Portfolios & Strategies

TRADING STRATEGIES (OPTIONS) – PART 2

 

TABLE OF CONTENTS

 

• Options Basics – Structure of an Options Contract
• Options Basics – ITM, ATM an OTM Options
• Options Basics – Intrinsic Value and Time Value of Options
• Options Basics – Options Pricing Framework
• Applying Options – Using Options when your view is bullish
• Applying Options – Using Options when your view is bearish
• Options Strategies – Types of Options Strategies available
• Basic Options Strategies – Protective Put, Covered Calls, Collars
• Non-Directional Options Strategies – Straddles, Strangles, Butterflies
• Spread Options Strategies - How Options spreads are classified
• Spread Options Strategies – Bull Call Spread, Bear Put Spread, Calendar Spreads
• One Step Higher – Understanding Option Greeks
• Annexure 1 – Choosing between futures and options
• Annexure 2 – 10 things to keep in mind when buying options
• Annexure 3 – 10 things to keep in mind when selling options
• Annexure 4 – Deciding when to buy and when to sell an option

 

 

OPTION BASICS – STRUCTURE OF AN OPTIONS CONTRACT…

Before we get into the more complex areas of trading strategies using options, it would be worthwhile to revisit the basics of options. An Option is a contract that gives the buyer of the option the right, but not the obligation, to buy or sell the underlying asset on a stated date, at a stated price by paying a premium. Essentially, the option has a buyer who acquires the right and a seller / writer who gives that right.

Since the option buyer gets a right without an obligation he pays a price for this right called option premium. It is this price of right (without obligation) that is traded in the options market. Broadly, options can be Call Option (right to buy) or put option (right to sell). In India, all options are European options so we will not dwell on American options.

 

Four legs of any options contract

 

Why does a trader choose to buy or sell a call option or a put option? The matrix below captures the trading expectation in each specific case.

Action	Expectation	Option Premium	Payoff
Buy a Call Option	Stock will go up	Pays the premium to the seller of call	Unlimited profit after premium cost is covered
Sell a Call Option	Stock will not go above a price	Gets the premium from the buyer of call	Profit limited to premium. Unlimited loss if price goes up
Buy  Put Option	Stock will go down	Pays the premium to the seller of put	Unlimited profit after premium cost is covered
Sell a Put option	Stock will not go below a price	Gets the premium from the buyer of put	Profit limited to premium. Unlimited loss if price falls

 

The most important thing about options is that an option is asymmetric. For example, in a futures transaction, both the buyer and seller have unlimited scope for profits and losses. However, in options, the buyer has limited loss and unlimited profit, while the seller has limited profits and unlimited losses. That makes options more amenable for option trading strategies.

 

 

OPTION BASICS – ITM, ATM AND OTM OPTIONS… 

 

ITM, ATM and OTM options

 

One of the important aspects of options is “Moneyness”. That means; whether the option is in-the-money or out of the money? You must have heard these terms frequently in options trading but let us first look at that in an illustration before getting to the definition. These pertain to a situation when the spot index is at 4000 level.

 

In the money (ITM) option: ITM option gives the holder a positive cash flow, if it were exercised immediately. A call option is said to be ITM, when spot price is higher than strike price. The put option is said to be ITM when spot price is lower than strike price.

At the money (ATM) option: ATM option would lead to zero cash flow if it were exercised immediately. Therefore, for both call and put ATM options, strike price is equal to spot price. Often, ATM options are not practical so most options traders use NTM (Near to money) options which are contiguous strikes.

Out of the money (OTM) option: OTM option is one with strike price worse than the spot price for the holder of option. A call option is said to be OTM, when spot price is lower than strike price. A put option is said to be OTM when spot price is higher than strike price.

 

Remember that when we talk of ITM or OTM, we don’t consider the premium cost at all. It is just a comparison of the spot price and the strike price of the option.

 

 

OPTION BASICS – INTRINSIC VALUE AND TIME VALUE OF OPTION…

 

Intrinsic value of an option is much easier to understand. For example, if a stock is quoting at Rs.520, then the 500 strike call will have an intrinsic value of Rs.20 (520 – 500). Intrinsic value has more to do with stock price than with the option. Time value is what the option market assigns to the right, over and above the intrinsic value. The chart below will clarify.

 

Intrinsic Value and Time Value

 

• Intrinsic value: is the amount by which option is in the money i.e. amount an option buyer will realize, without adjusting for premium paid, if exercised instantly. Only ITM options have intrinsic value whereas ATM options and OTM options have zero intrinsic value. Remember, the intrinsic value of an option can never be negative. In case of call option, intrinsic value is the excess of spot price (S) over the strike price (X), i.e. intrinsic value = (S - X). For put options the intrinsic value is (X – S)

• Time value: is the residual option premium left after intrinsic value is removed from the option price. Obviously, ATM and OTM options will have only time value because the intrinsic value of such options is zero. ITM options will have intrinsic value and time value and when we talk of time decay in options; it is this time value component that actually decays. We will understand this concept of time decay in much greater when we get into actual options related strategies and options Greeks.

 

 

OPTION BASICS – OPTIONS PRICING FRAMEWORK… 

The key to options strategy is buying underpriced options and selling overpriced options. But how do you decide whether an option is underpriced or overpriced. In equity trading and investing, you can find out underpriced and overpriced stocks by discounting future cash flows to arrive at the intrinsic value of the stock. In the case of options, you just deploy the Black and Scholes model.

