L.

S RAHEJA COLLEGE OF ARTS AND COMMERCE

JUHU ROAD, SANTACRUZ (W), MUMBAI 400 054

PROJECT REPORT ON

OPTION TRADING STRATEGIES SUBMITTED BY HARSHIT SHAH

IN PARTIAL FULFILLMENT OF THE REQUIREMENT OF

T.Y.B.COM (FINANCIAL MARKETS) SEMESTER V

PROJECT GUIDE

PROF. GOVIND SOWANI

UNIVERSITY OF MUMBAI
2011 2012

DECLARATION

I hereby declare that I have successfully completed the project on Option trading strategies for the academic year 2011-2012. The project is done under the guidance of Prof. Govind Sowani and is submitted in the partial fulfillment of the requirements for the award of the degree of Bachelor of Commerce (Financial Markets) The information provided in the project is true and to the best of my knowledge.

Signature of the Student Harshit Shah Roll No: 42 T.Y.B. Com (Financial Markets)

CERTIFICATE

This is to certify that Mr. Harshit Shah student of TY-B.Com (Financial Markets) Semester V of L. S. Raheja College of Arts & Commerce has successfully completed the project on Option Trading Strategies under the guidance of Prof. Govind Sowani for the academic year 2011-2012.

Course Co-ordinator (Prof. Abdul Kadir Khan)

Principal

College Seal

Project Guide (Prof. Govind Sowani)

External Guide

ACKNOWLEDGEMENT

When a student ventures any avenue of learning he/she embarks upon a mission of exploration. The inception of this project report draws upon the contribution of many individuals. First and Foremost, I would like to express my heartfelt thanks to Prof. Govind Sowani for taking Keen interest and timely help in spite of his tight working schedule, who provided me with all his supports in order to make this effort possible and effective. I would be failing in my duty if I do not acknowledge with a deep sense of gratitude and sacrifices made by my parents and thus have helped me in completing the project work successfully. I would also like to thank to all who provided me all the necessary support and who took interest in providing me all the necessary information that I required for the making of my study successful.

Executive Summary

Derivatives - Overview
The last two decades have witnessed a phenomenal growth in trade and industry the world over. Gone are the days when capital used to remain within the boundaries of nations. In this era of globalisation and liberalization, technology, capital and other sources are not only crossing the borders of nations, but are also increasing the volume of international trade. The rapidity with which the concepts of corporate finance, bank finance and investment finance have changed in recent years has given birth to new financial products known as Derivative Instruments. As the name suggests, derivative instruments are financial instruments whose value is derived from an underlying asset or securities such as foreign exchange (forex), treasury bills (T-Bills), bonds, shares, share indices and commodities. In recent times, there are different types of derivatives which are evolved, vis--vis, Equity derivatives, Commodity derivatives, Currency derivatives, Energy derivatives, Weather Derivatives, etc.

Derivatives can be traded on:i. ii. Over-the-counter (OTC) market Exchanges.

Types of Derivatives

Derivatives

Forwards

Futures

Options

Swaps

Warrants

Baskets

i.

Those that are traded on the floor of an exchange, such as Futures and Options.

ii.

Those that are traded over-the-counter (OTC), such as Forwards, Options and Swaps.

The main differences between these two types of derivatives instruments are in counterparty risk and liquidity. While exchange traded instruments do not carry any counterparty risk, OTC instruments do. Further, in exchange traded instruments, one can exit at any time at the prevailing rate because these instruments are quoted regularly on the exchange. OTC instruments do not carry such liquidity; they can be terminated only at the disadvantage of the holder.

i. Forwards Contracts:A forward contract is a contract between two parties to buy or sell an asset at a certain future date for a certain price that is pre-decided on the date of the contract. The future date is referred to as expiry date and the pre-decided price is referred to

as Forward Price. It may be noted that forwards are private contracts and their terms are determined by the parties involved, i.e., they are customized.

ii. Futures Contracts:A futures contract is an agreement between a seller and a buyer which requires the seller to deliver to the buyer a specified quantity of security, commodity or forex at a fixed time in the future, at a price agreed to at the time of entering into the contract. A futures contract is a exchange traded contract, i.e., they are standardized contract.

iii. Options Contracts:An Options is a contract between two parties in which one party has the right, but not the obligation to buy / sell some underlying assets. Options are deferred delivery contracts that give the buyer the right, but not the obligation, to buy / sell a specified commodity or security at a set price on or before a specified future date.

iv. Swaps:Swaps are derivatives where counterparties to exchange cash flows or other variables associated with different investments. Many times a swap will occur because one party has a comparative advantage in one area such as borrowing funds under variable interest rates, while another party can borrower more freely as the fixed rate. . A "plain vanilla" swap is a term used for the simplest variation of a swap. There are many different types of swaps, but three common ones are: Commodity swaps, Interest Rate Swaps & Currency Swaps.

v. Warrants:Options generally have lives up to one year, the majority of options traded on option exchanges having a maximum maturity of nine months. Longer dated options are called warrants and are generally traded over-the-counter.

vi. Baskets:Basket options are options on portfolios of underlying assets. The underlying asset is usually a moving average or a basket of assets. E.g.:- Nifty Index.

Factors Contributing to growth of Derivatives

Price Volatility Globalization of Markets Technological Advances Advances in Financial theories

1. Price Volatility

Greater Price volatility after the break-down of Bretton Woods System. Helps to hedge the risk faced in other countries. Resulted in fast transmission of information which affected the market price. Lead to the development of Black-Scholes option pricing model.

