Option strategies

A discussion on ways to profit from Options

with limited reward and controlled risk

By Shiva Galrani

AgendaOption Basics

Strategies for making limited profit with limited risk Straddle / Strangle (for volatile times) Spreads (for directional moves) Butterflies (for sideways markets)

For each strategy we will discuss Definition with example When to enter & points to watch Steps in / Steps out Knowing your Risk / Reward / Breakeven

No Charts !!Only have

Option P&L Graphs

Options are weapons of Financial Mass Destruction

90% of Options expire worthless (so you should always sell options and not buy them)

Options are only for Pro’s who have years of experience and deep pockets

Options are only for speculators

Options need to be tracked intraday and watched every minute

Option Myths

Option BasicsOptions gives the buyer a right (not an obligation) to buy (or sell) the underlying at an agreed strike price before a predetermined time.

Options gives the seller an obligation (not a right) to deliver (or buy) the underlying at an agreed strike price before a predetermined time.

The buyer pays a premium to the seller for getting this right

Each Option has to specify – Underlying instrument, Quantity, strike price, and expiry date.

Only 4 types of action possible in options

All options can be in any one of the three statuses – ATM, OTM or ITM depending on the difference between underlying price, strike price and option type (call or put)

Action Expected Outcome

Call option buy Profit if price goes up

Put option buy Profit if price goes down

Call option sell Profit if price goes down

Put option sell Profit if price goes up

Option Basics contd…Options value has two components

Intrinsic value (Difference between underlying price and strike price)

Time value (Difference between option price and Intrinsic value)

Minimum value of both of the above is always zero and never negative.

Divide Time value by number of trading days left to expiry to know the value you will lose / gain everyday on your bought / sold options.

Nifty is at 6040 and 6000 Call is at 120 and 6100 Put is at 105

Intrinsic value of Call option is 40 (6040 – 6000) and time value is 80 (120-40)

Intrinsic value of Put option is 60 (6100-6040) and time value is 45 (105-60)

Nifty is at 6040 and 6100 Call is at 70 and 6000 Put is at 65

Intrinsic value of Call option is 0 (6040 – 6100) and time value is 70 (70-0)

Intrinsic value of Put option is 0 (6100-6040) and time value is 65 (65-0)

Option PricingBlack & Schloes valuation method is the most popular type of “theoretical” option pricing and depends on

Underlying price

Strike price

Type of option (Call or Put)

Time to expiry

Interest rates

Historical Volatility

Based on the above the price that is found will be different than the market price. This is due to the expected or implied volatility because others are known or fixed.

If the market expects volatility to increase (due to results….Infy) the options price will increase (and decrease after results)

Questions?

The basic topics discussed here are too brief and additional study is highly recommended

Straddle / Strangle

Straddle / StrangleStraddle / Strangle is a strategy where you want to profit from an expected Volatile movement in the underlying. Direction of movement is not known.

Example – Before Infy results you want to profit from the volatile movement post results. Infy spot is at 2500. We want to make a profit whether Infy moves up or down.

If you buy 2500 call at & 2500 put at 150 each – This is a straddle

If you buy 2600 call at & 2400 put at 80 each – This is a strangle.

When to enter – You enter before an event that is expected to cause volatile movement (results, announcements like bonus, takeovers etc.)

The cost of straddle should be less than half of the recent high – recent low.

Look at the last few Infy results and the %ge move. The cost of straddle should be less than this %ge of the current price.

Straddle / Strangle cont…Maximum risk = Net price paid (in Infy above –

300 for straddle and 160 for strangle)

Maximum reward – Theoretically Unlimited

Breakeven down – Strike less net debit (2500–300 = 2200

for straddle or 2400 – 160 = 2240 for strangle)

Breakeven up – Strike Plus net debit (2500 + 300 = 2800

for straddle or 2600+160 = 2760 for strangle)

Straddles are costlier than strangles but their breakeven are tighter. Buy

Strangles only if a move past breakeven is expected. Cheap is not always best.

Exiting the position – 3 ways

1. Simply sell both the legs after the announcement (and hopefully the stock has moved). Do this immediately if the movement is not enough to cover net debit.

2. Sell profitable option to lock in profit and keep the losing option for some time in hope of retracement

3. Sell the losing option immediately in hope of continuation of trend. You can extend this by converting the profitable option into a spread by selling another higher strike option.

Questions?

