What exactly is an option trading strategy?
An option trading strategy is a hybrid combination of futures and options, or of two different options, that results in a product with defined risk, returns, or both. Option strategies are possible due to the unique nature of options, which are volatile in nature.
Options strategies are generally classified into six categories, which are as follows:
- Bullish strategies
- Bearish strategies
- Moderately bullish strategies
- Moderately bearish strategies
- Volatile strategies
- Range bound strategies
Protective Puts, Covered Calls and Collars
These are the three most fundamental strategies that are employed on a regular basis. These three options strategies are simple to understand and execute in the F&O Market, despite the fact that they are part of a larger set of options strategies. Let’s take a closer look at each of these strategies.
Protective Put strategy
Assume you bought a stock with the intention of holding it for the long term. Unfortunately, there was a global issue with the sector shortly after you purchased the stock, and you now expect the stock to be weak in the short run.One option is to sell the stock. However, this comes at a cost and is not consistent with a long-term investment strategy. A “Protective Put” strategy is another option. In a protective put, you keep your cash market positions but buy a lower put option at the same time.
Now once your put option premium is paid, you continue to profit indefinitely. On the downside, your risk is limited to the difference between the purchase price and the strike price of the put option plus the option premium. That is the most you can lose. In practise, traders hold the cash market position and continue to book profits on the put option when the price falls. Of course, this opens the door to the long position, which you should be wary of.
Example: An investor purchases a stock in the cash market for Rs.1000 and protects the position by purchasing a 990 put option for Rs.10 X Lot Size.
The protective put strategy has a maximum loss of Rs (-20). That is the difference between the spot and strike prices (1000-990) plus the option premium of Rs.10. However, regardless of how low the stock price falls, you can never lose more than Rs.20 X Lot Size.
The breakeven point (BEP) is the point at which you make no profit or lose no money. This level is reached at a cost of Rs.1010. This can be translated as the (purchase price of Rs.1000 + option premium of Rs.10)
What is the significance of Break Even Point(BEP)? Profits for the trader are limitless above the BEP. By simply paying a Rs.10 premium, the trader not only protects against downside risk, but also ensures that the bullish view is maintained.
Covered Call Strategy
While the protective put is a low-risk strategy, the covered call is not so much. When a stock does not move for an extended period of time, a covered call is used to reduce the cost of holding it. Rather than letting the investment sit idle, you can sell higher call options, earn the premium, and lower the cost of holding the stock. Assume you bought a stock with the intention of holding it for the long term.
The price of the stock fell after you purchased it, but you remain optimistic about its long-term prospects. You can sell slightly higher calls that will most likely expire worthless, converting the premiums into income.
There are two types of price movements to be wary of. You have nothing to worry about as long as the stock remains stable at current levels or rises to the higher call strike price, because you will earn the premium. If the price rises above the strike price, the losses on the sold call are potentially limitless. However, your long stock position fully compensates for this.
On the downside, your risk is completely open, and you should be wary of it.
Example: An investor purchases a stock in the cash market for Rs.1000 and sells a call option for Rs.1020 at Rs.10.
The covered call strategy has a maximum profit of Rs.30. That is the difference between the strike price and the spot price (1020-1000) plus the option premium of Rs.8. However, regardless of how high the stock price rises, your profit cap is Rs.30. At the strike price at which the call is sold, the maximum profit is always realised. Any profit on the spot position is offset by losses on the call option sold.
However, as the table above shows, the downside is that the losses can be limitless. As a result, this strategy should only be used on stocks with strong fundamentals and that you intend to hold for the long term.
The covered call strategy’s breakeven point is Rs.990, which is the purchase price of Rs.1000 less the premium of Rs.10. When your net effective losses on the spot position fall below 990, your net effective losses begin to rise.
The collar strategy is a hybrid of a protective put strategy and a covered call strategy. The strategy is divided into three stages. First and foremost, you are long the stock. Second, you purchase a lower put option. Third, you sell a more expensive call option.