A price is what one pays to acquire or use something of value. The concept of price is clear to almost everybody when we discuss commodities. There is a price to be paid for the purchase of food grain, oil, petrol, metal, etc. the price one pays for use of a unit of another persons money is called interest rate. And the price one pays in ones own currency for a unit of another currency is called as an exchange rate. Prices are generally determined by market forces. In a market, consumers have demand and producers or suppliers have supply, and the collective interaction of demand and supply in the market determines the price. These factors are constantly interacting in the market causing changes in the price over a short period of time. Such changes in the price are known as price volatility.

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The changes in demand and supply influencing factors culminate in market adjustments through price changes. These price changes expose individuals, producing firms and governments to significant risks. The break-down of the BRETTON WOODS agreement brought an end to the stabilizing role of fixed exchange rates and the gold convertibility of the dollars. The globalization of the markets and rapid industrialization of many underdeveloped countries brought a new scale and dimension to the markets. This price volatility risk pushed the use of derivatives like futures and options increasingly as these instruments can be used as hedge to protect against adverse price changes in commodity, foreign exchange, equity shares and bonds.

2. Globalization of the Markets

Earlier, managers had to deal with domestic economic concerns; what happened in other part of the world was mostly irrelevant. Now globalization has increased the size of markets and as greatly enhanced competition .it has benefited consumers who cannot obtain better quality goods at a lower cost. It has also exposed the modern business to significant risks and, in many cases, led to cut profit margins In Indian context, South East Asian currencies crisis of 1997 had affected the competitiveness of our products vis--vis depreciated currencies. Export of certain goods from India declined because of this crisis. Steel industry in 1998 suffered its worst set back due to cheap import of steel from south East Asian countries. Suddenly blue chip companies had turned in to red. Thus, it is evident that globalization of industrial and financial activities necessitates use of derivatives to guard against future losses. This factor alone has contributed to the growth of derivatives to a significant extent.

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3. Technological Advances
A significant growth of derivative instruments has been driven by technological break-through. Advances in this area include the development of high speed processors, network systems and enhanced method of data entry. Closely related to advances in computer technology are advances in telecommunications. Improvement in communications allow for instantaneous worldwide conferencing, Data transmission by satellite. At the same time there were significant advances in software programmed without which computer and telecommunication advances would be meaningless. These facilitated the more rapid movement of information and consequently its instantaneous impact on market price. Although price sensitivity to market forces is beneficial to the economy as a whole resources are rapidly relocated to more productive use and better rationed overtime the greater price volatility exposes producers and consumers to greater price risk. Derivatives can help a firm manage the price risk inherent in a market economy.

4. Advances in Financial Theories

Advances in financial theories gave birth to derivatives. Initially forward contracts in its traditional form, was the only hedging tool available. Option pricing models developed by Black and Scholes in 1973 were used to determine prices of call and put options. The work of economic theorists gave rise to new products for risk management which led to the growth of derivatives in financial markets.

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Introduction to Options
An option is a contract written by a seller that conveys to the buyer the right, but not the obligation to buy (in the case of a call option) or to sell (in the case of a put option) a particular asset, at a particular price (Strike price / Exercise price) in future. In return for granting the option, the seller collects a payment (the premium) from the buyer. Exchange traded options form an important class of options which have standardized contract features and trade on public exchanges, facilitating trading among large number of investors. They provide settlement guarantee by the Clearing Corporation thereby reducing counterparty risk. Options can be used for hedging, taking a view on the future direction of the market, for arbitrage or for implementing strategies which can help in generating income for investors under various market conditions.

The power of options lies in their versatility. They enable you to adapt or adjust your position according to any situation that arises. Options can be as speculative or as conservative as you want. This means you can do everything from protecting a position from a decline to outright betting on the movement of a market or index. In India, Options can be played on stocks or indices.

NOTE: - There are no index options in BSE. Whereas, both stock and index options can be played on NSE.

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Types of Options
Options are basically of two types:A) Call Option i. Long Call ii. Short Call B) Put Option i. Long Put ii. Short Put

Bullish Options:i. Long Call ii. Short Put

Bearish Options:i. Short Call ii. Long Put

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Options Lingo
Call option: A call option gives the holder the right but not the obligation to buy an asset at a certain date for a certain price.

Put option: A put option gives the holder the right but not the obligation to sell an asset by a certain date for a certain price.

Index options: These options have the index as the underlying. In India, they have a European style settlement. E.g. Nifty options, Mini Nifty options, etc.

Stock options: Stock options are options on individual stocks. A stock option contract gives the holder the right to buy or sell the underlying shares at the specified price. They have an American style settlement.

Buyer of an option: The buyer of an option is the one who by paying the option premium buys the right but not the obligation to exercise his option on the seller/writer.

Writer / seller of an option: The writer / seller of a call / put option is the one who receives the option premium and is thereby obliged to sell/buy the asset if the buyer exercises on him.

Option price/premium: Option price is the price which the option buyer pays to the option seller. It is also referred to as the option premium.

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Expiration date: The date specified in the options contract is known as the expiration date, the exercise date, the strike date or the maturity.

Strike price: The price specified in the options contract is known as the strike price or exercise price.

American options: American options are options that can be exercised at any time up to the expiration date.

European options: European options are options that can be exercised only on the expiration date itself.

In-the-money option: An in-the-money (ITM) option is an option that would lead to a positive cash-flow to the holder if it were exercised immediately. A call option on the index is said to be in-the-money when the current index stands at a level higher than the strike price (i.e. spot price > strike price). If the index is much higher than the strike price, the call is said to be deep ITM. In the case of a put, the put is ITM if the index is below the strike price.

At-the-money option: An at-the-money (ATM) option is an option that would lead to zero cash-flow if it were exercised immediately. An option on the index is at-themoney when the current index equals the strike price (i.e. spot price = strike price).

