future and options trading strategies

Future & Option Trading Strategies

Assignment One

Himanshu Ahire 13

Executive Full Time PGDM ( 2009-2010 )

Trimester 4

Symbiosis Institute of Management Studies

F&O Trading Strategies - Himanshu Ahire

1

Introduction 4

Hedgers 4

Speculators 5

Arbitrageurs 5

Market Players 6

The Exchanges 6

Financial Institution 6

Market Makers 6

Day traders 7

Premium Sellers 7

Spread Traders 7

Theoretical Traders 7

Future & option Trading Strategies 8

Long & Short Futures 8

Long position 8

Short position 9

Options In-the-money, At-the-money, Out-of-the-money 10

At-the-money 10

In-the-money 10

out-of-the-money 10

Trading Strategies 11

Bullish Strategies 11

Long call 11

Covered Calls 12

Protective Put 13

Bull Call Spread 14

Bull Put Spread 15

Call Back Spread 16


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Naked Put 17

Bearish Strategies 18

Long Put 18

Naked Put 19

Put Back-spread 20

Bear call spread 21

Bear put spread 22

Neutral Strategies 23

Reversal 23

Conversion 24

The Collar 25

Long Straddle 26

Short Straddle 27

Long Strangle 28

Short Strangle 29

The Butterfly 30

Ratio Spread 31

Condor 32

Calendar Spread 33

Bibliography 34


3

Introduction

Derivatives are financial instruments which derives their value from underlying asset. These underlying assets can be Shares, Bonds, Interest Rates, Market Volatility, currencies & Commodities. Derivatives market can be OTC or Exchange Traded. Primary goal of derivatives trading is to transfer underlying price risk from one party to another. Hence derivatives helps mitigating risk from future uncertainties. Although main objective of derivatives is to mitigate risk it can be used for profit making. Hence Derivatives traders can be classified as

• Hedgers• Speculators• Arbitrageurs

Hedgers

Generally hedgers have substantial interest ( exposure ) in spot market. Hence they participate in derivatives market to mitigate adverse price movement risk in spot market.hedgers can take various positions in derivatives market based on their exposure in spot market. Generally they take opposite position in derivatives market compare to spot market. Hedging can also be used to protect existing future or options positions. For Example following are option positions & their respective possible future/options hedge positions.

Option Position Hedge Position

Long Call : Increases in value as the underlying increases in value

Short UnderlyingShort CallLong Put

Short Call :Decreases in value as the underlying increases in value

Long Underlying Long CallShort Put

Long Put : Decreases in value as the underlying increases in value

Long UnderlyingShort PutLong Call

Short Put : Increases in value as the underlying decreases in value

Short UnderlyingLong PutShort Call


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Speculators

Speculators have profit motive. They tried to get benefit from market movement. They bets on derivative position based on personal view. Generally they have high risk appetite. Their main objective is to make quick gain by market movement. Because of their one sided view there is possibility of large profit or Large loss.

Arbitrageurs

Arbitrageurs want to make risk-less profit. They tend to exploit market inefficiencies. Generally In the market, future & options prices are closely related to respective underlying spot market. For Example

When the Underlying Security... Increase in Value Decrease in Value

The Long Call will Increase in Value Decrease in Value

The Short Call will Decrease in Value Increase in Value

The Long Put will Decrease in Value Increase in Value

The Short Put will Increase in Value Decrease in Value

But sometimes due to market inefficiencies there is some difference between spot market & derivative markets.They can utilized these differences between spot market & Derivatives market to make profit.


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Market Players

With the possible exception of futures contracts, option trading is not a zero-sum game. In other words, for every winner there doesn't have to be a loser. Therefore, because there are so many different combinations and ways options can be hedged against each other.The main defferance between spot & Derivatives market is that in derivatives trading there are more players and multiple agendas. In the derivatives markets, the players fall into four categories:

• The Exchanges • Financial Institution • Market Makers • Individual (Retail) Investors

The Exchanges

The exchange is a place where market makers and traders gather to buy and sell stocks, options, bonds, futures, and other financial instruments.

Financial Institution

Financial institutions are professional investment management companies that typically fall into several main categories: mutual funds, hedge funds, insurance companies, stock funds. In each case, these money managers control large portfolios of stocks, options, and other financial instruments.

