Options Trading Strategies: Playing with Options strategically: Part 2

Options make trading in neutral and volatile markets easy

In the previous article, we learned about the various Options strategies that can be employed for a bullish or a bearish view on the market or on a particular stock. In this article, we will learn the various Options strategies that can be employed when one has a neutral or a volatile view about the movement of the market or a particular stock.

Neutral Market Strategy: A neutral market strategy is employed when the outlook for the market or a stock is stable. That is, the market or the stock is not expected to move too much in any one direction and remain more or less at the same level.

Volatile Market Strategy: A volatile market strategy is employed when the outlook for the market or a stock is unstable. That is, the market or the stock is expected to move up or down significantly from its present level.

STRADDLE
A Straddle involves simultaneous buying (long straddle) or selling (short straddle) of a Call Option as well as a Put Option of the same stock or index with the same strike price and with the same expiry date.

Buying A Straddle (Long Straddle): A long straddle is a strategy when you have a volatile view on the market or a particular stock and you feel that a particular stock or an index will move significantly on either side. It involves buying a Call as well as a Put.

For example, if a stock ABC is trading at a price of Rs 100 in the spot market, you buy a 100 strike price Call at a premium of say, Rs 20 and a 100 strike price Put at a premium of say, Rs 18, with the same expiry, then
The total premium paid for this strategy will be Rs 20 + Rs 18 = Rs 38.
This is the total loss that you can incur on this transaction. Hence, if the lot size of ABC is 200, your net total loss is limited to Rs 38 x 200 = Rs 7,600. While your loss is limited, your profits can, however, be unlimited to the extent of the movement of the stock ABC above or below the breakeven point which is
Breakeven for the Call = Strike price of the Call + total premium paid for the straddle,

That is, Rs 100 + Rs 38 = Rs 138

Breakeven for the Put = Strike price of the Put – total premium paid for the straddle, that is Rs 100- Rs 38 = Rs 62
The breakeven point for the above example is Rs 62 on the lower side and Rs 138 on the upper side. Any move below Rs 62 or above Rs 138 results in a profitable position for the buyer of the straddle.

Basically, you believe that ABC will have a volatile move. The only glitch is that you are unsure as to whether it will move up or down. This is normally the case when some news is expected pertaining to the markets or a stock which can impact the stock price, either favourably or adversely.

This news can be of a varied nature, there may be election results, the budget, expectations of a good quarterly result, anticipation of a huge order, a huge deal going through, etc. Whatever the reason, the stock is expected to react violently.

Selling A Straddle (Short Straddle): You would sell a straddle when you have a neutral view on the market. Basically, if you feel that a particular stock or an index will not move significantly, you will sell a Call as well as sell a Put.

For example: If a stock ABC is around 100 and you feel that there will not be any great movement in the stock price in the near term, you sell a 100 Call Option at a premium of say Rs 20, and simultaneously sell a 100 Put Option at a premium of say, Rs 18. In this case you receive a total premium of Rs 20 + Rs 18 = Rs 38 upfront upon selling this straddle.

With a lot size of say 200, the total premium amount received by you on the sale of this Straddle would be Rs 38 x 200 = Rs 7,600. This is the maximum profit that you can have as the seller of this straddle. Whereas, the loss can be unlimited if ABC moves significantly on either side - above or below the breakeven point.

Breakeven for the Call = Strike price of the Call + total premium paid for the straddle, that is, Rs 100 + Rs 38 = Rs 138

Breakeven for the Put = Strike price of the Put- total premium paid for the straddle, that is, Rs 100- Rs 38 = Rs 62

The seller of a straddle has to keep aside margin amounts for selling the Call and the Put. Also, as the time of expiry nears, the premium drops in value and this is favourable for the seller.

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STRANGLE
A Strangle is similar to a straddle in the sense that here too you simultaneously buy/sell a Call and a Put with the same expiry. But it differs from a straddle in terms of the strike price, which is different for the Call and the Put.

