Option Strategies

I Option Strategies for Speculation: If the options are used as a pure speculative vehicle, then the option strategy
for the speculator will depend upon his expectation of the market prices of the underlying asset. The expectations
and the options strategy have been presented in the below table:

Expectation of Market Price Option Strategy

1 Sharp increase in price Buy a Call option
2 Sharp decrease in price Buy a Put option
3 Moderate increase in price Sell a Put option
4 Moderate decrease in price Sell a Call option

II Option Strategies for Hedging: Options can be used in combination with underlying asset to create a risk-less
position. Some of the common strategies have been discussed below:

a) Covered Calls: A covered call option strategy involves the purchase of underlying asset (say, shares) and
sale of a call option on that share. It refers to taking long position in stock and short position in call. The
position (strategy) is called covered because the investor owns the stock and can deliver it if the call option,
which he has sold, is exercised by the option holder. In covered call strategy, the investor is willing to sell
the shares at a fixed price, limiting the gain, if the share price rises. If the share price does not rise above
strike price, the investor will make a profit equal to the premium received as the call option will end out of
the money. This strategy can be written as [(+s)+(-c)] where +s means buying the shares and –c means
selling a call option.
A reverse covered call position can be created by taking a short position in the asset and a long position in
the call option. In this case, the investor is selling the asset now to purchase at a later stage under the call.
This position can be written as [(-s)+(+c)].
b) Protective Puts: The protective puts strategy involves buying a stock and buying a put option for the same
stock i.e. a long position in both the stock and the put option. In this strategy, the buying of put option
protects the investor against the loss in price of shares. So, the loss of the investor is limited to the premium
paid and the profit potentials are infinite. This strategy can be written as [(+s)+(+p)] where +s means buying
the shares and +p means buying the put option.
Protective put strategy offers some insurance against price decline as it attempts to limit the losses. It in fact
helps in applying the concept of portfolio insurance. The cost of protection is that in case of price increase,
the profit is reduced by the put premium paid.
A reverse of protective put can be created by taking a short position in put as well as short position in the
asset. In this case, the investor is selling the asset now and may be asked to purchase at a later date under the
put option. This strategy can be written as [(-s)+(-p)].

III Strategies with combination of Call and Put: Option strategies can be created by combining call and
put option on the same underlying assets. Some of such strategies are:
a) Straddle: It is a frequently used strategy of options trading. Straddle is an offsetting position taken by an
investor in the options market by (i) simultaneously holding both put and call options for same strike
price and the same expiry period called long straddle or (ii) simultaneously writing both put and call
option for same strike price and the same expiry period called short straddle. The objective of a straddle
strategy may be examined in the light of the following:

Suppose, the current share price is Rs.200, and it is expected to be Rs.250 in two month’s time. An
investor enters a call option at a premium of Rs.5 per share for a strike price of Rs.220 per share.

After two months, if the market price is more than Rs.220 (say Rs.245), he will exercise the option and
make a net profit of Rs.245 – Rs.220 – Rs.5 = Rs.20 per share. However, if the price happens to be
Rs.220 or less, then he will allow the option to lapse. His loss in such a situation would be the premium
paid i.e.Rs.5 per share. So, by entering into a call option, he can make profit only when the actual price
on the expiry date happens to be more than the strike price. However, he can ensure profit even if the
price falls below the strike price by simultaneously buying a put option at the same strike price for the
same expiry period. In case, the market price happens to be less than the strike price, he will let the call
option lapse but exercise the put option and make profit. So, he will be able to make profit whether the
market price is more or less than the respective break-even level. This is possible by undertaking the
straddle strategy.

In long straddle, the investor will have to pay premium on the call as well as on the put option contract,
but will get profit irrespective of the fact whether the price rises or falls below the strike price. The pay
off for the holder of the long straddle has been shown in the below figure:
In the above example, along with the call option, the holder will also take a long position in a Put option
with a strike price Rs.220 with a premium of Rs.10.