Out-of-the-money option: An out-of-the-money (OTM) option is an option that would lead to a negative cash-flow if it were exercised immediately. A call option on the index is out-of-the-money when the current index stands at a level which is less than the strike price (i.e. spot price < strike price). If the index is much lower than the

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strike price, the call is said to be deep OTM. In the case of a put, the put is OTM if the index is above the strike price.

Intrinsic value of an option: The option premium can be broken down into two components - intrinsic value and time value. The intrinsic value of a call is the amount the option is ITM, if it is ITM. If the call is OTM, its intrinsic value is zero. Putting it another way, the intrinsic value of a call is Max [0, (St K)] which means the intrinsic value of a call is the greater of 0 or (St K). Similarly, the intrinsic value of a put is Max [0, K St], i.e. the greater of 0 or (K St). K is the strike price and St is the spot price.

Time value of an option: The time value of an option is the difference between its premium and its intrinsic value. Both calls and puts have time value. An option that is OTM or ATM has only time value. Usually, the maximum time value exists when the option is ATM. The longer the time to expiration, the greater is an option's time value, all else equal.

Practically, Option Premium = Intrinsic Value + Time Value

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Options Pay-off
The optionality characteristic of options results in a non-linear payoff for options. In simple words, it means that the losses for the buyer of an option are limited; however the profits are potentially unlimited. For a writer (seller), the payoff is exactly the opposite. His profits are limited to the option premium; however his losses are potentially unlimited. These nonlinear payoffs are fascinating as they lend themselves to be used to generate various payoffs by using combinations of options and the underlying. We look here at the six basic payoffs (pay close attention to these pay-offs, since all the strategies are derived out of these basic payoffs).

Payoff profile of buyer of asset: Long asset

In this basic position, an investor buys the underlying asset, ABC Ltd. shares for instance, for `2220, and sells it at a future date at an unknown price, St. Once it is purchased, the investor is said to be "long" the asset. The following figure shows the payoff for a long position on ABC Ltd. Payoff for investor who went Long ABC Ltd. at `2220 The figure shows the profits/losses from a long position on ABC Ltd. The investor bought ABC Ltd. at `2220. If the share price goes up, he profits. If the share price falls he loses.

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Payoff profile for seller of asset: Short asset

In this basic position, an investor shorts the underlying asset, ABC Ltd. shares for instance, for `2220, and buys it back at a future date at an unknown price, St. Once it is sold, the investor is said to be "short" the asset. The following figure shows the payoff for a short position on ABC Ltd.

Payoff for investor who went Short ABC Ltd. at `2220 The figure shows the profits/losses from a short position on ABC Ltd... The investor sold ABC Ltd. at `2220. If the share price falls, he profits. If the share price rises, he loses.

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Payoff profile for buyer of call options: Long call

A call option gives the buyer the right to buy the underlying asset at the strike price specified in the option. The profit/loss that the buyer makes on the option depends on the spot price of the underlying. If upon expiration, the spot price exceeds the strike price, he makes a profit. Higher the spot price more is the profit he makes. If the spot price of the underlying is less than the strike price, he lets his option expire un-exercised. His loss in this case is the premium he paid for buying the option. The below diagram gives the payoff for the buyer of a three month call option (often referred to as long call) with a strike of `2250 bought at a premium of `86.60.

Payoff for buyer of call option The figure shows the profits/losses for the buyer of a three-month Nifty 2250 call option. As can be seen, as the spot Nifty rises, the call option is in-the-money. If upon expiration, Nifty closes above the strike of `2250, the buyer would exercise his option and profit to the extent of the difference between the Nifty-close and the strike price.

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The profits possible on this option are potentially unlimited. However if Nifty falls below the strike of `2250, he lets the option expire. His losses are limited to the extent of the premium he paid for buying the option.

Payoff profile for writer (seller) of call options: Short call

A call option gives the buyer the right to buy the underlying asset at the strike price specified in the option. For selling the option, the writer of the option charges a premium. The profit/loss that the buyer makes on the option depends on the spot price of the underlying. Whatever is the buyer's profit is the seller's loss. If upon expiration, the spot price exceeds the strike price, the buyer will exercise the option on the writer. Hence as the spot price increases the writer of the option starts making losses. Higher the spot price more is the loss he makes. If upon expiration the spot price of the underlying is less than the strike price, the buyer lets his option expire un-exercised and the writer gets to keep the premium. The below diagram gives the payoff for the

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writer of a three month call option (often referred to as short call) with a strike of `2250 sold at a premium of `86.60

Payoff for writer of call option

The figure shows the profits/losses for the seller of a three-month Nifty 2250 call option. As the spot Nifty rises, the call option is in-the-money and the writer starts making losses. If upon expiration, Nifty closes above the strike of `2250, the buyer would exercise his option on the writer who would suffer a loss to the extent of the difference between the Nifty-close and the strike price. The loss that can be incurred by the writer of the option is potentially unlimited, whereas the maximum profit is limited to the extent of the up-front option premium of `86.60 charged by him.

Payoff profile for buyer of put options: Long put

A put option gives the buyer the right to sell the underlying asset at the strike price specified in the option. The profit/loss that the buyer makes on the option depends on the spot price of the underlying. If upon expiration, the spot price is below the

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strike price, he makes a profit. Lower the spot price more is the profit he makes. His loss in this case is the premium he paid for buying the option. The below diagram gives the payoff for the buyer of a three month put option (often referred to as long put) with a strike of `2250 bought at a premium of `61.70.

