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#FRM Tutorial on Options Trading Strategies

February 11, 2010
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The simmering Sino-US relationships, paroxysms in European bond market and the domestic budget of this fiscal around the corner are the contributors of high volatility in NIFTY.

The latest fuel to burn the superficial bonhomie between the two super powers is the America’s decision to sell Taiwan $6 billion-worth of weaponry. This is playing an active role in bringing the confidence indexes to their all time lows.

Late last month the yield on 10-year government bonds issued by Greece vaulted to 7.1%, which is the highest since the country became an EU member. This yield is 400bps more than that on German bunds, which are considered to be the safest investment in EU. The panic abated on 3-Feb, when the European Commission endorsed the Greek government’s plan to cut the deficit to 3% of GDP by 2012. The storm in Greece has compelled many sleepers like Portugal and Spain to wake-up and start preparing for similar crises in domestic bonds.

Latest updates from Central Statistical Organization (CSO) has although updated the growth estimate to 7.2%, many are skeptical about the numbers because of the negative growth in the agriculture, thanks to the monsoon this year.

Traders of imminent I-banks have started getting the margin calls in their vanilla strategies. ABC Bank didn’t have any prior experience and exposure to the options. They want to enter in options trading and want to profit from the present condition of the Indian market.

All the six traders of the ABC Bank have different opinions on the importance and the outcome of the scenario. Depending on the view of the traders, we have to advise the best strategy for the novice traders of ABC bank.

Case I:

Trader1: I think despite the bad numbers in agriculture by CSO, the good part is that overall Indian economy will grow at much higher rate (7.2%) than previously expected. I think the budget should be investor-friendly. If I talk about Sino-US relationships, it is not breaking news. It had been going on since 4th Nov, ’09, the day Obama entered white-house.

You: Tell us something about EU bond market and your overall view in the Indian context.

Trader1: According to me, the EU bond market squall can be another crisis in the offing if not nipped in a week or so. This may affect the Indian stock and bond market. Overall I would say I am conservatively bullish and conservatively bearish, but Congress’s investor-friendly budget as expected would lead the show.

You: From your feedback, the best strategy for you would be buy a call option, but as you are bearish because of EU bonds, I would suggest selling a call option at higher strike price. This strategy is also called Bull Spread.

Case II:

Trader2: My expectations are exactly opposite to what Trader1 thinks on the importance of the events.

You: This means that you think the probability of the EU bonds affecting Indian markets would be more than the impact of budget. For this outlook, the best suited strategy would be to sell call option at lower strike price and to buy a call option. Bear Spread.

Case III:

Trader3: I am interested in short term options and for that period only possible outcome is the budget, which has equal chances of being good or bad news for Indian investors. No matter what the outcome of the budget is going to be, Nifty has got to run. China-US relations and EU bonds are not sufficient factors to move Nifty.

You: Buy a call and buy a put at same strike price. Straddle.

Case IV:

Trader4: My expectations are same as Trader 3, but I don’t want to spend too much money upfront. Moreover the range boundaries which Nifty is going to break are higher than those expected by Trader 3.

You: Buy call and put of different strike prices depending on your range boundaries. Strangle.

Case V:

Trader5: I am interested in short term options and for that period the only possible outcome is the budget, which has more chances of being good news for Indian investors. No matter what the outcome of the budget is going to be, Nifty has got to run. China-US relations and EU bonds are not sufficient factors to move Nifty. Overall Nifty is going to break the range boundary. There are 90% chances that the broken boundary is going to be the upper one.

You: If you are confident about the broken boundary to be the upper boundary, go for the Strap strategy. Strap involves buying 2 call options and 1 put option at same strike price.

Case VI:

Trader6: Every year we get a new budget. A few years back there were tensions between Middle East and US, and now it’s between China and US. Few months ago Dubai made news about sovereign debt default, now it is Greece or any country for that matter. All this so called big news is not going to be very significant unless our market obeys strong market efficient hypotheses. There’s so much positive and negative information that it cancels out in the end. The only thing that remains is the irrationality and the psychology of the investor. So I think Nifty is going to trade between a range, unlike a biotech company about to launch a new drug. So my expectations are that the market would be range bound and would not want to spend too much upfront.

You: Buy two calls at different strike prices and sell two calls at intermediate strike prices. Butterfly spread.

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