Market Strategies Using Options

Navin BafnaInvestment Banking

Jan 2008

SEGMENTS

CAPITAL MARKET

CASH FUTURES & OPTIONS

FUTURES OPTIONS

CALL PUTONE – TWO THREE MONTH

OPTIONS

CALL PUT

CALL PUT The buyer of the option has the

right, but not the obligation to buy an agreed quantity of a particular underlying instrument from the seller of the option at a certain time (the expiration date) for a certain price (the strike price).

The seller (or "writer") is obligated to sell the commodity or financial instrument should the buyer so decide.

The buyer pays a fee (called a premium) for this right.

A put option is a financial contract between two parties, the seller (writer) and the buyer of the option.

The put allows its buyer the right but not the obligation to sell a commodity or financial instrument (the underlying instrument) to the writer (seller) of the option at a certain time for a certain price (the strike price).

The writer (seller) has the obligation to purchase the underlying asset at that strike price, if the buyer exercises the option.

TERMS TO REMEMBER

STRIKE PRICE SPOT PRICE PREMIUM TERM MARKET SENTIMENT

USING OPTIONS – MARKET STRATEGIES

Bullish Bearish Neutral Volatile

IMPORTANTStraddle

Buy/Sell both the options at same strike price

Buy – Long Straddle Sell – Short Straddle

Strangle

Buy/Sell both the options at different strike price

Buy – Long Strangle Sell – Short Strangle

BULLISH

Buy Call Sell Put Bull Spread Diagonal Spread

BUY CALL Strategy View

Investor thinks that the market will rise significantly in the short-term. .

Strategy ImplementationCall options are bought with a strike price of a. The more bullish the investor is, the higher the strike price should be.

Upside PotentialProfit potential is unlimited and rises as the market rises.

Breakeven Point at ExpiryStrike price plus premium

Downside RiskLimited to the premium paid - incurred if the market at expiry is at, or below, the strike a

MarginNot required

SELL PUT Strategy View

Investor is certain that the market will not go down, but unsure/unconcerned about whether it will rise.

Strategy ImplementationPut options are sold with a strike price a. If an investor is very bullish, then in-the-money puts would be sold.

Upside PotentialProfit potential is limited to the premium received. The more the option is in-the-money, the greater the premium received.

Breakeven Point at ExpiryStrike price less premium

Downside RiskLoss is almost unlimited. High risk strategy Potential huge losses incurred if the market crashes.

MarginAlways required

BULL SPREAD Strategy View

Investor thinks that the market 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

Strategy ImplementationCall option is bought with a strike price of ‘a’ and another call option sold with a strike of b’, producing a net initial debit,ORPut option is bought with a stike of ‘a’ and another put sold with a strike of b, producing a net initial credit.

Upside PotentialLimited in both cases Calls: difference between strikes minus initial debitPuts: net initial creditMaximum profit if market at expiry is above the higher strike.

Downside RiskLimited in both cases -Calls: net initial debitPuts: difference between strikes minus initial creditMaximum loss if at expiry market is below the lower strike.

MarginPossibility for margin requirements to be off-set

DIAGONAL SPREAD Strategy View

Investor thinks that the market will be weak in the short-term, but then rally later.

Strategy ImplementationA near-dated call option is sold, and a longer-dated, further out-of-the-money call option is bought.

Upside PotentialUnlimited, if the bought option is held after the short option expires (the position then becomes a straight-forward buy call). If the position is closed at expiry of the near option, maximum profit will accrue if the market is at the level of the sold strike.

Downside RiskLimited to the difference in strikes plus/minus the initial debit/credit when establishing the spread

MarginYes, but off-set may apply.

CommentThere is a risk of the sold options being called (i.e. being exercised

BEARISH

Buy Put Sell Call Bear Spread Diagonal Spread Put Hedge

BUY PUT Strategy View

Investor thinks that the market will fall significantly in the short-term. .

Strategy ImplementationPut option is bought with a strike price of a. The more bearish the investor is, the lower the strike price should be.

Upside PotentialProfit potential is unlimited (well, not really unlimited of course as the market can not fall below zero).

Breakeven Point at ExpiryStrike price minus premium paid.

