Option Strategy Final Editn

8/4/2019 Option Strategy Final Editn

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L.S RAHEJA COLLEGE OF ARTS AND COMMERCE

JUHU ROAD, SANTACRUZ (W), MUMBAI 400 054

PROJECT REPORT ON

OPTION TRADING STRATEGIES

SUBMITTED BY HARSHIT SHAH

IN PARTIAL FULFILLMENT OF THE REQUIREMENT OF

T.Y.B.COM (FINANCIAL MARKETS)

SEMESTER V

PROJECT GUIDE

PROF. GOVIND SOWANI

UNIVERSITY OF MUMBAI

2011 2012


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DECLARATION

I hereby declare that I have successfully completed the project on Option

trading strategies for the academic year 2011-2012. The project is done under

the guidance of Prof. Govind Sowani and is submitted in the partial fulfillment of

the requirements for the award of the degree of Bachelor of Commerce

(Financial Markets)

The information provided in the project is true and to the best of my knowledge.

Signature of the Student

Harshit Shah

Roll No: 42

T.Y.B. Com (Financial Markets)


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CERTIFICATE

This is to certify that Mr.Harshit Shah student of TY-B.Com (Financial Markets)

Semester V of L. S. Raheja College of Arts & Commerce has successfullycompleted the project on Option Trading Strategies under the guidance of

Prof. Govind Sowani for the academic year 2011-2012.

Course Co-ordinator Principal

(Prof. Abdul Kadir Khan)

College Seal

Project Guide External Guide

(Prof. Govind Sowani)


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ACKNOWLEDGEMENT

When a student ventures any avenue of learning he/she embarks upon a

mission of exploration. The inception of this project report draws upon the

contribution of many individuals. First and Foremost, I would like to express my

heartfelt thanks to Prof. Govind Sowani for taking Keen interest and timely help

in spite of his tight working schedule, who provided me with all his supports in

order to make this effort possible and effective.

I would be failing in my duty if I do not acknowledge with a deep sense of

gratitude and sacrifices made by my parents and thus have helped me in

completing the project work successfully. I would also like to thank to all who

provided me all the necessary support and who took interest in providing me all

the necessary information that I required for the making of my study successful.


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Executive Summary


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The last two decades have witnessed a phenomenal growth in trade and industry theworld over. Gone are the days when capital used to remain within the boundaries of

nations. In this era of globalisation and liberalization, technology, capital and other

sources are not only crossing the borders of nations, but are also increasing the

volume of international trade. The rapidity with which the concepts of corporate

finance, bank finance and investment finance have changed in recent years has given

birth to new financial products known as Derivative Instruments. As the name

suggests, derivative instruments are financial instruments whose value is derived

from an underlying asset or securities such as foreign exchange (forex), treasury bills

(T-Bills), bonds, shares, share indices and commodities.

In recent times, there are different types of derivatives which are evolved, vis--vis,

Equity derivatives, Commodity derivatives, Currency derivatives, Energy derivatives,

Weather Derivatives, etc.

Derivatives can be traded on:-

i. Over-the-counter (OTC) market

ii. Exchanges.

Derivatives - Overview


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i. Those that are traded on the floor of an exchange, such as Futures and

Options.

ii. Those that are traded over-the-counter (OTC), such as Forwards, Options and

Swaps.

The main differences between these two types of derivatives instruments are in

counterparty risk and liquidity. While exchange traded instruments do not carry any

counterparty risk, OTC instruments do. Further, in exchange traded instruments, one

can exit at any time at the prevailing rate because these instruments are quoted

regularly on the exchange. OTC instruments do not carry such liquidity; they can be

terminated only at the disadvantage of the holder.

i. Forwards Contracts:-

A forward contract is a contract between two parties to buy or sell an asset at a

certain future date for a certain price that is pre-decided on the date of the contract.

The future date is referred to as expiry date and the pre-decided price is referred to

Derivatives

Forwards Futures Options Swaps Warrants Baskets

Types of Derivatives


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as Forward Price. It may be noted that forwards are private contracts and their terms

are determined by the parties involved, i.e., they are customized.

ii. Futures Contracts:-

A futures contract is an agreement between a seller and a buyer which requires the

seller to deliver to the buyer a specified quantity of security, commodity or forex at a

fixed time in the future, at a price agreed to at the time of entering into the contract.

A futures contract is a exchange traded contract, i.e., they are standardized contract.

iii. Options Contracts:-

An Options is a contract between two parties in which one party has the right, but

not the obligation to buy / sell some underlying assets. Options are deferred delivery

contracts that give the buyer the right, but not the obligation, to buy / sell a specified

commodity or security at a set price on or before a specified future date.

iv. Swaps:-

Swaps are derivatives where counterparties to exchange cash flows or other variables

associated with different investments. Many times a swap will occur because one

party has a comparative advantage in one area such as borrowing funds under

variable interest rates, while another party can borrower more freely as the fixed

rate. . A "plain vanilla" swap is a term used for the simplest variation of a swap. There

are many different types of swaps, but three common ones are: Commodity swaps,

Interest Rate Swaps & Currency Swaps.
http://www.investopedia.com/terms/f/fixedinterestrate.asphttp://www.investopedia.com/terms/f/fixedinterestrate.asphttp://www.investopedia.com/terms/f/fixedinterestrate.asphttp://www.investopedia.com/terms/f/fixedinterestrate.asp


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v. Warrants:-

Options generally have lives up to one year, the majority of options traded on option

exchanges having a maximum maturity of nine months. Longer dated options are

called warrants and are generally traded over-the-counter.

vi. Baskets:-

Basket options are options on portfolios of underlying assets. The underlying asset is

usually a moving average or a basket of assets. E.g.:- Nifty Index.


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1. Price Volatility

A price is what one pays to acquire or use something of value. The concept of price is

clear to almost everybody when we discuss commodities. There is a price to be paid

for the purchase of food grain, oil, petrol, metal, etc. the price one pays for use of a

unit of another personsmoney is called interest rate. And the price one pays in ones

own currency for a unit of another currency is called as an exchange rate.

