Common Option Trading Strategies

Option trading involves various strategies that traders use to capitalize on market movements, manage risk, and achieve specific objectives. Here are some common option trading strategies:

Table of Contents

• Long Call
• Long Put
• Covered Call
• Protective Put
• Straddle
• Strangle
• Butterfly Spread
• Iron Condor
• Collar
• Ratio Spread

Long Call

This strategy involves buying call options, giving the right to purchase the underlying asset at a specified price within a certain time frame. Traders use this when they expect the price of the underlying asset to rise significantly.

A long call option strategy works similarly to the general definition in options trading. It involves purchasing a call option on a particular Indian stock, anticipating that its price will increase significantly within a specified period.

Let's provide an example using an Indian stock:

Assume you are bullish on a company listed on the National Stock Exchange (NSE) or Bombay Stock Exchange (BSE), let's call it "ABC Ltd." The current market price of ABC Ltd. stock is ₹100 per share, and you expect it to rise in the next few months.

• Stock: ABC Ltd.
• Current Stock Price: ₹100 per share
• Call Option Details:
  • Strike Price: ₹110
  • Expiration Date: 3 months from now
  • Premium (Cost of the Option): ₹5 per share

In this scenario:

• You decide to execute a long call strategy on ABC Ltd.
• You purchase one call option contract for ABC Ltd. with a strike price of ₹110.
• The premium per share is ₹5, and since each options contract usually represents 100 shares, the total cost would be ₹500 (₹5 premium * 100 shares per contract).

Outcome Scenarios at Expiration:

1. ABC Ltd.'s stock price remains below the ₹110 strike price:

   • If the stock price remains below ₹110 by the expiration date, the call option expires worthless.
   • You lose the premium paid (₹500 in this case), which is the maximum potential loss.

2. ABC Ltd.'s stock price rises above the ₹110 strike price:

   • If the stock price rises above ₹110 before or at the expiration date, the call option becomes profitable.
   • For instance, if the stock price reaches ₹120 by expiration, your call option allows you to buy the stock at ₹110, which is below the market price.
   • Your profit would be calculated as follows:
     • Market price at expiration: ₹120
     • Minus the strike price: ₹110
     • Minus the premium paid: ₹5
     • Total Profit per share = ₹120 - ₹110 - ₹5 = ₹5
   • Since each options contract represents 100 shares, the total profit would be ₹500 (₹5 profit per share * 100 shares per contract).

Long Put

Similar to the long call, the long put involves buying put options, providing the right to sell the underlying asset at a predetermined price within a specified time. Traders use this when they anticipate the price of the underlying asset will drop.

A long put option strategy involves buying a put option for a particular Indian stock, anticipating that its price will decrease significantly within a specified period.

Let's illustrate this strategy with an example using an Indian stock:

Assume you have a bearish outlook on a company listed on the National Stock Exchange (NSE) or Bombay Stock Exchange (BSE), let's call it "XYZ Ltd." The current market price of XYZ Ltd. stock is ₹150 per share, and you expect it to decline in the near future.

• Stock: XYZ Ltd.
• Current Stock Price: ₹150 per share
• Put Option Details:
  • Strike Price: ₹140
  • Expiration Date: 2 months from now
  • Premium (Cost of the Option): ₹8 per share

In this scenario:

• You decide to implement a long put strategy on XYZ Ltd.
• You purchase one put option contract for XYZ Ltd. with a strike price of ₹140.
• The premium per share is ₹8, and since each options contract typically represents 100 shares, the total cost would be ₹800 (₹8 premium * 100 shares per contract).

Outcome Scenarios at Expiration:

1. XYZ Ltd.'s stock price remains above the ₹140 strike price:

   • If the stock price stays above ₹140 by the expiration date, the put option expires worthless.
   • You lose the premium paid (₹800 in this case), which is the maximum potential loss.

2. XYZ Ltd.'s stock price falls below the ₹140 strike price:

   • If the stock price drops below ₹140 before or at the expiration date, the put option becomes profitable.
   • For example, if the stock price declines to ₹130 by expiration, your put option allows you to sell the stock at ₹140, which is above the market price.
   • Your profit would be calculated as follows:
     • Strike price: ₹140
     • Minus the market price at expiration: ₹130
     • Minus the premium paid: ₹8
     • Total Profit per share = ₹140 - ₹130 - ₹8 = ₹2
   • Since each options contract represents 100 shares, the total profit would be ₹200 (₹2 profit per share * 100 shares per contract).

Covered Call

Traders who own the underlying asset sell call options against it. If the price remains below the strike price, they keep the premium. If the price surpasses the strike price, they may have to sell their asset at the strike price.

A covered call strategy involves owning the underlying stock of a company and simultaneously selling (writing) call options against that stock. This strategy is executed when an investor or trader holds a long position in a particular stock and wants to generate additional income from that position by selling call options.

Let's illustrate this strategy with an example using an Indian stock:

Assume you own 100 shares of "PQR Ltd.," a company listed on the National Stock Exchange (NSE) or Bombay Stock Exchange (BSE), and you're moderately bullish on its short-term performance. The current market price of PQR Ltd. stock is ₹200 per share.

