Options trading isn’t a one-size-fits-all experience but rather a personalized approach that can be done through custom strategies that fit well for your trading plan. For better results in options trading, investors can combine various techniques to better deal with the market as they lock in profits or minimize their potential losses.
Our guide will discuss the importance of combining trading techniques and the major factors to consider when building custom trading strategies. Many traders use a common combination of techniques that work well for a multi-strategy approach—we’ll reveal examples of these combinations and how they work in execution. To give a well-rounded look at combining techniques, we’ll highlight the pros and cons as well as the primary risk management strategies to use when trading using multiple techniques.
Key Takeaways Upfront
- Custom options strategies can help traders maximize their profit potential.
- Flexibility is one of the biggest advantages of options trading.
- Readers will learn how to combine techniques to create their own strategies.
Understanding Basic Options Strategies
This section of the guide will discuss each of the options trading strategies most commonly used by online option investors. The best traders and investors use a blend of these strategies to adjust to different scenarios and circumstances. Good trading is all about being able to pivot your approach at a moment’s notice, so we’ll highlight a wide range of strategies that traders should have in their arsenal.
Purpose
Options trading allows investors to use many strategies and techniques to achieve their trading goals. Before we get into the wide range of options and methods available, it’s important to note three primary reasons for trading options: to generate income, speculate on an asset’s future price movement, or protect a position through hedging.
Key Points
Check out what we consider the core options strategies that any online trader or investor should be familiar with. These strategies can be used in a wide range of scenarios to ensure that investors can lock in profits in a timely manner and sell options before they begin devaluing.
- Covered Calls: This strategy involves selling a call option on a stock you already own. It’s designed to generate income from the investor’s premiums from selling the options.
- Iron Condor: A strategy where investors profit from low volatility in a sideways market, the iron condor is made of two option pairs—a bought OTM call and a sold call closer to the money and a bought OTM put and a sold put closer to the money.
- Short Put: In this trading strategy, an investor sells a put option on a security where they eventually profit from a stock price increase. They receive a premium for selling the option, and the hope is that the stock price remains at or above the strike price until the expiration date.
- Married Put: Traders use this technique to protect a stock position from potential losses while they can simultaneously gain. A married put is done by buying a stock and purchasing a put option for the same stock. Thanks to the put option, investors have the right to sell the stock at the strike price in a specific time frame.
- Straddles: A neutral options strategy involves buying or selling both a call and put option at the same strike price and expiration date. Traders can profit from market volatility without correctly predicting the stock price changes or which direction the market turns.
- Strangles: This technique involves holding a call and put on the same underlying asset. It can only be profitable if the underlying asset does not experience a sharp price swing. It’s used by inventors who think the asset will move significantly but are unsure which direction.
- Protective Collar: This one involves two strategies, including the protective put and covered call. Traders buy the downside put and sell the upside call to protect themselves against big losses while limiting large upside gains.
- Bull Call Spread: Traders or investors buy a call option with a lower strike price and sell a call option with a higher strike price. This is a popular move by investors expecting the stock price to increase but only moderately.
- Butterfly Spread: Like strangles and straddles, butterfly spreads are a market-neutral options strategy that combines a bear and bull spread. The idea is to create a position with a fixed risk and profit cap. It involves buying and selling options contracts with three different strike prices.
- Long Call: This strategy gives the buyer the right to buy a stock of other assets at a predetermined price within a specific time frame. The long call holder is another name for the buyer, and they pay the seller a premium for this right. Essentially, the long call holder has the right to buy the asset but is not obligated to do so.
- Long Puts: Investors use this strategy to pay for the right to sell stock at a set price in the future. They buy a put option to profit from a stock’s decline. Long puts have potential huge profits, but they come with limited losses. The max profit is the strike price minus the price of the put.
The Importance of Combining Strategies
What makes combining options trading strategies so crucial for investors? We’ll discuss why it’s essential for investors and traders to use a combination of trading techniques to maximize their overall experience and develop a growing portfolio with a healthy amount of risk.
Purpose
Combining multiple techniques can help investors limit risk and hedge against potential losses from losing positions. Various strategies can also help investors increase their returns by taking advantage of certain market conditions. There are several other benefits to using several methods in tandem, and we’ll discuss them further in the key points below. The ultimate purpose is to create more flexibility for traders and investors, allowing them to conduct even better risk management on their investments.
Key Points
Adjust Your Risk/Reward Profile
Spread strategies, profiting from the price difference between two securities, allow investors to control their risk/reward at the beginning of the trade. Traders and investors simultaneously buy and sell related securities (legs) to profit from upward and downward price movements. At the same time, they can minimize exposure to market direction risk.