Market Makers

Market makers are the traders on the floor of the exchanges who create liquidity by providing two-sided markets. In each counter, the competition between market makers keeps the spread between the bid and the offer relatively narrow. Nevertheless, it's the spread that partially compensates market makers for the risk of willingly taking either side of a trade. In general, there are four trading techniques that characterize how different market makers trade options. Any or all of these techniques may be employed by the same market maker depending on trading conditions.

• Day Traders • Premium Sellers • Spread Traders • Theoretical Traders


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Day traders

Day traders, on or off the trading screen, tend to use small positions to capitalize on intra-day market movement. Since their objective is not to hold a position for extended periods, day traders generally don't hedge options with the underlying stock. At the same time, they tend to be less concerned about delta, gamma, and other highly analytical aspects of option pricing.

Premium Sellers Just like the name implies, premium sellers tend to focus their efforts selling high priced options and taking advantage of the time decay factor by buying them later at a lower price. This strategy works well in the absence of large, unexpected price swings but can be extremely risky when volatility skyrockets.

Spread Traders Like other market makers, spread traders often end up with large positions but they get there by focusing on spreads. In this way, even the largest of positions will be somewhat naturally hedged. Spread traders employ a variety of strategies buying certain options and selling others to offset the risk. Some of these strategies like reversals, conversions, and boxes are primarily used by floor traders because they take advantage of minor price discrepancies that often only exist for seconds. However, spread traders will use strategies like butterflies, condors, call spreads, and put spreads that can be used quite effectively by individual investors.

Theoretical Traders

By readily making two-sided markets, market makers often find themselves with substantial option positions across a variety of months and strike prices. The same thing happens to theoretical traders who use complex mathematical models to sell options that are overpriced and buy options that are relatively underpriced. Of the four groups, theoretical traders are often the most analytical in that they are constantly evaluating their position to determine the effects of changes in price, volatility, and time.


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Future & option Trading Strategies

Long & Short Futures

The Pay-off of a futures contract on maturity depends on the spot price of the underlying asset at the time of maturity and the price at which the contract was initially traded. There are two positions that could be taken in a futures contract:

Long position

one who buys the asset at the futures price takes the long position. The pay-off for a long position in a futures contract on one unit of an asset is:

Long Pay-off = Future Price at Expiry – Future Purchase price

• Maximum Profit = Unlimited• Profit Achieved When Market Price of Futures > Purchase Price of Futures• Profit = (Market Price of Futures - Purchase Price of Futures) x Contract Size• Maximum Loss = Unlimited• Loss Occurs When Market Price of Futures < Purchase Price of Futures• Loss = (Purchase Price of Futures - Market Price of Futures) x Contract Size +

Commissions Paid• Breakeven Point = Purchase Price of Futures Contract


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Short position

one who sells the asset at the futures price takes the short position.Short Pay-off = Future short position price - Future short position at Expiry

• Maximum Profit = Unlimited• Profit Achieved When Market Price of Futures < Selling Price of Futures• Profit = (Selling Price of Futures - Market Price of Futures) x Contract Size• Maximum Loss = Unlimited• Loss Occurs When Market Price of Futures > Selling Price of Futures• Loss = (Market Price of Futures - Selling Price of Futures) x Contract Size +

Commissions Paid• Breakeven Point = Selling Price of Futures Contract


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Options In-the-money, At-the-money, Out-of-the-money

Call Option Put Option

In-the-money Strike Price less than Spot Price of underlying asset

Strike Price greater than Spot Price of underlying asset

At-the-money Strike Price equal to Spot Price of underlying asset

Strike Price equal to Spot Price of underlying asset

Out-of-the-money Strike Price greater than Spot Price of underlying asset

Strike Price less than Spot Price of underlying asset

At-the-money

An option is said to be 'at-the-money', when the option's strike price is equal to the underlying asset price. This is true for both puts and calls.

