Option Trading Strategies with example

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Here are the 4 trades that I will discuss –

  1. CEAT India – Directional trade, inspired by Technical Analysis logic
  2. Nifty – Delta neutral, leveraging the effect of Vega
  3. Infosys – Delta neutral, leveraging the effect of Vega
  4. Infosys – Directional trade, common sense fundamental approach

For each transaction I will evaluate both the good and bad aspects. Keep in mind, all images displayed here were provided by the traders and I simply formatted them for my needs.

So, let’s get started.

– CEAT India

A 27 year-old novice executed the trade, his initial ever foray into options trading.

His logic for the trade was that CEAT Ltd, which had been trading around Rs. 1260 per share, was in good shape and had undoubtedly seen a strong upswing, but he thought the rally would start to taper off due to its seeming lack of energy.

He might have concluded that looking at the last few candles, the trading range in the last three days had been dwindling.

He invested in 1220 (OTM) Puts paying a premium of Rs.45.75/- per lot on 28th September. The expiration date for the contract was 29th October. Here is an overview:

To gain a better understanding, I posed a few queries to the trader.

  1. What drove your decision to trade options instead of futures?
    1. Investing in futures carries a risk, particularly in this situation as swift reversals can occur and changes to the market-to-market value may be harsh if there is a sudden reversal.
  2. Given the time remaining until expiry, why did I select an option with a slightly out-of-the-money strike price rather than one with a much deeper OTM valuation?
    1. Because of their lack of liquidity, stock options are best used with strikes at or near the ATM.
  3. What about stoploss?
    1. The plan for this trade is to close it off if CEAT reaches a new high. This would prove that the current uptrend is still going strong, and thus my decision to take a contrarian short call was incorrect.
  4. What about target?
    1. The stock is currently trending upwards, meaning it’s a great time to secure profits as soon as it seems reasonable. Reversals can be sudden, so there may be no point in keeping short trades open. Considering this, it might be beneficial to reverse the trade and purchase a call option.
  5. What about holding period?
    1. I’m trading on the premise of value appreciation. Thus, I don’t plan to hold this until maturity. There’s plenty of time left before it expires, which means even a minimal stock price fall should result in a considerable rise in premium.

Note – the QnA is reproduced in my own words, the idea here is to produce the gist and not the exact word to word conversation.

So after he bought CEAT PE, this is what happened the very next day –

 

Stock price fell to 1244, and the premium went up to 52/-. He had been accurate in his prediction that should the expiration date remain far away, a slight decrease in the stock rate would result in a substantial rise of the option premium. Content with 7/- gain (per lot), he chose to close his trade.

Looking back I guess this was probably a good move.

I respect the trader’s first-time options dealing. The clarity of their thought process is admirable and, were I in the same situation, I’d have gone about it differently.

  1. From the chart analysis, it was evident that exhaustion had set in for the rally. Thus, I opted for selling call options instead of buying them. Doing so would not necessarily guarantee a sudden fall in stock prices but rather could lead to the stock entering a sideways movement which is more favourable for option sellers.
  2. I would use the normal distribution calculation to choose strikes, always keeping liquidity in mind.
  3. I planned on executing the trade (selling calls) in the 2nd half of the series to take advantage of time decay.

When it comes to directional trading, I don’t generally care for the naked option; the lack of risk and reward visibility makes this approach unappealing. On the other hand, I may make an exception if I see a flag formation in my technical analysis – then I may initiate a naked long call trade.

  1. Stocks ought to have gone up roughly 5-10% in line with the preceding trend.
  2. It seems as though some profit taking is going on by week hands, evidenced by the correction occurring while trade volume remains low.

I find this a good setup to buy call options.

 – RBI News play (Nifty Options)

A person from Delhi executed a Nifty Index options trade based on RBI’s monetary policy announcement. I found this trade to be structured and thoughtfully crafted.

Here is the background for this trade.

The Reserve Bank of India’s (RBI) monetary policy announcement was eagerly awaited by the market, with many poised to guess the decision that would be taken. It was generally expected that RBI would reduce the repo rate by 25 basis points.

RBI’s monetary policy is awaited with anticipation by market players, as it tends to be a major factor in influencing the direction of the market.

This trader has made a few observations about the current market situation. They consider recent events and shifts in the market.

  1. It is common to observe that the market does not follow any particular course in the days leading up to a statement, particularly 2 or 3 before it is made. This pattern is applicable for stocks too – for instance just before their quarterly results are revealed.
  2. Prior to the announcement/event, there is generally an increase in the market’s volatility.
  3. Since the volatility skyrockets, both call and put option premiums experience a significant increase.

I can’t truly confirm the accuracy his initial remarks, but it’s reasonable to accept the 2nd and 3rd.

In light of the RBI’s policy statement, coupled with a favourable time value and heightened volatility (see image below), he chose to write options on September 28th.

 

Nifty was sitting close to 7780, so the 7800 strike was the ATM option. The two options, 7800 CE and PE, were trading at 203 and 176 respectively – attaining a total premium of Rs.379/- from writing them both.

 

After speaking with him, I will explain his plan of action in my own words so you can gain an understanding of it.

