Thousands of strategies, indicators, and setups are overwhelming and often contradictory when trading options online. Many inventors and traders fall into the trap of overcomplicating their strategies—our guide will address how cutting down to just three setups can transform your results. You only need three high-probability setups that work in bull, bear, and sideways markets.
Let’s break down the only three options trading setups you’ll ever need!
Why Fewer Setups = More Profit
We’ve talked in other guides and blogs about how many traders get into the problem of overtrading, excessive buying and selling of options contracts, which can result in a lot of unnecessary capital loss for the investor. Overtrading can look like having too big of a position size for each investment or it could look like having too many open positions. Frequent trading can result in traders taking on positions with lackluster returns (or potential losses) or holding too many positions for too short a time when they should be focusing on fewer, long-term trades.
The Overwhelm Problem
Too many strategies lead to decision fatigue or difficulty in making good decisions due to the high volume of decisions that need to be made. Traders who have too much on their plates can also experience the following problems as well:
- Reduced profitability over time
- The potential for unnecessary losses
- Increased trading costs
- Neglecting long-term (and more profitable) strategies
- A damaged reputation in the options market
The Power of Specialization
It’s best to focus on quality over quantity when you’re trading options online. Mastery beats variety every time. Traders, especially newer or inexperienced ones, should focus on a few quality trades that are likely to turn a steady profit over a longer time horizon compared to employing high-risk strategies with a large number of positions. Having a trading plan and a steady approach while focusing on fewer positions is the key to profitability. And it’s best to trade in industries, sectors, or asset classes that you’re more familiar with, hence the power of specialization.
Proof in Practice
Top traders focus on 1–3 repeatable setups that can work in different kinds of market conditions. We’ll see three good strategies in this guide, including covered calls for neutral to bullish markets, vertical spreads for bull or bear markets, and the long straddle or strangle for volatile markets. By relying on strategies that work well in various market conditions, you can develop a consistent options trading plan that can generate consistent and steady returns.
Quick Tip: Backtest and track the performance of each setup individually
Setup #1 – The Covered Call (Neutral to Bullish)
The covered call is an options trading strategy that involves buying 100 shares of a stock or some other kind of underlying asset, while also selling a call option on the same stock with a strike price that’s at-the-money or slightly out-of-the-money. By owning a stock and selling a call, the investors can create income from the call options premium, and they can still profit from the stock’s potential upside.
Potential Outcomes
- If the stock price stays the same or decreases, the investors keep the premium from the sale, and the call option expires as worthless.
- When the stock price increases significantly beyond the strike price, the investor could be obligated to sell the shares of the stock or underlying asset at the strike price. This could ultimately lead to the potential upside being capped.
- If the stock price increases just a bit, the call option might be assigned, where the holder exercises their right to buy the stock. The investor would then be obligated to sell their stock at the strike price.
Best Market Condition
When is it best for traders or investors to use the covered call strategy? The ideal market conditions are in either sideways markets or slightly bullish markets. Sideways markets are also known as “rangebound” or “consolidation markets,” and they occur when the stock or security price fluctuates within a narrow range, and it’s unclear if it’s an upward or downward trend. In a slightly bullish market, the expectation is that there will be some moderate upward movement, but not an outright bullish trend.
Ideal Trader
- Covered calls are best for conservative traders due to the fact that they won’t incur any extra costs if the option holders exercise their right to buy the shares.
- It’s a strategy that also works well for income-focused traders who are able to collect premiums for writing call options.
- The covered call isn’t the best strategy for aggressive traders because the move is centered around predictable traders that produce steady returns.
Entry Rules
To enter a covered call trade, investors need to select stocks that are currently trending up or consolidating, to accommodate for slightly bullish or sideways markets. You must choose a strike price that is just above the resistance level and an expiration date that is between 30 to 45 days out.
Exit Strategy
Let Expire Worthless or Roll—Investors have the choice to let their option expire as worthless and keep the premium they got from selling the call or they can roll the option to a further expiration date to give the investment more time to develop a profit.
Example Trade
A good example of a covered call would be if you bought a certain stock for $70 per share and you believed that it would rise to $80 within a single year. However, you’re also willing to sell at $75 within six months. The covered call would be a good choice for investors with this time horizon and market outlook. Traders using a covered call can generate income from the premium they get from selling options as they wait for the appreciation!
