Option Trading Strategies : Part One

Option trading is really fun if you apply it properly.  Yeah, it’s really tough to follow that last word of the previous sentence. :- ) But let’s find some way to make is easier. Nifty and Sensex has recovered approximately 80% from its low. So the trend is bullish!! Let’s start with bullish option strategies. Some very fine bullish strategies are available which we can use to minimise our risk and to maximise profit, of course they have some assumptions and the most important thing here is to apply right strategy at right time! For that, we have professional advisors. But this article will help you to understand what is he applying and why is he applying that particular strategy at particular time. The motive behind writing this article is to spread “Option trading awareness “, it does not mean you should leave you financial advisor, but yeah this article will give you enough knowledge to have an debate with your financial advisor and to find out best option strategy in bullish trend . I strongly believe, for consistency in performance one should have financial advisor in stock exchange. Ok… enough lecture!! Let’s come to the point now. I am here to write something about option strategies. Well, I don’t have any shame in saying that I m new in option trading, and i think i can understand problem faces by new trader in option trading very well so trying my best to explain option strategies in easy language. No need for any technical language. Don’t make things complicated. We will explain it in some part.(may be more than 10) !! So it’s gonna be long journey…! stay with me  and enjoy the ride.

Bullish Trend: Option Strategies: Part I

When trader is expecting some up move in security or stock he can apply bullish strategies. He should be careful with his calculation about the degree of up move and time frame for the same. Again i would suggest please refer your financial advisor before applying any option strategy practically in your trading account.

Note:

In following article…

Lot size is 100 for any trade so that we can calculate it and compare it easily.

OTM = out of money option

ATM=at the money option

ITM=at the money option

 To know more about these terms you should read the 1st basic article on option trading. I have posted the same article on this website earlier. Please stay with us for more detailed study on option trading. Your comments, suggestions will be fuel for my future articles.

Refer this link before you start. It will help you to understand option strategy better.

http://bizcovering.com/investing/derivative-option-trading-basic/

Bull Calendar or Horizontal Spread

Strategy :

Sell 1 Near-Term OTM Option Call
Buy 1 Long-Term OTM Option Call

Strike price: same

Expiry date: different

The options trader applying this strategy is very bullish for the long term and he is selling the near month expiry calls with the intention to enjoy the long term calls for free. So if you like to have bullish view and you are more comfortable with bullish trades you can be more comfortable with this strategy too. Try this…! and yes one more thing… please don’t be so serious when you read the article.   It is profit giving strategies and one should smile while reading. So smile!! Ok… that’s enough. No over acting please !!

Unlimited profit:

Once the near month options expire worthless, this strategy turns into a discounted long option call strategy.  So the upside profit potential for the bull calendar spread becomes unlimited. Reason to smile again with unlimited profit and limited risk. But remember professional guidance is must for any option trade.

Limited Risk:

Risk in this strategy is same as the investment. If stock price goes down and stays down till expiry day of the longer term expiry call.

Let’s do it practically:

If in month of June, a trader calculates that ABC stock trading at Rs.40 is going to rise gradually over the next 3  months. He enters a bull calendar spread by buying an OCT 45 OTM call for Rs.200 and writing a JUL 45 OTM call for Rs.100. The net investment required to put on the spread is a debit of Rs.100.

In month July, The stock price of ABC goes up to Rs.42 and the JUL 45 call expires worthless. Subsequently, the price of ABC stock rises to Rs.49 in October. The OCT 45 call expires in the money and is worth Rs.400 on expiration. Since the initial debit was Rs.100, his profit comes to Rs.300.In case the price of ABC remains at or below Rs.45 all the way until expiration of the long term option call in October, the option trader will lose the initial investment of Rs.100 as both calls expire at rate zero.

So you got the point? Don’t worry you can read it again. Its very simple. But i would say do not leave this example until you understand it 100%.

Bull Call Spread

Strategy :

Sell 1 OTM Option Call
Buy 1 ITM Option Call

Strike price: different

Expiry date: same

The options trader applies this strategy is bullish for near term. Instead of buying ITM he can buy ATM too.

(Try to understand one simple thing, when you learn option trading from someone else they may give you one patterned trade, but in option trading … or i would say in stock exchange there is not rule. You can trade the same logic of option trading in different security and can trade it differently. But this strategy can help you to understand the basic. !! )

When OTM is shorted the risk of trader on this trade of buying ITM option calls, is reduced by the trader, but at the same time the profit of the trade will be reduced to one level.

