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Option Combinations

Lesson 6 of 7
Duration 5:39
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There are several well-defined multi-leg option strategies, otherwise known as spreads. Each strategy has its own particular risk and rewards and investors will trade a specific strategy based on predictions they have on the price of the underlying. This course covers six of the most popular strategies.

Study Notes:

Technically any multi-leg option combination is considered a spread. However, there are well-defined option combination strategies that are used by investors when they believe the underlying price will behave in a certain way. This lesson will provide a brief overview of six popular strategies:

  • Straddles,
  • Strangles,
  • Iron Condors,
  • Butterflys,
  • Vertical Spreads, and
  • Calendar Spreads

For more information on option strategies please review the option strategy courses in Traders’ Academy. Any profit or losses described may not consider other expenses such as commission or exchange fees.

What is a Straddle?

A long straddle is a position where the investor is long both the call and put in the same strike in the same expiration. If the investor believes the underlying price will move a certain percentage within a certain time frame but is unsure if it will rise or fall, they may buy a long straddle. A long straddle has unlimited upside profit, and the downside profit is only limited by the stock price going to 0.

An investor may want to sell the straddle if they felt that the price of the underlying was going to stay within a certain range up to expiration to take in the premium. A short straddle has unlimited upside risk, and the downside risk is only limited by the stock going to zero.

What is a Strangle?

A strangle is like a straddle, except that the calls and puts have different strikes. The buyer is long both the call and the put and the seller is short both the call and the put. The premium is lower for the spread, but the stock must move a greater difference for the buyer to realize a profit or the seller to realize a loss. Like a long straddle, a long strangle has unlimited profit potential on the upside and is limited only by the underlying going to zero.    

What is an Iron Condor?

An iron condor is a delta neutral strategy composed of a long and short put and a long and short call in which the buyer of the iron condor will profit when the underlying stays within a certain range and the seller will profit when the underlying moves out of that range.  Unlike the straddle and strangle the long iron condor has limited upside and downside profit and the short iron condor has limited upside and downside risk.

What is a Butterfly?

 A butterfly combines bull and bear spreads using three strikes and four options. Two contracts in an at-the-money strike and one contract in each “wing”; an out-of-the-money and an in-the-money strike. The wings are equidistant from the at-the-money strike.   A long butterfly consists of buying the wings and selling the middle. A buyer of the butterfly profits if the stock moves and the seller profits if it stays within a certain range. A butterfly has limited risk and profit potential based on the strikes chosen.

What is a Vertical Spread?

A vertical spread consists of a long and short option in the same underlying, same expiration, same option right, and different strikes. The vertical spread allows the investor to minimize risk while potentially profiting from a directional move in the underlying. The four main types of vertical spreads; bull call, bear call, bull put, and bear put. A bull call spread is also a debit call spread where the investor buys the lower call strike and sells the higher strike benefitting from an upside move. A bull put spread or put credit spread    payout chart looks like the bull call spread except that the investor is selling the higher put strike and buying the lower put strike taking in a credit.

A bear put spread also known as a put debit spread and a call bear spread, or call credit spread payout chart look alike.  In a bear put spread the investor buys the higher put strike and sells the lower put strike whereas in the call bear spread the investor sells the lower call strike and buys the higher call strike.

For the two credit spreads the maximum profit is the premium taken in from the sale of the spread and the maximum loss is the distance between the strikes minus the premium.

For the two debit spreads the maximum loss is the premium paid for the spread and the maximum profit is the distance between the two strikes minus the premium paid.

What is a Calendar Spread?

A calendar spread consists of a long and short position in the same option right but in two different expirations. If the positions are in two different strikes than it is diagonal calendar spread and if they are in the same strike than it is a horizontal calendar spread. Generally, an investor sells the nearer expiration and buys the longer-term expiration looking to profit as the short-term option value decays quicker than the long-term and the underlying remains within a small trading range.

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Disclosure: Interactive Brokers

The analysis in this material is provided for information only and is not and should not be construed as an offer to sell or the solicitation of an offer to buy any security. To the extent that this material discusses general market activity, industry or sector trends or other broad-based economic or political conditions, it should not be construed as research or investment advice. To the extent that it includes references to specific securities, commodities, currencies, or other instruments, those references do not constitute a recommendation by IBKR to buy, sell or hold such investments. This material does not and is not intended to take into account the particular financial conditions, investment objectives or requirements of individual customers. Before acting on this material, you should consider whether it is suitable for your particular circumstances and, as necessary, seek professional advice.

The views and opinions expressed herein are those of the author and do not necessarily reflect the views of Interactive Brokers, its affiliates, or its employees.

Disclosure: Options Trading

Options involve risk and are not suitable for all investors. Multiple leg strategies, including spreads, will incur multiple commission charges. For more information read the "Characteristics and Risks of Standardized Options" also known as the options disclosure document (ODD) or visit ibkr.com/occ

Disclosure: Options (with multiple legs)

Options involve risk and are not suitable for all investors. For information on the uses and risks of options, you can obtain a copy of the Options Clearing Corporation risk disclosure document titled Characteristics and Risks of Standardized Options by clicking the link below. Multiple leg strategies, including spreads, will incur multiple transaction costs. "Characteristics and Risks of Standardized Options"

Disclosure: Multiple Leg Strategies

Multiple leg strategies, including spreads and straddles, will incur multiple commission charges.

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