94 ADVANCED TRADING STRATEGIES IN OPTIONS

11
Creating Low-Risk Trading Strategies
Using Derivative Products
Mayank Joshipura and Ajab Gandhi

The article analyses the derivative market with real time

examples. The objective of this paper is to find out that option
trading strategies which can lower the risk. The paper focuses
on Strip and Strap trading strategy and Synthetic Bull spread
with selling out-of-the money call options and buying futures
and at-the-money put options. Specifically the strategy Covered
Call with detailed analysis is covered in the paper with examples
from Indian derivative market. A strategy which has low risk is
created with at the money and out of the money options contract.
Various low risk strategies like synthetic bull spread, strip, strap
are constructed and compared.

Introduction
Option is a product which offers non-linear payoff to the buyer and seller of the
option contract. The buyer has only right and no obligation in addition to limited
loss and unlimited profit potential, whereas the exact opposite scenario is true for
the seller of an option. So it seems that rules of the game are tiled in favour of the

© Mayank Joshipura and Ajab Gandhi. Printed with permission.

 Creating Low-Risk Trading Strategies Using Derivative Products 95

buyer and not the seller. But the odds of wining are heavily in favour of the sellers
and that makes the game equally attractive for buyers as well as sellers.

Option is the only product which allows the trader to make profit by just
taking a view on volatility of the market regardless of knowing anything about
the direction. The most famous strategy to play with volatility is a Straddle.

Straddle
Buying/Selling one call option and one put option of same strike price and same
expiry.

1. Long Straddle
A trader expects the market to be extremely volatile in the near future with equal
probability, will go and buy call and put option of the underlying asset with
same strike price and expiry.

Payoff
In case if the market goes up in a big way, the call option will give profit and if
the market goes down the put option will give profit. The maximum loss would
be restricted to the total premium paid to buy both the options.

2. Short Straddle
A trader with range bound expectation about the market will go for a short straddle.
In this case if the market remains at the same level at expiry, the trader gets a
maximum profit equal to the total premium received but if the market turns
extremely volatile he may suffer unlimited loss.

In case of straddle we assume equal probability of the market to rise and fall in
big way from our chosen strike price level. But a trader may have a biased view
towards the market. For such traders two famous variants of straddle strategy have
been created which have become very popular. Let us understand both of them.

I. Long Strap
A Strap is buying two call options and buying one put option of the same strike
price.
96 ADVANCED TRADING STRATEGIES IN OPTIONS

It is equivalent of buying one straddle and one extra call option. This extra
call option shows traders bias towards upward movement in underlying. The
bias in favour of upward market movement is 2/3rd compared to market moving
downward is 1/3rd.

Illustration1
This strategy is formulated by using the last traded price of IDBI on 25th April
2007 option contracts with expiry on 31st May 2007. May Future Contract
closed at Rs.89.50 on 25th April, 2007.

To create a Long Strap:

Buy 2 call options with strike price of Rs.90 @ Rs.5.10
Buy 1 put option with strike price of Rs.90 @ Rs.5.40
(in Rs.)
Buy 2 call options 2 * 5.10 = 10.20
Buy 1 put option 1 * 5.40 = 5.40
Initial Cash Flow (CF0) 15.60

Break even point: On upward move at Rs.97.80 and

On downward move at Rs.74.40
Table I: Profit/Loss at the Time of Expiry
(in Rs.)
Market price Profit from Profit from Cash flow CF0 Total
on expiry ST 2 call options Rs.90 put at expiry cash flow
of Rs.90 option bought CFT=(2)+(3) =(4)+(5)
options bought
(1) (2) (3) (4) (5) (6)
<90 0 90 – ST 90 – ST –15.60 74.4 – ST
Profit if ST < 74.4
Loss if 74.4<ST < 90
>90 2(ST – 90) 0 2(ST – 90) –15.60 2(ST – 97.8)
Profit if ST > 97.8 and
will increase with
multiplier of 2 Loss if
ST < 97.8
1 All prices are taken from www.nseindia.com
 Creating Low-Risk Trading Strategies Using Derivative Products 97

High Risk – High Return with Substantial Upward Bias

From the above table we can see that a trader will incur loss, if price stays anywhere
between 74.40 and 97.80. Thus a trader should enter this strategy if he expects
the stock price to make wild moves (rises more than 9% from current level, 89.5
to 97.8) by the end of May, to make the trade profitable. It’s a very high-risk
strategy, but if price goes beyond 97.80 profit will shoot up as the profit earned
will be from two call options.

Graph 1: Long Strap Strategy

Compiled by Ajab Gandhi, IRC-Ahmedabad.

