Options Trading Strategies

You only have to do this one thing if you want to earn money. It’s the one thing some of the richest people on the Earth have done and are doing. This thing is also mentioned in the ancient literature and cultures. But most people will fear doing it! John D. Rockefeller did it since his childhood and he became a billionaire. Andrew Carnegie did it, too and he became a tycoon. What is the greatest money making secret in the history of mankind? What is the one thing that works for everyone? And the answer is……

GIVE AWAY MONEY!

That’s right. Give it away.

Now you must be thinking that I have completely gone Crazy. But trust me it really works. But I do agree that to give away money you need to have the same in first place. There are some weirdest money making ways available on the internet. But those of whom who are interested in making money through trading, we have various ways of Stock trading, Hedge funds, Options etc. In this article I am going to discuss some of the option trading strategies and some numerical examples of the same to help you achieve this goal. Before actually bombarding you with the option trading strategies, let me first explain to you what exactly the meaning of trading an option is.

An Option gives you the right to buy or sell an asset at a certain price and by a certain date. Let’s say you want to buy a guitar from your friend. And your friend wants $1500 for it. If you don’t have the money to buy it right now, you can tell your friend that you will pay  $500 right now if he holds the guitar for you for a month. But if you don’t come up with $1500 by then, your friend can keep the $500 and can do whatever he wants with the guitar.

In this case the guitar is the asset, and your right to buy it under those specific terms is an option. But if your friend realizes that the guitar is worth $5000, he will still have to sell it to you for $1500 because you have that right, and thus you’ll make a profit. If the guitar breaks, you probably won’t want to spend $1500 entirely to buy it, but you’ll lose the $500 you used to buy that option. This is pretty much how an option trading works, but it’s very complicated and risky in practice. This article will show you how to get started with the various options trading strategies.

Strategy 1: LONG CALL

This is one of the option trading strategies for aggressive investors who are very bullish about a stock or an index. Buying calls can be an excellent way to capture the upside potential with limited downside risk. It is the most basic of all options trading strategies. It is comparatively an easy strategy to understand. When you buy it means you are bullish on a stock or an index and you expect to rise in future.

Best time to Use:	When you are very bullish on the stock or index.
Risk:	Risk is limited to the Premium. (There is a maximum loss if market expires at or below the option strike price).
Reward:	Reward is Unlimited
Breakeven:	(Strike Price + Premium)

Example

John is bullish on Nifty. On 25th May, the Nifty is at 5943.55. John buys a call option with a strike price of Rs. 5900 and at a premium of Rs. 108 which is expiring on 31st July. If the Nifty goes above 6008 (5900+108), Mr. John will make a net profit (after deducting the premium) on exercising the option. In case the Nifty stays at or falls below 5900, he can forego the option (it will expire worthless) with a maximum loss of the premium.

The Input table gives you the data of the price, premium and Break even point whereas the Output table gives the data of the payoffs. Payoff means the profit or loss incurred in the transaction.

Input

Strategy: Buy call Option
	Current Nifty Index	5943.55
Call Option	Strike Price (Rs.)	5900
Mr. John Pays	Premium (Rs.)	108
Break Even Point (Rs	(Strike price + premium)	6008

Output

The Payoff Schedule
On expiry Nifty Closes at	Net payoff
5600	-108
5700	-108
5800	-108.00
5900	-108.00
6008	0
6100	92
6200	192

 

ANALYSIS: It limits the downside risk to the extent of premium (Rs. 108) which is paid by Mr. John. But if there is rise in Nifty then the potential return is unlimited. This is one of the option trading strategies that will offer you the simplest way to benefit. And that is why it is the most common choice among first time investors in Options.

Strategy 2: SHORT CALL

In the strategy that we discussed above, we were hoping that the stock would rise in future and hence we adopted a strategy of LONG CALL there. But this strategy of SHORT CALL is opposite of that. When you expect the underlying stock to fall you adopt this strategy. An investor can sell Call options when he is very bearish about a stock / index and expects the prices to fall. This is a position which offers limited profit potential. Investor can incur large losses if the underlying price starts increasing instead of decreasing. Though this strategy is easy to execute it can be quite risky since the seller of the Call is exposed to unlimited risk.

Best time to Use:	When you are very bearish on the stock or index.
Risk:	Risk here becomes Unlimited
Reward:	Reward is limited to the amount of premium
Breakeven:	Strike Price+ Premium

Example:

Matt is bearish about Nifty and expects it to fall. Matt sells a Call option with a strike price of Rs. 5900 at a premium of Rs. 108, when the current Nifty is at 5943.55. If the Nifty stays at 5900 or below, the Call option will not be exercised by the buyer of the Call and Matt can retain the entire premium of Rs.154.

