Option Trading Strategies - Chapter 3

What exactly is meant by an option trading strategy? An option trading strategy is a hybrid combination of futures and options or of two different options to create a product that can have defined risk or defined returns or both. Option strategies are possible due to the unique nature of options; being asymmetric in nature. Broadly, options strategies can be divided into 6 categories as under:

• Bullish strategies
• Bearish strategies
• Moderately bullish strategies
• Moderately bearish strategies
• Volatile strategies
• Range bound strategies

In the chapter we shall look at various strategies and for greater clarity we will classify them and bucket into one of the above strategy baskets.

Protective Puts, Covered Calls and Collars

These are the 3 most basic strategies that are used on a regular basis. Within the gamut of options strategies, these three strategies are easy to understand and also very simple to execute in the F&O Market. Let us look at each of these strategies in detail.

• Protective Put strategy

Assume that you purchased a stock to hold from a long term perspective. Unfortunately, after you bought the stock there was a global issue with the sector and now you are expecting the stock to be weak in the short run. What do you do? One way to do it is to exit the stock. But that has a cost and is not in line with a long term approach to investing. The other option is to do a “Protective Put” strategy. In a protective put, you hold on to your cash market positions but simultaneously buy a lower put option (right to sell).

How does the pay off work. On the upside, you continue to enjoy unlimited profits once your put option premium is covered. On the downside, you risk is limited to the difference between (purchase price – put option strike price) + option premium. That is your maximum loss. Practically, what traders do is to hold on to the cash market position and keep booking profits on the put option when the price dips. Of course, that leaves the long position open and you need to be wary of that. Let us see how this strategy actually works.

Illustration 1: An investor buys a stock in the cash market at Rs.800 and protects the position by purchasing a 790 put option by paying a premium of Rs.5. Let us see how the payoffs pan out.

You can represent the profit simulation graphically as under:

What are the key takeaways from the above illustration?

• The maximum loss on the protective put strategy as we can see is Rs.(-15). That is the sum of the gap between spot price and strike price (800-790) plus the option premium of Rs.5. However, low the stock price goes, you can never lose more than Rs.15.

• Breakeven point (BEP) is the level at which you make no profit / no loss. That level arises at a price of Rs.805. That can be interpreted as the (purchase price of Rs.800 + sunk option premium of Rs.5)

• Why BEP is important? Above the BEP, the profits for the trader are unlimited. By just paying a premium of Rs.5, the trader can not only protect the downside risk, but also ensures that the bullish view is maintained.

• Covered Call strategy

While the protective put is a limited risk strategy, the covered call is not exactly a limited risk strategy. The covered call is used to reduce the cost of holding a stock when it does not move for a long time. Instead of letting the investment remain idle, you can sell higher call options, earn the premium and reduce the cost of holding the stock. Assume that you purchased a stock to hold from a long term perspective. After you bought the stock, the price of the stock came down but you continue to be confident of the long term prospects. You can sell slightly higher calls that are likely to expire worthless so that the premiums become your income.

How does the pay off work. There are two kinds of price movements you need to be wary of. As long as the stock is stagnating around the current levels or up to the higher call strike price, you have nothing to worry about because you will earn the premium. If the price shoots above the strike price, then the losses on the sold call can be unlimited. But that is fully covered by your long stock position. However, on the downside, your risk is fully open and you need to be wary of that.

Illustration 2: An investor buys a stock in the cash market at Rs.800 and sells an Rs.820 call option at Rs.8. Let us see how the payoffs pan out.

Here is a graphical representation of the profit / loss of the strategy

What are the key takeaways from the above illustration?

• The maximum profit on the covered call strategy as we can see is Rs.28. That is the sum of the gap between strike price and spot price (820-800) plus the option premium of Rs.8 received. However, high the stock price goes, your profit ceiling is Rs.28. Maximum profit always arises at the strike price at which call is sold. Above that, any profit on spot position is negated by losses on the call option sold.
• However, on the downside, as you can see from the table above, the losses can be unlimited. Hence this strategy must only be adopted on stocks that have strong fundamentals and where you can hold for the long term.
• The breakeven point for the covered call strategy is Rs.792 which is the purchase price of Rs.800 less the premium of Rs.8 that you have received. Below 792, your net effective losses on the spot position start increasing.

• Collar strategy

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In the covered call strategy we saw that the downside risk was open. Essentially, the collar combines a protective put strategy and a covered call strategy. Here there are 3 phases to the strategy. First, you are long on the stock. Secondly, you buy a lower put option. Thirdly, you sell a higher call option. How does this help?

