Saturday, 10 October 2015

Options Trading Strategies


Over the past few years Options Trading Strategies have gained a lot of popularity. These are highly diversified strategies, which when used correctly, can give you some awesome results.
Despite of this, there are many investors who shy away from Options. They need to remember and bear this in mind:
Anything used wisely and correctly can get you the desired results. And so do Options

When you use Options trading strategies wisely, they will protect, grow and diversify your position.If you are looking for Risk Management and Position trading, then Options are the right tool you are looking for. The key here lies in finding the right strategy for your advantage.
So let’s try to understand what Options are and what are its unique strategies available to investors.

What are Options?


There are several Options Trading Strategies available, but you need to first understand what options are: Option specifically gives you the right to buy or sell an asset at a certain price and a certain date.
Understanding what exactly this means can be a bit intimidating at first. So let’s take a small example to understand what options are:

Example: Buying a Guitar Analogy for Buying an Option.

Options Trading Strategies Analogy
  • Let’s say you want to buy a guitar from your friend. And your friend wants $1500 for it.
  • If you don’t have the money to buy it right now, you can tell your friend that you will pay you $500 right now if he holds the guitar for you for a month.
  • But if you don’t come up with $1500 by then, your friend can keep the $500 and can do whatever he wants with the guitar.
    In this case, the guitar is the asset, and your right to buy it under those specific terms is an option.
  • But if your friend realizes that the guitar is worth $5,000, he will still have to sell it to you for $1500 because you have that right, and thus you’ll make a profit.
  • If the guitar breaks, you probably won’t want to spend $1500 entirely to buy it, but you’ll lose the $500 you used to buy that option.
  • This is pretty much how an options trading works, but it’s very complicated and risky in practice.
So moving forward, let’s learn a few Options Trading Strategies. Strategies that we will be discussing are:
  • #1: Long Call Strategy
  • #2: Short Call Strategy
  • #3: Long Put Strategy
  • #4: Short Put Strategy
  • #5: Long Straddle Strategy
  • #6: Short Straddle Strategy

# 1: Long Call Strategy 


  • This is one of the option trading strategies for aggressive investors who are very bullish about a stock or an index.
  • Buying calls can be an excellent way to capture the upside potential with limited downside risk.
  • It is the most basic ofall options trading strategies. It is comparatively an easy strategy to understand.
  • When you buy it means you are bullish on a stock or an index and you expect to rise in future.
Best time to Use:When you are very bullish on the stock or index.
Risk:Risk is limited to the Premium. (There is a maximum loss if market expires at or below the option strike price).
Reward:Reward is Unlimited
Breakeven:(Strike Price + Premium)
Let us now understand through this example how to fetch the data from the website and how to determine the Payoff schedule for Long Call Strategy.

How to download Options Data?

Options Trading Strategies-1

Step 1: Visit the stock exchange website

  1. Go to http://www.nseindia.com/.
  2. Select Equity Derivatives
  3. In Search box put CNX Nifty
  4. The Current Nifty Index Price is given on the Right hand top corner. Note it down in your excel spreadsheet.
  5. Please note that in this example, we have taken NSE (National Stock Exchange, India). You may download similar dataset for other international stock exchanges like NYSE, LSE etc

Step 2: Find the Option Premium

Next step is to find the Premium. For this, you will have to select some of the data according to your requirements.
Options Trading Strategies-2So in case of Long Put strategy, we will select the following data.
  • Instrument Type: Index Options
  • Symbol: NIFTY
  • Expiry Date: Select the required expiry date.
  • Option Type: Call (For further examples we will select Put, for Put option)
  • Strike Price: Select the required Strike Price. In this case, I have selected 7600.
  • Once all the information is selected you may click on Get Data. The premium price will be displayed then which you will require for the further calculations.