More Adaptability
Using multiple trading strategies allows traders to adjust and adapt to changing market conditions with nimbleness because specific strategies work much better in certain scenarios than others. Traders well versed with these techniques can adapt much more quickly to what the market throws their way because there are strategies to navigate just about any situation.
Combining Long and Short Options
Investors and traders might also consider simultaneously combining long and short options to produce income from a transaction or to leverage income in their favor. This move simulates a long stock position where the net results include the same risk/reward profile for the option’s term. Combining long and short options has unlimited appreciation potential but carries a considerable risk if the underlying stock falls in value.
Combining Options with Different Expiration Dates
There are several methods for combining options with different expirations, including diagonal spreads, calendar spreads, long calendar spreads, combination, or butterfly spreads. More investors using these strategies hope to profit from an asset that does not change in price too much until the shorter-term option expires.
There are circumstances where investors might do well to combine strategies. Still, there are instances where combining different options can benefit investors or traders. These plans help investors with flexibility and allow them to act nimbly when there are considerable changes within the market.
Key Factors to Consider When Building Custom Strategies
Before building custom trading strategies several key factors must be considered before diving headlong into combining trading techniques and tying up your capital with the investments you have in mind. A lot of this has to do with your personal trading needs and objectives, but some of it is rooted in market conditions, so it can be subject to change based on current conditions.
Purpose
All traders should go into an online session knowing how much profit they’re willing to take, how much loss they’re willing to incur, how much capital is allocated to each position, and what their ultimate end goal is with each trade they conduct. It’s key to consider and evaluate your needs and objectives when creating these custom strategies. Let’s look at the top factors to consider before combining multiple strategies into one.
Key Points
Market Outlook
Choose options strategies based on the current market conditions. For bullish markets, use approaches like long call, short put, bull put spread, sull call spread, bull butterfly spread, or bull condor spread.Regarding bearish markets, it’s best to use strategies like long puts, naked calls, bear call spreads, and bear put spreads. Many neutral strategies include covered calls, puts, straddles, strangles, iron condors, and calendar spreads.
Risk Tolerance
Investors will want to manage risk when blending multiple strategies. For instance, narrower credit spreads point to lower perceived risk. This makes investors more confident in the ability of the issuer to meet their debt obligations. Therefore, they’re willing to accept a lower yield. Regarding low-risk options strategies, trades will often use the strategy of selling a call spread and a put spread, which results in a high probability of profit. This is due to the low probability, which ultimately results in limited risk in the event that the trade doesn’t go according to plan.
Volatility Expectations
Implied volatility (IV) plays a significant role in online options trading, and the same can be said for designing custom strategies. IV is used to determine options prices, calculate the expected move of an underlying asset, and measure directional risk. Implied volatility is crucial when building a custom strategy because it allows investors to figure out how profitable a potential strategy might be and to forecast where the market might be going in an attempt to determine which combination of trading techniques will work best for the conditions at hand.
Time Horizon
This refers to the time that a trader or investor will hold an investment. It is used to determine an investor’s asset allocation and risk level. Investors need to match expiration dates with their trading goals and objectives. Holding onto an investment for a certain period of time may or may not be the best move, depending on the combination of trading techniques being used.
Commonly Used Techniques for Customization
Now that we’ve addressed the importance of combining strategies and the main factors to consider before combining multiple trading techniques, let’s move on to the most common trading strategies that investors like to use for customization. These methods have the best track record of success and enjoy the most popularity among traders and investors.
Purpose
This next section will highlight the practical options and techniques often combined to form custom strategies. It’s key to establish what kind of trader you hope to be before combining strategies, research how assets have performed in the past, and come up with a trading plan that includes entry and exit points.
Key Points
These three spread trading approaches are some of the best ways for traders and investors to use several strategies on a single trade, thus creating a unique, customized trade.
Vertical Spread
This technique involves simultaneously buying and selling the same type of option. With vertical spreads, you deal with different strike prices but the same expiration date. One higher and one lower strike price in the same expiration cycle leads to a “vertical spread.” Investors can use them to speculate on the direction of a stock, keep risk at bay while having leveraged exposure to equities, and take advantage of high or low volatility levels.
Horizontal Spread
Some traders call these “calendar spreads,” and they involve buying and selling options with the same underlying security and strike price but different expiration dates. The goal with horizontal spreads is to profit from volatile price fluctuations over a period of time. They’re relatively low risk and provide insights into relatively predictable price fluctuations.
Diagonal Spread
Traders buy and sell two options contracts of the same type but with different strike prices and expiration dates. They buy a longer-term option and sell a shorter-term option, ultimately benefiting from the difference in how quickly the possibilities decay over time. Most traders use the diagonal spread to profit from the underlying asset’s price remaining stable or moving in a favorable direction.