Prices are generally determined by market forces. In a market, consumers have

demand and producers or suppliers have supply, and the collective interaction of

demand and supply in the market determines the price. These factors are constantly

interacting in the market causing changes in the price over a short period of time.

Such changes in the price are known as price volatility.

Greater Price volatility after the break-downof Bretton Woods System.Price Volatility

Helps to hedge the risk faced in othercountries.

Globalization ofMarkets

Resulted in fast transmission of informationwhich affected the market price.

TechnologicalAdvances

Lead to the development of Black-Scholesoption pricing model.

Advances in Financialtheories

Factors Contributing to growth of Derivatives


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The changes in demand and supply influencing factors culminate in market

adjustments through price changes. These price changes expose individuals,

producing firms and governments to significant risks. The break-down of the

BRETTON WOODS agreement brought an end to the stabilizing role of fixed exchange

rates and the gold convertibility of the dollars. The globalization of the markets and

rapid industrialization of many underdeveloped countries brought a new scale and

dimension to the markets.

This price volatility risk pushed the use of derivatives like futures and options

increasingly as these instruments can be used as hedge to protect against adverse

price changes in commodity, foreign exchange, equity shares and bonds.

2. Globalization of the Markets

Earlier, managers had to deal with domestic economic concerns; what happened in

other part of the world was mostly irrelevant. Now globalization has increased the

size of markets and as greatly enhanced competition .it has benefited consumers who

cannot obtain better quality goods at a lower cost. It has also exposed the modern

business to significant risks and, in many cases, led to cut profit margins

In Indian context, South East Asian currencies crisis of 1997 had affected the

competitiveness of our products vis--vis depreciated currencies. Export of certain

goods from India declined because of this crisis. Steel industry in 1998 suffered its

worst set back due to cheap import of steel from south East Asian countries.

Suddenly blue chip companies had turned in to red. Thus, it is evident that

globalization of industrial and financial activities necessitates use of derivatives to

guard against future losses. This factor alone has contributed to the growth of

derivatives to a significant extent.


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3. Technological Advances

A significant growth of derivative instruments has been driven by technological

break-through. Advances in this area include the development of high speed

processors, network systems and enhanced method of data entry. Closely related to

advances in computer technology are advances in telecommunications. Improvement

in communications allow for instantaneous worldwide conferencing, Data

transmission by satellite. At the same time there were significant advances in

software programmed without which computer and telecommunication advances

would be meaningless. These facilitated the more rapid movement of information

and consequently its instantaneous impact on market price.

Although price sensitivity to market forces is beneficial to the economy as a whole

resources are rapidly relocated to more productive use and better rationed overtime

the greater price volatility exposes producers and consumers to greater price risk.

Derivatives can help a firm manage the price risk inherent in a market economy.

4. Advances in Financial Theories

Advances in financial theories gave birth to derivatives. Initially forward contracts in

its traditional form, was the only hedging tool available. Option pricing models

developed by Black and Scholes in 1973 were used to determine prices of call and put

options. The work of economic theorists gave rise to new products for risk

management which led to the growth of derivatives in financial markets.


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An option is a contract written by a seller that conveys to the buyer the right, but

not the obligation to buy (in the case of a call option) or to sell (in the case of a

put option) a particular asset, at a particular price (Strike price / Exercise price) in

future. In return for granting the option, the seller collects a payment (the

premium) from the buyer. Exchange traded options form an important class of

options which have standardized contract features and trade on public

exchanges, facilitating trading among large number of investors. They provide

settlement guarantee by the Clearing Corporation thereby reducing counterparty

risk. Options can be used for hedging, taking a view on the future direction of the

market, for arbitrage or for implementing strategies which can help in generating

income for investors under various market conditions.

The power ofoptions lies in their versatility. They enable you to adapt or adjust your

position according to any situation that arises. Options can be as speculative or as

conservative as you want. This means you can do everything from protecting a

position from a decline to outright betting on the movement of a market or index.

In India, Options can be played on stocks or indices.

NOTE: - There are no index options in BSE. Whereas, both stock and index options

can be played on NSE.

Introduction to O tions
http://www.investopedia.com/terms/o/option.asphttp://www.investopedia.com/terms/o/option.asp


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Options are basically of two types:-

A)Call Option

i. Long Call

ii. Short Call

B)Put Option

i. Long Put

ii. Short Put

Bullish Options:-

i. Long Call

ii. Short Put

Bearish Options:-

i. Short Call

ii. Long Put

T es o O tions


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Call option: A call option gives the holder the right but not the obligation to buy an

asset at a certain date for a certain price.

Put option: A put option gives the holder the right but not the obligation to sell an

asset by a certain date for a certain price.

Index options: These options have the index as the underlying. In India, they have a

European style settlement. E.g. Nifty options, Mini Nifty options, etc.

Stock options: Stock options are options on individual stocks. A stock option contract

gives the holder the right to buy or sell the underlying shares at the specified price.

They have an American style settlement.

Buyer of an option: The buyer of an option is the one who by paying the option

premium buys the right but not the obligation to exercise his option on the

seller/writer.

Writer / seller of an option: The writer / seller of a call / put option is the one who

receives the option premium and is thereby obliged to sell/buy the asset if the buyer

exercises on him.

Option price/premium: Option price is the price which the option buyer pays to the

option seller. It is also referred to as the option premium.

Options Lingo


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Expiration date: The date specified in the options contract is known as the expiration

date, the exercise date, the strike date or the maturity.

Strike price: The price specified in the options contract is known as the strike price or

exercise price.

American options: American options are options that can be exercised at any time up

to the expiration date.

European options: European options are options that can be exercised only on the

expiration date itself.

