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Home Articles Futures and Options (F&O) – Part 3

Futures and Options (F&O) – Part 3

Mr. Rahul Singh | Posted On Thursday, February 05,2009, 12:54 PM

Futures and Options (F&O) – Part 3

 

 

Options Strategies
Let us refresh our memory on Options which I covered in my previous article F&O Part 1 and F&O Part 2. Options are financial instruments that give the buyer the right to buy (for a call option) or sell (for a put option) the underlying security at some specific point of time in the future (European Option), which is fixed in advance i.e. when the option is written. Call options increase in value as the underlying stock increases in value. Likewise put options increase in value as the underlying stock decreases in value.

In this article we will discuss some most commonly used options strategies. These strategies depend on whether investors are growth-oriented or conservative, or short-term aggressive traders. Options are generally used to speculate on the movement of the price of underlying asset or hedge an existing position or investment. An option strategy is implemented by combining one or more option positions and possibly an underlying stock position. Options strategies can favor movements in the underlying stock that are bullish, bearish, neutral, event driven and stock combination. The option positions used can be long and/or short positions in calls and/or puts at various strikes. Before we begin our discussion, I would like to explain few important terms used extensively in options:

Options Premium
An option Premium is the price of the option that a buyer pays to purchase the contract from the seller.

Strike Price
The Strike (or Exercise) Price is the price at which the underlying security (in this case, XYZ) can be bought or sold as specified in the option contract from the seller. The strike price also helps to identify whether an option is In-the-Money, At-the-Money, or Out-of-the-Money when compared to the price of the underlying security.

Expiration Date
The Expiration Date is the day on which the option is no longer valid and ceases to exist.

In-the-Money option (ITM)
The option is said to be in-the-money option when the strike price (SP) is less than the market price (MP) of the underlying asset for a call option or the strike price is more than the market price for a put option.
i.e. SP < MP     For Call option
      SP > MP     For Put option

At-the-money option (ATM)
The option is said to be at-the-money option when strike price is equal to the market price of the underlying asset.
i.e. SP = MP       For both Put and Call option

Out-of-the-money option (OTM)
This is when the strike price is more than the market price of the underlying asset for call option while the strike price is less than the market price for the put option.
i.e. SP > MP     For Call option
      SP < MP     For Put option

Time Decay
Generally, the longer the time remaining until an option’s expiration, the higher its premium will be. This is because the longer an option’s lifetime, greater is the possibility that the underlying share price might move so as to make the option in-the-money. All other factors affecting an option’s price remaining the same, the time value portion of an option’s premium will decrease (or decay) with the passage of time. Note: This time decay increases rapidly in the last several weeks of an option’s life. When an option expires in in-the-money, it is generally worth only its intrinsic value.

Intrinsic Value
For call options, this is the difference between the underlying stock's price and the strike price. For put options, it is the difference between the strike price and the underlying stock's price. In the case of both puts and calls, if the respective difference value is negative, the intrinsic value is given as zero.

Volatility
Volatility is the tendency of the underlying security’s market price to fluctuate either up or down. It reflects a price change’s magnitude; it does not imply a bias toward price movement in one direction or the other. Thus, it is a major factor in determining an option’s premium. The higher the volatility of the underlying stock, the higher the premium because there is a greater possibility that the option will move in-the-money. Generally, as the volatility of an underlying stock increases, the premiums of both calls and puts overlying that stock increase, and vice versa.

Leverage
Options can provide leverage. This means an option buyer can pay a relatively small premium for market exposure in relation to the contract value (usually 100 shares of underlying stock). An investor can see large percentage gains from comparatively small, favorable percentage moves in the underlying equity. Leverage also has downside implications. If the underlying stock price does not rise or fall as anticipated during the lifetime of the option, leverage can magnify the investment’s percentage loss. Leverage is like a magnifying force – it magnifies both the upside gain as well as downside loss.

Now, let’s begin our discussion on various options strategies.

