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Options: Trading strategies (Part I) - Views on News from Equitymaster
 
 
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  • Mar 12, 2001

    Options: Trading strategies (Part I)

    Buy low; sell high – simple, and an age-old formula for making money in the stock markets when the sentiment is bullish. Sell high, buy low a similar formula for making money when the sentiment in bearish. What do you do when the markets are stagnant, range bound or volatile? Well options could provide some of the answers. (For introduction to options please follow this link)

    Bullish Markets

    In a bullish market the following strategies could be used to make profits:

    • Buy a call option
    • Sell a put option
    • Bullish spreads.

    Buying a call option

    Buying a call option means to purchase the right to buy a stock or the index at a pre-decided price known as the strike price. This is done with the perception that the cash market price will be higher than the strike price and therefore, the stock or the index will be available at a discount to the buyer (of the option) compared to the market price. The option premium is the price paid to buy an option.

    In the example illustrated the strike price for the call option is Rs 1000 and the option premium is Rs 40. The option is exercised (used) only if the value of the index or the underlying stock is greater than Rs 1000. Suppose the call is exercised when the market price is Rs 1100 then the gross advantage for the buyer is Rs 100. However, the buyer has paid Rs 40 to buy the option therefore this amount is subtracted from the gross advantage to get the gain.

    The gain can be derived using the formula for the buyers in a call option

    Gain = Market price –Strike price – Premium.
          1100 – 1000 –40 = Rs 60

    If the option is not exercised then the gain for the seller will be equal to the premium collected. Rs 40 in this case.

    But if the option is exercised the seller will lose by an amount equal to the difference between the Market price and strike price. Higher the difference between market price and the strike price higher the gain made buy the buyer.

    The seller of the call option, proceeds with the expectation that the price of the stock or the index will not be higher than the strike price and therefore the option will not be exercised. The premium that is paid by the buyer is the sellers net gain only in case the option is not exercised.

    Selling a put option

    With a view that the price of the stock will not go down below the strike price the seller agrees to write a put option. The buyer this time buys the right to sell the stock at the strike price (a put option). If the market price does not go below the strike price then the seller gains are equal to the premium paid.

    But if the price falls below the strike price then the buyer gains by an amount that is equal to the difference between the strike price and market price. The net gains would be the gross advantage (strike price – market price) minus the premium paid.

    Here the strike price for the put option is Rs 1,000. The seller is of the conviction that the price will not go down below this figure. The buyer feels that prices may go below the strike price and pays the premium of Rs 40. The gain for the seller is limited to Rs 40. However, if the markets start going down the seller may incur heavy losses.

    For the seller in a put option
    Gain = Premium = Rs 40

    For the buyers if the index falls below strike price to Rs 900 the gain is then given by

    Gain = Strike price – Market price – Premium
          = 1000- 900- 40 = Rs 60

    Bullish spreads

    These are formed by the combination of options of similar types. A bullish spread is used when there is indication to what value the market will move up to. The spread is created by buying and selling call options. The strike price of the call option that is sold (known as short call) is higher than strike price of the call that is bought (long call). As a result the premium on the call that is sold will be lower than the premium on the long call. Therefore, the bullish call spread requires investment. Here the profit is limited. Selling the call partially covers up for the premium paid for buying the call. Expectation is that the market will remain range bound. If the markets rise the profits are arrested as the short call is exercised and causes losses. Bullish spreads can also be created using put options.

    The strike price for the call option that is bought is Rs 1,000 and the strike price for the call option that is sold is Rs 1200

    Premium to be paid for the option that is bought Rs 40 while that which is sold is Rs 35. Net investment = P (brought) – P (Sold)
    40 – 35 = Rs 5

    Gain on bullish spread = Gain on long call – loss on short call – investment

    Case 1
    When the market remain below Rs 1,000. Both call options will expire.

    Loss = 0 – 0 - 5 = Rs 5

    Case 2
    When market is above Rs 1,000 but below Rs 1,200. If the market price is Rs 1,100 then

    Gain = 100 – 0 - 5 = Rs 95

    Long call is in the money (profit) while the short call expires.

    Case 3
    If the market is at Rs 1,300

    Gain = 300 – 100 - 5 = Rs 195
    Both the options will be exercised. Long call is in the money and the short call is out of money (loss). The profit on the long call will be accompanied by a loss on the short call and therefore the gain will remain the same irrespective to the rise in the stock / index.

    Bearish Markets

    In a bearish market the following strategies could be used:

    • Sell a call option
    • Buy a put option

    The first two are exactly opposite to the profiles of a long call and a short put and therefore have not been explained once again.

    • Bearish spreads.

    Bearish spreads.

    A bearish spread is used when there is expectation that the market will move down. The method is the same but the strike price of the call option that is purchased is higher than strike price of the call that is sold. As a result the premium on the call that is sold will be higher than the premium on the call that is bought. Therefore, the bearish call spread involves an initial cash inflow. Here again the profit is limited. Selling the call covers up for the premium paid for buying the call. This reduces the hedging cost.

    Here the strike price of the option that is sold is Rs 1,000 and the strike price of the option that is bought is Rs 1,200.

    The premium received on short call is Rs 40 and the premium paid on the long call is Rs 35
    Net inflow = 40 - 35 = Rs 5

    Gain = Loss on call that is sold – Gain on option that is bought+ net inflow.

    Case 1
    When the market remains below Rs 1,000 both the options expire.
    Gain =0 + 0 + 5 = Rs 5

    Case 2
    When market is above Rs 1,000 but below Rs 1,200. If the market price is Rs 1,100 then there will be a loss as the short call will be exercised. The long call expires and the short call is out of the money. The cash flow profile will be

    Gain = -100 + 0 + 5 = Rs -95

    Case 3
    If the market is above Rs 1,300 then there will be a loss of Rs 300 on the short call and a gain of Rs 100 on the long call. Therefore, loss will be arrested.

    Gain = -300 + 100 + 5 = Rs -195

    This strategy is entered with the anticipation that the Index will not rise above the strike price of the short call therefore; the gain is limited to the initial inflow.

    To be concluded.

     

     

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