Chapter 4 b

Option Trading strategies

1
 Option Strategy
●Option strategies are the simultaneous, and often mixed, buying or
●selling of one or more options that differ in one or more of the

● options' variables.

●This is often done to gain exposure to a specific type of opportunity

●or risk while eliminating other risks as part of a trading strategy.

● A very straight forward strategy might simply be the buying or selling

● of a single option, however option strategies often refer to a

●combination of simultaneous buying and or selling of options.

2
 Option Strategy
Options strategies allow to profit from movements in the underlying
that are bullish, bearish or neutral.

In the case of neutral strategies, they can be further classified into

those that are bullish on volatility and those that are bearish on volatility.

The option positions used can be long and/or short positions in call

1 Bullish
2 Bearish
3 Neutral or non directional
4 Volatility based
5 Directional

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 A Bullish strategies
Bullish options strategies are employed when the options trader
●

expects the underlying stock price to move upwards.

●It is necessary to assess how high the stock price can go and the
time frame in which the rally will occur in order to select the
optimum trading strategy.
The most bullish of options trading strategies is the simple call
●

buying strategy used by most options traders.

Stocks seldom go up by leaps and bounds. Moderately bullish
●

options traders usually set a target price for the bull run and utilize
bull spreads to reduce cost.
●(It does not reduce risk because the options can still expire
worthless.)
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 Bullish strategies
They usually cost less to employ for a given nominal amount of
●

exposure.
The bull call spread and the bull put spread are common examples of
●

moderately bullish strategies.

Mildly bullish trading strategies are options strategies that make money
●

as long as the underlying stock price does not go down by the option's
expiration date.
● These strategies may provide a small downside protection as well.
●Writing out-of-the-money covered calls is a good example of such a
strategy.

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 B. Bearish Strategies
Bearish options strategies are employed when the options trader
●

expects the underlying stock price to move downwards.

●It is necessary to assess how low the stock price can go and
the time frame in which the decline will happen in order to
select the optimum trading strategy.
The most bearish of options trading strategies is the simple put
●

buying strategy utilized by most options traders.

Stock prices only occasionally make steep downward moves.
●

●Moderately bearish options traders usually set a target price for

the expected decline and utilize bear spreads to reduce cost.

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 Bearish strategies
The bear call spread and the bear put spread are common
●

examples of moderately bearish strategies.

Mildly bearish trading strategies are options strategies that make
●

money as long as the underlying stock price does not go up by the

options expiration date.
These strategies may provide a small upside protection as well.
●

● In general, bearish strategies yield less profit with less risk of loss.

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 C Neutral or non directional strategies

●Neutral strategies in options trading are employed when

the options trader does not know whether the underlying
stock price will rise or fall.
Also known as non-directional strategies, they are so
●

named because the potential to profit does not depend

on whether the underlying stock price will go upwards.
Rather, the correct neutral strategy to employ depends
●

on the expected volatility of the underlying stock price.

● Eg Collar
● Butterfly
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 D Volatility based strategies
●The higher the volatility level for a given stock or futures market,
the more time premium there will be in the prices for the options of
that stock or futures market.
Conversely, the lower the volatility the lower the time premium.
●

●Thus if you are buying options, ideally you would like to do so

when volatility is low which will result in paying relatively less for an
option than if volatility were high.
●Conversely, if you are writing options you will generally want to do
so when volatility is high in order maximize the amount of time
premium you receive.

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 examples

● Straddle
● Strangle
● Calendar spread

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 E Directional Strategies

Trading strategies based on the investor’s assessment of the

●

broad market or a specific security’s direction.