Bullish Strategies
Bullish options strategies are employed when the options trader expects the underlying stock price to move upwards. It is necessary to assess how high the stock price can go and the time frame in which the rally will occur in order to select the optimum trading strategy.

Stocks seldom go up by leaps and bounds. Moderately bullish options traders usually set a target price for the bull run and utilize bull spreads to reduce cost. (It does not reduce risk because the options can still expire worthless.) While maximum profit is capped for these strategies, they usually cost less to employ for a given nominal amount of exposure. The bull call spread and the bull put spread are common examples of moderately bullish strategies.

Mildly bullish trading strategies are options strategies that make money as long as the underlying stock price does not go down by the options expiration date. These strategies may provide a small downside protection as well. Writing out-of-the-money covered calls is a good example of such a strategy.

Long Call
This is the most common option trading among investors.

How to design: Buy 1 call.
Margins: No
Market Outlook: Bullish. Investors believe that the share price will rise well above the strike price. The more bullish your view the further out of the money you can buy to create maximum leverage.
Profit: The profit increases as the market rises. The break-even point (BEP) will be the options strike price plus the premium (OP) paid for the option i.e.
     BEP = Strike Price + OP.
Loss: The maximum loss is the premium paid for the option. Any point between the strike price A, and the break-even point you will make a loss although not the maximum loss.
Volatility: The option value will increase as volatility increases (good) and will fall as volatility falls (bad).
Time Decay: As each day passes the value of the option erodes.

Short Put
How to design: Sell 1 put.
Margins: Yes
Market Outlook: Bullish. The share price will not fall below the strike price. If it does you are obligated to buy at the strike price, or buy the option back to close.
Profit: The maximum profit is the premium you sold the option for. The break-even point will be the options strike price, minus the premium received for the option.
Loss: The maximum loss is the strike price less the premium received.
Volatility: The option value will increase as volatility increases (bad) and will decrease as volatility decreases (good).
Time Decay: As each day passes the value of the option erodes (good).

Bull Call Spread
How to design: Buy an at-the-money call option while simultaneously Sell a higher striking out-of-the-money call option of the same underlying security and the same expiration month.
Margins: No
Market Outlook: Bullish. The share price will expire above the higher strike price and not below the lower strike price. The strategy provides protection if your view is wrong.
Profit: The maximum profit is limited to the difference between the strike price of two options less the cost of the spread i.e. net premium paid.
Loss: The maximum loss is also limited to the cost of the spread (Calls). The bull call spread strategy will result in a loss if the stock price declines at expiration. Maximum loss cannot be more than the initial debit taken to enter the spread position.
Volatility: You are not affected by volatility.
Time Decay: It depends on the underlying share price, if it is below lower strike price, then time decay works against you. If it is above higher strike price, then it works for you.

Example: Suppose ABC stock is trading at Rs. 420 in June. An options trader executes a bull call strategy by buying a JUL 400 call (it means call put option has the strike price of Rs. 400 and will expire in the last week of July) for Rs. 3,000 (option premium) and selling a JUL 450 call for Rs. 1,000. The net debit (or investments) to trader (i.e. he paid to enter this strategy) to enter the trade is Rs. 2,000.

If ABC stock goes up and trades at Rs. 460 on expiration in July, both the call options expire in-the-money (because market price is more than the strike price). However, the trader will earn profit on JUL 400 call (because he is the buyer) but he will loose money in JUL 450 (because he is the seller of that call)
Intrinsic value of JUL 400 call= (Market price - Strike price) * No. of underlying stocks
               = (Rs. 460- Rs. 400)* 100 = Rs. 6,000
Intrinsic value of JUL 450 call= (Market price - Strike price) * No. of underlying stocks
               = (Rs. 460- Rs. 450)* 100 = Rs. 1,000

Hence, the trader’s net profit to the trader is equal to Rs. 6,000-1,000 = Rs. 5,000
Subtracting the initial debit of Rs. 2,000, the options trader's net profit comes to Rs. 5,000-2,000 = Rs. 3,000.