Step 3: Populate the data set in Excel Spreadsheet

Once you have got the Current Nifty Index Price and the Premium data, you can proceed further to calculate your Input-output data as follows in an excel Spreadsheet.
Options Trading Strategies 3
  • As you can see in the image above, we have filled the data for Current Nifty index, Strike Price and Premium.
  • We then have calculated the Break-even point. Break-even point is nothing but the price that the stock must reach for the option buyers to avoid any loss if they exercise the option.
  • For Call Option, this is how we calculated the Break-even point:
Breakeven Point= Strike Price + Premium

Step 4: Create the Payoff Schedule

Next we come to the Payoff schedule. This basically tells you how much profit you will make or how much will you lose at a specific Nifty index. Note that in case of options you are not obliged to exercise them and hence you are able to limit your loss to the amount of premium paid.
The spreadsheet shows the following information:
  • Various Closing price of Nifty
  • The Net payoff from this call option.
The formula used in this case is the IF function of excel. This is how the formula works:
  • If Nifty closing price is less than the Strike price, we will not exercise the option. Thus in this case you only lose the amount of premium paid (220).
  • At and above the breakeven point, you will start making a profit. So in this case the Nifty closing price is more than the Strike price, and the Profit that you make is calculated as = (Nifty closing Price-Strike Price-Premium).
You can check the formula used in the image above, in case you want to use it in your Spreadsheet.
Please note that for each strategy we will be including an input data and an Output data. Input data is your strike price, Current Nifty index, Premium and Break-even point. Output data will include the payoff schedule. This generally will give you clear picture of how much will you make or lose at different Nifty Closing prices.
Strategy: Buy call Option
Current Nifty Index7655.05
Call OptionStrike Price (Rs.)7600
Premium (Rs.)220
Break Even Point (Rs.) = (Strike price + premium)7820

The Payoff Schedule
On expiry Nifty Closes atNet payoff from call option (Rs.)
7300-220
7400-220
7500-220.00
7600-220.00
78200
8000180
8100280
Long Call Strategy

Long Call Strategy Analysis

  • It limits the downside risk to the extent of premium that you pay.
  • But if there is a rise in Nifty then the potential return is unlimited.
  • This is one of the option trading strategies that will offer you the simplest way to benefit.
And that is why it is the most common choice among first-time investors in Options.

#2: Short Call Strategy


  • In the strategy that we discussed above, we were hoping that the stock would rise in future and hence we adopted a strategy of long call there.
  • But the strategy of a short call is opposite of that. When you expect the underlying stock to fall you adopt this strategy.
  • An investor can sell Call options when he is very bearish about a stock / index and expects the prices to fall.
  • This is a position which offers limited profit potential. An Investor can incur large losses if the underlying price starts increasing instead of decreasing.
  • Though this strategy is easy to execute, it can be quite risky since theseller of the Call is exposed to unlimited risk.
Best time to Use:When you are very bearish on the stock or index.
Risk:Risk here becomes Unlimited
Reward:Reward is limited to the amount of premium
Breakeven:Strike Price+ Premium

Short Call Strategy Example

  • Matt is bearish about Nifty and expects it to fall.
  • Matt sells a Call option with a strike price of Rs. 7600at a premium of Rs. 220, when the current Nifty is at 1.
  • If the Nifty stays at 7600 or below, the Call option will not be exercised by the buyer of the Call and Matt can retain the entire premium of Rs.220. 

Short Call Strategy Inputs

Strategy: Sell call Option
Current Nifty Index7655.1
Call OptionStrike Price (Rs.)7600
Premium (Rs.)220
Break Even Point (Rs.) = (Strike price + premium)7820

 Short Call Strategy Outputs

The Payoff Schedule
On expiry Nifty Closes atNet payoff from call option (Rs.)
7300220
7400220
7500220
7600220
78200
8000-180
8100-280
Short Call Strategy

Short Call Strategy Analysis

  • Use this strategy when you have a strong expectation that the price will certainly fall in future.
  • This is a risky strategy, as the stock prices rises, the short call loses money more quickly.
  • This strategy is also called Short Naked Call since the investor does not own the underlying stock that he is shorting.

