What is option strategy?
There are many types of options strategies to maximize earnings when using futures and options contracts for one’s trades. In general, these can be divided into buying call options or put options at a certain frequency. The options strategies are detailed below as follows:
1. Long Call
A long call is when options traders buy call options such that they leverage their trades by taking advantage of rising prices. Traders who utilize long calls are confident or bullish towards a particular stock, index, or exchange-traded fund. As they are sure its price is going to increase at some point in the future, they take a call option for it at a predetermined price so that when its price increases, they are still obligated to buy it at the lower price set by them earlier. This way they can sell that security for a much higher price by using their call option to their advantage. Hence, a long call allows traders to maximize earnings by being bullish towards a particular stock and mitigating the risk associated with buying it directly.
2. Long Put
On the other hand, a long put strategy is a short-selling options strategy. Long puts are ideal for traders who have a bearish sentiment towards a certain stock, exchange-traded fund, or index. Over here, traders are waiting for prices to fall so they can take advantage of their put options as leverage. By setting the put option at a predetermined high price early on when the price was higher, the trader gets to take advantage of the falling prices by short selling their contracts once the security’s market value falls. Now, the security may be trading for a lower price than the options contract, but one is obligated to sell their security at the contract’s maturity, thereby earning returns.
3. Covered Call
The third type of options strategy is the covered call which is the preferred strategy for those who are lower risk takers and are willing to limit their potential to walk away with higher earnings in exchange for most protection in case the stock performs unexpectedly. One may expect a slight or minimal change in the price of the security if they opt for the covered call strategy. It involves buying around 100 shares from the underlying asset followed by selling a call option against all of those shares. Upon selling the call one will collect the premium which lowers their cost basis on the shares they purchased while giving the trader a cushion against an underperforming stock.
Risk vs Reward with Options Trading
There are risks and rewards to each and every option strategy. The main risk for each of these strategies is that the stock price moves in the opposite direction than was expected or not at all. This is why some traders prefer a downside protection options strategy like the covered call to protect their bases. The rewards with some strategies like the long call and long put are higher than the potential rewards of using a covered call options strategy. Hence, based on personal investment goals and one’s risk appetite, one can pick the options strategies best geared to them.
Complex Options Strategies for Volatile Markets:
Options strategies for a volatile market are the ones that enable traders to sail over and profit from wild price swings in the market in any direction that is, whether the prices rise, fall or stay neutral. Here the real challenge is to gauge how much the surge would be, to make the best options strategy decisions. Here are some of the best options strategies for volatile market. These are important and yet simple ones from which even beginners to stock investing can benefit.
1. Long Strangle
In a long strangle, you choose to buy an Out The Money call and Out The Money Put option of the same expiry. OTM call option is a call option where the strike price is higher than the current price of the underlying asset. OTM put option is an option where the strike price is lower than the current price of the underlying asset. Here the strike price could be changed if the trader so wishes, but then the current price must be away by the same distance from both call and put strike prices.
The long strangle strategy is cheaper for the simple reason that both put and call options are out the money and have no intrinsic value (your premium is cheaper). Here, the bet is really on the degree of implied volatility in the prices. Here, you do not benefit from pocketing the premium, as you do in other strategies such as a short straddle.
Usually a significant event like policy announcements, earnings releases, global factors is when it’s an excellent time to enter into a long strangle.
Let us look at an example:
Let us assume, BSE Sensex spot price is Rs. 15,000.
You bought an OTM Call option at the strike price of Rs.16000.
You bought an OTM Put option at the strike price of Rs. 14000.
You paid a premium of Rs. 50 for OTM Call option
You paid a premium of Rs. 40 for OTM Put option
The net premium paid is Rs.90.
Upper breakeven point would be (OTM Call strike price + total premium paid): Rs. 16090.
Lower breakeven point would be (OTM Put strike price – total premium paid): Rs.13910.
Now the trader will make a profit if prices move beyond the range of Rs. 13,910-Rs.16090, in either direction.
Now the advantages are:
- The minimum loss here is very less. It is as much as the net premium paid if the prices do not move at all or move only between the two strike prices.
- The upside profit is unlimited because prices can move in either direction and profit will be made as long as they rise beyond the break even points on either side.
- At a time, only one of the options will make a profit. So the profit has to be significant enough to cover the premium and the cost of the other option.
- You should enter into a long strangle only when you expect a sharp movement in prices but are unsure of which way the prices are likely to move.
