All You Need to Know About Option Trading and Option Strategies

5 mins read

22 June 2024

All You Need to Know About Option Trading and Option Strategies

If you look at the equity market since last year, you will notice that retail participation has increased significantly over the period. Much of the retail interest has been focused on the variety of initial public offerings inundating the market. Sure, the recent bullishness has dampened somewhat, but many investors, including you, possibly, still remain positive on the Indian equity market and with good reason.

While long-term investors usually buy stocks in cash, do you really know the multiple facets of the market? Derivative is one of the popular yet less known segments of the market. A contract between different parties in the market, a derivative’s value is based on a pre-decided financial security or index, be it stocks, bonds, commodities, market indexes or currencies. In simpler terms, derivatives can be considered a type of advanced investing strategy as these are secondary securities and their values are derived from the actual value of the underlying primary security. For example, if the Nifty50 Index is at 16,352.45 points today, a derivative set to mature one month later may peg the index at 17,000 points, on the date of maturity, and this proposed value would be based on an analysis of various metrics.

Types of derivatives

Investors usually leverage derivatives for two reasons – to mitigate risk via hedging, or assume risk in the expectation of potential returns in the future, also known as speculation. The most common types of derivatives include futures contracts, forward contracts, options, swaps, and warrants. Futures are pre-decided agreements between parties to buy or sell the underlying security at a fixed price, on a pre-determined date. Futures function on a simple logic, the buyer, and the seller, have different opinions on the potential price of the underlying security. While the buyer believes that, at the end of the pre-decided period, the actual price of the security will be higher than its current price, the seller believes differently.

While the forwards contract follows the same principle as futures, the forward contract is a private and customisable agreement between the two participants. It is traded over the counter and settled at the end of the maturity period. On the other hand, futures are standardised and trade on exchanges, with prices being settled every day, till the date of maturity.

Options made easy

Even as options contracts work on the same underlying principal as forwards and futures, with the buyer and seller agreeing to a pre-decided time and price, the key difference here is that the parties have the option of not sticking to the actual sale, at the time of delivery. There is no actual obligation to complete the trade.

Now, let us consider what are calls and puts in options trading. Under the call option, the buyer has the right, but not the obligation, to buy the security at the pre-decided price, before the decided date. This allows them the possibility to make a profit if the value of the security does rise in the future. On the other hand, the put option gives the seller the right, but not the obligation, to sell the security at the pre-decided price, any time before the maturity of the contract. If the actual price of the security falls before the maturity of the contract, the put option helps the seller limit losses by selling at the pre-decided higher price.

How to make profits trading in puts and calls

There are several popular option strategies being followed by traders. These include –

Bull Call Spread: A bullish strategy which involves purchasing one At-The-Money (ATM) call option and selling the Out Of-The-Money call option, the bull spread call requires both options to have the same underlying security and the same maturity date. This strategy protects you when the prices drop but the profit is also curtailed proportionately, meaning that both profit and loss are capped. It is useful if you are not too bullish on the security, helping you make a profit if it does rise, but also ensuring you limit losses if it drops.
Bull Put Spread: If you are positive on the movement of the security, this strategy is for you. It is similar to the bull call spread, except that, here, you purchase put options. The rest of the metrics remain the same. This strategy will help you when you expect the security’s price to rise slightly, move sideways, or fall in a limited manner.
Call Ratio Back Spread: This is one of the simplest strategies you can use when you are strongly bullish on the security. Under this strategy, you can purchase two OTM call options and sell one ITM call option and it will help you make unprecedented profit if the prices do rise in the future. Further, even if the prices fall before the pre-decided date, you will still end up making some profit as you have the option to forego the loss-making trade.

Now that you know all about option trading and option strategies, you can start your journey by taking small risks and building your appetite in line with your experience.

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Option Trading Strategies with example

Trading for professionals: Options trading

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MarketopediaTrading for professionals: Options tradingOption Trading Strategies with example

Options Trading: Comprehensive Guide

Options trading is a versatile and complex form of trading that involves contracts giving the buyer the right, but not the obligation, to buy or sell an asset at a predetermined price before the contract expires. Here, we’ll delve into various aspects of options trading, providing detailed insights into strategies, types, analysis, and tips. This guide aims to cater to both beginners and experienced traders, ensuring a thorough understanding of the options trading landscape.

What is Options Trading?

