Options Trading Strategies: Playing with Options strategically: Part 1

In the context of stock markets, strategies are specific plans designed keeping in mind the various market scenarios

A strategy is defined as a plan of action designed to achieve a particular goal. When applied in the context of stock markets, strategies are specific plans designed keeping in mind the various market scenarios (example: bullish, bearish, neutral, volatile, etc) and applying them in accordance with the investor’s views.

In the previous articles, we have learned the basics of Options trading, the various terminologies, the factors affecting Options pricing, and the mechanism of how to trade in Options.

We shall now explore the various Options Strategies that have evolved over the years keeping in mind the various market scenarios, outlooks, risk-reward ratios and investing capacities of different classes of investors.

Before making any investment decision, an investor generally has one of the following four different views about the movement of the markets.
1. A bullish view
2. A bearish view
3. A volatile view
4. A neutral view

These four form the premise of most Option strategies.

Note: Just remember this one statement which will form the backbone of all different Options strategies. The Buyer of an option (Call or Put) has a limited loss and an unlimited profit potential. The Seller of an option (Call or Put) has a limited profit and an unlimited loss potential.

Let us now start with an in-depth look into the various Options strategies.

I. BULLISH STRATEGIES
a. Buy A Call Option: If you are bullish about a stock, say ABC at the current market price of, say, Rs 100 and you feel that the stock will move up in the coming days, you can buy a Call option of ABC with a strike price of 100 at a premium of, say, Rs 20.

This is the maximum loss that you as a Call option buyer can incur, whereas the profit can be unlimited.

If the lot size of the stock ABC is say 200. Your total purchase price is 20 x 200 = Rs 4,000 and this is also the total loss that you can incur on the transaction.

If the stock ABC closes above the Rs 100 mark on the expiry day, you will receive the sum equal to the difference between the Spot Price (closing price) - Strike Price (100).

For example: If the closing price of ABC is Rs 130, you as an Options buyer will receive a sum of Rs 130- Rs 100 = Rs 30. After deducting your purchase price of Rs 20 from this, your total net profit will be Rs 10. So your total net profit on the transaction will be 10 x 200 = Rs 2,000.

Conversely, if the stock ABC closes at or below the strike price of Rs 100. The premium of your Option will drop in value. You can choose to either square off your position. Example: If the premium drops to Rs 12, you can square off your position by selling your call Option at that premium and book your loss.

Or in the worst case scenario, if ABC closes below Rs 100 on expiry, the Option expires worthless and the premium of Rs 20 which you had paid for the contract now becomes zero and your total loss on the transaction is Rs 4,000 (i.e., your entire premium paid).

As the time to expiry nears, the premium loses time value and drifts closer to zero and hence time decay is an enemy of the Options buyer.

Payoff table for investors at various spot prices of ABC for an Options buyer.

 

 

 

 

 

 

 

 

b. Sell A Put Option: If you are bullish on the same stock ABC, you can conversely opt to sell an ABC 100 PUT option. As an Options seller, you will receive the premium from the Options buyer. In this case, if you sell the ABC 100 Put at the premium of Rs 20, you will receive Rs 20 x 200 = Rs 4,000 from the Options buyer. This is your total profit for the transaction.

Now if ABC closes above 100 on expiry, the buyer would not exercise his rights and you get to keep the entire premium amount in your pocket.
But if ABC closes below Rs 100 on expiry, say at Rs 70. You will be asked to pay the difference of Rs 30. After deducting the premium of Rs 20 that you received, your total net loss would be Rs 30- Rs 20 = Rs 10 x 200 = Rs 2,000. If ABC closes way down say Rs 50 on expiry, your loss would be huge, Rs 50- Rs 20 = Rs 30 x 200 = Rs 6,000. Thus, we see that the loss can be unlimited for an Options seller.

The Options seller can square off his position at any time if he thinks that his position is running into deep losses and reduce his loss and hence the term unlimited loss is not entirely true. As the time to expiry nears, the premium loses time value and drifts closer to zero and the probability of the Options buyer exercising his Options diminishes and hence time decay is a friend of the Options seller.

Note: An Options seller has to set aside margin amounts as prescribed by the exchange and these are a percentage of the total contract value.