In-the-money option: An in-the-money (ITM) option is an option that would lead to a

positive cash-flow to the holder if it were exercised immediately. A call option on the

index is said to be in-the-money when the current index stands at a level higher than

the strike price (i.e. spot price > strike price). If the index is much higher than the

strike price, the call is said to be deep ITM. In the case of a put, the put is ITM if the

index is below the strike price.

At-the-money option: An at-the-money (ATM) option is an option that would lead to

zero cash-flow if it were exercised immediately. An option on the index is at-the-

money when the current index equals the strike price (i.e. spot price = strike price).

Out-of-the-money option: An out-of-the-money (OTM) option is an option that

would lead to a negative cash-flow if it were exercised immediately. A call option on

the index is out-of-the-money when the current index stands at a level which is less

than the strike price (i.e. spot price < strike price). If the index is much lower than the


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strike price, the call is said to be deep OTM. In the case of a put, the put is OTM if the

index is above the strike price.

Intrinsic value of an option: The option premium can be broken down into two

components - intrinsic value and time value. The intrinsic value of a call is the amount

the option is ITM, if it is ITM. If the call is OTM, its intrinsic value is zero. Putting it

another way, the intrinsic value of a call is Max [0, (St K)] which means the intrinsic

value of a call is the greater of 0 or (St K). Similarly, the intrinsic value of a put is

Max [0, K St], i.e. the greater of 0 or (K St). K is the strike price and St is the spot

price.

Time value of an option: The time value of an option is the difference between its

premium and its intrinsic value. Both calls and puts have time value. An option that is

OTM or ATM has only time value. Usually, the maximum time value exists when the

option is ATM. The longer the time to expiration, the greater is an option's time

value, all else equal.

Practically,

Option Premium = Intrinsic Value + Time Value


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The optionality characteristic of options results in a non-linear payoff for options. In

simple words, it means that the losses for the buyer of an option are limited;

however the profits are potentially unlimited. For a writer (seller), the payoff is

exactly the opposite. His profits are limited to the option premium; however his

losses are potentially unlimited. These nonlinear payoffs are fascinating as they lendthemselves to be used to generate various payoffs by using combinations of options

and the underlying. We look here at the six basic payoffs (pay close attention to

these pay-offs, since all the strategies are derived out of these basic payoffs).

Payoff profile of buyer of asset: Long asset

In this basic position, an investor buys the underlying asset, ABC Ltd. shares for

instance, for `2220, and sells it at a future date at an unknown price, St. Once it is

purchased, the investor is said to be "long" the asset. The following figure shows the

payoff for a long position on ABC Ltd.

Payoff for investor who went Long ABC Ltd. at `2220

The figure shows the profits/losses from a long position on ABC Ltd. The investor

bought ABC Ltd. at `2220. If the share price goes up, he profits. If the share price falls

he loses.

Options Pay-off


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Payoff profile for seller of asset: Short asset

In this basic position, an investor shorts the underlying asset, ABC Ltd. shares for

instance, for `2220, and buys it back at a future date at an unknown price, St. Once it

is sold, the investor is said to be "short" the asset. The following figure shows the

payoff for a short position on ABC Ltd.

Payoff for investor who went Short ABC Ltd. at `2220

The figure shows the profits/losses from a short position on ABC Ltd... The investor

sold ABC Ltd. at `2220. If the share price falls, he profits. If the share price rises, he

loses.


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Payoff profile for buyer of call options: Long call

A call option gives the buyer the right to buy the underlying asset at the strike price

specified in the option. The profit/loss that the buyer makes on the option depends

on the spot price of the underlying. If upon expiration, the spot price exceeds the

strike price, he makes a profit. Higher the spot price more is the profit he makes. If

the spot price of the underlying is less than the strike price, he lets his option expire

un-exercised. His loss in this case is the premium he paid for buying the option. The

below diagram gives the payoff for the buyer of a three month call option (often

referred to as long call) with a strike of`2250 bought at a premium of`86.60.

Payoff for buyer of call option

The figure shows the profits/losses for the buyer of a three-month Nifty 2250 call

option. As can be seen, as the spot Nifty rises, the call option is in-the-money. If upon

expiration, Nifty closes above the strike of`2250, the buyer would exercise his option

and profit to the extent of the difference between the Nifty-close and the strike price.


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The profits possible on this option are potentially unlimited. However if Nifty falls

below the strike of `2250, he lets the option expire. His losses are limited to the

extent of the premium he paid for buying the option.

Payoff profile for writer (seller) of call options: Short call

A call option gives the buyer the right to buy the underlying asset at the strike price

specified in the option. For selling the option, the writer of the option charges a

premium.

The profit/loss that the buyer makes on the option depends on the spot price of the

underlying. Whatever is the buyer's profit is the seller's loss. If upon expiration, the

spot price exceeds the strike price, the buyer will exercise the option on the writer.

Hence as the spot price increases the writer of the option starts making losses. Higher

the spot price more is the loss he makes. If upon expiration the spot price of the

underlying is less than the strike price, the buyer lets his option expire un-exercised

and the writer gets to keep the premium. The below diagram gives the payoff for the


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writer of a three month call option (often referred to as short call) with a strike of

`2250 sold at a premium of `86.60

Payoff for writer of call option

The figure shows the profits/losses for the seller of a three-month Nifty 2250 call

option. As the spot Nifty rises, the call option is in-the-money and the writer starts

making losses. If upon expiration, Nifty closes above the strike of `2250, the buyer

would exercise his option on the writer who would suffer a loss to the extent of thedifference between the Nifty-close and the strike price. The loss that can be incurred

by the writer of the option is potentially unlimited, whereas the maximum profit is

limited to the extent of the up-front option premium of`86.60 charged by him.

Payoff profile for buyer of put options: Long put

A put option gives the buyer the right to sell the underlying asset at the strike price

specified in the option. The profit/loss that the buyer makes on the option depends

on the spot price of the underlying. If upon expiration, the spot price is below the


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strike price, he makes a profit. Lower the spot price more is the profit he makes. His

loss in this case is the premium he paid for buying the option. The below diagram

gives the payoff for the buyer of a three month put option (often referred to as long

put) with a strike of`2250 bought at a premium of`61.70.