Payoff for buyer of put option The figure shows the profits/losses for the buyer of a three-month Nifty 2250 put option. As can be seen, as the spot Nifty falls, the put option is in-the-money. If upon expiration, Nifty closes below the strike of `2250; the buyer would exercise his option and profit to the extent of the difference between the strike price and Nifty-close. The profits possible on this option can be as high as the strike price. However if Nifty rises above the strike of `2250, he lets the option expire. His losses are limited to the extent of the premium he paid for buying the option.

Payoff profile for writer (seller) of put options: Short put

A put option gives the buyer the right to sell the underlying asset at the strike price specified in the option. For selling the option, the writer of the option charges a premium.

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The below diagram gives the payoff for the writer of a three month put option (often referred to as short put) with a strike of `2250 sold at a premium of `61.70.

Payoff for writer of put option The figure shows the profits/losses for the seller of a three-month Nifty 2250 put option. As the spot Nifty falls, the put option is in-the-money and the writer starts making losses. If Nifty closes below the strike of `2250, the buyer would exercise his option on the writer who would suffer a loss to the extent of the difference between the strike price and Nifty close. The loss that can be incurred by the writer of the option is a maximum extent of the strike price whereas the maximum profit is limited to the extent of the up-front option premium of `61.70 charged by him.

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OPTIONS STRATEGIES

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Strategy 1: LONG CALL

For aggressive investors who are very bullish about the prospects for a stock / index, buying calls can be an excellent way to capture the upside potential with limited downside risk.

Buying a Call Option is the basic of all Option strategies. It is an easy strategy to understand. When you buy a Call Option it means you expect the stock / index to rise in the future. When to Use: Investor is very aggressive and he is very bullish about the stock/ index. Risk: Limited to the premium paid. Reward: Unlimited Break-even Point: Strike Price + Premium.

Example: Mr. XYZ is bullish on Nifty on 24th June, when the Nifty is at 4191. He buys a call options with a strike price of `4600 at a premium of `36, expiring on 31st July. If the Nifty goes above 4636, Mr. XYZ will make a net profit (after deducting the premium) on exercising the option. In case the Nifty stays at or falls below 4600, he can forego the option (it will expire worthless) with a maximum loss of the premium.
Strategy : Buy Call Option Current Nifty index 4191

Call Option Mr. XYZ Pays

Strike Price (`) Premium (`) Break Even Point (`) (Strike Price + Premium)

4600 36 4636

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The payoff schedule:On expiry Nifty closes at Net payoff from Call option

4100 4300 4500 4636 4700 4900 5100 5300

(`) -36 -36 -36 0 64 264 464 664

The payoff profile:-

Long Call
150 100 50 0 -50 4000 4300 Nifty 4636 Profit 4700 4900

Analysis

This strategy limits the downside risk to the extent of premium paid. But the potential return is unlimited in case of rise in Nifty. A long call option is the simplest way to benefit if you believe that the market will make an upward move. As the stock price / index rises, the long Call moves into profit more and more quickly.

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Strategy 2: SHORT CALL

When you buy a Call you are hoping that the underlying stock / index would rise. When you expect the underlying stock / index to fall you do the opposite. When an investor is very bearish about a stock / index and expects the prices to fall, he can sell Call options. This position offers limited profit potential and the possibility of large losses on big advances in underlying prices. Although easy to execute it is a risky strategy since the seller of the call is exposed to unlimited risk.

Selling a Call option is the just the opposite of buying a Call option. Here the seller of the option feels the underlying price of the stock / index to fall in the future. When to Use: Investor is very aggressive and he is very bearish about the stock/ index. Risk: Unlimited. Reward: Limited to the amount of the premium. Break-even Point: Strike Price + Premium.

Example: Mr. XYZ is bearish about Nifty and expects it to fall. He sells a Call option with a strike price of `2600 at a premium of `154, when the current Nifty is at 2694. If the Nifty stays at 2600 or below, the Call option will not be exercised by the buyer of the option and Mr. XYZ can retain the entire premium of `154.

Strategy : Sell Call Option Current Nifty index Call Option Mr. XYZ receives Strike Price (` ) Premium (` ) Break Even Point (` ) (Strike Price + Premium)* 2694 2600 154 2754

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The payoff schedule:On expiry Nifty closes at 2400 2500 2600 2700 2754 2800 2900 3000 Net payoff from Call option (`) 154 154 154 54 0 -46 -146 -246

The payoff profile:-

Short Call
200 0 2400 -200 -400 Nifty Profit 2600 2754 2900 3000

Analysis

This strategy is used when an investor is very aggressive and has a strong expectation of a price fall (and certainly not a price rise). This is a risky strategy since as the stock price / index rises, the short call loses money more and more quickly and losses can be significant if the stock price / index fall below the strike price.

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Strategy 3: SYNTHETIC LONG CALL

In this strategy, we purchase a stock since we feel bullish about it. But what if the price of the stock went down? You wish you had some insurance against the price fall. So buy a Put on the stock. This gives you the right to sell the stock at a certain price which is the strike price. The strike price can be the price at which you bought the stock (ATM strike price) or slightly below (OTM strike price).

In case the price of the stock rises you get the full benefit of the price rise. In case the price of the stock falls, exercise the Put Option (remember Put is a right to sell). You have capped your loss in this manner because the Put option stops your further losses. It is a strategy with a limited loss and (after subtracting the Put premium) unlimited profit (from the stock price rise). The result of this strategy looks like a Call Option Buy strategy and therefore is called a Synthetic Call.

But the strategy is not Buy Call Option (Strategy 1). Here you have taken an exposure to an underlying stock with the aim of holding it and reaping the benefits of price rise, dividends, bonus rights etc. and at the same time insuring against an adverse price movement.

In simple buying of a Call Option, there is no underlying position in the stock but is entered into only to take advantage of price movement in the underlying stock.

