Modules for Traders
Trading Strategies 1
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Option Strategies and the Use of Options
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 a 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 (right but not an obligation to buy an underlying asset at a preset price called the strike price) 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. If this strategy works and underlying stock prices do move significantly, it can give you decent returns since 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.
When is a good time to go for a long strangle?
When you are expecting markets to move significantly in either direction, it’s usually after a significant event. This can be a significant news event, data disclosure, monetary policy announcements, earnings releases, annual budget announcements, global factors, currency fluctuations, among other triggers. That 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
If you are only getting into the business of stock investing and wish to hedge your risks, a long straddle is a good strategy since it is simple, with limited risk and unlimited profit potential.
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’s straightforward because 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, prices 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. Bull Cut Spread
A bull call spread is an options trading strategy designed to benefit from a stock's limited increase in price. The strategy uses two call options to create a range consisting of a lower strike price and an upper strike price. The bullish call spread helps to limit losses of owning stock, but it also caps the gains. Commodities, bonds, stocks, currencies and other assets form the underlying holdings for call options.
5. Bull Put Spread?
A bull put spread is an options strategy that an investor uses when they expect a moderate rise in the price of the underlying asset. The strategy employs two put options to form a range, consisting of a high strike price and a low strike price. The investor receives a net credit from the difference between the two premiums from the options.
Investors typically use put options to profit from declines in a stock's price, since a put option gives them the ability—though not the obligation—to sell a stock at or before the expiration date of the contract. Each put option has a strike price, which is the price at which the option converts to the underlying stock. Investors pay a premium to purchase a put option.
6. Married Put
In a married put strategy, an investor purchases an asset–such as shares of stock–and simultaneously purchases put options for an equivalent number of shares. The holder of a put option has the right to sell stock at the strike price, and each contract is worth 100 shares.
An investor may choose to use this strategy as a way of protecting their downside risk when holding a stock. This strategy functions similarly to an insurance policy; it establishes a price floor in the event the stock's price falls sharply.
There are options strategies like the above that are simple and can be put to use by beginner investors. There are also incrementally complex options strategies that involve two to four transaction stages. There are also different call and put options, in the money, out of the money and at the money.
A Quick Recap
- Options strategies for a volatile market are the ones that enable traders to sail over and profit.
- Long Straddle Strategy: Investor buys a call option and a put option at the same time. Both options should have the same strike price and expiration date.
- In a long strangle, you choose to buy an Out The Money call and Out The Money Put option of the same expiry.
- A bull call spread is an options trading strategy designed to benefit from a stock's limited increase in price.
- A bull put spread is an options strategy that an investor uses when they expect a moderate rise in the price of the underlying asset.
- In a married put strategy, an investor purchases an asset–such as shares of stock–and simultaneously purchases put options for an equivalent number of shares.