2. Long Straddle
A long straddle is ideal for volatile markets when you expect significant movement in prices, but you are less confident about which way the prices will move. It involves buying a long call option and a long put option. Here, you purchase equal lots of at the money (ATM) call and ATM put option contracts expiring on the same date. At the money contracts are ones where the strike price is equal to the current price of the underlying security. You can pick a more extended expiration date to benefit from the price movement, or you can choose a cheaper contract nearing expiration.
Since you have to pay the premium upfront to buy a long straddle, this is a net debit transaction.
Let us see a hypothetical example.
The stock of Company ABC is trading at Rs.60.
For the same stock, ATM calls (same as the strike price of Rs. 60) are trading at Rs.3. You purchase a lot of 100 ATM call options for Rs. 300.
Simultaneously, you also purchase ATM puts (strike price is Rs. 60) trading at Rs. 4. You are buying 100 ATM put options for Rs. 400.
You will pay a net debit of Rs.700 for the two premiums, for the long straddle
This will also be your maximum loss including the commission fees and other expenses (which we have not included here to keep it simple for you to understand) if the prices do not change at all on the date of contract expiration.
There is unlimited profit potential if prices move significantly in either direction. The only catch is, price movement has to be large enough to cover the cost of the premium on the other side (call or put+premium.) Let us see the different profit and loss scenarios you will incur in a long straddle.
Let us assume, ABC stocks are trading at Rs. 64 on the date of contract expiry:
Since the current price is higher than the strike price of your contract, your call options will be worth Rs. 400. You will recover Rs400 from your total debit payment of Rs.700.
If ABC stocks are trading at Rs. 69 on the date of contract expiry:
The current price is higher than the strike price; your call options will be worth Rs.900 and your put options will go unexercised. You would recover your debit payment of Rs.700 and make a profit of Rs.200.
If ABC stocks are trading at Rs. 53 on the date of contract expiry:
The current price would be lower than the strike price of Rs.60. Your call options would go unexercised since you will not buy the stock at the higher strike price. Your put options will be worth Rs.700. With the premium paid upfront, you will just about break even with no profit no loss.
If ABC stocks trade at Rs. 51 on the date of the contract expiry:
The current price of the underlying stock would be lower than the strike price. Your call options would be worth Rs.900, while your put options would go unexercised. You will pocket a profit of Rs.200.
Breakeven points will be:
Breakeven point 1 is the strike price plus premium paid, which is Rs. (60+700): Rs.760.
Breakeven point 2 is the strike price minus premium paid, which is Rs.640.
You will profit from a long straddle when the prices on either side breach the breakeven points. In other words, when there is a significant price movement or high implied volatility in either direction. Here you also have the freedom to close your position before contract expiration, by merely selling off the call or put options.
3. Strip Straddle
Investors enter into a strip straddle when they are expecting a significant drop in the prices of the underlying stock. And that explains why an investor buys more put options than call options in this type of straddle strategy, which for all other practical purposes is similar to a long straddle. The call options are bought to cover losses if prices rose, instead of falling drastically, as you had expected.
In a strip strategy, you buy more put options and fewer call options but at the same expiration date.
4. Strip Strangle
This is for investors who are expecting two things – a significant movement in prices and expecting the movement to be in the downward direction. The second is an expectation for a massive drop in prices of the underlying stocks. In a strip strangle, you buy more OTM (out the money) puts than OTM call options. In out the money options, there is no intrinsic value. Here you will profit when there is a significant price movement in either direction, but you will benefit more when the prices of the underlying stock drop massively.
This is because the strike price for, say the put option would be lower than the current price of the stock (since the option contract is OTM). But you are expecting the prices to fall significantly lower for that lower strike price to make sense. The farther out the money you are, cheaper will be the premium, and closer to the money you are, the premium will get expensive. But being too far out the money may also dent your profit.
5. Long-Gut strategy
A long gut strategy is for you when you know for sure there is a massive price movement in the offing, but you do not know which direction the prices could turn. Here also, the risk is limited, and profit potential is unlimited. In a long gut, you buy an equal amount of In The Money call options (strike price is lower than the current prices of the underlying stock) and In The Money put options (strike price is higher than the current rates). Here, you will profit when the stock prices either rise or fall dramatically. You will make a profit when the cost of the underlying security increases or drops breaching the two breakeven points that can be calculated as such-
Upper breakeven point=Strike price of ITM call options+total premium paid.
Lower breakeven point=Strike price of ITM put options-total premium paid.
One of the most significant advantages of options strategies is, they enable you to make profits even when you do not know in which direction the price movements are headed.