Input

Strategy: Sell call Option
	Current Nifty Index	5943.55
Call Option	Strike Price (Rs.)	5900
Mr. Matt receives	Premium (Rs.)	108
	Break Even Point (Rs.) = (Strike price + premium)	6008

 Output

The Payoff Schedule
On expiry Nifty Closes at	Net payoff
5600	108
5700	108
5800	108
5900	108
6008	0
6100	-92
6200	-192

ANALYSIS: This strategy is used when an investor has a strong expectation that the price will certainly fall in future. This is a risky strategy, as the stock prices rises, the short call loses money more quickly. This strategy is also called Short Naked Call since the investor does not own the underlying stock that he is shorting.

Strategy 3: LONG PUT

Long Put is different from Long Call. Here you must understand that buying a Put is the opposite of buying a Call. When you are bullish about the stock / index, you buy a Call. But when you are bearish, you can buy a Put option. A Put Option gives the buyer of the Put a right to sell the stock (to the Put seller) at a pre-specified price. He thereby limits his risk. Thus the Long Put here becomes a Bearish strategy. You as investor can buy Put options to take advantage of a falling market.

Best time to Use:	When the investor is bearish about the stock /index.
Risk:	Risk is limited to the amount of Premium paid.
Reward:	Unlimited
Breakeven:	Stock Price – Premium

Example:

Jacob is bearish on Nifty on 24th April, when the Nifty is at 5943.55. He buys a Put option with a strike price Rs. 5900 at a premium of Rs. 37, expiring on 31st May. If the Nifty goes below 5863 (5900-52), Jacob will make a profit on exercising the option. In case the Nifty rises above 5900, he can give up the option (it will expire worthless) with a maximum loss of the premium. 

Input

Strategy: Buy Put Option
	Current Nifty Index	5943.55
Put Option	Strike Price (Rs.)	5900
Mr. Jacob pays	Premium (Rs.)	37
	Break Even Point (Rs.) = (Strike price – premium)	5863

Output

The Payoff Schedule
On expiry Nifty Closes at	Net payoff
5600	263
5700	163
5800	63
5863	0
5900	-37
6000	-37
6100	-37

                                                                                                            ANALYSIS: If you are bearish you can profit from the declining stock prices by buying Puts. You will be able to limit your risk to the amount of premium paid but your profit potential remains unlimited. This is one of the widely used options trading strategies when an investor is bearish.

Strategy 4: SHORT PUT

In long Put we saw that when the investor is bearish on a stock he buys Put. But selling a Put is opposite of buying a Put. An investor will generally sell the Put when he is Bullish about the stock. In this case the investor expects the stock price to rise. When an investor sells a Put, he earns a Premium (from the buyer of the Put). Here the investor has sold someone the right to sell him the stock at the strike price. If the stock price increases above the strike price, this strategy will make a profit for the seller, since the buyer will not exercise the Put. But, if the stock price decreases below the strike price, more than the amount of the premium, the Put seller will start losing money. The potential loss is unlimited here.

Best time to Use:	When the investor is very Bullish on the stock or the index.
Risk:	Put Strike Price –Put Premium.
Reward:	It is limited to the amount of Premium.
Breakeven:	Stock Price – Premium

Example

Richard is bullish on Nifty when it is at 5943.55. Richard sells a Put option with a strike price of Rs. 5900 at a premium of Rs. 37 expiring on 31st July. If the Nifty index stays above 5900, he will gain the amount of premium as the Put buyer won’t exercise his option. In case the Nifty falls below 5900, Put buyer will exercise the option and the Richard will start losing money. If the Nifty falls below 5863, which is the breakeven point, Richard will lose the premium and more depending on the extent of the fall in Nifty.

Input

Strategy: Sell Put Option
	Current Nifty Index	5943.55
Put Option	Strike Price (Rs.)	5900
Mr. Richard receives	Premium (Rs.)	37
Break Even Point (Rs.)	= (Strike price – premium)	5863

Output

The Payoff Schedule
On expiry Nifty Closes at	Net payoff
5600	-263
5700	-163
5800	-63
5863	0
5900	37
6000	37
6100	37

ANALYSIS: Selling Puts can lead to regular income but it should be done carefully since the potential losses can be significant. This strategy is an income generating strategy.

