Option strategies part ii
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The document describes two option strategies: a long combo and a protective call/synthetic long put. A long combo is a bullish strategy that involves selling an out-of-the-money put and buying an out-of-the-money call on the same stock. This provides upside exposure similar to owning the stock but at a lower cost. Profits are made if the stock rises above the break-even point. A protective call/synthetic long put involves shorting a stock and buying a call option to hedge against downside risk. If the stock falls, profits are made on the short position. The long call limits losses if the stock rises unexpectedly. This strategy hedges upside movement in the
Option strategies part ii
- 2. Strategy – Long Combo– Sell a Put, Buy a Call A Long Combo is a Bullish strategy. If an investor is expecting the price of a stock to move up he can do a Long Combo strategy. It involves selling an OTM (lower strike) Put and buying an OTM (higher strike) Call. This strategy simulates the action of buying a stock (or a futures) but at a fraction of the stock price. It is an inexpensive trade, similar in pay-off to Long Stock, except there is a gap between the strikes (please see the payoff diagram). As the stock price rises the strategy starts making profits. Let us try and understand Long Combo with an example.
- 3. Strategy – Long Combo– Sell a Put, Buy a Call When to Use: Investor is Bullish on the stock. Risk: Unlimited (Lower Strike + net debit) Reward: Unlimited Breakeven : Higher strike + net debit
- 4. Strategy – Long Combo– Sell a Put, Buy a Call Example: A stock ABC Ltd. is trading at Rs. 450. Mr. XYZ is bullish on the stock. But does not want to invest Rs. 450. He does a Long Combo. He sells a Put option with a strike price Rs. 400 at a premium of Rs. 1.00 and buys a Call Option with a strike price of Rs. 500 at a premium of Rs. 2. The net cost of the strategy (net debit) is Rs. 1
- 5. Strategy – Long Combo– Sell a Put, Buy a Call ABC Ltd. Current Market Price (Rs.) 450 Sells Put Strike Price (Rs.) 400 Mr. XYZ receives Premium (Rs.) 1.00 Buys Call Strike Price (Rs.) 500 Mr. XYZ pays Premium (Rs.) 2.00 Net Debit (Rs.) 1.00 Break Even Point (Rs.) (Higher Strike + Net Debit) Rs. 501
- 6. Strategy – Long Combo– Sell a Put, Buy a Call The payoff schedule ABC Ltd. closes at (Rs.) Net Payoff from the Put Sold (Rs.) Net Payoff from the Call purchased (Rs.) Net Payoff (Rs.) 700 1 198 199 650 1 148 149 600 1 98 99 550 1 48 49 501 1 -1 0 500 1 -2 -1 450 1 -2 -1 400 1 -2 -1 350 -49 -2 -51 300 -99 -2 -101 250 -149 -2 -151
- 7. Strategy – Long Combo– Sell a Put, Buy a Call For a small investment of Re. 1 (net debit), the returns can be very high in a Long Combo, but only if the stock moves up. Otherwise the potential losses can also be high.
- 8. Protective Call / Synthetic Long Put This is a strategy wherein an investor has gone short on a stock and buys a call to hedge. An investor shorts a stock and buys an ATM or slightly OTM Call. The net effect of this is that the investor creates a pay-off like a Long Put, but instead of having a net debit (paying premium) for a Long Put, he creates a net credit (receives money on shorting the stock). In case the stock price falls the investor gains in the downward fall in the price. However, incase there is an unexpected rise in the price of the stock the loss is limited. The pay-off from the Long Call will increase thereby compensating for the loss in value of the short stock position. This strategy hedges the upside in the stock position while retaining downside profit potential.
