OPTION STRATEGY RELATED DEFINITIONS

1. Option Spreads:
Option Spreads involve combining options on the same underlying and of
same type (call/ put) but with different strikes and maturities. These are
limited profit and limited loss positions. They are primarily categorized into
three sections as:
 Vertical Spreads
 Horizontal Spreads
 Diagonal Spreads.

Vertical Spreads
Vertical spreads are created by using options having same expiry but different
strike prices. Further, these can be created either using calls as combination
or puts as combination. These can be further classified as:
 Bullish Vertical Spread
o Using Calls
o Using Puts
 Bearish Vertical Spread
o Using Calls
o Using Puts

Horizontal Spread
Horizontal spread involves same strike, same type but different expiry options.
This is also known as time spread or calendar spread. Here, it is not possible to
draw the pay off chart as the expiries underlying the spread are different.
Underlying reasoning behind horizontal spreads is that these two options
would have different time values and the trader believes that difference
between the time values of these two options would shrink or widen. This is
essentially a play on premium difference between two options prices
squeezing or widening.
Diagonal spread
Diagonal spread involves combination of options having same underlying but
different expiries as well as different strikes. Again, as the two legs in a spread
are in different maturities, it is not possible to draw pay offs here as well.
These are much more complicated in nature and in execution. These
strategies are more suitable for the OTC market than for the exchange traded
markets.

2. Breakeven point: For options trading, the breakeven point is the market price that an
underlying asset must reach for an option buyer to avoid a loss if they exercise the option.
 For Buy call, the breakeven point is Strike price + Premium paid.
 For Buy Put, the breakeven point is Strike price – Premium paid.

3. Objectives of Option trading strategies:

Complex option strategies consist of combined positions of more than one option. They can be
used to profit from volatile markets, or profit from flat markets, or lock in positions. The various
objectives of Option trading strategies are as follows.

 Helps to trade based on specific views on the underlying price. (Strongly bullish,
strongly bearish, moderately bullish, moderately bearish, range bound market, volatile
market)
 It can be used to hedge risk
 It can be used as a cost reduction structure (by adding a sell leg, premium flows in,
which can reduce the premium outflow in a buy leg already entered)
 It can be used for making a zero-cost structure.
 It can be used for complement an existing position. Eg: Protective put hedges against a
falling stock price.
 It helps to synthetically derive a structure without actually entering into the instrument
– Eg: Synthetic long call, Synthetic long put.
 It helps to get some additional inflow of premium in a multileg strategy. Eg: Covered
call.

4. Protective Put: Stock holders can purchase a protective put to hedge against losses from a
declining stock. If the stock prices rises the trader will reap unlimited gains while losing
only the premium paid for the put. If the stock declines the gains in the put will offset the
losses in the stock, which will protect against large losses.

5. Covered call: Covered call writers can realize supplemental returns on stock holdings by
selling rights in their stock positions. This strategy can provide additional income versus
simply holding the stock, but does not protect against losses if the stock price falls.

6. Risk reward ratio: Risk-reward ratio, also known as reward-to-risk ratio or profit-loss ratio,
is a measure that compares maximum possible profit we can gain from a trade with the
risk (maximum possible loss) of the trade.
Eg: Maximum possible loss of Rs 600 and maximum potential profit of Rs 1,800. That would
be a risk-reward ratio of 600 / 1,800 = 1:3

7. Put call ratio: The put-call ratio is a measurement that is widely used by investors to gauge
the overall mood of a market.
Put call ratio is the ratio of OI of Call divided by OI of Put option of all strike prices
It can also be derived by dividing the Volume of Put option by Volume of Call option of all
strikes.

If the ratio is > 1.2, it shows that there are more puts than calls, means market has become
extremely bearish and it is time for reversal. Hence PCR can be viewed as a contra indicator
with an expectation of a buy mode, as market is expected to come out of an oversold zone.
In such a situation, buy call position can be initiated. Similarly, a lower PCR indicates more
Call positions than Put positions, indicating an over bought situation, indicating a
forthcoming reversal in the market sentiments.
8. Volatility and Types of Volatilities
9. Implied Volatility: Implied volatility is the market's forecast of a likely movement in a
security's price. It is a metric used by investors to estimate future fluctuations (volatility)
of a security's price based on certain predictive factors. Implied volatility is denoted by the
symbol σ (sigma). It can often be thought to be a proxy of market risk. It is commonly
expressed using percentages and standard deviations over a specified time horizon.

When applied to the stock market, implied volatility generally increases in bearish markets,
when investors believe equity prices will decline over time. IV decreases when the market is
bullish. This is when investors believe prices will rise over time. Bearish markets are
considered to be undesirable and riskier to the majority of equity investors.

