Types of Options Trading Strategies for Indian Stock Markets

In the preceding chapters, we have explored various aspects of options and other associated concepts. We will now delve deeper into options trading, which offers investors and traders a versatile tool for achieving their investment goals. 

You must have heard of this concept several times when people talked about the possibility of options trading yielding stellar returns. 

But what does it mean or entail? At its core, an option is a financial contract that gives the buyer the right, but not the obligation, to buy (through a call option) or sell (through a put option) an asset at a predetermined price before the contract expires. This predetermined price is known as the strike price. 

This arrangement helps traders strategise around different market conditions without the immediate need to invest in the underlying asset directly. This enables traders to fulfil a variety of goals including making speculative gains, and generating, or achieving a hedge against other investments. 

Thus, it is accurate to say that options can be tailored to fit a wide range of scenarios, making them a powerful component of modern financial portfolios. We will now move on to the basics of options trading.

Basics of Options Trading

Key Terms of Option Trading

A thorough understanding of certain key terms associated with options trading will help you grasp the concept better. Below are the key terms:

Strike Price: The price at which one can buy the underlying asset (in the case of a call option) or sell it (in the case of a put option) according to the conditions of an options contract.

Expiry Date: The date on which the option expires and ceases to exist; the option must be exercised before this date if the holder wishes to utilise the rights granted by the contract.

Call Option: A contract that gives the buyer the right to buy the underlying asset at the strike price until the expiration date.

Put Option: A contract that gives the buyer the right to sell the underlying asset at the strike price until the expiration date.

Rights and Obligations of Options Trading

Below are the rights and obligations of parties involved in options trading:

Buyers of Options (Holders): Buyers have the right to exercise their option to buy (in the case of calls) or sell (in the case of puts) the underlying asset. They are not obligated to exercise this right.

Sellers of Options (Writers): Option sellers have an obligation to fulfil the contract's terms if the option buyer exercises their right. This means they may have to buy or sell the underlying asset at the strike price, depending on whether they sold a call or a put.

Leverage in Options Trading

Options allow traders to control a larger amount of the underlying asset with a smaller amount of capital (the premium paid for the option). This leverage can significantly amplify gains if the market moves in the trader’s favour; however, it can also magnify losses. Losses increase particularly for the sellers of options and may become unlimited depending on how the market moves. Therefore, while leverage can increase profitability, careful risk management is required to prevent huge losses.

Basic Options Trading Strategies

Options strategies can range from straightforward to complex depending on the number of positions they involve. They can range from one to multiple positions. Here are some of the basic strategies used by traders. Each of these strategies serves different market outlooks and risk tolerance levels, providing traders with a variety of tools to manage their investment portfolios effectively. Whether aiming for protection, income, or speculative gains, these strategies allow investors to tailor their market participation according to their financial goals and market predictions.

Covered Call

This strategy entails holding a long position in an underlying asset, followed by selling a call option on the same asset. The aim here is to generate income through the premium received for selling the call. If the stock price rises above the strike price, the seller may have to sell the stock at the strike price, effectively capping the upside potential but reducing the cost basis of the held asset. This strategy is suitable for moderately bullish investors who are willing to sell their stock if it reaches or exceeds a certain price.

Wondering how that works? Here is an example:

Assume you own 100 shares of Company XYZ trading at ₹3,500 each. You sell a call option with a strike price of ₹3,700, expiring in one month, and receive a premium of ₹150 per share. If XYZ's price stays below ₹3,700, you retain the premium and your shares. If it exceeds ₹3,700, you might sell your shares at ₹3,700 but retain the premium, effectively getting ₹3,850 per share (strike price + premium).

Protective Put

A protective put is another strategy that involves buying a put option for an asset already owned. But why is it called protective? This strategy acts as insurance and protects the investment against a significant decline in the asset's price below the strike price. If the asset’s price drops, the put increases in value. This offsets some or all the loss in the asset and thus protects from losses while allowing for growth.

Here is an example to illustrate this:

You own 100 shares of Company XYZ, currently priced at ₹3,500 per share. To protect against a possible price drop, you purchase a one-month put option with a strike price of ₹3,500 for a premium of ₹200 per share. If XYZ's price falls below ₹3,500, the put option's value increases, offsetting the stock's loss. This strategy guarantees you can sell at ₹3,500 regardless of the market price falling lower.

Long Call

In a long call strategy, the trader buys a call option expecting that the market price of the underlying asset will rise significantly beyond the strike price and make the option more valuable. This strategy offers unlimited upside potential, with the risk limited to the premium paid. It is ideal for investors who are very bullish on the underlying asset.

Suppose you believe Company XYZ, now at ₹3,500, will soon rise. You buy a three-month call option with a strike price of ₹3,700, paying a premium of ₹250 per share. If XYZ’s price jumps to ₹4,200, you exercise your option to buy at ₹3,700, making a profit of ₹250 per share (market price - strike price - premium).

Long Put

A long put strategy involves buying a put option if the trader expects the underlying asset's price to fall significantly below the strike price. It allows the trader to profit from the decline in the asset's price. The risk is limited to the cost of the put option. This low risk makes this strategy appealing to bearish investors who want to benefit from potential drops in the asset's price.

