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OPTION

STRATEGIES
AN OVERVIEW

By
Dhruv Joshi
Gaurav Deshmukh
Shivanesan
Varsha Yadav
Jagdeesh
Rathod
Deep
Majumder
Papathi

Option Strategies
Introduction
Since the 1970s the number of options traded on stock exchanges all over
the world
has massively increased. Options offer stock traders a major opportunity
for hedging purposes involving the risk they bear when they are trading in
stocks or other commodities. In a number of situations large returns can
be achieved with the use of options. Options can be used in strategies
combined with holding stocks and there is the possibility to only trade in
options
Users of Option trading strategies are speculators, hedgers, and
arbitrageurs. Options can be used to create portfolios with unique
features, capable of achieving investment objectives not attainable with
futures.

Trading Strategies
Here are trading strategies for the various participants:
1. Arbitrage
The purchase and sale of the same security in different market to take
advantage of a price disparity between two markets is termed as
arbitrage. This strategy involves risk-less profit from market mispricing.
Before March 2001, a major part of the volume on the stock exchange was
accounted for by arbitrage of shares between the NSE and the BSE as
they followed settlement periods and different carry-forward mechanisms.
Profits in this activity were not substantial but it involves practically no
risk, so most of the jobbers, sub-brokers and large investors safely traded
in shares.
2. Hedging
Hedging represents a strategy by which an attempt is to be made to limit
the losses in one position by simultaneously taking a second offsetting
position. The offsetting position may be in same or different security. In
most cases hedgers are not perfect because they cannot eliminate all
losses. Typically, a hedge strategy strives to prevent large losses without
significantly reducing the gains.
3.

Speculation

A Speculator has a definite outlook about future prices and therefore buys
put or call option depending upon this perception. If a he has a bullish
outlook, he will buy calls or sell puts. As a bearish perception the
speculator will buy put and write calls. He will earn a profit if his view is in
right direction. If he is not, he will lose the money. A speculator buys call
or put options if his price outlook in a particular direction is very strong.
But if he is either neutral or not so strong, he would prefer to write a call
or a put option to earn premium.
4. Option Spreads
This is a strategy to take advantage of relative price changes. This
involves buying and selling different options simultaneously, creating a
price spread that widens or narrows depending on what happens to the
prices of the underlying assets. Options spreads in which two legs of the
spreads have different strike prices but the same expiry date are called
vertical spreads. However, an option spread that has two expiration dates
but the same strike price is called a horizontal spread. This is also a
speculative strategy but with limited risk and return compared to naked
speculation.
Some important option spreads are as follows:
(a) Bullish Option Spreads-These make profits when the asset prices go
up. Purchasing an option with a low strike price and selling one with
a higher strike price with the same expiration date creates such
spreads.
(b)Bearish Option Spreads- A bearish option spread gives a profit when
the price of the underlying asset falls. This spread involves selling
an option with a comparatively low strike price and buying one with
higher strike price for the same expiration date.
5. Butterfly spread
This is a spread position involving options with three different strike
prices. This position involves buying a call option with a higher strike
price, selling two call options with the mid-strike price and buying another
that has a lower strike price. The mid-strike price will be usually close to
the spot price. Thus, in this strategy one long option is in-the-money, two
short options are at-the-money and one long option is out-of-the-money. In
this strategy the investor pays the premium for the two options receives
premium on the other two. The net premium paid is very small. Profit
potential in this strategy will be very limited, since the short options
neutralize the gains on the long options beyond the difference in the strike

prices. The risk of losses is also very limited in this case. This option
strategy can be made by using call and put option.
6. Calendar or Time Spread
This is also known as horizontal spread. This is because different option
contracts having the same strike price with different expiration periods are
used in this strategy. An options or futures spread established by
simultaneously entering a long and short position on the same underlying
asset but with different delivery months.
7. Straddles
These are created by simultaneous sale or purchase of the options. These
involve buying the put and a call (long straddle) or selling a put and a call
(short straddle). This strategy is often used by speculators who believe
that the prices of the asset will move significantly in one direction or the
other (long straddle), or remain fairly constant (short straddle).
a) Long straddle- A long straddle is created by buying an equal number
of calls and puts with the same strike price and with the same
expiration date. This is beneficial if the prices of the underlying
assets move substantially in either direction. If prices fall, the put
option is profitable, and if prices rise, the call option will yield gains.
b) Short straddle- This is reverse of the long straddle. Here, the
investor sells an equal number of calls and puts for the same strike
price and with the same expiration date. This strategy is adopted
only when prices are expected to be stable. This strategy yields
profits if prices are stable, but leads to losses if future prices move
substantially in the either direction, which is just the opposite of the
long straddle position.
If the future price is the same as the strike price, both the call and the put
option will expire worthless and the investor will retain the total premium
received from writing the options.
8. Straps/ Strips
Strips involve a long position in one call and two puts with the same
expiration dates and strike prices. A strap involves a long position in two
calls and one put with the same expiration dates and strike prices. An
investor uses strips when he thinks that there will be a large price
movement in the stock, but a fall is more likely. A strap investors view is
the same about volatility, but considers an increase in the stock price
more likely.