The following two strategies can be combined in a way where traders and investors can balance profit potential and risk:
Iron Condors
This technique is used by investors to profit from the underlying asset closing between the middle strike prices at the expiration date. The Iron Condor strategy involves four options contracts: a short out sold at a price below the current stock price, a long put bight at a price further out-of-the-money than the short put, a short call sold at a price above the current stock price, and a long call bought at a price further out-of-the-money than the short call.
Iron Butterflies
This trading technique is used for investors to profit from price movement in a narrow range during a period where implied volatility is on the decline.
Let’s look at a few other trading strategies that work well with one another and benefit the trader by working in combination with one another:
Ratio Spreads
This involves buying and selling options in an unequal ratio. They can be used on either calls or puts, and traders typically use a standard ratio of 2:1 (selling two options and buying one). Traders use them to maximize profits when specific price movements are expected. They’re most profitable when the options’ implied volatility is falling or when the underlying asset’s price moves in favor of the trade while they run the stock price moving outside of the strike price.
Hedges
Traders can use hedging strategies like protective puts (buying a put option on a stock you already own on a share-by-share basis) or collars (a put option to hedge downside risk and a call option to finance the put’s purchase) to mitigate losses while pursuing gains.
Examples of Custom Options Strategies
When applied to stocks and options in real-world trading, how do these strategies look? The following section will review a few examples in greater detail to show how combining specific strategies can be helpful under certain market conditions.
Purpose
To better illustrate these trading strategies and concepts in action, we’ve included some clear examples of different market conditions and which trading approaches are best to use in each scenario. We hope this can bring more depth and understanding of the concepts we’ve covered in this guide.
Key Points
Example 1—Maximizing Profits in a Rising Market
Combining a bull call spread with a short put creates a trading strategy known as a double bull spread. Investors use this strategy when they expect the stock price to rise. The bull call spread involves buying one call and selling another call at a higher strike price. The short put generates income for traders.
In this scenario, the maximum profit occurs when the strike price exceeds the upper call strike price. The short put also receives a premium when the investor enters the trader. The maximum loss in a double bull spread is the initial cost of the position, and it occurs when the stock price goes below the lower put strike price.
Example 2—Trading in Range-Bound Market
One of the best ways to trade in choppy or sideways markets is to combine an iron condor with a ratio spread. Though there’s no formal name for the combination of these two trading techniques, it’s one where investors can enjoy large potential profits if the market moves significantly in a single direction and still maintain downside protection. Traders benefit from price movements through the ratio spread side of the trade and enjoy downside protection through the iron condor part of the trade.
To include an iron condor in the trade, an investor must sell one ATM call option, buy two slightly out-of-the-money call options, sell one ATM put option, and buy two somewhat out-of-the-money put options. Next, add the ratio spread to the iron condor—sell two contracts of a slightly OTM call option and buy one contract of a far OTM call option. Combining these two strategies creates a larger short position on the call side. The idea is to maximize profits if the underlying asset price increases greatly with a significant market movement.
Example 3—Effectively Manage Time Decay
Let’s look at a final example where an investor might combine a calendar spread with a protective collar to manage time decay. A calendar spread involves buying and selling the same kind of option for the same underlying asset at the same strike price but at a different expiration date. A protective collar is a combination of a protective put and a covered call where the goal is to protect against downside losses, but also limiting upside gains.
When traders combine the protective collar with a calendar spread, a number of things occur—the combined collar locks in a wide range of potential outcomes. First, the stock price is bracketed, which reduces its exposure to risk. The calendar spread becomes profitable from directional or neutral stock price movement toward the strike price. The protective collar side of the trade limits any upside gains, but it also protects the investor against any sort of downside losses.
Pros and Cons of Custom Options Strategies
Custom options strategies have problems like any other trading strategies that new or seasoned investors use. Learn the greatest pros and cons of creating and using your own trading strategy during your online trading sessions.
Purpose
It’s important to understand the advantages and potential pitfalls of creating their strategies, so we’ve compiled a list of the primary pros and cons you’ll encounter when forming and implementing customized trading strategies. While there’s much to be gained from these creative strategies and techniques, a learning curve and the discipline or correct timing are needed to pull them off successfully.
Key Points
Pros
- Trades have much more control over their risk/reward profiles. Rather than employing only a few strategies, they can employ multiple strategies to achieve the desired result.
- Combining strategies improves adaptability to various market conditions, allowing traders to pivot quickly when the time is right.
- Using multiple techniques maximizes profit by letting trades profit in various market conditions.
Cons
- Using multiple trading techniques can lead to a more complex trading plan requiring closer monitoring.