 

Black & Scholes Model for Options Pricing

 

The above formula may be intimidating but don’t lose sleep over it. Most trading software offers you Black & Scholes intrinsic value calculations automatically. You just need to feed inputs and get the output in the form of intrinsic value of a call or a put. You can also use an excel file to calculate the Black & Scholes formula. But what is really important is to understand the parameters that go into the Black and Scholes formula. Each component of the formula above is a factor that impacts the value of the call or put option.

 

Factors that go into determining option intrinsic value

The table below is illustrative and in that it captures the five key factors in the above formula that impact the value of an option. The table captures how the movement of each of these factors impacts the value of a call option and also the value of a put option. The corresponding usage in the above formula has been mentioned next to each factor as used in the Black and Scholes Formula above.

 

Option Valuation Factor	How it impacts call options	How it impacts put options
Underlying Stock Price (S)	If spot price goes up call option value goes up	If spot price goes up put option value goes down
Exercise Price (K)	As you move to higher strikes, the call option value goes down	As you move to higher strikes, the put option value goes up
Volatility (s)	As volatility goes up, the value of the call option goes up	As volatility goes up, the value of the put option goes up
Time to expiry (t)	As time to expiry reduces, the value of call option goes down	As time to expiry reduces, the value of put option goes down
Interest rates (r)	Higher interest rates will reduce the present value of the strike price and increase the value of the call option	Higher interest rates will reduce the present value of the strike price and hence reduce the value of the put option

 

There are two important takeaways from the table above.

• The value of an option consists of the intrinsic value and the time value. In the above table, the first two factors viz. strike price and the exercise price are the factors that go into determination of intrinsic value of the option. The last 3 parameters viz. volatility, time to expiry and interest rates impact the time value of the option.
• One question traders often ask is whether dividends also impact the value of an option. Dividend declaration is interpreted in corporate finance as partial liquidation of a company and to that extent the price of the stock falls. Higher dividends are negative for call options but positive for puts. That is captured in the stock price.

 

 

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

 

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 View	Investor Action	Investor pay-off
Has a bullish view on Tata Motors and expects the stock to go up from Rs.110 to Rs.140 during the month	Investor buys Tata Motors 120 Call option in Sep-20 contract by paying a premium of Rs.5	CMP (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

 

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.

 

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

 

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.

 

 

APPLYING OPTIONS – USING OPTIONS WHEN YOUR VIEW IS BEARISH…

Just as you can use options to make the best of bullish market conditions, you can also use options for bearish market conditions. The beauty of options is that it can help you work markets both ways.

Here we look at 3 popular bearish option strategies; meaning options trading when your view is bearish about a stock. Here are 3 such interesting option trading strategies for bearish markets or where you have a bearish view on a stock.

 

Extremely bearish about a stock

 

This is the simplest way to play a bearish market is to buy a put option. A put option is a right to sell a stock or an index without the obligation to well. That means; you pay the premium to get the right to sell without the obligation. Here again, since you are buying the put option, premium is your option price and represents the maximum loss that you could incur. Here is a practical way to look at it.

Investor View	Investor Action	Investor pay-off
Has a bearish view on Reliance Industries and expects the stock to go down from Rs.2200 to Rs.2000	Investor buys RIL 2100 put option in Aug-20 contract at a premium of Rs.22	CMP (2160) - Loses Premium CMP (2110) – Loses Premium CMP (2080) – Net Loss of Rs.2 CMP (2020) – Net Profit Rs.58

The break-even point for the naked long put option is Rs.2078 (strike price of Rs.2100 - premium of Rs.22). It is only below the price level of Rs.2078 that the trader makes net profit. Above Rs.2100, the trader is indifferent as he loses entire premium irrespective of the price. Below Rs.2100 he starts to recover his premium cost and keeps recovering it till the breakeven point of Rs.2078. From that point, profits can be unlimited.

 

When you are short on futures and buy insurance with call option

 

A protective call is also a bearish strategy but it comes with a built in insurance. In naked puts, the premium is high and in majority of cases, they expire worthless. Instead you can sell futures when you are bearish and sell a higher strike call option to protect. If you look at SBI as an illustration, you can sell SBI Futures at Rs.230 and protect yourself with a 235 call option at Rs.3, then your maximum risk is still Rs.8. But then your breakeven point is Rs.227 as at that point you will cover the cost of the put option too. This strategy is more suited when you are bearish and want to bring down your breakeven point.

 

Moderately bearish strategy via Bear put spread strategy…

 

If you are moderately bearish on a stock, you can save on costs by doing it entirely with options and locking your profits and risk. In a bear put strategy you buy a higher strike put and sell a lower strike put. So your maximum loss is limited to your net premium. In the case of Tata Motors, you can buy a 125 put option at Rs.10 and sell a 110 put option at Rs.4. Your maximum loss will be the net cost of Rs.6. Your maximum profit will be Rs.11 at the price level of Rs.110. In terms of margins, this can be very efficient as margins on spread positions are very low in India. However, this limits upsides and that has to be kept in mind.