#3: Long Put Strategy


  • Long Put is different from Long Call. Here you must understand that buying a Put is the opposite of buying a Call.
  • When you are bullish about the stock / index, you buy a Call. But when you are bearish, youmay buy a Put option.
  • A Put Option gives the buyer a right to sell the stock (to the Put seller) at a pre-specified price. He thereby limits his risk.
  • Thus, the Long Pu there becomes a Bearish strategy.You as an investor can buy Put options totake advantage of a falling market.
Best time to Use:When the investor is bearish about the stock /index.
Risk:Risk is limited to the amount of Premium paid.
Reward:Unlimited
Breakeven:(Stock Price – Premium)

Long Put Strategy Example

  • Jacob is bearish on Nifty on 6th September, when theNifty is at 1.
  • He buys a Put option with a strike price Rs. 7600at a premium of Rs. 50, expiring on24th
  • If Nifty goes below 7550 (7600-50), Jacob will make a profit on exercising the option.
  • In case theNifty rises above 7600, he can give up the option (it will expire worthless) with a maximum loss of the premium.

Long Put Strategy Input

Strategy: Buy Put Option
Current Nifty Index7655.1
Put OptionStrike Price (Rs.)7600
Premium (Rs.)50
Break Even Point (Rs.) = (Strike price – premium)7550

Long Put Strategy Output

The Payoff Schedule
On expiry Nifty Closes atNet payoff from call option (Rs.)
7200350
7300250
7400150
750050
75500
7600-50
7700-50
Long Put Strategy

Long Put Strategy Analysis

  • If you are bearish you can profit from the declining stock prices by buying Puts. You will be able to limit your risk to the amount of premium paid, but your profit potential remains unlimited.
This is one of the widely used options trading strategies when an investor is bearish.

#4: Short Put Strategy


  • In long Put, we saw when the investor is bearish on a stock he buys Put. But selling a Put is opposite of buying a Put.
  • An investor will generally sell the Put when he is Bullish about the stock. In this case,the investor expects the stock price to rise.
  • When an investor sells a Put, he earns a Premium (from the buyer of the Put). Here the investor has sold someone the right to sell him the stock at the strike price.
  • If the stock price increases above the strike price, this strategy will make a profit for the seller since the buyer will not exercise the Put.
  • But, if the stock price decreases below the strike price, more than the amount of the premium, the Put seller will start losing money. The potential loss is unlimited here.
Best time to Use:When the investor is very Bullish on the stock or the index.
Risk:Put Strike Price –Put Premium.
Reward:It is limited to the amount of Premium.
Breakeven:(Stock Price – Premium)

Short Put Strategy Example

  • Richard is bullish on Nifty when it is at 7703.6.
  • Richard sells a Put option with a strike price of Rs. 7600at a premium ofRs. 50, expiring on 24th
  • If the Nifty index stays above 7600, he will gain the amount of premium as the Put buyer won’t exercise his option.
  • In case the Nifty falls below 7600, Put buyer will exercise the option and the Richard will start losing money.
  • If the Nifty falls below7550, which is the breakeven point, Richard will losethe premium and more depending on the extent of the fall in Nifty.

Short Put Strategy Input

Strategy: Sell Put Option
Current Nifty Index7703.6
Put OptionStrike Price (Rs.)7600
Premium (Rs.)50
Break Even Point (Rs.) = (Strike price – premium)7550

Short Put Strategy Output 

The Payoff Schedule
On expiry Nifty Closes atNet payoff from call option (Rs.)
7200-350
7300-250
7400-150
7500-50
75500
760050
770050
Short Put Strategy

Short Put Strategy Analysis

  • Selling Puts can lead to regular income, but it should be done carefully since the potential losses can be significant.
  • This strategy is an income generating strategy.

#5: Long Straddle Strategy


  • The long straddle strategy is also known as buy straddle or simply “straddle”. It is one of the neutral options trading strategies that involve simultaneously buying a put and a call of the same underlying stock.
  • The strike price and expiration date are the same. By having long positions in both call and put options, this strategy can achieve large profits no matter which way the underlying stock price heads.
  • But the move has to be strong enough.
Best time to Use:When the investor thinks that the underlying stock / index will experience significant volatility in the near term.
Risk:Limited to the initial premium paid.
Reward:The reward here is Unlimited
Breakeven:1.                 Upper Breakeven Point = Strike Price of Long Call + Net Premium Paid.2.                 Lower Breakeven Point = Strike Price of Long Put – Net Premium Paid.

