Overview

Advanced Trading Strategies in Options

Option or choice is a derivative financial instrument whose market is growing fast. It is a contract between a buyer and a seller. Option gives a buyer the right (but not the obligation to buy or sell the contract) while the seller has an obligation to honor the contract. To get most out of the option an appropriate option strategy has to be adopted. Trading in options involves high risk. The buyer can lose the premium if he does not exercise his option; while the seller has unlimited loss potential if the buyer decides to exercise his right. To ensure a certain level of profits a trader (whether buyer or seller) must use strategies that act as a hedging device to either minimize losses or lock a certain minimum profit level The main parameters which affect the options contract are the price, volatility, time value of the options contract, the market movement, risk bearing capacity of the investor etc. A number of trading strategies are available and depending upon the investor s capability of taking risk a combination of these strategies is created to trade options in the derivative market. Options are traded in the form of American options and European options. The difference lies in the exercise period. While an American option can be traded at any exercise day during the life of option, European option can be traded only on the day of expiration date of the contract. Two types of options are the calls and puts. The four basic strategies concerned with options trading are the long call, short call, long put and short put. A combination of these strategies forms the advanced trading strategies in options. The trading strategies are in the form of single option contract or a combination type contracts or generally spread contracts which also falls in the category of combination type. According to the payoff diagram the various strategies are also named like the straddles, strangles, ratio spreads, calendar spreads etc. Researches shows that the most heavily traded combination strategies are straddles, vertical (bull and bear) spreads, ratio spreads and the strangles. Moderately active traded strategies include collars, delta-neutral combinations, doubles and diagonal spreads. Butterfly spreads, horizontal spreads, tree spreads and straddle spreads are not actively traded. Condors, guts, iron butterfly and covered calls and puts are rarely trade. While evidences show that box spreads, jelly rolls or synthetics are traded negligibly. This book focuses the strategies that can be used by investors with bullish, bearish or neutral views of the market. Similarly it also highlights the various advanced trading strategies that can be adopted by an investor to make money with options. Using strategies is an art in order to time the market movements. The book is divided into two sections- section I-Single and combination strategies and section II-Spread Strategies.

The investor who is new to options trading has to know some of the elementary concepts in options and its trading. The first article Options Trading Basics by Patel Rahul, Ajab Gandhi and Smitha Ramachandran in Section I Single and Combination Strategies highlights the concepts of options i.e the risk in options, how volatility affects options trading and the profit potential in options. The article also deals briefly about the history of options and how it became traded in organized exchanges. The article also covers the basic strategies and the profit potential associated with it. It gives an overview of various advanced strategies along with the risk and profit potential associated with each strategies. The second article in the first section, Options Pricing, Hedging, Trading is a book review of the said book (edited by A.C. Reddi) written by Yash Paul Pahuja. This book explains in depth the concept of option pricing and the path-breaking work of Fischer Black and Myron Scholes on the subject. The article gives a glimpse of covered strategies, spread strategies and the Ratio combinations. As such this book will be useful for both to experts who can sharpen their skills, and beginners to familiarize themselves with the subject. The next article An Overview of Covered Call and Put Strategies by Archana Mehta elaborates the covered call and put strategy. This is a single option strategy. As the name suggests in covered calls call options are used while in covered puts only put options are used. These strategies are low risk low profit strategy and are loved by risk averse investors. The article also brings out a comparison between these strategies along with the benefits of both the strategies. The fourth article Strangle: A Protective Strategy by Smitha Ramachandran gives an overview of Strangle Strategy. This article talks about the short and long strangles and their characteristics, risk associated and profit potential. Strangle a neutral strategy, is sometimes referred to as bottom vertical combination when an investor buys a put and a call with the same expiration date but with different strike prices or as top vertical combination if the strangle is sold. An analysis of this strategy is made with respect to the stock of TATA Steel. This strategy is protective in nature as entering into this position will generate profit even if the market goes in either direction. The fifth article Straddle: The Most Popular Strategy by Radha A Purswani talks about the straddle strategy and how it is used to hedge the risk associated with options. One of the actively used strategies in trading options is the straddle. It a neutral combination strategy involving both the call and put options and investors enters into this trading position when they are not sure of the direction of market movement. An investor before entering into options contract should do a background analysis of the market. It will help the investor to minimize risk and maximize profit. So along with the knowledge of entering into various options strategies it is always very helpful to have knowledge about the analyzing the market movement volatility and the risk.