If the price of stock ABC goes down to Rs. 380 on expiration, both the options expire worthless. The trader will loose his investment of Rs. 2,000, which is also his maximum possible loss.

Bearish Strategies
Bearish options strategies are the mirror image of bullish strategies. They are employed when the options trader expects the underlying stock price to move downwards. It is necessary to assess how low the stock price can go and the time frame in which the decline will happen in order to select the optimum trading strategy.

Stock prices only occasionally make steep downward moves. Moderately bearish options traders usually set a target price for the expected decline and utilize bear spreads to reduce cost. While maximum profit is capped for these strategies, they usually cost less to employ. The bear call spread and the bear put spread are common examples of moderately bearish strategies.

Mildly bearish trading strategies are options strategies that make money as long as the underlying stock price does not go up by the options expiration date. These strategies may provide a small upside protection as well. .

Long Put
How to design: Buy 1 ATM put.
Margins: No
Market Outlook: Bearish. Investors believe the share price will expire well below the strike price. It is used to profit from an expected fall in a share. This strategy is commonly used to provide protection to stocks held in your portfolio. If the share price falls, the profit from the Put will offset the loss on the Share.
Profit: The maximum profit is limited to the strike price less the cost of the option (Option Premium), as the share can only fall as low as zero.
Loss: The maximum loss is equal to the amount of premium paid for the option.
Volatility: The option value will increase as volatility increases (good) and will fall as volatility falls (bad).
Time Decay: As each day passes the value of the option erodes (bad).

Short Call
How to design: Sell 1 call.
Margins: Yes
Market Outlook: Bearish. The share price will expire below the strike price A. If it does you will get to keep the option premium.
Profit: The maximum profit is the premium you sold the option. The break-even point will be the options strike price A, plus the premium received for the option.
Loss: The maximum loss for this trade is unlimited.
Volatility: The option value will increase as volatility increases (bad) and will decrease as volatility decreases (good).
Time Decay: As each day passes the value of the option erodes (good).

Bear Call Spread
A bear call spread is a limited profit, limited risk options trading strategy that can be used when the options trader is moderately bearish on the underlying security.
How to design: Buy 1 OTM Call (higher strike price) and Sell 1 ITM Call option (lower strike price) on the same underlying security expiring in the same month.
Margins: Yes
Market Outlook: Bearish. The options trader thinks that the price of the underlying asset will go down moderately in the near term.
Profit: The maximum profit is limited to the difference net premium received i.e. the premium received for the short call minus the premium paid for the long call.
Loss: The maximum loss is also limited to the difference in the strike price of two options -Net Premium. If the stock price rise above the strike price of the higher strike call at the expiration date, then the bear call spread strategy suffers a maximum loss equals to the difference in strike price between the two options minus the original credit taken in when entering the position.
Volatility: You are not affected by volatility.
Time Decay: It depends on the underlying share price, if it is below A, then time decay works for you. If it is above B, then it works against you.

Example: Suppose ABC stock is trading at Rs. 380 in June. An options trader executes a bear call spread by buying a JUL 400 call (it means call put option has the strike price of Rs. 400 and will expire in the last week of July) for Rs. 1,000 (option premium) and selling a JUL 350 call for Rs. 3,000. The net credit to trader (i.e. he receives Rs. 2000 to enter this strategy) taken to enter the trade is Rs. 2,000.

If ABC stock goes up and trades at Rs. 420 on expiration in July, both the call options expire in-the-money (because market price is more than the strike price). However, the trader will earn profit on JUL 400 call (because he is the buyer) but he will loose money in JUL 350 (because he is the seller of that call and has to pay the buyer).
Intrinsic value of JUL 400 call= (Market price - Strike price) * No. of underlying stocks
               = (Rs. 420- Rs. 400)* 100 = Rs. 2,000
Intrinsic value of JUL 350 call= (Market price - Strike price) * No. of underlying stocks
               = (Rs. 420- Rs. 350)* 100 = Rs. 7,000

Hence, the trader’s net loss is equal to Rs. 7,000-2,000 = Rs. 5,000
Subtracting the initial credit of Rs. 2,000, the options trader's net loss comes to Rs. 5,000-2,000 = Rs. 3,000.

