Option Strategies

You might have often heard or even felt yourself that trading options can be a tricky business. But, have you ever wondered why? One of the major reasons for the constant failure is the lack of knowledge and avoiding the use of the right option strategies. 

Just as in school when you knew the basic formulas of mathematics, the calculations became easier, similarly with the right strategies, you won’t feel disconnected from the concept of option trading. 

There are various strategies that are used by the traders, depending on their risk appetite and comfort. But the question that arises before discussing the strategies is, what exactly is options trading? 

Let us simply understand this with the help of an example.

Let us suppose that you are willing to buy land and its price currently is ₹50,00,000. 

But you know that in the future its price will increase. So, you got into an agreement with the seller, that in the near future on a particular date, you will buy that land for ₹50,00,000. 

The seller who thinks that the prices will decrease in the future agrees, and you both get into a contract.

So if in the future, the prices increase the buyer will earn a substantial profit. But on the other hand, if the price does not change, in fact, decreases from its current value then the option contracts give you the choice to exit the trade without exercising. 

Simply put, options trading is a process in which two individuals who have different sentiments in the market enter into an option contract that is executed in the future at a fixed price and at a fixed date. 

Now, let us have a quick look at some of the strategies which you can use to sail that profitable boat in options trading. 

Option Trading Strategies 

“The essence of strategy is choosing what not to do.”….By Prof. Michael Porter. 

No doubt, the stock market is full of volatility, and defining a profit well in advance can only be assumed.

Similarly, when entering into the options contract it becomes important to work strategically to book your profit. Here to pick the right strategy it is important to determine volatility, volume, trend, and other aspects of the market which can use the best indicator for option trading.

There are various strategies that a person can use to successfully trade in options. 

They might sound tricky in the beginning, but as soon as you start getting a hang of it, you will realize how easy it is to avoid option trading mistakes and possibly minimize the losses.

Let us have a look at some of the strategies so that you are extra sure of your profit after this. 

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Bull Call Spread 

One of the most commonly used strategies is the bull call spread. 

This spread strategy uses two leg options to secure the profits in the trading style. But, in what situations can you use this? 

Let us take the example of Lavi who is skeptical of buying the shares of Tata Motors. 

She is somewhat expecting that because the last quarter reports were good, this quarter will give good returns. 

But, the dicey situation is stopping her from taking a very bullish call right now. So, she is moderately bullish. 

In this case, bull call spread comes in great use as she can acquire two positions, such as, 

• Buy 1 at the money (ATM) call options and on the other hand, 
• Sell 1 on the money (OTM) call option. 

Note- All the strikes should belong to the same category and the options should be a part of the same expiry. 

Let us understand this with the calculations and examples. 

Spot price- 7200 

1. Buy at an ATM of 7150 (paying a premium of 50)
2. Sell at an OTM of 7250 (receiving a premium of 25)

Net cash flow of premium= 50-25= ₹25

Let us take different scenarios in which the market can move now. 

Condition 1- market expires below the ATM option (7100) 

The intrinsic value of call option is Spot price- strike price 

ATM- 7100-7150 = -50 (maximum value is 0, so the intrinsic value will be 0)

OTM- 7100-7250= 0, but this option was written, so the premium dosen’t go anywhere. 

In this case, the net cash flow will be -50+25= ₹25

So, if the options were not spread, it would have been a loss of ₹50. 

Condition 2- Market Expires at ₹7150 

In this case, the intrinsic value in both cases will be 0. So, here there will be a net loss of 50-25= 25

Condition 3- Market expires at ₹7250

In this condition, the intrinsic value in the first case= 7250-7150= 100

Since you paid a premium of 50, the profit, in this case, will be 100-50 = 50

The intrinsic in the second case = 7250- 7250= 0, the premium of ₹25 stays, so the total profit= 50+25= 75

So, you can see that the loss is restricted to 25 and not more than that, so this is the use of this strategy. 

