Know Different Types Of Option Trading Strategies

8.1 COVERED CALL

• You own shares in a company which you feel may rise but not much in the near term (or at best stay sideways). You would still like to earn an income from the shares. The covered call is a strategy in which an investor Sells a Call option on a stock he owns (netting him a premium). The Call Option which is sold in usually an Out of the money Call. The Call would not get exercised unless the stock price increases above the strike price. Till then the investor in the stock (Call seller) can retain the Premium with him. This becomes his income from the stock. This strategy is usually adopted by a stock owner who is Neutral to moderately Bullish about the stock.
• An investor buys a stock or owns a stock which he feel’s is good for medium to long term but is neutral or bearish for the near term. At the same time, the investor does not mind exiting the stock at a certain price (target price). The investor can sell a Call Option at the strike price at which he would be fine exiting the stock (Out of the Money strike). By selling the Call Option the investor earns a Premium. Now the position of the investor is that of a Call Seller who owns the underlying stock. If the stock price stays at or below the strike price, the Call Buyer will not exercise the Call. The Premium is retained by the investor.
• In case the stock price goes above the strike price, the Call buyer who has the right to buy the stock at the strike price will exercise the Call option. The Call seller (the investor) who has to sell the stock to the Call buyer, will sell the stock at the strike price. This was the price which the Call seller (the investor) was anyway interested in exiting the stock and now exits at that price.
• So besides the strike price which was the target price for selling the stock, the Call seller (investor) also earns the Premium which becomes an additional gain for him. This strategy is called as a Covered Call strategy because the Call sold is backed by a stock owned by the Call Seller (investor). The income increases as the stock rises, but gets capped after the stock reaches the strike price. Let us see an example to understand the Covered Call strategy.

When to Use

This is often employed when an investor has a short-term neutral to moderately bullish view on the stock he holds. He takes a short position on the Call option to generate income from the option premium. Since the stock is purchased simultaneously with writing (selling) the Call, the strategy is commonly referred to as “buy-write”.

Risk:
If the Stock Price falls to zero, the investor loses the entire value of the Stock but retains the premium, since the Call will not be exercised against him. So maximum risk = Stock Price Paid – Call Premium Upside capped at the Strike price plus the Premium received. So if the Stock rises beyond the Strike price the investor (Call seller) gives up all the gains on the stock.

Reward: Limited to (Call Strike Price – Stock Price paid) + Premium received
Breakeven: Stock Price paid – Premium Received
Example:

Mr. A bought XYZ Ltd. for Rs 3850 and simultaneously sells a Call option at an strike price of Rs 4000. Which means Mr. A does not think that the price of XYZ Ltd. will rise above Rs. 4000. However, incase it rises above Rs. 4000, Mr. A does not mind getting exercised at that price and exiting the stock at Rs. 4000.
(TARGET SELL PRICE = 3.90% return on the stock purchase price)

Mr. A receives a premium of Rs 80 for selling the Call. Thus net outflow to Mr. A is (Rs. 3850 – Rs. 80) = Rs. 3770. He reduces the cost of buying the stock by this strategy.

If the stock price stays at or below Rs. 4000, the Call option will not get exercised and Mr. A can retain the Rs. 80 premium, which is an extra income. If the stock price goes above Rs 4000, the Call option will get exercised by the Call buyer.
The entire position will work like this:
Strategy- Buy Stock+ Sell Call Option
– Mr. A Buys the stock XYZ- Market Price- Rs.3850
– Call Options- Strike Price- Rs.4000
– Mr. A. Receives- Premium- Rs.80
– Breakeven Point (Rs)- Stock Price Paid- Premium Received- Rs.3770
Example:
1) The price of XYZ Ltd. stays at or below Rs. 4000. The Call buyer will not exercise the Call Option. Mr. A will keep the premium of Rs. 80. This is an income for him. So if the stock has moved from Rs. 3850 (purchase price) to Rs. 3950, Mr. A makes Rs. 180/- [Rs. 3950 – Rs. 3850 + Rs. 80 (Premium) ] = An additional Rs. 80, because of the Call sold.
2) Suppose the price of XYZ Ltd. moves to Rs. 4100, then the Call Buyer will exercise the Call Option and Mr. A will have to pay him Rs. 100 (loss on exercise of the Call Option). What would Mr. A do and what will be his pay – off?
a) Sell the Stock in the market at- Rs.4100
b) Pay Rs. 100 to the Call Options buyer- – Rs.100
c) Pay Off (a – b) received- Rs.4000 (This was Mr.A’s target price)
d) Premium received on Selling Call Option- Rs.80
e) Net Payment (c+d) received by Mr. A- Rs.4080
f) Purchase price of XYZ limited- Rs.3850
g) Net profit- Rs.4080-3850 – Rs.230
h) Return- (4080-3850/3850)*100= 5.97% — (which is more than the target return of 3.90%)
The payoff Schedule