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When to use: when ownership is desired of stock yet investor is concerned about near month downside risk. The outlook is considerably bullish. Risk: Losses limited to Stock price + Put premium Put Strike price. Reward: Profit potential is unlimited. Break-even Point: Put Strike price + Put premium + Stock price Put Strike Price.

Example: Mr. XYZ is bullish about ABC Ltd. He buys ABC Ltd at current market price of `4000 on 4th July. To protect against fall in the price of ABC Ltd, he buys a Put option with a strike price `3900 (OTM) a premium of `143.80 expiring on 31st July.

Strategy : Buy Stock + Buy Put Option Buy Stock (Mr. XYZ pays) Current Market Price of ABC Ltd. (`) Strike Price (`) Buy Put (Mr. XYZ pays) Premium (`) 143.80 Break Even Point (`) (Put Strike Price + Put Premium + Stock Price Put Strike Price)* 4143.80 4000

3900

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Example: ABC Ltd is trading at `4000 at 4th July. Buy 100 shares of the stock at `4000. Buy 100 July Put options with a Strike price of `3900 at a premium of `143.80 per Put.

Net Debit (Payout)

= = =

Stock Bought + Premium Paid `4000 + `143.80

`414380/-

Maximum Loss

= = =

Stock Price + Put Premium Put Strike `4000 + `143.80 - `3900 ` 24,380/-

Maximum Gain Break-even

Strike

= = = =

Unlimited (as the stock rises)

Put Strike + Put Premium + Stock Price Put

`3900 + `143.80 + `4000 `3900 `4143.80/-

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The payoff schedule:ABC Ltd. closes at on expiry 3400.00 3600.00 3800.00 4000.00 4143.80 4200.00 4400.00 4600.00 4800.00 Payoff from the Stock (`) -600.00 -400.00 -200.00 0 143.80 200.00 400.00 600.00 800.00 Net Payoff from the Put Option (`) 356.20 156.20 -43.80 -143.80 -143.80 -143.80 -143.80 -143.80 -143.80 Net Payoff ( `) -243.80 -243.80 -243.80 -143.80 0 56.20 256.20 456.20 656.20

The payoff chart (Synthetic Long Call):-

Buy Stock

Buy Put

Synthetic Long Call

Analysis

This is a low risk strategy. It limits the loss in case of fall in market but the potential profit remains unlimited when the stock price rises. A good strategy when you buy a stock for medium or long term, with the aim of protecting any downside risk. The pay-off resembles a Call Option buy and is therefore called as Synthetic Long Call.

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Strategy 4: LONG PUT

Buying a Put is opposite of buying a Call. When an investor buys a Call option, he is bullish on the stock / index. If an investor is bearish, he can buy a Put option. A Put option gives a right to the seller to sell the stock (to the Put seller) at a predetermined price and thereby limiting his risk.

A Long Put is a Bearish strategy. To take advantage of a falling market an investor can buy Put options. When to Use: Investor is bearish about the stock / index. Risk: Limited to the amount of Premium paid. (Maximum loss if stock / index expire at or above the option strike price.) Reward: Unlimited. Break-even Point: Stock Price Premium.

Example: Mr. XYZ is bearish on Nifty on 24th June, when Nifty is at 2694. He buys a Put option with a strike price of `2600 at a premium of `52 expiring on 31st July. If the Nifty goes below 2548, Mr. XYZ will make a profit on exercising the option. In case the Nifty rises above 2600, he can forego the option (it will expire worthless) with a maximum loss of the premium.
Strategy : Buy Put Option Current Nifty index Put Option Mr. XYZ Pays Strike Price (`) Premium (`) Break Even Point (`) (Strike Price Premium) 2694 2600 52 2548

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The payoff schedule:On expiry Nifty closes at 2300 2400 2500 2548 2600 2700 2800 2900 Net Payoff from Put Option (`) 248 148 48 0 -52 -52 -52 -52

The payoff profile:-

Long Put
300 200 100 0 -100 2300 2400 Nifty 2548 Profit 2700 2800

Analysis

A bearish investor can profit from declining stock price by buying Puts. He limits his risk to the amount of premium paid but his profit potential remains unlimited. This is one of the widely used strategy when an investor is bearish.

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Strategy 5: SHORT PUT

An investor s ells Put when he is Bullish about the stock. When you sell a Put, you earn a Premium (from the buyer of the Put). You have sold someone the right to sell you the stock at the strike price. If the stock price increases beyond the strike price, the short put position will make a profit for the seller by the amount of the premium, since the buyer will not exercise the Put option and the Put seller can retain the Premium (which is his maximum profit). But, if the stock price

decreases below the strike price, by more than the amount of the premium, the Put seller will lose money.

When to Use: Investor is very Bullish about the stock / index. The main idea is to make short term income. Risk: Unlimited. Reward: Limited to the amount of Premium received. Break-even Point: Put Strike - Premium.

Example: Mr. XYZ is bullish on Nifty when it is 4190.10. He sells a Put option with a strike price of `4100 at a premium of `170 expiring on 31st July. If the Nifty index stays above 4100, he will gain the amount of premium as a Put buyer wont exercise his option. In case the Nifty falls below 4100, Put buyer will exercise the option and Mr. XYZ will start losing money. If the Nifty falls below 3930, which is the breakeven point, Mr. XYZ will lose the premium and more depending on the extent of the fall in Nifty.
Strategy : Sell Put Option Current Nifty index Put Option Mr. XYZ receives Strike Price (`) Premium (`) Break Even Point (`) (Strike Price - Premium) 4191.10 4100 170 3930

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The payoff schedule:On expiry Nifty Closes at 3400 3500 3700 3900 3930 4100 4300 4500 Net Payoff from the Put Option (`) -530 -430 -230 -30 0 170 170 170

The payoff profile:-

Short Put
400 200 0 -200 -400 -600 Nifty Profit 3400 3700 3930 4300 4600

Analysis

Selling Puts can lead to regular income in a rising or range bound markets. But it should be done carefully since the potential losses can be significant in case the price of the stock / index falls. This strategy can be considered as an income generating strategy.