  1. Why are you shorting 7800 CE and 7800 PE?
    1. Since there is still some time left before expiry and volatility is elevated, I think that the options are costly and premiums are higher than normal. Eventually, when the volatility fades, I reckon that the cost of the options will drop as well, presenting a situation where I can repurchase both of them at a much lower cost.
  2. Why did you choose to short ATM option?
    1. Given the likelihood that I will be placing market orders at the time of exit, it’s important to minimize any loss due to impact cost. To this end, ATM options were an obvious choice thanks to their lower impact costs.
  3. For how long do you plan to hold the trade?
    1. Volatility typically reduces as we approach the announcement period. Through experience, I recommend taking action and closing the trade a few minutes prior to the official statement. The Reserve Bank of India is slated to make this declaration at 11:00 AM on September 29th; therefore, I anticipate squaring off the trade by 10:50 AM.
  4. What kind of profits do you expect for this trade?
    1. I expect around 10 – 15 points profits per lot for this trade.
  5. What is you stop loss for this trade?
    1. Volatility can make or break a trade, so it’s best to set your stop loss accordingly. This trade also has a built-in stop loss based on time – keeping in mind that you should always exit shortly before the RBI announcement is made.

He initiated the trade based on his ideas. I was more positive about this one compared to the prior CEAT transaction, which I believe had a lot of good luck involved in it. This one seemed to make more sense.

He succeeded in finalizing the trade just before the RBI declared their policy decision the next day, as was expected.

As expected, the volatility slid and both options dropped in price. The 7800 CE was trading at 191 and the 7800 PE at 178 , with a combined premium value of 369. This overnight trade proved to be quite successful as he managed to gain 10 points for every lot.

Just to give you a perspective – this is what happened immediately after the news hit the market.

My opinion of this trade is that I generally agree with the concept of fluctuation heading up in the lead-up to large market occurrences. But these trades should be executed a few days prior and not merely 24 hours ahead.

All too often, traders and investors who partake in option trading around news announcements underestimate the impact of volatility on their trades. Despite the seemingly simple logic behind Long Straddles – i.e. making money in either direction – the market can remain range-bound due to a sudden change in volatility or have a muted reaction altogether. As such, it is critically important to factor in volatility when carrying out these trades, as simply buying both Call and Put options might not have the desired result.

When a news story is released, the markets usually react. If the news is positive, Call options will rise; however, more often than not the Put option premiums decrease at a faster rate than the Call option gains value. Consequently, you may lose more on Put options and gain less on Calls. This is why I think selling options before an event can be beneficial.

 

– Infosys Q2 Results

This other Delhiite traded much better than the previous trader did. The outcome was more favourable.

Infosys was due to announce their Q2 results on 12th October, and thus a trade was set up four days before the event. The goal being that while news would drive volatility up, the option could be bought back when the volatility had lowered. It was a well-crafted plan.

Infosys was trading close to Rs.1142/- per share, so he decided to go ahead with the 1140 strike (ATM).

On 8th October at approximately 10:35 AM, the 1140 CE was priced at 48/- with an implied volatility of 40.26%, while the 1140 PE traded at 47/- and its implied volatility was recorded as 48%. In total, 95 was gained per lot.

I asked the same questions during the initial trade as before, and received very comparable answers. Thus, I shall not be posting a question and answer selection here.

The market anticipated Infosys’s Q2 results would be fairly satisfactory; however, they ended up being even better than expected. Here are the details:

In the July-September quarter, Infosys reported a net profit of $519 million, up 1.6 % from the same period last year. Revenue saw an 8.7 % surge to reach $2.39 billion, while a 6% sequential increase exceeded the forecasted 4-4.5 % growth.

The net profit in rupee terms increased by 9.8%, amounting to Rs.3,398 crore, while the revenue rose at a rate of 17.2% to Rs.15,635 crore compared to last year.

The declaration came in at 9:18 AM, three minutes after trade started, and the trader successfully finished their deal at the same time.

The 1140 CE traded at 55/- with implied volatility dropping to 28%, and the 1140 PE was sold at 20/- with its implied volatility slumping to 40%.

Take note: The Call option rose more slowly than the Put option fell, for a total premium of 75 a lot. His reward was 20 points per lot.

I’m confident this trader has some experience, which is clear from the trade’s construction. If I were to perform this trade, I would likely adopt a very similar approach.

 – Infosys Q2 aftermath (fundamentals based)

This trade was executed by a fellow from Mumbai whom I am personally acquainted with. His fundamental analysis skills are quite remarkable, and now he is exploring the possibilities of options trading – combining his knowledge with this new form of investing. It will be fascinating to observe where this journey takes him.

Here is the background to the trade –

Infosys recently announced an impressive set of figures, however the stock on 12th Oct saw a 5% dip, with a further 1% drop the following day.

After further digging, he concluded that the dip in the stock was far greater than anticipated because of Infosys reducing their revenue guidance. This was a sensible analysis on their part, but he felt that the market had already taken it into account. Nonetheless, the 6% decrease was still higher than what one might have predicted given all this information.

He was positive that the market had severely overreacted to the guidance, and had not considered the good aspects of the results.

He was convinced that, when both good and bad news were provided together, the market would always respond more strongly to the negative. This was demonstrated in Infosys’ case.

He went long on a call option, expecting the market would eventually respond to the second quarter results.

He opted to acquire Infosys’s 1100 CE at 18.9/- which was slightly OTM. His plan was to keep the investment active until the 1100 strike moved into ITM. He was ready to face a risk of Rs.8.9/- on this venture, meaning that if the premium dipped to Rs.10, he would be closing the trade with a loss.

Once the transaction was completed, the stock recovered, allowing him to close the deal on 21st October.

He more than doubled his money on this trade. It was certainly a lucrative move!

Realizing the logic behind the trade was built using comprehension of financial statements, business basics, and options theory is key.

In terms of this trade, I’m fairly confident in making naked trades. The entry was logical, however, the exit and stoploss weren’t. Due to the long expiry period, I would have risked with more OTM options.

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