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In Low Risk Options Strategy we’ll take a look at a trading strategy designed for the modern market: the zero-cost cylinder.
To setup a zero-cost cylinder a trader buys a call and sells a put, or sells a call and then buys a put, with both options being out of the money. From buying the call the trader guarantees participation in the increasing price of the option. Selling the put obliges that the trader buy the option at the agreed price if it gets to that point. This strategy is tailored to protect the trader from the risk that the underlying asset will rise or fall to a defined price in the future. The strike price that’s chosen is so the premium collected from the sale of the option is identical to the premium used in buying the other option.
For example, if the underlying asset trades at $100, a trader could buy a put option with a $95 strike price at $0.95 and sell a call with a $104 strike price for $0.95. As both premiums are equal the net cost of this trade is zero.
It isn’t always feasible to carry out this strategy as the option’s premiums do not always match. That being the case, traders can determine how close to a net cost of zero they want to be. Selecting puts and calls that are out of the money by different strikes can generate a net credit or net debit to the account. The more out of the money the option, the lower its premium is. For that reason, to generate a collar with a small cost, the trader can select a call option that is noticeably out of the money than the corresponding put option is. In the earlier example, that might be a strike price of $105.
To generate a collar with a credit to the account, traders would do the reverse— select a put option that’s farther out of the money than the corresponding call. In the example, that might be a strike price of $94.
When the option’s expire, the greatest loss would be the price of the stock at the lower strike price, even if the underlying stock price plummets. The greatest gain would be the price of the stock at the higher strike, even if the underlying stock value jumps to new highs. If the stock closed inside the strike prices there would be no affect on its value.
If the collar did bring about a net cost, or debit, then the profit would be decreased by that outlay. If the collar brought about a net credit then that sum is carried to the total profit.
Low Risk Options Strategy Conclusion
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