In-the-moneyA call option is said to be in-the-money when the strike price of the option is less than the underlying asset price. For example, a Sensex call option with strike of 3900 is 'in-the-money', when the spot Sensex is at 4100 as the call option has value. The call holder has the right to buy a Sensex at 3900, no matter how much the spot market price has risen. And with the current price at 4100, a profit can be made by selling Sensex at this higher price.

out-of-the-moneyOn the other hand, a call option is out-of-the-money when the strike price is greater than the underlying asset price. Using the earlier example of Sensex call option, if the Sensex falls to 3700, the call option no longer has positive exercise value. The call holder will not exercise the option to buy Sensex at 3900 when the current price is at 3700. (Please see table)


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Trading Strategies

Bullish Strategies

Long call

For aggressive investors who are bullish about the short-term prospects for a stock, buying calls can be an excellent way to capture the upside potential with limited inside risk.

• Maximum Profit = Unlimited• Profit Achieved When Price of Underlying >= Strike Price of Long Call + Premium Paid• Profit = Price of Underlying - Strike Price of Long Call - Premium Paid• Max Loss = Premium Paid + Commissions Paid• Max Loss Occurs When Price of Underlying <= Strike Price of Long Call• Breakeven Point = Strike Price of Long Call + Premium Paid


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Covered Calls

For conservative investors, selling calls against a long stock position can be an excellent way to generate income without assuming the risks associated with uncovered calls. In this case, investors would sell one call contract for each 100 shares of stock they own.

• Profit Potential: Limited • Loss Potential: Unlimited • Upside Profit at Expiration If Assigned: Premium Received + Difference (if any)

Between Strike Price and Stock Purchase Price • Upside Profit at Expiration If Not Assigned: Any Gains in Stock Value + Premium

Received • BEP: Stock Purchase Price - Premium Received


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Protective Put

For investors who want to protect the stocks in their portfolio from falling prices, protective puts provide a relatively low-cost form of portfolio insurance. In this case, investors would purchase one put contract for each 100 shares of stock they own.

• Maximum Profit = Unlimited• Profit Achieved When Price of Underlying > Purchase Price of Underlying + Premium

Paid• Profit = Price of Underlying - Purchase Price of Underlying - Premium Paid• Max Loss = Premium Paid + Purchase Price of Underlying - Put Strike + Commissions

Paid• Max Loss Occurs When Price of Underlying <= Strike Price of Long Put• Breakeven Point = Purchase Price of Underlying + Premium Paid


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Bull Call Spread

For bullish investors who want to a nice low risk, limited return strategy without buying or selling the underlying stock, bull call spreads are a great alternative. This strategy involves buying and selling the same number of calls at different strike prices to minimize both the cash outlay and the overall risk.

• Max Profit = Strike Price of Short Call - Strike Price of Long Call - Net Premium Paid - Commissions Paid

• Max Profit Achieved When Price of Underlying >= Strike Price of Short Call• Max Loss = Net Premium Paid + Commissions Paid• Max Loss Occurs When Price of Underlying <= Strike Price of Long Call• Breakeven Point = Strike Price of Long Call + Net Premium Paid


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Bull Put Spread

For bullish investors who want a nice low risk, limited return strategy, bull put spreads are another alternative. Like the bull call spread, the bull put spread involves buying and selling the same number of put options at different strike prices. Since puts with the higher strike are sold, the trade is initiated for a credit.

• Max Profit = Net Premium Received - Commissions Paid• Max Profit Achieved When Price of Underlying >= Strike Price of Short Put• Max Loss = Strike Price of Short Put - Strike Price of Long Put Net Premium Received

+ Commissions Paid• Max Loss Occurs When Price of Underlying <= Strike Price of Long Put• Breakeven Point = Strike Price of Short Put - Net Premium Received


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Call Back Spread

For bullish investors who expect big moves in already volatile stocks, call back spreads are a great limited risk, unlimited reward strategy. The trade itself involves selling a call (or calls) at a lower strike and buying a greater number of calls at a higher strike price.

• Maximum Profit = Unlimited• Profit Achieved When Price of Underlying >= 2 x Strike Price of Long Call - Strike Price

of Short Call +/- Net Premium Paid/Received• Profit = Price of Underlying - Strike Price of Long Call - Max Loss• Max Loss = Strike Price of Long Call - Strike Price of Short Call +/- Net Premium Paid/

Received + Commissions Paid• Max Loss Occurs When Strike Price of Long Call• Upper Breakeven Point = Strike Price of Long Call + Points of Maximum Loss• Lower Breakeven Point = Strike Price of Short Call


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Naked Put

For bullish investors who are interested in buying a stock at a price below the current market price, selling naked puts can be an excellent strategy. In this case, however, the risk is substantial because the writer of the option is obligated to purchase the stock at the strike price regardless of where the stock is trading.