IV doesn't predict the direction in which the price change will proceed. For example, high
volatility means a large price swing, but the price could swing upward (very high), downward
(very low), or fluctuate between the two directions. Low volatility means that the price likely
won't make broad, unpredictable changes.

10. VIX: VOLATILITY INDEX

Volatility Index is a measure of market's expectation of volatility over the near term. Volatility
is often described as the 'rate and magnitude of changes in prices' and in finance often
referred to as risk. Volatility Index is a measure, of the amount by which an underlying Index
is expected to fluctuate, in the near term, (calculated as annualised volatility, denoted in
percentage e.g. 20%) based on the order book of the underlying index options.

India VIX is a volatility index based on the NIFTY Index Option prices. From the best bid-ask
prices of NIFTY Options contracts, a volatility figure (%) is calculated which indicates the
expected market volatility over the next 30 calendar days.
 ('VIX' is a trademark of Chicago Board Options Exchange, Incorporated ('CBOE') and Standard
& Poor's has granted a license to NSE, with permission from CBOE, to use such mark in the
name of the India VIX and for purposes relating to the India VIX.)

The Cboe Volatility Index, or VIX, is a real-time market index representing the market’s
expectations for volatility over the coming 30 days.
Investors use the VIX to measure the level of risk, fear, or stress in the market when making
investment decisions.
Traders can also trade the VIX using a variety of options and exchange-traded products, or
they can use VIX values to price derivatives.
The VIX generally rises when stocks fall, and declines when stocks rise.

During its origin in 1993, VIX was calculated as a weighted measure of the implied volatility
of eight S&P 100 at-the-money put and call options, when the derivatives market had limited
activity and was in its growing stages.
As the derivatives markets matured, 10 years later, in 2003, the Cboe teamed up with
Goldman Sachs and updated the methodology to calculate VIX differently. It then started
using a wider set of options based on the broader S&P 500 Index, an expansion that allows
for a more accurate view of investors’ expectations of future market volatility. A
methodology was adopted that remains in effect and is also used for calculating various
other variants of the volatility index.

What Does the VIX Tell Us?

The Cboe Volatility Index (VIX) signals the level of fear or stress in the stock market—using
the S&P 500 index as a proxy for the broad market—and hence is widely known as the “Fear
Index.” The higher the VIX, the greater the level of fear and uncertainty in the market, with
levels above 30 indicating tremendous uncertainty.

11. BREAKOUT STRATEGIES

Breakout strategies is used when market is expected to move widely on either sides
( upwards or downwards) owing to reasons like unexpected events etc. The 3 commonly
used strategies are Long straddle, long strangle and Short Butterfly.

S.no STRATEGY VIEW LEGS COMMENT RISK REWARD

Break
out on BUY CALL OTM
LONG either + strategy requires greater UNLIMITE
3 STRANGLE sides BUY PUT OTM movement in either sides LIMITED D
Break LIMITED
out on Underlying expected TO
LONG either BUY CALL ATM + greater movement in either PREMIU UNLIMITE
4 STRADDLE sides BUY PUT ATM sides M D
5 SHORT Break BUY 1 ITM CALL Profits are Limited and LIMITED LIMITED
BUTTERFLY out on + BUY 1 known in advance
either OTM CALL +
sides SELL 2 ATM
 CALLs
12. STRATEGIES FOR RANGEBOUND MARKETS:

When price of the underlying trades in a narrow range (limited up/down movements over a period
of time), it is called a rangebound market.

It is difficult to make money using futures contract during rangebound markets.

The commonly used strategies in rangebound markets are

REWAR
S.no STRATEGY VIEW LEGS COMMENT RISK D
SELL CALL ATM Want premium in range
SHORT Range + SELL bound market. But ready to UNLIMITE
1 STRADDLE bound PUT ATM face losses if market moves D LIMITED
SELL CALL OTM Want premium in range
SHORT Range + SELL PUT bound market. But ready to UNLIMITE
2 STRANGLE bound OTM face losses if market moves D LIMITED
SELL 1 ITM CALL
+ SELL 1
OTM CALL +
LONG Range BUY 2 ATM Losses are limited and
2 BUTTERFLY bound CALLs known in advance LIMITED LIMITED

13. STRATEGIES FOR MODERATELY BULLISH MARKET

REWAR
S.no STRATEGY VIEW LEGS COMMENT RISK D
BUY CALL ITM or
BULL CALL Moderatel ATM + SELL Cost reduction , BE on Buy LIMITE
6 SPREAD y Bullish OTM CALL a CALL D LIMITED
Sell ATM Put gives inflow.
BULL PUT Moderatel SELL PUT ATM + Risk reduced by Buy OTM LIMITE
7 SPREAD y Bullish BUY PUT OTM PUT D LIMITED