II. Long Strip

Strip buying two put options and buying one call option of the same strike price.

It is an equivalent of buying one straddle and one extra put option. This extra
put option shows traders bias towards downward movement in underlying. The
bias in favour of downward market movement is 2/3rd compared to market moving
upward is 1/3rd.
98 ADVANCED TRADING STRATEGIES IN OPTIONS

Illustration 2
The strategy is formulated using last traded price of IDBI on 25th April 2007
option contracts with expiry on 31st May 2007. May future contract closed at
Rs.89.50 on 25th April, 2007.

To create a Long Strip:

Buy 2 put option with strike price of Rs.90 @ Rs.5.40
Buy 1 call option with strike price of Rs.90 @ Rs.5.10
(in Rs.)
Buy 2 put options 2 * 5.40 = 10.80
Buy 1 call option 1 * 5.10 = 5.10
Initial Cash Flow (CF0) 15.90

Break even point: On downward move at Rs.82.05 and

On upward move at Rs.105.90

Table II: Profit/Loss at the Time of Expiry

(in Rs.)
Market price Profit from Profit from Cash flow CF0 Total
on expiry ST Rs.90 call 2 put options at expiry cash flow
options of Rs.90 bought CFT=(2)+(3) =(4)+(5)
bought
(1) (2) (3) (4) (5) (6)
ST <90 0 2(90 – ST) 2(90 – ST) –15.90 2(82.95 – ST),
Profit if ST < 82.95
and will increase with
multiplier of 2.
Loss if 82.95<ST< 90
ST >90 ST – 90 0 (ST – 90) –15.90 (ST – 105.90)
Profit if ST > 105.90

High Risk – High Return with Substantial Downward Bias

From the above table we can see that a trader will incur loss, if price stays anywhere
between 82.50 and 105.90. Thus a trader should enter this strategy if he expects
the stock price to make wild moves (falls more than 7% from current level, 89.50
to 82.00) by the end of May, to make the trade profitable. It’s a very high-risk
2 All prices are taken from www.nseindia.com
 Creating Low-Risk Trading Strategies Using Derivative Products 99

strategy, but if price goes below 82.95, profit will shoot up as the profit earned
will be from two put options.

Graph 2: Long Strap Strategy

Compiled by Ajab Gandhi, IRC-Ahmedabad.

Synthetic Bull Spread: An Innovation in Option Trading Strategies

Synthetic Bull Spread
Synthetic bull spread can be crated by buying one future contract/having long
position in stock, buying one at-the-money put option and one deep out-of-money
call option.

Who should use and why to use?

An investor having a long position in a stock and feel that prices have already
reached near to its peak but may still have some momentum to play in near term,
at the same time he is afraid of some event in near future which may hit the stock
badly and leads to erosion of wealth.
100 ADVANCED TRADING STRATEGIES IN OPTIONS

When to use?
This strategy can provide better payoff when stock is in huge uptrend and calls
are in heavy demand and over valued at the same time put option may have lack
of demand and undervalued.

How to use?
Illustration 3
Synthetic bull spread can be created as explained below using an example of
IDBI stock. Option prices are the last traded price on 25/04/2007 with option
expiry on 31st May, 2007.

A new trader will have to take a long position by buying IDBI stock whereas
a trader already having a position in IDBI stock will have to just invest in the call
and put option.

Long Position in IDBI

Suppose a trader already has IDBI stock of price Rs.88.75. Therefore he needs to
invest in a call and a put option.
Buy IDBI 90 Rs.put option @ Rs.5.40
Sell IDBI 100 Rs.call option @ Rs.2.15
(in Rs.)
Buy IDBI 90 put option - 5.40
Sell IDBI 100 call option 2.15
Initial Cash Flow (CF0) - 3.25

Thus the investment required to be made by the trader is Rs.3.25

From the Table III we can see that this strategy gives a maximum profit of
Rs.9.00 and a maximum loss of Rs.2.00 with breakeven point at Rs.90.75. Besides
the profit keeps on rising as price closes further higher whereas the maximum
loss is Rs.2.00 only which is less than the total net premium paid as the put
option is in-the-money by Rs.1.25

3 All prices are taken from www.nseindia.com

 Creating Low-Risk Trading Strategies Using Derivative Products 101

Table III: Profit/Loss at the Time of Expiry

(in Rs.)
IDBI on Profit/loss Payoff Payoff from CFT = CF0 Net
31/05/2007 on stock from Rs.90 Rs.100 (2)+(3)+(4) cashflow=
held Put bought Call sold (5)+(6)
(1) (2) (3) (4) (5) (6) (7)
ST < 88.75 88.75 – ST 90 – ST 0 1.25 –3.25 –2.00
88.75<ST <90 ST –88.75 90 – ST 0 1.25 –3.25 –2.00
90< ST <100 ST –88.75 0 0 ST –88.75 –3.25 ST –92.00
ST >100 ST –88.75 0 100 – ST 11.25 –3.25 9.00

Graph 3: Synthetic Bull Spread

Compiled by Ajab Gandhi, IRC-Ahmedabad.