Payoff for buyer of put option

The figure shows the profits/losses for the buyer of a three-month Nifty 2250 put

option. As can be seen, as the spot Nifty falls, the put option is in-the-money. If upon

expiration, Nifty closes below the strike of`

2250; the buyer would exercise his option

and profit to the extent of the difference between the strike price and Nifty-close.

The profits possible on this option can be as high as the strike price. However if Nifty

rises above the strike of`2250, he lets the option expire. His losses are limited to the

extent of the premium he paid for buying the option.

Payoff profile for writer (seller) of put options: Short put

A put option gives the buyer the right to sell the underlying asset at the strike price

specified in the option. For selling the option, the writer of the option charges a

premium.


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The below diagram gives the payoff for the writer of a three month put option (often

referred to as short put) with a strike of`2250 sold at a premium of`61.70.

Payoff for writer of put option

The figure shows the profits/losses for the seller of a three-month Nifty 2250 put

option. As the spot Nifty falls, the put option is in-the-money and the writer starts

making losses. If Nifty closes below the strike of `2250, the buyer would exercise his

option on the writer who would suffer a loss to the extent of the difference between

the strike price and Nifty close.

The loss that can be incurred by the writer of the option is a maximum extent of the

strike price whereas the maximum profit is limited to the extent of the up-front

option premium of`61.70 charged by him.


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OPTIONS

STRATEGIES


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Strategy 1: LONG CALL

For aggressive investors who are very bullish about the prospects for a stock /

index, buying calls can be an excellent way to capture the upside potential with

limiteddownsiderisk.

Example:

Mr. XYZ is bullish on Nifty on 24th June, when the Nifty is

at 4191. He buys a call options with a strike price of

`4600 at a premium of `36, expiring on 31st

July. If the

Nifty goes above 4636, Mr. XYZ will make a net profit

(after deducting the premium) on exercising the option.

In case the Nifty stays at or falls below 4600, he can

forego the option (it will expire worthless) with a

maximum loss of the premium.

Strategy : Buy Call Option

Current Nifty index 4191

Call Option Strike Price (`) 4600

Mr. XYZ Pays Premium (`) 36

Break Even Point(`) (Strike Price

+ Premium)

4636

Buying a Call Option is

the basic of all Option

strategies. It is an easy

strategy to understand.

When you buy a Call

Option it means you

expect the stock / index

to rise in the future.

When to Use: Investor

is very aggressive and

he is very bullish aboutthe stock/ index.

Risk: Limited to the

premium paid.

Reward: Unlimited

Break-even Point:

Strike Price + Premium.


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The payoff schedule:-

The payoff profile:-

-50

0

50

100

150

4000 4300 4636 4700 4900

Long Call

Nifty Profit

This strategy limits the downside risk to theextent of premium paid. But the potentialreturn is unlimited in case of rise in Nifty. Along call option is the simplest way tobenefit if you believe that the market willmake an upward move. As the stock price /index rises, the long Call moves into profitmore and more quickly.

Analysis

On expiry Nifty closes at Net payoff from Call option(`)

4100 -36

4300 -36

4500 -36

4636 0

4700 64

4900 264

5100 464

5300 664


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Strategy 2: SHORT CALL

When you buy a Call you are hoping that the underlying stock / index would

rise. When you expect the underlying stock / index to fall you do the opposite.

When an investor is very bearish about a stock / index and expects the prices to

fall, he can sell Call options. This position offers limited profit potential and

the possibility of large losses on big advances in underlying prices. Although

easy to execute it is a risky strategy since the seller of the call is exposed to

unlimited risk.

Selling a Call option is

the just the opposite of

buying a Call option.

Here the seller of the

option feels the

underlying price of the

stock / index to fall in the

future.

When to Use: Investor is

very aggressive and he is

very bearish about the

stock/ index.

Risk: Unlimited.

Reward: Limited to the

amount of the premium.

Break-even Point: Strike

Price + Premium.

Example:

Mr. XYZ is bearish about Nifty and expects it to fall.

He sells a Call option with a strike price of`2600 at a

premium of`154, when the current Nifty is at 2694. If

the Nifty stays at 2600 or below, the Call option will

not be exercised by the buyer of the option and Mr.

XYZ can retain the entire premium of`154.

Strategy : Sell Call Option Current Nifty index 2694

Call Option

Strike Price (`) 2600

Mr. XYZ receives Premium (` ) 154Break Even Point (` )

(Strike Price +

Premium *2754


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The payoffschedule:-


-400

-200

0

200

2400 2600 2754 2900 3000

Short Call

Nifty Profit

This strategy is used when an investor is

very aggressive and has a strongexpectation of a price fall (and certainly nota price rise). This is a risky strategy since asthe stock price / index rises, the short callloses money more and more quickly andlosses can be significant if the stock price /index fall below the strike price.

Analysis

On expiry Nifty closes at Net payoff from Call

option (`)

2400 154

2500 154

2600 154

2700 54

2754 0

2800 -46

2900 -146

3000 -246


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Strategy 3: SYNTHETIC LONG CALL

In this strategy, we purchase a stock since we feel bullish about it. But what if the

price of the stock went down? You wish you had some insurance against the price

fall. So buy a Put on the stock. This gives you the right to sell the stock at a certain

price which is the strike price. The strike price can be the price at which you

bought thestock (ATM strike price) or slightly below (OTM strike price).

In case the price of the stock rises you get the full benefit of the price rise. In case

the price of the stock falls, exercise the Put Option (remember Put is a right to sell).

You have capped your loss in this manner because the Put option stops your

further losses. It is a strategy with a limited loss and (after subtracting the Put

premium) unlimited profit (from the stock price rise). The result of this strategy

looks like a Call Option Buy strategy and therefore is called a Synthetic Call.