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Bull Put Spread 

Just like the bull call spread, there is a bull put spread as well. It is used when you are bullish and want to take the pull option. In the case of bull put spread, you can, 

• Buy 1 OTM Put option, and  
• Sell 1 ITM Put option

(the conditions remain the same as in bull call spread)

Example- Nifty 7805

1. Buy 7700 put option (premium of 72)
2. Sell 7900 (receive a premium of 160)

Let us see the four conditions that we saw in the case of the bull call spread 

Condition 1- The market expired at 7600 

In put option (strike- spot)

₹(7700-7600)= 100 (intrinsic value)

Profit will be (because you are taking a long position in this)= 100-72= ₹28

In second case= 7900-7700= 300

160-300=-140

The overall profit, in this case, will be 28-140= -112

Condition 2- Market expires at 7700

So in the first case, the intrinsic value will be 7700-7700= 0 (loss of 72 premium)

In the second case, the intrinsic value will be 7900-7700= 300 (160-200=-40)

overall = -40-72= -112

Condition- Market expires at 7900

In both cases, the intrinsic value will be 0. So the payout will be, 160-72= 88

So, it is quite evident that in the conditions above, the loss is capped at 112, and this gives you an added advantage. 

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Bear Put Spread 

Just like all the other spreads, it is also a multi-legged strategy. This is best suitable when you are bearish but not outrageously. 

So, in the cases where you know that the market has a possibility of going down, but are not 100 percent sure, you can use the bear put strategy. 

In this, you can, 

• Buy an ITM put option 
• Sell an OTM put option 

(This is not always fixed but also depends on the risk appetite of the trader)

NIFTY- 6485

• Buy 6600 (premium 160)
• Sell 6400 (premium received 70)

Condition 1- If the market expires at 6800

Strike price- spot price = intrinsic value 

Buy-side- 6600-6800= -200= 0 (loss of the 160 premium)

Sell-side- The premium was received, so it will stay intact. 

Overall- 160+70= –₹90 

Condition 2- Market expires at 6600

In both situations, the intrinsic value will be zero, so it will be similar to condition one, having a net overall value of –90

Condition 3- If the market expires at 6400

Buy side- 6600-6400= 200 (Premium was 160)

Retained- 200-160= 40 

Sell- 6400-6400= 0 (70 premium will be retained)

Total outcome- 40+70= ₹110

Condition 4- Expired at 6200 

buy – 6600-6200= 400 

Retained = 400-160= ₹240

Sell- 6400-6200= 200  

The loss of 70 premium = 200-70= ₹130

Outcome- 240-130= ₹110

So the profit here is capped at ₹110 and the loss at ₹90

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Bear Call Spread 

Just like the bull call spread is used when you are moderately bullish, the bear call spread is used when you are moderately bearish. Let us understand this in a similar fashion with the help of different conditions. 

To execute this strategy effectively you can, 

• Buy one on the money (OTM) call option 
• Sell one in the money (ITM) call option 

NIFTY- 6222

Buy 6400 (premium ₹30)

Sell 6100 (receive a premium of 130)

Condition 1- Market expires at 6500 

On  the buying side, the intrinsic value will be 6500-6400= 100 (call option- spot price- strike price)

In this we paid a premium of 30, so we will get to retain 100-30 =₹70 

On the selling part, the intrinsic value will be 6500-6100= 400. Now in this case we received a premium so the loss will be, 400-130= -270

Total loss in this scenario will be, -270+70= ₹200

Condition 2- Market expires at 6400

Buy side- 6400-6400= 0 (loss of ₹30 premium) 

Sell side- 6400-6100= 300 (loss of 130 premium) 

300-130= -170

Total loss- -30-170= -200

Condition 3- Market expires at 6100 

Buy side- 6100-6400= 0 (loss of ₹30 premium)

Sell side- 6100-6100= 0 (premium was received so it will be retained)

Total – -30+130= ₹100 

Studying all the spread techniques, you must have realized one thing for sure that it sometimes lessens the profits but when looked at otherwise, a little profit is better than bearing a huge loss.

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Covered Call 

Another strategy that you can use to minimize your losses is the covered call. In a covered call, you sell the option contract of a stock that you already have. 

Let us understand this more clearly. Suppose you bought 100 shares of Reliance Industries for ₹2000 each and then sold them for ₹2300 each. Now overall you made a profit of ₹90,000. 