 

 

OPTIONS STRATEGIES – TYPES OF OPTIONS STRATEGIES AVAILABLE…

An option trading strategy is a hybrid combination. It can either be a combination of a future and option or a combination of two or more options. But strategies have a very important purpose. By combining two different streams of pay-off flows, the strategy can be structured in such ways that the risk can be measured, controlled and monitored. Option strategies are possible due to the unique nature of options; being asymmetric in nature. Broadly, options strategies can be divided into 6 categories as under:

• Bullish strategies: These are the strategies you typically apply when you expect the stock price or the index to move up decisively.
• Bearish strategies: These are the strategies you typically apply when you expect the stock price or the index to move down decisively.
• Moderately bullish strategies: In this strategy, you are still bullish but your expectations are tempered.
• Moderately bearish strategies: In this strategy, you remain bearish on the market but you believe downside potential is limited.
• Volatile strategies: The view is that the stock or index will be extremely volatile but you are not sure of the direction of the price movement.
• Range bound strategies: The view here is that the stock or the market will be in a range and your strategy is designed to make the best of a range-bound move.

We shall now club the above categories into 3 sets of options strategies viz. basic options strategies, non-directional strategies and spread strategies.

 

 

BASIC OPTIONS STRATEGIES – PROTECTIVE PUTS, COVERED CALLS, COLLARS…

These are 3 of the most basic and commonly used strategies. Since they are simple, these strategies are extensively used. We shall focus on Protective Put, Covered Call and Collar strategy.

 

Protective Put strategy

When to use this strategy: It often happens that you are bullish on a stock but are worried about some risk events. For example, you may be positive on Britannia but you also want to be protected if COVID hits demand for food products. You can remain bullish even while taking insurance on the downside. That is called protective put.

In a protective put you buy a stock / futures and protect the long position by purchasing a put option with lower strike. Here is what happens. On the upside, you enjoy unlimited profits once your put option premium is covered. On the downside, you risk is limited to the difference between (purchase price – put option strike price) + option premium. That is your maximum loss. You are still bullish but you are also protected. Here is how it works.

Example 1: An investor buys a stock in cash market at Rs.750 and protects the position by purchasing a 740 put option paying a premium of Rs.6. Let us see how the payoffs pan out.

 

Spot Prices	Long Price	Put Strike	Put Premium	ITM/OTM	P/L on Spot	P/L on Option	Net P/L
700	750	740	-6	ITM	-50	40	-16
720	750	740	-6	ITM	-30	20	-16
740	750	740	-6	ATM	-10	0	-16
760	750	740	-6	OTM	10	0	4
780	750	740	-6	OTM	30	0	24
800	750	740	-6	OTM	50	0	44
820	750	740	-6	OTM	70	0	64

You can represent the profit simulation graphically as under:

 

Here are key takeaways from the protective put pay-off table and chart.

 

• The maximum loss on this protective put is Rs.16. That is the sum of the gap between spot price and strike price (750-740) plus the option premium of Rs.6. This is insurance because however low the stock price goes, you will never lose more than Rs.16

• Breakeven point (BEP) is the level of no profit / no loss. That level arises at a price of Rs.756. That can be interpreted as (purchase price of Rs.750 + option premium of Rs.6). This is the price at which the chart intercepts the X-axis.

• What is special about the protective put? Above the BEP, profits are unlimited. By just paying a premium of Rs.6, the trader protects the downside risk, but also ensures that the bullish view is maintained.

 

Protective Put strategy is best suited when you have confidence in the up-move but don’t want to take chances with downside risks.

 

Covered Call strategy

When to use this strategy: It happens that you are bullish on a stock but expect the upsides to be limited. Here your view is moderately bullish. Covered call is normally applied when you already own the stock or are long futures. You can remain moderately bullish even as you reduce your cost of holding by selling calls options. That is a covered call.

Covered call is not exactly a limited risk strategy but used to reduce the cost of holding a stock. How does the pay off work in a covered call? There are two kinds of price movements you need to be wary of. As long as the stock stagnates around current levels or up to a level, you have nothing to worry about because you will earn the premium. If the price shoots above the strike price, then the losses on the sold call can be unlimited. But that is fully covered by your long stock position. On the downside, your risk is fully open and this strategy must only be applied with strict stop loss.

Illustration 2: An investor buys a stock in the cash market at Rs.800 and sells an Rs.820 call option at Rs.8. Let us see how the payoffs pan out.

 

Spot Prices	Long Price	Call Strike	Call Prem Recd	ITM/OTM	P/L on Spot	P/L on Option	Net P / L
740	800	820	8	OTM	-60	0	-52
760	800	820	8	OTM	-40	0	-32
780	800	820	8	OTM	-20	0	-12
800	800	820	8	OTM	0	0	8
820	800	820	8	ATM	20	0	28
840	800	820	8	ITM	40	-20	28
860	800	820	8	ITM	60	-40	28

 

You can present the profit simulation graphically as under.

 

Here are your key takeaways from the covered call pay-off table and chart.

 

• The maximum profit on the covered call strategy is Rs.28. That is the sum of the gap between strike price and spot price (820-800) plus the option premium of Rs.8 received. This always occurs at the strike at which you sell the call option.

• On the downside, the losses can be unlimited. Hence this strategy must only be adopted on stocks that have strong fundamentals and where you can hold for the long term. Below Rs.792, the losses on this strategy can be unlimited.