Directional trading can mean a basic strategy of going long if the
●

market or security is perceived as heading higher, or taking short

positions if the direction is downward.
●However, the term is more widely used in connection with options
trading, since a number of strategies can be used to capitalize on a
move higher or lower in the broad market or a particular stock.
● While directional trading requires the trader to have a strong
conviction about the market or security’s near-term direction, the
trader also needs to have a risk mitigation strategy in place to
protect investment capital in the event of a move to the opposite
direction. 11
 E Directional Strategies

● Call
● Put
● Bull call
● Spread

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 Strategies 1. Straddle
1 Straddle
An option strategy comprised of a long(buy) call and a long put,
having the same strike price and the same expiry date.
This strategy is used when a stock's price is expected to
fluctuate considerably in either direction. Use when volatility is very

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Straddle
A person buys simultaneously a call and a put option on
ICICI Ltd. for the same expiration date and strike price ie Rs 80.
He pays Rs 5 for the call and Rs 4 for the put. There is a large
move in the stock price expected in the future. Recognize the
strategy and create a payoff.

pg- 119

Long call long put

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 Short straddle
A trader should adopt this strategy when he expects less volatility in
the near future.

Here, a trader will sell one Call Option & one Put Option of the same
strike price, same expiry date and of the same underlying asset.

If the stock/index hovers around the same levels then both the options
will expire worthless and the option writer (i.e. trader) will get the premium

However this is a very risky strategy.

If the price moves up or down sharply then the losses will be significant
for the option writer (trader).
So this strategy should be implemented only if you are ready to take
calculated risk i.e. it should be precisely quantified.

Risk: Unlimited Reward: Limited 15

Suppose NIFTY is trading around 5200 levels, Mr. X does not expect
the market to move sharply in the near future and implements a
Short Straddle Strategy. He will sell one 5200 Call Option for a
premium of Rs. 100 & sell one 5200 Put Option for a premium
of Rs. 80. Lot size of NIFTY is 50.

His account will get credited by Rs. 9000. [(100+80)*50]

Short call, short put

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 2. Strangle

2 Strangle
An option strategy comprised of a long put and a long call with
the same expiry date and underlying asset where the call
strike price is greater than the put strike price 17
2 Strangle
A person buys a put and a call option for Rs 8 and Rs 6 respectively.
The strike prices were Rs 220 and Rs 230, respectively.
The maturity date is same for both options. The person feels
that there will be large movement in SBI stocks, but is not very sure in
which direction. Recognize the strategy and create the payoff.

Long call, long put

Refer pg – 121.

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 3 Collar
A protective options strategy that is implemented after a long position in a
stock has experienced substantial gains. The strategy is used mainly
to "protect" the gains on the asset, rather than to earn excess profits.
By entering into a collar, the puts protect the investor from a decrease
in stock prices, while the out of the money calls allow the investor to
earn a bit more profit.

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Suppose stock XYZ is trading at $40 a share on January 1. You want to invest 1000 $ in the
stock, but you’re worried that the market could tank within the next couple of months and take
XYZ down with it. You decide March 20 is far enough into the future to protect you from
the imminent market decline you’re worried about.
You also decide that if you could sell XYZ for $50 between now and March 20, you’d be happy
with that gain; but you don’t want to have to sell XYZ for any less than $30 over that time period.
So, buy 100 shares of XYZ at $40; sell one March call option on XYZ with a strike price
of $50; and buy one March put option with a strike price of $30.
Recognize the strategy and create a payoff.
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Stock, call , put
 4 Butterfly

A butterfly is a limited risk, non-directional options strategy that is

designed to have a large probability of earning a limited profit when
the future volatility of the underlying asset is expected to be lower

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 A person buys two call options on shares of Hindustan Lever Ltd for
Rs 18 and Rs 14 at strike prices of RS 194 and Rs 206 respectively. He
also sells two call options for Rs 15 at a strike price of Rs 200. All
options are of same maturity date. The maximum profit will be Rs 4 at a
share price of Rs 200 and he has limited loss to 2. Recognize strategy,
create a payoff.
Sol Refer pg 112
The person does not expect the stock price to move significantly
and goes for this strategy. The
person has limited his loss
to Rs 2. He will make a profit if
the price of HLL at maturity of
the option is between Rs 194
and Rs 206. The maximum
profit will be Rs 4 at a share
price of Rs 200.

Two calls...same maturity

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 5 Bullish Put Spread

A vertical spread is a position consisting of the purchase of

an option and the sale of another option on the same
underlying security with a different strike price or
expiration date. Most basic of option trading strategy

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A person buys a put option for ITC Ltd at a strike price of Rs 745 and pays a
premium of Rs 50 and at the same time sells a put option for ITC at a strike
price of Rs 760 at a premium of Rs 55. Both the options have same maturity.
The person thinks the share price of ITC is going to increase by the time the
options mature. He has limited his downside risk to Rs 10. The maximum overall
profit he can make is Rs 5. Recognize the strategy and create a payoff.

