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Trading strategies

INTRODUCTION

Options are instruments whereby the right is given by the option seller to the option buyer to buy or sell a specific asset at a specific price on or before a specific date.

TYPES OF OPTION
A financial derivative that represents a contract sold by one party (option writer) to another party (option holder). The contract offers the buyer the right, but not the obligation, to buy (call) or sell (put) a security or other financial asset at an agreed-upon price (the strike price) during a certain period of time or on a specific date (exercise date)

Call Option: A call option gives the holder the right but not the obligation to buy an asset by 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.

The option premium can be broken down into 2 components:

Intrinsic value: Value investors that follow fundamental analysis look at both qualitative and quantitative aspects of a business to see if the business is currently out of favor which the market and is really worth much more than its current valuation. Intrinsic value in options is in the money portion of the options premium. E.g.: If a call option strike price is $ 15 and the underlined stocks market Price is $25 then the intrinsic value of call option is $10.

Time value: 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 exits when option is ATM. The longer the time to expiration, the greater is an options time value, or else equal. At expiration, an option should have more time value.

OPTION STRATEGIES

(1) STRANGLE STRATEGY: In strangle strategy trader/ investor calls for buying out of the money puts and out of the money call options with different strike prices but the same expiration date.

MARKET VIEW FOR STRATEGY: A strangle option strategy is a basic volatility strategy which will require dramatic price moves to pay out profitably.

Scrip t

Instrum ent Type

Opti on Type

B/S

Stri ke Pric e 560 0 560 0

Premium/Pr Quant Expiry ice ity date

Payoff table
57 50 28-72012 28-72012 Nifty Price Pay Off Of Pay off of Total Pay Call Put Off

Nifty

Option

Call

Nifty

Option

Put

65

50

5000 5100

-2850 -2850 -2850

26750 21750 16750

23900 18900 13900

Payoff Chart

5200

5300
5400 5500 5600 5700 5800 5900

-2850
-2850 -2850 -2850 2150 7150 12150

11750
6750 1750 -3250 -3250 -3250 -3250

8900
3900 -1100 -6100 -1100 3900 8900

6000
6100 6200

17150
22150 27150

-3250
-3250 -3250

13900
18900 23900

RISK AND REWARD:

Maximum loss for the long strangles options strategy is when the underlying stock price on expiration date is trading between the strike prices of the options bought. Large gains for the long strangle option strategy are attainable when the underlying stock price makes a very strong move either upwards or downwards at expiration.

(2) STRADDLE STRATEGY: In straddle strategy trader/ investor calls for buying at the money puts and at of the money call options were the strike price is same of both the options.

MARKET VIEW FOR STRATEGY: A straddle option strategy is a basic volatility strategy which will require dramatic price moves to pay out profitably.

Scrip t

Instrum ent Type

Opti on Type Call Put

B/S

Stri ke Pric e 560 0 550 0

Premium/Pr ice

Quanti Expiry ty date

Payoff Table
57 45 50 50 28-72012 28-72012 Nifty Price Pay Off Pay off Total Of Call of Put Pay Off

Nifty Nifty

Option Option

B B

5000

-2850 -2850

22750 17750

19900 14900

Payoff chart

5100

5200
5300 5400 5500 5600 5700 5800 5900 6000 6100

-2850
-2850 -2850 -2850 -2850 2150 7150 12150 17150 22150

12750
7750 2750 -2250 -2250 -2250 -2250 -2250 -2250 -2250

9900
4900 -100 -5100 -5100 -100 4900 9900 14900 19900

RISK AND REWARD: Maximum loss for the long straddle options strategy is when the underlying stock price on expiration date is trading at the strike prices of the options bought. Large gains for the long straddle option strategy are attainable when the underlying stock price makes a very strong move either upwards or downwards at expiration.

(3) BULL CALL SPREAD STRATEGY: In bull call spread strategy trader/ investor calls for buying one in the money call, sell one out of the money calls at different strike prices.
MARKET VIEW FOR STRATEGY: A bull call spread option strategy is generally applied when one expects market will move from moderately bullish to bullish.

Scrip t

Instrume Opti nt Type on Type Option Option Call Put

B/S

Nifty Nifty

B S

Strik Premium/Pri Quanti e ce ty Pric e 5500 85 50 5600 20 50

Expiry date

Payoff Table
28-7-2012 28-7-2012 Nifty Price Pay Off Pay off Total Of Call of Put Pay Off

5000

-4250 -4250 -4250 -4250 -4250

1000 1000 1000 1000 1000

-3250 -3250 -3250 -3250 -3250

Payoff Chart
5100 5200 5300 5400

5500
5600 5700 5800 5900 6000 6100

-4250
750 5750 10750 15750 20750 25750

1000
1000 -4000 -9000 -14000 -19000 -24000

-3250
1750 1750 1750 1750 1750 1750

RISK AND REWARD: The maximum profit for bull call spread will generally occur as underlying stock price rise above the higher strike price. Maximum loss for the bull call spread is limited to the premium paid while entering the trade.