14. STRATEGIES FOR MODERATELY BEARISH MARKET

REWAR
STRATEGY VIEW LEGS COMMENT RISK D
BEAR PUT Moderatel BUY PUT ITM + Cost reduction, BE on Buy a
SPREAD y Bearish SELL PUT OTM PUT LIMITED LIMITED
BEAR CALL Moderatel SELL CALL ATM + Sell ATM CALL gives inflow.
SPREAD y Bearish BUY CALL OTM Risk reduced by Buy OTM CALL LIMITED LIMITED

15. BULL CALL SPREAD

A bull spread is created when the underlying view on the market is positive
but the trader would also like to reduce his cost on position. This is done when
the trader has a moderately bullish view on the market. He takes one long call
position with lower strike and sells a call option with higher strike. As lower
strike call will cost more than the premium earned by selling a higher
 strike call, although the cost of position reduces, the position is still a net
cash outflow position to begin with.
Secondly, as higher strike call is shorted, all gains on long call beyond the
strike price of short call would get negated by losses of the short call. To take
more profits from his long call, trader can short as high strike call as possible,
but this will result in his cost coming down only marginally, as higher strike
call will fetch lesser and lesser premium.
Say, for example, a trader is bullish on market, so he decides to go long on
10200 strike call option by paying a premium of 350 and he expects market to
not go above 10800, so he shorts a 10800 call option and receives a premium
of 140. His pay off for various price moves will be as follows:

Value of a LONG CALL option including cost = MAX((SPOT PRICE – SPOT PRICE),0) – Premium
Paid
-
Value of a SHORT CALL option including cost = MAX((SPOT PRICE – SPOT PRICE),0) +
Premium received

Option Call Call

Long/Short Long Short
Strike 10200 10800
Premium 350 140
Spot 10500

CMP Long Call Short Call Net Flow

9500 -350 140 -210
9600 -350 140 -210
9700 -350 140 -210
9800 -350 140 -210
9900 -350 140 -210
10000 -350 140 -210
10100 -350 140 -210
10200 -350 140 -210
10300 -250 140 -110
10400 -150 140 -10
10500 -50 140 90
10600 50 140 190
10700 150 140 290
10800 250 140 390
10900 350 40 390
11000 450 -60 390
11100 550 -160 390
11200 650 -260 390
11300 750 -360 390
 11400 850 -460 390
11500 950 -560 390

Refer excel for working.

As can be seen from the above pay off chart, it is a limited profit and limited
loss position. Maximum profit in this position is 390 and maximum loss is 210.
BEP for this spread is 10410.

16. LONG STRADDLE

Straddle is a strategy which involves two options of same strike prices and same
maturity. A long straddle position is created by buying a call and a put option of
same strike and same expiry whereas a short straddle is created by shorting a
call and a put option of same strike and same expiry.

Long straddle is entered when the trader feels that market shall breakout on
either sides.

Long Straddle
Let us say a stock is trading at Rs 6,000 and premiums for ATM call and put
options are 257 and 136 respectively.
If a person buys both a call and a put at these prices, then his maximum loss
will be equal to the sum of these two premiums paid, which is equal to 393.
And, price movement from here in either direction would first result in that
person recovering his premium and then making profit. This position is
undertaken when trader’s view on price of the underlying is uncertain but he
thinks that in whatever direction the market moves, it would move
significantly in that direction.
Now, let us analyse his position on various market moves. Let us say the stock
price falls to 5300 at expiry. Then, his pay offs from position would be:
Long Call: - 257 (market price is below strike price, so option expires
worthless) Long Put: - 136 - 5300 + 6000 = 564
Net Flow: 564 – 257 = 307
As the stock price keeps moving down, loss on long call position is limited to
premium paid, whereas profit on long put position keeps increasing.
Assume the stock price shoots up to 6700.
Long Call: -257 – 6000 + 6700 = 43
Long Put: -136
Net Flow: 443 – 136 = 307
As the stock price keeps moving up, loss on long put position is limited to
premium paid, whereas profit on long call position keeps increasing.
Thus, it can be seen that for huge swings in either direction the strategy yields
profits. However, there would be a band within which the position would
result into losses. This position would have two Break even points (BEPs) and
they would lie at “Strike – Total Premium” and “Strike + Total Premium”.
Combined pay-off may be shown as follows:
It may be noted from the table and picture, that maximum loss of Rs. 393
would occur to the trader if underlying expires at strike of option viz. 6000.
Further, as long as underlying expires between 6393 and 5607, he would
always incur the loss and that would depend on the level of underlying. His
profit would start only after recovery of his total premium of Rs. 393 in either
direction and that is the reason there are two breakeven points in this
strategy
 LONG STRADDLE
1000

