(A) Option Trading Strategies &

Option Spreads

Objectives;

Understand hedging strategies in option trading; Understand the basic principals of option pricing; Know about concept of spreads and types of spreads; Understand various combinations of call and put options like butterfly spread; Know about the various types of combinations like straddles, strips, straps, box spreads etc.

Long Call

For aggressive investors who are very bullish about the prospects for a stock/index, buying a calls can be excellent way to capture the upside potential with limited downside risk. When to Use: Investor is very bullish Risk: Limited to the premium Reward: Unlimited Breakeven : Strike price + Premium

Ex:

Current Index 4191.10 Call option Strike price 4600 Mr. X pays Premium 35.35 BEP 4635.35 This strategy limits the downside risk to the extent of premium & reward is unlimited. This is the most common choice among first time investors in options.
Ex: Refer Worksheet

Short Call

When an investor is bearish about a stock and expects the prices to fall, he can sell call options. It offers limited profit potential and the possibility of large losses on big advances in underlying prices. When to use: Investor is very aggressive and very bearish about the stock/index Risk: Unlimited Reward: Limited to the extent of premium Breakeven point: Strike price + premium

Ex:
Current Bankex Call option Strike price Mr. X Receive Premium BEP 2694 2600 154 2754

This strategy is used when an investor is very aggressive and has a strong expectation of a price fall (and certainly not a price rise). This strategy is called Short Naked call since the investor does not own the underlying stock.

Long Put
When an investor is bearish, he can buy a put option. It gives the buyer right to sell the stock. When to use: Investor is bearish about the stock. Risk: limited to the premium Reward: Unlimited Break even point: Strike price Premium

Ex:

Current Index 2694 Put option Strike price 2600 Mr. X pays Premium 52 BEP 2548 A bearish investor can profit from declining stock price by buying puts.

Short Put
An investor sells Put when he is Bullish about the stock expects the stock price to rise or stay sideways at the minimum. When to use: Investor is very Bullish and idea to make a short term income. Risk: Strike price Put premium Reward: Limited BEP : Put strike price Premium

Ex:
Current Bankex Call option Strike price Mr. X Receive Premium BEP 4191.10 4100 170.5 3929.5

Selling puts can lead to regular income in a rising or range bound markets. But it should be done carefully since the potential losses can be significant in case the price of the stock/index falls. This strategy can be considered as an income generating strategy.

Synthetic Long Call: Buy Stock, Buy Put (Long stock, Long Put)

This strategy is insurance against the price fall, so buy Put on the stock. The strike price can be bought price (ATM) or slightly below (OTM). Investor taken an exposure to an underlying stock with the aim of holding it and reaping the benefits of price rise, dividends, bonus right etc. and at the same time insuring against an adverse price movement. It is strategy with a limited loss (premium) and unlimited profit (stock price rise).

When to use: Investor is concerned about near-term downside risk. Risk: stock price(bought price)+premium paid Reward: Unlimited BEP : Bought price + Premium

Ex: Buy stock (Rs.) Strike price(Rs.) Buy Put Premium BEP
This is a low risk strategy. Ex: Refer worksheet

4000 3900 143.80 4143.80

An investor buying a common stock expects that its price would increase. However there is risk that the price may in fact fall
Ex: An investor buys a share Rs.100 Purchase a Put at Rs.16 Exercise price Rs.110 He will exercise, only when share price less than Rs.110

Profit/Loss for selected share values (right to Sell) Share Price 70 80 90 100 110 120 130 140 Exercise Price 110 110 110 110 110 110 110 110 Profit on E Price 24* 14 4 (NE) -6 -16 -16 -16 -16 Profit/loss in share held -30** -20 -10 0 10 20 30 40 Net Proft/ Loss -6*** -6 -6 -6 -6 4 14 24

* 110 70 = 40 16 = 24 ** 70 - 100 = -30 *** -30 + 24 = -6

Covered Call:

Investors own shares in a company and he may feel price rise but not much in the near term. This is strategy SELLS a call option on a stock he owns (Obl. to sell) and he sells an OTM call. When to use: Investor has a short-term neutral to moderately bullish. Risk: If the stock price falls to zero, loses the entire value of the stock and retain premium, since call will not be exercised. Reward: Limited (call strike price -stock price paid ) + premium received BEP : Stock price paid premium received.

Buy Stock + Sell Call option

Rs. Buy stock Market price 3850 Short Call Strike price 4000 Receives Premium 80 BEP (stock price premium recd.) 3770

Writing a covered calls i.e., agreeing to sell the stock.