Remember Straddles and Strangles are volatile strategies with greater risk of Time decay. If your expected volatile move does not happen, exit both legs quickly to avoid loss due to Time decay

Spreads

SpreadsSpreads are directional strategy where buy one strike and sell another strike to profit from a movement in the underlying

Type of spreads (assume Nifty is at 6040)

Both legs should be of same type (call or put). You are bullish if you buy lower strike and sell higher strike. You are bearish if you buy higher strike and sell lower strike

Choose your strike based on your view and the expiry time left.

Use Spreads instead of straddles / strangles before an event if you have a bias towards the direction the stock will move after the event.

Spread type Direction Action Net cost

Bull Call Spread Bullish Buy 6100 Call & sell 6200 Call Net Debit

Bull Put Spread Bullish Buy 5900 Put & sell 6000 Put. Net Credit

Bear Call Spread Bearish Sell 6100 Call & buy 6200 Call Net Credit

Bear Put Spread Bearish Sell 5900 Put & Buy 6000 Put. Net Debit

Spreads cont….For sake of brevity, I will consider only Bull Call spread & Bull Put Spread

Bull Call Spread – Assume Nifty at 6040 and we buy 6100 call at 80

and sell 6200 call at 45 (Our expectation is Nifty will cross 6200)

Net Debit / Max risk = Net Cost (80-45 = 35)

Max Reward = Strike difference less net debit (6200-6100-35 = 65)

Breakeven at expiry = Higher strike less net debit (6200 – 35 = 6165)

Risk Reward ratio = 65/35 or 1.85

Bear Put Spread –Assume Nifty at 6040 and we sell 6000 put at 90

and buy 5900 put at 30 (Our expectation is Nifty will fall to 5900)

Net Credit / Max reward = Cost of Puts (90-30 = 60)

Max Risk = Strike difference less net credit (6000-5900-60 = 40)

Breakeven at expiry = Higher strike less net credit (6000 – 60 = 5940)

Risk Reward ratio = 60/40 or 1.5

Try to aim for at least RR ratio of 2 without venturing into far OTM

Spreads TipsFirst decide on your view. Get confirmation from charts that your view is valid (by using any analysis you are using, - MA crossover, Pivot break, RSI etc.)

Leg into the strike that will profit with the view coming true first and if price continues to validate your view, enter the next leg to cap your spread.

Example – Nifty is at 5850 in June end. Your view is Nifty will touch 6000 in July.

Get validation on charts (MA crossover, Pivot break, RSI etc.)

Buy at spot 5900 on validation and hold with SL of half of spread. Say 5900/6000 spread cost is 100/60 (RR - 40/60 = 1.5), you buy 5900 call at 100 with SL at 80.

Hold for 2 days max and if markets go up to say 5950, 5900 call moves to 130 and 6000 call moves to 75. Sell 6000 call to make your net debit 25. This way you have reduced your Net debit from 40 to 25 and R/R is now 25/75 = 3!.

If market does not go your way, your SL is hit at 80 and you lose half of what you were ready to lose in the spread.

Questions?

Remember Spreads give their maximum reward in last week of expiry.

Butterfly

ButterflyButterfly is a range bound strategy where you look to profit if the market closes within the range defined by the butterfly.

Assume Nifty is at 5850 and you expect it to close near to 5900 by expiry.

You can construct a butterfly by using puts or calls (not both)

You can buy 5800 call 1 lot, sell 5900 call 2 lots and buy 6000 call 1 lot.

You can buy 5800 put 1 lot, sell 5900 put 2 lots and buy 6000 put 1 lot.

Note that the strike prices are same distance away and share same expiry date

Butterfly = Bull Call spread + Bear Call spread (more on this later)

Don’t enter butterfly before any major news or results that might cause a volatile movement in price.

Butterfly can be entered as late as 10 days before expiry). This helps in validating your view but increases the net debit.

The maximum movement in butterfly prices comes in the last few days of expiry.

Butterflies are suitable for sideways markets but you can make them adapt to range bound market by factoring your view. For example if Nifty is at 5850 and you expect expiry near 6100, you can trade a butterfly for net debit of 10 for a probable profit of 90

Butterfly contd…As per our example, assume Nifty is at 5850 and you expect it to close near to 5900 by expiry.

