(a) option trading a

8/2/2019 (a) Option Trading a

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(A) Option Trading Strategies &Option Spreads


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Objectives;

Understand hedging strategies in option trading;

Understand the basic principals of option pricing;

Know about concept of spreads and types ofspreads;

Understand various combinations of call and put

options like butterfly spread; Know about the various types of combinations

like straddles, strips, straps, box spreads etc.


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Long Call For aggressive investors who are very bullish about

the prospects for a stock/index, buying a calls canbe excellent way to capture the upside potential

with limited downside risk. When to Use: Investor is very bullish

Risk: Limited to the premium

Reward: Unlimited

Breakeven : Strike price + Premium


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Ex:

Current Index 4191.10

Call option Strike price 4600

Mr. X pays Premium 35.35

BEP 4635.35

This strategy limits the downside risk to the

extent of premium & reward is unlimited.This is the most common choice amongfirst time investors in options.

Ex: Refer Worksheet


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Short Call When an investor is bearish about a stock and

expects the prices to fall, he can sell call options.It offers limited profit potential and the possibility

of large losses on big advances in underlyingprices.

When to use: Investor is very aggressive andvery bearish about the stock/index

Risk: Unlimited

Reward: Limited to the extent of premium

Breakeven point: Strike price + premium


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Ex:

Current Bankex 2694


Mr. X Receive Premium 154

BEP 2754

This strategy is used when an investor is veryaggressive and has a strong expectation of a

price fall (and certainly not a price rise). Thisstrategy is called Short Naked call since theinvestor does not own the underlying stock.


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Long Put

When an investor is bearish, he can buy aput option. It gives the buyer right to sell

the stock. When to use: Investor is bearish about the

stock.

Risk: limited to the premium

Reward: Unlimited

Break even point: Strike price Premium


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Ex:

Current Index 2694

Put option Strike price 2600

Mr. X pays Premium 52

BEP 2548

A bearish investor can profit from declining

stock price by buying puts.


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Short Put

An investor sells Put when he is Bullishabout the stock expects the stock price

to rise or stay sideways at the minimum. When to use: Investor is very Bullish and

idea to make a short term income.

Risk: Strike price Put premium

Reward: Limited

BEP : Put strike price Premium


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Ex:

Current Bankex 4191.10


Mr. X Receive Premium 170.5

BEP 3929.5

Selling puts can lead to regular income in a risingor range bound markets. But it should be done

carefully since the potential losses can besignificant in case the price of the stock/indexfalls. This strategy can be considered as anincome generating strategy.


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Synthetic Long Call:

Buy Stock, Buy Put (Long stock, Long Put) This strategy is insurance against the price fall,

so buy Put on the stock. The strike price can be

bought price (ATM) or slightly below (OTM). Investor taken an exposure to an underlying

stock with the aim of holding it and reaping thebenefits of price rise, dividends, bonus right etc.

and at the same time insuring against anadverse price movement.

It is strategy with a limited loss (premium) and

unlimited profit (stock price rise).


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When to use: Investor is concerned about

near-term downside risk. Risk: stock price(bought price)+premium paid

Reward: Unlimited

BEP : Bought price + PremiumEx: Buy stock (Rs.) 4000

Strike price(Rs.) 3900

Buy Put Premium 143.80BEP 4143.80

This is a low risk strategy.

Ex: Refer worksheet


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An investor buying a common stock expectsthat its price would increase. Howeverthere is risk that the price may in fact fall

Ex: An investor buys a share Rs.100

Purchase a Put at Rs.16Exercise price Rs.110

He will exercise, only when share price lessthan Rs.110


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Profit/Loss for selected share values (right to Sell)

Share Exercise Profit on E Profit/loss Net Proft/Price Price Price in share held Loss70 110 24* -30** -6***80 110 14 -20 -690 110 4 -10 -6100 110 (NE) -6 0 -6110 110 -16 10 -6120 110 -16 20 4130 110 -16 30 14

140 110 -16 40 24

* 110 70 = 40 16 = 24** 70 - 100 = -30

*** -30 + 24 = -6


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Covered Call: Investors own shares in a company and he may feel

price rise but not much in the near term.

This is strategy SELLS a call option on a stock heowns (Obl. to sell) and he sells an OTM call.

When to use: Investor has a short-term neutral tomoderately bullish.