But the strategy is not Buy Call Option (Strategy 1). Here you have taken an

exposure to an underlying stock with the aim of holding it and reaping the benefits

of price rise, dividends, bonus rights etc. and at the same time insuring against an

adverse pricemovement.

In simple buying of a Call Option, there is no underlying position in the stock but is

entered into only to take advantage of price movement in the underlying stock.


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When to use: when

ownership is desired of

stock yet investor is

concerned about near

month downside risk.

The outlook is

considerably bullish.

Risk: Losses limited to

Stock price + Put

premium Put Strike

price.

Reward: Profit

potential is unlimited.

Break-even Point: PutStrike price + Put

premium + Stock price

Put Strike Price.

Example:

Mr. XYZ is bullish about ABC Ltd. He buys ABC Ltd at

current market price of `4000 on 4th

July. To protect

against fall in the price of ABC Ltd, he buys a Put option

with a strike price`

3900 (OTM) a premium of`

143.80

expiring on 31st

July.

Strategy : Buy Stock + Buy Put Option

Buy Stock

(Mr. XYZ pays)

Current Market Price of

ABC Ltd. (`)

4000

Strike Price (`) 3900

Buy Put

(Mr. XYZ pays)

Premium (`)

143.80

Break Even Point (`)

(Put Strike Price + Put

Premium + Stock Price

Put Strike Price)*

4143.80


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Example:

ABC Ltd is trading at `4000 at 4th

July.

Buy 100 shares of the stock at `4000.

Buy 100 July Put options with a Strike price of`3900 at a premium of`143.80

per Put.

Net Debit (Payout) = Stock Bought + Premium Paid

= `4000 + `143.80

= `414380/-

Maximum Loss = Stock Price + Put Premium Put Strike

= `4000 + `143.80 - `3900

= ` 24,380/-

Maximum Gain = Unlimited (as the stock rises)

Break-even = Put Strike + Put Premium + Stock Price Put

Strike= `3900 + `143.80 + `4000`3900= `4143.80/-


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ABC Ltd. closes at

on expiry

Payoff from the

Stock (`)

Net Payoff from the

Put Option (`)

Net Payoff

(`)

3400.00 -600.00 356.20 -243.803600.00 -400.00 156.20 -243.80

3800.00 -200.00 -43.80 -243.80

4000.00 0 -143.80 -143.80

4143.80 143.80 -143.80 0

4200.00 200.00 -143.80 56.20

4400.00 400.00 -143.80 256.20

4600.00 600.00 -143.80 456.20

4800.00 800.00 -143.80 656.20

The payoff chart (Synthetic Long Call):-

+ =

Buy Stock Buy Put Synthetic Long Call

This is a low risk strategy. It limits the lossin case of fall in market but the potential

profit remains unlimited when the stockprice rises. A good strategy when you buya stock for medium or long term, with theaim of protecting any downside risk. Thepay-off resembles a Call Option buy and istherefore called as Synthetic Long Call.

Analysis


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34

Strategy 4: LONG PUT

Buying a Put is opposite of buying a Call. When an investor buys a Call option, he is

bullish on the stock / index. If an investor is bearish, he can buy a Put option. A Put

option gives a right to the seller to sell the stock (to the Put seller) at a pre-

determined price and thereby limiting his risk.

A Long Put is a Bearishstrategy. To take

advantage of a falling

market an investor can

buy Put options.


is bearish about the

stock / index.

Risk: Limited to theamount of Premium

paid. (Maximum loss if

stock / index expire at

or above the option

strike price.)

Reward: Unlimited.

Break-even Point:

Stock Price Premium.

Example:

Mr. XYZ is bearish on Nifty on 24th

June, when Nifty is at

2694. He buys a Put option with a strike price of`2600 at

a premium of `52 expiring on 31st

July. If the Nifty goes

below 2548, Mr. XYZ will make a profit on exercising the

option. In case the Nifty rises above 2600, he can forego

the option (it will expire worthless) with a maximum loss

of the premium.

Strategy : Buy Put Option

Current Nifty index 2694

Put Option Strike Price (`) 2600

Mr. XYZ Pays Premium (`) 52


(Strike Price -

Premium)

2548


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35



-100

0

100

200

300

2300 2400 2548 2700 2800

Long Put

Nifty Profit

A bearish investor can profit from decliningstock price by buying Puts. He limits his riskto the amount of premium paid but his profitpotential remains unlimited. This is one of thewidely used strategy when an investor isbearish.

Analysis

On expiryNifty closes

at

Net Payoff from

Put Option (`

)2300 248

2400 148

2500 48

2548 0

2600 -52

2700 -52

2800 -52

2900 -52


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36

Strategy 5: SHORT PUT

An investor sells Put when he is Bullish about the stock. When you sell a Put, you

earn a Premium (from the buyer of the Put). You have sold someone the right to

sell you the stock at the strike price. If the stock price increases beyond the strike

price, the short put position will make a profit for the seller by the amount of the

premium, since the buyer will not exercise the Put option and the Put seller can

retain the Premium (which is his maximum profit). But, if the stock price

decreases below the strike price, by more than the amount of the premium, the

Putseller will lose money.


is very Bullish about

the stock / index. The

main idea is to makeshort term income.

Risk: Unlimited.

Reward: Limited to the

amount of Premium

received.

Break-even Point: Put

Strike - Premium.

Example:

Mr. XYZ is bullish on Nifty when it is 4190.10. He sells a Put

option with a strike price of `4100 at a premium of `170expiring on 31

stJuly. If the Nifty index stays above 4100, he

will gain the amount of premium as a Put buyer wont

exercise his option. In case the Nifty falls below 4100, Put

buyer will exercise the option and Mr. XYZ will start losing

money. If the Nifty falls below 3930, which is the break-

even point, Mr. XYZ will lose the premium and more

depending on the extent of the fall in Nifty.