• Therefore, the breakeven point (BEP) for the covered call strategy is Rs.792 which is the purchase price of Rs.800 less the premium of Rs.8 that you have received. This strategy must be adopted only if you are confident of the stock not sustaining below this level.

 

Collar strategy

When to use this strategy: The collar is actually a combination of a protective put and the covered call. You are running loss on a stock and want to protect the downside risk with a put option. However, to reduce your breakeven, you also sell a higher call so that the premium received on the call option partially compensates you for the premium paid on the put option. However, this is a moderately bullish strategy with downside protection and cannot be used when you are decisively bullish on the stock or index.

In the covered call strategy, the downside risk was open. Here there are 3 phases to the collar strategy. First, you are long on the stock. Secondly, you buy a lower put option. Thirdly, you sell a higher call option. How does this help?

In covered call, downside risk was open. Now that risk is closed by buying a lower put. The beauty of the collar strategy is that it is a limited loss and limited profit strategy. Such strategies are popularly referred to as closed option strategies.

Example 3: Investor X buys a stock in the cash market at Rs.500 and sells an Rs.520 call option at Rs.7. He also buys Rs.490 put by paying a premium of Rs.4. Here is the payoff.

 

Spot Prices	Long Price	Put Strike	Put Prem Paid	ITM/OTM	Call Strike	Call Prem Recd	ITM/OTM	P/L on Spot	P/L on Put	P/L on Call	Net Profit / Loss
470	500	490	-4	ITM	520	7	OTM	-30	20	0	-7
480	500	490	-4	ITM	520	7	OTM	-20	10	0	-7
490	500	490	-4	ATM	520	7	OTM	-10	0	0	-7
500	500	490	-4	OTM	520	7	OTM	0	0	0	3
510	500	490	-4	OTM	520	7	OTM	10	0	0	13
520	500	490	-4	OTM	520	7	ATM	20	0	0	23
530	500	490	-4	OTM	520	7	ITM	30	0	-10	23

 

 You can present the graphic simulation of payoffs of a collar as under

 

Here are some key takeaways from the collar strategy pay-off chart.

• The maximum loss on collar is Rs.7. However, low the price of the stock goes, total loss can never be more than Rs.7. How do we logically arrive at this maximum loss of Rs.7? You maximum loss on the spot/put position is Rs.10 (500-490) plus put premium of Rs.4. But this loss of 14 gets reduced by the Rs.7 you received on the 520 call sold. Hence maximum loss on Collar is limited to Rs.7 (14-7).

• However, the maximum profit is capped at Rs.23 from Rs.520 price onwards. How is this maximum profit arrived at? The gap between the call strike and purchase price (520-500) is Rs.20. To that you add the net premium received (7-4). That adds up to Rs.23 and irrespective of how high the stock goes; you only earn Rs.23 maximum.

• The breakeven point for the collar strategy is Rs.497 as can be seen from the table. From the purchase price of Rs.500, you reduce the net premium received of Rs.3 (7-4). That is also the point at which the chart intercepts and you are profitable above 497.

 

Here is a quick summing up of the basic strategies in options.

• Protective put is a bullish strategy in stocks and indices where the trader is positive on upside movement but wants to take insurance for protection.
• While protective put can give unlimited profits on the upside, the options are wasting assets and high put premiums normally work against the strategy.
• Covered calls can be used either to earn premium and reduce the cost of holdings or to make the best of your limited upside view on the stock.
• Covered calls have limited upsides but downsides can be unlimited and the remains a big risk if the price was to fall sharply.
• A combination of a protective put and covered call is the Collar Strategy. It entails purchasing a stock, buying lower strike put and selling a higher strike call. As a result the losses and profits are capped, making it a closed strategy.
• The collar strategy cannot be used for a decisively bullish view. Another downside of the collar strategy is that it is a multi-legged strategy. Creating a collar and closing the collar entails a total of 6 transactions so the transaction costs and statutory costs add up.

 

 

NON-DIRECTIONAL OPTIONS STRATEGIES – STRADDLES, STRANGLES, BUTTERFLIES…

 

 STRADDLES, STRANGLES AND BUTTERFLY SPREADS

The really challenge in options strategies are felt when the direction of the stock or index is not too clear. You find it hard to choose between bullish and bearish. Here you can play on volatility, without worrying about the direction of the price movement. These are non-directional strategies. Broadly, we shall look at 3 non-directional strategies here viz. straddles, strangles and Butterflies.

 

Straddle strategy

A long straddle is a volatile strategy that is intended to be profitable when the stock is highly volatile and shows a sharp movement either on the upside or on the downside. Here the bet is on volatility and not on direction of the stock price. If you expect volatility, you can go long on straddle and if you expect market to be range-bound, you can be short on straddle.

Example 4: A long time Infosys trader expects the stock to become volatile around results time but is not sure of direction. The stock is currently quoting at Rs.955 so he opts to buy Rs.950 call at Rs.28 and an Rs.950 put at Rs.12. Now look at the pay off.