Options trading involves buying and selling options contracts on an underlying asset, such as stocks, ETFs, or commodities. An option gives the holder the right, but not the obligation, to buy (call option) or sell (put option) the underlying asset at a specified price (strike price) before the expiration date.

Types of Options Trading

Call Options

A call option gives the buyer the right to buy the underlying asset at a specific price, known as the strike price. Traders buy call options when they believe the price of the asset will go up. For example, if an investor buys a call option on a stock, they hope the stock price will increase, so they can buy it at the strike price, which is lower than the market price. Call options are important in many trading strategies. One strategy, the bull call spread, involves buying a call option at a lower strike price and selling another call option at a higher strike price. This approach can limit the potential profit but also reduces the initial cost and risk.

Put Options

A put option gives the buyer the right to sell the underlying asset at a specific price, known as the strike price. Traders buy put options when they think the price of the asset will go down. For example, if an investor buys a put option on a stock, they expect the stock price to decrease, allowing them to sell it at the strike price, which is higher than the market price. Put options are key in strategies like the bear put spread, where a trader buys a put option at a higher strike price and sells another put option at a lower strike price. This strategy helps reduce risk and limit potential losses.

Other types include American and European options, which differ in terms of exercise dates.

1. Call Options

Definition: A call option gives the holder the right, but not the obligation, to buy an underlying asset (like a stock) at a specified price (strike price) within a certain time period. This means the investor can purchase the stock at the strike price before the option expires, regardless of the current market price.
Example: Suppose you believe Reliance Industries’ stock, currently trading at ₹2,500, will increase in the next month. You buy a call option with a strike price of ₹2,600. If the stock rises to ₹2,800, you can buy it at ₹2,600 and sell at ₹2,800, making a profit.

2. Put Options

Definition: A put option gives the holder the right, but not the obligation, to sell an underlying asset at a specified price within a certain time period. This provides the investor protection against a decline in the asset’s price, ensuring they can sell at the strike price even if the market price falls.
Example: You own shares of Tata Motors, currently trading at ₹450, and fear it might drop. You buy a put option with a strike price of ₹440. If the stock falls to ₹400, you can still sell at ₹440, minimizing your loss.

3. Covered Calls

Definition: This strategy involves owning the underlying asset and selling call options on that asset. It’s a way to generate extra income from the asset you already own by selling the right to buy it at a higher price.
Example: You own Infosys shares worth ₹1,500 each. You sell a call option with a strike price of ₹1,600. If the stock stays below ₹1,600, you keep the premium from the option sale. If it rises above ₹1,600, you sell the shares at this higher price, but miss out on any additional gains.

4. Protective Puts

Definition: This strategy involves buying a put option for an asset you already own. It acts as a form of insurance against a decline in the asset’s price.
Example: You own HDFC Bank shares worth ₹1,400 each. To protect against a potential drop, you buy a put option with a strike price of ₹1,350. If the stock falls to ₹1,300, the put option allows you to sell at ₹1,350, reducing your loss.

5. Straddles

Definition: A straddle involves buying both a call and a put option with the same strike price and expiration date. It is used when an investor expects significant volatility but is unsure of the direction of the price movement.
Example: You expect big news for ICICI Bank that could swing the stock price significantly. You buy both a call and a put option with a strike price of ₹700. If the stock moves significantly in either direction, you profit from the movement.

6. Strangles

Definition: A strangle involves buying a call and a put option with different strike prices but the same expiration date. It’s used when you expect volatility but are unsure of the direction and want a cheaper strategy than a straddle.
Example: You expect volatility in Bharti Airtel’s stock, which is trading at ₹500. You buy a call option with a strike price of ₹520 and a put option with a strike price of ₹480. If the stock moves significantly above ₹520 or below ₹480, you profit.

7. Spreads

Definition: Spreads involve buying one option and selling another option of the same type (calls or puts) with different strike prices or expiration dates. It’s used to limit risk and potential loss.
Example: A bull call spread on Wipro involves buying a call option with a strike price of ₹400 and selling another call with a strike price of ₹420. If Wipro’s stock rises to ₹415, your profit is limited, but so is your risk.

Popular Options Trading Strategies

Understanding and implementing various options trading strategies can significantly enhance your trading outcomes. Strategies are categorized based on market outlook: bullish, bearish, and neutral.