Strategy : Sell Put Option

Current Nifty index 4191.10

Put Option Strike Price (`) 4100

Mr. XYZ

receivesPremium (`) 170


(Strike Price - Premium)

3930


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37



-600

-400

-200

0

200

400

3400 3700 3930 4300 4600

Short Put

Nifty Profit

Selling Puts can lead to regular income in arising or range bound markets. But it shouldbe done carefully since the potential lossescan be significant in case the price of thestock / index falls. This strategy can beconsidered as an income generatingstrategy.

Analysis

On expiry NiftyCloses

at

Net Payofffrom the Put

Option (`)

3400 -5303500 -430

3700 -230

3900 -30

3930 0

4100 170

4300 170

4500 170


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38

Strategy 6: COVERED CALL

You own shares in a company which you feel may rise but not much in the near

term (or at best stay sideways). You would still like to earn an income from the

shares. The covered call is a strategy in which an investor Sells a Call option on

a stock he owns (netting him a premium). The Call Option which is sold in

usually an OTM Call. The Call would not get exercised unless the stock price

increases above the strike price. Till then the investor in the stock (Call seller) can

retain the Premium with him. This becomes his income from the stock. This

strategy is usually adopted by a stock owner who is Neutral to moderately

Bullish about the stock.

An investor buys a stock or owns a stock which he feels is good for medium to

long term but is neutral or bearish for the near term. At the same time, the

investor does not mind exiting the stock at a certain price (target price). The

investor can sell a Call Option at the strike price at which he would be fine

exiting the stock (OTM strike). By selling the Call Option the investor earns a

Premium. Now the position of the investor is that of a Call Seller who owns the

underlying stock. If the stock price stays at or below the strike price, the Call

Buyer will not exercise the Call. The Premiumis retained by the investor.

In case the stock price goes above the strike price, the Call buyer who has the

right to buy the stock at the strike price will exercise the Call option. The Call

seller (the investor) who has to sell the stock to the Call buyer will sell the stock

at the strike price. This was the price which the Call seller (the investor) was

anyway interested in exiting the stock and now exits at that price. So besides


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39

the strike price which was the target price for selling the stock, the Call seller

(investor) also earns the Premium which becomes an additional gain for him.

This strategy is called as a Covered Call strategy because the Call sold is backed by

a stock owned by the Call Seller (investor).

When to Use: This is

often employed when

an investor has a

short term neutral to

moderately bearishview on the stock he

holds. He takes a short

position on the call

option to generate

income from the

option premium.

Risk: If the Stock Price

falls to zero, the

investor loses theentire value of the

Stock but retains the

premium, since the

Call will not be

exercised against

Reward: Limited to

(Call Strike Price

Stock Price paid) +

Premium received

Break-even Point:

Stock Price paid

Premium received.

Example:

Mr. A bought XYZ Ltd. for `3850 and simultaneously sells a

Call option at a strike price of `4000. Which means Mr. A

does not think that the price of XYZ Ltd. will rise above

`4000. However, in case it rises above `4000, Mr. A does

not mind getting exercised at that price and exiting the

stock at `4000 (TARGET SELL PRICE = 3.90% return on

the stock purchase price). Mr. A received a premium of`80

for selling the Call. Thus net outflow to Mr. A is ( 3850

`80) = `3770. He reduces the cost of buying the stock by

this strategy.

Strategy : Buy Stock + Sell Call Option

Mr. A buys the

stock XYZ Ltd.

Market Price (`) 3850

Call Options Strike Price (`) 4000

Mr. A receives Premium (`) 80

Break Even Point

(`) (Stock Price

paid - Premium

Received)

3770


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40

Example:-

1) The price of XYZ Ltd. stays at or below `4000. The Call buyer will not exercise

the Call Option. Mr. A will keep the premium of `80. This is an income for him. So if

the stock has moved from 3850 (purchase price) to 3950, Mr. A makes `180/-

[`3950 `3850 + `80 (Premium)] = an additional `80, because of the Callsold.

2) Suppose the price of XYZ Ltd. moves to `4100, then the Call Buyer will

exercise the Call Option and Mr. A will have to pay him `100 (loss on exercise

of the CallOption). What would Mr. A do and what will be his pay off?

a) Sell the Stock in the market at :

b) Pay Rs. 100 to the Call Options buyer :

c Pa Off a b received :

`4100

- `100

`4000

(This was Mr. As

target price)

d) Premium received on Selling Call Option: `80

e) Net payment (c + d) received by Mr. A : `4080

f) Purchase price of XYZ Ltd. : `3850

g) Net profit : `4080`3850

`230

h) Return (%) : (`4080 `3850) X

`3850

: 5.97% (which is morethan the

target return of3.90%).


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41


XYZ Ltd. price closesat

(`)

Net Payoff

(`)

3600 -170

3700 -703740 -30

3770 0

3800 30

3900 130

4000 230

4100 230

4200 230

4300 230

The payoff chart (Covered Call):-

+ =

Buy stock Sell Put Covered Call


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42

Strategy 7: COVERED PUT

This strategy is opposite to a Covered Call. A Covered Call is a neutral to bullish

strategy, whereas a Covered Put is a neutral to Bearish strategy. You do this

strategy when you feel the price of a stock / index is going to remain range

bound or move down. Covered Put writing involves a short in a stock / index

along with a short put on the options on the stock/index.

The Put that is sold is generally an OTM Put. The investor shorts a stock

because he is bearish about it, but does not mind buying it back once the price

reaches (falls to) a target price. This target price is the price at which the

investor shorts the Put (Put strike price). Selling a Put means, buying the stock at

the strike price ifexercised. If the stock falls below the Put strike, the option will

be exercisedand will have to buy the stock at the strike price (which is anyway

his target price to repurchase the stock). The investor makes a profit because he

has shorted the stockand purchasing it at the strike price simply closes the short

stock position at a profit. And the investor keeps the Premium on the Put sold.

The investor is covered here because he shorted the stock in the first place.

If the stock price does not change, the investor gets to keep the Premium. He can

use this strategy as an income in a neutral market. Let us understand this with an

example.


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43

When to Use: If the

investor is of the view

that the markets are

moderately bearish.

