Option Strategies - Straps

Straps

Salient Features          

a) Market is expected to take volatile move but its direction is not clear
        b) Farther the exercise price from strike price more will be profit
        c) Unlimited profit and limited loss

Introduction:

When an investor expects the prices at the time of expiry of contract to remain outside a range of prices, he may enter into the Strips strategy, which is created by selling two calls and a put of same strike price. This strike price is the level from which he expects the prices to move farther. Let us take an example to understand this in detail- an investor takes following positions on 27th May 2005 when Nifty Spot was Rs.2070. Action Option type Strike Premium Total investment Long Call 2050 49 Long Call 2050 49 Long Put 2050 34 132

Here he buys two Nifty Calls and one Nifty Put of the same Strike price of Rs.2050 for which he pays a net amount of Rs.132 as premium {Rs.98 (49*2) paid for two Long Call positions and Rs.34 paid for a Long Put position} to create the position. His cash flow at different levels of Nifty closing on 30th June05(last Thursday of the following month) are as follows: Index Long call Long call Long put Investment Cash flow 1940               -           110         110 -132        88.00 1960               -             90           90 -132        48.00 1975               -             75           75 -132        18.00 1985               -             65           65 -132        (2.00) 2050               -             -             -   -132     (132.00) 2120               70           -             -   -132       (62.00) 2125               75           -             -   -132       (57.00) 2140               90           -             -   -132       (42.00) 2180             130           -             -   -132        (2.00) 2200             150           -             -   -132        18.00 2250             200           -             -   -132        68.00 2300             250           -             -   -132      118.00 2350             300           -             -   -132      168.00

Thus it is clear from above example that his profits will occur when the Index closes beyond a certain range (here it is Rs.1985 to Rs.2180), whereas in case of Index closing within this range, he will make loss.

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Option Strategies - Strangles

Strangles

Salient Features          

a) Market is expected to take volatile move and remain outside a certain range of prices.
        b) Unlimited profit and limited loss

Introduction:

When an investor expects the prices at the time of expiry of contract to remain outside a level of prices, he may enter into the Strangles strategy, which is created by buying a call of higher level and buying a Put of lower level. Both of these price levels (of buying Call & buying Put) are nearly the boundaries, which he expects the prices to remain outside. If the prices remain outside the boundary he makes a profit otherwise loss. Let us take an example to understand this in detail- an investor takes following positions on 27th May 2005 when Nifty Spot was Rs.2070. Action Option type Strike Premium Total investment Long Call 2100 24   Long Put 2000 18 42

Here he buys Nifty Call and Put option of Strike price Rs.2100 and Rs.2000 respectively for which he pays a net amount of Rs.42 as premium (Rs.24 paid for Long Call position and Rs.18 paid for Long Put position) to create the position. His cash flow at different levels of Nifty closing on 30th June05(last Thursday of the following month) are as follows: Index Long call Long put Investment Cash flow 1850               -            150 -42                 108.00 1900               -            100 -42                   58.00 1950               -              50 -42                    8.00 1960               -              40 -42                   (2.00) 1975               -              25 -42                  (17.00) 2000               -              -   -42                  (42.00) 2050               -              -   -42                  (42.00) 2100               -              -   -42                  (42.00) 2125               25            -   -42                  (17.00) 2140               40            -   -42                   (2.00) 2150               50            -   -42                    8.00 2200             100            -   -42                   58.00 2250             150            -   -42                 108.00

Thus it is clear from above example that his profits will occur when the Index closes beyond a certain range of prices (here it is Rs.1960 to Rs.2140) whereas in case of Index closing within this range he will make loss.

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Option Strategies - Butterfly Spread

Butterfly Spread

Salient Features          

a) Market is expected to remain with in a certain range of prices

b) Unlimited profit and limited loss

Butterfly spread is one of the most important spread trading strategy used by traders. It involves position in options with three different strike prices.

It can be created by buying a call option with a lower strike price X(1), buying a call option with a relatively high strike price X(3), and selling two call options with a strike price X(2), halfway between X(1) and X(3).

A butterfly spread leads to profit if the stock price stays close to X(2),but ends in loss (though it is small) if there is a significant price movement in either direction.

It is therefore an appropriate strategy for an investor who thinks large price movements are unlikely.

This strategy requires a small initial investment. An example would clear things up.

Nifty closed at 5,703.3 on Friday. Now 5,700 call for October series is quoting at Rs. 107.5, similarly 5,800 call and 5,600 call are quoting at Rs. 171.5 and Rs. 60.6 respectively.

