Modules for Traders
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Glossary: 12 terms related to options trading strategies
1. Bear call ladder
Also referred to as a short call ladder, the bear call ladder is an options strategy that’s used by traders during times of increased volatility and when the outlook of the market is likely to turn bullish. To set up this strategy:
- Sell 1 lot of in the money (ITM) call options
- Purchase 1 lot of at the money (ATM) call options
- Purchase 1 lot of out of the money (OTM) call options
2. Protective put
Also known as the married put, the protective put is an options strategy that’s generally used by traders to hedge their risk. One of the prerequisites for setting up a protective put is that you need to first own the shares of a company. Once you’ve bought the shares of a company, you would then need to purchase a put options contract of the stock. Make sure that the lot size of the put options contract matches the total number of shares that you own.
3. Bull ratio spread
The bull ratio spread is an options trading strategy that traders use when they have a bullish outlook, but the market doesn’t seem to move much. The strategy is designed to generate profits when the price of the asset moves up slightly. To set up this strategy:
- Sell 2 lots of out of the money (OTM) call options
- Purchase 1 lot of at the money (ATM) call options
4. Bear ratio spread
Also known as a put ratio spread, ratio put spread, and ratio bear spread, this options strategy is used by traders when they have a bearish outlook on an asset. The bear ratio spread allows you to generate profits when the price of the asset moves declines. To set up this strategy:
- Sell 2 lots of out of the money (OTM) put options
- Purchase 1 lot of at the money (ATM) put options
Also known as a hedge wrapper, the collar is an options strategy that’s generally used by traders to hedge short-term downside risks on a stock that they already own. In addition to limiting the losses, the collar options strategy also limits your profits. The strategy is useful for times when traders feel that a particular stock has good long-term growth potential but suffers from high short-term downside risk. To set up a collar trading strategy:
- Firstly, you need to own the shares of a company with an active derivatives segment.
- The next step is to sell an out of the money (OTM) call option contract of the stock.
- And finally, you need to buy an out of the money (OTM) put option contract of the same stock.
6. Calendar spread
Also known as time spread or horizontal spread, a calendar spread is an options trading strategy where you’re required to execute the same type of option for a given asset at the same strike price, but with different expiration dates. There are three versions of the calendar spread, namely:
- Bull calendar spread
- Bear calendar spread
- Neutral calendar spread
7. Iron condor
The iron condor is a market-neutral trading strategy. What this essentially means is that this particular options strategy can be used when the market is neither trending up nor trending down. The iron condor is quite famous among traders since it can allow them to take advantage of low volatility market conditions. To set up this strategy:
- Sell 1 lot of out of the money (OTM) put options
- Sell 1 lot of out of the money (OTM) call options
- Buy 1 lot of further out of the money (OTM) put options
- Buy 1 lot of further out of the money (OTM) call options
8. Butterfly spread
The butterfly spread is an options trading strategy that combines two other spread strategies - bull spread and bear spread. The strategy is market neutral and works best when the market itself has low volatility. And so, you get to enjoy maximum profits only when the market doesn’t move by much prior to expiry. The butterfly spread is designed to limit the downside risk and provide you with limited profits.
A butterfly spread involves four options contracts with three different strike prices, but with the same expiration date. And, all of the three strike prices should be equidistant from each other. There are five major variants of butterfly spreads, namely:
- Long call butterfly spread
- Short call butterfly spread
- Long put butterfly spread
- Short put butterfly spread
- Iron butterfly
9. Iron butterfly
The iron butterfly is a market-neutral options trading strategy. Designed to work in low-volatility environments, the iron butterfly strategy allows you to take advantage of range bound market situations. Although the strategy limits the maximum upside that you can enjoy, it helps you limit your downside risk as well. To set up this strategy:
- Buy 1 lot of put options at strike price A
- Sell 1 lot of put options at strike price B
- Sell 1 lot of call options at strike price B
- Buy 1 lot of call options at strike price C
The strike prices A, B, and C should be equidistant and in an ascending order in terms of value.
10. Max pain
Max pain is the strike price of an asset where the total number of open contracts, which includes both put option contracts and call option contracts, are the highest. Since max pain is essentially just a particular strike price of an asset, it is also referred to as the max pain price by options traders.
11. Max pain theory
The max pain theory or the maximum pain theory states that as the options expiry date comes closer, the price of an asset would always tend to move towards a strike price where the maximum number of options would expire worthless. And that this particular strike price would be the maximum pain strike price, since it would cause the maximum amount of pain (read losses) to the maximum number of options buyers.
It also states that the option buyers who hold onto their contracts till expiry will lose money. The reason for that can be attributed to the fact that option sellers typically hedge their positions, whereas option buyers don’t.
12. Put-Call ratio
The Put-Call ratio or the PCR is basically an indicator that allows traders to gauge the market sentiment to determine whether it is bullish or bearish. It is calculated using the following formula:
PCR ratio = Total number of traded puts ÷ total number of traded calls
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