 

Infosys Stock	Call Strike	Put Strike	Call Premium	Put Premium	P/L on Long Call	P/L on Long Put	P/L on Long Straddle	P/L on Short Straddle
900	950	950	-28	-12	0	50	10	-10
910	950	950	-28	-12	0	40	0	0
920	950	950	-28	-12	0	30	-10	10
930	950	950	-28	-12	0	20	-20	20
940	950	950	-28	-12	0	10	-30	30
950	950	950	-28	-12	0	0	-40	40
960	950	950	-28	-12	10	0	-30	30
970	950	950	-28	-12	20	0	-20	20
980	950	950	-28	-12	30	0	-10	10
990	950	950	-28	-12	40	0	0	0
1000	950	950	-28	-12	50	0	10	-10
1010	950	950	-28	-12	60	0	20	-20
1020	950	950	-28	-12	70	0	30	-30

  

The above payoff can be graphically presented in a chart form as under.

 

 

Here are the key takeaways from the payoffs on a straddle strategy

• Long straddle is a volatile strategy and it makes a profit only when the price movement is large enough to cover the call and put premiums. The maximum loss on long straddle is Rs.40 which is the total premium paid on call and put (28 + 12). Once the premium cost is covered, profits can be unlimited either ways.

• The straddle strategy has two breakeven points. There is a lower breakeven point at Rs.910 (950-40) and an upper breakeven point at Rs.990 (950+40). If Infosys moves below Rs.910 or above Rs.990, then long straddle is profitable.

• The last column of the table is of a short straddle where the payoff is exact mirror image of long straddle. You can use that straddle if you expect Infosys to be range-bound. However, it is a high risk strategy as beyond the break even limits, the losses can be unlimited on both the sides.

 

Strangle strategy

There are two problems in a straddle. Firstly, since call and put are at the same strike, the overall cost can be quite high. A better way would be to opt for a higher call and lower put. The second problem for straddle sellers is the too small profitable range and that can be expanded by taking a broader strike range. Both these short comings of straddle are addressed by the strangle strategy.

Example 5: Back to the Infy strategy again! A trader expects Infosys to become volatile this quarter but is not sure of the direction. The stock is currently quoting at Rs.955 so he opts to buy Rs.970 call at Rs.12 and an Rs.940 put at Rs.8 Now look at the pay off.

 

Infosys Stock	Call Strike	Put Strike	Call Premium	Put Premium	P/L on Long Call	P/L on Long Put	P/L on Long Strangle	Profit on Short Strangle
900	970	940	-12	-8	0	40	20	-20
910	970	940	-12	-8	0	30	10	-10
920	970	940	-12	-8	0	20	0	0
930	970	940	-12	-8	0	10	-10	10
940	970	940	-12	-8	0	0	-20	20
950	970	940	-12	-8	0	0	-20	20
960	970	940	-12	-8	0	0	-20	20
970	970	940	-12	-8	0	0	-20	20
980	970	940	-12	-8	10	0	-10	10
990	970	940	-12	-8	20	0	0	0
1000	970	940	-12	-8	30	0	10	-10
1010	970	940	-12	-8	40	0	20	-20
1020	970	940	-12	-8	50	0	30	-30

  

 The strangle strategy can be graphically presented as under:

 

 

What are the key takeaways from the above illustration?

• Long strangle is also a volatile strategy but is an improvement over the straddle. Since the range is broadened, the overall premium cost comes down. Profit arises only when the price movement is large enough to cover the call and put premiums. The maximum loss on long strangle is Rs.20 which is the total premium paid on call and put (12 + 8). Once the premium cost is covered, profits are unlimited either ways.

• The strangle strategy also has two breakeven points. There is a lower breakeven point at Rs.920 (940-20) and an upper breakeven point at Rs.990 (970+20). If Infosys moves below Rs.920 or above Rs.990, then long strangle is profitable.

• The last column of the table pertains to a short strangle where the payoff is the exact mirror image of long strangle. You can use the short strangle strategy only if you expect Infosys to be range-bound. However, short strangle is an intrinsically risky strategy.

 

Butterfly Spread

Butterfly spread can be viewed as an extension of short straddle. In short straddle, the risk of volatility is unlimited on either side. To put a cap to this risk of short straddle, trader buys one out of the money call and one out of the money put. That is a butterfly spread and it is another closed strategy. However, the Butterfly has 4 legs to initiation and 4 legs to closure. That will significantly add to the costs of the strategy, when you consider the transaction and statutory costs. Hence complex strategies like Butterfly Spread and Condor are only used when the transaction cost can be covered and liquidity is sufficient in all strikes.

 

 

SPREAD OPTIONS STRATEGIES – HOW OPTIONS SPREADS ARE CLASSIFIED…

 

 What are option spreads?

After simple strategies and non-directional strategies, we move to spreads. Spreads are extremely powerful in that they are locked strategies and put limits on risk and return. These spreads have two advantages. Firstly, they work irrespective of market movement and volatility. Secondly, it allows the trader to bet on spreads, without worrying about which stock will go up and which will go down. Spreads are categorized into three segments viz. vertical spreads, horizontal spreads and diagonal spreads.

Vertical Spreads

Vertical spreads are created by combining two options having the same expiry but different strike prices. Such spreads can be created either using calls as combination or puts as combination. Bull call spreads and bear put spreads are two of the most popular vertical spreads and we shall look at them more elaborately later.

Horizontal Spread

Horizontal spread involves combining two options with the same strike but different expiry. For example, buying a Nifty 11,500 August call and selling an 11,500 September is an example of horizontal spread. This is how a calendar spread chart would look like.

