Option strategies

By:
Prashant sharma
Vasu kanna
 Options
• A contract that gives the holder the right, but not
the obligation, to buy or sell an asset at a
prespecified price for a specified price within a
specified period of time
• American option - can be exercised at any time
before the expiration date
• European option - can only be exercised on the
expiration date
• Style has nothing to do with trading location
 Definitions of a Call and a Put
• Call option
– an option that gives a purchaser the right, but not
the obligation, to buy the underlying security from
the writer of the option at a prespecified exercise
price on a prespecified date
• Put option
– an option that gives a purchaser the right, but not
the obligation, to sell the underlying security to the
writer of the option at a prespecified price on a
prespecified date
 Call option (buy)
• An investor buys one European Call option on
one share of Neyveli Lignite at a premium of
Rs.2 per share on 31 July. The strike price is
Rs.60 and the contract matures on 30
September. It may be clear form the graph that
even in the worst case scenario, the investor
would only lose a maximum of Rs.2 per share
which he/she had paid for the premium. The
upside to it has an unlimited profits opportunity.
 Put option (buy)
• An investor buys one European Put Option
on one share of Neyveli Lignite at a
premium of Rs. 2 per share on 31 July.
The strike price is Rs.60 and the contract
matures on 30 September. The adjoining
graph shows the fluctuations of net profit
with a change in the spot price.
 Why purchase or write a call
• Purchasing a call option is a bullish strategy that makes
money if the underlying commodity price rises.
• Writing a call is a neutral or bearish strategy.
• Buying a call is a limited loss strategy with a potentially
unlimited gain, writing a call is the opposite.
• Options are wasting assets, their time value erodes as
expiration approaches.
• Option prices are also directly related to the level of
underlying spot price volatility.
• Thus, buying an option is a bet that either a) the spot price
will increase enough to offset the loss in time value and/or b)
the spot price volatility will increase enough to offset the loss
in time value.
 OPTIONS VS FUTURES/ FORWARDS
Pt of Difference OPTION FUTURES/FWDS
RIGHT Only buyer has the Both the parties
right have rights
RISK Only for the seller For both the
parties
OBLIGATION Only for the seller For both the
parties
PREMIUM Buyer pays upfront No one pays

SETTLEMENT Can expire without Settlement is must-

being exercised it never expires
MARGIN Seller deposits Both deposit
 HEDGING
• The best hedging strategies can be created
with the help of option contracts, since these
not only protect risk but also provide an
opportunity to have gains.
 SYNTHETICS
• Synthetics are the result of combining different
derivative contracts to generate a new derivative
product. Sometimes when ordinary purchase or
sale of securities and derivatives are combined to
create a new product to counterbalance the risk, it
is called synthetics. For creating a synthetic,
different derivatives/ simple transactions are
executed on the same share at the same time by a
trader with the objective of creating a ‘win- win’ or
a ‘ no profit- no loss’ situation.
 SYNTHETICS-STRADDLE
• A Straddle is a combination of a PUT and a CALL
option on the same underlying instrument. Under
this, a trader buys a call option as well as a put
option at the same strike price with the same strike
date for both the contracts. If the price of the
underlying instrument increases, then call
generates profit & the put becomes worthless.
Whereas, if price of the underlying decreases, then
put generates the return and the call becomes
worthless. This strategy can even be adopted to
speculate without having any holding of the
underlying instrument.
 Why straddle
• Straddle is not a directional bet
• It’s a bet on volatility
• Large move is beneficial

DRAW PAYOFF
Pay off of long straddle

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 SYNTETICS-STRANGLE
• It is a combination of a put and a call on the same
underlying instrument. Under this, a trader buys a
call option as well as a put option at different strike
prices, but he has the same strike date for both the
contracts. The difference in strike prices is the
spread of the hedger.
 Why strangles
• Play on the volatility
• Larger movement expected
• When asset trading at 100, you can buy a call
at 105 and buy a put at95. If asset rises above
105 call is valuable.
• If asset falls below 95 put becomes valuable
• In the range, both options expire worthless

DRAW PAYOFF
Pay off of long strangle

K1 K2
 SYNTHETICS-COLLAR
• It is a set of two option transactions executed on
the same type of option contract having same
expiry but different exercise price. The aim is to
have a gain from the difference between two
exercise prices. By same type of option we mean
either it is a call option or a put option. Collar can
be of two types:
• BULLISH COLLAR
BEARISH COLLAR
 SYNTHETICS-BULLISH COLLAR
• Here, the trader takes up a long position on the call
option at the lower strike price and sells call option
at higher strike price at the same time on the same
share. Duration of both the call options should be
the same. Alternatively, a bullish collar is the one, in
which a call option that is more in- the-money is
purchased and another call option which is less in-
the-money is sold. By doing so, the operator gets
the following two benefits:
• 1. Zero or low cost because for the long call, he
pays the premium and for short call, he receives the
premium.
 SYNTHETICS-BULLISH COLLAR
• 2. A range bound gain i.e. his gain will be equal to
the difference between the strike prices of both the
options and loss will be zero.

DRAW PAYOFF
Payoff of bull spread using call
options

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K2
 SYNTHETICS-BEARISH COLLAR
• A bearish collar is created by a bear. Under this, he
takes a long position on a put option at a higher
strike price and a short position on a put option at a
lower strike price, simultaneously on the same
share. Alternatively, a bearish collar is one, in which
a put option that is less in-the-money is sold and
another put option, which is more in-the-money is
purchased.
• Now, when the prices decline in the future, he will
have a range bound gain equal to the difference
between the strike prices of both the options.
 SYNTHETICS-BEARISH COLLAR
• Results of this can be summed up as follows:
• 1. Zero or low cost, because for the long put, he
pays the premium and for the short put, he receives
it.
• 2. A range bound gain i.e. his gain will be equal to
the difference between the strike prices of both the
option contracts and loss will be zero.