Now, there was some news in the market which made the prices consolidate for some time. Now, you have become very skeptical about the market going bullish. So what will you do in such a case? 

To earn profits for the short-term, you can sell the call option contract of the same stock. Since you are selling the option contract, you will be the one getting the premium. Now, there can be three scenarios. 

Case 1- The prices of the stock moves up (the market turns bullish)

Now, in this case, the stock prices will move further high, so it is without any doubt that you will be able to earn good profits from that. But what about the call option contract that you sold? 

In a case when the market goes bullish, the call option buyer will execute the order, but you will still be able to make a profit from the premium amount that you received. 

So, in such a case, you will benefit on both sides. 

Case 2- The market goes bearish, that is, the prices of the stock goes down

In this case, you might face a significant loss. But you also sold the option contract. So now, the call option buyer will not execute the order, but you will still get the premium as it is non-refundable. 

So, in all, you will be able to minimize or cover your losses from the fall in stock prices. 

Case 3-The market consolidates and there is no change in the stock price

In such a case, although you will not be able to earn profits from the stocks, but since you received a premium on the call option writing, you will still benefit from this situation. 

So you can see that using the covered call strategy, you can easily safeguard your profits and make the most out of all the situations.  

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Married Put Strategy 

Also known as covered put, this is another options trading strategy that can be used to minimize the losses that you can incur during options trading. This strategy is useful when the sentiment of the trader is moderately bearish. 

In the covered put strategy, you sell the underlying stocks and also sell a put option contract. Let us understand this with the help of an example. 

Suppose you bought 100 shares at a price of ₹50 per share and sold a put option of 45 and received a premium of ₹2. (lot size- 100)

Premium given= ₹200

Case 1- If the market goes down to 40 

In this case, since you purchased the put option you can execute your order at ₹45 instead of ₹40. So, where you would have faced a loss of ₹10, you will bear a loss of ₹5 only. 

Case 2- If the market goes up and reached ₹55

In this case, for the put option the only loss that you will bear will be of the premium because in this case, it will be worthless to execute the order. You can still sell the 100 shares that you purchased for ₹5000 for ₹5500. 

So, using the married put, you minimize your losses as you buy a put option with a cost lesser than the current market price. So, just in case the market moves bearish, you can minimize your losses. 

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Option Strategies Straddle 

Many times, there are strategies that are not designed according to the market direction but in a way that it can sustain the unpredictable market movements too. 

These are called market-neutral strategies. So, now as we have studied the spreads, let us move on to the straddle strategies. 

These are used by professional traders who don’t move according to the market, but sometimes end up taking decisions against the grain. Let us understand two types of straddle strategies. 

• Long Straddle 
• Short Straddle 

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Long Straddle 

A long straddle is considered to be one of the easiest strategies to understand and also to implement. Isn’t that an added advantage? So, what exactly is a long straddle strategy? 

In a long straddle strategy, you have to buy a call option and a put option simultaneously. Now, it is very important that both the options belong to the same strike, same expiry, and the same underlying. 

If an option for the call, that is. 7700 CE is trading at 77, and 7700PE is trading at 88. The strategy here is to buy both so that the fear of the market moving against your sentiment is eradicated. 

Condition 1- If the market expires ar 7300 

In the call option, 7300-7700= -400= 0 

So here, there is a loss of ₹77 premium. 

But in the put option, 7700-7300= ₹400 

Premium retained will be 400-88= ₹321, so here even when the call option was not a successful bet, the put option managed to save the major losses, so in this case, the profit will be, 321-77= ₹244

Condition 2- If the market expires at 8000

In this, in the call option- 

8000-7700= 300, the premium here will be retained. The profit in such case will be 300-77= 223

In the put option- 

7700-8000= -300(0), in this case the premium will not be retained. So, in this case the call option will make the money. 

The overall profit in this case will be 223-83= 140

Condition3- market expires at 7435

Call option- 7435-7700= -265, in this case, the premium will of 77 will be lost. Let us now look at the case of put option. 

Put option- 7700-7435= 265, the premium of 83 will be retained and the total payoff will now be, 

265-83= 182

So, with the above scenarios we can see that no matter how the market is moving, a trader can be relaxed because he/she will be making balanced profits. 

