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07 January 2012

Option to beat the bear

(old one... may be useful in learning, trading)

Business cycles play a dominant role in defining the stock market direction. Options offer the flexibility to generate income at any stage of a business cycle, even in a bear market, without owning any stock. There are two ways of making profit in a bear market: selling a call option or buying a put option. When the markets are expected to be moderately bearish or remain range-bound, it is advisable to use a combination of options. This helps in reducing the cost of trade and also enables an investor to earn income through option prices. The strategy that employs a combination of call options is termed 'bear call spread', while the one that uses put options is termed 'bear put spread'.

Bear call spread: This involves purchasing an OTM (out of the money) call and simultaneously selling an ITM (in the money) call. The OTM call will have a higher strike price compared to the ITM call. The call options purchased and sold must have the same underlying stock or index and expiry date. An investor who uses this strategy will get net credit as the ITM call will be costlier than the OTM call due to the presence of intrinsic value and time value (see Trade Terms, September 2009). If the stock/index falls as anticipated, both calls will expire worthless and the investor can retain the net credit. The net credit is the maximum profit that this strategy can generate. If the stock/index rises, it will result in a loss. However, the loss will be restricted to the difference between the strike prices of the call options, minus the net credit.

Bear put spread: This involves buying an ITM put option and simultaneously selling an OTM put option with the same underlying stock/index and expiry date. The ITM put option will have a higher strike price compared to the OTM put option. The transaction will result in a net debit payment, which is also termed 'cost of trade'. The strategy results in maximum profit if the stock/index crashes below the strike price of the OTM put option. On the other hand, if the market rises, the loss will be restricted to the net debit payment.

Both strategies work well when the markets are expected to be bearish in the near term and they also restrict losses if expectations prove to be incorrect. However, the profit potential of these strategies is limited.

Let us consider an example. Suppose the XYZ Index is trading at 4,400 and the markets are expected to be moderately bearish in the near term. The call options on the index with strike prices of Rs 4,340 and Rs 4,650 are available for Rs 65 and Rs 28, respectively. The put options with strike prices of Rs 4,350 and Rs 4,600 are available at Rs 25 and Rs 70, respectively. The market lot is 50 contracts. Tarun wants to use the bear call spread, while Rahul wants to use the bear put spread. We are assuming zero brokerages and commissions in this example.

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The cost involved in the bear call spread is Rs 1,850, which is the difference between the amount received from selling the ITM call option (50x65=Rs 3,250) and the amount paid to purchase the OTM call option (50x28=Rs 1,400). The amount, Rs 1,850, constitutes net income for Tarun and also his maximum gain if the markets fall. However, if the markets rise, the loss will be limited to Rs 13,650, which is the difference between the strike prices of two call options (purchased and sold) and the net premium [(4,650-4,340-(65-28))x50]. The break-even point of the bear call is at the XYZ Index level of 4,377, which is the sum of the lower strike price call (Rs 4,340) and the net premium (Rs 37) [see Bear Call Spread Pay-off]

The cost in the bear put spread is Rs 2,250, which is the difference between the cost of the put option purchased (50x70=Rs 3,500) and the amount received from selling the put option (50x25=Rs 1,250). This amount is also the maximum loss in case the market moves against expectations. The profit potential is limited to Rs 10,250, which is the difference between the strike prices of put options and the net premium paid [(4,600-4,350-(70-25))x50]. The break-even point is reached at the index level of 4,555, which is the difference between the strike price of the put purchased (Rs 4,600) and the net premium paid (Rs 45) [see Bear Put Spread Pay-off.]

Src:Businesstoday

Option Strategy

Option Strategies for Indian Stock Exchanges

http://india.avasaram.com/

06 January 2012

Know a Web Links

Know Weblinks related to Options

OPTIONS TRADING STRATEGIES MODULE-workbook-final

[PDF]

SMART WAY TO INVEST IN GOLD

Option Bingo

http://futureoptionsbasics.blogspot.com/2008/12/strategy-for-nifty-option-players-14th.html

http://www.investmentkit.com/articles/category/stock-market-2/

Options Strategy:

Options Strategy (Old Article... may be useful in learning)

The success of an option strategy depends on the accuracy with which one can predict market movement. This task is not made easy by market volatility, which is defined as the variation of an asset return around its long-term average. Its two sub-phases are high and low volatility. In the January 2010 issue (The Long & Short of Straddle), we had explained how long and short straddles are effective in highly volatile and low volatile markets, respectively. In most option strategies, the losses from inexact market expectations are marginal, but in a short straddle these can be high if predictions of low market volatility are incorrect. To help limit such losses in volatile markets is a strategy called 'butterfly'.