Pg 107

Solution

He makes a profit if the spot price at

maturity is more than Rs 755 and loss
if it is less than this price.

Buy put, sell put same time

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6 Vertical Bullish Call Spread

A person buys a call option and sells a

call option of M& M at the same time. The
strike price of the sold call is Rs 115 and
of the bought call is 110. The person has
limited his risk to Rs 2 and the over all
profit to Rs 3. He makes a profit if the
spot price is more than 112. Draw a
payoff.
●Pg 106
●Buy call and sell call at same time

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 7 Calender Spread

The profit and loss lines are

●

not straight.
●That’s because the back-
month put is still open when
the front-month put expires.
Straight lines and hard
●

angles usually indicate that

all options in the strategy
have the same expiration
date. 27
●A person sells an HDFC bank August 2019 call option for Rs 8 at
strike price of Rs 230. At the same time , he buys an HDFC bank
September 2019 call option for Rs 10 at the same strike price.
●When the August 2019 call option matures, the September 2019
call option is sold in the market. The strategy is used when not too
much movement is expected in the stock market.
The person will make a profit if the stock price is between Rs 225
●

and Rs 249. The maximum profit is Rs 4.75 at a stock price of Rs

240 . Create a payoff.

Pg 117
●

Different strike rates, different spot rates

●

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 8 Strategies- Bearish vertical call
spread

Suppose XYZ stock is trading at $37 in June. An options trader bearish

on XYZ decides to enter a bear call spread position by buying a JUL 40
call for $100 and selling a JUL 35 call for $300 at the same time,
giving him a net $200 credit for entering this trade. 30
 9 Covered call
A covered call is when the investor has a long position in an asset
combined with a short position in a call option on the same
underlying asset.
●There is no margin requirement for a covered call; this is because
the underlying securities are sitting right there - there is no
question of creditworthiness.

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 Covered call
Mr Rajiv has bought -

-an underlying stock XYZ at Rs 20 -

he intends to Sell a Call option at
Strike Price similar to Price of Stock
, that is, Rs 20
- Premium of Rs 6.90.
- The maximum loss is considered
to be 20 - 6.90 = 13.10
Create a payoff.

Stock + Call

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 10 Protective put

ABC stock trades for $75 and its one-month Rs 70 puts trade for $3. The
●

premium $300 premium. Such a trader expects the price of ABC to trade
above Rs 67 in the coming month. Draw a payoff. ( stock + put)

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11&12 Short call/put ladder

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●Suppose XYZ stock is trading at $35 in June. An options trader
executes a short call ladder strategy by selling a JUL 30 call for
$600, buying a JUL 35 call for $200 and a JUL 40 call for $100.
Initial credit is 300$. Max loss expected is 200$.Create a payoff.

Short call ladder= sell 1 call, buy 2 call

●

Short put ladder= sell put, buy 2 put

●

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13 &14 long call/put ladder

Buy one call+ sell 2 call

buy one put+ sell 2 put

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 15Condor
Condor
● Sell 1 ITM Call 40
● Buy 1 ITM Call (Lower Strike) 35
● Sell 1 OTM Call 50
● Buy 1 OTM Call (Higher Strike) 55

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●The condor option strategy is a limited risk, non-directional option
trading strategy that is structured to earn a limited profit when the
underlying security is perceived to have little volatility.
●Suppose XYZ stock is trading at $45 in June. An options trader
enters a trade by buying a JUL 35 call for $1100, writing a JUL 40
call for $700, writing another JUL 50 call for $200 and buying
another JUL 55 call for $100. The net debit required to enter the
trade is $300, which is also his maximum possible loss. The Max
profit is expected to be 200.

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 16 Strips
● Buy 1 ATM Call
● Buy 2 ATM Puts

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●Suppose XYZ stock is trading at 40 in June. An
options trader implements a strip by buying two
JUL 40 puts for 400 and a JUL 40 call for 200. The
net debit taken to enter the trade is 600, which is
also his maximum possible loss. Between the spot
prices of Rs 37 and Rs 48 there is the loss
potential. Create a payoff.