800

600

400

200

0
4900 5400 5900 6400 6900
-200

-400

-600

Long Call Long Put Long Straddle

Option Call Put
Long/Short Long Long
Strike 6000 6000
Premium 257 136
Spot 6000

Long
SPOT Long Call Long Straddle
Put
5000 -257 864 607
5100 -257 764 507
5200 -257 664 407
5300 -257 564 307
5400 -257 464 207
5500 -257 364 107
5607 -257 257 0
5600 -257 264 7
5700 -257 164 -93
5800 -257 64 -193
5900 -257 -36 -293
6000 -257 -136 -393
6100 -157 -136 -293
6200 -57 -136 -193
6300 43 -136 -93
6393 136 -136 0
6400 143 -136 7
6500 243 -136 107
6600 343 -136 207
6700 443 -136 307
6800 543 -136 407
6900 643 -136 507
 7000 743 -136 607
--------------------------------------------------------------
Short Straddle
This would be the exact opposite of long straddle. Here, trader’s view is that
the price of underlying would not move much or remain stable. So, he sells a
call and a put so that he can profit from the premiums. As position of short
straddle is just opposite of long straddle, the pay off chart would be just
inverted, so what was loss for long straddle would become profit for short
straddle.

Strangle
This strategy is similar to straddle in outlook but different in implementation,
aggression and cost.
Long Strangle
As in case of straddle, the outlook here (for the long strangle position) is that
the market will move substantially in either direction, but while in straddle,
both options have same strike price, in case of a strangle, the strikes are
different. Also, both the options (call and put) in this case are out-of-the-
money and hence the premium paid is low.

Short Strangle
This is exactly opposite to the long strangle with two out-of-the-money
options (call and put) shorted. Outlook, like short straddle, is that market will
remain stable over the life of options. Pay offs for this position will be exactly
opposite to that of a long strangle position. As always, the short position will
make money, when the long position is in loss and vice versa

Covered Call
This strategy is used to generate extra income from existing holdings in the
cash market. If an investor has bought shares and intends to hold them for
some time, then he would like to earn some income on that asset, without
selling it, thereby reducing his cost of acquisition

Protective Put
Any investor, long in the cash market, always runs the risk of a fall in prices
and thereby reduction of portfolio value and MTM losses. A mutual fund
manager, who is anticipating a fall, can either sell his entire portfolio or short
futures to hedge his portfolio. In both cases, he is out of the market, as far as
profits from upside are concerned.

COLLAR
A collar strategy is an extension of covered call strategy. Readers may recall
that in case of covered call, the downside risk remains for falling prices; i.e. if
the stock price moves down, losses keep increasing (covered call is similar to
short put). To put a floor to this downside, we long a put option, which
essentially negates the downside of the short underlying/futures (or the
synthetic short put).

Butterfly Spread
As collar is an extension of covered call, butterfly spread is an extension of
short straddle. The downside in short straddle is unlimited if market moves
significantly in either direction. To put a limit to this downside, along with
short straddle, trader buys one out of the money call and one out of the
money put. Resultantly, a position is created with pictorial pay-off, which
looks like a butterfly and so this strategy is called “Butterfly Spread”.
Butterfly spread can be created with only calls, only puts or combinations of
both calls and puts. Here, we are creating this position with help of only calls

Bullish Vertical Spread using Puts

The call on the market is bullish, hence, the trader would like to short a put
option. If prices go up, trader would end up with the premium on sold puts.
However, in case prices go down, the trader would be facing risk of unlimited
losses. In order to put a floor to his downside, he may buy a put option with a
lower strike. While this would reduce his overall upfront premium, benefit
would be the embedded insurance against unlimited potential loss on short
put. This is a net premium receipt strategy.

Bearish Vertical Spread using calls

Here, the trader is bearish on the market and so he shorts a low strike high
premium call option. The risk in a naked short call is that if prices rise, losses
could be unlimited. So, to prevent his unlimited losses, he longs a high strike
call and pays a lesser premium. Thus in this strategy, he starts with a net
inflow.

Bearish Vertical Spread using puts

Here, again the trader is bearish on the market and so goes long in one put
option by paying a premium. Further, to reduce his cost, he shorts another
low strike put and receives a premium.