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This sophisticated strategy is so called because its pay-off, when represented graphically, resembles a butterfly (at expiration). Like straddles, butterfly has two break-even points and two legs that are useful in the two sub-states of volatility—long call butterfly for less volatile and short call butterfly for highly volatile markets. But unlike straddles, which require a combination of two options, butterfly uses a combination of four options. While it restricts losses, the strategy also curbs the gains. Here's how to set up the two legs of a butterfly:

Long call butterfly: It involves selling two ATM (at the money) call options, and buying one ITM (in the money) and one OTM (out of the money) call option. All options must have the same underlying security and expiry date. An important condition is the equidistance between strike prices. So, if two sold ATM calls have a strike price of X, the ITM call bought should have a strike price of X-a and that of OTM call bought should be X+a. To enter this strategy, the investor needs to pay a net debit. This is the maximum loss he suffers in case of unrealised expectations. The strategy is useful in markets likely to show limited volatility in the near future. The investor gains if the price of the underlying security closes at the strike price of sold calls.

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Short call butterfly: It involves buying two ATM calls, and selling a lower strike ITM call and a higher strike OTM call. The options should have the same underlying security and expiry date, and must maintain equidistance in strike prices. If two ATM call options are bought at Z strike price, the ITM call sold should have a strike price of Z-b, and OTM call sold, Z+b. This strategy is useful in volatile markets. The maximum loss is if the underlying security closes at the strike price of ATM calls, and the maximum profit is if it closes at the strike prices of ITM and OTM calls. So, profit will be earned irrespective of the rise or fall of the market.

Consider an example. On March 1, Nikhil thinks the market may show limited volatility and uses the long call butterfly. The XYZ Index is trading at 4,500. Call options at strike prices of Rs 4,400, Rs 4,500 and Rs 4,600 are available at Rs 105, Rs 65 and Rs 40, respectively. Ten days later, Rohit thinks the market will be highly volatile and uses the short call butterfly. On March 10, the XYZ Index is trading at 4,600. Call options at strike prices of Rs 4,400, Rs 4,600 and Rs 4,800 are available at Rs 210, Rs 70 and Rs 55, respectively. The market lot is 50 contracts and we assume zero brokerage and commissions.

On March 1, Nikhil sells two ATM call options at a strike price of Rs 4,500 (X), and buys one ITM call option at Rs 4,400 (X-a; a=100) and an OTM call option at Rs 4,600 (X+a). The strike prices are equidistant. He gets Rs 6,500 (65 x 2 x 50) by selling two ATM call options and pays Rs 5,250 (105 x 50) and Rs 2,000 (40 x 50) to buy ITM and OTM call options, respectively. Nikhil needs to pay a net debit of Rs 750 (5,250+2,000-6,500) to enter this position. This is the maximum loss in case of unrealised expectations. The maximum profit is earned if the index closes at 4,500, the strike price of the ATM option. The lower break-even point, 4,415 is calculated by adding the net premium (Rs 15) to the strike price of the lower strike ITM call (4,400). The upper break-even point of 4,585 is calculated by subtracting the net premium from the strike price of the higher strike OTM call (4,600). For the strategy to be profitable, the XYZ Index must close within the two break-even points on the date of expiry. Even if the expectation of low volatility is incorrect, the loss will be marginal as opposed to short straddle’s unlimited losses (see Long Call Butterfly).

On March 10, Rohit buys two ATM call options at a strike price of Rs 4,600 (Z), and sells an ITM call option at Rs 4,400 (Z-b; b=200) and an OTM call option at Rs 4,800 (Z+b). The strike prices are equidistant. He pays Rs 7,000 (70 x 50 x 2) to buy two ATM options and gets Rs 10,500 (210 x 50) and Rs 2,750 (55 x 50) by selling ITM and OTM calls, respectively. He earns a net credit of Rs 6,250 (10,500+2,750-7,000), the most gain he can earn. The lower break-even point, 4,525, is calculated by adding the strike price of lower strike ITM call (4,400) and net premium received (Rs 125). The upper break-even point, 4,675, is calculated by subtracting the net premium from the higher strike OTM call (4,800). To ensure profit, the market should move beyond the break-even points. The profit potential is limited compared to an unlimited one from long straddle (see Short Call Butterfly).

src: Businesstoday