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Strategy 6: COVERED CALL

You own shares in a company which you feel may rise but not much in the near term (or at best stay sideways). You would still like to earn an income from the shares. The covered call is a strategy in which an investor Sells a Call option on a stock he owns (netting him a premium). The Call Option which is sold in usually an OTM Call. The Call would not get exercised unless the stock price increases above the strike price. Till then the investor in the stock (Call seller) can retain the Premium with him. This becomes his income from the stock. This strategy is usually adopted by a stock owner who is Neutral to moderately Bullish about the stock.

An investor buys a stock or owns a stock which he feels is good for medium to long term but is neutral or bearish for the near term. At the same time, the investor does not mind exiting the stock at a certain price (target price). The investor can sell a Call Option at the strike price at which he would be fine exiting the stock (OTM strike). By selling the Call Option the investor earns a Premium. Now the position of the investor is that of a Call Seller who owns the underlying stock. If the stock price stays at or below the strike price, the Call Buyer will not exercise the Call. The Premium is retained by the investor.

In case the stock price goes above the strike price, the Call buyer who has the right to buy the stock at the strike price will exercise the Call option. The Call seller (the investor) who has to sell the stock to the Call buyer will sell the stock at the strike price. This was the price which the Call seller (the investor) was anyway interested in exiting the stock and now exits at that price. So besides
38

the strike price which was the target price for selling the stock, the Call seller (investor) also earns the Premium which becomes an additional gain for him. This strategy is called as a Covered Call strategy because the Call sold is backed by a stock owned by the Call Seller (investor).

When to Use: This is often employed when an investor has a short term neutral to moderately bearish view on the stock he holds. He takes a short position on the call option to generate income from the option premium. Risk: If the Stock Price falls to zero, the investor loses the entire value of the Stock but retains the premium, since the Call will not be exercised against Reward: Limited to (Call Strike Price Stock Price paid) + Premium received Break-even Point: Stock Price paid Premium received.

Example:
Mr. A bought XYZ Ltd. for `3850 and simultaneously sells a Call option at a strike price of `4000. Which means Mr. A does not think that the price of XYZ Ltd. will rise above `4000. However, in case it rises above `4000, Mr. A does not mind getting exercised at that price and exiting the stock at `4000 (TARGET SELL PRICE = 3.90% return on the stock purchase price). Mr. A received a premium of `80 for selling the Call. Thus net outflow to Mr. A is (`3850 `80) = `3770. He reduces the cost of buying the stock by this strategy.
Strategy : Buy Stock + Sell Call Option Mr. A buys the 3850 Market Price (`) So maximum risk = Stock Price Paid Call Premium stock XYZ Ltd. Call Options Mr. A receives

him.

Strike Price (`) Premium (`) Break Even Point (`) (Stock Price paid - Premium Received)

4000 80 3770

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Example:1) The price of XYZ Ltd. stays at or below `4000. The Call buyer will not exercise the Call Option. Mr. A will keep the premium of `80. This is an income for him. So if the stock has moved from 3850 (purchase price) to 3950, Mr. A makes `180/[`3950 `3850 + `80 (Premium)] = an additional `80, because of the Call sold.

2) Suppose the price of XYZ Ltd. moves to `4100, then the Call Buyer will exercise the Call Option and Mr. A will have to pay him `100 (loss on exercise of the Call Option). What would Mr. A do and what will be his pay off? a) Sell the Stock in the market at b) Pay Rs. 100 to the Call Options buyer c) Pay Off (a b) received : : : `4100 - `100 `4000 (This was Mr. As target price) `80 `4080 `3850 `4080 `3850 `230 h) Return (%) : (`4080 `3850) X 100 `3850

d) Premium received on Selling Call Option: e) Net payment (c + d) received by Mr. A : f) Purchase price of XYZ Ltd. g) Net profit : :

: 5.97% (which is more than the target return of 3.90%).

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The payoff schedule:XYZ Ltd. price closes at (`) 3600 3700 3740 3770 3800 3900 4000 4100 4200 4300
Net Payoff

(`) -170 -70 -30 0 30 130 230 230 230 230

The payoff chart (Covered Call):-

+
Buy stock Sell Put

=
Covered Call

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Strategy 7: COVERED PUT

This strategy is opposite to a Covered Call. A Covered Call is a neutral to bullish strategy, whereas a Covered Put is a neutral to Bearish strategy. You do this strategy when you feel the price of a stock / index is going to remain range bound or move down. Covered Put writing involves a short in a stock / index along with a short put on the options on the stock/index. The Put that is sold is generally an OTM Put. The investor shorts a stock because he is bearish about it, but does not mind buying it back once the price reaches (falls to) a target price. This target price is the price at which the investor shorts the Put (Put strike price). Selling a Put means, buying the stock at the strike price if exercised. If the stock falls below the Put strike, the option will be exercised and will have to buy the stock at the strike price (which is anyway his target price to repurchase the stock). The investor makes a profit because he has shorted the stock and purchasing it at the strike price simply closes the short stock position at a profit. And the investor keeps the Premium on the Put sold. The investor is covered here because he shorted the stock in the first place. If the stock price does not change, the investor gets to keep the Premium. He can use this strategy as an income in a neutral market. Let us understand this with an example.