You buy 5800 call 1 lot 110, sell 5900 call 2 lots at 60 and buy 6000 call 1 lot at 30

Net cost / debit (also your max risk)

20 (110-60-60+30)

Max profit – Difference in strike less

net debit (6000-5900-20) = 80

Breakeven up – Upper strike less

net debit (6000-20 = 5980)

Breakeven down – Lower strike plus

net debit (5800+20 = 5820)

Risk Reward = 20 / 80 = 4

Butterfly Entry TipsAs per our example, assume Nifty is at 5850 and you expect it to close near to 5900 by expiry.

Start with a Bull Call spread and convert it to Butterfly. Note that Butterfly can be broken down into a Bull Call spread and a Bear Call Spread.

Going by the example given in Bull call spread, we enter 5800 call at 110, hold for some time and then sell 5900 call at 85 to give a Bull Call spread at net debit of 25.

Once Nifty crosses 6000 (our proposed upper limit), we look to enter a bear call spread with same entry rules. Wait for validation of a dip (MA crossover etc.). Assume we get our signal to short at 6075 and we short 5900 call at 100 and when market comes back to 6020 we buy 6000 call at 50.

Thus the bear call spread net credit is 50 (100-50). We now have a butterfly with negative cost of 25. We do not have any risk of loss in the trade

In case if we do not get any validation of market reversing, our bull call spread is already near max profit and we can look at something else to do in the market

Warning – The above steps though sounding logical require a great level of expertise and agility in order placement and execution. It is strongly suggested to enter all legs of butterfly simultaneously in the beginning and once we are confident of staggered entry, to start by experimenting in Spreads and then finally try staggered entries in Butterfly.

Butterfly Exit TipsIf market is far away from the butterfly strike one week before expiry with no hope for retracement, exit all the butterfly legs at best possible price.

In our example if market is above 6200 or below 5600 we exit with whatever we are able to salvage. Even with an initial net debit of 20, we should be able to salvage some amount.

Those who can take the risk can cover partly to let other legs expire worthless. For example market is at 5600, we sell 6000 leg at 2 and 5800 leg at 8 to get net loss of 10 (20-2-8). We are taking risk of holding the 2 lots of 5900 call short till expiry.

If the market is within the strikes range, hold on till couple of days before expiry.

First exit the leg that has the most chance of expiring worthless then the second third etc.

For example if nifty is at 5920, sell 6000 call at 10 and buy one lot of 5900 call at 30. Net Debit is 20.

On expiry day sell 5800 call at 140 and buy 5900 call at 25. Net credit is 115. Overall net credit on exit is 105. Initial debit was 20 giving us a profit of 85 per lot.

Warning – Same as for entry tips….more here as expiry day is very volatile in ATM options. Suggest to exit all strikes simultaneously to avoid loss.

Make sure to exit all in the money options before expiry so as to avoid higher STT charge.

Real example of Infy trade before results in JulyResults date 12th July and July expiry on 25th July

Infy spot was 2500 and view was Infy above 2800 post results and July expiry near 2700.

Trade initiated on 10th July Infy was at 2480Bought 4 lots 2600 call at 105 and sold 4 lots 2700 call at 75. Net cost per lot = 30On 11th Infy goes to 2550. Bought 2800 2 lots at 75 and sold 2700 call 2 lots at 110.

Now holding 2 lots Bull call spread at 30 debit (2600 call at 105 and 2700 call sold at 75)Also holding 2 lots butterfly at negative cost of 5 (2 lots 2600 call at 105, 4 lots 2700 call at 93 (75+110)/2 and 2 lots of 2800 call bought at 75

After result Infy went to 2800, sold Bull call spread at 102 (2600 sold at 272 and bought 2700 call at 170) Net profit on BCS – 72 Rs (102 – 30) * 2 lots = 18,000.

Waited till last week of expiry for exiting butterflies. On 22nd July, Infy broke its prior week high of 2865 and went to 2900. Legged out of butterfly by covering 2700 call at 155. Legged out of 2800 call at 72 and 2600 call at 260 before day end. Net profit on exit was 22 (76+280-155-155) * 2 sets = 5,500.

Butterflies require more of patience and less tinkering. Start with a view, trade the view in its logical direction to build the butterfly and wait for expiry to exit according to the market conditions.

Questions?

GoodiesResources for Learning option strategies

http://www.optiontradingpedia.com/

http://www.theoptionsguide.com/

Few Good books on learning Option strategies.

Download it from here and here

Excel resource to plan option strategiesOptions Bible