- There’s the potential for over-complication using several different strategies in your trading plan.
- Multileg strategies can result in higher transaction costs.
Risk Management in Custom Strategies
Discover how you can effectively manage risk using customized options trading strategies. It’s the best way to preserve as much capital as possible and still give certain positions a chance without sticking around too long to experience unnecessary losses. We’ll address how to manage this risk and many others in the next section of the guide.
Purpose
Risk management is critical to building more complex options trading strategies. The same principles apply to risk management with more simplistic options trades also apply to customized strategy. Keeping your losses to a minimum is essential to your long-term trading plan, so work diversification into your portfolio, correctly allocate capital to each trade, and use stop-loss orders and profit targets to your advantage.
Key Points
Position Sizing
Keep the capital allocated to each position to a small size, usually 1-2% of the total money you have available for investing. Doing so lets investors avoid overexposure in any one trade, which makes potential losses minimal in the grand scheme of their total capital. Having a bit of capital spread across multiple investments, with some cash on hand, is the best way to operate in online options trading.
Diversification Across Different Asset Classes
Traders do best when their portfolios are option strategies across different asset classes. The idea is that if one investment loses value, the others compensate for that loss. The ultimate goal is to have a mix of investments with various expected risks and returns from spreading money across a wide range of assets to reduce risk and volatility.
Setting Stop-Loss and Target Profit Orders
Many effective trading options involve locking in profit or cutting losses at just the right time. Traders can set up stop-loss orders, where their positions are automatically sold once they have lost some money. Likewise, they can set up target-profit orders to lock in a profit and then have that position automatically sold before the stock takes a turn.
Tools for Building and Backtesting Custom Strategies
Investors and traders designing custom strategies should backtest their plans to see if they’re realistic in execution. There are several places where investors can access backtesting tools, often available on options trading platforms, and backtesting software.
Purpose
Backtesting resources and tools are great for constructing, analyzing, and testing custom options strategies to determine whether they’re viable, practically effective, and ultimately profitable. Let’s briefly discuss the pros of using backtesting tools and where investors can find them to determine whether their trading combinations are worth the time and effort.
Key Points
Backtesting tools are usually offered at the best online options trading apps. There’s no need to download separate software—these products come with the options trading app you use! For popular backtesting custom strategies, we’d encourage you to check out options trading apps like Interactive Brokers or TradeStation to access these helpful tools.
Backtesting can help refine strategies before using real capital. It’s almost like a gambling app with a demo mode to let potential players test the games before putting their money at stake. Online trading apps are the same; they only use backtesting as a method for newcomers to test potential trades for free!
After backtesting strategies and executing the trades using real capital, investors want to track their trading performances through options trading journals. These journals are helpful in highlighting what’s working or not working in a trading strategy.
Customize Strategies, Test Them, and Execute with Caution
Customizing strategies in options trading can help traders maximize their profit potential while minimizing potential losses in many cases. The ability for traders to use multiple methods to address the current market conditions and the positions currently sitting in their portfolio leads to maximum flexibility in executing quick trade decisions. Traders and investors can use these techniques to pivot when there are significant market movements that pose threats to their portfolios’ values. As traders learn which trading techniques are best used in combination with options, it’s key for them to backtest the strategies and take action with proper risk management.
Key Points
- Experiment with building your strategies using the techniques outlined in our custom options strategy guide.
- Maximize profits by tailoring strategies to specific market conditions and personal risk tolerance.
- Combine options techniques and backtest them cautiously with a demo account or real capital to determine whether they’re worth the time and effort.
Frequently Asked Questions
This section of our guide will address common questions readers may have about custom options strategies. We’ve answered these questions and compiled everything in this FAQ section so you can get the key highlights and main points of what we’re covering in this review.
Can Beginners Create Custom Options Strategies?
Yes, beginners are welcome to create custom strategies, but it’s best to become familiar with the best methods in certain market conditions. We’d encourage new traders to read guides like this one and access other educational material on options trading to learn as much as they can about effective custom options strategies. It’s also critical for new traders to backtest these combinations to ensure their trading plan is viable and profitable.
What’s the Best Options Strategy for Low-Risk Trading?
A few good places to begin would be selling call or put options and a collar strategy, which can protect your investments against downside risk. Trading using a covered call and the iron condor are a few other options strategies ideal for low-risk trading endeavors.
How Can I Test My Strategy before Trading Real Money?
Most options trading brokers have backtesting tools or resources that let investors test out strategies (or combinations of strategies) without using any of their own capital. There are also standalone apps that are geared specifically toward backtesting options trades. In both cases, investors can find out if their strategies are worth it, and they don’t have to perform real-world trades using real money.