Spot Price Strike Call Option Put Option Profit on Profit on Net Profit = Profit on Call +
Price for Premium Premium Call Put Profit on Put – Call Option
Call and Premium – Put Option
Put Premium
245 220 -5 -10 25 0 10
235 220 -5 -10 15 0 0 BEP
225 220 -5 -10 5 0 -10
215 220 -5 -10 0 5 -10
205 220 -5 -10 0 15 0 BEP
195 220 -5 -10 0 25 10
 Profit

Pay off if put is exercised Pay off if Call is exercised

205 Strike Price 235 Price of underlying asset

Total Premium 220

-15

Loss

The above figure shows that the holder of a straddle will be able to make profit in case of most of the market prices
of the share. In case of long straddle, an investor breaks-even at both (Strike price – Total Premium) and Strike
price + Total Premium). At any price below or more than these two break-even levels, the straddle holder enjoys a
profit. The maximum loss between these two break-even levels will be limited to the amount of total premium
paid. Long straddle position should be taken up when variation in the asset price are expected on either side.

In a long straddle, an investor breaks-even at both (Strike price – Total Premium) and at Strike price + Total
Premium).
However, if the investor takes the short straddle by selling both the call and the put options at the same strike price
and for same expiration period, his profit will be limited to total premium received but the losses would occur
whether there is an increase or decrease in the price of the asset. A short straddle is a risky position. Only in case
when the asset is close to strike price on the expiration date, a profit can be earned. However, loss from large
variations is higher. Short straddle position should be taken up when variation in the asset price is expected in a
very limited range around the strike price. The short straddle has been depicted in the below figure:

Profit

Total Premium
Strike Price of Underlying Asset
Price

Pay off if put is exercised Pay off if Call is exercised

Loss
b) Strips: It is trading strategy of taking a long position (buy) in one call and two puts with the same strike
price and same expiration date. This strategy may be adopted when chances of prices going down are
more than chances of going it up. In case of down movements the profit are double as compared to what
the gains would be if the prices increase. If the prices do not move, he loses the most.
c) Straps: This strategy is consisting of a long position in two calls and one put at the same strike price and
for same expiration period. Being a revered position of strip, it should be used when the expectations of
prices going up are more than the prices going down.
d) Strangles: This strategy involves buying a put option and a call option with the same expiration date but
with different strike prices. The call strike price is higher than put strike price. The higher call strike price
means lower premium and lower put strike price means lower premium for the option holder. So, in case
of strangle the initial outflow (i.e. premiums) and the amount of maximum loss are lower than in straddle
strategy.

IV Spreading: Spread is a strategy involving two or more options of the same type (call or put). It is
called a bull spread when it is created by buying a call with lower strike price and selling a call at a
higher strike price for the same expiration period. The bull spread may be adopted when the prices are
expected to go up. A bull spread when created with call options requires an initial investment because
option premium on short call (at higher strike price) would be less than the option premium on long call
(at lower strike price). Bull spread can also be created by buying a put with a lower strike price and
selling a put with a higher strike price. This will result in positive upfront cash flow.

A bear spread is created by buying call at a higher strike price and selling a call at a lower strike price.
This strategy is adopted when prices are expected to move down. A bear spread could also be created by
using two put options i.e. buying a put with higher strike price and selling a put with lower strike price.
This strategy would lead to higher gains if the prices fall. A bear spread created with calls will involve an
initial cash inflow whereas a bear spread with puts will involve cash outflow because the price of put
purchased is more than the price of put sold.

A butterfly spread strategy is built by buying a call option at a lower strike price (K1) and another call at a
higher strike price (K3) and selling two calls at a strike price (K2) between lower strike price and higher
strike price.
The strike price (K2) for short calls is close to current price of the asset. A butterfly spread leads to profit
if the asset prices are close to K2 at the expiration date, and will result in loss (limited) if there is a high
variation in prices in either direction. So, the butterfly spread is a strategy for an investor who do not
expect large movement in price. The strategy also requires some initial cash outlay because of premium
difference.