Buying A Strangle (Long Strangle): A long strangle is a volatile strategy. You buy an out-of-the-money Call and also an out-of-the-money Put when you have a volatile view about the stock.

For example: For the stock ABC with a price of Rs 100, you buy an ABC Call with a strike price of Rs 130 at a premium of Rs 10 and you buy an ABC Put with a strike price of Rs 70 at a premium of Rs 8. The total premium paid for this strangle is Rs 10 + Rs 8 = Rs 18 and this is the total loss that can be incurred on this strangle.

The breakeven for this strangle: ABC Call 130 = Strike price + total premium paid, that is, Rs 130 + Rs 18 = Rs 148

ABC Put 70 = Strike price - total premium paid, that is, Rs 70- Rs 18 = Rs 52 The position will be profitable only if the stock moves above Rs 148 on the upper side or below Rs 52 on the lower side.

As these strike prices are out-of-the-money, the premium is lower. But at the same time, the stock would have to make a much greater movement on either side for the position to become profitable.

The cost of buying a strangle is less than that of a straddle and hence the potential loss in a strangle is also low.

Selling A Strangle (Short Strangle): This is a neutral market strategy. You would sell a strangle when you have a neutral view about the stock or the market. You sell an out-of-the-money Call and also an out-of-the-money Put.

For example: Sell a 130 Call of ABC at a premium of Rs 10, and sell a 70 Put at a premium of Rs 8. The net amount that you will receive on the sale of this transaction is Rs 10 + Rs 8 = Rs 18. This is your total profit for this strangle. Whereas the loss can be unlimited if ABC moves significantly on either side - above or below the breakeven points.

The breakeven for this strangle: ABC Call 130 = Strike price + total premium paid, that is, Rs 130 + Rs 18 = Rs 148

ABC Put 70 = Strike price - total premium paid, that is, Rs 70- Rs 18 = Rs 52

Basically, if you are a seller, it is advisable to sell strangles rather than straddles since the stock has to move significantly more in a strangle than in a straddle for your position to run into losses, minimizing the risk.

BUTTERFLY
Butterfly is a strategy made up of 3 sets of either Calls or Puts with the same expiry but different strike prices.

Long Call Butterfly: This is a neutral strategy. Buying 1 ITM (in-the-money) Call, selling 2 ATM (at-the-money) Calls, and buying 1 OTM (out-of-the money) Call. The strike prices should be equidistant.

For example: If ABC is trading at Rs 100 in the spot market, then one can buy ITM 80 Call option at Rs 40, sell two ATM 100 Call Option at a premium of Rs 20 and buy one OTM 120 Call Option at a premium of Rs 10.

Total premium paid for the buy side = Rs 40 + Rs 10 = Rs 50
Total premium received for the sell side = Rs 20 + Rs 20 = Rs 40
The net premium paid is Rs 50 – Rs 40 = Rs 10, which is the maximum loss likely on this transaction.

Breakeven points: Strike price of higher Call - Net premium paid = Rs 120- Rs 10 = Rs 110Strike price of lower Call + Net premium paid = Rs 80 +Rs 10 = Rs 90

The strategy has a limited risk, limited return potential. The maximum profit too is limited and is realized when the stock remains range-bound at expiry.

Short Call Butterfly: This is exactly the opposite of a Long Call Butterfly. It is a volatile market strategy. Selling 1 ITM (in-the-money) Call, buying 2 ATM (at-the-money) Calls and selling 1 OTM (out-of-the money) Call. The strike price should be equidistant. This results in a net premium being received by the investor.

The maximum profit is limited to the total premium received on this transaction and it occurs when the stock ends up on either side of the higher or lower strike price on expiry.

The maximum loss occurs when the stock price remains unchanged on expiry.

There are many more Option Strategies which are either a modification of the above-mentioned strategies or various permutations and combinations of Puts, Calls, Spot and Futures markets. But the ones described above are the most commonly used oneS.

Source: Nirmal Bang