Strategy - BUY A CALL
- Strategy Outlook
Investor takes a view that the underlying will rise significantly in the short-term.
- Implementation of this Strategy
Call options are bought with a strike price determined by the extent of bullishness
of the investor. The more bullish the investor is, the higher the strike price would
be.
- Upside Potential
Profit potential is unlimited and rises as the underlying rises.
- Breakeven Point at Expiry
Strike price plus premium paid.
- Downside Risk
Limited to the premium paid. This maximum loss is incurred if the underlying on
expiry is at or below the strike price of the call option bought.
- Margin
Not required.
- Remarks
If the underlying rises lesser than expected the value of the position will decrease
as the time value of the option decreases as the expiry comes closer.
When to buy a call?
- Bullish Speculation with limited risk
The primary motivation of this investor is to realize financial reward from an increase
in price of the underlying security while restricting his losses in case of any
adverse movement in the price.
Experience and precision are keys to selecting the right option (expiration and/or
strike price) for the most profitable result.
In general, the more out-of-the-money the call is the more bullish the strategy,
as higher increases in the underlying stock price are required for the option to
reach the break-even point.
- As Stock Substitute
An investor who buys a call instead of purchasing the underlying stock considers
the lower cost of purchasing a call option versus an equivalent amount of stock
as a form of insurance. The uncommitted capital is "insured" against a decline in
the price of the call option's underlying stock, and can be invested elsewhere.
This investor is generally more interested in the number of shares of stock underlying
the call contracts purchased, than in the specific amount of the initial investment
- one call option contract for each 100 shares he wants to own. While holding the
call option, the investor retains the right to purchase an equivalent number of
underlying shares at any time at the predetermined strike price until the contract
expires.
An investor might purchase the call instead of the underlying security so that he
is able to buy the underlying security at a reasonable price without taking the
chance of missing out on an upward move in the underlying security.
He might also want to do this if he had a large amount of cash coming in the near
future, and had a smaller amount of cash available now. Feeling that a market movement
upwards is about to occur and he doesn't want to miss out he would leverage his
money now and buy the call.
- Diversification
Another investor may purchase calls if his portfolio consists of low volatile stocks,
but he wants to take out a small percentage of his assets for trading in highly
volatile stocks.
He would then be participating in some higher risk securities while limiting his
risk to a fixed amount.
- Leverage
A third type of investor may purchase call options as pure speculation. He may expect
Satyam prices to increase and buy Satyam call option.
If the expectation materializes, he will make much more profit than the investor
who purchased Satyam shares with the same expectation and same capital.
This facility to make a big profit from/on a small investment is the most attractive
feature for a trader.
Strategy - SELL A PUT
- Strategy Outlook Investor is certain that the market will not go down,
but unsure about whether it will rise significantly in the short term.
- Implementation of this Strategy
Put options are sold with a strike price suited to the extent of bullish sentiments
of the investor. If an investor is very bullish, then in-the-money puts would be
sold.
Generally out-of-money puts are sold in stocks where the investor is bullish on
the stock.
- Upside Potential
Profit potential is limited to the premium received. The more the option is in-the-money,
the greater is the premium received.
- Breakeven Point at Expiry
Strike price less premium.
- Downside Risk
Unlimited. Losses on the position will increase as the market rises. If the investor
is not very certain of his view bearish spread might be a better alternative.
- Margin
Required.
- Remarks
If the price of the underlying security rises steadily or even remains stable as
time passes this position is benefited, as the premium will fall with the time value
getting eroded as expiry comes closer.
- When to Write a Put?
For bullish investors who are interested in buying a stock at a price below the
current market price, selling naked put can be an excellent strategy.
In this case, however, the risk is substantial because the writer of the option
is obligated to purchase the stock at the strike price regardless of where the stock
is trading.
Using the same Satyam example stated above, if the investor expects the price of
the share to rise he can earn the premium by selling the put option. This amount
will reduce his cost of buying the stock.
Warning:
The put option writer can make huge losses if the price of the underlying decreases
steeply.