• Max Profit = Premium Received - Commissions Paid• Max Profit Achieved When Price of Underlying >= Strike Price of Short Put• Maximum Loss = Unlimited• Loss Occurs When Price of Underlying < Strike Price of Short Put - Premium Received• Loss = Strike Price of Short Put - Price of Underlying - Premium Received + Commissions

Paid• Breakeven Point = Strike Price of Short Put - Premium Received


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Bearish Strategies

Long Put

For aggressive investors who have a strong feeling that a particular stock is about to move lower, long puts are an excellent low risk, high reward strategy. While risk is limited to the initial investment, the profit potential is unlimited.

• Maximum Profit = Unlimited• Profit Achieved When Price of Underlying = 0• Profit = Strike Price of Long Put - Premium Paid• Max Loss = Premium Paid + Commissions Paid• Max Loss Occurs When Price of Underlying >= Strike Price of Long Put• Breakeven Point = Strike Price of Long Put - Premium Paid


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Naked Put

Selling naked calls is a very risky strategy which should be utilized with extreme caution. By selling calls without owning the underlying stock, you collect the option premium and hope the stock either stays steady or declines in value. If the stock increases in value this strategy has unlimited risk.

• Maximum Loss = Unlimited• Loss Occurs When Price of Underlying < Strike Price of Short Put - Premium Received• Loss = Strike Price of Short Put - Price of Underlying - Premium Received + Commissions

Paid• Breakeven Point = Strike Price of Short Put - Premium Received


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Put Back-spread

For aggressive investors who expect big downward moves in already volatile stocks, backspreads are great strategies. The trade itself involves selling a put at a higher strike and buying a greater number of puts at a lower strike price. As the stock price moves lower, the profit potential is unlimited.

• Maximum Profit = Unlimited• Profit Achieved When Price of Underlying < 2 x Strike Price of Long Put - Strike Price

of Short Put + Net Premium Received• Profit = Strike Price of Long Put - Price of Underlying - Max Loss• Max Loss = Strike Price of Short Put - Strike Price of Long Put - Net Premium

Received + Commissions Paid• Max Loss Occurs When Price of Underlying = Strike Price of Long Put• Upper Breakeven Point = Strike Price of Short Put• Lower Breakeven Point = Strike Price of Long Put - Points of Maximum Loss


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Bear call spread

For investors who maintain a generally negative feeling about a stock, bear spreads are a nice low risk, low reward strategies. This trade involves selling a lower strike call, usually at or near the current stock price, and buying a higher strike, out-of-the-money call. This spread profits when the stock price decreases and both calls expire worthless.

• Max Profit = Net Premium Received - Commissions Paid• Max Profit Achieved When Price of Underlying <= Strike Price of Short Call• Max Loss = Strike Price of Long Call - Strike Price of Short Call - Net Premium

Received + Commissions Paid• Max Loss Occurs When Price of Underlying >= Strike Price of Long Call• Breakeven Point = Strike Price of Short Call + Net Premium Received•


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Bear put spread

For investors who maintain a generally negative feeling about a stock, bear spreads are another nice low risk, low reward strategy. This trade involves buying a put at a higher strike and selling another put at a lower strike. Like bear call spreads, bear put spreads profit when the price of the underlying stock decreases.

• Max Profit = Strike Price of Long Put - Strike Price of Short Put - Net Premium Paid - Commissions Paid

• Max Profit Achieved When Price of Underlying <= Strike Price of Short Put• Max Loss = Net Premium Paid + Commissions Paid• Max Loss Occurs When Price of Underlying >= Strike Price of Long Put• Breakeven Point = Strike Price of Long Put - Net Premium Paid


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Neutral Strategies

Reversal Primarily used by floor traders, a reversal is an arbitrage strategy that allows traders to profit when options are underpriced. To put on a reversal, a trader would sell stock and use options to buy an equivalent position that offsets the short stock.

• Profit = Sale Price of Underlying - Strike Price of Call/Put + Put Premium - Call Premium


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Conversion

Primarily used by floor traders, a conversion is an arbitrage strategy that allows traders to profit when options are overpriced. To put on a conversion, a trader would buy stock and use options to sell an equivalent position that offsets the long stock.

