Part 5: Option Trading Strategies – Spreads, Straddle, Strangle, Covered Call & More

NISM Series VIII – Part 5: Option Trading Strategies – Spreads, Straddle, Strangle, Covered Call & More

This is Part 5 of the NISM Series VIII Equity Derivatives short notes series. Option trading strategies are tested extensively in the NISM Series 8 exam. This post covers all major strategies including spreads, straddles, strangles, covered calls, protective puts, collars, and butterfly spreads in clear, exam-ready language.

Quick Answer (Featured Snippet): Option trading strategies combine multiple options contracts (calls or puts) to create specific risk-reward profiles. The main strategies are spreads, straddles, strangles, covered calls, protective puts, collars, and butterfly spreads — each suited to a different market outlook.

1. Options Spreads

A spread strategy involves combining two or more options of the same type (all calls or all puts) on the same underlying asset, but with different strike prices or different expiry dates.

Types of Spreads Vertical Spread

Created using options with the same expiry date but different strike prices. Can be constructed with all calls or all puts.

• Bullish Vertical Spread: Profits when the underlying price rises. Created by buying a lower strike option and selling a higher strike option of the same type
• Bearish Vertical Spread: Profits when the underlying price falls. Created by buying a higher strike option and selling a lower strike option of the same type

Horizontal Spread (Calendar Spread / Time Spread)

Created using options with the same strike price and same type but different expiry dates. Since the two legs expire at different times, it is not possible to draw a single pay-off diagram for this strategy.

Diagonal Spread

Combines options of the same underlying but with both different strikes AND different expiry dates. This is the most complex of the three spread types, both in structure and in execution.

2. Straddle

A straddle involves buying or selling one call and one put at the same strike price and same expiry date. The outlook determines whether to go long or short on the straddle.

Long Straddle

View: The underlying will move significantly, but the direction is uncertain.

Construction: Buy one ATM Call + Buy one ATM Put (same strike, same expiry)

• Maximum Loss = Total premium paid for both options
• Break-even points = Strike Price ± Total Premium Paid
• Maximum Profit = Unlimited (if the underlying moves sharply in either direction)

Short Straddle

View: The underlying will remain stable, with minimal price movement.

Construction: Sell one ATM Call + Sell one ATM Put (same strike, same expiry)

• Maximum Profit = Total premium received
• Maximum Loss = Unlimited (if the underlying moves sharply in either direction)
• Pay-off is the exact mirror image of the long straddle

3. Strangle

A strangle is similar to a straddle, but the call and put options have different strike prices (both OTM). This makes the strangle cheaper to enter than a straddle.

Long Strangle

View: The underlying will move substantially in either direction (similar to long straddle), but the trader wants a lower-cost strategy.

Construction: Buy one OTM Call (higher strike) + Buy one OTM Put (lower strike)

• Both options are out-of-the-money, so the net premium paid is lower than a straddle
• Requires a larger move in the underlying to become profitable
• Maximum Loss = Total premium paid

Short Strangle

View: The underlying will remain within a price range (neutral outlook).

Construction: Sell one OTM Call + Sell one OTM Put

• Maximum Profit = Total premium received
• Maximum Loss = Unlimited in either direction
• Provides a wider profitable range compared to a short straddle

Straddle vs Strangle – Quick Comparison

4. Covered Call

View: The trader holds the underlying stock (or futures) and expects the market to remain flat or move slightly upward.

Construction: Hold the underlying stock/futures (long) + Sell (write) a call option on the same stock

• This strategy generates additional income (the premium received from selling the call) on existing stock holdings
• The sold call "covers" the position, meaning if the call is exercised, the trader can deliver the shares already held

Strike Selection in Covered Call

• If the call strike is close to the current stock price: higher premium is collected upfront, but the upside gain from stock appreciation is capped early
• If the call strike is far from the current stock price: lower premium is collected, but allows a longer ride on the stock's upward movement before being called away

Risk: If the stock price falls significantly, the covered call only partially offsets losses through the premium collected. The downside is not fully protected.

5. Protective Put

View: The trader holds the underlying stock (long in cash market) and wants to protect against a fall in prices.

Construction: Hold the underlying stock (long) + Buy a put option on the same stock

• If the stock price falls, the put option gains value and offsets the loss on the stock position
• If the stock price rises, the loss is limited to the premium paid for the put
• The pay-off profile of a protective put is similar to that of a long call — hence it is also called a synthetic long call position

This strategy is used by portfolio managers who are bullish long-term but want downside protection in the near term.

6. Collar Strategy

A collar is an extension of the covered call strategy. It adds downside protection to a covered call position.

Construction:

• Hold the underlying stock (long)
• Sell an OTM Call option (generates income, caps upside)
• Buy an OTM Put option (provides downside protection)

• The premium received from selling the call partially or fully offsets the cost of buying the put
• The strategy sets a floor (minimum value) and a ceiling (maximum value) for the position
• Suitable for investors who want to protect an existing stock position at minimal additional cost

7. Butterfly Spread

A butterfly spread is an extension of the short straddle. In a short straddle, the downside is unlimited if the market moves significantly in either direction. The butterfly spread limits this downside by adding protective positions.

Construction (using only calls):

• Sell 1 ATM Call + Sell 1 ATM Put (short straddle)
• Buy 1 OTM Call (above current price) + Buy 1 OTM Put (below current price)

The resulting pay-off diagram resembles the shape of a butterfly — hence the name.

• View: The market will remain close to the current level (neutral)
• Maximum Profit: Achieved when the underlying is exactly at the middle strike at expiry
• Maximum Loss: Limited to the net premium paid
• Can be constructed using only calls, only puts, or a combination of both

Summary of Option Strategies – Market Outlook

Quick Revision – Must-Know Points

• Vertical spread: same expiry, different strikes
• Horizontal spread: same strike, different expiry (calendar spread)
• Long straddle: buy call + buy put (same strike) — profits from big moves
• Short straddle: sell call + sell put (same strike) — profits from stability
• Strangle uses OTM options; cheaper than straddle but needs bigger move to profit
• Covered call = long stock + short call; generates income but caps upside
• Protective put = long stock + long put; acts like insurance on a portfolio
• Collar = long stock + short call + long put; limits both upside and downside
• Butterfly spread = limited risk, limited reward; profits when market stays flat

Internal Links

• Part 4 – Introduction to Options & Option Greeks
• Part 6 – Trading System, Clearing & Settlement
• NISM Series 8 Free Mock Test
• NISM Series 8 Full Study Material

This is Part 5 of the NISM Series VIII Short Notes series on PassNISM.in. Continue to Part 6 – Introduction to Trading Systems, Clearing & Settlement.