8.2 Long Straddle

Long straddle is perhaps the simplest market neutral strategy to implement. Once implemented, the P&L is not affected by the direction in which the market moves. The market can move in any direction, but it has to move. As long as the market moves (irrespective of its direction), a positive P&L is generated. To implement a long straddle all one has to do is –
1. Buy a Call option
2. Buy a Put option
Ensure –
1. Both the options belong to the same underlying
2. Both the options belong to the same expiry
3. Belong to the same strike
This is done to , to take advantage of a movement in either direction, a soaring or plummeting value of the stock / index. If the price of the stock increases, the call is exercised while the put expires worthless and if the price of the stock decreases, the put is exercised, the call expires worthless.
Either way if the stock shows volatility to cover the cost of the trade, profits are to be made. With Straddles, the investor is direction neutral. All that he is looking out for is the stock to break out exponentially in either direction.
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
Example-
Suppose Nifty is at 16450 on 27th Jan. An investor, Mr. A enters a long straddle by buying a Feb Rs 16500 Nifty Put for Rs. 85 and a Feb 16500 Nifty Call for Rs. 122. The net debit taken to enter the trade is Rs 207, which is also his maximum possible loss.
Strategy : Buy Put + Buy Call

The payoff schedule

As you can see- If the market goes up, the trader gains in Call options far higher than the loss made (read premium paid) on the put option. Similarly, if the market goes down, the gains in the Put option far exceeds the loss on the call option. Hence irrespective of the direction, the gain in one option is good enough to offset the loss in the other and still yield a positive P&L.

Lets understand one scenario- as can be seen from the table if Nifty expires at 15800, put option makes money This is a scenario where the gain in the put option not only offsets the loss made in the call option but also yields a positive P&L over and above. At 15800

• 16500 CE will expire worthless, hence we lose the premium paid i.e Rs. 122
• 16500 PE will have an intrinsic value of 700. After adjusting for the premium paid i.e Rs.85, we get to retain 400 – 88 = 615
• The net payoff would be 615 – 122 =+ 493

As you can see, the gain in put option after adjusting for the premium paid for put option and after adjusting for the premium paid for the call option still yields a positive P&L.

Till the time Nifty is in the range of 15800 to 16293 the put option has a positive P&L and if Nifty goes above 16800 then call option will give a positive P&L

What can go wrong with the straddle?

1. Theta Decay – All else equal, options are depreciating assets and this particularly hurts long positions. The closer you get to expiration, the lesser time value of the option. Time decay accelerates exponentially during the last week before expiration, so you do not want to hold onto out-of-the-money or at-the-money options into the last week and lose premiums rapidly.

2. Large breakevens –As shown above, the breakeven points were 207 points away from the strike. The lower breakeven point was 16293 and the upper breakeven was 16707, considering the ATM strike was 16500. In percentage terms, the market has to move 1.25% (either ways) to achieve breakeven. This means that from the time you initiate the straddle, the market or the stock has to move atleast 1.25% either ways for you to start making money…and this move has to happen within a maximum of 30 days. Further if you want to make a profit of atleast 1% on this trade, then we are talking about a 1% move over and above 1.25% on the Nifty.

8.3 Short Straddle

A Short Straddle is the opposite of Long Straddle. It is a strategy to be adopted when the investor feels the market will not show much movement. He sells a Call and a Put on the same stock for the same maturity and strike price. It creates a net income for the investor. If the stock does not move much in either direction, the investor retains the Premium as neither the Call nor the Put will be exercised. However, incase the stock moves in either direction, up or down significantly, the investor’s losses can be significant. So this is a risky strategy and should be carefully adopted and only when the expected volatility in the market is limited. If the stock value stays close to the strike price on expiry of the contracts, maximum gain, which is the Premium received is made.

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

Example
Suppose Nifty is at 16450 on 27th Jan. An investor, Mr. A, enters into a short straddle by selling a Feb Rs 16500 Nifty Put for Rs. 85 and a Feb 16500 Nifty Call for Rs. 122. The net credit received is Rs. 207, which is also his maximum possible profit.