• Profit = Strike Price of Call/Put - Purchase Price of Underlying + Call Premium - Put Premium


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The Collar

For bullish investors who want to nice low risk, limited return strategy to use in conjunction with a long stock position, collars are a great alternative. In this case, the collar is created by combining covered calls protective puts.

• Max Profit = Strike Price of Short Call - Purchase Price of Underlying + Net Premium Received - Commissions Paid

• Max Profit Achieved When Price of Underlying >= Strike Price of Short Call• Max Loss = Purchase Price of Underlying - Strike Price of Long Put - Net Premium

Received + Commissions Paid• Max Loss Occurs When Price of Underlying <= Strike Price of Long Put• Breakeven Point = Purchase Price of Underlying + Net Premium Paid


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Long Straddle

For aggressive investors who expect short-term volatility yet have no bias up or down (i.e., a neutral bias), the long straddle is an excellent strategy. This position involves buying both a put and a call with the same strike price, expiration, and underlying. The potential loss is limited to the initial investment. The potential profit is unlimited as the stock moves up or down.

• Maximum Profit = Unlimited• Profit Achieved When Price of Underlying > Strike Price of Long Call + Net Premium

Paid OR Price of Underlying < Strike Price of Long Put - Net Premium Paid• Profit = Price of Underlying - Strike Price of Long Call - Net Premium Paid OR Strike

Price of Long Put - Price of Underlying - Net Premium Paid• Max Loss = Net Premium Paid + Commissions Paid• Max Loss Occurs When Price of Underlying = Strike Price of Long Call/Put• Upper Breakeven Point = Strike Price of Long Call + Net Premium Paid• Lower Breakeven Point = Strike Price of Long Put - Net Premium Paid


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Short Straddle

For aggressive investors who don't expect much short-term volatility, the short straddle can be a risky, but profitable strategy. This strategy involves selling a put and a call with the same strike price, expiration, and underlying. In this case, the profit is limited to the initial credit received by selling options. The potential loss is unlimited as the market moves up or down.

• Max Profit = Net Premium Received - Commissions Paid• Max Profit Achieved When Price of Underlying = Strike Price of Short Call/Put• Maximum Loss = Unlimited• Loss Occurs When Price of Underlying > Strike Price of Short Call + Net Premium

Received OR Price of Underlying < Strike Price of Short Put - Net Premium Received• Loss = Price of Underlying - Strike Price of Short Call - Net Premium Received OR

Strike Price of Short Put - Price of Underlying - Net Premium Received + Commissions Paid

• Upper Breakeven Point = Strike Price of Short Call + Net Premium Received• Lower Breakeven Point = Strike Price of Short Put - Net Premium Received•


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Long Strangle

For aggressive investors who expect short-term volatility yet have no bias up or down (i.e., a neutral bias), the long strangle is another excellent strategy. This strategy typically involves buying out-of-the-money calls and puts with the same strike price, expiration, and underlying. The potential loss is limited to the initial investment while the potential profit is unlimited as the market moves up or down.

• Maximum Profit = Unlimited• Profit Achieved When Price of Underlying > Strike Price of Long Call + Net Premium

Paid OR Price of Underlying < Strike Price of Long Put - Net Premium Paid• Profit = Price of Underlying - Strike Price of Long Call - Net Premium Paid OR Strike

Price of Long Put - Price of Underlying - Net Premium Paid• Max Loss = Net Premium Paid + Commissions Paid• Max Loss Occurs When Price of Underlying is in between Strike Price of Long Call

and Strike Price of Long Put• Upper Breakeven Point = Strike Price of Long Call + Net Premium Paid• Lower Breakeven Point = Strike Price of Long Put - Net Premium Paid•


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Short Strangle

For aggressive investors who don't expect much short-term volatility, the short strangle can be a risky, but profitable strategy. This strategy typically involves selling out-of-the-money puts and calls with the same strike price, expiration, and underlying. The profit is limited to the credit received by selling options. The potential loss is unlimited as the market moves up or down.

