Options — A derivative product

When the market seems bullish, buy call option or sell put option having the strike price of nearest hurdle level (support and resistance). When the market seems bearish, buy put option or sell call option of the nearest hurdle level. When it's range bound, sell call or put option of the next hurdle level (if selling call, take the below support, if selling put, take the above resistance level - because they will have higher premiums to be eaten). The immediate hurdle level strike price will be your at the money option.

TCS call option having strike price of 3120 (currently the stock price is 3100) and premium is 88.4 has the payoff graph like this where profit grows as the stock price go up but the loss is limited which is total of the premium paid per lot.

Reliance 1900 put option payoff graph when the reliance is trading at 1925 and has the premium of 51.80. As the stock price decreases, the put option buyer continues to book more profit and has maximum loss fixed as the cost of option.

The lower the strike price, higher is the rate of change of premium of call options, if market goes up as they become more in the money and vice versa as they become more out of the money. The higher the strike price, higher is the rate of change of premium of put options, if market goes down as they become more ITM and vice versa as they become more OTM. ITM options are more profitable than OTM with ATM being in middle of them.

The grey column in the middle is the strike price. The data to the left is of call options and while to the right is of put options. The data in the yellow region are ITM options while on the white are OTM options. The strike price which is near to the underlying price is ATM and that’s the strike price which differentiate between yellow and white color.

Buying option is cheaper than selling options. For buying, you have to pay premium * lot size, which means limited risk. For selling, you have to pay, some extra margin as well. On an average, if you want to sell option positionally, it takes roughly 1.5-2lacs. Why so? Well stock prices can fluctuate wildly and hence Premium may increase drastically, to maintain this unlimited risk of seller, margins are on higher side.

See the payoff chart below for Reliance 1900 put buying and 1900 call selling (both are bearish view only when reliance is at 1925) — just check the risk involved and the capital needed and along with that do observe the which trade has higher probability to come in profit.

Reliance 1900 put option buying having premium 51.80

Reliance 1900 call option selling having premium 88.55

So, why does people sell options instead of just buying? There are few Option Greeks which determine option price. One of them is THETA, which says if the stock price isn’t changing, then the premium of that option will be 0 at the time of expiry. It has higher probability of being in the profit than buying options.

In India, European concept of expiry is followed. Hence, call options are written as CE and put options are written as PE.

What is option chain and how to interpret open interest and premium?

Option chain records the data of option. Option chain has data mostly from seller’s perspective (that’s what I feel- when I say this, I mean I don’t refer option chain aggressively) but if someone is interested, there are various people’s channel available on YouTube who share there knowledge about it. The call strike price with higher open interest acts as resistance and the put strike price with highest OI acts as support (Disclaimer - works effectively in stocks and not index)

How to analyze when to take option trade or when to exit? — Let’s understand that via brief table summary.

Long buildup — buy the option

Long unwinding — exit the long position

Short buildup — short the option

Short covering — exit the short position

Hedging your existing investment via options

Suppose you have XYZ stock bought at 400 levels, now it has shot to 540 levels. Now you start fearing that a small correction might come but it still has the potential to go up. So you don’t want to exit your holdings but also want to make the most of this correction. So you can buy OTM put option (which should be atleast 2–3 strike price lower, for this example let’s assume 480 strike price was selected). How does this benefit? As it’s OTM option, premium would obviously be cheaper, less premium erosion and when the correction comes you get to mint some money. How much quantity to buy? Well, usually that depends on the delta of the option. It’s advisable to buy atleast 50% of the quantity (like if I have 1000 quantity of shares, I will go for approx those many lots of put option which will fetch me atleast 500 quantity). Why so? Well with the correction, premium will increase more and more as it’s delta will increase. But, why buy OTM options? Well, hedging comes with additional cost, the nearer strike price will be too costly and the farthest strike prices won’t see any movement in premium when correction comes. This strategy is called nothing but the PROTECTIVE PUT strategy.

Now you may ask what about the stocks not from derivative segment, how to use this strategy on them. Well, there’s the concept of BETA, measures the rate of performance of a particular stock with respect to index. It’s value ranges from -1 to 1. So, let’s assume, you have portfolio of ABC stock having 0.4 as Beta value, then look for the derivative stock having same beta value and is also expecting correction or maybe pick up the PQR derivative stock from the same sector having same Beta value as if the sector is to see correction, then this strategy can save you from your ABC stock correction as well.

