Article

Top 5 Options Trading Strategies

06 Mar 2020

Options strategies combine different stock market positions with a view to managing risk or enhancing returns. Why are options unique? Unlike futures, options are asymmetric. For example, when one person buys futures and another sells futures, the risk of price fluctuation is equal for both. However, in an option the buyer has limited risk and unlimited return potential while the seller has unlimited risk potential and limited returns. This makes options strategies possible. Here are five popular options strategies.

Protective Put strategy

If you bought Reliance Industries at Rs.1485, how do you protect from a price fall. Create a protective put strategy by purchasing a put option of lower strike. So you can buy a 1480 strike put option at Rs.8. A put option is a right to sell and the premium is a sunk cost. If the price goes above Rs.1493 (1485 + 8), you profits are unlimited. On the downside, your maximum loss is cannot exceed Rs.13 {(1485-1480) + 8}. In short, you limit your loss by paying a small premium of Rs.8.

Covered Call strategy

A covered call strategy is normally used when you want to reduce the cost of holding a stock. If you bought SBI at Rs.340 for long term, but the stock falls to Rs.328; what do you do?. You are confident of the long term prospects of SBI, but in the next 3 months you don’t expect the stock to cross Rs.350. You can start by selling the near month 350 call at Rs.20 and repeat for 3 months. Here is how the returns table will look like.

Details

First Month

Second Month

Third Month

SBI 350 call sold at

Rs.20

Rs.21

Rs.20

Position closed at

Rs.5

Rs.25

Rs.4

Net Profit / Loss

Rs.15

Rs.(-5)

Rs.16

You have booked a net profit of Rs.26 on SBI calls in 3 months. At the end of 3 months, your effective cost of holding SBI has come down to Rs.314 (340 – 26). The only risk is if the stock falls sharply, you don’t have protection on the downside. That is where a butterfly comes in.

Butterfly strategy

Butterfly combines a protective put and covered call. Here, the premium received on the higher call sold, reduces the net cost of the put option purchased. This increases chances of profits. Butterfly is a multi-leg transaction, so watch out for transaction costs.

Bull call spread strategy

This option strategy is generally used when you are moderately bullish on a stock. You buy a call option of a lower strike and sell the call option of the same stock of a higher strike. For example, Tata Motors is currently quoting at Rs.153 and you expect the stock to touch Rs.170 at best in March 2020. You can create bull call spread by buying 150 March call option at Rs.12 and selling 170 call option at Rs.5. Your net cost of Rs.7 (12-5) will be the maximum loss on this strategy. Maximum profit on this strategy will be made at Rs.170. Beyond that, whatever you make on the 150 call, you lose on the 170 call. Hence, this strategy should only be used when you are moderately bullish.

Long strangle strategy

Normally, Infosys is very volatile on the day of the results but it has generally been hard to estimate the direction. Here, you can use volatile strategy like a Long Strangle. It entails buying a higher strike call and a lower strike put on the same stock. For example if you are expecting major volatility in Infy next month, you can create a Strangle by buying 820 March call at Rs.12 and also an 800 March put at Rs.16. Total cost of the Strangle and also maximum loss will  be Rs.28 (16+12). You will be profitable above 848 (820+28) or below 772 (800-28). This is a high cost strategy so you must only use it when you are confident of a large move either ways.

Go ahead and make the best of these options strategies. You can manage your risk and your returns better.

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Beginner's Corner

Top 5 Options Trading Strategies

06 Mar 2020

Options strategies combine different stock market positions with a view to managing risk or enhancing returns. Why are options unique? Unlike futures, options are asymmetric. For example, when one person buys futures and another sells futures, the risk of price fluctuation is equal for both. However, in an option the buyer has limited risk and unlimited return potential while the seller has unlimited risk potential and limited returns. This makes options strategies possible. Here are five popular options strategies.

Protective Put strategy

If you bought Reliance Industries at Rs.1485, how do you protect from a price fall. Create a protective put strategy by purchasing a put option of lower strike. So you can buy a 1480 strike put option at Rs.8. A put option is a right to sell and the premium is a sunk cost. If the price goes above Rs.1493 (1485 + 8), you profits are unlimited. On the downside, your maximum loss is cannot exceed Rs.13 {(1485-1480) + 8}. In short, you limit your loss by paying a small premium of Rs.8.

Covered Call strategy

A covered call strategy is normally used when you want to reduce the cost of holding a stock. If you bought SBI at Rs.340 for long term, but the stock falls to Rs.328; what do you do?. You are confident of the long term prospects of SBI, but in the next 3 months you don’t expect the stock to cross Rs.350. You can start by selling the near month 350 call at Rs.20 and repeat for 3 months. Here is how the returns table will look like.

Details

First Month

Second Month

Third Month

SBI 350 call sold at

Rs.20

Rs.21

Rs.20

Position closed at

Rs.5

Rs.25

Rs.4

Net Profit / Loss

Rs.15

Rs.(-5)

Rs.16

You have booked a net profit of Rs.26 on SBI calls in 3 months. At the end of 3 months, your effective cost of holding SBI has come down to Rs.314 (340 – 26). The only risk is if the stock falls sharply, you don’t have protection on the downside. That is where a butterfly comes in.

Butterfly strategy

Butterfly combines a protective put and covered call. Here, the premium received on the higher call sold, reduces the net cost of the put option purchased. This increases chances of profits. Butterfly is a multi-leg transaction, so watch out for transaction costs.

Bull call spread strategy

This option strategy is generally used when you are moderately bullish on a stock. You buy a call option of a lower strike and sell the call option of the same stock of a higher strike. For example, Tata Motors is currently quoting at Rs.153 and you expect the stock to touch Rs.170 at best in March 2020. You can create bull call spread by buying 150 March call option at Rs.12 and selling 170 call option at Rs.5. Your net cost of Rs.7 (12-5) will be the maximum loss on this strategy. Maximum profit on this strategy will be made at Rs.170. Beyond that, whatever you make on the 150 call, you lose on the 170 call. Hence, this strategy should only be used when you are moderately bullish.

Long strangle strategy

Normally, Infosys is very volatile on the day of the results but it has generally been hard to estimate the direction. Here, you can use volatile strategy like a Long Strangle. It entails buying a higher strike call and a lower strike put on the same stock. For example if you are expecting major volatility in Infy next month, you can create a Strangle by buying 820 March call at Rs.12 and also an 800 March put at Rs.16. Total cost of the Strangle and also maximum loss will  be Rs.28 (16+12). You will be profitable above 848 (820+28) or below 772 (800-28). This is a high cost strategy so you must only use it when you are confident of a large move either ways.

Go ahead and make the best of these options strategies. You can manage your risk and your returns better.