Strategy 5: LONG STRADDLE

The long straddle strategy is also known as buy straddle or simply “straddle”. It is one of the neutral options trading strategies that involve simultaneously buying of a put and a call of the same underlying stock. The same strike price and expiration date are the same. By having long positions in both call and put options, this strategy can achieve large profits no matter which way the underlying stock price heads. But the move has to be strong enough.

Best time to Use:	When the investor thinks that the underlying stock / index will experience significant volatility in the near term.
Risk:	Limited to the initial premium paid.
Reward:	The reward here is Unlimited
Breakeven:	Upper Breakeven Point = Strike Price of Long Call + Net Premium Paid. Lower Breakeven Point = Strike Price of Long Put – Net Premium Paid.

Example

Mr. Harrison goes to the NSE website. He fetches the data for Current Nifty Index, Strike Price (Rs.), and Premium (Rs.). He then selects the index derivative. In instrument type Harrison selects index options, in symbol he selects nifty, expiry date is 31 January 2013, option type will be call, and Strike price is 5900. Call Premium paid is RS 108. Now in, option type he selects Put, Strike price is same as above i.e.  5900. So Put premium paid is 37.

The data for our input table is as follows:

Current nifty index is 5943.55

Strike price is 5900

Total premium paid is 108+37 which equals to 145.

Upper Breakeven point is calculated as 5900+145 which comes to 6045

Lower Breakeven point is calculated as 5900-145 which comes to 5755

We will assume on expiry Nifty Closes as on expiry Nifty Closes at 5200,5300,5400,5500 and so on.

Input

Strategy: Buy Put + Buy Call
	Current Nifty Index	5943.55
Call and Put Option	Strike Price (Rs.)	5900
	Call Premium (Rs.)	108
Mr. Harrison pays	Put Premium (Rs.)	37
	Total Premium (Rs)	145
	Break Even Point (Rs.)	6045
	Break Even Point (Rs.)	5755

Output

The Payoff Schedule
On expiry Nifty Closes at	Net payoff from Put Purchased (Rs.)	Net payoff from call Purchased (Rs.)	Net Payoff (Rs.)
5200	663	-108	555
5300	563	-108	455
5400	463	-108	355
5500	363	-108	255
5600	263	-108	155
5700	163	-108	55
5755	108	-108	0
5800	63	-108	-45
5875	-12	-108	-120
5900	-37	-108	-145
5945	-37	-63	-100
6000	-37	-8	-45
6045	-37	37	0
6100	-37	92	55
6200	-37	192	155
6300	-37	292	255
6400	-37	392	355
6500	-37	492	455
6600	-37	592	555

 

 

Strategy 6: SHORT STRADDLE

A Short Straddle is exactly the opposite of Long Straddle. Investor can adopt this strategy when he feels that the market will not show much movement. Thereby 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.

Best time to Use:	When the investor thinks that the underlying stock will experience very little volatility in the near term.
Risk:	Unlimited
Reward:	Limited to the premium received
Breakeven:	Upper Breakeven Point = Strike Price of Short Call + Net Premium Received Lower Breakeven Point = Strike Price of Short Put – Net Premium Received

Example

Mr. Buffey goes to the NSE website and fetches the data for Current Nifty Index, Strike Price (Rs.), and Premium (Rs.). He then selects the index derivative. In instrument type he selects index options, in symbol he selects nifty, expiry date is 31 January 2013, option type will be call, and Strike price is 5900. Call Premium paid is RS 108. Now in, option type he selects Put, Strike price is same as above i.e.  5900. So Put premium paid is 37.

Input

Strategy: Sell Put + Sell Call
	Current Nifty Index	5943.55
Call and Put Option	Strike Price (Rs.)	5900
	Call Premium (Rs.)	108
	Put Premium (Rs.)	37
Mr. Buffey receives	Total Premium (Rs)	145
	Break Even Point (Rs.)	6045
	Break Even Point (Rs.)	5755

Output

The Payoff Schedule
On expiry Nifty Closes at	Net payoff from Put Sold (Rs.)	Net payoff from call Sold (Rs.)	Net Payoff (Rs.)
5200	-663	108	-555
5300	-563	108	-455
5400	-463	108	-355
5500	-363	108	-255
5600	-263	108	-155
5700	-163	108	-55
5755	-108	108	0
5800	-63	108	45
5855	-8	108	100
5900	37	108	145
5935	37	73	110
6000	37	8	45
6045	37	-37	0
6100	37	-92	-55
6200	37	-192	-155
6300	37	-292	-255
6400	37	-392	-355

 

 

ANALYSIS: If the stock moves up or down significantly, the investor’s losses can be significant. This is a risky strategy. It should be carefully adopted only when the expected volatility in the market is limited.

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