• Max Profit = Net Premium Received - Commissions Paid• Max Profit Achieved When Price of Underlying is in between the Strike Price of the

Short Call and the Strike Price of the Short Put• Maximum Loss = Unlimited• Loss Occurs When Price of Underlying > Strike Price of Short Call + Net Premium

Received OR Price of Underlying < Strike Price of Short Put - Net Premium Received• Loss = Price of Underlying - Strike Price of Short Call - Net Premium Received OR

Strike Price of Short Put - Price of Underlying - Net Premium Received + Commissions Paid

• Upper Breakeven Point = Strike Price of Short Call + Net Premium Received• Lower Breakeven Point = Strike Price of Short Put - Net Premium Received


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The Butterfly

Ideal for investors who prefer limited risk, limited reward strategies. When investors expect stable prices, they can buy the butterfly by selling two options at the middle strike and buying one option at the higher and lower strikes. The options, which must be all calls or all puts, must also have the same expiration and underlying.

• Max Profit = Strike Price of Short Call - Strike Price of Lower Strike Long Call - Net Premium Paid - Commissions Paid

• Max Profit Achieved When Price of Underlying = Strike Price of Short Calls• Max Loss = Net Premium Paid + Commissions Paid• Max Loss Occurs When Price of Underlying <= Strike Price of Lower Strike Long Call

OR Price of Underlying >= Strike Price of Higher Strike Long Call• Upper Breakeven Point = Strike Price of Higher Strike Long Call - Net Premium Paid• Lower Breakeven Point = Strike Price of Lower Strike Long Call + Net Premium Paid•


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Ratio Spread

For aggressive investors who don't expect much short-term volatility, ratio spreads are a limited reward, unlimited risk strategy. Put ratio spreads, which involve buying puts at a higher strike and selling a greater number of puts at a lower strike, are neutral in the sense that they are hurt by market movement.

• Max Profit = Strike Price of Short Call - Strike Price of Long Call + Net Premium Received - Commissions Paid

• Max Profit Achieved When Price of Underlying = Strike Price of Short Calls• Maximum Loss = Unlimited• Loss Occurs When Price of Underlying > Strike Price of Short Calls + ((Strike Price of

Short Call - Strike Price of Long Call + Net Premium Received) / Number of Uncovered Calls)

• Loss = Price of Underlying - Strike Price of Short Calls - Max Profit + Commissions Paid

• Upper Breakeven Point = Strike Price of Short Calls + (Points of Maximum Profit / Number of Uncovered Calls)

• Lower Breakeven Point = Strike Price of Long Call +/- Net Premium Paid or Received


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Condor Ideal for investors who prefer limited risk, limited reward strategies. The condor takes the body of the butterfly - two options at the middle strike - and splits between two middle strikes. In this sense, the condor is basically a butterfly stretched over four strike prices instead of three.

• Max Profit = Strike Price of Lower Strike Short Call - Strike Price of Lower Strike Long Call - Net Premium Paid - Commissions Paid

• Max Profit Achieved When Price of Underlying is in between the Strike Prices of the 2 Short Calls

• Max Loss = Net Premium Paid + Commissions Paid• Max Loss Occurs When Price of Underlying <= Strike Price of Lower Strike Long Call

OR Price of Underlying >= Strike Price of Higher Strike Long Call• Upper Breakeven Point = Strike Price of Highest Strike Long Call - Net Premium

Received• Lower Breakeven Point = Strike Price of Lowest Strike Long Call + Net Premium

Received


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Calendar Spread Calendar spreads are also known as time or horizontal spreads because they involve options with different expiration months. Because they are not exceptionally profitable on their own, calendar spreads are often used by traders who maintain large positions. Typically, a long calendar spread involves buying an option with a long-term expiration and selling an option with the same strike price and a short-term expiration.

The maximum possible profit for the neutral calendar spread is limited to the premiums collected from the sale of the near month options minus any time decay of the longer term options. This happens if the underlying stock price remains unchanged on expiration of the near month options.

The maximum possible loss for the neutral calendar spread is limited to the initial debit taken to put on the spread. It occurs when the stock price goes down and stays down until expiration of the longer term options.


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Bibliography

NCFM derivatives module

www.nseindia.com

http://www.theoptionsguide.com/

http://en.wikipedia.org/wiki/Main_Page


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http://www.nseindia.com

http://www.nseindia.com

http://www.theoptionsguide.com

http://www.theoptionsguide.com



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