 

Diagonal spread

Diagonal spread involves combination of options having same underlying but different expiry as well as different strikes. Hence they are complex and more of correlation spreads rather than clean spreads. These diagonal spreads not too commonly used and are more suitable for the OTC market, rather than the listed derivatives market.

 

 

SPREAD OPTIONS STRATEGIES – BULL CALL, BEAR PUTS AND CALENDARS

 

Bull Call Spread

Bull call spread is a moderately bullish strategy where the trader buys a lower strike call option and sells a higher strike call option of the same expiry. As in any vertical spread, the maximum profit and the maximum loss are fixed making it a closed strategy.

Example 6: Trader Buys an August 2000 RIL call option of a stock at Rs.30 and sells an August 2100 call of the same stock at Rs.12. This is an example of a bull call spread.

 

Stock Price	Lower Call Strike	Upper Call Strike	Premium paid	Premium received	P/L on Lower call	P/L on higher call	Total Profit
1700	2000	2100	-30	12	0	0	-18
1800	2000	2100	-30	12	0	0	-18
1900	2000	2100	-30	12	0	0	-18
2000	2000	2100	-30	12	0	0	-18
2100	2000	2100	-30	12	100	0	82
2200	2000	2100	-30	12	200	-100	82
2300	2000	2100	-30	12	300	-200	82
2400	2000	2100	-30	12	400	-300	82
2500	2000	2100	-30	12	500	-400	82
2600	2000	2100	-30	12	600	-500	82
2700	2000	2100	-30	12	700	-600	82

 

 The pay-off of the bull-call spread can be presented as below.

 

 

 Here are some key takeaways from the bull call spread

• The maximum loss in the above bull-call spread is Rs.18. That is the net premium paid in the strategy (30 - 12). The total loss will not exceed this level.

• Maximum profit is Rs.82, which is calculated by the strike difference (2100-2000) less the net premium of Rs.18.

• This bull call spread has a breakeven of Rs.2018 (lower strike + net cost) and maximum profit occurs at the upper strike. BEP is the point of intersection of the chart.

 

Bear Put Spread

A mirror of the bull call is the Bear Put spread which is a moderately bearish strategy. It entails buying a higher strike put option and selling a lower strike put option of the same expiry. The maximum profit and maximum loss are fixed and hence it is a closed strategy.

Example 7: Trader Buys an August 1000 put option of a stock at Rs.20 and sells an August 900 put of the same stock at Rs.6. This is an example of a bear put spread. Let us see how the payoffs work.

 

Stock Price	Higher Put Strike	Lower Put Strike	Premium paid	Premium received	P/L on higher put	P/L on lower put	Total Profit
800	1000	900	-20	6	200	-100	86
850	1000	900	-20	6	150	-50	86
900	1000	900	-20	6	100	0	86
950	1000	900	-20	6	50	0	36
1000	1000	900	-20	6	0	0	-14
1050	1000	900	-20	6	0	0	-14
1100	1000	900	-20	6	0	0	-14
1150	1000	900	-20	6	0	0	-14
1200	1000	900	-20	6	0	0	-14

  

Here is a graphical representation of a bear put strategy

 

 

Here are the takeaways from the pay-off chart of the bear put spread

• The maximum loss in the bear put spread strategy is Rs.14. That is the net premium paid in the strategy (20 -6). The total loss can never exceed this level.

• Maximum profit is Rs.86, which is calculated by the strike difference (1000-900) less the net premium of Rs.14.

• This bear put spread has a breakeven of Rs.986 (upper put strike - net cost) and the maximum profit occurs at the lower put strike of 900. BEP is the X-axis intersection.

 

 

ONE STEP HIGHER – UNDERSTANDING OPTION GREEKS…

 

An important part of options strategy is how to trade based on option Greeks. You must have heard of Options Delta, Gamma and Theta very frequently. Here we focus on the five major Option Greeks and look at the delta, gamma and theta in slightly greater detail.

Option Greeks measure sensitivity of the option price to various parameters that impact the value of an option. Such sensitivity can either be on the positive side or on the negative side. Option price refers to the option value calculated by the Black & Scholes model.

 

Delta – Measure of option price sensitivity to changes in stock price

 

This is perhaps the most popular among the various Greeks that are used by options traders and it ranges between -1 and +1. Delta measures the amount or the extent to which the value of the option will change if the market moves up / down by 1 point. Calls have positive delta while puts have a negative delta. If the delta of a strike is 0.4 then an Rs.30 move in the stock price will impact the price of a call positively by Rs.12 and the price of a put option gets impacted negatively by Rs.12.

 

Gamma – Measure of option price sensitivity to changes in Delta

 

Gamma is a second level derivative and is also among the Greeks used by options traders quite extensively. Gamma measures the extent to which the DELTA of the option will change if the market moves up / down by 1 point. Gamma is also calculated separately for call and put options of the same strike. Gamma actually measures the momentum and is used actively by smart options traders to trade in and out of an option.

