Demystifying Derivatives: Option Trading Techniques Part 1

In our Demystifying Derivatives series, we have, over the past several months discussed the basics of derivatives and how they work in the market. At the start of this series, we said that, this series is not just meant for readers interested in derivatives trading but even equity investors in general, may find knowledge of derivatives useful in understanding how stock markets work. Volumes in the derivatives (F&O) market are much more than that of the cash market and as such, derivatives activity has a major influence on share prices.

In our last post, Demystifying Derivatives: Futures Trading Techniques, we had discussed several futures trading strategies. In this post, we will discuss some simple options trading strategies. Options are more complex securities than futures. If you have basic knowledge of options, you will be able to follow this blog post quite easily, but for benefit of readers who do not have a basic knowledge of options, we will do a brief recap of options.

Brief recap of Options

An options contract, grants the buyer of the contract, the right to buy or sell the underlying asset (stock or index) at a certain price (known as the strike price) but not an obligation to do the same. The seller of the contract, also known as the options writer, gives you this right at a price known as the options premium. Since, options contract is a right and not an obligation, the buyer will exercise option, only if it is profitable. Therefore, in an option, unlike futures, the downside is limited (to the price / premium of the option). There are two kinds of options – call option and put option. A call option gives the buyer the right to buy a stock or index at a certain price (strike price), irrespective of the market price market price of the asset is more than the strike price then the call option buyer will make a profit. If this profit is more than the options premium, the buyer will make a net profit. If the market price is less than the strike price, then the buyer will not exercise the option; in such a situation, his / her loss will be the options premium.

A put option gives the buyer the right to sell a stock or index at a certain price (strike price), irrespective of the market price of the asset. If the market price of the asset is less than the strike price then the put option buyer will make a profit. If this profit is more than the options premium, the buyer will make a net profit. If the market price is more than the strike price, then the buyer will not exercise the option and lose the options premium. This is in brief how options work, but we recommend that you read our post, Demystifying Derivatives: Basics of Futures and Options Part 1, in case you need a better understanding of options.

Buying versus Selling Options

Let us first discuss the two most basic option strategies – buying options versus selling them. The risk implications of these two strategies are very different.

Buying an option:

Irrespective of your price outlook of the underlying asset (stock or index), when you are buying an asset, when you are buying an option, you are essentially limiting your downside risk. Asset prices are volatile and may not go in the direction, you expect it to. You buy a call option expecting price to go up, but if the price comes down then you do not make a loss because you will not exercise the option. But if the price goes up then you make profits. Similarly if you buy a put option expecting price to go down, but if the price goes up then you do not make a loss because you will not exercise the put. But if the price goes down then you make profits. When you are buying an option your profits are unlimited (it can be any number, large or small, depending on the difference between market price and strike price), but your losses are limited only to the options premium.

You should buy naked calls or puts only if you are reasonably confident about a favorable directional move for your trade. If you know technical analysis, you should buy call options if the 30 day DMA (daily moving average) is trending upwards. Investors familiar with technical analysis should also look at what the momentum indicators (like MACD and RSI) are telling you. It is best to buy call options around support levels. When buying put options, see if there is a downward trend in the 30 day chart and reinforce your decision with signals from momentum oscillators. It is best to buy call options around resistance levels.

Selling an option:

You can sell options which in derivatives parlance, is also known as writing an option. The pay-off of an options writer (seller) is exactly the opposite of an options buyer. If you are selling an option, your maximum profit is the premium you get by selling (loss of the options buyer is profit of the options writer), but your losses can be unlimited.

You may be thinking that, why would anyone enter in a trade, where profits are limited but losses can be unlimited? There are several reasons. A comprehensive discussion why options writing can be quite profitable is outside the scope of our series, but will try to explain, why option writing makes sense in very simplistic terms. When you are buying an option, you are expecting the market price of the asset (stock or index) to go in a particular direction. For example, if you buy a call option, you expect the market price to go above the strike price; not just go above, you expect the market price to be higher than the strike price by at least the premium amount. Similarly, when you are buying put options, you expect the market price to fall and be less than the strike price by at least the premium amount. In other words, when you are buying an option you expect the asset price to rise (in case of call options) or fall (in case of put options) by at least a certain amount. However, there are three possibilities.

1. The asset price may rise / fall by the amount the options buyers want it to.


2. The asset prices may move in the direction the options buyers want it to, but may not rise / fall above or below the strike price.


3. The asset prices may move in the direction the options buyers want it to and even rise / fall above or below the strike price, but may not rise / fall above or below the strike price by the premium amount.


4. The asset prices may move opposite the direction, options buyers want it to.

Option buyers make profits only in scenario number 1, whereas option writers make money (even though limited to the option premium) in the other three scenarios. Unlike stocks, options have an expiry date; options in India expire on the last Thursday of the series month, e.g. options of December series will expire on December 29. Going back to the four scenarios discussed above, there is limited time for scenario 1 to play out in favor of the option buyer. By this very simplistic logic, therefore, the odds are in favor of the options writer.

The price of the option is also an important factor. The theoretical price of an option is related to several factors, like time to expiry at the time of the transaction, risk free interest rate, asset price volatility etc through a complex relationship known as Black Scholes formula. However, the market premium of an option is different from the theoretical (Black Scholes) price. If the market premium is higher than the theoretical (or fair) price, then it favors the option writers; if the market price of a product is higher than fair price, then obviously the seller is at an advantage. The difference between the market premium of an option and its theoretical price is attributed to a factor known as implied volatility (IV). In India, it is believed that IV is quite high and therefore, option writers may have an advantage.

Not just in India, if you read books and blogs of very successful traders in the US, you will see that, most of them made more money by writing options rather than by buying options. However, you must remember that when you are writing options, your losses can be unlimited. I know a number of traders, who made huge losses writing options when unexpected news caused the market to make a huge directional move. We do not want Advisorkhoj readers to make losses and therefore, you should not write options unless you are very knowledgeable about markets.

Conclusion

In this post, we have discussed two broad option strategies – long calls / puts (buying call or put options) and naked calls / puts (writing call or put options). In fact, you think of these two strategies as four strategies: long call (if you expect price to rise), long put (if you expect price to fall), naked call (if you expect price to fall or remain range-bound) and naked put (if you expect price to rise or remain range-bound). There are many complex option trading techniques which require considerable expertise to understand and execute. In the next part of this series, we will discuss some, slightly more complex, option trading techniques. However, all the option trading techniques that we will discuss in the next post will have limited downside risk. Please stay tuned......