3D Options Guide

  


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Strategy Credit / Debit Neutral Neutral to Bullish Bullish Very Bullish If Volatility Increases Time Decay
Buy Stock Debit n/a n/a
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Strategy Credit / Debit Very Bearish Bearish Bearish to Neutral Neutral If Volatility Increases Time Decay
Sell Stock Credit n/a n/a
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Strategy Credit / Debit Neutral If Volatility Increases Time Decay
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Long Call Spread

Long Call

A long call gives you the right to buy the underlying stock at strike price A.

Calls may be used as an alternative to buying stock outright. You can profit if the stock rises, without taking on all of the downside risk that would result from owning the stock. It is also possible to gain leverage over a greater number of shares than you could afford to buy outright because calls are always less expensive than the stock itself.

But be careful, especially with short-term out-of-the-money calls. If you buy too many option contracts, you are actually increasing your risk. Options may expire worthless and you can lose your entire investment, whereas if you own the stock it will usually still be worth something.

Long Call Spread

Long Call Spread

A long call spread gives you the right to buy stock at strike price A and obligates you to sell the stock at strike price B if assigned.

This strategy is an alternative to buying a long call. Selling a cheaper call with higher-strike B helps to offset the cost of the call you buy at strike A. That ultimately limits your risk. The bad news is, to get the reduction in risk, you’re going to have to sacrifice some potential profit.

Short Put Spread

Short Put Spread

A short put spread obligates you to buy the stock at strike price B if the option is assigned but gives you the right to sell stock at strike price A.

A short put spread is an alternative to the short put. In addition to selling a put with strike B, you’re buying the cheaper put with strike A to limit your risk if the stock goes down. But there’s a tradeoff — buying the put also reduces the net credit received when running the strategy.

Long Calendar Spread

Long Calendar Spread

When running a calendar spread with calls, you’re selling and buying a call with the same strike price, but the call you buy will have a later expiration date than the call you sell. You’re taking advantage of accelerating time decay on the front-month (shorter-term) call as expiration approaches. Just before front-month expiration, you want to buy back the shorter-term call for next to nothing. At the same time, you will sell the back-month call to close your position. Ideally, the back-month call will still have significant time value.

If you’re anticipating minimal movement on the stock, construct your calendar spread with at-the-money calls. If you’re mildly bullish, use slightly out-of-the-money calls. This can give you a lower up-front cost.

Because the front-month and back-month options both have the same strike price, you can’t capture any intrinsic value on the options. You can only capture time value. However, as the calls get deep in-the-money or far out-of-the-money, time value will begin to disappear. Time value is maximized with at-the-money options, so you need the stock price to stay as close to strike A as possible.

Protective Put

Protective Put

Purchasing a protective put gives you the right to sell stock you already own at strike price A. Protective puts are handy when your outlook is bullish but you want to protect the value of stocks in your portfolio in the event of a downturn. They can also help you cut back on your antacid intake in times of market uncertainty.

Protective puts are often used as an alternative to stop orders. The problem with stop orders is they sometimes work when you don’t want them to work, and when you really need them they don’t work at all. For example, if a stock’s price is fluctuating but not really tanking, a stop order might get you out prematurely. If that happens, you probably won’t be too happy if the stock bounces back. Or, if a major news event happens overnight and the stock gaps down significantly on the open, you might not get out at your stop price. Instead, you’ll get out at the next available market price, which could be much lower.

If you buy a protective put, you have complete control over when you exercise your option, and the price you’re going to receive for your stock is predetermined. However, these benefits do come at a cost. Whereas a stop order is free, you’ll have to pay to buy a put. So it would be nice if the stock goes up at least enough to cover the premium paid for the put.

Covered Call

Covered Call

Selling the call obligates you to sell stock you already own at strike price A if the option is assigned.
Some investors will run this strategy after they’ve already seen nice gains on the stock. Often, they will sell out-of-the-money calls, so if the stock price goes up, they’re willing to part with the stock and take the profit.

Covered calls can also be used to achieve income on the stock above and beyond any dividends. The goal in that case is for the options to expire worthless.

If you buy the stock and sell the calls all at the same time, it’s called a ”Buy / Write.” Some investors use a Buy / Write as a way to lower the cost basis of a stock they’ve just purchased.

Naked Put

Naked Put

Selling the put obligates you to buy stock at strike price A if the option is assigned.

When selling puts with no intention of buying the stock, you want the puts you sell to expire worthless. This strategy has a low profit potential if the stock remains above strike A at expiration, but substantial potential risk if the stock goes down. The reason some traders run this strategy is that there is a high probability for success when selling very out-of-the-money puts. If the market moves against you, then you must have a stop-loss plan in place. Keep a watchful eye on this strategy as it unfolds.

Long Put

Long Put

A long put gives you the right to sell the underlying stock at strike price A. If there were no such thing as puts, the only way to benefit from a downward movement in the market would be to sell stock short. The problem with shorting stock is you’re exposed to theoretically unlimited risk if the stock price rises.

But when you use puts as an alternative to short stock, your risk is limited to the cost of the option contracts. If the stock goes up (the worst-case scenario) you don’t have to deliver shares as you would with short stock. You simply allow your puts to expire worthless or sell them to close your position (if they’re still worth anything).

But be careful, especially with short-term out-of-the-money puts. If you buy too many option contracts, you are actually increasing your risk. Options may expire worthless and you can lose your entire investment.

Long Put Spread

Long Put Spread

A long put spread gives you the right to sell stock at strike price B and obligates you to buy stock at strike price A if assigned.