Downside RiskLimited to the premium paid - incurred if at expiry the market is at or above the strike ‘a’

MarginNot required

SELL CALL Strategy View

Investor is certain that the market will not rise and is unsure/unconcerned whether it will fall.

Strategy ImplementationCall option is sold with a strike price of a. If the investor is very certain of his view then at-the-money options should be sold, if less certain, then out-of-the-money ones should be sold.

Upside PotentialLimited to the premium received - received if the market at expiry is at, or below, the option strike.

Downside RiskUnlimited Losses on the position will worsen as the market rises. [If the investor likes the idea of the strategy, but not the downside risk, they might be interested in a bear spread].

MarginAlways required

BEAR SPREAD Strategy View

Investor thinks that the market will not rise, but wants to cap the risk. Conservative strategy for one who thinks that the market is more likely to fall than rise

Strategy ImplementationCall option is sold with a strike price of ‘a’ and another call option bought with a strike of ‘b’, producing a net initial credit,ORPut option is sold with a stike of ‘a’ and another put bought with a strike of ‘b’, producing a net initial debit.

Upside PotentialLimited in both cases -Calls: net initial credit Puts: difference between strikes minus initial debitMaximum profit if market at expiry is below the lower strike.

Downside RiskLimited in both cases -Calls: difference between strikes minus initial creditPuts: net initial debitMaximum loss if at expiry market is above the higher strike.

MarginPossibility for margin requirements to be off-set

DIAGONAL SPREAD Strategy View

Investor thinks that the market will be flat or rise only slightly in the short-term, but will then fall later.

Strategy ImplementationSell a near-dated put option and buy a longer dated out-of-the-money put.

Upside PotentialLarge, if the bought option is held after the short option expires (the position then becomes a straight-forward buy put). If the position is closed at expiry of the near option, maximum profit will accrue if the market is at the level of the sold strike.

Downside RiskLimited to the difference in strikes plus/minus the initial debit/credit when establishing the spread

MarginYes, but limited.

PUT HEDGE - Hold stock, Buy Put

Strategy ViewInvestor holds stock and is worried about a market fall. Put options can be bought to protect the value of the stock position, while not preventing the position to benefit in the event of a market rise.

Strategy ImplementationPut options are bought with a strike price of ‘a’. The number of put options bought will depend on the bearishness of the investor and the size of the stock holding.

Upside PotentialProfit potential is unlimited, being the ordinary return on the stock minus the fixed premium paid for the put option.

Downside RiskPotentially limited, (depending on the hedge ratio initially applied)

The gains on the put options - as the market falls - will off-set the stock losses.

MarginNot required

Neutral & Volatile

Sell Straddle Sell Strangle Long Butterfly Calendar Spread Covered Call

Buy Straddle Buy Strangle Short Butterfly

Long Butterfly Strategy View

Investor thinks that the market will not be volatile, but wants to cap the downside risk. .

Strategy ImplementationCall option with low strike b bought and 2 call options with medium strike a sold and call option with high strike c bought. (The same position can be created with puts, but is less common).

Upside PotentialLimited - to the difference between the lower and middle strikes minus the net debit of establishing the spread

Downside RiskLimited to the initial net debit of establishing the spread

MarginMargin could be possible.

Short Butterfly Strategy View

Investor mildly thinks that the market will be volatile.

Strategy ImplementationCall option is sold with strike b, two call options are bought with strike a and a call option is sold with strike c.[A similar position can be created with puts].

Upside PotentialLimited to initial credit received.

Downside RiskLimited to the difference between the lower and middle strikes minus the initial spread credit.

MarginOff-set may be available.

CALENDAR SPREAD Strategy View

Investor thinks that the market will be weak in the short-term, but rally in the longer-term.

Strategy ImplementationNear dated call option is sold, and a longer-dated call option with the same strike is bought. [If the investor holds the opposite view, then a comparable strategy can be constructed with puts].

Upside PotentialLarge, if the bought option is held after the short option expires (the position then becomes a straight-forward buy call). If the position is closed at expiry of the near option, maximum profit will accrue if the market is at the level of the sold strike.

Breakeven Point at ExpiryStrike price plus premium

Downside RiskLimited to the initial debit incurred for establishing the spread. .

MarginOff-set may be available.

Real Options

ESSAR – Hutch Vodafone IDFC – Hutch India

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you !!!