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Options Trading Strategies - Part 2 - Outside View
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Options Trading Strategies - Part 2
Aug 26, 2010

Previously we examined some commonly used option trading strategies. These included outright directional strategies, protective puts, and covered calls. In this article, we'll discuss another way to make directional bets as well as volatility trading. So let's get right to it.

If you thought the price of an asset would rise, a common directional strategy would be to purchase an ATM call option. Let's assume the Nifty is trading at Rs. 5000 and there is a 3 month ATM call option for Rs. 150 and a 3 month OTM call option (strike of Rs. 5200) trading for Rs. 50. If we simply purchase the ATM option, we will make a profit if the Nifty closes above Rs. 5150 after three months. What if there was a way to effectively reduce our option premium so that we can increase our chances of making a profit?

The strategy I'd like to discuss is known as a call spread. In a call spread, we purchase the ATM call option and simultaneously sell the OTM call option. What does this do? Relative to the pure directional strategy, it effectively reduces our option premium. The proceeds from the sale of the OTM call can be used to offset part of the cost of the ATM call.

Back to our example, if we purchase the ATM option for Rs. 150 and sell the OTM option for Rs. 50, our net cost is Rs. 100. It means that we will make a profit if the Nifty closes above Rs. 5100 (which is better than before, when we were only profiting at levels above Rs. 5150). The downside to this strategy is that our profit is capped because we have sold a call at a strike of Rs. 5200. If the prices go above Rs. 5200, the profit from the long call will exactly offset the loss from the short call, and the effective payout is zero. So we can only make a profit up to the Rs. 5200 level. The maximum net profit we can make on this trade is Rs. 100 (if the price rises to Rs. 5200)

Using the call spread does two things. First, it increases your chances of making a profit, because the net option cost is lower. Second, it caps upside potential. A strategy like this should be used when one expects the price of an asset to rise, but not rise very much. A put spread works in a similar way to a call spread (we use it if we expect the price of an asset to go down). It requires the purchase of an ATM put, and the simultaneous sale of an OTM put.

When one hears of volatility trading, they'd most likely assume that retail investors cannot be involved. This is partially true. To trade volatility, one must have the ability to buy and sell options. In general, one needs a large account size to be able to sell (i.e. write) naked options. (To sell a naked option means selling without holding an offsetting position)

The easiest volatility trade is a known as a straddle. In a long straddle, an investor buys both a put and a call option on an asset with the same strike price and time to expiry. Using our example, if the Nifty is trading at Rs. 5000, and there is an ATM call and put trading at Rs. 150 each. If we purchase both (which will cost Rs. 300), we will make a profit if the Nifty ends up below Rs. 4700 or above Rs. 5300. If it ends up between Rs. 4700 and Rs. 5300 we will make a loss. Our maximum loss occurs if the Nifty closes at 5000 (and both options expire worthless). This is a long volatility trade because the further away the Nifty moves from its initial point, the greater the profit is.

This strategy should be used if we expect the stock market to make a large move, but we don't know the direction it will go in. This can be easily applied to individual companies. Let's assume a company is about to release a new product it will either do very well or very badly (we don't know which). The stock price will likely end up a lot higher or a lot lower, and a long straddle would be a good trade.

The opposite of a long straddle is a short straddle. A short straddle involves selling both an ATM call and put, with the hope that the price doesn't move anywhere. (Note that selling a straddle requires the ability to write naked options).

There are a variety of other ways to trade volatility. These include using strangles (where we purchase an OTM call and an OTM put). The payoff structure is similar to a straddle but our maximum loss is lower, and our chance of making a profit is also lower.

Other strategies include using an option plus the underlying stock to create a delta neutral portfolio. The way this works is the following: To go long volatility, we buy a call and sell the stock such that we have no delta exposure (remember that ATM options have a delta of 0.5 and a stock by definition has a delta of 1). If we own two ATM options for every stock sold, our delta will be zero. The option will have a positive vega (i.e. volatility), so we will make money if vega rises. Because option deltas change over the life of the option, such a strategy requires continuous hedging to ensure that the delta of the net position is always at zero.

Volatility trading strategies for options can get quite complicated and technical. It is important to understand the risks involved when getting involved in volatility trading, as they are quite different to conventional directional trading with options. Next week, will take a look at some of the more exotic and unconventional derivatives out there. This column, A Fresh Perspective, is authored by Asad Dossani. Asad is a financial analyst and columnist. He actively trades his own and others' funds, investing primarily in currency, commodity, and stock index derivative products. Prior to this, he worked at Deutsche Bank as an analyst in the FX derivatives team. He is a graduate of the London School of Economics. Asad is a keen observer of macroeconomic trends and their effects on global financial markets. He is deeply passionate about educating investors, and encouraging individuals to take part in and profit from financial markets. To put it colloquially, he wishes to take Wall Street products and turn them into Main Street profits!

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2 Responses to "Options Trading Strategies - Part 2"

Asad

Aug 27, 2010

Hi Dinesh,

Options are priced to take into account of dividends. Assume we have a 3 month call option on a stock, and the stock is due to pay a dividend during that time. The premium on the call option will be lower by the dividend amount at the time you initially buy the option. So when the dividend is paid, the option's price is not affected. Effectively, in exchange for not receiving the dividend, the option is cheaper to start with.

Regards,
Asad

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Dinesh

Aug 26, 2010

Hi Asad,
What is the effect of dividend declaration on the option price. For eg. in case of Patni computers, it has declared Rs 63 as special dividend with record date as Aug 31st 2010. So on record date price of stock will be adjusted with Rs 63 as stock owner will receive dividend. But since long calls/short puts do not receive any dividend how does market forces react to this mispricing?

Thanks,
Dinesh

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