Hence, the writer should watch his position carefully and exit quickly to cut losses.
Strategy - BULLISH SPREAD
- Strategy Outlook
Investor takes the view that the underlying security will not fall, but wants to
cap the risk. Conservative strategy for one who thinks that the market is more likely
to rise than fall.
- Implementation of this Strategy
Call option is bought with a lower strike price and another call option sold with
a higher strike, producing a net initial debit,OR Put option is bought with a lower
strike and another put sold with a higher strike, producing a net initial credit.
- Upside Potential
Limited in both cases - Calls: difference between strikes minus initial debit
Puts: net initial credit Maximum profit is when the underlying security at
expiry is at or above the higher strike.
- Downside Risk
Limited in both cases - Calls:net initial debit
Puts: difference between strikes minus initial credit
- Margin
Margin requirements may be off-set.
- Remarks
Time value erosion not too significant due to the balanced position..
When to use a Bullish Spread ?
- Moderately Bullish
An investor often employs the bullish call spread in moderately bullish market environments
and wants to capitalize on a modest advance in price of the underlying stock.
Say the investor expects the security XYZ currently quoting at 170 to advance to
around 177 - 180 level at the most, it would be far more attractive to enter into
a bull spread than buy an outright call.
Effectively he shall be buying the 170-strike price call of XYZ at Rs. 7 but his
cost in this position shall be reduced to the extent of the premium received in
the sale of the 180-strike price XYZ call at Rs 4. His break even in this case is
173 and his maximum profit is achieved at 180.
- Risk Reduction
An investor will also turn to this spread when there is discomfort with either the
cost of purchasing and holding the long call alone, or with the conviction of his
bullish market opinion.
- The Benefit
The bull call spread can be considered a doubly hedged strategy. The price paid
for the call with the lower strike price is partially offset by the premium received
from writing the call with a higher strike price.
Thus, the investor's investment in the long call, and the risk of losing the entire
premium paid for it, is reduced or hedged.
On the other hand, the long call with the lower strike price caps or hedges the
financial risk of the written call with the higher strike price.
If the investor is assigned an exercise notice on the written call and must sell
an equivalent number of underlying shares at the strike price, those shares can
be purchased at a predetermined price by exercising the purchased call with the
lower strike price.
As a trade-off for the hedge it offers, this written call limits the potential maximum
profit for the strategy
- Warning:
The investor needs to keep an eye on this spread. If the underlying security moves
up in price too steeply, too quickly, the time value premium of the short call could
rise substantially. If this happens, that call may need to be bought back early.
Also, if the price of the underlying security rises too high, the short call may
go in the money. The trader should be aware of this and buy the call back before
it is exercised.
Again if this strategy is implemented with American style options, there is a risk
or premature assignment on the short option position and it may even result in a
net loss or unanticipated cash outflow.
Strategy - DIAGONAL SPREAD
- Strategy Outlook
Investor takes a view that the underlying security will be weak in the short-term
but will rally later.
- Implementation of this Strategy
A call option with near month expiry is sold, and a higher strike call option with
farther month expiry is bought.
- Upside Potential
Unlimited, if the long option position is held after the short option expires (the
position then becomes a simple buy call).
If the position is closed at expiry of the near option, maximum profit will accrue
if the underlying is at the level of the sold strike.
- Downside Risk
Limited to the difference in strikes plus/minus the initial debit/credit when establishing
the spread.
- Margin
Yes, but off-setting may apply.
- Remarks
There is a risk of the sold options being called (i.e. being exercised).
When to enter into a Diagonal Spread ?
The diagonal spread is entered into when there is a firm long term bullish view
of the underlying security but the investor would prefer to cash in on any immediate
subdued movement of the underlying security.
This could be in anticipation of any favourable corporate news/earnings report that
could be profitably employed.
The fast time decay in case of near month option could also be a temptation to enter
into this strategy while simultaneously buying of an longer expiry out-of-money
call option.
Warning: The strategy has substantial risk in the near term. Though spread
margins are lower initially, the expiry of the near term option leads to a naked
exposure to the long term option which then becomes near.