Ex: An investor bought a share Rs.100 writing a call at Rs.3 Exercise price Rs.105

Share Price

Profit/Loss for selected share values (Obl. to Sell) Exercise Profit on E Profit/loss Net Proft/ Price Price in share held Loss

90
95 100 105 110 115 120

105
105 105 105 105 105 105

(NE ) 3
3 3 3 - 2* -7 -12

-10**
-5 0 5 10 15 20

- 7***
-2 3 8 8 8 8

** 90 - 100 = -10 *** -10 - 3 = -7 * 105 110 = -5 + 3 = -2;

SPREADS & COMBINATIONS:

SPREADS: It involves taking a position in two or more options of the same type. Bull Spread: (Using Call) - It is a bullish sentiment of a trader. - Created by purchasing a call option (ITM) & selling another call (OTM) on same stock with same expiry, but at higher exercise price. - At expiry, if stock remains below the two calls, both calls would unexercised, loss limited to initial cost of spread.

Bull spread.. Contd

-

Call with a lower exercise price greater premium (call holder)

Call with a higher exercise price lower premium (call writer) - It requires initial investment. Pay premium more than receive. - If stock price (S1) between two exercise prices; Purchased call (E1) : In-the-money Call sold (E2) : Out-of-money - If stock price (S1) greater than E- both the calls in the money and pay-off equals the difference between exercise of price of the two options.
-

Pay-off results from a bull spread strategy (Using Calls): While E1 & E2 are the respective strike prices of the calls and short and S1 stock price at the time of exercising calls
Price of Stock S1E2 E1<S1<E2 S1E1 Pay off from Long call S1 E1 S1 E1 0 (NE) Pay off from Short call S1 E2 0 (NE) 0 (NE) Total pay-off E2-E1 S1-E1 0

Ex; Current value Rs. 55

Buy a call option E1 = Rs.50 for Rs.8 Sell a one call E2 = Rs.60 for Rs.2 Both being same stock with same expiry day. Initial credit = -8 + 2 = -6
If S1 = 50 or less : None call would be exercised Net loss (Rs.8 2)= Rs.-6 If S1 = 58 : only E1 will exercised Pay off = Rs.58 - Rs.50 = Rs.8 Net profit = Rs.8 + 8 +2 = Rs.2 If S1 60 : both will exercised Pay-off would 60 - 50 = Rs.10

Solution:
Price of Stock S1E2 S1 60 Pay off from Long call E1 S1 E1 S1 50 = 10 Pay off from Total Net P /L Short call pay-off =payoff-cost E2 S1 E2 E2 - E1 S1 - 60 60 - 50=10 10 6 = 4

E1<S1<E2 50<58<60
S1E1 5050

S1 E1 58-50 = 8
0 (NE) 0

0 (NE) 0
0 (NE) 0

S1-E1 58 50 = 8
0 0

86=2

-6

Illustration: PP 243 , Ex: 10.1 Refer worksheet 3.0

Buy low strike Call

Sell high strike Call

Bull Call Spread

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BEAR SPREADS: Used as a strategy when one is bearish of the market, believing that it is more likely to go down than up. Bear spreads limit both the upside profit potential and the downside risk.

Bear Spread (Put options): Buys a put with high exercise price (ITM) & sells a put at a lower price (OTM). Initial investment (premium) i.e., payable is more than the premium receivable.
Pay off from Short put E1 0 0 -E1-S1 Total pay-off 0 E2- S1 E2-E1

Price of Stock

Pay off from Long put E2 S1E2 0 E1<S1<E2 E2-S1 S1E1 E2-S1

Ex; Current value of a stock is Rs. 32 Buy a put option E2 = Rs.35 for Rs.3 Sell a one put E1 = Rs.30 for Rs.1 Both being same stock with same expiry day. Initial credit = -3 + 1 = -2
If S1 >= 35 or less : None put would be exercised Net loss (Rs.-3 +1)= Rs.-2 If S1 between E1: only E2 will exercised Pay off = E2 S1 E1 will not exercised If S1 <= E2: both will exercised pay-off would E2 E1

Solution:
Price of Stock S1 >E S > 30 Pay off from Long put E2 0 (NE) 0 Pay off from Total Net P /L Short put pay-off =payoff-cost E1 0 (NE) 0 0 0 -2

E1<S1<E2 30<S1<35
S1< E2 S1 < 35

E2 S1 35 S1
E2 - S1 35 S1

0 (NE) 0
-E1 - S1 -30 S1

E2 - S1 35 S1
E2 - E1 35 - 30

35S1 35 33=2

52=3

Illustration : PP 244 , Ex: 10.2

Buy high strike Put

Sell low strike Put

Bear Put Spread

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Strategies contd..