Introduction to Options and Futures

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4.4

We’ve come a long way with respect to options, haven’t we? We’ve taken an in-depth look at call and put options, their payoff calculations, and even touched upon the moneyness of an options contract.

Let’s now look at some options trading strategies. As a matter of fact, options trading can be a good way to enjoy returns if you know what you’re doing. That’s exactly what we’re here to learn. In this chapter, we’ll take a look at some different options trading strategies and dissect them one after the other.

## The long call

One of the simplest of options trading strategies, the long call is a great strategy for investors who expect the price of the share to go up by the contract expiry date. Let’s look at some relevant particulars for using this strategy when you’re performing options trading in India.

• Execution: To execute a long call, you’re required to buy the call option of a stock.
• Expected market movement: Since you expect the share price of the stock to go upward, your market view is bullish.

We’ll now take a theoretical example to understand the long call trading strategy better.

Say the shares of Larsen & Toubro are currently trading at Rs. 1,000 per share. You buy one call option of L&T with the following details.

• The lot size is 100 shares.
• The strike price of the call option is also Rs. 1,000 per share.
• The cost (or premium) for the call option is Rs. 10,000.

Now, we’ll calculate the profits at expiry for various possible prices of L&T’s shares.

 Column A Column B Column C Column D Column E Column F Spot price of one share at expiry Cost of purchasing 100 shares at the spot price at expiry  (as per the lot size) Cost of purchasing 100 shares at the strike price as per the call option (Rs. 1,000 x 100 shares) Is the call option exercised? (Yes, if B > C) (No, if B < C) Premium paid for the call option Profit from the long call position (B-C-E, if option is exercised) (E, if option isn’t exercised) 1,500 1,50,000 1,00,000 Yes 10,000 40,000 1,400 1,40,000 1,00,000 Yes 10,000 30,000 1,300 1,30,000 1,00,000 Yes 10,000 20,000 1,200 1,20,000 1,00,000 Yes 10,000 10,000 1,100 1,10,000 1,00,000 Yes 10,000 0 1,000 1,00,000 1,00,000 Yes/No 10,000 (10,000) 900 90,000 1,00,000 No 10,000 (10,000) 800 80,000 1,00,000 No 10,000 (10,000) 700 70,000 1,00,000 No 10,000 (10,000)

Plotting the profit levels on a graph, we get the following line.

Here, see how the loss is limited to Rs. 10,000 (the premium paid) as the share price falls? And how the profit keeps increasing unlimitedly as the share price increases? Given this inference, these are the particulars of the profit/loss from a long call strategy.

• Potential for profit: Technically, with the long call, there’s no limit to the amount of profit that you can earn, because there’s no limit to how high the share price can rise.
• Potential for loss: In case the stock price doesn’t move according to your expectations, your losses are limited. In fact, the maximum loss that you’re likely to suffer from is the amount of premium that you paid to purchase the call option.

## The long put

The long put is the inverse of a long call. You can employ this strategy if you expect the price of a share to go down by the contract expiry date. For the long put strategy, these are the main particulars.

• Execution: To execute a long put, all that you need to do is purchase the put option of a stock.
• Expected market movement: Your market view is bearish, since you’re expecting the share price to go down.

Let’s again take a theoretical example to understand the long put trading strategy better.

Again, say the shares of Larsen & Toubro are currently trading at Rs. 1,000 per share. You buy one put option of L&T with the following details.

• The lot size is 100 shares.
• The strike price of the put option is also Rs. 1,000 per share.
• The cost (or premium) for the put option is Rs. 10,000.

Let us now calculate the profits at expiry for various possible prices of L&T’s shares.

 Column A Column B Column C Column D Column E Column F Spot price of one share at expiry Cost of selling 100 shares at the spot price at expiry  (as per the lot size) Cost of selling 100 shares at the strike price as per the put option (Rs. 1,000 x 100 shares) Is the put option exercised? (No, if B > C) (Yes, if B < C) Premium paid for the put option Profit from the long put position (E, if option isn’t exercised) (C-B-E, if option is exercised) 1,300 1,30,000 1,00,000 No 10,000 (10,000) 1,200 1,20,000 1,00,000 No 10,000 (10,000) 1,100 1,10,000 1,00,000 No 10,000 (10,000) 1,000 1,00,000 1,00,000 No/Yes 10,000 (10,000) 900 90,000 1,00,000 Yes 10,000 0 800 80,000 1,00,000 Yes 10,000 10,000 700 70,000 1,00,000 Yes 10,000 20,000 600 60,000 1,00,000 Yes 10,000 30,000 500 50,000 1,00,000 Yes 10,000 40,000 400 40,000 1,00,000 Yes 10,000 50,000 300 30,000 1,00,000 Yes 10,000 60,000

Plotting the profit levels on a graph, we get the following line.

Here, see how the loss is limited to Rs. 10,000 (the premium paid) as the share price increases? And how the profit keeps increasing till Rs. 90,000 as the share price decreases to its lowest possible value (zero)? Given this inference, these are the particulars for the profit/loss from a long put strategy.