Now, as an example, suppose you are doubtful about Company XYZ's future. Currently, at ₹3,500, you buy a three-month put option with a strike price of ₹3,500, paying a premium of ₹300 per share. If XYZ’s price drops to ₹3,000, you can exercise your option to sell at ₹3,500, gaining ₹200 per share after deducting the premium (strike price—market price—premium).

Advanced Options Trading Strategies

Now, moving on from the basic strategies, let us look at some advanced option trading strategies below:

Long Straddle

A long straddle strategy consists of simultaneously purchasing a call option and a put option with identical strike prices and expiry dates. This approach aims to take advantage of substantial price shifts in either direction. While this strategy requires a higher investment because of the sum of the premiums for both options, it provides the possibility of unlimited gains. The maximum risk is limited to the total amount of premiums paid. The long straddle is ideally suited for highly volatile markets where the price movement direction is unpredictable.

Assume you expect significant volatility in Company XYZ, currently trading at ₹1,000, due to an upcoming earnings report but are unsure of the direction. You buy both a call and a put option with a strike price of ₹1,000, expiring in one month. The call costs you a premium of ₹50, and the put also costs ₹50, totalling ₹100. If XYZ's price jumps to ₹1,150 or drops to ₹850, you could exercise the profitable option (call for a rise, put for a drop). This way, you can potentially profit after covering the ₹100 premium paid.

Short Straddle

The short straddle is essentially the reverse of the long straddle. It involves the sale of both a call and a put option at the same strike price and expiration. This strategy benefits from low volatility in the market as the seller aims to retain the premium received from selling the options. However, it carries significant risks. You must thus be mindful of this strategy, as potential losses are unlimited in case of substantial price movement in either direction.

Company XYZ is trading at ₹1,000, and you predict low volatility. You sell a call and a put option both at a strike price of ₹1,000, receiving a premium of ₹60 each, totalling ₹120. If XYZ's price remains close to ₹1,000 at expiration, you keep the ₹120 premium. However, if XYZ moves significantly beyond the strike price in either direction, your losses could exceed the premium received due to the unlimited risk nature of the strategy.

Long Strangle

A long strangle is similar to a long straddle, but the options purchased have different strike prices. The call option has a higher strike price, and the put option has a lower one. This strategy also seeks to profit from significant price movements and is cheaper to set up than a long straddle. This is because of the lower premiums associated with out-of-the-money options. However, it requires a larger price move to become profitable.

Expecting a big move in Company XYZ's stock price from the current ₹1,000 but suspecting it might need a larger swing, you buy a call option with a strike of ₹1,050 for ₹30 and a put option with a strike of ₹950 for ₹30, spending a total of ₹60 on premiums. This setup benefits from cheaper premiums than a straddle. For you to profit, XYZ needs to move above ₹1,110 or below ₹890, surpassing your total premium cost and the distance from the strikes.

Short Strangle

On the contrary, a short strangle strategy consists of selling a call and a put option at strike prices that are different from each other. It bets that the stock price will remain between these two values. Like the short straddle, it generates income from the premiums received but poses a high risk if substantial price movements occur outside of the strike prices set.

As an example, consider company XYZ is stable at ₹1,000, and you expect it to stay within a range. You sell a ₹1,050 call and a ₹950 put and receive a premium of ₹35 each, totalling ₹70. If XYZ's price stays between these strikes by expiration, you retain the premium. However, significant moves beyond either strike expose you to potentially unlimited losses.

Iron Condor

The iron condor is a more advanced strategy that involves setting up four different options to capitalise on stocks with minimal price movement. This strategy combines selling two out-of-the-money options (one call and one put) and buying further out-of-the-money call and put options to protect against substantial losses. It aims to profit from the premium income while keeping risks limited, provided the stock's price remains within a specific range.

Now, suppose company XYZ  is trading at ₹1,000, and you are expecting minimal price movement. You set up an iron condor by selling a ₹1,050 call and a ₹950 put and buy a ₹1,100 call and a ₹900 put to cap potential losses. You collect smaller premiums on the sold options and pay premiums for the bought options, reducing your net income but limiting your risk. Profit is maximised if XYZ stays between ₹950 and ₹1,050.

Butterfly Spread

The butterfly spread strategy utilises multiple call or put options at different strike prices to benefit from stocks that are expected to have little to no price movement. This complex strategy involves buying and selling options at three different strike prices and aims to earn profits through the premiums of the options sold, offset slightly by the cost of the options purchased.

Suppose company XYZ is trading at ₹1,000, and you anticipate little movement. You buy a ₹990 call, sell two ₹1,000 calls, and buy a ₹1,010 call. The premiums paid for the ₹990 and ₹1,010 calls are offset by the premiums received from selling the ₹1,000 calls. This strategy offers a profit if XYZ's price stays near ₹1,000 at expiration but limits your maximum profit and loss due to the structure of buying and selling options at different strikes.

Wrapping Up

These options trading strategies demonstrate how traders can leverage different market conditions. Each strategy has its specific use case, depending on market volatility, expected price movements, and the trader's risk tolerance. If you wish to gain success in options trading, a deep understanding of these strategies and continuous learning to adapt to ever-changing market conditions will be invaluable. You must also implement effective risk management practices to safeguard investments and achieve consistent returns.