Bullish Strategies

Bull Call Spread

A Bull Call Spread is an options trading strategy designed to capitalize on a moderate increase in the price of the underlying asset. This strategy involves buying a call option at a lower strike price while simultaneously selling another call option at a higher strike price. Both options have the same expiration date. Here’s how it works in detail:

Buying the Lower Strike Call Option: This is the first step in creating a bull call spread. By purchasing a call option at a lower strike price, you acquire the right to buy the underlying asset at that price. This position benefits if the underlying asset’s price rises above the strike price before expiration.
Selling the Higher Strike Call Option: To offset the cost of buying the lower strike call option, you sell a call option at a higher strike price. This action generates a premium, which helps reduce the net cost of the overall strategy. However, selling the higher strike call also caps your maximum profit potential.

Profit and Loss Potential:

Maximum Profit: The maximum profit is achieved if the underlying asset’s price is above the higher strike price at expiration. The profit is the difference between the two strike prices, minus the net premium paid.
Maximum Loss: The maximum loss is limited to the net premium paid for the spread, which occurs if the underlying asset’s price is below the lower strike price at expiration.

Example:

Suppose a stock is trading at Rs. 50, and you anticipate a moderate rise. You buy a call option with a strike price of Rs. 45 (paying a premium of Rs. 5) and sell a call option with a strike price of Rs. 55 (receiving a premium of Rs. 2). The net cost of the strategy is Rs. 3 (Rs. 5 paid – Rs. 2 received). If the stock rises to Rs. 60 at expiration, the spread’s value is Rs. 10, resulting in a net profit of Rs. 7 (Rs. 10 spread – Rs. 3 net cost).

Bull Put Spread

A Bull Put Spread is an options trading strategy aimed at profiting from a moderate increase or stable price in the underlying asset while providing limited risk. This strategy involves selling a put option at a higher strike price while buying another put option at a lower strike price. Both options have the same expiration date. Here’s a detailed look at how it works:

Selling the Higher Strike Put Option: By selling a put option at a higher strike price, you receive a premium. This position obligates you to buy the underlying asset at the strike price if the option is exercised. Selling the higher strike put is beneficial if the underlying asset’s price remains above this strike price.
Buying the Lower Strike Put Option: To limit potential losses from the higher strike put option, you buy a put option at a lower strike price. This position gives you the right to sell the underlying asset at the lower strike price, thus providing a safety net against significant price drops.

Profit and Loss Potential:

Maximum Profit: The maximum profit is achieved if the underlying asset’s price is above the higher strike price at expiration. The profit is the net premium received from the spread.
Maximum Loss: The maximum loss occurs if the underlying asset’s price is below the lower strike price at expiration. The loss is the difference between the two strike prices, minus the net premium received.

Example:
Suppose a stock is trading at Rs. 50, and you expect it to stay stable or rise moderately. You sell a put option with a strike price of Rs. 55 (receiving a premium of Rs. 5) and buy a put option with a strike price of Rs. 45 (paying a premium of Rs. 2). The net premium received is Rs. 3 (Rs. 5 received – Rs. 2 paid). If the stock remains above Rs. 55 at expiration, both options expire worthless, and you keep the net premium of Rs. 3 as profit.

In conclusion, both the Bull Call Spread and Bull Put Spread are strategies that can help traders take advantage of anticipated moderate price increases in the underlying asset while limiting potential losses. They are popular choices among traders for managing risk and capitalizing on market movements.

Bearish Strategies

Bear Put Spread

A Bear Put Spread is an options trading strategy used when a trader anticipates a moderate decline in the price of the underlying asset. This strategy involves buying a put option at a higher strike price while simultaneously selling another put option at a lower strike price.

Both options have the same expiration date. Here’s a detailed look at how this strategy works:

Buying the Higher Strike Put Option: This is the first step in creating a bear put spread. By purchasing a put option at a higher strike price, you gain the right to sell the underlying asset at that price. This position benefits if the price of the underlying asset falls below the strike price before expiration.
Selling the Lower Strike Put Option: To offset some of the costs associated with buying the higher strike put option, you sell a put option at a lower strike price. This action generates a premium, which reduces the net cost of the overall strategy. However, selling the lower strike put also limits your maximum profit potential.

Profit and Loss Potential:

Maximum Profit: The maximum profit is achieved if the underlying asset’s price is below the lower strike price at expiration. The profit is the difference between the two strike prices, minus the net premium paid.
Maximum Loss: The maximum loss is limited to the net premium paid for the spread, which occurs if the underlying asset’s price is above the higher strike price at expiration.