Strategy : Sell Put + Sell Call

The payoff schedule

As can be seen above- If Market expires at 15800 the loss in the put option is so large that it eats away the premium collected by both the CE and PE, resulting in an overall loss. At 15800 –
o 16500 CE will expire worthless, hence we get the retain the premium received i.e 122
o 16500 PE will have an intrinsic value of 700. After adjusting for the premium received i.e Rs.85, we lose 700 – 85 = – 615
o The net loss would be 615 – 122 = – 493
As you can see, the gain in call option is offset by the loss in the put option.
From the table above you can see –
1. The maximum profit 207 occurs at 16500, which is the ATM strike
2. The strategy remains profitable only between the lower and higher breakdown numbers
3. The losses are unlimited in either direction of the market

8.4 Long Strangle

A Strangle is a slight modification to the Straddle to make it cheaper to execute. This strategy involves the simultaneous buying of a slightly out-of-the-money (OTM) put and a slightly out-of-the-money (OTM) call of the same underlying stock and expiration date.
Here again the investor is directional neutral but is looking for an increased volatility in the stock / index and the prices moving significantly in either direction. Since OTM options are purchased for both Calls and Puts it makes the cost of executing a Strangle cheaper as compared to a Straddle, where generally at the money strikes are purchased. Since the initial cost of a Strangle is cheaper than a Straddle, the returns could potentially be higher. However, for a Strangle to make money, it would require greater movement on the upside or downside for the stock / index than it would for a Straddle.
As with a Straddle, the strategy has a limited downside (i.e. the Call and the Put premium) and unlimited upside potential

When to Use: The investor thinks that the underlying stock / index will experience very high levels of 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
Example:
Suppose Nifty is at 16500 in Jan. An investor, Mr. A, executes a Long Strangle by buying a Rs. 16300 Nifty Put for a premium of Rs. 23 and a Rs 16700 Nifty Call for Rs 43. The net debit taken to enter the trade is Rs. 66, which is also his maximum possible loss.
Strategy : Sell Put + Sell Call

Payoff Schedule

Lets assume market expires at 15800 (much below the PE strike)

At 16700, the premium paid for the call option i.e. 43 will go worthless. However the put option will have an intrinsic value of 500 points. The premium paid for the Put option is 23 hence the total profit from the put option will be 500 – 23 = +477
We can further deduct for the premium paid for call option i.e. 43 from the profits of Put option and arrive at the overall profitability i.e. 477 – 43 = +434
If the Market expires at 16234 (lower breakeven)
At 16234, the 16300 put option will have an intrinsic value of 66. The put option’s intrinsic value offsets the combined premium paid towards both the call and put option i.e.23 +43 = 66. Hence at 16234, the strangle neither makes money nor losses money.
Thus, to summaries in Strangle –
1. The maximum loss is restricted to the net premium paid
2. The loss would be maximum between the two strike prices
3. Upper Breakeven point = Call strike + net premium paid
4. Lower Breakeven point = Put strike – net premium paid
5. Profit potentially is unlimited

8.5 Short Straggle

A Short Strangle is a slight modification to the Short Straddle. It tries to improve the profitability of the trade for the Seller of the options by widening the breakeven points so that there is a much greater movement required in the underlying stock / index, for the Call and Put option to be worth exercising. This strategy involves the simultaneous selling of a slightly out-of-the-money (OTM) put and a slightly out-of-the-money (OTM) call of the same underlying stock and expiration date.
This typically means that since OTM call and put are sold, the net credit received by the seller is less as compared to a Short Straddle, but the break even points are also widened. The underlying stock has to move significantly for the Call and the Put to be worth exercising. If the underlying stock does not show much of a movement, the seller of the Strangle gets to keep the Premium.
When to Use: This options trading strategy is taken when the options investor thinks that the underlying stock will experience 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
Example:
Suppose Nifty is at 4500 in May. An investor, Mr. A, executes a Short Strangle by selling a Rs. 4300 Nifty Put for a premium of Rs. 23 and a Rs. 4700 Nifty Call for Rs 43. The net credit is Rs. 66, which is also his maximum possible gain.

Payoff Schedule

As you can see from the table above, the strategy results in a loss as and when the market moves in any particular direction. However the strategy remains profitable between the lower and upper breakeven points. Recall –
o Upper breakeven point is at 16766
o Lower breakeven point is at 16234
o Max profit is net premium received, which is 66
In other words you get to take home 66 as long as the market stays within 16766 and 16234. This is a fantastic proposition. More often than not market stays within certain trading ranges and therefore the market presents such beautiful trading opportunities.
Thus,
1. The payoff of the short strangle looks exactly opposite of the long strangle
2. The profits are restricted to the extent of the net premium received
3. The profits are maximum as long as the stock stays within the two strike prices
4. The losses are potentially unlimited