A butterfly spread can be created by buying 5,800 call and 5,600 call and selling two 5,700 call. Total investment is Rs. 17.9 (60.6+171.5- 2*107.1=17.9).

So if the Nifty is trading greater than 5,617 or less than 5,783 then this strategy is profitable, and if the Nifty is higher than 5,800 or less than 5,600 then the investor loses his initial investment i.e. Rs. 17.9.

If the Nifty closes in between 5,600-5,617 and 5,783-5,800 range then the investor recovers some of his/her initial investment but overall it will be in loss though less than Rs. 17.9.

It has to be noted that we are not including broking charges, inclusion of broking charges will reduce range at which the Nifty has to close.

The maximum profit from this strategy is Rs. 82.1 when the Nifty closes at 5,700.

Butterfly spreads can also be created using put options. In this case, the investor buys a put with a low strike price, buys a put with a high strike price, and sells two puts with an intermediate strike price.

The butterfly spread in the above example would be created by buying a 5,600 and 5,800 put and selling two 5,600 put.

If investors think that there will be volatility than they can short the butterfly spread, by reversing the above positions. 

Example  2

Introduction:

When an investor expects the prices at the time of expiry of contract to remain close to the current prevailing prices in the market, he may enter into the Butterfly strategy, which is created by buying two call options, one with low strike price and the other with comparatively high strike price, and selling two call options having the strike price which lies in the middle of above two strike prices and which is close to the current prevailing market price. Let us take an example to understand this in detail- an investor takes following positions on 27th May 2005 when Nifty Spot was Rs.2070. Action Option type Strike Premium Total investment Long Call 2000 84   Short Call 2050 49   Short Call 2050 49   Long Call 2100 24 10

Expecting that the market will remain close to the Spot Nifty price of Rs.2050 he creates a Butterfly Spread by selling two Nifty Calls of Rs.2050 and buying two Nifty calls of strike price Rs.2000 and Rs.2100 respectively for which he pays a net amount of Rs.10 as premium {Rs.98 (49*2) received for shorting two Calls and Rs.84 and Rs.24 paid for two Call options}. His cash flow at different levels of Nifty closing on 30th June05 (last Thursday of the following month) are as follows: Index Long Call 2000 Short Call 2050 Short Call 2050 Long Call 2100 Total investment Cash flow 1960         -        -          -   0 -10          (10) 1990         -        -          -   0 -10          (10) 2010        10      -          -   0 -10           -   2030        30      -          -   0 -10           20 2050        50      -          -   0 -10           40 2070        70     (20)      (20) 0 -10           20 2090        90     (40)      (40) 0 -10           -   2120      120     (70)      (70) 20 -10          (10) 2150      150   (100)    (100) 50 -10          (10)

Thus it is clear from above example that his profits will occur when the Index will close between a certain range (here it is Rs.2020 to Rs.2080) whereas in case of Index closing beyond this range he will make loss.

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Option Strategies - Top straddle or Straddle sell

Top straddle or Straddle sell

Salient Features

a) Market is expected to move in sideways zone         b) Unlimited loss and limited profits  Introduction: When an investor expects sideways movement in the market then he may enter into a top straddle strategy that means selling a Call and a Put together of the same strike price and same expiry date. Let us take an example to understand this in detail- an investor takes following positions on 27th May 2005 when Nifty Spot was Rs.2070. Action Option type Strike Premium Total investment Short Call 2050 49   Short Put 2050 34 -83 Here he sells Nifty Call and Put option of Strike price Rs.2050 for which he receives a net amount of Rs.83 as premium (Rs.49 received for short Call position and Rs.34 received for short Put position) to create the position. His cash flow at different levels of Nifty closing on 30th June05(last Thursday of the following month) are as follows: Index Long call Long Put Investment Cash flow 1900               -           (150) 83                      (67) 1950               -           (100) 83                      (17) 2000               -             (50) 83                       33 2050               -              -   83                       83 2100              (50)            -   83                       33 2150            (100)            -   83                      (17) 2200            (150)            -   83                      (67) 2250            (200)            -   83                    (117) 2300            (250)            -   83                    (167) Thus it is clear that his profits will occur when the exercise price remains within a certain range of prices (here it is Rs.2000 to Rs.2100). In case of exercise price going beyond the range he will make loss. Here the upper level of range of prices is more than and lower level of range is less than the strike price of call and put taken. This strategy is useful when we expect the market to remain sideways and do not move beyond the current levels.