• Stock: PQR Ltd.
• Current Stock Holdings: 100 shares
• Stock Price: ₹200 per share

Now, you decide to execute a covered call strategy:

• Call Option Details:
  • Strike Price: ₹220
  • Expiration Date: 1 month from now
  • Premium (Income from Selling the Option): ₹10 per share

In this scenario:

• You own 100 shares of PQR Ltd.
• You decide to sell one call option contract for PQR Ltd. with a strike price of ₹220.
• The premium received per share is ₹10, and since each options contract typically represents 100 shares, the total income generated would be ₹1,000 (₹10 premium * 100 shares per contract).

Outcome Scenarios at Expiration:

1. PQR Ltd.'s stock price remains below the ₹220 strike price:

   • If the stock price stays below ₹220 by the expiration date, the call option expires worthless.
   • You keep the premium received (₹1,000 in this case) as additional income.

2. PQR Ltd.'s stock price rises above the ₹220 strike price:

   • If the stock price increases above ₹220 before or at the expiration date, the call option becomes exercised.
   • As you already own the shares, you will sell your 100 shares at the strike price of ₹220, which might limit potential gains as the stock moves above that price.
   • Your maximum profit from the stock is capped at the strike price plus the premium received (₹220 + ₹10 = ₹230) regardless of how high the stock price goes.

The covered call strategy is considered a conservative income-generating strategy as it provides an additional income stream (from the premium received by selling the call option) against the potential limited upside on the stock's appreciation beyond the strike price

Protective Put

This involves buying a put option to protect against a drop in the price of the underlying asset. It acts as insurance, limiting potential losses.

A protective put strategy remains fundamentally the same as described earlier. It's an options trading strategy used by investors to protect against potential losses in a stock position. However, it involves the Indian stock market and its related instruments.

For example:

Let's consider an investor who holds 500 shares of a company listed on the National Stock Exchange (NSE) of India. The stock is currently trading at ₹150 per share. To safeguard against potential downside risk, the investor purchases NSE put options with a strike price of ₹140 that expire in two months. Each options contract represents 100 shares, so the investor buys 5 put option contracts.

Suppose the cost of each put option contract is ₹4. Therefore, the total cost of purchasing these 5 put option contracts would be ₹2,000 (₹4 premium x 100 shares x 5 contracts).

Scenario 1: Stock Price Increases or Remains Stable If the stock price rises or remains above ₹150 or stable until the expiration of the put options, the investor is in a profitable position with their stock holding. However, the put options act as a form of insurance. Even if the stock doesn't decrease in value, the investor is protected against significant losses because they have the right to sell the shares at the strike price of ₹140 if the stock were to plummet.

Scenario 2: Stock Price Decreases Suppose the stock price falls below ₹140 before the put options expire. For instance, if the stock price drops to ₹130, the investor can exercise their put options. They have the right to sell their shares at the higher strike price of ₹140, thereby limiting their potential losses. Without the put options, the investor would have faced more substantial losses had they only held the stock.

As with any options strategy, a protective put in the Indian share market comes with risks. These risks include the potential loss of the premium paid for the put options if the stock price remains above the strike price until the option expiration.

Straddle

Involves buying both a call and a put with the same strike price and expiration date. Traders use this strategy when they expect significant price volatility but are unsure about the direction of the movement.

A straddle is an options trading strategy where an investor simultaneously buys a call option and a put option with the same expiration date and the same strike price on the same underlying stock.

The straddle strategy is used when an investor anticipates significant volatility in the price of the underlying stock but is unsure about the direction of the price movement. By employing a straddle, the investor aims to profit from a substantial price movement in either direction.

Here's an example of a straddle strategy in the Indian share market:

Suppose a company, XYZ Ltd., is trading at ₹200 per share, and an investor expects a significant price movement in the stock due to an upcoming earnings announcement or any other major event. The investor decides to implement a straddle strategy.

• XYZ Ltd. is currently trading at ₹200 per share.
• The investor purchases both a call option and a put option with a strike price of ₹200 each.
• Each option contract represents 100 shares.

Let's assume the call option costs ₹10 per share, and the put option also costs ₹10 per share. Therefore, the total cost of initiating the straddle strategy would be ₹2,000 (₹10 premium x 100 shares x 2 contracts).

Scenario 1: Significant Price Increase If after the earnings announcement or the anticipated event, the stock price of XYZ Ltd. surges to ₹250 per share, the call option would be "in the money." The investor can exercise the call option, buying shares at the strike price of ₹200 and selling them at the market price of ₹250, making a profit.

Scenario 2: Significant Price Decrease Conversely, if the stock price declines to ₹150 per share after the event, the put option would be "in the money." The investor can exercise the put option, selling shares at the higher strike price of ₹200 while the market price is ₹150, thus making a profit.

Scenario 3: Minimal Price Movement If the stock price of XYZ Ltd. remains around ₹200 per share or experiences minimal movement after the event, both the call and put options may expire worthless, resulting in a loss equal to the premium paid to initiate the straddle strategy.