Risk: If the stock price falls to zero, loses the entirevalue of the stock and retain premium, since call will

not be exercised. Reward: Limited (call strike price -stock price paid ) +

premium received

BEP : Stock price paid premium received.


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Buy Stock + Sell Call option

Rs.

Buy stock Market price 3850

Short Call Strike price 4000

Receives Premium 80

BEP (stock price premium recd.) 3770


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Writing a covered calls i.e., agreeing to sell the stock.

Ex: An investor bought a share Rs.100

writing a call at Rs.3

Exercise price Rs.105


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Profit/Loss for selected share values (Obl. to Sell)

Share Exercise Profit on E Profit/loss Net Proft/

Price Price Price in share held Loss

90 105 (NE ) 3 -10** - 7***

95 105 3 - 5 - 2

100 105 3 0 3

105 105 3 5 8

110 105 - 2* 10 8

115 105 - 7 15 8

120 105 -12 20 8

** 90 - 100 = -10

*** -10 - 3 = -7

* 105 110 = -5 + 3 = -2;


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SPREADS & COMBINATIONS:

SPREADS: It involves taking a position in two ormore options of the same type.

Bull Spread: (Using Call)

- It is a bullish sentiment of a trader.

- Created by purchasing a call option (ITM) &selling another call (OTM) on same stock with

same expiry, but at higher exercise price.- At expiry, if stock remains below the two calls,

both calls would unexercised, loss limited to initial

cost of spread.


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Bull spread.. Contd

- Call with a lower exercise price greater premium (call

holder)

- Call with a higher exercise price lower premium (call

writer)

- It requires initial investment. Pay premium more than

receive.

- If stock price (S1) between two exercise prices;

Purchased call (E1) : In-the-money

Call sold (E2) : Out-of-money- If stock price (S1) greater than E- both the calls in the

money and pay-off equals the difference between

exercise of price of the two options.


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Pay-off results from a bull spread strategy

(Using Calls):While E1 & E2 are the respective strike prices of

the calls and short and S1 stock price at thetime of exercising calls

Price of Pay off from Pay off from Total

Stock Long call Short call pay-off

S1E2 S1 E1 S1 E2 E2-E1

E1


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Ex; Current value Rs. 55

Buy a call option E1 = Rs.50 for Rs.8

Sell a one call E2 = Rs.60 for Rs.2

Both being same stock with same expiry day.

Initial credit = -8 + 2 = -6

If S1 = 50 or less : None call would be exercisedNet loss (Rs.8 2)= Rs.-6

If S1 = 58 : only E1 will exercised

Pay off = Rs.58 - Rs.50 = Rs.8

Net profit = Rs.8 + 8 +2 = Rs.2

If S1 60 : both will exercised

Pay-off would 60 - 50 = Rs.10


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Solution:Price of Pay off from Pay off from Total Net P /L

Stock Long call Short call pay-off =payoff-costE1 E2

S1E2 S1 E1 S1 E2 E2 - E1

S1 60 S1 50 = 10 S1 - 60 60 - 50=10 10 6 = 4

E1


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Buy low strike Call Sell high strike Call

Bull Call Spread

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BEAR SPREADS:

Used as a strategy when one is bearishof the market, believing that it is morelikely to go down than up.

Bear spreads limit both the upside profitpotential and the downside risk.


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Bear Spread (Put options):

- Buys a put with high exercise price (ITM) & sells a

put at a lower price (OTM).- Initial investment (premium) i.e., payable is more

than the premium receivable.

Price of Pay off from Pay off from Total

Stock Long put Short put pay-off

E2 E1

S1E2 0 0 0E1


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Ex; Current value of a stock is Rs. 32

Buy a put option E2 = Rs.35 for Rs.3Sell a one put E1 = Rs.30 for Rs.1

Both being same stock with same expiry day.

Initial credit = -3 + 1 = -2If S1 >= 35 or less : None put would be exercised

Net loss (Rs.-3 +1)= Rs.-2

If S1 between E1: only E2 will exercised

Pay off = E2 S1

E1 will not exercised

If S1


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Solution:Price of Pay off from Pay off from Total Net P /L

Stock Long put Short put pay-off =payoff-costE2 E1

S1 >E 0 (NE) 0 (NE) 0

S > 30 0 0 0 - 2

E1


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Buy high strike Put Sell low strike Put

Bear Put Spread

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Strategies contd..

(a) option trading a

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