Strategies of Options Contracts

Options are of two types – calls and puts. Calls give the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a given future date. Puts give the buyer the right, but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given date.

We look here at some Strategies of options contracts. We refer to single stock options here. However since the index is nothing but a security whose price or level is a weighted average of securities constituting the index, all strategies that can be implemented using stock futures can also be implemented using index options.

  1. Hedging: Have underlying buy puts
  2. Speculation: Bullish security, buy calls or sell puts
  3. Speculation: Bearish security, sell calls or buy puts

Hedging: Have underlying buy puts

Owners of stocks or equity portfolios often experience discomfort about the overall stock market movement. As an owner of stocks or an equity portfolio, sometimes you may have a view that stock prices will fall in the near future. At other times you may see that the market is in for a few days or weeks of massive volatility, and you do not have an appetite for this kind of volatility. The union budget is a common and reliable source of such volatility: market volatility is always enhanced for one week before and two weeks after a budget. Many investors simply do not want the fluctuations of these three weeks. One way to protect your portfolio from potential downside due to a market drop is to buy insurance using put options.

Index and stock options are a cheap and easily implemental way of seeking this insurance. The idea is simple. To protect the value of your portfolio from falling below a particular level, buy the right number of put options with the right strike price. If you are only concerned about the value of a particular stock that you hold, buy put options on that stock. If you are concerned about the overall portfolio, buy put options on the index. When the stock price falls your stock will lose value and the put options bought by you will gain, effectively ensuring that the total value of your stock plus put does not fall below a particular level. This level depends on the strike price of the stock options chosen by you. Similarly when the index falls, your portfolio will lose value and the put options bought by you will gain, effectively ensuring that the value of your portfolio does not fall below a particular level. This level depends on the strike price of the index options chosen by you.

Portfolio insurance using put options is of particular interest to mutual funds who already own well-diversified portfolios. By buying puts, the fund can limit its downside in case of a market fall.

Speculation: Bullish security, buy calls or sell puts

There are times when investors believe that security prices are going to rise. For instance, after a good budget. Or good corporate results, or the onset of a stable government. How does one implement a trading strategy to benefit from an upward movement in the underlying security? Using options there are two ways one can do this:

  1. Buy call options; or
  2. Sell put options

We have already seen the payoff of a call option. The downside to the buyer of the call option is limited to the option premium he pays for buying the option. His upside however is potentially unlimited. Suppose you have a hunch that the price of a particular security is going to rise in a month’s time. Your hunch proves correct and the price does indeed rise, it is this upside that you cash in on. However, if your hunch proves to be wrong and the security price plunges down, what you lose is only the option premium.

Having decided to buy a call, which one should you buy? Given that there is a number of one—month calls trading, each with a different strike price, the obvious question is: which strike should you choose? Let us take a look at call options with different strike prices. Assume that the current price level is 1250, risk-free rate is 12% per year and volatility of the underlying security is 30%. The following options are available:

  1. A one month call with a strike of 1200.
  2. A one month call with a strike of 1225.
  3. A one month call with a strike of 1250.
  4. A one month call with a strike of 1275.
  5. A one month call with a strike of 1300.

Which of these options you choose largely depends on how strongly you feel about the likelihood of the upward movement in the price, and how much you are willing to lose should this upward movement not come about. There are five one—month calls and five one—month puts trading in the market. The call with a strike of 1200 is deep in—the—money and hence trades at a higher premium. The call with a strike of 1275 is out—of—the—money and trades at a low premium. The call with a strike of 1300 is deep—out—of—money. Its execution depends on the unlikely event that the underlying will rise by more than 50 points on the expiration date. Hence buying this call is basically like buying a lottery. There is a small probability that it may be in—the—money by expiration, in which case the buyer will make profits. In the more likely event of the call expiring out—of—the—money, the buyer simply loses the small premium amount of Rs.27.50.

