategies that combine low risk with minimal potential losses, thereby limiting downside risk and a high probability of profit considering the trader's market outlook, will be the choice criteria for options traders.
Strategies For Reducing Risk and Maximising Profits
Options strategies for reducing risk and maximising potential profits involve combining different options to produce the required risk-reward profile. The following option combinations are the popular strategies for achieving the profile of reduced risk with high probability profit potential.
Long Straddle
The straddle is an options strategy where you buy a call option with the view that the market will go up and a put option with the view that the market will go down at the same strike price and expiration rate. Since you hold both a call and a put, it does not matter which direction the market moves in as long as it moves significantly.
Example:
Suppose FTSE Bursa Malaysia KLCI Futures (FKLI) at 1600.
You buy one FTSE Bursa Malaysia KLCI Options (OKLI) at the money call and put at the strike price of 1600 for the same expiration. Figure 1 below demonstrates thepotential profits from significant moves in either direction for the straddle strategy.
This strategy is best suited when you expect high volatility but you are unsure if the price will rise or fall, for example, before major events such as earnings reports, central bank announcements, or any situation likely to cause significant volatility.
Figure1: OKLI Straddle Strategy – Buy 1 Call & Buy 1 Put at the same strike at 1600 for the same expiration
Long Strangle
A long strangle is executed by buying an out-of-the-money call and an out-of-the-money put at different strike prices for the same expiration. The strangle is cheaper than a straddle because you purchase the options a bit further from the current price. However, you still benefit if the price moves significantly in either direction.
Example:
Suppose FKLI at 1600.
You buy one OKLI out-of-the-money call at 1610
- You buy one OKLI out-of-the-money put at the strike price of 1590 for the same expiration.
- The diagram for the straddle strategy is in Figure 2 below, which shows the potential profits from significant moves in either direction.
- The advantage of the strangle over the straddle strategy is the lower cost, thus the lower potential loss. However, for the strangle to be profitable, the FKLI must move even further than in the straddle.
Figure 2: OKLI Strangle Strategy- Buy 1 Call at 1610 & Buy 1 Put at 1590
Long Iron Butterfly
A long iron butterfly is a combination of 4 options with the same expiration date. It involves:
- Selling one at-the-money call option
- Selling one at-the-money put option with the same strike as the call
- Buying one out-of-the-money call option with a higher strike than the at-the-money call
- Buying one out-of-the-money put option with a lower strike than the at-the-money put
Example:
Suppose FKLI at 1600.
- You sell 1 OKLI at-the-money call option at 1600;
- You sell 1 OKLI at-the-money put option at 1600;
- You buy 1 OKLI out-of-the-money call option at 1650;
- You buy 1 OKLI out-of-the-money put option at 1550.
The long iron butterfly is a limited-risk, limited-reward options strategy that profits when the underlying asset's price stays close to the middle strike price at expiration.
You aim to benefit from low volatility and the maximum profit achieved if the underlying asset price expires near the middle of the short call or short put strikes. In the example above, the maximum profit is achieved when the option expires with the underlying asset FKLI at or near 1600.
The maximum loss is limited and occurs when the underlying price moves sharply in either direction beyond the long put or call strike prices. The loss is the difference between the strike prices of the bought and sold options minus the premium received. (See Figure 3)
Figure 3: OKLI Long Iron Butterfly Strategy – Buy 1 Call at 1650, Sell 1 Call & Sell 1 Put at 1600, Buy 1 Put at 1550
Long Iron Condor Spread
A long iron condor is a combination of 4 options with the same expiration date. It involves:
- Selling one out-of-the-money call option
- Buying one further out-of-the-money call option
- Selling one out-of-the-money put option
- Buying one further out-of-the-money put option
Example:
- Suppose FKLI at 1600.
- You sell 1 OKLI out-of-the-money call at 1620
- You buy 1 OKLI further out-of-the-money call option at 1650
- You sell 1 OKLI out-of-the-money put option at 1580
- You buy 1 OKLI further out-of-the-money put option at 1550
The long iron condor is another limited risk, limited reward strategy that profits when the underlying asset's price stays within a specific range. You want to profit from low volatility, similar to the long iron butterfly strategy.
In the above case, the maximum profit is achieved when OKLI stays between the strike prices of the two sold options, 1580 and 1620. The profit is the net premium received, the difference between the premiums of the sold and bought options.
The maximum loss occurs if the underlying price moves sharply beyond the long put or long call strike prices. The loss is the difference between the strike prices of the call or put spread minus the premium received. (See Figure 4)
Figure 4: OKLI Long Iron Condor Strategy – Sell 1 Call at 1620, Sell I Put at 1580, Buy 1 Call at 1650 & Buy 1 Put at 1550
Delta Neutral Strategies
The four strategies above, the straddle, strangle, iron butterfly and iron condor, are called delta-neutral strategies. Delta-neutral strategies aim to eliminate or minimise exposure to market direction and primarily focus on time decay and volatility. A delta-neutral options trader seeks to profit regardless of market direction while maximising profit with minimal potential risk.
There are downsides to the delta-neutral options strategies, amongst which is the difficulty in setting up and managing the positions since they are combinations of various options.
Other considerations when putting on delta-neutral strategies are: -
- Increased risk of slippage and execution risk, where one leg of the trade is filled at a less favourable price.
- Continuous monitoring of the positions and adjustments may be needed to rebalance the delta.
- High transaction costs due to the many legs of the strategy.
- The limited profit potential of delta-neutral strategies is aimed at consistency and may miss out on prominent trends or market moves.
Despite the above drawbacks, delta neutral strategies are considered as high probability strategies as they allow for smaller and more consistent gains. By capturing consistent profits with limited risk, these strategies allow you to maximise your returns.
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