The sixth article Volatility and the Long Straddle by Dan Passarelli throws light on the long straddle strategy for trading volatile stocks without concern for direction. The investor is advised when to buy an option and the apt strategy to be adopted when the stock shows high volatility. The realized and implied volatility is explained and how long straddle make profits from increases in volatility is also dealt with. The long straddle is that option strategy which can profit two ways by an increase in realized volatility and an increase in implied volatility. i.e. buying a straddle is buying volatility. Article seven in the first section Analysis of Long Straddle Option Strategy by Shraddhesh Doshi and Malay Mehta has brought out the results of a study conducted to understand the behaviour of long straddle with respect to changes in the variables that affected the individual legs of the straddle strategy. The study was conducted with the help of ONGC stock traded in National Stock Exchange. The four basic options position long call, long put, short call, short put can be used independently, together or in conjunction with other financial instruments to create a number of option-trading strategies. The eighth article Combination of Trading Strategies: Combining the advantages of the Strangle with Other Trading Strategies by Aditya Iyengar discusses results of option trading strategies applied to actual market conditions and explores the possibility of formulating a new strategy which is a combination of two or more strategies. The ninth article Sideways Satisfaction by Yesenia Salcedo talks about the strategies which are adopted for profitable trading when the investor is confident that the market moves sideways. This article describes the neutral strategies in addition to Iron Condor which is most popularly adopted strategy when the market moves in sideway direction is explained. The next article Trading the Volatility: Skew in Options by Lawrence McMillan describes the volatility skews in option and how one can trade volatility. Volatility is one of the important factors to be considered in options contract. One can make an arbitrage profit by selling the costlier options and buying the cheaper ones on the same underlying stock known as volatility skew. An experienced investor who can identify the skews will be able to generate superior performance results over a period of time The last article Creating low risk trading strategies using Derivative products by Mayank Joshipura and Ajab Gandhi analyses the derivative market with real time. The objective of this paper is to find out that option trading strategies which can lower the risk. The paper focuses on Strip and Strap trading strategy and Synthetic Bull spread with selling out of the money call options and buying futures and at the money put options. Specifically the strategy Covered Call with detailed analysis is covered in the paper with examples from Indian derivative market. Articles in Second II-Spread Strategies largely talks about various spread strategies their profit potential and risks associated with each strategy. The first article in this section An Introduction to Spread Strategies by Ajab Gandhi briefly introduces options

and then explains in detail spread strategies which are a collection of option strategies, used by traders to mitigate loss and achieve limited profits with lower margins. It describes various advantages and disadvantages of spread strategies and concludes by stating its potential for tremendous rewards if used with the right approach. Article thirteen Option Trading Strategy: An Overview of Butterfly Spread by Smitha Ramachandran describes in detail about Butterfly spread. This is a neutral strategy chosen by risk averse investors as the risk associated with this strategy is limited to the premium paid. The article details the long and short butterfly spread and stock of Maruti Udyog Ltd is analysed. One of the option strategies that can be done with any number of options is the ratio spread strategy or its opposite, the negative ratio spread strategy, better known as the backspread strategy. These strategies are suited for risk-loving investors, as they can result in tremendous losses if used without caution. They are better suited for American type of options as they lose value due to time decay. The fourteenth article The Ratio Spread and the BackSpread: Option Strategies for the Risk Lovers by Amandio F C Da Silva details the ratio spread-the call ratio and put ratio spreads as well as the call backspread and put backspread. The fifteenth article The Calendar Spread: A Time Spread Strategy by Amandio F C Da Silva details calendar spread and analysis of this strategy is also done. Calendar spreads can provide a way to add value to one s portfolio through the purchase of a long term option with a reduced cost basis, provided by a near term option that the investor sold. A Calendar Spread takes advantage of time value differentials during neutral markets. The sixteenth article The Box Spread Strategy: Always a Winning move by Amandio F C Da Silva explores the box spread strategy. The article throws light on the Indian context about this strategy. It is not yet well-known in India and has a few limitations that have not made it very popular any where in the world. However it is a risk-free strategy that gives the same profit amount in any market circumstances and is a time neutral investment that can be used for both European as well as American options. Article seventeen Comparison of Spread Strategies to Create Profitable Trading Opportunities by Mayank Joshipura and Ajab Gandhi deals with various spread strategies. Here in this paper an attempt has been done to compare various spread strategies and the payoff generated from those strategies. The conclusion from the study is that the success of a spread strategy depends on selection of right exercise price, liquidity of options market, bid ask spread, transaction cost and future outlook of an individual regarding the price of underlying at the expiry.

A phenomenon of booking profits by an arbitrager in case of price disparity is mostly witnessed in the financial markets. Eighteenth article Trading Arbitrage with Box Spread Strategy by Radha A Purswani gives a brief review of different theories that propose the possibility of arbitrage opportunities. An attempt is made to empirically prove the existence of arbitrage with Box Spread Strategy. The second last article Choosing the "Right" Strategy: The Iron Condor by Andrew Neyens describes in detail the iron condor strategy and how it is different form the basic condor strategy. A comparison of condor and iron condor is made and the author is of the view that Iron condor is preferable over the condor because of its advantages which are also dealt in the article. There are ways of estimating the risks associated with options, such as the risk of the stock price moving up or down, implied volatility moving up or down, or how much money is made or lost as time passes, also known as time decay. The risk in options are estimated using any one of the variables and are denoted by Greeks-delta, gamma, vega, theta and rho. The last article The Greeks: What They Are and How to Use Them by Tom Preston explains what Greeks are and how are they used to estimate risks. A value addition which talks about the Greeks and strategies are also provided.

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