This strategy is an alternative to buying a long put. Selling a cheaper put with strike A helps to offset the cost of the put you buy with strike B. That ultimately limits your risk. The bad news is, to get the reduction in risk, you’re going to have to sacrifice some potential profit.

Short Call Spread

Short Call Spread

A short call spread obligates you to sell the stock at strike price A if the option is assigned but gives you the right to buy stock at strike price B.

A short call spread is an alternative to the short call. In addition to selling a call with strike A, you’re buying the cheaper call with strike B to limit your risk if the stock goes up. But there’s a tradeoff — buying the call also reduces the net credit received when running the strategy.

Put Calendar Spread

Put Calendar Spread

When running a calendar spread with puts, you’re selling and buying a put with the same strike price, but the put you buy will have a later expiration date than the put you sell. You’re taking advantage of accelerating time decay on the front-month (shorter-term) put as expiration approaches. Just before front-month expiration, you want to buy back the shorter-term put for next to nothing. At the same time, you will sell the back-month put to close your position. Ideally, the back-month put will still have significant time value.

If you’re anticipating minimal movement on the stock, construct your calendar spread with at-the-money puts. If you’re mildly bearish, use slightly out-of-the-money puts. This can give you a lower up-front cost.

Because the front-month and back-month options both have the same strike price, you can’t capture any intrinsic value. You can only capture time value. However, as the puts get deep in-the-money or far out-of-the-money, time value will begin to disappear. Time value is maximized with at-the-money options, so you need the stock price to stay as close to strike A as possible.

For this Playbook, I’m using the example of a one-month calendar spread. But please note it is possible to use different time intervals. If you’re going to use more than a one-month interval between the front-month and back-month options, you need to understand the ins and outs of rolling an option position.

Naked Call

Naked Call

Selling the call obligates you to sell stock at strike price A if the option is assigned.

When running this strategy, you want the call you sell to expire worthless. That’s why most investors sell out-of-the-money options.

This strategy has a low profit potential if the stock remains below strike A at expiration, but unlimited potential risk if the stock goes up. The reason some traders run this strategy is that there is a high probability for success when selling very out-of-the-money options. If the market moves against you, then you must have a stop-loss plan in place. Keep a watchful eye on this strategy as it unfolds

Iron Condor

Iron Condor

You can think of this strategy as simultaneously running an out-of-the-money short put spread and an out-of-the-money short call spread. Some investors consider this to be a more attractive strategy than a long condor spread with calls or puts because you receive a net credit into your account right off the bat.

Typically, the stock will be halfway between strike B and strike C when you construct your spread. If the stock is not in the center at initiation, the strategy will be either bullish or bearish.

The distance between strikes A and B is usually the same as the distance between strikes C and D. However, the distance between strikes B and C may vary to give you a wider sweet spot (see Options Guy’s Tips below).

You want the stock price to end up somewhere between strike B and strike C at expiration. An iron condor spread has a wider sweet spot than an iron butterfly. But (as always) there’s a tradeoff. In this case, your potential profit is lower.

Iron Butterfly

Iron Butterfly

You can think of this strategy as simultaneously running a short put spread and a short call spread with the spreads converging at strike B. Because it’s a combination of short spreads, an iron butterfly can be established for a net credit.

Ideally, you want all of the options in this spread to expire worthless, with the stock at strike B. However, the odds of this happening are fairly low, so you’ll probably have to pay something to close your position.

It is possible to put a directional bias on this trade. If strike B is higher than the stock price, this would be considered a bullish trade. If strike B is below the stock price, it would be a bearish trade.

Double Diagonal

Double Diagonal

At the outset of this strategy, you’re simultaneously running a diagonal call spread and a diagonal put spread. Both of those strategies are time-decay plays. You’re taking advantage of the fact that the time value of the front-month options decay at a more accelerated rate than the back-month options.

At first glance, this seems like an exceptionally complicated option strategy. But if you think of it as capitalizing on minimal stock movement over multiple option expiration cycles, it’s not terribly difficult to understand how it works.

Typically, the stock will be halfway between strike B and strike C when you establish the strategy. If the stock is not in the center at this point, the strategy will have a bullish or bearish bias. You want the stock to remain between strike B and strike C, so the options you’ve sold will expire worthless and you will capture the entire premium. The put you bought at strike A and the call you bought at strike D serve to reduce your risk over the course of the strategy in case the stock makes a larger-than-expected move in either direction.

You should try to establish this strategy for a net credit. But you may not be able to do so because the front-month options you’re selling have less time value than the back-month options you’re buying. So you might choose to run it for a small net debit and make up the cost when you sell the second set of options after front-month expiration.

As expiration of the front-month options approaches, hopefully the stock will be somewhere between strike B and strike C. To complete this strategy, you’ll need to buy to close the front-month options and sell another put at strike B and another call at strike C. These options will have the same expiration as the ones at strike A and strike D. This is known as “rolling” out in time. See rolling an option position for more on this concept.

Most traders buy to close the front-month options before they expire because they don’t want to carry extra risk over the weekend after expiration. This helps guard against unexpected price swings between the close of the market on the expiration date and the open on the following trading day.

Once you’ve sold the additional options at strike B and strike C and all the options have the same expiration date, you’ll discover you’ve gotten yourself into a good old iron condor. The goal at this point is still the same as at the outset—you want the stock price to remain between strike B and C. Ultimately, you want all of the options to expire out-of-the-money and worthless so you can pocket the total credit from running all segments of this strategy.

Some investors consider this to be a nice alternative to simply running a longer-term iron condor, because you can capture the premium for the short options at strike B and C twice.