• Potential for profit: The profit potential of a long put is limited since the share price can only fall up to a certain point - which is zero.
• Potential for loss: With a long put, the maximum amount of loss that you will have to bear is limited to the amount of premium you paid to purchase the put option.

The bull call spread strategy is typically used by traders expecting a rise in the share price. Although this strategy limits the gains, many traders prefer this since it can also reduce the overall out-of-pocket costs. Take a look at the particulars of a bull call spread strategy.

• Execution: To execute a bull call spread, you purchase an at the money (ATM) call option and sell an out of the money (OTM) call option. Both the call options have the same underlying stock and the same expiry date.
• Expected market movement: With a bull call spread, your market view is moderately bullish as you still expect the share price to rise, but not exponentially.

Let’s take up a theoretical example to understand this better.

• Now, let’s say Reliance Industries is currently trading in the spot market at Rs. 1,527.
• You buy one call option (also known as the long call) with a strike price of Rs. 1,500 (at the money). The premium that you pay for this call option is Rs. 70.
• You sell one call option (also known as the short call) with a strike price of Rs. 1,600 (out of the money). The premium that you receive for this call option is Rs. 40.
• So, at this point in time, your total out-of-pocket cost is just Rs. 30. See how it’s reduced?

Let us now calculate the profits/losses from these two options contracts at expiry, for various possible spot prices for the shares of Reliance Industries.

 A B C D E F G H Spot price at expiry Strike price of the long call (that you bought) Strike price of the short call (that you sold) Do you exercise the long call? (No, if A < B) (Yes, if A > B) Profit from your long call Does the buyer of your short call exercise their option? (No, if A < C) (Yes, if A > C) Profit or loss from your short call Total profit or loss from the bull call spread (E+G+40-70) 1) 1,400 1,500 1,600 No 0 No 0 (30) 2) 1,500 1,500 1,600 No/Yes 0 No 0 (30) 3) 1,600 1,500 1,600 Yes 100 No/Yes 0 70 4) 1,700 1,500 1,600 Yes 200 Yes (100) 70

So here, let’s take some time to understand what the columns here mean.

A. Column A represents the market price of the share of Reliance Industries on the expiry date of the contracts.

B. Column B shows the strike price of the ATM call option that you purchased.

C. Column C shows the strike price of the OTM call option that you sold.

D. Now, you have an ATM call option with you, right? At the expiry date, you’ll exercise this option to buy if the strike price is lower than the spot price (i.e. if column B is         lower than column A). This choice is what column D shows you.

E. In column E, you can see the possible profits (not considering the premium paid) depending on whether or not you exercise your ATM call option.

• For instance, in cases 1 and 2, you’ll choose to not exercise your call option. So, you will not make any profit from that option.
• In case 3, you’ll exercise your call and buy the share of Reliance Industries for Rs. 1,500 instead of Rs. 1,600 (spot price). This means, you make a profit of Rs. 100, right?
• And in case 4, your profit would be Rs. 200 (1,700-1,500)

F. Similarly, remember the OTM call option that you sold? The trader who bought that option will choose to exercise it if the strike price for that option is lower than the        spot price (i.e. if column C is lower than column A). This is what column F represents.

G. In column G, you can see the possible profits or losses (not considering the premium received) depending on whether or not the trader who purchased your OTM call         exercises that option.

• For instance, in cases 1, 2, and even 3, they will choose to not exercise their call option. So, you will not make any profit/loss from that option.
• But in case 4, they will exercise the option because they can buy the share at Rs. 1,600 instead of the spot price of Rs. 1,700. So, you will have to sell that share at a loss of Rs. 100.

H. In column H, we see the total profit/loss from the strategy as a whole. That is basically calculated as follows.

 The profit from the ATM call option + the profit or loss from the OTM call + the premium you received (Rs. 40) - the premium you paid (Rs. 70)

Let’s plot the overall profit/loss from column H on a graph to see how the pattern for a bull call spread appears.

Based on this trend, these are the particulars for the profit/loss from a bull call spread strategy.

• Potential for profit: The profit that you can earn from a bull call spread is limited. Once the spot price of the stock rises above the OTM call option that you sold, your profit is stagnated and you cease to enjoy higher profits.
• Potential for loss: Just like how the profit potential is restricted, the maximum loss that you get to suffer is also limited. If the market movement doesn’t match your expectations, you’ll only end up losing the amount of premium you paid to purchase the two call options.

The bear put spread strategy is the inverse of a bull call spread. It is generally used by traders who are expecting a fall in the share price. Even though this strategy limits the gains, it is still preferred by many since it can also reduce the overall out-of-pocket costs.  Take a look at the particulars of a bear put spread strategy.

• Execution: To execute a bear put spread, you purchase an in the money (ITM) put option and sell an out of the money (OTM) put option.
• Expected market movement: With a bear put spread, your market view is moderately bearish as you still expect the share price to fall, but not exponentially.

Here’s a theoretical example to understand this strategy better.

