Demystifying Derivatives: Option trading techniques Part 2

In our previous post, Demystifying Derivatives: Option Trading Techniques Part 1, we discussed some basic option trading techniques. If you are buying options, then your risk is limited to the option premiums. If you are writing (selling) options, then your risk is unlimited. In this blog post, we will discuss some slightly complex option trading strategies, where your downside risk is limited.

Covered Calls

In this strategy you will buy shares of the stock and at the same time write call options of the stock. Instead of buying shares of the stock you can also buy stock futures. You can also use this strategy with an index (e.g. Nifty), by buying ETFs or index futures. The volume of shares (or futures) bought should be more or less equal to the number of shares of the underlying stock in the call option. If the share price goes up then, you will make a profit in the long position (shares or futures) and a loss in the call option. But the profit will be more than the lossbecause when you write a call option you get a premium. Similarly, if the share price falls, you will make a loss in shares / futures, but make a profit in the call option. The maximum profit in the call option will be the premium. On the other hand, the loss in shares / futures can be unlimited. You will use this strategy when you are bullish about the stock or index in the short term, but also want to give yourself some downside protection.

Married Puts

In this strategy, if you own shares and are bullish about its long term prospects, you will buy put options to give yourself short term downside protection. This strategy is equivalent to buying an insurance policy for your investment. The cost of the insurance policy is the put option premium. If the share price goes up, you make profit on your shares and the put option will expire worthless. However, if the share price falls, you will make a loss on your shares and a profit in the put option position. The maximum loss will be your premium.

Bull Call Spread

In this strategy, you will buy call options of a stock or index at a certain strike price and simultaneously write call options of the same series at a higher strike price. The premium you pay for the first position (long call) will partly be funded by the premium you receive by writing the call at higher strike price. The difference in the two strike prices should be more than the difference between the two premiums for this strategy to be profitable. If the share price goes up, you will make a profit in the first position and a loss in the second position, but you will make a net profit. If the share price falls, you will make a loss in the first position and a profit in the second position. The maximum loss in the first position will be the premium and the maximum profit in the second position will also be the premium; in effect, your maximum loss will be the difference between the two premiums. You will use this strategy, if you are bullish about the stock or index but expect it price to be range-bound.

Bear Put Spread

This strategy is similar to the previous strategy, except for the fact that this is bearish strategy. In this strategy, you will buy put options of a stock or index ata certain strike price and simultaneously write put options of the same the series at a lower strike price. If the share price falls, you will make a profit in the first position and a loss in the second position, but you will make a net profit. If the share price goes up, then the maximum loss in your first position will be the premium and similarly the maximum profit in your second position will be premium; your maximum loss will be the difference between the two premiums. You will use this strategy, if you are bearish about the stock or index within a range.

Long Straddle

If you think that a stock is poised for a big move but you are unsure of the direction (up or down), you can employ long straddle. In this strategy, you will buy call and out options of the stock at the same strike price. If the share price goes up, you will make a profit in the call option and loss in the put option. While the profit in the call option can be unlimited, the maximum loss in the put option will be limited to the premium. Similarly if share price falls, you will make a loss in the call option and profit in the put option. While the profit in the put option can be unlimited, the maximum loss in the call option will be limited to the premium.

Long Strangle

The maximum loss in the previous strategy, long straddle will be the premiums of the call option and the put option. A long strangle, is a variant of a long straddle, having the same objective, but costs less money than the straddle. Before we discuss long strangle, let us understand an important concept related to option pricing. If the current market price of a stock is higher than the strike price of a call option, then the option is said to be “in the money”. If the current market is same or nearly the same as the strike price, the option is said to be “at the money”. If the current market price is lower than the strike price of the call option, the option is said to be “out of money”. Similarly, if the current market price is lower than strike price of a put option, then the option is said to be in the money and if it is higher than the strike price, the option is said to be “out of money”. You should know that, premiums of “in the money” options (call or put) are higher than “at the money” options; premiums of “at the money options” are higher than “out of money” options. In a long strangle, you will buy out of money call options and put options. Since you are buying out of money call and put options, their strike prices naturally will be different (as opposed to long straddle strategy). This strategy is cheaper than long straddle because you are buying out of money options.

Conclusion

In this post, we have discussed some option trading strategies and in what circumstances traders will use these strategies. There are more complex option trading strategies, but they are outside the scope of our post because they require considerable expertise. With this post, we have come to the end of our Demystifying Derivatives series. Derivative trading is not for all investors and if you do not have the necessary knowledge, you should not try your hand at it. However, understanding how derivatives work will improve your overall understanding of market movement because derivatives market activities have a huge influence on the stock market (F&O market volumes are many times higher than cash market volumes). We hope that, this series has helped you understand how futures and options work, how professional traders use these instruments and your overall understanding of the stock market.