Example:
Suppose a stock is trading at Rs. 50, and you expect its price to fall. You buy a put option with a strike price of Rs. 55 (paying a premium of Rs. 6) and sell a put option with a strike price of Rs. 45 (receiving a premium of Rs. 3). The net cost of the strategy is Rs. 3 (Rs. 6 paid – Rs. 3 received). If the stock falls to Rs. 40 at expiration, the spread’s value is Rs. 10, resulting in a net profit of Rs. 7 (Rs. 10 spread – Rs. 3 net cost).

Bear Call Spread

A Bear Call Spread is an options trading strategy used when a trader anticipates a moderate decline or neutral movement in the price of the underlying asset. This strategy involves selling a call option at a lower strike price while simultaneously buying another call option at a higher strike price. Both options have the same expiration date. Here’s a detailed look at how this strategy works:

Selling the Lower Strike Call Option: By selling a call option at a lower strike price, you receive a premium. This position obligates you to sell the underlying asset at the strike price if the option is exercised. Selling the lower strike call benefits if the underlying asset’s price remains below this strike price.
Buying the Higher Strike Call Option: To limit potential losses from the lower strike call option, you buy a call option at a higher strike price. This position gives you the right to buy the underlying asset at the higher strike price, thus providing a safety net against significant price increases.

Profit and Loss Potential:

Maximum Profit: The maximum profit is achieved if the underlying asset’s price is below the lower strike price at expiration. The profit is the net premium received from the spread.
Maximum Loss: The maximum loss occurs if the underlying asset’s price is above the higher strike price at expiration. The loss is the difference between the two strike prices, minus the net premium received.

Example:
Suppose a stock is trading at Rs. 50, and you expect its price to decline or remain stable. You sell a call option with a strike price of Rs. 45 (receiving a premium of Rs. 7) and buy a call option with a strike price of Rs. 55 (paying a premium of Rs. 2). The net premium received is Rs. 5 (Rs. 7 received – Rs. 2 paid). If the stock remains below Rs. 45 at expiration, both options expire worthless, and you keep the net premium of Rs. 5 as profit.

In conclusion, both the Bear Put Spread and Bear Call Spread are strategies that allow traders to benefit from anticipated moderate declines in the price of the underlying asset while limiting potential losses. These strategies are popular among traders for managing risk and capitalizing on bearish market conditions.

Neutral Strategies

Iron Condor

An Iron Condor is an advanced options trading strategy designed to profit from low volatility in the underlying asset. This strategy involves selling an out-of-the-money call and put, while simultaneously buying further out-of-the-money call and put options to limit potential losses. The Iron Condor benefits when the underlying asset remains within a specific price range until expiration.

Selling an Out-of-the-Money Call: This option is sold at a higher strike price than the current market price.
Selling an Out-of-the-Money Put: This option is sold at a lower strike price than the current market price.
Buying a Further Out-of-the-Money Call: This call is bought at an even higher strike price than the sold call, providing protection against a significant price increase.
Buying a Further Out-of-the-Money Put: This put is bought at an even lower strike price than the sold put, providing protection against a significant price decrease.

Example:
Suppose Nifty is trading at Rs. 18,000.

Sell a call option with a strike price of Rs. 18,200, receiving a premium of Rs. 150.
Sell a put option with a strike price of Rs. 17,800, receiving a premium of Rs. 160.
Buy a call option with a strike price of Rs. 18,400, paying a premium of Rs. 90.
Buy a put option with a strike price of Rs. 17,600, paying a premium of Rs. 80.

Net Premium Received: (150 + 160) – (90 + 80) = Rs. 140

Maximum Profit: The total premium received, Rs. 140, if Nifty stays between Rs. 17,800 and Rs. 18,200.

Maximum Loss: The difference between the strike prices of the sold and bought options, minus the net premium received. Here, the difference is Rs. 200 (18,200 – 18,000 or 18,000 – 17,800), and the net premium received is Rs. 140. So, the maximum loss is 200 – 140 = Rs. 60 per share.

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Trading for professionals: Options trading

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option trading strategies top 18 strategies every investor should know

Learn about Option Strategies

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MarketopediaLearn about Option Strategiesoption trading strategies top 18 strategies every investor should know

One thing I’ve seen in all the conversations I’ve had with options traders, both seasoned and new, is that most view trading options as a hit-or-miss proposition.