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Short Straddle 

Just like a long straddle, there is a short straddle strategy as well. The basic reason behind this is also to stay in profit no matter in which direction the market is progressing at that time.

There are a lot of traders who are relatively scared of the short straddle strategy as in this the losses are comparatively less capped. In the long straddle we were buying, but in the short straddle,

• Sell an ATM call option
• Sell an ATM put option

Let us start understanding this with the help of an example. 

Suppose Nifty currency is at ₹7660. So now 7660 is an ATM option. 

• Now 7600 Call- 77 premium 
• 7600 put- 88 premium 

Now, if you are selling both, you will receive a premium of 77+88= 165

Now, let us discuss the various scenarios around it.   

Condition 1- Expiry around 7300 

Call option- 7300-7660= -360 (0) 

In  this case, the premium will be retained. 

Put option- 7660-7300= 360 

Premium- 360-88= -272 

Total loss- 272-77= -195

Condition 2- Market expires at 7600

The intrinsic value in both the cases in this will be 0. This is a very favorable condition as the premium on both sides will be retained. So, in this case, the total profit will be 77+88= 165

Condition3- Expiry at 7765

Call option- The intrinsic value in this case= 7765-7600= 165

Net Profit- 165-77= 88

Put option- 7600-7755= 0, the premium will be retained of 88. 

In this case, no money is made or lost. 

Now to use these strategies, one must use the right trading platform.

So let’s discuss few apps for option trading that helps you to do proper analysis and applying the above strategies seamlessly.

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App for Option Trading

Although there are many stockbrokers but there are only few offering the trading platform that helps traders to learn option and execute trade in options seamlessly.

Almost each of these trading platforms follows some of the common features like:

Advanced option chain: No doubt these trading platforms are one of the best apps for option chain analysis. Offering the in-built option chain and the integrated Sensibull allow traders to customize the analysis features and further trade strategically.

Easy User Interface: The app user interface is the one making it the best. The following apps offer an easy user interface thus making it easier for traders to understand the trend, option chain, and placing order.

Option Strategy Builder: What makes these apps unique is the strategy builder thus helping you to customize and apply the strategy of your choice.

Have discussed the features, let’s know which are apps suitable for the option traders. Here is the list:

 

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Pros and Cons of Option Trading 

Not just this style of trading, but every other style also comes with pros and cons. Let us discuss them in brief. 

Pros

• It gives you the right to either buy or sell the contract and also for your specified time. 
• Does not require the financial commitment as you need in trading shares. You will have to pay just the premium amount and then you have the time span for the others. So, it is comparatively less costly than shares. 
• The investor who is paying the premium is also free to exit the contract when he/she wants to. 
• The chances of high returns are much more in Option trading. 
• As we discussed earlier, you can diversify your options using various strategies and capping your losses. 

Just like the two sides of a coin, you might have often heard about the risks associated with option trading.

Let us have a look at some of the cons of option trading. 

• Sometimes the writer of the option, usually the one on the selling side can face a lot of loss. 
• Requires to make profit in a short span of time. 
• It also requires extensive research and knowledge as you will have to make sure that you enter at the right point and for the right time span. 
• Since there are chances of higher rewards, there are also chances of higher risks. 
• The liquidity involved with options trading is less.

So, in a nutshell, it is a matter of your risk appetite and comfort as well. 

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Is Option Trading Safe? 

The next question that arises here is, is option trading safe? You might have heard that it is a difficult style of trading to pursue. But what is exactly the case? 

The risks involved with options trading are definitely high but so are the rewards. If you have a good knowledge of how options work, the strategies, and the research, it becomes a little less complicated and also gets easier. 

It is better than stocks as it requires less financial commitments initially. The time span is shorter so you can earn profits from little market fluctuations as well. 

So, option trading is safe if you have a good risk appetite and the right strategies. 

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Conclusion 

Option trading might look a little complicated initially but when you get the hang of it, it becomes easier. With the use of the right strategies, you can easily maximize your profits and also cap your losses.

We hope that by now you might have cleared all your doubts regarding option trading strategies. 

Explore your options with options trading and have a great time!

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