Learn how to trade options, even in volatile markets, using neutral strategies.

Neutral options trading strategies are employed when a trader believes that an underlying asset price will move, but is unsure of the direction. As the potential for profit with these strategies doesn’t depend on the direction in which the price moves, but the amount it moves, neutral options strategies can be useful for trading in volatile markets, or for taking advantage of volatility following surprise economic and company announcements. Neutral strategies include butterfly spread, straddle, strangle and risk reversal.

Butterfly spread

Butterfly spreads are used when the future volatility of the underlying asset is expected to be different to the implied volatility, or the volatility that is implied by the market price of the option, taking the option pricing model into account. The main benefit of using butterfly spreads is that they are a capped-risk strategy.

Long butterfly

A long butterfly position will make a profit if the future volatility is lower than the implied volatility, and the maximum profit will occur if the price doesn’t move at all.

To enter a butterfly trade, a trader would purchase to call options on the same underlying asset with the same expiration date with different strike prices. A the same time, the trader would sell two call positions on the same asset with the same expiration date, with a strike price halfway between the two call options he bought.

If Macquarie Group shares are priced at $30, the trader could buy one $40 call option and one $20 call option. If these options were priced at $1 a share, the price of the options contracts would be $2,000 ($1 x 1,000 shares x 2 contracts). He would also sell two $30 call options – if these were priced at $0.50 a share, he would receive a $1,000 premium ($0.50 x 1,000 shares x 2 contracts), which would lower his initial debit to $1,000.

If the share price remains static, the $30 and $40 call options would expire, worthless. Meanwhile, the profit on the $20 option is $10 per share ($30 share price – $20 option = $10), or $10,000 for the entire contract. The maximum profit is therefore the profit on that option, minus the initial debit.

The maximum loss would occur if the share price fell below $20 or rose above $40 – at $20, all the options expire worthless. At $40, any profit from the two long calls will be cancelled out by the loss made on the two short calls. In either situation, the trader suffers the maximum loss, which was the debit taken to enter the trade.

Short butterfly

A short butterfly spread will make a profit if the future volatility is higher than the implied volatility. In a short butterfly, the options trader would sell two calls at different strike prices, while buying two calls with a strike price halfway between the two call options he sold.

So, again using Macquarie Group as an example, the trader would sell one $40 call option and one $20 call option. If these were priced at $1 a share, the price of the two options contracts would be $2,000. As the trader is going short, this $2,000 would be credited rather than debited.

He would also buy two call options at $30 – if these were priced at $0.50 a share, the $1,000 cost of the contracts would be subtracted from his initial credit, bringing his profit down to $1,000. This is the maximum profit attainable with this strategy.

If, at the expiry, the share price fell to $20, all options would expire worthless and the trader would keep the $1,000 profit. If the share price remains static, all the options would expire worthless except the $20 call option. As this had been sold short, it would then need to be bought back to close the transaction. As the option is now worth $10 a share (the difference between the current share price and the option share price), or $10,000 in total, the trader would make a $9,000 loss.

In a short butterfly, both the maximum profits and losses are known from the outset of the trade – the maximum profit is the credit remaining from the options premiums, while the maximum loss occurs if the underlying share price remains at the strike price.

Straddle

A straddle is an options strategy that involves holding a position on both a put and a call with the same strike price and expiration date. A long straddle is when the trader buys both options, while a short straddle is when the trader sells both options. A long straddle is profitable if the stock has a significant change in value, while a short straddle is profitable if there are no significant moves.

Long straddle example

If SP AusNet is going to release its quarterly financial results at the end of the month, this could result in large price movements. However, the trader might not know whether the price will rise or fall. He then enters into a long straddle, buying a put and a call option with the same strike price of $0.90. If the options are priced at $0.10 per share, an options contract of 1,000 shares would cost $100 to open; making the initial debit for the two options contracts $200. If the price rises to $1.50, the put option will expire worthless. However, the call option will be worth $0.60 a share (the difference between the opening and current price), or $600 for the entire contract. This will make the trader’s net profit $500 (excluding commission charges).

Likewise, if the shares had dropped to $0.70, the call option would have expired worthless, while the put option would now be worth $0.20 a share, or $200. In this case the net profit would be $100. The risk of a long straddle is limited to the premium paid for the options, $100 in this case, while the profits can be unlimited.

Short straddle example

In contrast, the potential profits of a short straddle are known from the outset, but the risks are unlimited. If a trader thinks that the $45 share price of AGL will remain static, he could enter a short straddle by selling both a call option and a put option priced at $45 with the same expiration date. If the options contracts are priced at $2 an option, the total price for each contract is $2,000. As the premium for a short position is credited rather than debited, the trader will receive $4,000 as the total premium.

The total profit a trader can make using this strategy is the original credit, $4,000 in this case, which will happen if the share price doesn’t move. If the stock rises by more than $4 a share, the put option will expire worthless, and the trader will have made a loss of over $4,000 on the call option, eliminating his profits. The same thing would happen if the stock falls by over $4 a share – the call option would expire worthless, while the trader will have made a loss of over $4,000 on the put option.

Strangle

Like a straddle, a strangle is an options strategy that involves holding a position in both a put and a call option. However, although both options have the same expiration dates, they have different strike prices. A long strangle is when the holder buys both options, while a short strangle is when the holder sells both options. Long strangles are designed to profit from large price movements, while short strangles make a profit when the price remains constant.

Long strangle

If we use AGL as an example again, to enter a long strangle, an options trader could buy a $40 put option, and a $50 call option. If the options contracts are priced at $1.50 a share, the opening debit would be $3,000 ($1.50 x 1,000 shares x 2 contracts). If AGL’s share price rises to $55, the $40 put would expire worthless, while the call would now be worth $5 a share, or $5,000 in total, making a total profit of $2,000 ($5,000 – $3,000 opening debit). Like a long straddle, the risk is limited to the premium paid for the options, while the profits can be unlimited.

Short strangle

A short strangle is when a trader sells a put and a call option on the same underlying asset with the same expiration date, but with different strike prices. The trader sells a put option with a lower strike price and a call option with a higher strike price. Like a short straddle, a short strangle’s profits are in the initial premium credit and are limited to that amount, whereas the risk is unlimited.

Risk reversal

Risk reversal involves being long on one option and short on another option, both for the same underlying asset with the same expiration date. Going long using a risk reversal strategy would involve buying the call option and selling the put option. So if SP AusNet is quoted at $0.90 and you believed it would go up in value, you would buy a $0.90 call while selling a $0.90 put.

As the price of the options contract is the same for both the call and the put, this would make your initial investment $0 (if we assume the contract is $0.10 an option, or $100, the initial debit would be $100 call – $100 put = $0). If the price goes up to $1.10, the put option would expire worthless, while you would make $0.20 a share on the call option, or $200. As you had already broken even when you opened the position, you would get to keep the entire $200 (minus commissions) as a profit. When going long using risk reversal, your net exposure is the same as it would have been when going long on the underlying asset.

This information has been prepared by Jacqueline Pretty at IG Markets Limited (ABN 84 099 019 851) (AFSL 220440). No representation or warranty is given as to the accuracy or completeness of the above information, consequently any person acting on it does so entirely at his or her own risk. IG Markets accepts no responsibility for any use that may be made of these comments and for any consequences that result.