- 9. Protective Call / Synthetic Long Put When to Use: If the investor is of the view that the markets will go down (bearish) but wants to protect against any unexpected rise in the price of the stock. Risk: Limited. Maximum Risk is Call Strike Price – Stock Price + Premium Reward: Maximum is Stock Price – Call Premium Breakeven: Stock Price – Call Premium
- 10. Protective Call / Synthetic Long Put Example : Suppose ABC Ltd. is trading at Rs. 4457 in June. An investor Mr. A buys a Rs 4500 call for Rs. 100 while shorting the stock at Rs. 4457. The net credit to the investor is Rs. 4357 (Rs. 4457 – Rs. 100).
- 11. Protective Call / Synthetic Long Put Sells Stock (Mr. A receives) Current Market Price (Rs.) 4457 Buys Call Strike Price (Rs.) 4500 Mr. A pays Premium (Rs.) 100 Break Even Point (Rs.) (Stock Price – Call Premium) 4357
- 12. Protective Call / Synthetic Long Put The payoff schedule ABC Ltd. closes at (Rs.) Payoff from the stock (Rs.) Net Payoff from the Call Option (Rs.) Net Payoff (Rs.) 4100 357 -100 257 4150 307 -100 207 4200 257 -100 157 4300 157 -100 57 4350 107 -100 7 4357 100 -100 0 4400 57 -100 -43 4457 0 -100 -100 4600 -143 0 -143 4700 -243 100 -143 4800 -343 200 -143 4900 -443 300 -143 5000 -543 400 -143
- 13. Strategy – Covered Put This strategy is used when it is felt the price of a stock / index is going to remain range bound or move down. Covered Put writing involves a short in a stock / index along with a short Put on the options on the stock / index. The Put that is sold is generally an OTM Put. The investor shorts a stock because he is bearish about it, but does not mind buying it back once the price reaches (falls to) a target price. This target price is the price at which the investor shorts the Put (Put strike price). Selling a Put means, buying the stock at the strike price if exercised . If the stock falls below the Put strike, the short put will be exercised and investor will have to buy the stock at the strike price (which is anyway his target price to repurchase the stock). The investor makes a profit because he has shorted the stock and purchasing it at the strike price simply closes the short stock position at a profit. And the investor keeps the Premium on the Put sold. The investor is covered here because he shorted the stock in the first place. If the stock price does not change, the investor gets to keep the Premium. He can use this strategy as an income in a neutral market.
- 14. Strategy – Covered Put When to Use: If the investor is of the view that the markets are moderately bearish. Risk: Unlimited if the price of the stock rises substantially Reward: Maximum is (Sale Price of the Stock – Strike Price) + Put Premium Breakeven: Sale Price of Stock + Put Premium
- 15. Strategy – Covered Put Example Suppose ABC Ltd. is trading at Rs 4500 in June. An investor, Mr. A, shorts Rs 4300 Put by selling a July Put for Rs. 24 while shorting an ABC Ltd. stock. The net credit received by Mr. A is Rs. 4500 + Rs. 24 = Rs. 4524.
- 16. Strategy – Covered Put Sells Stock 9 Mr. A receives) Current Market Price (Rs.) 4500 Sells Put Strike Price (Rs) 4300 Mr A receives Premium (Rs) 24 Break Even Point (Rs) ( Sale price of Stock + Put Premium) 4524
- 17. Strategy – Covered Put The payoff schedule ABC Ltd. closes at (Rs.) Payoff from the stock (Rs.) Net Payoff from the Put Option (Rs.) Net Payoff (Rs.) 4000 500 -276 224 4100 400 -176 224 4200 300 -76 224 4300 200 24 224 4400 100 24 124 4450 50 24 74 4500 0 24 24 4524 -24 24 0 4550 -50 24 -26 4600 -100 24 -76 4635 -135 24 -111 4650 -160 24 -136
- 18. Strategy – Long Straddle A Straddle is a volatility strategy and is used when the stock price / index is expected to show large movements. This strategy involves buying a call as well as put on the same stock / index for the same maturity and strike price, to take advantage of a movement in either direction, a soaring or plummeting value of the stock / index. If the price of the stock / index increases, the call is exercised while the put expires worthless and if the price of the stock / index decreases, the put is exercised, the call expires worthless. Either way if the stock / index shows volatility to cover the cost of the trade, profits are to be made. With Straddles, the investor is direction neutral. All that he is looking out for is the stock / index to break out exponentially in either direction.