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When to Use: If the investor is of the view that the markets are moderately bearish. Risk: Unlimited if the price of the stock rises substantially. Reward: Maximum is (Sale Price of the stock Strike Price) + Premium. Break-even Point: Sale Price of stock + Put Premium.

Example: Suppose ABC Ltd is trading at `4500 in June. An investor, Mr. A, shorts `4300 Put by selling a July Put for `24 while shorting an ABC Ltd stock. The net credit received by Mr. A is `4500 + `24 = `4524.

Strategy : Short Stock + Short Put Option Sells Stock (Mr. A receives) Sells Put Current Market Price (`) Strike Price (`) Premium (`) Break Even Point (`) (Sale price of Stock + Put Premium) 4500

4300 24 4524

Mr. A receives

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The payoff schedule:ABC Ltd. closes at (`) Payoff from the stock (`) Net Payoff from the Put Option (`)

Net Payoff ( `)

4000 4100 4200 4300 4400 4450 4500 4524 4550 4600 4635 4650

500 400 300 200 100 50 0 -24 -50 -100 -135 -160

-276 -176 -76 24 24 24 24 24 24 24 24 24

224 224 224 224 124 74 24 0 -26 -76 -111 -136

The payoff chart (Covered Put):-

Sell stock

Sell Put

Covered Put

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Strategy 8: LONG COMBO

A Long Combo is a Bullish strategy. If an investor is expecting the price of a stock to move up he can do a Long Combo strategy. It involves selling an OTM (lower strike) Put and buying an OTM (higher strike) Call. This strategy simulates the action of buying a stock (or a futures) but at a fraction of the stock price. It is an inexpensive trade, similar in pay-off to Long Stock, except there is a gap between the strikes (please see the payoff diagram). As the stock price rises the strategy starts making profits. Let us try and understand Long Combo with an example.

When to Use: Investor is Bullish on the stock. Risk: Unlimited (Lower Strike price + Net Debit) Reward: Unlimited. Break-even Point: Higher Strike Price + Net Debit

Example: A stock ABC Ltd is trading at `450. Mr. XYZ is bullish on the stock. But he does not want to invest `450. He does a Long Combo. He sells a Put option with a strike price of `400 at a premium of `1 and buys a Call option with a strike price of `500 at premium of `2. The net cost of the strategy (net debit) is `1.
Strategy : Sell a Put + Buy a Call ABC Ltd. Current Market Price (`) 450

Sells Put Mr. XYZ recd Buys Call Mr. XYZ pays

Strike Price (`) Premium (`) Strike Price (`) Premium (`) Net Debit (`) Break Even Point (`) (Higher Strike + Net Debit)

400 1.00 500 2.00 1.00 501

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The payoff schedule:ABC Ltd. closes at ( `) 700 650 600 550 501 500 450 400 350 300 250 Net Payoff from the Put Sold (`) 1 1 1 1 1 1 1 1 -49 -99 -149 Net Payoff from the Call purchased ( `) 198 148 98 48 -1 -2 -2 -2 -2 -2 -2 Net Payoff ( `) 199 149 99 49 0 -1 -1 -1 -51 -101 -151

For a small investment of `1 (net debit), the returns can be very high in a Long Combo, but only if the stock moves up. Otherwise the potential losses can also be high.

The payoff chart (Long Combo):-

Sell put

Buy call

Long Combo

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Strategy 9: LONG STRADDLE

A Straddle is a volatility strategy and is used when the stock / index is expected to show large movements. This strategy involves buying a call as well as put on the same stock / index for the same maturity and strike price, to take advantage of a movement in either direction. If the price of the stock / index increases, the call is exercised while the put expires worthless and if the price of the stock / index decreases, the put is exercised, the call expires worthless. Either way if the stock / index show volatility to cover the cost of the trade, profits are to be made.

When to Use: The investor thinks that the underlying stock / index will experience significant volatility in the near term. Risk: Limited to the initial premium paid (net debit). Reward: Unlimited. Break-even Point: Upper = Strike price of Long Call + Net Premium paid. Lower = Strike price of Long Put Net premium paid.

Example: Suppose Nifty is at 4450 on 27th April. An investor, Mr. A enters a long straddle by buying a May `4500 Nifty Put for `85 and a May `4500 Nifty Call for `122. The net debit taken to enter the trade is `207, which is also his maximum possible loss.
Strategy : Buy Put + Buy Call Nifty index Call and Put Mr. A pays Current Value Strike Price (`) Total Premium (Call + Put) (`) Break Even Point (`) (`) 4450 4500 207 4707(U)

4293(L)

47

The payoff schedule:On expiry Nifty closes at

3800 3900 4000 4100 4200 4234 4293 4300 4400 4500 4600 4700 4707 4766 4800 4900 5000 5100 5200 5300

Net Payoff from Put purchased (`)

615 515 415 315 215 181 122 115 15 - 85 - 85 - 85 - 85 - 85 - 85 - 85 - 85 - 85 - 85 - 85

Net Payoff from Call purchased (`)

- 122 - 122 - 122 - 122 - 122 - 122 - 122 - 122 - 122 - 122 - 22 78 85 144 178 278 378 478 578 678

Net Payoff (` )
493 393 293 193 93 59 0 -7 - 107 - 207 - 107 -7 0 59 93 193 293 393 493 593

The payoff profile (Long Straddle):-

Buy Put

Buy Call

Long Straddle

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Strategy 10: SHORT STRADDLE

It is a strategy to be adopted when the investor feels the market will not show much movement. He sells a Call and a Put on the same stock / index for the same maturity and strike price. It creates a net income for the investor. If the stock / index do not move much in either direction, the investor retains the Premium as neither the Call nor the Put will be exercised. However, in case the stock / index moves in either direction, up or down significantly, the investors losses can be significant. So this is a risky strategy and should be carefully adopted and only when the expected volatility in the market is limited. If the stock / index value stays close to the strike price on expiry of the contracts, maximum gain, which is the Premium received is made.