As a person who wants to speculate on the hunch that prices may rise, you can also do so by selling or writing puts. As the writer of puts, you face a limited upside and an unlimited downside. If prices do rise, the buyer of the put will let the option expire and you will earn the premium. If however your hunch about an upward movement proves to be wrong and prices actually fall, then your losses directly increase with the falling price level. If for instance the price of the underlying falls to 1230 and you’ve sold a put with an exercise of 1300, the buyer of the put will exercise the option and you’ll end up losing Rs.70. Taking into account the premium earned by you when you sold the put, the net loss on the trade is Rs.5.20.

Having decided to write a put, which one should you write? Given that there are a number of one-month puts trading, each with a different strike price, the obvious question is: which strike should you choose? This largely depends on how strongly you feel about the likelihood of the upward movement in the prices of the underlying. If you write an at—the—money put. The option premium earned by you will be higher than if you write an out—of—the—money put. However the chances of an at—the—money put being exercised on you are higher as well. In the example in Figure 4.10, at a price level of 1250, one option is in—the—money and one is out—of—the—money. As expected, the in—the—money option fetches the highest premium of Rs.64.80 whereas the out—of—the—money option has the lowest premium of Rs. 18.15.

Speculation: Bearish security, sell calls or buy puts

Do you sometimes think that the market is going to drop? That you could make a profit by adopting a position on the market? Due to poor corporate results, or the instability of the government, many people feel that the stocks prices would go down. How does one implement a trading strategy to benefit from a downward movement in the market? Today, using options, you have two choices:

  1. Sell call options; or
  2. Buy put options

We have already seen the payoff of a call option. The upside to the writer of the call option is limited to the option premium he receives upright for writing the option. His downside however is potentially unlimited. Suppose you have a hunch that the price of a particular security is going to fall in a month’s time. Your hunch proves correct and it does indeed fall, it is this downside that you cash in on. When the price falls, the buyer of the call lets the call expire and you get to keep the premium. However, if your hunch proves to be wrong and the market soars up instead, what you lose is directly proportional to the rise in the price of the security.

Having decided to write a call, which one should you write? Given that there are a number of one-month calls trading, each with a different strike price, the obvious question is: which strike should you choose? Let us take a look at call options with different strike prices. Assume that the current stock price is 1250, risk-free rate is 12% per year and stock volatility is 30%. You could write the following options:

  1. A one month call with a strike of 1200.
  2. A one month call with a strike of 1225.
  3. A one month call with a strike of 1250.
  4. A one month call with a strike of 1275.
  5. A one month call with a strike of 1300.

Which of these options you write largely depends on how strongly you feel about the likelihood of the downward movement of prices and how much you are willing to lose should this downward movement not come about. There are five one-month calls and five one-month puts trading in the market. The call with a strike of 1200 is deep in-the-money and hence trades at a higher premium. The call with a strike of 1275 is out-of-the-money and trades at a low premium. The call with a strike of 1300 is deep-out-of-money. Its execution depends on the unlikely event that the stock will rise by more than 50 points on the expiration date. Hence writing this call is a fairly safe bet. There is a small probability that it may be in-the-money by expiration in which case the buyer exercises and the writer suffers losses to the extent that the price is above 1300. In the more likely event of the call expiring out-of-the-money, the writer earns the premium amount of Rs.27.50.

As a person who wants to speculate on the hunch that the market may fall, you can also buy puts. As the buyer of puts you face an unlimited upside but a limited downside. If the price does fall, you profit to the extent the price falls below the strike of the put purchased by you. If however your hunch about a downward movement in the market proves to be wrong and the price actually rises, all you lose is the option premium. If for instance the security price rises to 1300 and you’ve bought a put with an exercise of 1250, you simply let the put expire. If however the price does fall to say 1225 on expiration date, you make a neat profit of Rs.25.

Having decided to buy a put, which one should you buy? Given that there are a number of one-month puts trading, each with a different strike price, the obvious question is: which strike should you choose? This largely depends on how strongly you feel about the likelihood of the downward movement in the market. If you buy an at-the-money put, the option premium paid by you will by higher than if you buy an out-of-the-money put. However the chances of an at-the-money put expiring in-the-money are higher as well.