Welcome back to the derivative segment. Here, we discuss the meanings and strategies related to derivatives, and how you can use derivatives to maximise your profits, or simply hedge your position. And this time we bring some Popular Option Trading Strategies exclusively for you.
Before we dive into option strategies, time for quick definitions. A derivative is an instrument that ‘derives’ its value from an underlying asset.
A Call option basically gives the buyer of the option the right but not the obligation to buy an underlying security within a particular time.
A Put option basically gives the buyer of an option the right but not the obligation to sell underlying security before the option expires.
A Spot price is the market price during any relevant time, the strike price is the price at which the option is exercised and an option premium is the price paid to buy an option.
To explore additional information you can have a look at Option Trading: Meaning, Types & Examples
Let’s get into it!
What is a Covered Call Option? Meaning
Basically, there are two scenarios of your asset possession when you can sell a call option.
The first can be when you issue the option without owning the underlying asset. This is called a naked call strategy.
On the other end of the spectrum, the second scenario can be when you own the underlying asset at the time of selling the call. This strategy is called covered call strategy.
Simply put, there can be two underlying motives, depending on the scenario. The first can be to make profits out of a steady stable market while owning the underlying stock. This is imply through option premium. Let’s understand this through incentives.
See, if the spot price before the expiry of the option does not exceed the sum of strike price and option premium, which in a stable market is highly unlikely; volatility against volatility, if you will, then there is really no incentive for the option buyer to exercise the option, in which case you, the seller of the option get to keep all the option premium to yourself.
The second motive could be to make money off of your position during short-term. Basically, if the markets are increasingly volatile. Basically, you buy the option with a higher strike price than the current spot price. In majority of cases, there is no single short term gain in price of shares, which means the probability of the option actually exceeding the spot price is less.
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Call Option Example:
Suppose you buy 10 shares worth Rs. 100 each, making your total investment worth Rs. 1000, and then you sell call option with a strike price of Rs. 110, at a premium of Rs. 3.
This can play out in several ways as discussed below.
The first is that at the expiry, the stock doesn’t move beyond Rs. 113, because for the buyer of the option, this is the price after which there is profit. In this case, you get to keep all of the option premium, maybe issue the same option again.
The second scenario can be that the stock does move beyond Rs. 113, say Rs. 120. In this case, you end up making Rs. 10 per share as profit from your original cost, plus an additional Rs. 3 per share for the option, making total profit of about Rs. 130 ( 10 + 3 = 13 * 10 shares). This is still decent amount of profit, given the fact that the risk is reduced substantially.
Also, huge movements in shares like this is usually an unlikely scenario, which means the first case is more likely to happen than this one, because it is obvious that if you hadn’t sold the call, you’d have made Rs. 20 per share. The thing is, in the long run, if you keep chasing such huge unlikely profits, there is a huge chance you might miss out on such lower risk substantial profits, which investors have pointed time and again add up more to fill the ocean, than such huge high-risk profits.
What is Option Straddle? (Long Straddle and Short Straddle)
Loosely defined, straddle basically means having your feet in both sides of a neutral position.
An option straddle is basically when you either buy or sell both types of at the exact same time and the exact same price. There are two types, for two different scenarios.
This is a strategy for rough tides, if you will. The basic idea is that you buy both call and put options of the same asset at the exact same strike price, at the same time. The idea is that it is known that there is existence of volatility, but not exactly known which direction.
Long Straddle Example:
Suppose you buy a call option for a share at Rs. 5 and a put option at Rs. 5 as well, both for the exact same strike price of Rs. 100.
If the stock falls, say down to Rs. 80, then your call option becomes worthless. But you can exercise the put option by buying the shares from the market at Rs. 80 and selling at Rs. 100. The same way, if the price goes to Rs. 120, put becomes worthless but call option can still yield profits.
In both cases, the maximum loss is limited to Rs. 10 i.e. the combined price of both options, while the maximum profit can be unlimited in case of rise and huge in case of fall. However, while you’re calculating the profits, because there is a higher cost involved, there are lower profits.
For instance, when the price falls down to Rs. 80, in this strategy you only make Rs. 10 per share, in contrast with someone who had only bought the put option, who ends up making Rs. 15.
This strategy is basically a means to make money out of relatively stable markets. The process if the opposite of long straddle strategy. In this one, you sell both call and put options of the same asset. While in long straddle the idea was to make money off of stock price movements, here the idea is to make money out of option premiums, which means if the higher the movement, the bigger the losses.
Short Straddle Example:
Suppose you sell a call and put option, each at Rs. 5 at the strike price of Rs. 100. If the price increases, to say Rs. 115, then the call option that was sold would be exercised, so you would have to buy at Rs. 110 but sell at Rs. 100 to the holder, making a loss of Rs. 5 (because Rs. 10 is recovered from the option premium received.)
Similarly, if the price falls to Rs. 85, the put option would be exercised, making a loss of Rs. 5. The idea here is that the profit would be maximum the closer spot price gets to strike price, because it reduces the chances of either option being exercise. In this scenario, as long as the price varies from Rs. 95-105, the seller of the option is in green because both the buyers have no incentive to exercise the option because strike price combined with premium would make them a loss.
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Option Trading Strategies: Key Takeaways
Studying option trading strategies not only empowers you to make profits off of options, it also opens up new avenues in your brain, new perspectives to think from. Maybe that’s why investors like Stephen Schwarzman and Warren Buffet emphasize on constant reading, upgradation of knowledge.
Option trading strategies do come in a variety of flavours, we have tried to explain some of the popular ones here. But, one thing to keep in mind, all the option strategies revolve around two fundamental options. You guessed it right! Call and Put Options. So, you can pick and build the best strategy to maximize your profits from a stock price movement. If you have any ideas to share, do drop in the comments below.