Pro Tip: Great for monthly cash flow from long-term holdings
Setup #2 – The Vertical Spread (Bull or Bear)
The vertical spread refers to an options trading strategy where investors buy and sell two options on the same underlying asset with the same expiration date but with different strike prices. To be used in a vertical spread, these options must be both a call or a put, and these trades offer a defined risk and reward profile. The vertical spread is a great go-to for investors or traders who want to use specific market movements to manage the possible risks or profits.
Two Flavors
- Bull Put Spread—This is a bullish strategy which expects the underlying asset to increase in price. Traders buy a put option at a lower strike price and sell a put option at a higher strike price. Each has the same expiration.
- Bear Call Spread—This bearish approach has traders expecting the underlying asset to decrease in price. It involves selling a call option at a lower strike price and buying a call option at a higher strike price. Each comes with the same expiration date.
Best Market Condition
The best market conditions for using vertical spreads will depend on which way the market is trending. The bull put spread is best used when traders or investors are expecting the price of the underlying asset to increase, while a bear call spread is best used if you’re expecting the prices to decline. Spreads are best when the markets are trending up or down with clear support/resistance.
Entry Rules
- Using indicators like moving averages or crossover, traders must pin down that the market is moving in a certain direction. You must get trend confirmation before committing to a vertical spread strategy.
- It’s best to choose trades that have a 70%+ probability of profit after you’ve established the trend and determined which strategy you’re going to use.
- Figure out what is at risk when using the vertical spread strategy. The maximum potential loss is limited to the cost of the spread plus the transaction costs. It’s the difference between the strike prices minus any credit received from selling the spread.
Exit Strategy
The key to succeeding with the vertical spread, be it a bull put spread or a bear call spread, is to achieve a 50–75% max profit before expiration. If the trade isn’t trending your way by the time of the expiration date, you can roll the expiration date out further to give it more time to become profitable.
Example Trade
Let’s look at an example of a vertical spread on the SPDR S&P 500 ETF Trust (SPY). You would use a vertical trade if you believe that SPY will stay stable over the next few weeks and not drop off significantly. Traders can set up the vertical spread in a way where you’re selling a $450 put option and buying a $440 put option. You can set the expiration date for a month or two to give the trade enough time to become profitable.
If SPY stays above $450 before the expiration date, the options would expire, and the trader gets to keep the premium from the sale of the put option. The other half of the trade (buying the $440 put option) works as a hedge, which can limit the potential losses if SPY falls below $440.
Pro Tip: Lower capital risk, ideal for small accounts
Setup #3 – The Long Straddle/Strangle (Volatility Play)
The straddle and strangle traders are both considered volatility plays and can be used to profit when there are volatility market conditions. Traders don’t even have to get the market direction correct—they simply profit from either trade as long as there is enough volatility.
- Long Straddle—Buying a call and a put with the same strike price and expiration date. It’s best used by traders who aren’t clear on the market direction, but they are anticipating a big price movement in the underlying asset.
- Long Strangles—Buying a call and put options on the same underlying asset with the same expiration date but with different strike prices. Like the long straddle, the long strangle profits from big underlying asset price movements and less on correctly predicting market direction.
Best Market Condition
Straddles and strangles, though slightly different, are two strategies that are best used in markets where high volatility is expected. The direction of the market isn’t always exactly known—it can go either way. These strategies thrive when there’s volatility, especially around events like earnings reports or Fed decisions. As long as there are volatile conditions, the trade using the straddle or strangle can profit, and they don’t even have to get the direction correct.
Entry Rules
What are the indicators that show traders they should be using the straddle or strangle strategy? You’ll want to look for a low IV rank, but also look for market conditions where a rising IV is expected. An upcoming catalyst is another key indicator that you might want to make a volatility play. This could be an event like an earnings announcement that is creating uncertainty for investors or a regulatory decision by the Fed, which could impact trader’s investments.
Exit Strategy
A good rule of thumb to exit a strangle or straddle play is to close when one leg doubles. When this occurs, it means that the trader’s position doubles in risk. They’re facing a loss that is twice as large if the underlying stock price moves in the wrong direction significantly.