• Now, let’s say Reliance Industries is currently trading in the spot market at Rs. 1,527.
• You buy one put option (also known as the long put) with a strike price of Rs. 1,600 (in the money). The premium that you pay for this put option is Rs. 70.
• You sell one put option (also known as the short put) with a strike price of Rs. 1,500 (out of the money). The premium that you receive for this put option is Rs. 40.
• So, at this point in time, your total out-of-pocket cost is again just Rs. 30.

Let us now calculate the profits/losses from these two options contracts at expiry, for various possible share prices of Reliance Industries.

 A B C D E F G H Spot price at expiry Strike price of the long put (that you bought) Strike price of the short put (that you sold) Do you exercise the long put? (No, if A > B) (Yes, if A < B) Profit from your long put Does the buyer of your short put exercise their option? (No, if A > C) (Yes, if A < C) Profit or loss from your short put Total profit or loss from the bear put spread (E+G+40-70) 1) 1,700 1,600 1,500 No 0 No 0 (30) 2) 1,600 1,600 1,500 No/Yes 0 No 0 (30) 3) 1,500 1,600 1,500 Yes 100 No/Yes 0 70 4) 1,400 1,600 1,500 Yes 200 Yes (100) 70

So here, let’s take some time to understand what the columns here mean.

A. Column A again represents the market price of the share of Reliance Industries on the expiry date of the contracts.

B. Column B shows the strike price of the ITM put option that you purchased.

C. Column C shows the strike price of the OTM put option that you sold.

D. Now, you have an ITM put option with you, right? At the expiry date, you’ll exercise this option to sell if the strike price is higher than the spot price (i.e. if column B is         higher than column A). This choice is what column D shows you.

E. In column E, you can see the possible profits (not considering the premium paid) depending on whether or not you exercise your ITM put option.

• For instance, in cases 1 and 2, you’ll choose to not exercise your put option. So, you will not make any profit from that option.
• In case 3, you’ll exercise your put and sell the share of Reliance Industries for Rs. 1,600 instead of Rs. 1,500 (spot price). This means, you make a profit of Rs. 100, right?
• And in case 4, your profit would be Rs. 200 (1,600-1,400)

F. Similarly, remember the OTM put option that you sold? The trader who bought that option will choose to exercise it if the strike price for that option is higher than the      spot price (i.e. if column C is higher than column A). This is what column F represents.

G. In column G, you can see the possible profits or losses (not considering the premium received) depending on whether or not the trader who purchased your OTM put      exercises that option.

• For instance, in cases 1, 2, and even 3, they will choose to not exercise their put option. So, you will not make any profit/loss from that option.
• But in case 4, they will exercise the option because they can sell the share to you at Rs. 1,500 instead of the spot price of Rs. 1,400. So, you will have to buy that share at a loss of Rs. 100.

H. In column H, we see the total profit/loss from the strategy as a whole. That is basically calculated as follows.

 The profit from the ITM put option + the profit or loss from the OTM put + the premium you received (Rs. 40) - the premium you paid (Rs. 70)

Let’s plot the overall profit/loss from column H on a graph to see how the pattern for a bear put spread appears.

Based on this example, these are the particulars for the profit/loss from a bear put spread strategy.

• Potential for profit: The profit that you can earn from a bear put spread is limited. Once the spot price of the stock falls below the OTM put option that you sold, your profit is stagnated and you cease to enjoy higher profits.
• Potential for loss: The maximum loss that you get to suffer with this strategy is also limited. If the market doesn’t move according to your expectations, you’ll only end up losing the amount of premium you paid to purchase the two put options.

## Wrapping up

Well, this brings us to the end of the chapter on strategies for options trading in India. These four are among the most commonly used trading strategies. To know more about the right strategy to employ for your trades, it can help to learn a bit about option Greeks. Curious to know what that is? Let’s find out in the upcoming chapter.

## A quick recap

• The long call is one of the simplest of options trading strategies. It is a great strategy for investors who expect the price of the share to go up by the contract expiry date.
• To execute a long call, you’re required to buy the call option of a stock. And since you expect the share price of the stock to go upward, your market view is bullish.
• The long put is the inverse of a long call. You can employ this strategy if you expect the price of a share to go down by the contract expiry date.
• To execute a long put, all that you need to do is purchase the put option of a stock.
• Your market view here is bearish, since you’re expecting the share price to go down.
• The bull call spread strategy is typically used by traders expecting a rise in the share price. Although this strategy limits the gains, many traders prefer this since it can also reduce the overall out-of-pocket costs.
• To execute a bull call spread, you purchase an at the money (ATM) call option and sell an out of the money (OTM) call option. Both the call options have the same underlying stock and the same expiry date.
• With a bull call spread, your market view is moderately bullish as you still expect the share price to rise, but not exponentially.
• The bear put spread strategy is the inverse of a bull call spread. It is generally used by traders who are expecting a fall in the share price. Even though this strategy limits the gains, it is still preferred by many since it can also reduce the overall out-of-pocket costs.
• To execute a bear put spread, you purchase an in the money (ITM) put option and sell an out of the money (OTM) put option.
• With a bear put spread, your market view is moderately bearish as you still expect the share price to fall, but not exponentially.