Bull Spread using Call Options:

Buy IDBI 90 Rs.Call @ Rs.4.90
Sell IDBI 100 Rs.Call @ Rs.2.15
102 ADVANCED TRADING STRATEGIES IN OPTIONS

(in Rs.)
Buy IDBI 90 call option – 4.90
Sell IDBI 100 call option 2.15
Initial Cash Flow (CF0) – 2.75

Thus the investment required to be made by the trader is Rs.2.75

Table IV: Profit/Loss at the Time of Expiry
(in Rs.)
IDBI on Payoff from Payoff from CFT = CF0 Netcash flow=
31/05/2007 Rs.90 Rs.100 Call sold (2) + (3) (4) + (5)
Call bought
(1) (2) (3) (4) (5) (6)
<90 0 0 0 –2.75 –2.75
90< ST <100 ST –90 0 ST –90 –2.75 ST –92.75
ST >100 ST –90 100 – ST 10.00 –2.75 8.25
From the above table we can see that this strategy gives a maximum profit of
Rs.8.25 and a maximum loss of Rs.2.75 with breakeven point at Rs.92.75.
Besides the profit keeps on rising as price closes further higher whereas the
maximum loss is Rs.2.75 only which is the difference between the premium paid
and premium received.
Graph 4: Bull Call Spread

Compiled by Ajab Gandhi, IRC-Ahmedabad.

 Creating Low-Risk Trading Strategies Using Derivative Products 103

Synthetic Bull Spread vs. Normal Bull Spread Using Call Options
The following table shows the superiority of Synthetic Bull Spread over the Normal
Bull Spread using call options in both the cases shown above. This comparison is
very important as both the strategies can be used with range bound to limited
positive outlook.
Table V: Synthetic Bull Spread vs. Normal Bull Spread
Maximum Profit (in Rs.) Maximum Loss (in Rs.)
Synthetic Bull Spread 9.00 2.00
Bull Spread Using Call Option Pair 8.25 2.75

Conclusion
Strip and Strap both are variants of straddle strategy with downward and upward
biasness respectively where substantial volatility is expected. But as both the strategies
need an outflow on payment of buying 3 options, it becomes very expensive and
high profit-high risk strategies and therefore should only be implemented by big
and experienced traders. These strategies are not for small or new traders in the
market and if they enter these strategies they may burn their fingers.

Synthetic Bull Spread is always a better option compared to bull spread using
call options when the market is expecting a big upward movement which creates
substantial demand for call options and makes them overvalued in the market.
On the other end when substantial upward movement is expected only a very
conservative investor will go and take protection for the stock held against any
probable fall by purchasing put option which in a bull sentiment is a very remote
possibility. Applying the same logic, it doesn’t give any incentive to the trader to
swim against the tide and try to make profit by purchasing put option and thus
betting on downward movement of the market.

(Dr. Mayank Joshipura, Assistant Professor with AES Post Graduate Institute of Business
Management, is a B.E (Power Electronics), MBA (Finance) and Ph.D with expertise
in International Financial Management, Capital Markets and Portfolio Management.
He is actively involved in conducting workshops on various financial investment topics.
He can be reached at mhj1975@yahoo.com; Ajab Gandhi is a Research Associate
with Icfai Business School Research Center, Ahmedabad. She can be reached
ajab_gandhi@hotmail.com).
104 ADVANCED TRADING STRATEGIES IN OPTIONS

References
1. Robert W Ward, “Options and Options Trading: A Simplified Course That Takes You from
Coin Tosses to Black-Scholes”, McGraw-Hill Professional, 2004.
2. John C Hull, “Fundamentals of Futures and Options Markets”, 4th Edition, Pearson
Education, Inc., 2002.
3. George A Fontanills, “Trade Options Online”, John Wiley and Sons, 2000.
4. Robert W Kolb, “Understanding Options”, John Wiley & Sons, Inc., 1995.
5. Sheldon Natenberg, “Option Volatility & Pricing: Advanced Trading Strategies and
Techniques”, McGraw-Hill Professional, 1994.
6. http://www.nseindia.com/
7. http://en.wikipedia.org/
8. http://www.marketwatch.com/
9. http://www.optionetics.com/
10. http://www.optionsxpress.com/
11. http://www.in-the-money.com/