Option Strategies
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This document provides an overview of options strategies. It defines derivatives and describes how they derive value from underlying assets. Common types of derivatives are discussed including futures and options. Basic option positions like calls and puts are explained. Popular options strategies like bull call spreads, bear put spreads, and butterfly spreads are defined and examples are provided to illustrate how the payoffs work. Long straddles and short straddles are also introduced as strategies used when volatility is expected to increase or decrease. Key option terms are defined throughout like premium, strike price, expiration date, and different option types.
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Option Strategies
- 1. Option Strategies By Ashwini Mahale :33 Kalpita Pitale: 46
- 2. Derivatives Derivatives are risk management instruments, which derive their value from an underlying asset. The underlying asset can be Bullion, Index, Share, Bonds, Currency, Interest, Etc.
- 3. Used by Banks, Securities firm, Companies, Investors, Housewives, ETC.
- 4. But why To hedge risk To gain access to cheaper money To make profit
- 5. Types of Derivatives ᵴFuture: The owner of a future has the obligation to sell or buy something in the future at a predetermined price. A future contract has standardized conditions. ᵴOptions: The owner of an option has the option to buy or sell something at a predetermined price on or before a predetermined date.
- 6. Types of Options ᵴCall Calls give the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a given future date. ᵴ Puts Puts give the buyer the right, but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given date.
- 7. Options are Contracts The option contract specifies: The The The The underlying instrument quantity to be delivered price at which delivery occurs date that the contract expires Three parties to each contract The Buyer The Writer (seller) The Clearinghouse
- 8. Core Concepts Index options: These options have the index as the underlying. In India, they have a European style settlement. E.g. Nifty options, Mini Nifty options etc. Stock options: Stock options are options on individual stocks. A stock option contract gives the holder the right to buy or sell the underlying shares at the specified price. They have an American style settlement. Buyer of an option: The buyer of an option is the one who by paying the option premium buys the right but not the obligation to exercise his option on the seller/writer. Writer / seller of an option: The writer / seller of a call/put option is the one who receives the option premium and is thereby obliged to sell/buy the asset if the buyer exercises on him.
- 9. Continued…. Option price/premium: Option price is the price which the option buyer pays to the option seller. It is also referred to as the option premium. Premium of an option = Option's intrinsic value + Options time value Expiration date: The date specified in the options contract is known as the expiration date, the exercise date, the strike date or the maturity. Strike price: The price specified in the options contract is known as the strike price or the exercise price. American options: American options are options that can be exercised at any time up to the expiration date. European options: European options are options that can be exercised only on the expiration date itself.
- 10. Continued…. In-the-money option: A call option is in-the-money if the strike price is less than the market price of the underlying security. A put option is in-the-money if the strike price is greater than the market price of the underlying security. At-the-money option: When the price of the underlying security is equal to the strike price, an option is at-the-money. Out-of-the-money option: A call option is out-of-the-money if the strike price is greater than the market price of the underlying security. A put option is out-of-the money if the strike price is less than the market price of the underlying security
- 11. Condition Call Strike price < underlying security price In-the-money Strike price > underlying security price Out-of-the-money Strike price = underlying security price At-the-money Put Out-of-the-money In-the-money At-the-money
- 12. Position of Call option buyer Trader’s rights- Buy underlying at strike price. Trader’s obligations- Nil. Premium paid or received - Paid. Risk profile - Limited, to the extent of the premium paid. Profit potential - Unlimited, if prices go up. Breakeven point - Strike price + Premium.
- 13. Position of Call option seller Trader’s rights- Nil. Trader’s obligations- Sell underlying at strike price. Premium paid or received - Received. Risk profile - Unlimited, if prices go up. Profit potential - Limited , to the extent of the premium received. Breakeven point - Strike price + Premium.