(4) BEAR PUT SPREAD STRATEGY: In bear put spread strategy trader/ investor calls for buying one in the money put, sell one out of the money put at different strike prices. MARKET VIEW FOR STRATEGY: A bear put spread option strategy is generally applied when one expects market to move from moderately bearish to bearish.

Scrip t

Instrum ent Type

Opti on Type Call

B/S

Nifty

Option

Strik Premium/Pr e ice Pric e 5400 85

Quant ity

Expiry date

50

28-7-2012

Payoff Table
Nifty Price Pay Off Pay off Total Of Call of Put Pay Off -4250 -4250 -4250 -4250 -4250 750 5750 10750 15750 20750 25750 30750 2000 2000 2000 2000 -3000 -8000 -13000 -18000 -23000 -28000 -33000 -38000 -2250 -2250 -2250 -2250 -7250 -7250 -7250 -7250 -7250 -7250 -7250 -7250

Nifty

Option

Put

5300 40

50

28-7-2012

Payoff Chart

5000 5100 5200 5300 5400 5500 5600 5700 5800 5900 6000 6100

RISK AND REWARD: The maximum profit for bear put spread will generally occur as underlying stock price decline below the lower strike price. The maximum loss for bear put spread will generally occur as underlying stock price rises above the higher strike price.

(5) COVERED CALL STRATEGY: In covered call strategy trader/investor writes a call option contract while at the same time buying equivalent number of shares in cash market or in future market.

MARKET VIEW FOR THE STRATEGY: Neutral to bullish on underlying stock.

Scrip t

Instrume nt Type

Optio n Type Cash Put

B/S

Strik e Pric e 5550

Premium/Pri ce

Quanti ty

Expir y date

Nifty Nifty

Cash Option

B S

5600 50

75 50 28-72012

Payoff Table
Nifty Price Pay Off Of Pay off of Total Pay Call Put Off

Payoff Chart

5000 5100 5200 5300 5400 5500 5600 5700 5800 5900 6000 6100

-45000 -37500 -30000 -22500 -15000 -7500 0 7500 15000 22500 30000 37500

2500 2500 2500 2500 2500 2500 0 -5000 -10000 -15000 -20000 -25000

-42500 -35000 -27500 -20000 -12500 -5000 0 2500 5000 7500 10000 12500

RISK AND REWARD: In this strategy client will expose to unlimited loss on downside and limited profit on upside. It gives protection from decline in price limited to the premium received so it reduces cost of ownership of stock. Investor/trader can further reduce cost of ownership by writing next price at expiry is around cost price of stock.

(6) BUTTERFLY STRATEGY:

In butterfly strategy trader/ investor calls for buying 1in the money call, sell 2 at the money calls and buy 1out of the money call options at different strike prices.

MARKET VIEW FOR THE STRATEGY:

A butterfly option strategy is applied when the market is range bound.

Scrip t Nifty Nifty Nifty

Instrum ent Type Option Option Option

Option Type Call Put Call

B/S

Strike Premium/P Quant Expiry Price rice ity date 5300 5500 5700 190 75 15 50 100 50 28-72012 28-72012 28-72012 Nifty Price

B S B

Payoff Table
Pay Off Pay off Pay off Total Of Call of Put of Call Pay Off

Payoff Chart

5100 5200 5300 5400 5500 5600 5700 5800 5900 6000

-9500 -9500 -9500 -4500 500 5500 10500 15500 20500 25500

7500 7500 7500 7500 7500 -2500 -12500 -22500 -32500 -42500

-750 -750 -750 -750 -750 -750 -750 4250 9250 14250

-2750 -2750 -2750 2250 7250 2250 -2750 -2750 -2750 -2750

RISK AND REWARD:

Maximum loss for the long butterfly spread is limited to the premium paid while entering the trade.
Maximum profit for the long butterfly spread is attained when underlying stock price remain unchanged at expiration.

Conclusion
Derivative have existed and evolved over a long time, with roots in commodities market .In the recent years advances in financial markets and technology has made derivatives easy for the investors. Derivatives market in India is growing rapidly unlike equity markets. Trading in derivatives require more than average understanding of finance. Being now markets, Maximum number of investors has not yet understood the full implications of the trading in derivatives.