When one begins an options trade, there is usually a sense of amusement, yet, many people are unaware of how detrimental this can be.

There are close to 475 option strategies, but in this chapter, we will discuss only some strategies you should know to understand the markets or stocks and map them with the right option strategy.

Here are the strategies that we will discuss:

Bullish strategies:

Bull Call Spread
Bull Put Spread
Call Ratio Back Spread
Bear Call
Ladder Call
Butterfly Synthetic Call
Straps

Bearish Spreads

Bear Call Spread
Bear Put Spread
Bull Put Ladder
Put Ratio Back spread
Strip
Synthetic Put

Neutral Strategies

Long & Short Straddles
Long & Short Strangles
Long & Short Iron Condor
Long & Short Butterfly
Box

Along with the above points, we will also discuss Max Pain for option writing, i.e. some key observations and practical aspects, and Volatility Arbitrage employing Dynamic Delta hedging.

One options strategy will be covered in each chapter so there is clarity and understanding over the strategy. This indicates that this module will consist of around 20 chapters. However, each chapter will be brief. I’ll go over each strategy’s history, execution, payoff, breakeven point, and potentially the best strikes to make.

Please bear in mind that while I will describe all of these methods using the Nifty Index as a benchmark, you can apply the same principles to any stock option.

The most crucial thing I want you to know is that this module cannot be considered as a Holy Grail. Nothing in the markets, including none of the tactics we discuss in this module, is a guaranteed way to make money. This lesson aims to examine a few straightforward but crucial tactics that, when used properly, can generate income.

Consider it this way: if you drive your car safely and well, you can utilise it to commute and ensure your family’s comfort. However, if you drive rashly, it could be dangerous for both you and anyone around you.

Similarly, these tactics generate income when used properly, if not, they might damage your P&L (Profit & Loss). I am responsible for ensuring you comprehend these techniques (help you learn how to drive a car). I will also explain the ideal circumstances in which you should apply these techniques.

But you have the power to make it work for you; this depends on your discipline and how much you understand the market. Having said that, I feel that as you spend more ‘quality’ time in the markets, your application of methods will improve.

Let’s now get started!

Technical Analysis, what is it?

Consider this analogy. Imagine you are vacationing in a foreign country where everything, including the language, culture, weather, and food, is new to you. On day 1, you do the regular touristy activities, and by evening you are starving and craving food. You want to end your day by having a great dinner. You ask around for a good restaurant, and you are told about a vibrant food street close by. You decide to give it a try. To your surprise, the food street has 100s of vendors selling different varieties of food. Everything looks different and interesting. You are clueless as to what to eat for dinner. To add to your dilemma, you cannot ask around as you do not know the local language. So given all this, how will you decide on what to eat?

Setting expectations

Market participants often approach technical analysis as a quick and easy way to profit. On the contrary, technical analysis is anything but quick and easy. If done right, consistently generating profits is possible, but to get to that stage, one must put in the required effort to learn the technique. A trading catastrophe is bound to happen if you approach TA as a quick and easy way to make money in markets. When a trading debacle happens, more often than not, the blame is on technical analysis and not on the trader’s inability to efficiently apply Technical Analysis. Hence before you start delving deeper into technical analysis, it is important to set expectations on what can and cannot be achieved with technical analysis.

1. Trades – TA is best used to identify short-term trades. Do not use TA to identify long-term investment opportunities. Long-term investment opportunities are best identified using fundamental analysis. Also, If you are a fundamental analyst, use TA to calibrate the entry and exit points.

2. Return per trade – TA – based trades are usually short-term in nature. Do not expect huge returns within a short duration of time. The right way to use TA is to identify frequent short-term trading opportunities that can give you small but consistent profits.

3. Holding Period – Trades based on technical analysis can last between a few minutes to a few weeks, usually not beyond that. We will explore this aspect when we discuss the topic of timeframes.

4. Holding Period – Trades based on technical analysis can last between a few minutes to a few weeks, usually not beyond that. We will explore this aspect when we discuss the topic of timeframes.

5. Risk – Often, traders initiate a trade for a certain reason; however, in case of an adverse movement in the stock, the trade starts to lose money. Usually, in such situations, traders hold on to their loss-making trade with the hope they can recover the loss. Remember, TA-based trades are short-term; if the trade goes bad, do remember to cut the losses and move on to identify the next opportunity.

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Learn about Option Strategies

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