DRAW THE PAYOFF

Payoff of bear spread using puts

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 SYNTHETICS- PROTECTIVE PUT
• This strategy involves a long position in a security
and purchase of a put option on the security.
• Due to this, long position in the security benefits
when market rises and when market falls, it is the
put option that benefits.
• Hence, this strategy can also be referred as “win-
win” strategy at the cost of the premium paid for
buying the option contract.
 SYNTHETICS-COVERED CALL
• Under this strategy- a short position in a security is
covered through purchase of a call option on the
same security.
• By doing so, the trader does not leave his short
position naked; instead it gets covered.
• This strategy is best suited for a bearish investor. It
helps in covering the risk arising from the increase
in share prices.
• When the future market actually declines, his short
position benefits him & the call remains worthless.
• While, if the market increases, he can exercise the
 SYNTHETICS- COVERED CALL
• Call option and save from incurring heavy
losses due to the contrary movement of the
market.
• He gets all this only at the cost of premium
that he pays for the purchase of the call
option.
 OPTIONS-COMBINATIONS
• When an investor takes a position in two different
types of options, on one single underlying asset
with the same expiry, it results in a combination.
Here, by different options , we mean that one
option is a call option and the other is a put option.
• Usually, the combination is created by using
EUROPEAN options; however, in certain cases
investors create it by using AMERICAN options. The
most common combinations are : STRIPS/
STRAPS/STRADDLE/ STRANGLE
 STRIPS
• When an investor buys one call option and two put
options with the same exercise price and same
expiry on a particular underlying asset ( share), it is
called STRIPS.
• Such a combination is created when the market
shows sideways movement with more probability
of having a southward movement in the near
future.
• EXAMPLE
• An investor takes one lot long position at a
premium of 35 on: RIL (300), 2300, July 2009, Call
American.
 STRIPS
• He also takes two lot long positions at a premium of
25 on the following option:
• RIL(300),2300, July 2009, Put American.
• As he is the buyer of both call and put option, he
pays the premium. His upside break-even is Rs 2385
• (2300+35+25*2) and down side break even is RS
2215 ( 2300-35-25*2).

DRAW PAYOFF
Payoff of strip

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 STRAPS
• When an investor buys one put option and two call
option with the same exercise price and same
expiry on a particular underlying asset (share) it is
called STRAPS.
• Such combination is created when the market
shows a sideways movement with more probability
of having a northward movement in the near
future.
• EXAMPLE
• An investor takes one long position at a premium of
25 in: RIL (300), 2300, July 2009, Put American.
 STRAPS
• He also takes two lot long positions at a premium of
35 on: RIL(300), 2300, July 2009, call American.
• As he buys both the call & put options, he pays the
premium.
• His upside breakeven is Rs 2385( 2300+35+25*2)
and downside breakeven is RS 2215 ( 2300-35-
25*2).

DRAW PAYOFF
Payoff of strap

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 DERIVATIVES IN INDIA
• The era of derivatives trading in India began with
amendments in the SCRA in December 1999.
• The amendment was to include the derivatives
(options, futures, forwards, swaps etc) in the ambit
of securities. Along with this, a regulatory
framework was also framed for trading of
derivatives on the regulated exchanges.
• The amendment provided that derivatives trading
in India shall be valid only if it is traded on a
recognized stock exchange.
• The effect of this amendment was that, derivatives
 DERIVATIVES IN INDIA
• Were regarded equivalent to other securities and
now, could be traded and settled as any other
eligible security is traded and settled on recognised
stock exchanges in India. The amendment also
provided that a proper trading & settlement system
is to be placed in order to provide for orderly
trading & settlement of trades in derivatives.
• Derivatives trading commenced in June 2000, only
after SEBI sent a notification in May 2000. This
provided detailed guidelines for trading &
settlement of derivatives in the system of BSE &
NSE.
 DERIVATIVES IN INDIA
• To give effect to this, a separate segment at these
two exchanges was developed as futures & options
(F&O) segment for trading in stock derivatives &
index derivatives.
• Contracts in index options were started in June
2000 on BSE & in June 2001 on NSE. Futures
contracts on individual stocks were started in
November 2001.
• Derivatives like option contracts offer two benefits,
i.e. protection from risk of loss, that too at a
nominal cost of the premium and a chance to have
 DERIVATIVES IN INDIA
• Unlimited gain from fluctuating prices of the
underlying asset. Similarly, futures provide for
counterbalancing risk arising from a commitment
and swap provides a chance to have loan at the
lowest possible rate of interest.
• Trading in these instruments involves a high degree
of risk. Therefore, all transactions are regulated by
the stock exchange rules in case of securities, and in
case of commodity it is regulated by the rules of the
concerned commodity exchange. The regulation
and intervention of exchange is mainly to
eliminate/
 DERIVATIVES IN INDIA
• Minimize counterparty risk. For all the exchange
traded derivatives, exchange happens to be the
counterparty. Exchange mainly regulates the
following:
• Decision about the underlying asset in which
trading is to be done
• Margin requirements
• Types of Derivatives offered
• Settlement of transactions
• Lot Size