In the covered call strategy, the downside risk was open. Now that risk is closed by buying a lower put option. In the protective put strategy, at times the cost of buying put option may be too high. By selling a higher call option, the premium received can partially compensate for the premium paid on the put option. The beauty of the collar strategy is that it is a limited loss and limited profit strategy. Such strategies are called closed option strategies.

Illustration 3: An investor buys a stock in the cash market at Rs.800 and sells an Rs.820 call option at Rs.8. He also buys Rs.790 put by paying a premium of Rs.5. Here is the payoff.

Here is a graphical presentation of the Collar

What are the key takeaways from the above illustration?

• The maximum loss on the collar strategy, as can be seen in the table above is Rs.7. However, low the price of the stock goes, your total loss can never be more than Rs.7. How is this Rs.7 figure arrived at? You maximum loss on the spot/put position is Rs.15 (800-790) plus put premium of Rs.5. But this loss of 15 gets reduced by the Rs.8 you received as premium on the 820 call you sold. Hence maximum loss on the Collar is limited to Rs.7 (15-8).
• On the upside the maximum profit will be limited to Rs. 23. How is this maximum profit arrived at? You first consider the gap between the call strike price and purchase price (820-800). To that you add the net premium received (8-5). The sum is Rs.23, which will be your maximum profit irrespective of how high the stock goes.
• The breakeven point for the collar strategy is Rs.797 as can be seen from the above table. From the purchase price of Rs.800, you reduce the net premium received of Rs.3 (8-5). As long as the stock price is above Rs.797, your collar is profitable.

In a nutshell, protective puts are bullish strategy that comes with protection on the downside. Covered calls are used to reduce the cost of holding the stock but come without downside protection. When you combine the protective put and the covered call, you have the collar which is a closed strategy with limits on losses on the downside and profits on the upside.

Straddles, Strangles and Butterfly Spreads

Option strategies are fine when you have a view on the direction of the market. What if you don’t have a bullish or bearish view? What if your only view is that the index or the stock is going to either become more volatile or less volatile? In such circumstances, you can use strategies like the straddles and strangles.

• Straddle strategy

The straddle strategy involves two options of same strike prices and same maturity. A long straddle position is created by buying a call and a put option of same strike and same expiry whereas a short straddle is created by selling a call and a put option of same strike and same expiry. A long straddle is a volatile strategy that is intended to be profitable when the stock is highly volatile and shows a sharp movement either on the upside or on the downside.

Illustration 4: A trader expects the stock of TCS to become volatile in the next 15 days but is not sure of the direction. The stock is currently quoting at Rs.2105 so the trader buys an Rs.2100 call at Rs.25 and an Rs.2100 put at Rs.15. Now look at the pay off.

Graphical representation of the above will be as under:

What are the key takeaways from the above illustration?

• Long on straddle is a volatile strategy and it makes a loss only when the stock remains stagnant. The maximum loss on the long straddle strategy is Rs.40 which is the sum of the premiums paid on the call and the put option (25 + 15). Once that premium is covered, then the price movement becomes profitable either way.
• The straddle being a volatile strategy it has two breakeven points. There is a lower breakeven point at Rs.2060 (2100-40) and an upper breakeven point at Rs.2140 (2100+40). If TCS moves either below Rs.2060 or above Rs.2140, then the long straddle is profitable.
• The last column is the reverse straddle which is a range bound strategy. The payoff of a short straddle is exactly the reverse of a long straddle. Beyond the break even limits, the losses can be unlimited in a short straddle. You need to be cautious about short straddles.

• Strangle strategy

The strangle strategy involves two options of different strike prices and same maturity. A long strangle position is created by buying a higher strike call and a lower strike put option of same expiry whereas a short strangle is created by selling a higher strike call and a lower strike put option of same expiry. A long strangle is a volatile strategy that is intended to be profitable when the stock is highly volatile and shows a sharp movement either on the upside or on the downside. The advantage of the Strangle over the straddle is that it lowers the cost of the buyer of the Strangle and expands the range of profitability for the seller of the Strangle. That is the reason, strangles are a lot more popular in practice compared to a straddle.

Illustration 5: A trader expects the stock of TCS to become volatile in the next 15 days but is not sure of the direction. The stock is currently quoting at Rs.2150 so the trader buys an Rs.2200 call at Rs.11 and an Rs.2100 put at Rs.9. Now look at the pay off.

The strangle strategy can be graphically presented as under:

What are the key takeaways from the above illustration?

