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Agenda
Option Basics
Strategies for making limited profit with limited risk
Straddle / Strangle (for volatile times)
Spreads (for directional moves)
Butterflies (for sideways markets)
For each strategy we will discuss
Definition with example
When to enter & points to watch
Steps in / Steps out
Knowing your Risk / Reward / Breakeven
No Charts !!
Only have
Option P&L
Graphs
Option Myths
Options are weapons of Financial Mass Destruction
90% of Options expire worthless (so you should always sell options
and not buy them)
Options are only for Pros who have years of experience and deep
pockets
Options are only for speculators
Options need to be tracked intraday and watched every minute
Option Basics
Options gives the buyer a right (not an obligation) to buy (or sell) the underlying at an agreed strike price before a
predetermined time.
Options gives the seller an obligation (not a right) to deliver (or buy) the underlying at an agreed strike price before
a predetermined time.
The buyer pays a premium to the seller for getting this right
Each Option has to specify Underlying instrument, Quantity, strike price, and expiry date.
Only 4 types of action possible in options
Action
Expected Outcome
All options can be in any one of the three statuses ATM, OTM or ITM depending on the difference between
underlying price, strike price and option type (call or put)
Option Pricing
Black & Schloes valuation method is the most popular type of theoretical
option pricing and depends on
Underlying price
Strike price
Type of option (Call or Put)
Time to expiry
Interest rates
Historical Volatility
Based on the above the price that is found will be different than the market
price. This is due to the expected or implied volatility because others are
known or fixed.
If the market expects volatility to increase (due to results.Infy) the options
price will increase (and decrease after results)
Questions?
Straddle / Strangle
Straddle / Strangle
Straddle / Strangle is a strategy where you want to profit from an expected Volatile
movement in the underlying. Direction of movement is not known.
Example Before Infy results you want to profit from the volatile movement post
results. Infy spot is at 2500. We want to make a profit whether Infy moves up or down.
If you buy 2500 call at & 2500 put at 150 each This is a straddle
If you buy 2600 call at & 2400 put at 80 each This is a strangle.
When to enter You enter before an event that is expected to cause volatile movement
(results, announcements like bonus, takeovers etc.)
The cost of straddle should be less than half of the recent high recent low.
Look at the last few Infy results and the %ge move. The cost of straddle should be less
than this %ge of the current price.
Questions?
Spreads
Spreads
Spreads are directional strategy where buy one strike and sell another strike to profit from a movement in the
underlying
Type of spreads (assume Nifty is at 6040)
Spread type
Direction Action
Net cost
Bullish
Net Debit
Bullish
Net Credit
Net Credit
Net Debit
Bearish
Both legs should be of same type (call or put). You are bullish if you buy lower strike
strike. You are bearish if you buy higher strike and sell lower strike
Choose your strike based on your view and the expiry time left.
Use Spreads instead of straddles / strangles before an event if you have a bias towards the direction the stock
will move after the event.
Spreads cont.
For sake of brevity, I will consider only Bull Call spread & Bull Put Spread
Bull Call Spread Assume Nifty at 6040 and we buy 6100 call at 80
and sell 6200 call at 45 (Our expectation is Nifty will cross 6200)
Net Debit / Max risk = Net Cost (80-45 = 35)
Max Reward = Strike difference less net debit (6200-6100-35 = 65)
Breakeven at expiry = Higher strike less net debit (6200 35 = 6165)
Risk Reward ratio = 65/35 or 1.85
Bear Put Spread Assume Nifty at 6040 and we sell 6000 put at 90
and buy 5900 put at 30 (Our expectation is Nifty will fall to 5900)
Net Credit / Max reward = Cost of Puts (90-30 = 60)
Max Risk = Strike difference less net credit (6000-5900-60 = 40)
Breakeven at expiry = Higher strike less net credit (6000 60 = 5940)
Risk Reward ratio = 60/40 or 1.5
Try to aim for at least RR ratio of 2 without venturing into far OTM
Spreads Tips
First decide on your view. Get confirmation from charts that your view is valid (by
using any analysis you are using, - MA crossover, Pivot break, RSI etc.)
Leg into the strike that will profit with the view coming true first and if price
continues to validate your view, enter the next leg to cap your spread.
Example Nifty is at 5850 in June end. Your view is Nifty will touch 6000 in July.
Get validation on charts (MA crossover, Pivot break, RSI etc.)
Buy at spot 5900 on validation and hold with SL of half of spread. Say 5900/6000
spread cost is 100/60 (RR - 40/60 = 1.5), you buy 5900 call at 100 with SL at 80.
Hold for 2 days max and if markets go up to say 5950, 5900 call moves to 130 and
6000 call moves to 75. Sell 6000 call to make your net debit 25. This way you
have reduced your Net debit from 40 to 25 and R/R is now 25/75 = 3!.
If market does not go your way, your SL is hit at 80 and you lose half of what you
were ready to lose in the spread.
Questions?
Butterfly
Butterfly
Butterfly is a range bound strategy where you look to profit if the market closes within the range defined by the
butterfly.
Assume Nifty is at 5850 and you expect it to close near to 5900 by expiry.
You can construct a butterfly by using puts or calls (not both)
You can buy 5800 call 1 lot, sell 5900 call 2 lots and buy 6000 call 1 lot.
You can buy 5800 put 1 lot, sell 5900 put 2 lots and buy 6000 put 1 lot.
Note that the strike prices are same distance away and share same expiry date
Butterfly = Bull Call spread + Bear Call spread (more on this later)
Dont enter butterfly before any major news or results that might cause a volatile
Butterfly can be entered as late as 10 days before expiry). This helps in
debit.
movement in price.
The maximum movement in butterfly prices comes in the last few days of expiry.
Butterflies are suitable for sideways markets but you can make them adapt to range bound market by factoring your
view. For example if Nifty is at 5850 and you expect expiry near 6100, you can trade a butterfly for net debit of 10 for a
probable profit of 90
Butterfly contd
As per our example, assume Nifty is at 5850 and you expect it to close near to
5900 by expiry.
You buy 5800 call 1 lot 110, sell 5900 call 2 lots at 60 and buy 6000 call 1 lot at
30
Net cost / debit (also your max risk)
20 (110-60-60+30)
Max profit Difference in strike less
net debit (6000-5900-20) = 80
Breakeven up Upper strike less
net debit (6000-20 = 5980)
Breakeven down Lower strike plus
net debit (5800+20 = 5820)
Risk Reward = 20 / 80 = 4
Make sure to exit all in the money options before expiry so as to avoid higher STT charge.
Questions?
Goodies
Resources for Learning option strategies
http://www.optiontradingpedia.com/
http://www.theoptionsguide.com/
Few Good books on learning Option strategies.
Download it from here and here
Excel resource to plan option strategies
Options Bible