- 19. Strategy – Long Straddle When to Use: The investor thinks that the underlying stock / index will experience significant volatility in the near term. Risk: Limited to the initial premium paid. Reward: Unlimited Breakeven: Upper Breakeven Point = Strike Price of Long Call + Net Premium Paid Lower Breakeven Point = Strike Price of Long Put - Net Premium Paid
- 20. Strategy – Long Straddle Suppose Nifty is at 4450 on 27th April. An investor, Mr. A enters a long straddle by buying a May Rs 4500 Nifty Put for Rs. 85 and a May Rs. 4500 Nifty Call for Rs. 122. The net debit taken to enter the trade is Rs 207, which is also his maximum possible loss.
- 21. Strategy – Long Straddle Nifty Index Current Value 4450 Call and Put Strike Price (Rs) 4500 Mr. A pays Total Premium (Call + Put) Rs 207 Break Even Point (Rs) 4707 (U) 4293 (L)
- 22. The payoff schedule On expiry Nifty closes at (Spot) Net Payoff from Put purchased (Rs.) Net Payoff from Call purchased (Rs.) Net Payoff (Rs.) 3800 615 -122 493 3900 515 -122 393 4000 415 -122 293 4100 315 -122 193 4200 215 -122 93 4234 181 -122 59 4293 122 -122 0 4300 115 -122 -7 4400 15 -122 -107 4500 -85 -122 -207 4600 -85 -22 -107 4700 -85 78 -7 4707 -85 85 0 4766 -85 144 59 4800 -85 178 93 4900 -85 278 193 5000 -85 378 293 5100 -85 478 393 5200 -85 578 493 5300 -85 678 593
- 23. Strategy – Short Straddle It is a strategy to be adopted when the investor feels the market will not show much movement. He sells a Call and a Put on the same stock / index for the same maturity and strike price. It creates a net income for the investor. If the stock / index does not move much in either direction, the investor retains the Premium as neither the Call nor the Put will be exercised. However, incase the stock / index moves in either direction, up or down significantly, the investor’s losses can be significant. So this is a risky strategy and should be carefully adopted and only when the expected volatility in the market is limited. If the stock / index value stays close to the strike price on expiry of the contracts, maximum gain, which is the Premium received is made.
- 24. Strategy – Short Straddle When to Use: The investor thinks that the underlying stock / index will experience very little volatility in the near term. Risk: Unlimited Reward: Limited to the premium received Breakeven: Upper Breakeven Point = Strike Price of Short Call + Net Premium Received Lower Breakeven Point = Strike Price of Short Put - Net Premium Received
- 25. Strategy – Short Straddle Suppose Nifty is at 4450 on 27th April. An investor, Mr. A, enters into a short straddle by selling a May Rs 4500 Nifty Put for Rs. 85 and a May Rs. 4500 Nifty Call for Rs. 122. The net credit received is Rs. 207, which is also his maximum possible profit.
- 26. Strategy – Short Straddle Nifty index Current Value 4450 Call and Put Strike Price (Rs.) 4500 Mr. A receives Total Premium (Call + Put) (Rs.) 207 Break Even Point (Rs.)* 4707(U) (Rs.)* 4293(L)
- 27. The payoff schedule On expiry Nifty closes at Net Payoff from Put Sold (Rs.) Net Payoff from Call Sold (Rs.) Net Payoff (Rs.) 3800 -615 122 -493 3900 -515 122 -393 4000 -415 122 -293 4100 -315 122 -193 4200 -215 122 -93 4234 -181 122 -59 4293 -122 122 0 4300 -115 122 7 4400 -15 122 107 4500 85 122 207 4600 85 22 107 4700 85 -78 7 4707 85 -85 0 4766 85 -144 -59 4800 85 -178 -93 4900 85 -278 -193 5000 85 -378 -293
- 28. Strategy – Long Strangle A Strangle is a slight modification to the Straddle to make it cheaper to execute. This strategy involves the simultaneous buying of a slightly out -of-the-money (OTM) put and a slightly out-of-the-money (OTM) call of the same underlying stock / index and expiration date. Here again the investor is directional neutral but is looking for an increased volatility in the stock / index and the prices moving significantly in either direction. Since OTM options are purchased for both Calls and Puts it makes the cost of executing a Strangle cheaper as compared to a Straddle, where generally ATM strikes are purchased. Since the initial cost of a Strangle is cheaper than a Straddle, the returns could potentially be higher. However, for a Strangle to make money, it would require greater movement on the upside or downside for the stock / index than it would for a Straddle. As with a Straddle, the strategy has a limited downside (i.e. the Call and the Put premium) and un limited upside potential.