Limited profits:

Maximum gain is possible for the bull call spread this strategy when the stock price moves above the higher strike price of the two calls and it is equal to difference between the strike prices of the two call options minus the initial investment to enter the position.

Calculating maximum profit:

1.        Max Profit = Strike Price of Short Call – Strike Price of Long Call – Net Premium Paid – Brokerage Paid

2.        Max Profit Achieved Price of Underlying is more than Strike Price of Short Call

Limited risk:

The bull call spread strategy will result in a loss if the stock price goes down at expiry date. Maximum loss cannot be more than the initial investment to enter the call spread position.

Calculating maximum loss:

1. Max Loss = Net Premium Paid + Commissions Paid
2. Max Loss Occurs When Price of Underlying is lesser Strike Price of Long Call

Breakeven Point(s):

When strike price of long call and net premium is calculated we can get break even point.

1. Breakeven Point = Strike Price of Long Call + Net Premium Paid

Let’s do it practically:

A trader calculates that ABC stock trading at Rs.42 will go up and enters a bull call spread and buying a JUL 40 call for Rs.300 and writing a JUL 45 call for Rs.100. The net investment is Rs.200.

The stock price of ABC closes at Rs.46 on expiry date. Both options expire in-the-money with the JUL 40 call having an intrinsic value of Rs.600 and the JUL 45 call having an intrinsic value of Rs.100. This means that the spread is now Rs.500 at expiry date. The trader had a debit of Rs.200 when he traded the spread, his net profit is Rs.300.

If in any case the price of ABC had gone to Rs.36, both options expire worthless. The option trader will lose his investment of Rs.200.

It was very clear I guess. But I would say one should try this pattern on paper for some days and one should track the accuracy of the trade with his or her personal mental state of mind when trade goes against calculation. Do not jump on any trade without professional guidance. This is my personal view. Rest, your wish!

Bull Put Spread

Strategy :

Sell 1 ITM Option Put
Buy 1 OTM Option Put

Strike price: different

Expiry date: same

The bull put spread option trading strategy can be used when the options trader thinks that the price of the stock or security will go up side in short term. Bull put spreads can be traded by selling a higher strike price ITM put and buying a lower strike price OTM put.

Limited Profit:

If the stock price ends above the strike price on expiry date, both options expire worthless and the bull put spread option strategy earns the maximum profit which is equal to the credit investment made to write the put, when entering the option trade.

Calculating maximum profit:

1. Max Profit = Net Premium Received – Brokerage Paid
2. Max Profit Achieved When Price of security greater than Strike Price of Short option Put

Limited Risk:

If the stock price drops below the lower strike price on expiration date, then the bull put spread strategy incurs a maximum loss equal to the difference between the strike prices of the two puts minus the net credit received when putting on the trade.

The formula for calculating maximum loss is given below:

1. Max Loss = Strike Price of Short option Put – Strike Price of Long option Put Net Premium Received + brokerage
2. Max Loss Occurs When Price of security traded is lower than Strike Price of Long option Put

Breakeven Point(s):

The stock price at which break-even is achieved for the bull put spread position formulae.

Breakeven Point = Strike Price of Short option Put – Net Premium Received

Let’s do it practically:

A trader calculates that ABC stock trading at Rs.43 is going to rally soon and enters a bull put spread option trade by buying a JUL 40 put for Rs.100 and writing a JUL 45 put for Rs.300. Thus, the trader receives credit of Rs.200 when entering the spread trade.

The stock of ABC goes as per expectation and closes at Rs.46 on expiry date. Both options expire at zero and the options trader keeps the entire credit of Rs.200 as profit, this is maximum profit he can get.

If the price of ABC had declined to Rs.38 instead, both options expire ITM with the JUL 40 call will have an intrinsic value Rs.200 and the JUL 45 call will have intrinsic value of Rs.700. This means that the spread is now worth Rs.500 at expiration. But at time of initiating trade the trader had received a credit of Rs.200, so his net loss comes to Rs.300. it is the maximum loss a trader can do in this trade.

Ok guys… Enough for this part I. Now try to understand all above strategies for some time. After that we will go further. Ifyou like this article you can give your comment below. If you don’t write , then also it won’t make any difference. ! kidding ! smile and spread the same. We will catch you soon with part II. Yes i promise, it won’t take lesser time than it took between  terminator and terminator II.

 

As usual…

time to say ..

ASTALAVISTA !!