- 14. Payoff profile of Call options Profit / Loss Strike : 100 & Premium : 5 20 15 10 5 0 -5 -10 -15 -20 90 95 100 105 Price 110 115 120 Buyer Writer
- 15. Position of Put option buyer Trader’s rights- Sell underlying at strike price. Trader’s obligations- Nil. Premium paid or received - Paid. Risk profile - Limited, to the extent of the premium paid. Profit potential - Unlimited*, if prices go down (BEP = Strike price Premium). Practically, Put option buyer’s profit is limited as the price of the asset can not go below zero (Max. profit = Strike price – Premium paid)
- 16. Position of Put option seller Trader’s rights- Nil. Trader’s obligations- Buy underlying at strike price. Premium paid or received - Received. Risk profile - Unlimited*, if prices go down. Profit potential - Limited, to the extent of the premium received (BEP = Strike price - Premium) Practically, Put option seller’s risk is limited as the price of the asset can not go below zero (Maximum loss = Strike price – Premium received)
- 17. Payoff profile of Put options Strike : 100 & Premium :5 15 Profit / Loss 10 5 0 -5 85 90 95 100 -10 -15 Price 105 110 115 Buyer Writer
- 19. Option strategies Option Strategies are calculated ways of using options singly or in combination in order to profit from one or more market movements. Option Strategies are a direct alternative to traditional buying and selling of stocks and offers greater profit potential with limited risk. Option strategies are merely the means through which you transform your "prediction" of future stock movement into money through option trading. Option Strategies give options traders the versatility to profit from any opinions that they have on an underlying stock and to limit risk even if that opinion moves against them. The creative use of Options Strategies makes stock options the most versatile financial instrument in the world today.
- 20. Bull call spread When to use: investor is moderately bullish. Risk: limited to any initial premium paid in establishing the position. Maximum loss occurs where the underlying falls to the level of the lower strike or below. Reward: limited to the difference between the two strikes minus net premium cost. Maximum profit occurs where the underlying rises to the level of the higher striker above. Break-even-point (BEP): strike price of purchased call+ net debit paid. Strategy : buy a call with a lower strike (ITM) +sell a call with a higher strike (OTM).
- 21. SPOT PRICE Buy CALL Example: 5050 Sell CALL strike price 5000 strike price premium paid 5100 100 premium received 50 Breakeven 5050 lot size 50 NIFTY @expiry Net Payoff 4900 -2500 4950 -2500 5000 -2500 5050 0 5100 2500 5150 2500 5200 2500
- 22. Net Payoff 3000 2000 1000 Net Payoff 0 4900 4950 5000 5050 5100 5150 5200 -1000 -2000 -3000 In the above graph , the breakeven happens the moment Nifty crosses 5050and risk is limited to a maximum of 2500(calculated as lot size *premium paid)
- 23. Bull put spread When to use: when the investor is moderately bullish. Risk: Risk is limited. Maximum loss occurs where the underlying falls to the level of the lower strike or below. Reward: limited to the net premium credit. Maximum profit occurs where underlying rises to the level of the higher strike or above. Breakeven: strike price of short put - net premium received
- 24. Example: SPOT PRICE Buy put strike price premium paid Breakeven 5050 Sell put 5000 strike price premium 50 received lot size 5100 100 5050 50 NIFTY @expiry 4900 4950 5000 5050 5100 5150 5200 Net Payoff -2500 -2500 -2500 0 2500 2500 2500
- 25. Net Payoff 3000 2000 Net Payoff 1000 0 4900 4950 5000 5050 5100 5150 5200 -1000 -2000 -3000 In the above diagram, the breakeven happens the moments Nifty crosses 5050 and risk is limited to maximum of 2500. payoff schedule for bull call /put spread is the same . Only difference is that in bull put spread there is an inflow of premium.
- 26. Bear call spread When to use: when the investor is mildly bearish on market. Risk: limited to the difference between the two strikes minus the net premium. Reward: limited to the net premium received for the position i.e., premium received for the Short call minus the premium paid for the long call. Break even point: lower strike + net credit
- 27. Example: SPOT PRICE 5050 SELL CALL BUY CALL strike price premium received 5000 strike price 100 premium paid Breakeven 5100 50 5050 lot size 50 NIFTY @expiry 4900 4950 5000 5050 5100 5150 5200 Net Payoff 2500 2500 2500 0 -2500 -2500 -2500
- 28. Net Payoff 3000 2000 1000 0 Net Payoff 4900 4950 5000 5050 5100 5150 5200 -1000 -2000 -3000 In the above graph , the breakeven happens the moment Nifty crosses 5050and risk is limited to a maximum of 2500(calculated as lot size *premium paid)
- 29. Bear put spread When to use: when you are moderately bearish on market direction Risk: limited to the net amount paid for the spread .i.e. The premium paid for Long position less premium received for short position. Reward: limited to the difference between the two strike prices minus the net premium paid for the position. Break even point: strike price of long put – net
- 30. Example SPOT PRICE 5050 SELL PUT strike price premium received BUY PUT 5000 strike price 5100 50 premium paid 100 Breakeven 5050 lot size 50 NIFTY @expiry 4900 4950 5000 5050 5100 5150 5200 Net Payoff -2500 -2500 -2500 0 2500 2500 2500
- 31. Net Payoff 3000 2000 1000 0 Net Payoff 4900 4950 5000 5050 5100 5150 5200 -1000 -2000 -3000 In the above diagram, the breakeven happens the moments Nifty crosses 5050 and risk is limited to maximum of 2500. payoff schedule for bear call /put spread is the same . Only difference is that in bear call spread there is an inflow of premium.
