What exactly is an option trading strategy?
An option trading strategy is a hybrid combination of futures and options, or of two or more different options, that results in a product with defined risk-returns. Option strategies are possible due to the unique nature of options, which are volatile in nature.
Options strategies are generally classified into six categories, which are as follows:
- Bullish strategies
- Bearish strategies
- Moderately bullish strategies
- Moderately bearish strategies
- Volatile strategies
- Range bound strategies
Protective Puts, Covered Calls and Collars
These are the three most basic techniques that are used on a consistent basis. Despite being part of a bigger set of options strategies, these three options strategies are straightforward to understand and implement in the F&O Market. Let’s look at each of these techniques in more detail.
Protective Put strategy
Assume you purchased a stock with the goal of owning it for a long time. Unfortunately, shortly after you purchased the stock, there was a global issue with the sector, and you now expect the stock to be weak in the short term. Selling the stock is one alternative. This, however, comes at a price and is incompatible with a long-term investing strategy. Another alternative is to use a “Protective Put” method. A protective put allows you to preserve your cash market holdings while also purchasing a lesser put option.
You can now benefit endlessly after paying the premium on your put option.
On the downside, your risk is limited to the difference between the purchase price and the strike price of the put option plus the option premium. That is the most you can lose.
Traders hold the cash market position for some time and continue to book profits on the put option when the price falls. Of course, this opens the door to the long position, which you should be wary of.
Example: An investor trader purchases a stock in the cash market for Rs.1000 and protects the position by purchasing a 990 put option for Rs.10 X Lot Size.
The protective put strategy has a maximum loss of Rs 20. That is the difference between the spot and strike prices (1000-990) plus the option premium of Rs.10. However, regardless of how low the stock price falls, you can never lose more than Rs.20 X Lot Size.
Covered Call Strategy
The covered call, unlike the protective put, is a high-risk strategy. A covered call is used to lower the cost of keeping a stock when it does not move for an extended length of time. Rather of letting your investment stay dormant, you can sell greater call options, earn the premium, and cut your stock’s cost of ownership. Assume you purchased a stock with the goal of owning it for a long time.
The stock’s price dropped after you bought it, but you’re still positive about its long-term prospects. You can convert premiums into income by selling slightly higher calls that will most likely expire worthless.
There are two types of pricing changes to watch out for. You won’t lose money if the stock stays flat at current levels or climbs to the higher call strike price, because you’ll be paid the premium. The losses on the sold call could be endless if the price rises above the strike price. Your long stock position, on the other hand, more than makes up for it.
On the negative side, your risk is wide open, and you should be cautious.
An investor buys a stock for Rs.1000 in the cash market and sells a call option for Rs.1020 at Rs.10.
The maximum profit from the covered call strategy is Rs.30. The option premium of Rs.8 is added to the difference between the strike price and the spot price (1020-1000). Your profit cap, however, is Rs.30, regardless of how high the stock price increases. The highest profit is always realised at the strike price at which the call is sold. Any gains on the spot position are offset by losses on the sold call option.
The negative, as shown in the table above, is that the losses can be endless. As a result, you should only employ this technique on equities that have excellent fundamentals and that you intend to keep for a long time.
The breakeven point for the covered call strategy is Rs.990, which is the purchase price of Rs.1000 less the premium of Rs.10. When your net effective losses on the spot position fall below 990, your net effective losses begin to rise.
The collar approach is a combination of a protected put and a covered call. There are three steps to the strategy. You are, first and foremost, long the stock. Second, you buy a put option with a lower strike price. Finally, you sell a more costly call option.
The covered call strategy has an open downside risk. By purchasing a lesser put option, you can now eliminate that risk. In the defensive put method, the cost of purchasing a put option can be excessively expensive at times. Selling a higher call option for a greater premium can partially offset the premium spent on the put option. The collar strategy has the advantage of having a low risk and high reward potential.
Such strategies are known as closed option strategies.
An investor buys a stock for Rs.1000 in the cash market and sells a call option for Rs.1020 for Rs.8. He also buys a Rs.990 put with a Rs.5 premium.
The maximum loss in the collar technique is Rs.7. Your total loss, however, can never exceed Rs.7, no matter how low the stock price falls. The maximum loss on the spot/put position is Rs.15, which is made up of Rs.10 (1000-990) plus a Rs.5 premium on the put. However, the Rs.8 premium you received on the 1020 call you sold offsets your 15-rupee loss. As a result, the Collar’s maximum loss is limited at Rs.7 (15-8).
The maximum profit will be restricted to Rs. 23. The difference between the call strike price and the purchase price (1020-) will be used to calculate the maximum profit.
You then add the net premium received (8-5). The total is Rs.23, which is your maximum profit regardless of how high the stock rises.
The collar strategy’s breakeven point is Rs.997.
Subtract the Rs.3 net premium earned from the Rs.1000 buying price (8-5). As long as the stock price is greater than Rs.997, your collar is lucrative.
Protective puts, in a nutshell, are a bullish strategy that offers downside protection.
Covered calls are used to reduce the cost of holding a stock, but they do not give any downside protection. The collar is a closed strategy with downside and upward profit limits that is created by combining the protective put and the covered call.
Please refer to this article for full list of Option trading strategies