When to Use: The investor thinks that the underlying stock / index will experience very little volatility in the near term. Risk: Unlimited Reward: Limited to the initial premium received (net credit). Break-even Point: Upper = Strike price of Short Call + Net Premium received. Lower = Strike price of Short Put Net premium received.

Example: Suppose Nifty is at 4450 on 27th April. An investor, Mr. A enters a short straddle by selling a May `4500 Nifty Put for `85 and a May `4500 Nifty Call for `122. The net credit taken to enter the trade is `207, which is also his maximum possible loss.
Strategy : Buy Put + Buy Call Nifty index Call and Put Mr. A receives Current Value Strike Price (`) Total Premium (Call + Put) (`) Break Even Point (`) (`) 4450 4500 207 4707(U)

4293(L)

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The payoff schedule:On expiry Nifty closes at 3800 3900 4000 4100 4200 4234 4293 4300 4400 4500 4600 4700 4707 4766 4800 4900 5000 Net Payoff from Put Sold (`) -615 -515 -415 -315 -215 -181 -122 -115 -15 85 85 85 85 85 85 85 85 Net Payoff from Call Sold (`) 122 122 122 122 122 122 122 122 122 122 22 -78 -85 -144 -178 -278 -378 Net Payoff (`) -493 -393 -293 -193 -93 -59 0 7 107 207 107 7 0 -59 -93 -193 -293

The payoff chart (Short Straddle):-

Sell Put

Sell Call

Short Straddle

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Stock Repair Strategy

Mr. X bought 100 shares of ABC Ltd. at `40; it currently trades at `30. The stock no longer appeals to him, and he is inclined to trade out of it but is not happy about having to take the loss. He thinks the stock might recover about half its decline, but does not believe it will be back to `40 anytime soon. At this point, he would just like to get his money back. The strategy of Stock Repair makes sense to him and he decides to use it. He finds the following one-month options: `30 call @ `3, `35 call @ `1.50. He buys the 30 call and writes (sells) two of the 35 calls. The table below shows the profit and loss possibilities from the combined position.

Stock Price at Expiration Position Long Stock Long 30 Call Short Two 35 Calls 30 -10 -3 3 31 -9 -2 3 32 -8 -1 3 33 -7 0 3 34 -6 1 3 35 -5 2 3

Combined

-10

-8

-6

-4

-2

The worksheet shows that, ignoring commissions, Mr. X breaks-even if ABC Ltd. returns to `35 at option expiration.

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Research Analysis

Objective:To understand the investment patterns & strategies adopted by the retail investors.

Sample Studied: Technique: Random Sampling Size: 100 Nature: Retail Investors

Tools used for Analysis:Questionnaire

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Major Findings
Around 100 retail investors of different age groups were asked few questions to find out their investment patterns and strategies. The findings of the survey are given below:

Finding 1:
80 68 70 60 50 40 30 20 10 0 18-25 years 26-45 years Cash Market 45-60 years 60 years above 21 11 25 16 19 13 10 42 45 59

71

Futures Market

Options Market

Options is traded by people mostly in age group of 26-45 years since their risk-taking capacity is more compared to others and they also desire more to leverage their investment and gain maximum returns. People above 60 years trade maximum in Cash Market since they still follow the philosophy of buy-and-hold for their successors.

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Finding 2:
79 80 70 60 50 40 30 20 10 0 18-25 years 26-45 years Hedging 46-60 years Speculation 60 years above 26 21 35 42 74 65 58

As the age of the people increases, they trade in Options for Hedging purposes. Whereas, in their early ages they speculate in Options in order to earn more profits.

Finding 3:

21%

14%

Cash Market Futures Options

65%

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Majority of the investors think that dealing in Futures is most risky, whereas trading in Options is comparatively less risky since the buyer of the option has limited risk. Cash Market is considered to be least risky.

Finding 4:

31%

Stock Options Index Options

69%

Majority of the investors deals in Stock Options as compared to Index Options. Since prices of a stock is generally more volatile than the Index. This helps to earn more profits but also contains greater risk.

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Conclusion

Options are traded mostly by investors having more risk-taking capacity. Hence, Options are mostly traded by people in the age group of 25-45 years.

Options are, nowadays, used more for speculation as compared to hedging. It is used as a hedging tool mostly by the people in the age group of 60 years above. Majority of the investors think that dealing in Futures is most risky, whereas trading in Options is comparatively less risky since the buyer of the option has limited risk. Cash Market is considered to be least risky. Stock Options are more traded than Index Options. This is maybe because Stocks have higher volatility than Index. Hence, more profits can be derived out of Stock options.

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Bibliography

Books: Robert Strong Introduction to Derivatives D.C. Patwari Options and Futures

References: NCFM Equity Markets module NCFM Derivatives (dealers) module NCFM Options Strategies module

Websites: www.investopedia.com www.nseindia.com www.bseindia.com www.sebi.gov.in www.moneycontrol.com www.optionstradingtips.com

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Questionnaire
1) Whats your age?

18-25 years 26-45 years 45-60 years 60 years & above

2) Where you mostly invest your money in?

Cash Market Futures Market Options market

3) Do you trade in Options? If yes then, i. Whats your underlying purpose for trading in Options?

Hedging Speculation
ii. What you prefer trading in?

Stock Options Index Options

4) According to you, which market is more risky?

Cash market Futures Options

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