A straddle strategy can be profitable if there is a significant price movement in either direction. However, it carries the risk of losing the entire premium paid if the stock price does not move significantly enough before the options expire.

Strangle

Similar to the straddle, but the call and put have different strike prices. This strategy is used when traders expect high volatility but aren't certain about the direction of the price movement.

A strangle is an options trading strategy that involves buying a call option and a put option simultaneously on the same underlying stock with different strike prices but the same expiration date. The strangle strategy is typically used when an investor expects significant price volatility in the underlying stock but is uncertain about the direction of the price movement.

Here's an example of a strangle strategy in the Indian share market:

Suppose a company, ABC Ltd., is trading at ₹300 per share, and an investor anticipates a substantial price movement due to an impending major announcement or event. The investor decides to implement a strangle strategy.

• ABC Ltd. is currently trading at ₹300 per share.
• The investor purchases a call option with a strike price of ₹320 and a put option with a strike price of ₹280.
• Both options have the same expiration date.
• Each option contract represents 100 shares.

Let's assume the call option costs ₹8 per share, and the put option costs ₹6 per share. Therefore, the total cost of initiating the strangle strategy would be ₹1,400 (₹8 premium x 100 shares x 1 call contract + ₹6 premium x 100 shares x 1 put contract).

Scenario 1: Significant Price Increase If after the anticipated event, the stock price of ABC Ltd. rises substantially to ₹350 per share, the call option would potentially be profitable. However, since the stock price is beyond the call option's strike price of ₹320, it may expire worthless.

Scenario 2: Significant Price Decrease Conversely, if the stock price declines significantly to ₹260 per share after the event, the put option would potentially be profitable. However, since the stock price is below the put option's strike price of ₹280, it may also expire worthless.

Scenario 3: Moderate Price Movement If the stock price of ABC Ltd. experiences moderate movement but stays within the range of ₹280 to ₹320, both the call and put options may expire worthless, resulting in a loss equal to the premium paid to initiate the strangle strategy.

A strangle strategy can be profitable if there is a substantial price movement in either direction. However, it involves the risk of losing the entire premium paid if the stock price doesn't move significantly enough before the options expire.

Butterfly Spread

Combines both long and short call (or put) options at three different strike prices. It's used when traders expect minimal price movement and low volatility.

A butterfly spread is a neutral strategy that involves using a combination of call or put options on the same underlying security with three different strike prices. This strategy is constructed to profit from minimal movement in the price of the underlying asset. A butterfly spread consists of two short options at the middle strike price and one long option each at a higher and lower strike price.

Here's an example of a butterfly spread in the context of the Indian share market:

Suppose a stock, XYZ Ltd., is currently trading at ₹500 per share, and an investor anticipates that the stock price will remain relatively stable in the near term. The investor decides to implement a butterfly spread strategy using call options.

• The investor decides to construct a call butterfly spread.
• The current stock price of XYZ Ltd. is ₹500 per share.
• Strike prices: ₹480, ₹500, and ₹520.
• The investor sells two call option contracts at the middle strike price of ₹500.
• The investor buys one call option contract each at the lower strike price of ₹480 and the higher strike price of ₹520.
• Each option contract represents 100 shares.

Assuming the premium for the ₹480 and ₹520 strike call options is ₹10 per share, and the premium for the ₹500 strike call options (short options) is ₹5 per share.

The total cost or debit to set up the butterfly spread would be:

• Debit from buying one ₹480 strike call option: ₹10 x 100 shares = ₹1,000
• Debit from buying one ₹520 strike call option: ₹10 x 100 shares = ₹1,000
• Credit from selling two ₹500 strike call options: ₹5 x 100 shares x 2 = ₹1,000

Total Debit (Cost of the Butterfly Spread) = ₹1,000 (₹480 call) + ₹1,000 (₹520 call) - ₹1,000 (₹500 call) = ₹1,000

Scenario:

If the stock price of XYZ Ltd. remains close to ₹500 upon nearing the expiration date:

• The ₹480 and ₹520 call options would expire out of the money and become worthless.
• The two short ₹500 call options would also expire worthless, resulting in the investor pocketing the premium received from selling them.
• The investor's maximum profit would be the difference between the premiums received and the premiums paid to set up the butterfly spread (excluding transaction costs).

However, if the stock price deviates significantly from ₹500, the profitability of the butterfly spread would be affected. The maximum loss would be limited to the initial debit or cost incurred to set up the spread.

Iron Condor

Combines a bear call spread and a bull put spread. Traders use this strategy when they expect the price of the underlying asset to remain within a specific range.

Collar

Involves buying a protective put while simultaneously selling a covered call. This strategy helps limit potential losses and caps potential gains.

Ratio Spread

Involves buying a certain number of options and selling more or fewer options of the same type. It's used to profit from a specific directional move while controlling risk.

Each strategy has its own risk-reward profile and suitability based on market conditions, volatility, and the trader's outlook. It's crucial to understand these strategies thoroughly, including their potential risks, before using them in actual trading scenarios. Moreover, traders often combine multiple strategies or adjust them based on changing market conditions to manage risk effectively.