Options Trading Strategies

[Sunil]

Nifty Options are slowly catching up with Nifty Futures in terms of participation interest. Especially in times where taking any directional trading call is becoming increasingly difficult & volatility has become order of the day, options (with its risk : return profile) can come quite handy to tackle the situation to one's benefit.

Using options, one can define one's risk (in terms of money which may be lost, but may also be limited) and one's reward too, (which may be limited or unlimited, depending on the strategy used)

Here, I'll discuss the various strategies which one can use with options. There are some strategies which use only one leg of option (eg. plain vanilla buying put), two legs (eg. staddle - buying a put + buying a call), and some which have more than two legs (eg. butterfly, condors, etc)

Plain vanilla "one legged" strategies can be taken anytime during the month, with even a shorter time period in mind, in terms of target - eg. Current Nifty = 4000; one may buy a PUT 4000 with a target of sub 3900 in one week's time, so if that target is achieved within one week & one is not bearish for more downside, then one may choose to square off the leg and book profit.

But, all other strategies, ESPECIALLY THE COMPLEX ONES USING MORE THAN TWO LEG OF OPTIONS, are taken with an eye on the expected settlement price of the underlying on the expiry/settlement day. (this will be understood in the relevant strategy's discussion)

I have categorised the various strategies as follows:

[ I ] BULLISH STRATEGIES - when one is having a bullish view on the direction of the underlying and expects the price of the underlying to rise over time. Various strategies under this are:
1. Long Call
2. Short Put
3. Bull Spread (using Call OR Put)
4. Bullish Combo / Synthetic Long (using Call AND Put)
5. Call Backspread (Ratio spread)
6. Short Put Spread + Call
7. Long Straddle + Put


[ II ] BEARISH STRATEGIES - when one is having a bearish view on the direction of the underlying, and expects the price of the underlying to fall over time. Various strategies under this are:
1. Long Put
2. Short Call
3. Bear Spread (using Call OR Put)
4. Bearish Combo / Synthetic Short (using Call AND Put)
5. Put BackSpread (Ratio Spread)
6. Short Call Spread + Put
7. Long Straddle + Call


[ III ] NEUTRAL STRATEGIES - when one is having no clue & view on the direction of the price of the underlying, but expects increased volatility to result in a one-sided directional movement (breakout or breakdown). Every trader's dream scenario where "Heads I win, Tails I win too" strategy is undertaken... but there are two scenarios here:

A. MARKET NEUTRAL BUT VOLATILITY BULLISH - when, one expects a good directional move in the price of the underlying, though is uncertain about the direction of the move.
1. Long Straddle
2. Long Strangle
3. Long Guts
4. Short Butterfly (with Call OR Put)
5. Short Condor (with Call OR Put)
6. Long Iron Butterfly (with Call AND Put)

B. MARKET NEUTRAL BUT VOLATILTY BEARISH - when, one expects the market to be stagnant and expects the underlying's price to expire around a particular level, or within a particular range. These are High Risk strategies, where one wants to earn premium by "selling" the strategy. One has to be absolutely sure about the expected expiry/settlement price or the very short term period expected price range. Taking advantage of TIME DECAY over here is the main aim/idea.
1. Short Straddle
2. Short Strangle
3. Short Guts
4. Long Butterfly (with Call OR Put)
5. Long Condor (with Call OR Put)
6. [Short Iron Butterfly (with Call AND Put)

Each strategy will be explained separately.

 

[Sunil]

Please note that, where in case of some strategies, Call OR Put can be used, one will have to separately calculate the risk : reward using Call and Put, and select the one which offers a better ratio in terms of risk appetite.

I believe that one has to strenghten theory first, before applying it in real life and taking position. So, after these strategies are explained, I would request all members to put in their appropriate strategy and have a discussion here, before trading on it.

THOSE WHO ALREADY KNOW THESE STRATEGIES CAN START FROM HERE

 

[Sunil]

LONG CALL

When to use:
When you are bullish on market direction and also bullish on market volatility.
A long call option is the simplest way to benefit if you believe that the market will make an upward move and is the most common choice among first time investors.
Being long on a call option means that you will benefit if the stock/future rallies, however, you risk is limited on the downside if the market makes a correction.
From the above graph you can see that if the stock/future is below the strike price at expiration, your only loss will be the premium paid for the option. Even if the stock goes into liquidation, you will never lose more than the option premium that you paid initially at the trade date.
Not only will your losses be limited on the downside, you will still benefit infinitely if the market stages a strong rally. A long call has unlimited profit potential on the upside.

 

[Sunil]

SHORT PUT

When to use:
When you are bullish on market direction and bearish on market volatility.
Like the Short Call Option, selling naked puts can be a very risky strategy as your losses are unlimited in a falling market.

 

[Sunil]

BULL SPREAD

USING CALL

When to use:
When you are mildly bullish on market price and/or volatility.

You can see from the above graph that a call bull spread can only be worth as much as the difference between the two strike prices. So, when putting on a bull spread remember that the wider the strikes the more you can make. But the downside to this is that you will end up paying more for the spread. So, the deeper in the money calls you buy relative to the call options that you sell means a greater maximum loss if the market sells off.

Like I mentioned, a call bull spread is a very cost effective way to take a position when you are bullish on market direction. The cost of the bought call option will be partially offset by the premium received by the sold call option. This does, however, limit your potential gain if the market does rally but also reduces the cost of entering into this position.

This type of strategy is suited to investors who want to go long on market direction and also have an upside target in mind. The sold call acts as a profit target for the position. So, if the trader sees a short term move in an underlying but doesn't see the market going past, say X, then a bull spread is ideal. With a bull spread he can easily go long without the added expenditure of an outright long stock and can even reduce the cost by selling the additional call option.



USING PUT

When to use:
When you are bullish on market direction and neutral on volatility.

A Put Bull Spread has the same payoff as the Call Bull Spread except the contracts used are put options instead of call options. Even though bullish, a trader may decide to place a put spread instead of a call spread because the risk/reward profile may be more favourable. This may be the if the ITM call options have a higher implied volatility than the OTM put options. In this case, a call spread would be more expensive to initiate and hence the trader might prefer the lower cost option of a put spread.

 

[Sunil]

BULLISH COMBO / SYNTHETIC LONG

 

[Sunil]

CALL BACKSPREAD / CALL RATIO SPREAD

Similar to a Long Straddle except the loss on the downside is limited.

When to use:
When you are bullish on volatility and bullish on market price. Note though, that you profit when prices fall, although the gains are greater if the market rallies.

A Backspread looks a lot like a Long Straddle except the payoff flattens out on the downside. The other key difference is that Backspreads are usually done at a credit. That is, the net difference for both legs means that you receive money into your account up front instead of paying (debit) for the spread. One may expreiment with 1:3 ratio too, if it offers better risk:reward ratio

Even though the payoff looks like a "long" type position, it is often referred to as a "short" strategy. Generally it is like this: if you receive money for the position up front it is called a "Short" position and when you pay for a position it is called being "Long".

 

[Sunil]

SHORT PUT SPREAD + CALL

 

[Sunil]

LONG STRADDLE + PUT

 

[Sunil]

LONG PUT

When to use:
When you are bearish on market direction and bullish on market volatility.
Like the long call a long put is a nice simple way to take a position on market direction without risking everything. Except with a put option you want the market to decrease in value.

Buying put options is a fantastic way to profit from a down turning market without shorting stock. Even though both methods will make money if the market sells off, buying put options can do this with limited risk.