The downside risk was open in the covered call strategy. That risk has now been eliminated by purchasing a lower put option. The cost of purchasing a put option in the protective put strategy can be prohibitively expensive at times. The premium received from selling a higher call option can partially compensate for the premium paid on the put option. The collar strategy has the advantage of being a limited loss and limited profit strategy. Such strategies are known as closed option strategies.
Example: An investor purchases a stock in the cash market for Rs.1000 and sells a call option for Rs.1020 for Rs.8. He also purchases a Rs.990 put for a premium of Rs.5.
The collar strategy has a maximum loss of Rs.7. However, no matter how low the stock price falls, your total loss can never exceed Rs.7. The maximum loss on the spot/put position is Rs.15, which is Rs.10 (1000-990) plus a Rs.5 put premium. However, your 15-rupee loss is offset by the Rs.8 premium you received on the 1020 call you sold. As a result, the maximum loss on the Collar is limited to Rs.7 (15-8).
The maximum profit will be limited to Rs. 23.The difference between the call strike price and the purchase price (1020-1000). You then add the net premium received (8-5). The total is Rs.23, which is your maximum profit regardless of how high the stock rises.
The breakeven point for the collar strategy is Rs.997.
You subtract the net premium received of Rs.3 from the purchase price of Rs.1000 (8-5). Your collar is profitable as long as the stock price is greater than Rs.997.
In a nutshell, protective puts are a bullish strategy that provides downside protection.
Covered calls are used to lower the cost of holding the stock but provide no downside protection. When you combine the protective put and the covered call, you get the collar, which is a closed strategy with downside and upside profit limits.
Straddles, strangles, and butterfly spreads
Option strategies are appropriate when you have a strong opinion about the market’s direction.
However, if you do not have a bullish or bearish market view and anticipate non-sideways market movement in any direction.
Straddles and strangles are strategies for when you expect non-sideways market movement in any direction.
Straddle Strategy :
The straddle strategy entails two options with the same strike prices and maturity.
A long straddle position is formed by purchasing a call and a put option with the same strike and expiry date, whereas a short straddle position is formed by selling a call and a put option with the same strike and expiry date. A long straddle is a volatile strategy that is intended to be profitable when the stock is highly volatile and moves sharply either up or down.
For example, a trader predicts that the TCS stock will become volatile in the next 15 days but is unsure of the direction. Because the stock is currently trading at Rs.2105, the trader purchases a Rs.2100 call at Rs.25 and a Rs.2100 put at Rs.15. Now consider the payoff.
Long on straddle is a risky strategy that only pays off when the stock remains stagnant. The maximum loss on the long straddle strategy is Rs.40, which is the sum of the call and put option premiums (25 + 15). Once that premium is paid, the price movement becomes profitable in either direction.
As a volatile strategy, the straddle has two breakeven points.
The lower breakeven point is Rs.2060 (2100-40), while the upper breakeven point is Rs.2140 (2100+40). The long straddle is profitable if TCS moves below Rs.2060 or above Rs.2140.
The reverse straddle, which is a range bound strategy, is shown in the last column. The payoff of a short straddle is the inverse of that of a long straddle. Losses in a short straddle can be limitless once the break even point is reached. Short straddles should be avoided at all costs.
The strangle strategy consists of two options with different strike prices but the same maturity. A long strangle position is formed by purchasing a higher strike call and a lower strike put option with the same expiry date, whereas a short strangle position is formed by selling a higher strike call and a lower strike put option with the same expiry date. A long strangle is a volatile strategy that is intended to be profitable when the stock is highly volatile and moves sharply either up or down. The Strangle has an advantage over the straddle in that it lowers the cost of the buyer and expands the range of profitability for the seller. As a result, strangles are far more popular in practise than straddles.
For example, suppose one expects SBIN stock to become volatile in the next 10 days but is unsure of the direction. Because the stock is currently trading at Rs.1150, he or she purchases a Rs.1200 call at Rs.11 and a Rs.1100 put at Rs.9.
Long on strangle is a risky strategy that loses money only when the stock remains in a range. The maximum loss on the long straddle strategy is Rs.70, which is half the difference between the strikes plus the total premiums paid on the call and put options (11 + 9). Once that premium is paid, the price movement becomes profitable in either direction.