 

Theta – Measures the time decay of an option as we move towards to expiry

 

This is a popular Greeks for option sellers since their profits are limited to premiums but risks are unlimited. Theta is also called a measure of time decay or simply it is referred to as time decay. Theta measures the extent to which the option price will change with each passing day. Theta is always negative because the value of an option always goes down with each passing day. Theta only refers to the decay of the time value and not of the intrinsic value of the option, which is a function of the price gap between the strike price and the market price. Normally, options are sold in such a way as to make the most of the time decay. They are useful in determining option selling turning points.

 

Vega – Sensitivity of the option price to changes in volatility

When you trade in options, you don’t just trade for price movement but also for volatility movement. That is because even assuming that the stock price remains static, if the volatility in the market goes up then the value of the call and put options go up. This sensitivity of option price to the change in volatility is measured by Vega. In other words, Vega is the extent to which theoretical price of the option will change if the volatility of the asset moves up/down by 1 percentage point.

 

Rho – The sensitivity of the option price to changes in interest rates

Rho represents the amount that the theoretical price will change if interest rates move up/down by 1 percentage point. This is not very popular among traders in options.

In terms of options strategy, delta and gamma are extensively used by traders who play on volatility. For institutions that are normally into option selling, Theta trading is an important Greek application.

 

 

ANNEXURE 1 – CHOOSING BETWEEN FUTURES AND OPTIONS …

As a trader, you can execute your view either with the help of futures or options. For example, if you are bullish on a stock, you can either buy futures or you can buy call options. Similarly, if you are negative on a stock, you can either sell futures or you can buy put options. How do you take this decision whether to execute the view with the help of futures or with the help of options?

The decision to buy or sell on the cash market is fairly straight forward; here you want to be part owner of the company. The real challenge is whether to buy a stock future or to buy a call option. Alternatively, should you sell stock futures or buy a put option. Here are 5 factors that will help you decide between futures and options.

Are you playing the stock for price or for time?

When you buy a stock like Reliance, you obviously expect the stock price to go up. If you have a 3 months target of 25% upside in the stock, should you opt for futures or for options? Buying futures will allow you to participate in the price movement but that is the only benefit you get. What if you also want to play on price expectations? The expectations based movement exists only in call options and put options and this is called the time value of money. The moral of the story is that if you are playing for price then play with futures but if you are playing for time then play with options.

Are you focusing on price movement or volatility?

If you expect banking stocks to go down sharply in the next quarter, then selling futures is the simple answer. When the target price is reached on the downside, you book profits on the short futures and take profits out. But such a sharp fall will also be accompanied by bouts of volatility. What if you are bullish but also expect the stock to be very volatile in the next few months. Then you should go for a put option. Volatility benefits the buyer of the put option because if the volatility is favourable then the buyer makes the profit and if volatility is unfavourable then losses are limited to premium. You get the dual benefit of price movement and volatility benefits in options.

Are you designing the trade around key events?

Quite often, events tend to be discrete. For example, you expect that ONGC will declare a bumper special dividend but you are not sure. Buying in futures market is risky as you are exposed both ways. Instead, you can play the event with a call option. If you are sceptical about the exact direction of the impact, you can also play through strangles, but that can be more expensive. Normally, key events and major announcements are best played with options rather than futures as you only stake the premium.

If there is deep under-pricing of options

When you see under-pricing of options with respect to intrinsic value, it is better to go for the options route. Here, the under-pricing can partially compensate you for the premium cost. Typically, if there is too much optimism in the market, call options tends to be overpriced as do put options. Similarly, when there is too much of pessimism in the stock markets, you will find most call options cheap. The Black and Scholes equation will help you to determine whether an option is underpriced and your trading terminal can also help. Buy options when you find deep under-pricing as they are a safer bet for you. In such times, options offer a better choice than futures.

If you need protection, always prefer options

You can hedge your cash market positions by selling futures, but that has a shortcoming. You can sell futures against your cash market position and lock in your losses. But you lock in profits too. Such a situation can be better handled with options. If you buy a lower put option then your total cost of the protection is limited to the gap plus the cost of option. Once that is covered, profits on the upside are unlimited. Therefore, if it is fixed return arbitrage then futures make more sense; but for protection options are better.

 

 

ANNEXURE 2 – TEN THINGS TO KEEP IN MIND WHEN BUYING OPTIONS

Whether you buy index options or stock options, there are some key points to remember when buying options. Options buying may look like a low risk venture as your loss is limited to premium, but in reality, option sellers make money more often. What are the tricks of the trade that option buyers must know and implement?

 

 10 things to remember when you buy options in the market…

• You can get options that expire in 1 month, 2 months and 3 months and there are long term options on indices. While liquidity is still concentrated in near month options, you can take an intelligent call on the tenure based on liquidity, your view on the stock and your risk appetite.

• In the case of call and put options, buyer has the right but not the obligation to buy or to sell. For this right without obligation the buyer pays a premium to the seller of the option. This premium is a sunk cost for the option buyer.

• Premium paid by you on a call or put option effectively is your maximum loss. There is only a premium margin that you need to pay initially. As an option buyer you don’t worry about MTM margins which are payable in case of futures.

• Every option purchase is a trade-off. If your options have a lower outstanding maturity then it will be available at a lower premium. But the lower outstanding maturity also means that the prospects of you making profits on options are limited.

• When volatility goes up, both calls and puts become more valuable. When markets are volatile there is a greater probability of the stock moving sharply either ways. Since options are non-linear, you make profits but don’t take the losses.