Payoff table for investors at various spot prices of ABC for an Options seller.

 

 

 

 

 

 

 

c. Bull Spreads: Spreads are strategies which generate a limited profit and limited loss situation. Bullish spreads are ones which help generate profits when there is a bullish market scenario.

Bull spread basically involves 2 Calls or 2 Puts

Bull Spread Using Call Option: For a Call, one should buy a low strike price Call and sell a higher strike price Call.

Eg: Buy a 100 strike price Call of ABC at Rs 20 and sell a 140 strike price Call of ABC at Rs 8. Thus your total premium paid for the spread is Rs 20- Rs 8 = Rs 12. This is maximum loss that you can suffer on this spread.

And your maximum profit is limited to the difference between the two strike prices minus the premium paid i.e., Rs 140 - Rs 100 = Rs 40- Rs 12 = Rs 28. Hence the total profit potential of this spread is Rs 28.

Basically you are limiting your profits on the 100 Strike price Call up to the point of Rs 140 and offsetting the loss if any on the 140 strike price call.

 

 

 

 

 

 

 

 

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Bull Spread Using Put Options: For a Bull spread using a Put options, one buys a lower strike price Put and sell a higher strike price Put.

Eg: Buy a 100 strike Put of ABC at Rs 20 and sell a 140strike price Put at Rs 45. The 140 Put premium is more because ABC at Rs 100 is already in the money.

The maximum profit in this Spread = Total premium received. i.e. Rs 45- Rs 20 = Rs 25

The maximum loss = Difference between strike prices -the premium received, i.e, Rs 140- Rs 100 = Rs 40- R25 = Rs 15, which is the maximum loss for this spread.

Payoff table for Bull spread using Put Options.

 

 

 

 

 

 

 

 

II. BEARISH STRATEGIES
A bearish view is one where you feel that the markets or the stock which you are focussed on will fall. Yes, it is actually possible to make money when the market is on a downward swing.

a. Buying A Put: A Put Option premium will increase with every fall in the market. An investor with a bearish outlook should purchase a Put Option. The profits can be unlimited to the extent of the fall in the stock or index whereas the loss is limited to the total amount paid as the premium. You can square off your position anytime if the position is going against you and book losses.

b. Selling A Call: You can also sell a Call if you feel that the stock is headed for a downfall. As a seller of a Call option, you will receive the premium for the sold Option from the buyer. In other words, it is like fixed income.

If the closing price of the stock on expiry remains below the strike, the buyer of the Option will not exercise his Option and the seller will get to keep the premium received. But if the stock moves up, he will be faced with an unlimited loss potential to the extent of the rise.

Of course, here too, the seller can square off his position at any time and limit the losses to some extent. Don’t forget, a seller of a Call has to keep aside margin amounts prescribed by the exchange.

c. Bear Spread Using Call Option: A bear spread using a Call Option, involves purchase of a higher strike price Call and selling of a lower strike price Call.

The maximum profit for such a Bear spread = Net premium received. The maximum loss for such a Bear spread = Higher strike price - Lower strike price- Net premium received.

For eg: The spot price of a stock ABC is 100. If you buy a 120 call Option at a premium of Rs 5 and sell a 80 Call option at a premium of Rs 20, then your
maximum profit for such a spread would be Rs 20- Rs 5 = Rs 15. . Your maximum loss for such a spread would be Rs 120- Rs 80-Rs 15 = - Rs 25

d. Bear Spread Using Put Options: A bear spread using a Put Option involves, buying at a higher strike price Put and selling a lower strike price Put.

The maximum profit for such a Bear spread = Higher strike price- Lower strike price- premium paid. The maximum loss for such a Bear spread = Total premium paid.

For eg: If you buy a 120 Put Option at a premium of Rs 20 and sell a 80 Put Option at a premium of Rs 5, then Total loss = Rs 20- Rs 5 = Rs 15, the total premium paid. The maximum profit = Rs 120- Rs 80 -Rs 15 = Rs 25.
In the next article we shall study the different strategies that can be employed if you have a Volatile or a Neutral view on the markets or a specific stocK.

Source: Nirmal Bang