On expiration in July, if ABC stock drops to Rs. 340, both the JUL 350 call and the JUL 400 call expires worthless and the bear call spread trader pockets his profit which is equal to the initial credit of Rs. 2,000

Neutral Strategies
Neutral strategies in options trading are employed when the options trader does not know whether the underlying stock price will rise or fall. Also known as non-directional strategies, they are so named because the potential to profit does not depend on whether the underlying stock price will go upwards or downwards. Rather, the correct neutral strategy to employ depends on the expected volatility of the underlying stock price.
Examples of neutral strategies are:

Short Straddle
How to design: Sell 1 at-the-money Call and Sell 1 at-the-money Put of the same underlying stock, striking price and expiration date simultaneously.
Margins: Yes
Market Outlook: Neutral. The share price will expire around the strike price. If it does you will get to keep the option premium from both sold options. This strategy is also used if your view is that volatility will decrease.
Profit: The maximum profit is the combined total premium you received for the sale of the options. One break-even point (Upper BEP) will be the strike price plus the combined options premium received. The other break-even point (Lower BEP) will be the strike price minus the combined options premium received.
Loss: The maximum loss for this trade is unlimited on the upside and limited on the downside to the strike price, as the share can’t fall below zero.
Volatility: The option value will decrease as volatility decreases which is good for both options. Alternatively an increase in volatility will be bad for both options.
Time Decay: As each day passes the value of the option erodes (good).

Example: Suppose ABC stock is trading at Rs. 400 in June. An options trader executes a short straddle by selling a JUL 400 put (it means put option has the strike price of Rs. 400 and will expire in the last week of July) for Rs. 2,000 (option premium) and a JUL 450 call for Rs. 2,000. The net credit to enter the trade is Rs. 4,000, which is also his maximum possible profit (because the trader is selling these options and getting premium).

If ABC stock goes up and trades at Rs. 500 on expiration in July, the JUL 400 put will expire worthless (because market price is more than the strike price) but the JUL 400 call expires in-the-money (because market price is greater than the strike price) and has an intrinsic value of :
Rs. 10,000 (Intrinsic value of call = (Market price - Strike price) * No. of underlying stocks).
               = (Rs. 500- Rs. 400)* 100 = Rs. 10,000
Subtracting the initial credit of Rs. 4,000, the options trader's loss comes to Rs. 10,000-4,000 = Rs. 6,000 (because trader has to pay Rs. 10,000 to the buyer of call option).

On expiration in July, if ABC stock is still trading at Rs. 400, both the JUL 350 put and the JUL 450 call expire worthless and the options trader gets to keep the entire initial credit of Rs. 4,000 taken to enter the trade as profit.

Short Strangle
How to design: Sell 1 out-of-the-money Call and Sell 1 out-of-the-money Put of same expiration date and same underlying stock but different strike price.
Margins: Yes
Market Outlook: Neutral. The share price will expire between the strike prices A and B. If it does you will get to keep the option premium from both sold options. This strategy is also used if your view is that volatility will decrease.
Profit: The maximum profit is the combined total premium you received for the sale of the options. One break-even point (Lower BEP) will be the strike price of short put minus the net options premium received. The other break-even point (Upper BEP) will be the strike price of short call plus the net options premium received.
Loss: The maximum loss for this trade is unlimited on the upside and limited on the downside to the strike price, as the share can’t fall below zero.
Volatility: The option value will decrease as volatility decreases which is good for both options. Alternatively an increase in volatility will be bad for both options.
Time Decay: As each day passes the value of the option erodes (good).

Example: Suppose ABC stock is trading at Rs. 400 in June. An options trader executes a short strangle by selling a JUL 350 put (it means put option has the strike price of Rs. 350 and will expire in the last week of July) for Rs. 1000 (option premium) and a JUL 450 call for Rs. 1000. The net credit to enter the trade is Rs. 2000, which is also his maximum possible profit (because the trader is selling these options and getting premium).