Long Straddle Strategy Example 

  • Harrison goes to the NSE website.
  • He fetches the data for Current Nifty Index, Strike Price (Rs.), and Premium (Rs.).
  • He then selects the index derivative. In instrument type Harrison selects index options, in symbol he selects nifty, the expiry date is 24th September, option type will be call, and Strike price is 7600.
  • Call Premium paid is RS 220. Now in, option type he selects Put, Strike price is same as above i.e. So Put premium paid is 50.
The data for our input table is as follows:
  • Current nifty index is 7655.05
  • Strike price is 7600
  • Total premium paid is 220+50 which equals to 270.
  • Upper Breakeven point is calculated as 7600+270 which comes to 7870
  • Lower Breakeven point is calculated as 7600-270 which comes to 7330
  • We will assume on expiry Nifty Closes as on expiry Nifty Closes at 6800, 6900, 7000, 7100 and so on.

Long Straddle Strategy Inputs 

Strategy: Buy Put + Buy Call
Current Nifty Index7655.05
Call and Put OptionStrike Price (Rs.)7600
Call Premium (Rs.)220
Put Premium (Rs.)50
Total Premium (Rs)270
Break Even Point (Rs.)7870
Break Even Point (Rs.)7330

Long Straddle Strategy Outputs

The Payoff Schedule
On expiry Nifty Closes atNet payoff from Put Purchased (Rs.)Net payoff from call Purchased (Rs.)Net Payoff (Rs.)
6800750-220530
6900650-220430
7000550-220330
7100450-220230
7200350-220130
7330220-2200
7400150-220-70
750050-220-170
7600-50-220-270
7652-50-168-218
7700-50-120-170
7870-50500
7900-508030
7983-50163113
8000-50180130
8100-50280230
8200-50380330
8300-50480430
Long Straddle Strategy

Long Straddle Strategy Analysis

  • 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 show volatility to cover the cost of the trade, profits are to be made.
  • If the stock /index lies between your upper and lower break even point you suffer losses to that extent.
  • 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.

#6: Short Straddle Strategy


  • A Short Straddle is exactly the opposite of Long Straddle.
  • Investor can adopt this strategy when he feels that the market will not show much movement. Thereby 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. 
Best time to Use:When the investor thinks that the underlying stock will experience very little volatility in the near term.
Risk:Unlimited
Reward:Limited to the premium received
Breakeven:1.     Upper Breakeven Point = Strike Price of Short Call + Net Premium Received2.     Lower Breakeven Point = Strike Price of Short Put – Net Premium Received

 Short Straddle Strategy Example

  • Buffey goes to the NSE website and fetches the data for Current Nifty Index, Strike Price (Rs.), and Premium (Rs.).
  • He then selects the index derivative. In instrument type he selects index options, in symbol he selects nifty, the expiry date is 24th September, option type will be call, and Strike price is 7600.
  • Call Premium paid is RS 220. Now in, option type he selects Put, Strike price is same as above i.e.
  • So Put premium paid is 50.

Short Straddle Strategy Inputs

Strategy: Sell Put + Sell Call
Current Nifty Index7655
Call and Put OptionStrike Price (Rs.)7600
Call Premium (Rs.)220
Put Premium (Rs.)50
Total Premium (Rs)270
Break Even Point (Rs.)7870
Break Even Point (Rs.)7330

Short Straddle Strategy Outputs

The Payoff Schedule
On expiry Nifty Closes atNet payoff from Put Sold (Rs.)Net payoff from call Sold (Rs.)Net Payoff (Rs.)
6800-750220-530
6900-650220-430
7000-550220-330
7100-450220-230
7200-350220-130
7330-2202200
7400-15022070
7500-50220170
760050220270
765250168218
770050120170
787050-500
790050-80-30
798350-163-113
800050-180-130
810050-280-230
820050-380-330
830050-480-430
830050-480-430
Short Straddle Strategy

Short Straddle Strategy Analysis

  • If the stock moves up or down significantly, the investor’s losses can be significant.
  • This is a risky strategy. It should be carefully adopted only when the expected volatility in the market is limited.

Conclusion


There are innumerable Options Trading Strategies available, but what will help you, in the long run, is “Being systematic and probability-minded”. No matter what strategy you use, it is essential that you have a good Knowledge of the Market and your Goal.
The key here is to understand which of the options trading strategies suits you more.
So really, which of options trading strategy suits you the most?

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