Learn some more Option Trading Strategies. No technical knowledge is needed. This article will explain logic behind the option trading strategies. It will explain how do strategies work. Its an art. This is the 3rd article published in option series articles. It is recommended you should read our first two articles published before. Links were given below.

This is the 3rd article published in option series articles. It is recommended  you should read our first two articles published before. Link of the article is given below.

Article 1: Option trading basic: http://bizcovering.com/investing/derivative-option-trading-basic/

Article 2: Option strategies Part one: http://bizcovering.com/investing/derivative-option-trading-basic/

Note:

In following article we will follow some assumptions.

Lot size is 100 for any trade so that calculation can be easier.

OTM = out of money option

ATM=at the money option

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ITM=at the money option

Before beginning of this article I would like to request readers, please do not forget to give your valuable comment below this article. Your comment will be good motivational input for next article on option trading strategies.

Let’s begin with the Option strategy Part II.

Call Backspread Strategy

Strategy:

Sell 1 ITM Option Call
Buy 1 OTM Option Call

Strike price: different

Expiry date: same

This strategy can be used when the option trader thinks the stock/security price will enjoy significant up move in coming days. He will sell 1 in the money call option and buy 2 out of money call option. This strategy will give unlimited profit and limited loss if the stock moves upside as assumed.

Unlimited Profit :

This trade will start giving profit as soon as the price of the security goes above upper breakeven point (we will have 2 breakeven points in this strategy). Sky is the limit for proft from this trade if the stock moves up side significantly.

  1. Profit Achieved When Price of stock >=  2 x Strike Price of Long Call option- Strike Price of Short Call option +/- Net Premium Paid/Received
  2. Profit = Price of stock – Strike Price of Long Call option – Max Loss possible

Limited Risk:

In this trading strategy maximum loss is limited. If the traded security closes at the strike price of the long call, both the calls will expire worthless and short call will expire in the money. Maximum loss is equal to the intrinsic value of the short call and net premium paid.

1.     Max Loss = Strike Price of Long Call option – Strike Price of Short Call option +/- Net Premium Paid or Received + Commissions Paid

Breakeven Point(s):

There are 2 break-even points in this strategy. The breakeven points can be calculated using the following formulae.

  1. Upper Breakeven Point = Strike Price of Long Call  option + Points of Maximum Loss
  2. Lower Breakeven Point = Strike Price of Short Call option

Let’s do it practically:

Suppose ABC stock last traded price is Rs.43 in June. A trader executes a 2:1 call back spread. He is selling a JUL 40 call option for Rs.400 and buying 2 lot of JUL 45 call options for Rs.200 each. The net debit/credit taken to enter the trade is 0.

On expiry date in July, if ABC stock is trading at Rs.45, both the JUL 45 calls expire worthless. At the same time the short JUL 40 call expires in the money with Rs.500. To close the position will result in the maximum loss of Rs.500 for the trader in case ABC stock rallies and is trading at Rs.50 on expiry day as expected, in July, all the options will expire in the money. The short JUL 40 call is worth Rs.1000 and needs to be bought. Since the two JUL 45 call bought is now in the money and price of both is worth Rs.500 each, their combined value of Rs.1000 to offset the losses from the written call. Therefore, he achieves breakeven at Rs.50. Above Rs.50, there will be no limit to the possible profit. For example, at Rs.60, each long JUL 45 call will be worth Rs.1500 while his single short JUL 40 call is only worth Rs.2000, result: profit of Rs.1000.

If the stock price falls to Rs.40 or below on expiry date, all the options involved will expire worthless. As the net debit to put on this trade was 0, there is no resulting loss.

The Collar Strategy

Strategy:

Long 100 Shares
Sell 1 OTM Call option
Buy 1 OTM Put option

Strike price: different

Expiry date: same

In collar strategy, trader will hold one lot of shares and simultaneously he will buy protective puts and he will sell call option against that holding. In this strategy put and call options will be out of money option trades. They will have same number of contracts and same expiry date. This strategy will save trader from sharp drop in price of the stock.

Most amazing thing about collar strategy is that you know, from beginning of the trade, the potential losses and gains on a trade. Your returns are likely to be somewhat fixed in a bull market due to selling the call, but at the same time, if your stock heads south, you’ll have full protection in your trade.

Limited Profit:

The formula for calculating maximum profit is given below:

  1. Max Profit = Strike Price of Short Call option – Purchase Price of stock + Net Premium Received – Commissions Paid

2.     Max Profit Achieved When Price of stock >= Strike Price of Short Call option

Limited Risk:

The formula for calculating maximum loss is given below:

  1. Max Loss = Purchase Price of stock- Strike Price of Long Put option – Net Premium Received + Commissions Paid
  2. Max Loss Occurs When Price of stock <= Strike Price of Long Put option

Breakeven Point(s):

The underlier price at which break-even is achieved for the collar strategy position can be calculated using the following formula.

Breakeven Point = Purchase Price of Underlying + Net Premium Paid

Let’s do it practically:

If trader is holding 100 shares of the stock ABC currently trading at Rs.48 in June. He decides to establish a collar by writing a JUL 50 call option for Rs.2 while simultaneously buying a JUL 45 put option for Rs.1. Since he pays Rs.4800 for the 100 shares of ABC, another Rs.100 for the put option but he gets Rs.200 for selling the call option, his total investment is Rs.4700.

On expiry day, the stock had blasted upside by 5 Rs to Rs.53. Since the striking price of Rs.50 for the call option is lower than the trading price of the stock, the call option is assigned and the trader sells the shares for Rs.5000, resulting in a Rs.300 profit (Rs.5000 minus Rs.4700 his investment). Now look at other side. If the stock goes down and on expiry if it is trading at Rs.43, the call writer would have had incurred loss of Rs.500 on paper for holding the 100 shares of ABC but ,as he is trading collar trade he is holding option of the JUL 45 protective put, he is enjoying right to sell his shares for Rs.4500 instead of Rs.4300. So his net loss is limited to only Rs.200 (Rs.4500 minus Rs.4700 his investment). Thus he is enjoying the rights both side. In case the stock price is not moving due to any reason, and it is at 48 only, in this case he can sell the stock for 4800 and get 100 Rs profit, because his cost is only 4700.

Option trading is play with numbers. If one can use this properly, stock market can be the best market to earn easy money. But one should always remember that there is no short cut. To master option trading one has to word hard on it. Please take advice from your financial advisor before trading in options. You can contact me anytime for your query. My email id and phone number is given in my profile. Please study the above strategy carefully and stay in touch. I will come back soon with some new strategies on option trading soon.

Till then… with your permission i would like to say…

“Astalavista”!!