Risk: Unlimited if the

price of the stock rises

substantially.

Reward: Maximum is

(Sale Price of the stock

Strike Price) +

Premium.

Break-even Point:

Sale Price of stock +

Put Premium.

Example:

Suppose ABC Ltd is trading at `4500 in June. An

investor, Mr. A, shorts `4300 Put by selling a July Put

for `24 while shorting an ABC Ltd stock. The net credit

received by Mr. A is `4500 + `24 = `4524.

Strategy : Short Stock + Short Put Option

Sells Stock

(Mr. A

receives)

Current Market

Price (`)

4500

Sells Put Strike Price (`) 4300

Mr. A receives

Premium (`) 24

Break Even Point

(`) (Sale price of

Stock + Put

Premium

4524


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44


The payoff chart (Covered Put):-

+ =

Sell stock Sell Put Covered Put

ABC Ltd.

closes at

`

Payoff from

the stock

`

Net Payoff

from the Put

O tion `

Net Payoff

`

4000 500 -276 224

4100 400 -176 224

4200 300 -76 224

4300 200 24 224

4400 100 24 124

4450 50 24 74

4500 0 24 24

4524 -24 24 0

4550 -50 24 -26

4600 -100 24 -764635 -135 24 -111

4650 -160 24 -136


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45

Strategy 8: LONG COMBO

A Long Combo is a Bullish strategy. If an investor is expecting the price of a stock

to move up he can do a Long Combo strategy. It involves selling an OTM

(lower strike) Put and buying an OTM (higher strike) Call. This strategy simulates

the actionofbuying a stock (or a futures) but at a fraction of the stock price. It is

an inexpensive trade, similar in pay-off to Long Stock, except there is a gap

between the strikes (please see the payoff diagram). As the stock price rises the

strategy starts making profits. Let us try and understand Long Combo with an

example.


is Bullish on the stock.

Risk: Unlimited (Lower

Strike price + Net

Debit)

Reward: Unlimited.

Break-even Point:

Higher Strike Price +

Net Debit

Example:

A stock ABC Ltd is trading at `450. Mr. XYZ is bullish on the

stock. But he does not want to invest `450. He does a Long

Combo. He sells a Put option with a strike price of `400 at

a premium of`1 and buys a Call option with a strike price

of`500 at premium of`2. The net cost of the strategy (net

debit) is `1.

Strategy : Sell a Put + Buy a Call

ABC Ltd. Current Market Price (`) 450

Sells Put Strike Price (`) 400

Mr. XYZ recd Premium (`) 1.00

Buys Call Strike Price (`) 500

Mr. XYZ pays Premium (`) 2.00

Net Debit (`) 1.00


(Higher Strike + Net Debit)501


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46


ABC Ltd. closes at

(`)

Net Payofffrom

the Put Sold (`)

Net Payoff from the

Call purchased

(`)

Net Payoff

(`)

700 1 198 199

650 1 148 149

600 1 98 99

550 1 48 49

501 1 -1 0

500 1 -2 -1

450 1 -2 -1

400 1 -2 -1350 -49 -2 -51

300 -99 -2 -101

250 -149 -2 -151

For a small investment of`1 (net debit), the returns can be very high in a Long

Combo, but only if the stock moves up. Otherwise the potential losses can also

be high.

The payoff chart (Long Combo):-

+ =

Sell put Buy call Long Combo


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47

Strategy 9: LONG STRADDLE

A Straddle is a volatility strategy and is used when the stock / index isexpected

to show large movements. This strategy involves buying a call as well asput on

the same stock / index for the same maturity and strike price, to take advantage

of a movement in either direction. If the price of the stock/ index increases, the

call is exercised while the put expires worthless and if the price of the stock /

index decreases, the put is exercised, the call expires worthless. Either way if

the stock / index show volatility to cover the cost of the trade, profits are to be

made.

When to Use: The

investor thinks that the

underlying stock /

index will experience

significant volatility inthe near term.

Risk: Limited to the

initial premium paid

(net debit).

Reward: Unlimited.

Break-even Point:

Upper = Strike price ofLong Call + Net

Premium paid.

Lower = Strike price of

Long Put Net

premium paid.

Example:

Suppose Nifty is at 4450 on 27th

April. An investor, Mr. A

enters a long straddle by buying a May`

4500 Nifty Put

for `85 and a May `4500 Nifty Call for `122. The net debit

taken to enter the trade is `207, which is also his

maximum possible loss.

Strategy : Buy Put + Buy Call

Nifty index Current Value 4450

Call and Put Strike Price (`) 4500

Mr. A pays Total Premium

Call + Put `

207

Break Even Point

(`)

4707(U)

(`) 4293(L)


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The payoff profile (Long Straddle):-

+ =

Buy Put Buy Call Long Straddle

On expiry

Nifty closes at

Net Payoff fromPut

purchased (`)

Net PayofffromCall

purchased (`)

Net Payoff

(`)

3800 615 -122 4933900 515 -122 3934000 415 -122 2934100 315 -122 1934200 215 -122 934234 181 -122 594293 122 -122 04300 115 -122 -74400 15 -122 -1074500 -85 -122 -2074600 -85 -22 -1074700 -85 78 -74707 -85 85 04766 -85 144 594800 -85 178 934900 -85 278 1935000 -85 378 2935100 -85 478 3935200 -85 578 4935300 -85

678593


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49

Strategy 10: SHORT STRADDLE

It is a strategy to be adopted when the investor feels the market will not show

much movement. He sells a Call and a Put on the same stock / index for the same

maturity and strike price. It creates a net income for the investor. If the stock /

index do not move much in either direction, the investor retains the Premium as

neither the Call nor the Put will be exercised. However, in case the stock / index

moves in either direction, up or down significantly, the investors losses can

be significant. So this is a risky strategy and should be carefully adopted and onlywhen the expected volatility in the market is limited. If the stock / index value

stays close to the strike price on expiry of the contracts, maximum gain, which is

the Premium received is made.