Option Strategies
Bull Call Spread

In a bull call spread strategy, an investor will simultaneously buy call


options at a specific strike price and sell the same number of calls at a
higher strike price. Both call options will have the same expiration month
and underlying asset. This type of vertical spread strategy is often used
when an investor is bullish and expects a moderate rise in the price of the
underlying asset.
Bear Put Spread

The bear put spread strategy is another form of vertical spread. In this
strategy, the investor will simultaneously purchase put options as a
specific strike price and sell the same number of puts at a lower strike
price. Both options would be for the same underlying asset and have the
same expiration date. This method is used when the trader is bearish and
expects the underlying asset's price to decline. It offers both limited gains
and limited losses.
Long Straddle

A long straddle options strategy is when an investor purchases both a call


and put option with the same strike price, underlying asset and expiration
date simultaneously. An investor will often use this strategy when he or
she believes the price of the underlying asset will move significantly, but
is unsure of which direction the move will take. This strategy allows the
investor to maintain unlimited gains, while the loss is limited to the cost of
both options contracts.

Long Strangle

In a long strangle options strategy, the investor purchases a call and put
option with the same maturity and underlying asset, but with different
strike prices. The put strike price will typically be below the strike price of
the call option, and both options will be out of the money. An investor who
uses this strategy believes the underlying asset's price will experience a
large movement, but is unsure of which direction the move will take.
Losses are limited to the costs of both options; strangles will typically be
less expensive than straddles because the options are purchased out of
the money.
Butterfly Spread

In a butterfly spread options strategy, an investor will combine both a bull


spread strategy and a bear spread strategy, and use three different strike
prices. For example, one type of butterfly spread involves purchasing one
call (put) option at the lowest (highest) strike price, while selling two call
(put) options at a higher (lower) strike price, and then one last call (put)
option at an even higher (lower) strike price.
Iron Condor

In this strategy, the investor simultaneously holds a long and short


position in two different strangle strategies. The iron condor is a fairly
complex strategy that definitely requires time to learn, and practice to
master.
Iron Butterfly

In this strategy, an investor will combine either a long or short straddle


with the simultaneous purchase or sale of a strangle. Although similar to a
butterfly spread, this strategy differs because it uses both calls and puts,
as opposed to one or the other. Profit and loss are both limited within a
specific range, depending on the strike prices of the options used.
Investors will often use out-of-the-money options in an effort to cut costs
while limiting risk.

Option Pricing
There is an enormous amount of options available at multiple stock
markets all over
the world. However, it is not always clear that these options are correctly
priced. To determine if an option carries the right price Fisher Black and
Myron Scholes developed in 1973 an option pricing model, known as the
Black-Scholes option pricing model. This model is the most widely used
and the best model available to determine if an option is correctly priced.
The formula for the Black-Scholes model is:
C ( S , T )=S ( d 1 ) K ert ( d 2 )
Where
K
S /+ ( r + 2 /2 ) T

ln
d 1=
K
S /+ ( r 2 /2 ) T

ln
d 2=
and
C = price of a call
S = current stock price
K = strike price
r = constant risk-free interest rate
T = time to maturity in years
= stock price volatility
For a put option the Black-Scholes formula is:

P ( S , T )=K ert (d 2 )S ( d 1 )
P = price of a put
Despite its heavy usage the Black-Scholes model has a number of
limitations. Black
and Scholes assumed a number of ideal conditions.
These are:
1) Interest rate is constant through time
2) The variance rate of return on the stock is constant
3) The stock pays no dividends
4) The model assumes the usage of European options
5) No transaction costs