40
17 Straps

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18 ratio spread
The ratio spread is a neutral strategy in options trading that involves buying a number
of options and selling more options of the same underlying stock and expiration date at
a different strike price. It is a limited profit, unlimited risk options trading strategy that is
taken when the options trader thinks that the underlying stock will experience little
volatility in the near term.

Buy 1 ITM Call

Sell 2 OTM Calls
● Buy 2 ATM Calls
● Buy 1 ATM Put
●Suppose XYZ stock is trading at $40 in June. An
options trader implements a strap by buying two
JUL 40 calls for $400 and a JUL 40 put for $200.
The net debit taken to enter the trade is $600,
which is also his maximum possible loss, between
range of 34 and 45 is loss potential .

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 Option Sum 1
Growell Ltd is considering buying the following call and
put options on December 15, 2019. Find the intrinsic and
time value of the options.
● Stock Infosys
● Spot Price Rs 4000

45
 Sum
Jan 2020 Call Premium Jan 2020 Put premium
● Strike Price Premium Strike Price Premium
● 3900 120 4100 125
● 4000 35 4000 40
● 4100 5 3900 10

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 Solution- Intrinsic value
Intrinsic value
Call spot -strike
● 3900( spot)-4000(strike)= -100 or 0
● 4000- 4000 = 0
● 4100-4000 =100 Rs
● Put = strike-spot
● 4000-3900= 100
● 4000-4000=0
● 4000-4100=-100 or 0 47
 Synthetic Options

Synthetic option positions, or 'synthetics', are constructed in such a manner as

to have the identical risk/reward 'profile' of, what is called, its 'equivalent' position.

Every 'position' has an 'equivalent position'.

Market Makers use them all the time in their daily market-making functions.

For example, a 'synthetic' Call option has the same profile as a 'regular' Call option
(its equivalent) without using any Call options in its construction..

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● 'Morphing' is trading at maximum efficiency
●Morphing is not turning a 'losing' position into a
'winning' position. Morphing is creating an entirely
new position with a single stroke. If it takes more
than one move, it's not morphing.

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● The six basic types of synthetic option positions are:
● (1) Long Stock = Long Call + *Corresponding Short Put.
● (2) Short Stock = Short Call + *Corresponding Long Put.
● (3) Long Call = Long Stock + Long Put.
●(4) Short Call = Short Stock + Short Put (also known as
'Covered Put').
● (5) Long Put = Short Stock + Long Call.
●(6) Short Put = Long Stock + Short Call (also known as
'Covered Call')
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 1. Synthetic long stock
The synthetic long stock is an options strategy used to simulate the
payoff of a long stock position.

A synthetic call or put mimics the unlimited profit potential and limited loss
of a regular put or call option without the restriction of having to pick a strike p

At the same time, the synthetic positions are able to curb the unlimited
risk that a cash or futures position has when traded by itself.

A synthetic option essentially has the ability to give traders the best of both
worlds, while diminishing some of the pain.

While synthetic options have many superior qualities compared to

regular options, that doesn't mean that they don't come with their
own set of problems.
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 Synthetic long stock

+ =
Short Synthetic
Long
put long stock
Call
52
 2 Synthetic short stock

+ =
Short Synthetic
Long
call short
put
stock
53
 Synthetic long call option

=
Long
Long Synthetic
stock
put Long call
54
 4 Synthetic short call

short short Synthetic

stock put short call

55
 5 Synthetic long put

short Long Synthetic

stock call long put
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Unlimited Profit Potential
The formula for calculating profit is given below:

Maximum Profit = Unlimited

Profit Achieved When Price of Underlying < Sale Price of Underlying - Premium Paid
Profit = Sale Price of Underlying - Price of Underlying - Premium Paid

The formula for calculating maximum loss is given below:

Max Loss = Premium Paid + Commissions Paid

Max Loss Occurs When Price of Underlying = Strike Price of Long Call
57
 6 Synthetic short put

long Short Synthetic

stock call short put
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