- 29. Strategy – Long Strangle When to Use: The investor thinks that the underlying stock / index will experience very high levels of volatility in the near term. Risk: Limited to the initial premium paid Reward: Unlimited Breakeven: Upper Breakeven Point = Strike Price of Long Call + Net Premium Paid Lower Breakeven Point = Strike Price of Long Put - Net Premium Paid
- 30. Strategy – Long Strangle Suppose Nifty is at 4500 in May. An investor, Mr. A, executes a Long Strangle by buying a Rs. 4300 Nifty Put for a premium of Rs. 23 and a Rs 4700 Nifty Call for Rs 43. The net debit taken to enter the trade is Rs. 66, which is also his maxi mum possible loss.
- 31. Strategy – Long Strangle Nifty index Current Value 4500 Buy Call Option Strike Price (Rs.) 4700 Mr. A pays Premium (Rs.) 43 Break Even Point (Rs.) 4766 Buy Put Option Strike Price (Rs.) 4300 Mr. A pays Premium (Rs.) 23 Break Even Point (Rs.) 4234
- 32. The payoff schedule On expiry Nifty closes at Net Payoff from Put purchased (Rs.) Net Payoff from Call purchased (Rs.) Net Payoff (Rs.) 3800 477 -43 434 3900 377 -43 334 4000 277 -43 234 4100 177 -43 134 4200 77 -43 34 4234 43 -43 0 4300 -23 -43 -66 4400 -23 -43 -66 4500 -23 -43 -66 4600 -23 -43 -66 4700 -23 -43 -66 4766 -23 23 0 4800 -23 57 34 4900 -23 157 134 5000 -23 257 234 5100 -23 357 334 5200 -23 457 434 5300 -23 557 534
- 33. Strategy – Short Strangle A Short Strangle tries to improve the profitability of the trade for the Seller of the options by widening the breakeven points so that there is a much greater movement required in the underlying stock / index, for the Call and Put option to be worth exercising. This strategy involves the simultaneous selling of a slightly out-of-the- money (OTM) put and a slightly out-of-the-money (OTM) call of the same underlying stock and expiration date. This typically means that since OTM call and put are sold, the net credit received by the seller is less as compared to a Short Straddle, but the break even points are also widened. The underlying stock has to move significantly for the Call and the Put to be worth exercising. If the underlying stock does not show much of a movement, the seller of the Strangle gets to keep the Premium.
- 34. Strategy – Short Strangle When to Use: This options trading strategy is taken when the options investor thinks that the underlying stock will experience little volatility in the near term. Risk: Unlimited Reward: Limited to the premium received Breakeven: Upper Breakeven Point = Strike Price of Short Call + Net Premium Received Lower Breakeven Point = Strike Price of Short Put - Net Premium Received
- 35. Strategy – Short Strangle Suppose Nifty is at 4500 in May. An investor, Mr. A, executes a Short Strangle by selling a Rs. 4300 Nifty Put for a premium of Rs. 23 and a Rs. 4700 Nifty Call for Rs 43. The net credit is Rs. 66, which is also his maximum possible gain.
