APPLYING OPTIONS – USING OPTIONS WHEN YOUR VIEW IS BULLISH…

search APPLYING OPTIONS – USING OPTIONS WHEN YOUR VIEW IS BULLISH…

 

What do you do when you expect the stock price to go up? In the cash market, you will buy the stock and hold it till the price moves up and then book profits. But, did you know that you can also replicate such a bullish view using options. Now we come to another challenge. The meaning of the term bullish itself is not very clear. Here are the different stages of bullishness you may have about a stock.

  • Extremely bullish about a stock
  • Very bullish but don’t rule out corrections
  • Moderately bullish but already holding the stock
  • Moderately bullish and not holding the stock

Is there a way you can create a bullish trade for each of the above trading conditions? The answer is an emphatic “Yes”. Let us look at how you can structure options strategy for different degrees of bullishness.

Extremely bullish about a stock

1 2 APPLYING OPTIONS – USING OPTIONS WHEN YOUR VIEW IS BULLISH…

In the above chart, the trader can just buy a call option. The negative payoff in the above chart is till the time the premium cost is recovered. After that, the profits are unlimited. When you are extremely bullish, buying a call option helps you to play the upside by paying a small price in the form of premium. You don’t need to lock up you capital by buying in equity. The premium is your option price and represents the maximum loss that you will incur in the transaction. Let us understand that better with a live example.

Investor ViewInvestor ActionInvestor pay-off
Has a bullish view on Tata Motors and expects the stock to go up from Rs.110 to Rs.140 during the monthInvestor buys Tata Motors 120 Call option in Sep-20 contract by paying a premium of Rs.5CMP (100) – Loses Premium
CMP (115) – Loses Premium
CMP (124) – Net Loss of Rs.1
CMP (140) – Net Profit Rs.15

In the above scenario it is clear that the break-even point for the naked long call option is Rs.125 (strike price of Rs.120 + premium of Rs.5). It is only after the price level of Rs.125 that the trader starts to make net profit. Below Rs.120, the trader is indifferent as he loses his entire premium of Rs.5. Above Rs.120 he starts to recover his premium cost and keeps recovering it till the breakeven point of Rs.125. After that, unlimited profits start.

Very bullish but don’t rule out corrections

2 2 APPLYING OPTIONS – USING OPTIONS WHEN YOUR VIEW IS BULLISH…

 

This is a protective put strategy. You will observe that the structure of the payoff of protective put is exactly like a naked call option. Then, how is this different? The difference lies in the fact that the naked call is just using options to speculate on the market. Here you are holding the position in the cash market and are using the put options to buy insurance and protect your downside risk.

If you buy Reliance at Rs.2120 and protect yourself with a 2100 put option at Rs.20, then your maximum risk is still Rs.40. Here, your breakeven point is Rs.2140 as at that point you will cover the cost of the put option too. Above that level, your profits are unlimited. On the downside, your total loss can never exceed Rs.40 i.e. (Premium of Rs.20) + (CMP 2120 – Strike Price 2100)

Moderately bullish but already holding the stock

If you are holding the stock and are moderately bullish, you can use covered call. This entails the selling of higher call options so that the premium received can be used to reduce your cost of holdings and boost your profits. On the upside, there is not much of risk as the short call is covered by your cash holding. However, on the downside, your risk is unlimited. Hence covered call is only used when you are confident of the stock not falling too sharply.

3 2 APPLYING OPTIONS – USING OPTIONS WHEN YOUR VIEW IS BULLISH…

The covered call strategy has two applications. It can be used when you are expecting the stock to face resistance. Secondly, it can be also used when you expected the stock to be range-bound and want to sell calls to reduce your cost of holding.

Moderately bullish and not holding the stock

4 1 APPLYING OPTIONS – USING OPTIONS WHEN YOUR VIEW IS BULLISH…

If you are holding the stock and moderately bullish, the covered call works perfect. But, what if you are not holding a stock and yet you are moderately bullish? In this case, you can use bull-call spread. This entails buying a lower strike and selling a higher strike call. Here is how it works.

Covered call is a moderately bullish strategy. Since you buy a lower strike call and sell a higher strike call, maximum loss is limited to net premium (premium paid – premium received). In the case of Reliance, you can buy a 2000 call option at Rs.70 and sell a 2100 call option at Rs.30. Your maximum loss will be the net cost of Rs.40. This is an improvement on the covered call strategy in the sense that the downside risk is also covered.

To know more about Options Strategy read here

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