October 15, 2013

This blog is an extension of our previous blog on “Getting Around The Options”

Trading in options is for more advanced investors which help them to leverage assets and manage some of the risks inbuilt in trading in the market. With options, one can make profit whether stocks are going up, down, or sideways. Options can be used to minimize losses, lock gains, and trade in large quantity of stock with a small cash outlay.

Options are traded by designing various strategies depending on the direction of the market. Also, as discussed in my earlier post, before trading options, it’s essential to gauge the effects volatility and time decay will have on your strategy.

**Option Strategies**

Option strategies involves buying and/or selling of one or more options that differ in one or more of the options’ variables such as time to expiration and expiration price.

Options strategies allow traders and investors to profit from movements in the underlying asset. The trader can use bullish, bearish or neutral strategies to corresponding upward, downward, or sideways movements in underlying asset. Neutral strategies can be further classified based on Bullishness or bearishness of volatility of underlying.

- Bullish strategies
- Bearish strategies
- Neutral or non-directional strategies
- Bullish on volatility
- Bearish on volatility

Be aware that “Options are not All Gold”. It needs an accurate and learned anticipation to think of and implement a strategy. They can get complicated and risky with involvement of too many variables such as Time, expiration, more than one underlying etc. Some strategies may expose you to theoretically unlimited losses.

**Spreads**

A spread is a strategy in which one buy one option and sell another that is identical to the first in all respects except either exercise price or time to expiration. The term spread is used here because the payoff is based on the difference, or spread between option exercise prices.

__Time Spread__

If the options differ by time to expiration, the spread is called time spread. Time spreads are strategies designed to exploit differences in perceptions of volatility of the underlying.

__Money Spreads__

Our focus is on money spreads in which two options differ only by exercise price. The investor buys an option with a given expiration and exercise price and sells an option with same expiration but different exercise price.

Now we are going to discuss few of the commonly used strategies across the globe while trading in the options. We will start with Risk management strategies and then discuss some Bullish strategies, Bearish strategies, and Neutral or non-directional strategies.

**Payoff vs. Profit**

Payoff is the increase in the value of the option.

Premium paid to buy the options is also deducted while calculating Profit.

**Risk Management Strategies with options and underlying**

These are strategies wherein investor sells or buys an option along with buying an underlying to safeguard the profit or minimize the losses in case of decline in the value of underlying.

**Covered Call****Protective Put or Married Put**

__Covered Call__

When the investor owns an asset and he is neutral or moderately bullish on stock in short term, he can sell a Call option to generate additional returns on the stock. This strategy is called as a Covered Call strategy because the Call sold is backed by a stock owned by the Call Seller (investor). The income increases as the stock rises, but gets capped after the stock reaches the strike price.

In this strategy, one would purchase the underlying asset, and simultaneously write (or sell) a call option on those same assets. This strategy is generally used when Investors have short-term position and a neutral opinion on the assets, and are looking to generate additional profits (through receipt of the call premium), or protect against a potential decline in the underlying asset’s value.

Let us try to understand Covered Call using Payoff Diagram.

- Buy underlying security XYZ at $20
- Sell Call option X at Strike Price similar to Price of Stock, that is, $20 for a Premium of $6.90.

If the Stock Price moves below $20, the maximum loss would be:

**$20 – $6.90 = $13.10**

which is less than the loss of $ 20 which would have occurred if no call has been sold. On the other hand if the Stock moves beyond $20 which is strike price of Call Option, the maximum profit is $6.90, which is premium received from selling the call. All the gain in the stock is given up by rising value of Call Option.

__Protective Put/Married Put__

Here an investor purchases the underlying security and a put option for an equivalent number of shares. This is implemented when investor anticipates positive movement in stock prices or is Bullish. To guard himself against short term losses or abrupt adverse movements he buys a Put option which will lessen the loss if stock plummets.

The Put Option here acts as insurance to the declining value of stock. The Payoff here is same as the Long Call. Therefore, this strategy is also known as synthetic long call spread.