- 36. Strategy – Short Strangle Nifty index Current Value 4500 Sell Call Option Strike Price (Rs.) 4700 Mr. A receives Premium (Rs.) 43 Break Even Point (Rs.) 4766 Sell Put Option Strike Price (Rs.) 4300 Mr. A receives Premium (Rs.) 23 Break Even Point (Rs.) 4234
- 37. The payoff schedule On expiry Nifty closes at Net Payoff from Put sold (Rs.) Net Payoff from Call sold (Rs.) Net Payoff (Rs.) 3800 -477 43 -434 3900 -377 43 -334 4000 -277 43 -234 4100 -177 43 -134 4200 -77 43 -34 4234 -43 43 0 4300 23 43 66 4400 23 43 66 4500 23 43 66 4600 23 43 66 4700 23 43 66 4766 23 -23 0 4800 23 -57 -34 4900 23 -157 -134 5000 23 -257 -234 5100 23 -357 -334 5200 23 -457 -434 5300 23 -557 -534
- 38. Collar A Collar is similar to Covered Call but involves another leg – buying a Put to insure against the fall in the price of the stock. It is a Covered Call with a limited risk. So a Collar is buying a stock, insuring against the downside by buying a Put and then financing (partly) the Put by selling a Call. The put generally is ATM and the call is OTM having the same expiration month and must be equal in number of shares. This is a low risk strategy since the Put prevents downside risk. However, do not expect unlimited rewards since the Call prevents that. It is a strategy to be adopted when the investor is conservatively bullish.
- 39. Collar When to Use: The collar is a good strategy to use if the investor is writing covered calls to earn premiums but wishes to protect himself from an unexpected sharp drop in the price of the underlying security. Risk: Limited Reward: Limited Breakeven: Purchase Price of Underlying – Call Premium + Put Premium
- 40. Collar Suppose an investor Mr. A buys or is holding ABC Ltd. currently trading at Rs. 4758. He decides to establish a collar by writing a Call of strike price Rs. 5000 for Rs. 39 while simultaneously purchasing a Rs. 4700 strike price Put for Rs. 27. Since he pays Rs. 4758 for the stock ABC Ltd., another Rs. 27 for the Put but receives Rs. 39 for selling the Call option, his total investment is Rs. 4746.
- 41. Collar ABC Ltd. Current Market Price (Rs.) 4758 Sell Call Option Strike Price (Rs.) 5000 Mr. A Receives Premium (Rs.) 39 Buy Put Option Strike Price (Rs.) 4700 Mr. A Pays Premium (Rs.) 27 Net Premium Received(Rs.) 12 Break Even Point (Rs.) 4746
- 42. Collar Example : If the price of ABC Ltd. rises to Rs. 5100 after a month, then, Mr. A will sell the stock at Rs. 5100 earning him a profit of Rs. 342 (Rs. 5100 – Rs. 4758) Mr. A will get exercised on the Call he sold and will have to pay Rs. 100. The Put will expire worthless. Net premium received for the Collar is Rs. 12 Adding (a + b + d) = Rs. 342 -100 + 12 = Rs. 254 This is the maximum return on the Collar Strategy. However, unlike a Covered Call, the downside risk here is also limited : If the price of ABC Ltd. falls to Rs. 4400 after a month, then, Mr. A loses Rs. 358 on the stock ABC Ltd. The Call expires worthless The Put can be exercised by Mr. A and he will earn Rs. 300 Net premium received for the Collar is Rs. 12 Adding (a + b + d) = - Rs. 358 + 300 +12 = - Rs. 46 This is the maximum the investor can loose on the Collar Strategy. The Upside in this case is much more than the downside risk.