If ABC stock goes up and trades at Rs. 500 on expiration in July, the JUL 350 put will expire worthless (because market price is more than the strike price) but the JUL 450 call expires in-the-money (because market price is greater than the strike price) and has an intrinsic value of :
Rs. 5000 (Intrinsic value of call = (Market price - Strike price) * No. of underlying stocks).
               = (Rs. 500- Rs. 450)* 100 = Rs. 5000
Subtracting the initial credit of Rs. 2000, the options trader's loss comes to Rs. 5000-2000 = Rs. 3000 (because trader has to pay Rs. 5000 to the buyer of call option).

On expiration in July, if ABC stock is still trading at Rs. 400, both the JUL 350 put and the JUL 450 call expire worthless and the options trader gets to keep the entire initial credit of Rs. 2000 taken to enter the trade as profit.

Long Put Butterfly
A long butterfly is similar to Short Straddle except the fact that loss is limited.
How to design: Buying 1 in-the-money Put and 1 out-of-the-money Put + Selling 2 at-the-money Puts
All these options must have same underlying stock and expiration dates. The strike price differs for these three puts (1 for ATM, 1 for OTM and 1 for ITM).
Margins: Yes
Market Outlook: Neutral. Investor thinks that the underlying stock will not rise or fall much by expiration (i.e. when the investor is bearish on volatility.
Profit: The maximum gain for the long put butterfly is attained when the underlying stock price remains unchanged at expiration. At this price, only the highest striking put expires in the money.
The maximum profit for this trade is limited to the strike price of (ATM - ITM) - Net premium paid for the spread.
There are 2 break-even points for the long put butterfly position. The breakeven points can be calculated using the following formulae.
Upper Breakeven Point = Strike Price of Highest Strike Long Put - Net Premium Paid
Lower Breakeven Point = Strike Price of Lowest Strike Long Put + Net Premium Paid
Loss: The maximum loss is = Net Premium Paid + Commissions Paid
Volatility: The option value will decrease as volatility decreases which is generally good for the strategy. Alternatively an increase in volatility will be generally bad for the strategy.
Time Decay: As each day passes the value of the option erodes (good). Most of the decay will occur in the final month before expiry.

Example: Suppose ABC stock is trading at Rs. 400 in June. An options trader executes a long put butterfly by selling a JUL 300 put (it means put option has the strike price of Rs. 300 and will expire in the last week of July) for Rs. 1,000 (option premium), writing 2 July 400 puts for Rs. 2,000 and a JUL 500 call for Rs. 5,000. The net debt taken to enter the trade is Rs. 4,000, which is also his maximum possible profit (because the trader is selling these options and getting premium).

If ABC stock is still trading at Rs. 400 on expiration in July, the JUL 400 and JUL 300 put will expire worthless (because market price is more than the strike price) but the JUL 500 pull has intrinsic value of Rs. 5000:
Intrinsic value of put = (Strike price - Market price) * No. of underlying stocks
               = (Rs. 500- Rs. 400)* 100 = Rs. 10,000

Subtracting the initial credit of Rs. 4,000, the options trader's profit comes to Rs. 10,000-4,000 = Rs. 6,000 (because trader is selling stocks at a higher rate than the market price).

Maximum loss results when the stock is trading below Rs. 300 or above Rs. 500. At Rs. 500, all the options expire worthless. Below Rs. 300, any "profit" from the two long puts will be neutralized by the "loss" from the two short puts. In both situations, the long put butterfly trader suffers maximum loss which is equal to the initial debit taken to enter the trade.

Event Driven
Event driven strategies in options trading are employed when the options trader is expecting some events which will influence the prices of underlying asset. In general, they benefit from the volatility in the price of stocks.