As a volatile strategy, the straddle has two breakeven points. The lower breakeven point is Rs.1080 (1100-20), while the upper breakeven point is Rs.1220 (1200+20). The long strangle is profitable if SBIN moves below Rs.1080 or above Rs.1220.
Short strangle is a strategy with a limited range. The payoff of a short strangle is the inverse of that of a long strangle. Losses in a short strangle can be limitless once the break even point is reached.
On the long side, the straddle and the Strangle are both volatile strategies, while on the short side, they are both range bound strategies. But note that the Strangle has an advantage for the buyer in the form of lower costs and the seller in the form of a wider range of profitability.
The butterfly spread is a variation on the short straddle. Remember that the downside risk in a short straddle is unlimited if the market moves significantly in either direction, up or down. To limit the downside, in addition to the short straddle, one purchases one out of the money call and one out of the money put. The butterfly spread is a closed strategy, but keep in mind that there are four legs to the initiation of the Butterfly Spread and four legs to the closure.
It is an expensive strategy because it has four legs and is complex in nature.
We’ve seen directional strategies, volatile strategies, and range bound strategies. We will look at spread strategies in the final section. Spreads are formed by combining options on the same underlying and of the same type (call/put) but with different strike prices and/or maturities. That sounds complicated, but it is actually quite simple. In a nutshell, these spread trades are about positions with limited profit and loss.
The three most common spreads are:
Vertical spreads are formed by combining options with the same expiry date but different strike prices. Furthermore, these can be created using either calls or puts as a combination. In addition, such vertical spreads can be bullish or bearish. Bull call spreads and bear put spreads are two of the most popular vertical spreads, and we will go over them in greater detail.
Horizontal spreads use the same strike, type, but different expiry dates.
A horizontal spread is created by purchasing a Nifty 11,500 July call and selling an 11,500 August call. This is also referred to as a time spread or a calendar spread.
A diagonal spread is a combination of options with the same underlying but different expiry dates and strike prices. Again, the two legs of a spread have different maturities and no pay offs are possible. These diagonal spreads are more complicated and thus better suited to the OTC market.
Bull Call Spread
A bull call spread is a moderately bullish strategy in which you purchase a lower strike call option and sell a higher strike call option of the same expiry date. The maximum profit and maximum loss are fixed in this contract, as in any vertical spread contract, and thus it is a closed strategy.
For example, suppose you buy a July 1100 call option on a stock for Rs.35 and sell an August 1200 call option on the same stock for Rs.17.
In the above bull-call spread, the maximum loss is Rs.18. This is the strategy’s net premium paid (35 -17). The total loss can never be greater than this amount.
The maximum profit is Rs.82, calculated by subtracting the strike difference (1100-1000) from the net premium of Rs.18.
The breakeven point for this bull call spread is Rs.1018 (lower strike + net cost), and the maximum profit occurs at the upper strike. The payoff is constant both above and below the upper strike.
Bear Put Spread:
A bear put spread is a moderately bearish strategy in which you buy a higher strike put option and sell a lower strike put option with the same expiry date. As with any vertical spread contract, the maximum profit and maximum loss are fixed, indicating that this is a closed strategy.
For example, suppose you buy a July 1100 put option on a stock for Rs.20 and sell a July 1000 put option on the same stock for Rs.6.
Here in this article we covered strategy for trading options. Trading strategy options are very complex and needs good practice and some paper trading to avoid heavy losses. Trading strategy in forex will also be covered shortly.
We will cover more deeply below topics and supply pdfs
- most successful options strategy – Big players take mostly sell side Strategies and spreads and whereas Retails traders look for Buy side strategies
- best option trading strategies for indian market pdf – will be published upon request. please comment for requesting.
- guaranteed profit option strategy – There is no one option strategy which can profit all the time, so all of them have success and failure percentages.
- option strategies with examples: Above some examples are given but if you need more then please comment and request.
- option trading strategies for beginners : Here we covered all strategies but feel free to request more if unclear.
- options trading strategies – Covered above are mostly used strategies.
- options trading strategies pdf – Will be published upon request. Please comment and request.