A Beginners Guide to Basics Option Trading Strategies For Beginners: Imagine having the power to own something at a price you want and not worry about the future uncertainties. Options trading gives you this power. Before dwelling deeper into the Ocean of Option trading strategies, let us have a quick snapshot of the concept of Options and its types.
Basics of Options Trading
“Options can be defined as a derivative instrument whose value is derived from the value of some other underlying Asset or Security. Options give the Buyer the right to buy or sell the underlying asset, and the seller is obligated to bind/honor the contract.” And as mentioned above, there are two types of options – Call Options (right to buy) and Put Options (right to sell)
- A call option gives the right to option buyer to buy the underlying security at a pre-decided price. The buyer of the option is expecting the price to increase in the future.
- A put option gives the right to option buyer to sell the underlying security at a pre-decided price. The buyer of the option is expecting the price to decrease in future
Before understanding the options strategies, let us understand the concept of Moneyness of an option.
Moneyness of an Option
The Moneyness of an option simply means the amount of money the option contract would make if they were to be exercised today. Moneyness of options are of three types-
- In the Money – An In the Money Option contract is one, which would make money if they were to be exercised today.
- At the Money – An At the Money Option contract is one, whose strike price is the closest to the current/spot price.
- Out of Money – An Out of Money Option contract is one, which would be worth nothing if they were to be exercised today.
Say, the spot price of Nifty is 10540, then the strike price of Call option 10400 would be called as In the money, the strike price of 10550 would be At the money and the strike price of 10650 would be an Out of Money Option.
Option Trading Strategies
Having understood the basics of options and various types of Options, let us try and understand some of the most basic and commonly used option trading strategies.
Basic Premise used while explaining these option strategies
- We will be discussing strategies which work in both bullish and bearish markets
- The strategies discussed here will have a minimum of two option position running simultaneously
- The underlying asset which will be consistently used while discussing this strategy will be the Nifty Index
- The strategies mentioned here does not guarantee to make money, nothing in the market guarantees to make money.
Option Trading Strategies – Bull Call Strategy:
Hypothesis while using this strategy:
- Bull Call Spread is a two-legged strategy i.e., it has two option positions running simultaneously.
- This strategy is used when one has a bullish view on the market.
- The simple assumption while executing this strategy is that there will be an upside catalyst in the Underlying Asset and one is expecting strength in it, in near future. So, the overall sentiment is bullish in the market
Scenarios under which this strategy is used:
- The Fundamental perspective – Say, if we are positive about the government announcing certain stimulus to boost the economy in these uncertain times of COVID-19 pandemic, but the previous announcements have not bought too much joy out of the market. So, any announcement made will be positive, but the uncertainty lingers in the market regarding the quantum of the impact of these announcements on the market
- The Technical Perspective – Say, the market has been bearish and the weakness is expected to continue. But the market is coming near the technical supports of moving averages and is also nearing the all-time lows. So a relief rally is expected but again the extent of the up move is uncertain. So employing this strategy would make sense.
- Quantitative Perspective – Say, if the stock price was trading at a certain range but due to some reason the market showed weakness and broke the range lows. But it is not making any fundamental and technical sense to break the range lows. So to play the pullback within the range again, this strategy can be employed and used.
Implementing Bull Call Spread:
So to implement this strategy, one has to buy One At the Money call option and sell/write one Out of money call option:
i.e., Buy One ATM call option and Sell One OTM call option.
The following are the assumptions under this strategy:
- All the strikes belong to the same underlying
- Both the options have the same expiry
- And both the legs have the same number of contracts
Let us understand it with the help of an Example:
Say, the Spot price of Nifty is 9310
- An At The Money call option bought = 9300 CE, Premium paid =75 units
- An Out of Money call option sold = 9400 CE. Premium received = 20 units
- So the net transfer of option units = 20-75 = -55 units.
- So, in general, at the initiation of this trade, the P/L always shows negative as one has to buy ITM option and sell OTM option
Now, let us understand the impact on the P/L at various levels of expiry:
Say, if the Nifty expires at 9200, then –
So, the Net Payoff using this strategy is -55 units (-75+20)
Say, if the Nifty expires at 9300, then –
So, the Net Payoff using this strategy is -55 units (-75+20)
Say, if the Nifty expires at 9400, then –
So, the Net Payoff using this strategy is 45units (25+20)
Say, if the Market expires at 9500, then –
Graphical Representation of payoff:
Breakeven Point for this Strategy:
The Breakeven Point (BEP) for this strategy is the point when the spot price equals the summation of At the money strike price and the maximum loss (Net debit) in this strategy
i.e., BEP = Strike price of ATM + Maximum loss = 9300 + 55 = 9355. So, when the spot price reaches 9355, this strategy reaches its breakeven point.
Option Trading Strategies – Bear Put Strategy:
Hypothesis while using this strategy:
- Bear Put Spread is a two-legged strategy i.e., it has two Put positions running simultaneously
- This strategy is used when one has a moderately bearish view of the market
- The simple assumption while executing this strategy is, there is negativity expected in the market, and selling in the market is due
Implementation of Bear Put Strategy:
To implement this strategy:
- We have to buy One In the Money Put Option
- Sell One Out of Money Put Option
Both the Options should have the same expiry date and same underlying Asset
The choice of option strikes depends on the aggressiveness of the trader.
Let us understand it with the help of an example:
- Say the Nifty spot is trading at 10050 today.
- So, any In the Money (ITM) Put Option will be 10200 PE.
- And, an out of Money (OTM) Put Option will be 10000 PE.
- The premium for 10200 PE is 180 units
- The premium for 10000 PE is 60 units
- So, this is a ‘Net Debit’ strategy
- So, the P/L at the beginning of this strategy is -120 units(60-180)
Say, if the Nifty expires at 10400, then –
So, the total P/L (net payoff) in this case is -120 units (-180+60)
Say, if the Nifty expires at 10300, then –
So, the total P/L (net payoff) in this case is -120 units (-180+60)
Say, if the Nifty expires at 10080, then –
So, the total P/L (net payoff) in this case is 0 units (-60+60). This is also the BEP for this strategy
Say, if the Nifty expires at 10000, then –
So, the total P/L (net payoff) in this case is 80units (20+60)
Say, if the Nifty expires at 9800, then –
So, the total P/L (net payoff) in this case is 80units (220-140)
Graphical Representation of Payoff-
To Conclude the Option Trading Strategies…..
- Options trading strategy is one of the most effective ways of hedging and having consistent return without taking too much risk
- A Bull Call Strategy is best suited when one has a moderately bullish view on the market
- A Bear Put Strategy is best suited when one has a moderately bearish view of the market
- The two strategies are best suited if you are a risk-averse trader and don’t mind having a cap on the profit potential
Hitesh Singhi is an active derivative trader with over +10 years of experience of trading in Futures and Options in Indian Equity market and International energy products like Brent Crude, WTI Crude, RBOB, Gasoline etc. He has traded on BSE, NSE, ICE Exchange & NYMEX Exchange. By qualification, Hitesh has a graduate degree in Business Management and an MBA in Finance. Connect with Hitesh over Twitter here!
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