Long Straddle
How to design: Buy 1 ATM Call and Buy 1 ATM Put simultaneously at the same underlying stock, striking price and expiration date.
Market Outlook: An investor may take a long straddle position if he thinks the market is highly volatile, but does not know in which direction it is going to move. If volatility increase, both bought options will increase in value.
Profit: The maximum profit for this trade is unlimited on the upside and limited on the downside to the strike price, as the share can’t fall below zero.
Loss: The maximum loss for this trade is the premium paid to buy both options.
Volatility: The option value will increase as volatility increases which is good for both options. Alternatively a decrease in volatility will be bad for both options.
Time Decay: As each day passes the value of the option erodes (bad).

Example: Suppose ABC stock is trading at Rs. 400 in June. An options trader executes a long straddle by buying a JUL 400 put (it means put option has the strike price of Rs. 400 and will expire in the last week of July) for Rs. 2,000 (option premium) and buying a JUL 400 call for Rs. 2,000. The net debt taken to enter the trade is Rs. 4,000, which is also his maximum possible loss (because the trader is investing money to buy these options from the seller).

If ABC stock is still trading at Rs. 500 on expiration in July, the JUL 400 put will expire worthless but JUL 400 call expires in the money (because market price is more than the strike price which is good for buyer of a call option).
Intrinsic value of call= (Market price - Strike price) * No. of underlying stocks
               = (Rs. 500- Rs. 400)* 100 = Rs. 10,000

Subtracting the initial credit of Rs. 4,000, the options trader's profit comes to Rs. 10,000-4,000 = Rs. 6,000 (because trader is buying stocks at a lower rate than the market price).

On expiration in July, if ABC stock is still trading at Rs. 400, both the JUL 400 put and the JUL 400 call expires worthless and the long straddle trader suffers a maximum loss which is equal to the initial debit of Rs. 4,000

Long Strangle
How to design: Buy 1 OTM Call and Buy 1 OTM Put of different strike price but the same underlying stock and expiration date.
Market Outlook: The owner of a long strangle makes a profit if the underlying price moves far enough way from the current price, either above or below. Thus, an investor may take a long strangle position if he thinks the underlying security is highly volatile, but does not know which direction it is going to move.
Profit: The maximum profit for this trade is unlimited on the upside and limited on the downside to the strike price A, as the shares can’t fall below zero. A large gain for the long strangle option strategy is possible when the underlying stock price makes a very strong move either upwards or downwards at expiration.
Loss: The maximum loss for this trade is the premium paid to buy both options.
Volatility: The option value will increase as volatility increases which is good for both options. Alternatively a decrease in volatility will be bad for both options.
Time Decay: As each day passes the value of the option erodes (bad).

Example: Suppose ABC stock is trading at Rs. 400 in June. An options trader executes a long strangle by buying a JUL 350 put (it means put option has the strike price of Rs. 350 and will expire in the last week of July) for Rs. 1,000 (option premium) and buying a JUL 450 call for Rs. 1,000. The net debt taken to enter the trade is Rs. 2,000, which is also his maximum possible loss (because the trader is investing money to buy these options from the seller).

If ABC stock goes up and trades at Rs. 500 on expiration in July, the JUL 350 put will expire worthless but JUL 450 call expires in-the-money (because market price is more than the strike price which is good for buyer of a call option).
Intrinsic value of call= (Market price - Strike price) * No. of underlying stocks
               = (Rs. 500- Rs. 450)* 100 = Rs. 5,000

Subtracting the initial credit of Rs. 2,000, the options trader's profit comes to Rs. 5,000-2,000 = Rs. 3,000 (because trader is buying stocks at a lower rate than the market price).

On expiration in July, if ABC stock is still trading at Rs. 400, both the JUL 350 put and the JUL 450 call expires worthless and the long strangle trader suffers a maximum loss which is equal to the initial debit of Rs. 2,000

Conclusion
There is around hundreds of different options strategies. However, my idea was to cover only selected few simple options to educate you. The rest of options strategies are based on a combination of these options. The successful use of options requires a willingness to learn what they are, how they work, and what risks are associated with particular options strategies. Individuals seeking expanded investment opportunities in today’s markets will find options trading challenging, often fast moving, and potentially rewarding.

In the next article, I will cover Trading mechanisms of Futures contracts.

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