There’s another way as well, but works mostly when it’s expected that the stock is going to be in range bound for some time. Then you can easily short sell call option. This strategy is called COVERED CALL strategy. Strike price logic will be same as protective puts, only issue is as it’s involve selling options, it involves huge capital deployment comparatively and has unlimited risks involved.

Few Option Trading Strategies

1. Bull spread

When the stock is going up, but looks like that after some movement it may face little resistance, in that case, but the lower strike price(SP) call option and hedge it by selling higher SP call option. The range between the strike price shouldn’t be that wide. For explanation, I have used Kotak Bank as reference which is currently at 1969, I am bullish on it and do expect it to go beyond 2000 but little dicey that it may not breach 2020 levels easily. So, here’s the payoff chart for this strategy.

Kotak Mahindra Bank share price

Call option of SP 1980 is bought and call option of 2020 SP is sold. See the estimated margin required, breakeven point and the payoff chart

Now you may think, why not go for simply buying call option with SP 1980 instead. Here’s the payoff, check the estimated margin (not much difference), payoff seems quite lucrative (right…. ) but see the breakeven point (this call option is profitable only after the share price reaches 2040 — why, well cost of option premium also needs to be considered. right 😉). Also, the max loss in previous case is almost 1/3rd than the loss here.

In the same way bull put spread can be setup, where buying the lower SP put option and selling the higher SP put can be done.

2. Bear spread

When the stock is falling, but looks like the downward momentum is about to fade, in that case, selling the lower SP put option and buying the higher SP put option. The exact opposite of Bull Spread. The same can be done via call options as well. Lets take Nifty as an example which is currently trading at 14153 and I am not bearish in it beyond 13880 levels.

Nifty 50 share price

Check out the bear spread payoff on weekly expiry of nifty where 13900 put is sold and 14200 put is bought. Max profit, max loss, estimated margin and breakeven needs to be observed

This is the case where only 14200 put was bought, the estimated margin is obviously less but max loss as increased. Max profit may seem huge but are we expecting 700 points fall in nifty at the moment ???

3. Butterfly spread

When there is a chance that the stock is supposedly going to be expiring at particular price, then this spread can be used. This strategy involves buying one lower SP call, one higher SP call and sell two middle SP call. The middle SP is the price where the expiry of particular stock is expected. The same can be done with puts as well. Currently ITC is trading at 205 and expecting it to expire at 205 only, then setting up this strategy by buying call option of 200 and 210 SP each and selling two lots of 205 SP. Check the payoff graph below.

This strategy works wonderfully only when it is ensured that the stock price will expire at the medium price. The maximum price is only incase the stock is at middle price. This strategy works best in stocks having low volatility, which makes it the non-directional or neutral strategy. Any sudden movement will give you loss, but the best thing is loss is way too less than most setups.

Note : The Iron Condor Option Strategy has the same setup.

4. Straddle and Strangle

Let’s assume today is a big event day which has the tendency to make the stock go any way which means either a sharp rally might come or a sharp fall may come. How to make the most of it with options??

Simply buy ATM call option and buy ATM put option just before the announcement happens. Why buy other side option? Well, as long as you don’t have insider information, why not hedge as profit will be good. This setup is called STRADDLE.

So, what’s STRANGLE and how does it differ? There’s not much difference except the strike price. In straddle, ATM option were considered means, both call and put options had same strike price but in case of strangle, it is OTM option which means buy one higher SP call option and one lower SP put option. WHY??? Well, OTM options are way cheaper than ATM options 😉😉

If the expected announcement/event isn’t that major, then closer range SP options must be considered. The key idea is that this strategy works wonder if the stock price happens to go beyond that range.

So, it’s a win-win, why bother wasting money on Straddle? Well, remember the concept of THETA (the option greek which eats over option premium faster for OTM options), so, if the announcement is not done on time, option premium will keep on reducing, thus generating losses.

This can be tried on days like quarterly results announcement days or RBI Monetary Policy meeting etc.

5. Strips and Straps

Slight variant to Straddle, STRIPS — buy one ATM call and buy two ATM put options — which means the news which is expected have negative bias but can be positive as well. STRAPS — buy two ATM call and buy one ATM put option — which means the expected news has positive bias but can go negative as well.

Picture courtesy — Google

Payoff chart courtesy — Opstra

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