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Option Strategies- Bottom straddle or Straddle purchase

Bottom straddle or Straddle purchase

Salient Features

a) Market is expected to take volatile move but its direction is not clear         b) Unlimited profit and limited loss  Introduction: When an investor expects volatile movements in the market but he is not sure of the direction of it then he may enter into a bottom straddle strategy that means buying a Call and a Put together of the same strike price and same expiry date. Let us take an example to understand this in detail- an investor takes following positions on 27th May 2005 when Nifty Spot was Rs.2070. Action Option type Strike Premium Total investment Long Call 2100 24   Long Put 2100 59 83 Here he buys Nifty Call and Put option of same Strike price (Rs.2100) he pays a net amount of Rs.83 as premium (Rs.24 paid for long Call position and Rs.59 paid for long Put position) to create the position. His cash flow at different levels of Nifty closing on 30th June05(last Thursday of the following month) are as follows: Index Long call Long Put Investment Cash flow 1900               -            200 -83                     117 1950               -            150 -83                       67 2000               -            100 -83                       17 2050               -              50 -83                      (33) 2100               -              -   -83                      (83) 2150               50            -   -83                      (33) 2200             100            -   -83                       17 2250             150            -   -83                       67 2300             200            -   -83                     117 Thus it is clear that his profits will occur only when the market moves beyond a certain range of prices (here it is Rs.2000 to Rs.2200), otherwise he will make loss (in case market remains within the range). This strategy is useful when we expect volatile movements in the market, which may be prior to any major announcements, ahead of financial results of company, election time, etc.

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Option strategies- Bull spread

Bull spread

Salient Featuresa) Market is expected to go up.
b) Limited profit or loss. 

Introduction:

Bull spread is used when the market is likely to go up, it can be created in two ways which are given below: 1st Buying a call of lower strike price and selling a call of higher strike price:- When an investor, expecting the market to go up, creates a spread by purchasing a call and selling another call of higher strike price. If the market moves upwards after the creation of spread, investor makes profit otherwise he loses. Let us take an example to understand this in detail- an investor takes following spread on 27th May 2005 when Nifty Spot was Rs. 2050. Action Option type Strike Premium Total investment Long Call 2000 84 Short Call 2100 24 60

Here he buys a Nifty call of Strike price Rs.2000 and sells a call of Strike price of Rs. 2100 (Higher strike price). For creating this spread he pays a net amount of Rs.60 as premium (Rs.84 paid for long position and Rs. 24 received from short position). Now, his cash flow at different levels of Nifty closing on 30th June05(last Thursday of the following month) are as follows: Index Long call Short call Investment Cash flow 1940               -              -   -60                      (60) 1970               -              -   -60                      (60) 2000               -              -   -60                      (60) 2030               30            -   -60                      (30) 2060               60            -   -60                        -   2090               90            -   -60                       30 2120             120           (20) -60                       40 2150             150           (50) -60                       40 2180             180           (80) -60                       40

Here we find that maximum profit and loss that he can incur are limited, thus it has low level of risk (lesser profits also). If he goes right in predicting the trend, then on an investment of Rs.60, he can earn Rs. 40. 2nd Buying a put of lower strike price and selling a put of higher strike price:- When an investor, expecting the market to go up, creates a spread by purchasing a put and selling another put of higher strike price. If the market moves upwards after creation of spread, investor makes profit otherwise he loses. Let us take an example to understand this in detail- an investor takes following spread on 27th May 2005 when Nifty Spot was Rs. 2050.   Action Option type Strike Premium Total investment Long Put 2000 18 Short Put 2100 59 -41 Here he buys a Nifty Put of Strike price Rs.2000 and sells a put of Strike price of Rs. 2100 (Higher strike price). For creating this spread he receives a net amount of Rs.41 as premium (Rs.18 paid for long position and Rs. 59 received from short position). Now, his cash flow at different levels of Nifty closing on 30th June05(last Thursday of the following month) are as follows:  Index Long Put Short Put Investment Cash flow 1940               60        (160) 41                      (59) 1970               30        (130) 41                      (59) 2000               -          (100) 41                      (59) 2030               -            (70) 41                      (29) 2060               -            (40) 41                         1 2090               -            (10) 41                       31 2120               -             -   41                       41 2150               -             -   41                       41 2180               -             -   41                       41 Here we find that maximum loss and profit that he can incur are limited, thus it has low level of risk (lesser profits also). If he goes right in predicting the trend, then on an investment of Rs.41, he can earn Rs. 41.

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