Another way to gauge when it’s appropriate to exit a volatility play is to exit the trade early to cut losses if there doesn’t appear to be any market volatility by a certain amount of days. Because these strategies thrive on volatility, it’s best to close out the trades prematurely to limit risks when it’s likely that the trade isn’t to be profitable.
Example Trade
Tesla (TSLA) and Nvidia (NVDA) are two stocks that are well known for their volatility in the options market making them the perfect stocks to incorporate into a straddle or strangle strategy. Let’s take a look at using the long straddle with Tesla stock.
If Tesla is expecting an earnings report or some other kind of major announcement, a straddle is a good strategy to employ, especially if you believe the stock will experience a substantial movement. To begin the straddle move, a trader could buy one with a strike price of $400 at-the-money, which is approximately the current stock price.
When the stock price goes above $400, the call option will increase in value, which leads to a profit. The same applies to the stock price falling well below the $400 strike price. Each of these scenarios secures a profit for the trade. On the other hand, the max loss is the total you paid for the call and put combined. This trade will lose money if the stock price remains stable at around $400.
Pro Tip: Don’t hold through expiration—manage early for profit
When to Use Each Setup
Find out when it’s best to use each of these basic options trades. We’ve prepared a quick reference table that you can use for a quick refresher on when each trade is appropriate. We even included a market checklist of the key metrics that you’ll want to monitor to give you clues on which play is going to best suit the current market conditions.
Quick-Reference Table
Market Condition | Best Setup | Goal |
|---|---|---|
Sideways | Covered Call | Income |
Bullish Trend | Bull Put Spread | Risk-Defined Profile |
Bearish Trend | Bear Call Spread | Hedge or Profit |
Volatility Spike | Straddle or Strangle | Big Move Bet |
Market Checklist
- Trend—Find out which way the market is going. Sometimes you won’t find a trend, as the direction can be unclear at times. Choose the right strategy based on the trend you’re seeing.
- Volatility—Check the market’s volatility levels. Use straddles or strangles for volatility plays. Otherwise, choose one of the other strategies once you’ve determined the market direction.
- Event Coming Up—Look at upcoming market events like product launches, earnings reports, or policy change implementations. Choose straddles or strangles for volatility plays or vertical spreads if you can establish that the market will trend in a certain direction.
- Capital Available—If you’re low on capital, stick with a conservative trading approach like the covered call, where you can generate some additional income. Use spreads or straddles/strangles more sparingly as they usually require more capital.
Why These Three Are All You Need
What is it about these three strategies that work well for such a wide array of market scenarios and trading styles? Covered calls, vertical spreads, and volatility moves can be applied to a wide variety of market conditions and trading styles, they’re easily repeatable and have built-in risk management.
- Coverage of All Market Types—The appeal of these three strategies for many investors is the fact that they can be used in a wide range of market types, including bear and bull markets, sideways or rangebound markets, or volatile markets.
- Risk Management Built-In—Covered calls can generate income and reduce some downside risks, and vertical spreads can limit potential loss to the net premium paid for the spread. Straddles and strangles don’t offer the same luxury to investors or traders, but you can easily apply effective risk management practices to these traders for a layer of protection.
- Easily Repeatable + Scalable—The vertical spreads, covered calls, and volatility plays can all be easily repeated by investors from different experience levels. Each is also quite scalable, allowing traders to apply for multiple shares or stocks, and the income potential is proportional to the number of shares or positions held.
- Compatible with Any Trading Style—Each of these strategies works well for traders are various skill levels, both new investors and high-experienced options traders. They can be easily adapted into a wide range of trading plans where each person has a unique taste for risk and ultimate trading goals.
Simplicity Wins in the Long Run
Most traders fail because they chase too many strategies. In the long run, simplicity is the thing in options trading that will most benefit investors, keeping them away from overtrading. If you’re new to trading and you’re interested in keeping your strategy tight, we’d recommend sticking with spreads, covered calls, and volatility plays to start and possibly expand from there.
Pick one of the strategies we’ve covered in this guide, learn it inside and out, test it, and trade it consistently. You’ll find over time that keeping your approach simple and mastering a few key traders will produce a much more harmonious outcome in terms of profit and your mental well-being. Use covered calls for neutral to bullish markets, straddles or strangles in volatile markets, and vertical spreads when you’re dealing with bearish or bullish conditions.
Which of these setups will you try next?