When to Use: The

investor thinks that

the underlying stock /index will experience

very little volatility in

the near term.

Risk: Unlimited

Reward: Limited to

the initial premium

received (net credit).

Break-even Point:

Upper = Strike price of

Short Call + Net

Premium received.

Lower = Strike price of

Short Put Net

remium received.

Example:

Suppose Nifty is at 4450 on 27th April. An investor, Mr. A

enters a short straddle by selling a May `4500 Nifty Put

for `85 and a May `4500 Nifty Call for `122. The net credit

taken to enter the trade is `207, which is also his

maximum possible loss.

Strategy : Buy Put + Buy Call

Nifty index Current Value 4450

Call and Put Strike Price (`) 4500

Mr. A receives Total Premium

(Call + Put) (`)

207

Break Even Point

(`)

4707(U)

(`) 4293(L)


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50


On expiryNifty

closes at

Net Payoff from Put

Sold (`)

Net PayofffromCall

Sold (`)

Net Payoff

(`)

3800 -615 122 -493

3900 -515 122 -393

4000 -415 122 -293

4100 -315 122 -193

4200 -215 122 -93

4234 -181 122 -59

4293 -122 122 0

4300 -115 122 7

4400 -15 122 107

4500 85 122 207

4600 85 22 1074700 85 -78 7

4707 85 -85 0

4766 85 -144 -59

4800 85 -178 -93

4900 85 -278 -193

5000 85 -378 -293

The payoff chart (Short Straddle):-

+ =

Sell Put Sell Call Short Straddle


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Mr. X bought 100 shares of ABC Ltd. at `40; it currently trades at `30. The stock no

longer appeals to him, and he is inclined to trade out of it but is not happy about

having to take the loss. He thinks the stock might recover about half its decline, but

does not believe it will be back to `40 anytime soon. At this point, he would just like to

get his money back. The strategy of Stock Repair makes sense to him and he decides

to use it.

He finds the following one-month options: `30 call @ `3, `35 call @ `1.50. He buys the

30 call and writes (sells) two of the 35 calls. The table below shows the profit and loss

possibilities from the combined position.

Stock Price at Expiration

Position 30 31 32 33 34 35

Long Stock -10 -9 -8 -7 -6 -5

Long 30 Call -3 -2 -1 0 1 2

Short Two 35 Calls 3 3 3 3 3 3

Combined -10 -8 -6 -4 -2 0

The worksheet shows that, ignoring commissions, Mr. X breaks-even if ABC Ltd.

returns to `35at option expiration.

Stock Repair Strategy


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52

Objective:-

To understand the investment patterns & strategies adopted by the retail

investors.

Sample Studied:-

Technique: Random Sampling

Size: 100

Nature: Retail Investors

Tools used for Analysis:-

Questionnaire

Research Analysis


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53

Around 100 retail investors of different age groups were asked few questions to find

out their investment patterns and strategies. The findings of the survey are given

below:

Finding 1:

Options is traded by people mostly in age group of 26-45 years since their risk-taking

capacity is more compared to others and they also desire more to leverage their

investment and gain maximum returns.

People above 60 years trade maximum in Cash Market since they still follow the

philosophy of buy-and-hold for their successors.

0

10

20

30

40

50

60

70

80

18-25 years 26-45 years 45-60 years 60 years above

68

25

42

71

21

59

45

19

1116

1310

Cash Market Futures Market Options Market

Major Findings


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54

Finding 2:

As the age of the people increases, they trade in Options for Hedging purposes.

Whereas, in their early ages they speculate in Options in order to earn more profits.

Finding 3:

0

10

20

30

40

50

60

70

80

18-25 years 26-45 years 46-60 years 60 years above

2126

35

42

7974

6558

Hedging Speculation

14%

65%

21%

Cash Market

Futures

Options


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55

Majority of the investors think that dealing in Futures is most risky, whereas trading

in Options is comparatively less risky since the buyer of the option has limited risk.

Cash Market is considered to be least risky.

Finding 4:

Majority of the investors deals in Stock Options as compared to Index Options.

Since prices of a stock is generally more volatile than the Index. This helps to earn

more profits but also contains greater risk.

69%

31%

Stock Options

Index Options


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56

Options are traded mostly by investors having more risk-taking capacity. Hence,

Options are mostly traded by people in the age group of 25-45 years.

Options are, nowadays, used more for speculation as compared to hedging. It is

used as a hedging tool mostly by the people in the age group of 60 years above.

Majority of the investors think that dealing in Futures is most risky, whereas

trading in Options is comparatively less risky since the buyer of the option has

limited risk. Cash Market is considered to be least risky.

Stock Options are more traded than Index Options. This is maybe because

Stocks have higher volatility than Index. Hence, more profits can be derived out of

Stock options.

Conclusion


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57

Books:-

Robert StrongIntroduction to Derivatives

D.C. PatwariOptions and Futures

References:-

NCFM Equity Markets module

NCFM Derivatives (dealers) module

NCFM Options Strategies module

Websites:-

www.investopedia.com

www.nseindia.com

www.bseindia.com

www.sebi.gov.in

www.moneycontrol.com

www.optionstradingtips.com

Bibliography
http://www.investopedia.com/http://www.nseindia.com/http://www.bseindia.com/http://www.sebi.gov.in/http://www.moneycontrol.com/http://www.moneycontrol.com/http://www.sebi.gov.in/http://www.bseindia.com/http://www.nseindia.com/http://www.investopedia.com/


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1) Whats your age?

18-25 years

26-45 years

45-60 years

60 years & above

2) Where you mostly invest your money in?

Cash Market

Futures Market

Options market

3) Do you trade in Options? If yes then,

i. Whats your underlying purpose for trading in Options?

Hedging

Speculation

ii. What you prefer trading in?

Stock Options

Index Options

4) According to you, which market is more risky?

Cash market

Futures

Options

Questionnaire

Documents

Option Strategy Final Editn