- 43. The Payoff schedule ABC Ltd. closes at (Rs.) Payoff from Call Sold (Rs.) Payoff from Put Purchased (Rs.) Payoff from stock ABC Ltd. Net payoff (Rs.) 4400 39 273 -358 -46 4450 39 223 -308 -46 4500 39 173 -258 -46 4600 39 73 -158 -46 4700 39 -27 -58 -46 4750 39 -27 -8 4 4800 39 -27 42 54 4850 39 -27 92 104 4858 39 -27 100 112 4900 39 -27 142 154 4948 39 -27 190 202 5000 39 -27 242 254 5050 -11 -27 292 254 5100 -61 -27 342 254 5150 -111 -27 392 254 5200 -161 -27 442 254 5248 -209 -27 490 254 5250 -211 -27 492 254 5300 -261 -27 542 254
- 44. Bull Call Spread Strategy A bull call spread is constructed by buying an in-the-money (ITM) call option, and selling another out-of-the-money (OTM) call option. Often the call with the lower strike price will be in-the-money while the Call with the higher strike price is out-of-the-money. Both calls must have the same underlying security and expiration month. The net effect of the strategy is to bring down the cost and breakeven on a Buy Call (Long Call) Strategy. This strategy is exercised when investor is moderately bullish to bullish, because the investor will make a profit only when the stock price / index rises. If the stock price falls to the lower (bought) strike, the investor makes the maximum loss (cost of the trade) and if the stock price rises to the higher (sold) strike, the investor makes the maximum profit.
- 45. Bull Call Spread Strategy When to Use: Investor is moderately bullish. Risk: Limited to any initial premium paid in establishing the position. Maximum loss occurs where the underlying falls to the level of the lower strike or below. Reward: Limited to the difference between the two strikes minus net premium cost . Maximum profit occurs where the underlying rises to the level of the higher strike or above Break-Even-Point (BEP): Strike Price of Purchased call + Net Debit Paid
- 46. Bull Call Spread Strategy Mr. XYZ buys a Nifty Call with a Strike price Rs. 4100 at a premium of Rs. 170.45 and he sells a Nifty Call option with a strike price Rs. 4400 at a premium of Rs. 35.40. The net debit here is Rs. 135.05 which is also his maximum loss.
- 47. Bull Call Spread Strategy Nifty index Current Value 4191.10 Buy ITM Call Option Strike Price (Rs.) 4100 Mr. XYZ Pays Premium (Rs.) 170.45 Sell OTM Call Option Strike Price (Rs.) 4400 Mr. XYZ Receives Premium (Rs.) 35.40 Net Premium Paid (Rs.) 135.05 Break Even Point (Rs.) 4235.05
- 48. The payoff schedule On expiry Nifty Closes at Net Payoff from Call Buy (Rs.) Net Payoff from Call Sold (Rs.) Net Payoff (Rs.) 3500.00 -170.45 35.40 -135.05 3600.00 -170.45 35.40 -135.05 3700.00 -170.45 35.40 -135.05 3800.00 -170.45 35.40 -135.05 3900.00 -170.45 35.40 -135.05 4000.00 -170.45 35.40 -135.05 4100.00 -170.45 35.40 -135.05 4200.00 -70.45 35.40 -35.05 4235.05 -35.40 35.40 0 4300.00 29.55 35.40 64.95 4400.00 129.55 35.40 164.95 4500.00 229.55 -64.60 164.95 4600.00 329.55 -164.60 164.95 4700.00 429.55 -264.60 164.95 4800.00 529.55 -364.60 164.95 4900.00 629.55 -464.60 164.95 5000.00 729.55 -564.60 164.95 5100.00 829. 55 -664.60 164.95 5200.00 929.55 -764.60 164.95
- 49. Bull Call Spread Strategy The Bull Call Spread Strategy has brought the breakeven point down (if only the Rs. 4100 strike price Call was purchased the breakeven point would have been Rs. 4270.45), reduced the cost of the trade (if only the Rs. 4100 strike price Call was purchased the cost of the trade would have been Rs. 170.45), reduced the loss on the trade (if only the Rs. 4150 strike price Call was purchased the loss would have been Rs. 170.45 i.e. the premium of the Call purchased). However, the strategy also has limited gains and is therefore ideal when markets are moderately bullish.