• Long on strangle is a volatile strategy and it makes a loss only when the stock remains in a range. The maximum loss on the long straddle strategy is Rs.70 which is half the gap between the strikes (50) plus the total premiums paid on the call and the put option (11 + 9). Once that premium is covered, then the price movement becomes profitable either ways.
• The straddle being a volatile strategy it has two breakeven points. There is a lower breakeven point at Rs.2080 (2100-20) and an upper breakeven point at Rs.2220 (2200+20). If TCS moves either below Rs.2080 or above Rs.2220, then the long strangle is profitable.
• The last column is the short strangle which is a range bound strategy. The payoff of a short strangle is exactly the reverse of a long strangle. Beyond the break even limits, the losses can be unlimited in a short strangle.
• Both the straddle and the Strangle are volatile strategies on the long side and range bound strategies on the short side. However, 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.

• Butterfly Spread

Just as the collar is an extension of covered call, the butterfly spread is an extension of short straddle. You will recollect that downside risk in short straddle is unlimited if market moves significantly in either direction (up or down). To put a limit to this downside, along with short straddle, trader buys one out of the money call and one out of the money put. The butterfly spread is a closed strategy but you need to remember that there are 4 legs to initiation of the Butterfly Spread and 4 legs to closure. That will significantly add to the costs of the strategy, when you consider the transaction and statutory costs. Hence butterfly spread is used sparingly by traders.

• Option Spreads

We have seen directional strategies, volatile strategies and we have also seen range bound strategies. In the last section we shall look at spread strategies. Spreads involve combining options on the same underlying and of same type (call/ put) but with different strikes and / or maturities. That sounds complicated but actually it is quite simple. In a nutshell, these spread trades are about limited profit and limited loss positions. Broadly, such spreads are categorized into three sections as:

• Vertical Spreads

Vertical spreads are created by using options having same expiry but different strike prices. Further, these can be created either using calls as combination or puts as combination. Also, such vertical spread can be bullish vertical spreads or bearish vertical spreads. Bull call spreads and bear put spreads are two of the most popular vertical spreads and we shall dwell in these two strategies in greater detail later.

• Horizontal Spread

Horizontal spread involves same strike, same type but different expiry options. For example, buying a Nifty 11,500 August call and selling an 11,500 September is an example of horizontal spread. This is also known as time spread or calendar spread. It is not possible to draw the pay off chart as the expiries underlying the spread are different.

• Diagonal spread

Diagonal spread involves combination of options having same underlying but different expiry as well as different strikes. Here again the two legs in a spread are in different maturities and it is not possible to draw pay offs. These diagonal spreads are more complicated and are therefore more suitable for the OTC market.

• Bull Call Spread

Bull call spread is a moderately bullish strategy where you buy a lower strike call option and sell a higher strike call option of the same expiry. Here, like in any vertical spread contract, the maximum profit and the maximum loss are fixed and hence it is a closed strategy.

Illustration 6: Trader Buys an August 1000 call option of a stock at Rs.25 and sells an August 1100 call of the same stock at Rs.7. This is an example of a bull call spread. Let us see how the payoffs work.

The bull call spread can be graphically presented as under:

Key takeaways from the payoff table

• The maximum loss in the above bull-call spread is Rs.18. That is the net premium paid in the strategy (25 -7). The total loss can never exceed this level.
• Maximum profit is Rs.82, which is calculated by the strike difference (1100-1000) less the net premium of Rs.18.
• This bull call spread has a breakeven of Rs.1018 (lower strike + net cost) and the maximum profit occurs at the upper strike. Above the upper strike and below the lower strike, the payoff is constant.

• Bear Put Spread

Bear Put spread is moderately bearish strategy where you buy a higher strike put option and sell a lower strike put option of the same expiry. Here, like in any vertical spread contract, the maximum profit and the maximum loss are fixed and hence it is a closed strategy.

Illustration 7: Trader Buys an August 1000 put option of a stock at Rs.20 and sells an August 900 put of the same stock at Rs.6. This is an example of a bear put spread. Let us see how the payoffs work.

Here is a graphical representation of a bear put strategy

Key takeaways from the payoff table

• The maximum loss in the above bear put spread is Rs.14. That is the net premium paid in the strategy (20 -6). The total loss can never exceed this level.

• Maximum profit is Rs.86, which is calculated by the strike difference (1000-900) less the net premium of Rs.14.

• This bear put spread has a breakeven of Rs.986 (upper put strike - net cost) and the maximum profit occurs at the lower put strike of 900. Above the upper strike and below the lower strike, the payoff is constant.