- 32. Long call butterfly When to use: when the investor is neutral on market direction and bearish on volatility. Risk: net debit paid. Reward: difference between adjacent strikes minus net debit Break even point: Upper breakeven point =strike price of higher strike long call – net premium paid Lower breakeven point =strike price of lower strike long call + net premium paid
- 33. Example SPOT PRICE ITM OTM 5050 ATM BUY 1 CALL 5000 100 BUY 1 CALL SELL 2 CALL 5100 5050 75 85 LOT SIZE 50 NET PREMIUM -5 STRIKE PRICE PREMIUM BREAKEVENS HIGHER LOWER 5095 5005
- 35. 2500 net payoffs net payoffs 2000 1500 1000 500 0 4870 4915 4960 5005 5050 5095 5140 5185 5230 -500 Conclusion: Here Losses Are Limited And Profits Are Unlimited
- 36. SHORT CALL BUTTERFLY When to use: you are neutral on market direction and bullish on Volatility. Neutral means that you expect the market to move in either direction -i.e. Bullish and bearish. Risk: limited to the net difference between the adjacent strikes (rs. 100 in this example) less the premium received for the position. Reward: limited to the net premium received for the option spread. Break even point: Upper breakeven point =strike price of highest strike short call - net premium received Lower breakeven point =strike price of lowest strike short call + net premium received
- 37. Example spot price ATM buy 2 call strike price 5050 premium 85 LOT SIZE NET PREMIUM BREAKEVENS HIGHER LOWER ITM sell 1 call 5000 5050 OTM sell 1 call 5100 100 75 50 5 5095 5005
- 39. 500 0 4870 4915 4960 5005 5050 5095 5140 5185 5230 -500 -1000 -1500 -2000 -2500 Conclusion: Here profits Are Limited And losses Are Unlimited Series1
- 40. LONG STRADDLE When to Use: The investor thinks that the underlying stock / index will experience significant volatility in the near term. Risk: Limited to the initial premium paid. Reward: Unlimited Breakeven: · Upper Breakeven Point = Strike Price of Long Call + Net Premium Paid · Lower Breakeven Point = Strike Price of Long Put - Net Premium Paid
- 41. Example SPOT PRICE 5050 BUY CALL BUY PUT strike price 5050 strike price 5050 premium received 50 premium paid 25 Breakeven LOWER BEP 5025 UPPER BEP 5075 lot size 50 NET PREMIUM 25
- 43. Net Payoff 7000 6000 5000 Net Payoff 4000 3000 2000 1000 0 4900 4925 4950 4975 5000 5025 5050 5075 5100 5125 5150 5175 5200 -1000 -2000 Conclusion: Here Losses Are Limited And Profits Are Unlimited
- 44. SHORT STRADDLE When to Use: The investor thinks that the underlying stock / index will experience very little volatility in the near term. Risk: Unlimited Reward: Limited to the premium received Breakeven: · Upper Breakeven Point = Strike Price of Short Call + Net Premium Received · Lower Breakeven Point = Strike Price of Short Put - Net Premium Received
- 45. Example SPOT PRICE SELL CALL strike price premium received 5050 SELL PUT 5100 strike price 50 premium paid Breakeven LOWER BEP UPPER BEP 5100 25 5075 5125 lot size NET PREMIUM 50 25
- 47. 2000 1000 0 4950 4975 5000 5025 5050 5075 5100 5125 5150 5175 5200 5225 5250 -1000 -2000 Net Payoff -3000 -4000 -5000 -6000 -7000 Conclusion : So Here Profits Are Limited And Losses Are Unlimited
- 48. Conclusion 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.
- 49. Thank You