• STT on options is charged on premium value and not on intrinsic value. This is a clear advantage for options buyers over futures. One of the main reasons for options trading growing in India is that the STT is imposed on premium value and not notional value.

• Option price comprises of two components; the intrinsic value and time value. All options have some time value but only ITM options have intrinsic value. Intrinsic value is a play on prices and strikes while time value is a play on volatility.

• Option is a wasting asset and hence time value of the option keeps reducing as the date of maturity approaches and almost comes close to zero by the time the maturity approaches. It is not advisable to hold call options too close to expiry.

• Options are flexible and dynamic products. For starters, you can speculate on the stock but also protect the value of your portfolio and traders must also look to hedge their positions. The non-linear nature of options gives a lot of flexibility from a buyer’s point of view.

• Options are amenable to combinations for different market situations. If you expect markets to be volatile Straddle or Strangle can help. Conversely, if you expect the market to remain range-bound, you can sell options.

 

 

 ANNEXURE 3 – TEN THINGS TO KEEP IN MIND WHEN SELLING OPTIONS

Whether you sell index options or stock options, there are some points to remember when selling options. Options selling may look like complex as your loss is unlimited, but in reality, option sellers make money more often. Here are 10 tricks of option selling.

 

10 points to keep in mind when selling options

• An option seller/writer takes a contrary view. If the option seller believes that the stock will not go below a certain level then the option writer will sell a put option. It is more of a non-affirmative view in the markets.

• Sellers of put and call options have unlimited risk. If the price movement goes against, you may end up booking huge losses. That is why; selling of options must never be done without a stop loss and ideally have an underlying position to reduce risk.

• All stock options have moved into delivery and hence all options positions open in the last week will start to suddenly attract substantially higher margins from the beginning of the last week and you must factor this in any short option.

• It is always advisable for option sellers to trade with strict stop losses. Irrespective of whether you have sold a call option or a put option, it is always advisable to keep stop losses so that your capital can be protected.

• When you sell options, they attract margins in the same way as buying and selling futures. The margin call will be adjusted against premium receivable. Selling options attract upfront margins and MTM margins in the same manner as long futures and short futures.

• Selling options works best when the stock is exhibiting a clear trend and taking strong support or meeting stiff resistance. If Tata Motors is exhibiting consistent bullish trend, traders can enhance profits by consistently selling put options of higher strikes.

• Should you sell ATM, ITM or OTM options? It is a trade-off. ITM option gives higher premiums but also comes with higher risk. The OTM option comes with much lower risk but also with much lower premium potential. Strike this balance among strikes judiciously.

• For the option seller, time value works in favour. When you sell an option, premium keeps depleting with time giving the seller an opportunity to book profits by buying it back at lower levels. Thus the option seller gains from Theta decay.

• Selling options is extremely effective as a cost reduction strategy by using covered calls. Even as you hold the stock in your portfolio, you can keep selling higher call options. If the options expire worthless, then premium earned will reduce your cost of holding.

• Remember, globally 80-90% of options expire worthless. As a seller of options you stand a better chance of making profits than a buyer of an option. However, you must be cautious while selling options considering its skewed risk-return structure.

 

 

 ANNEXURE 4 – DECIDING WHEN TO BUY AND WHEN TO SELL OPTIONS…

This may look like an inane question, but it is an important question that most traders must answer. Take the case of the famous Barings Bank of 1995. The bank sold Nikkei strangles heavily and when the Kobe earthquake struck, the bank had to take a $1 billion write-off and the capital got wiped out. Had Nick Leeson bought the strangle strategy, Barings would still have been around and Leeson would have been richly rewarded.

What should be your call option trading strategy? How do you decide when to buy and when to sell an option?

 

Is the option underpriced or overpriced?

You cannot calculate the intrinsic value of an option the way you calculate for equities but you can apply Black & Scholes model. If the price of the option is above the intrinsic value then it is overpriced and needs to be sold. If the price is below the intrinsic value it is time to buy the option.

 

Is market volatility going to increase or reduce?

Remember, that both call and put options benefit from volatility because it makes the option valuable on the upside but your downside risk is limited anyways. To know about Call and Put option and to know the basics of Derivatives Click here. Even if the stock price remains at the same place, the value of the option can go up if volatility goes up. It is always advisable to be buying options when the volatility is likely to go up and sell options when the volatility is likely to go down.

 

Look for key events with disruptive potential

Like Nick Leeson and Barings, people have lost billions of dollars selling options on sub-prime, silver and gold and ended with huge losses. Quite often, we lose perspective of the disruptive potential of certain events or announcements. If you sold options ahead of cataclysmic events then your capital could get wiped out.

 

Is your view affirmative or defensive?

This is an interesting point. An affirmative view is when you either expect the stock to decisively go up or down. In that case you either buy a call option or a put option as the case may be. But what if you have a defensive view? For example, if you believe that Tata Steel will not go above Rs.400, it is better to sell a 410 call option on Tata Stock, than trying and buying puts.

 

What is time left to expiry?

Time works against the buyer of the option and in favour of the seller. In the initial days of the month time decay is stable. But as expiry date approaches, you find the time decay beginning to work more rapidly. When options start losing value rapidly, it is not a very good idea to buy options unless you really want to take a risk and bet on volatility. You are best being a seller!