Using a Covered Call strategy trader can limit the loss in case of fall in market but the potential profit is also capped.

Let us try to understand Protective Put using Payoff Diagram.

- Buy Underlying security XYZ at $20
- Buy Put option X at Strike Price similar to Price of Stock , that is, $20 for a Price of $5.

Now when the stock moves beyond $ 20, **the profit is unlimited**. However, $5 paid to purchase put option is lost.

If the stock moves below $20, loss incurred in stock will be made good by the increase in the value of the Put option purchased. Thus the **maximum loss will be $5**, that is, the price of the Put option.

**Strategies for trading options**

*Bullish option strategies*

Bullish options strategies are implemented when the options trader believe the underlying stock price to move positively or in upward direction. Time frame in which the stock will reach the target price should be anticipated to employ an optimum trading strategy.

__Bull Call Spread__

Bull call spread strategy is employed when the trader is expecting the prices of the underlying to go up. Thus, an investor will simultaneously buy call options at a specific strike price and sell the same number of call options at a higher strike price. Remember we are working on money spreads only. Therefore, both call options will have the same expiration month and underlying asset. Bull Spread can also be created using the Put options.

The potential for profit is limited in this strategy and so is the risk for loss. If the stock move beyond the strike price of calls sold, the only loss will be loss of premium but the calls purchased at lower strike price will result into profit.

If the stock moves in adverse direction the maximum loss will be premium paid for buying the calls. Trader still gets to keep the premium he received from selling the call options.

Let us have a look at the Payoff diagram of Bull Call Strategy.

- Purchase Call option A with lower strike price XL $15, for $9
- Sell Call option B with higher strike price XH $25, for $ 5.40.
- Buyer expects price of underlying to go up.

If the stock moves in anticipated direction towards the higher strike price or beyond, that is $ 25 maximum profit would be:

**XH – XL – A + B = 25 – 15 – 9 + 5.40 = $6.40**

If the stock moves in adverse direction the maximum loss would be:

**A – B = 9 – 5.40 = ($3.60)**

Thus both the loss and the profit are capped in this strategy.

*Bearish options strategies** *

These option strategies are employed when the options trader believes the underlying price will move downwards. Time frame in which the stock will reach the target price should be anticipated to employ an optimum trading strategy.

There is scope of limited profit only in these strategies but they usually cost less to employ. The bear call spread and the bear put spread are common examples of bearish strategies.

__Bear Put Spread__

Bear Put spread strategy is employed when the trader is expecting the prices of the underlying to go down. Thus, an investor will simultaneously purchase put options as a specific strike price and sell the same number of puts at a lower strike price. Remember we are working on money spreads only. Therefore, Both Put options will have the same expiration month and underlying asset. These strategies can give a trader limited gains but the losses are also limited. Bear Put Strategy is cheaper than the Bull call spread to implement as the purchased put is of lower value than sold put.

The potential for profit is limited in this strategy and so is the risk for loss. If the stock move below the strike price (lower strike price) of Puts sold, the only loss will be loss of premium of the Puts but the Puts purchased at higher strike price will result into profit as their value increases.

If the stock moves in adverse direction the maximum loss will be premium paid for buying the puts. Trader still gets to keep the premium he received from selling the Put options.

Let us have a look at the Payoff diagram of Bear Put Strategy.

- Sell put option A with lower strike price XL of $15 for $2.60.
- Purchase put option B with higher strike price XH of $ 25 for $8.
- Buyer expects price of underlying to go down.

If the stock moves in anticipated direction towards the lower strike price or beyond, that is $ 15 maximum profit would be:

**XH – XL – B + A = 25 – 15 – 8.00 + 2.60 = $4.60**

If the stock moves in adverse direction the maximum loss would be:

**B – A = 8 – 2.60 = ($5.40)**

Thus both the loss and the profit are capped in this strategy.

Strategies in option trading are not limited to the strategies discussed above. Designing a strategy and implementing it is function of both technical understating and financial creativity.

We will discuss few of the Market Neutral Strategies in the next Blog.

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