Advance Trading Strategies & Derivative

Concepts
Section 1:
Volatility Spreads

2
Long Straddle

I. Buy 1 ATM Call & Buy 1 ATM Put.

II. Payoff = C1+P1

III. Initial Payout is the combined Premium paid on call & put option.

IV. Strategy is used when one expects huge movement in the underlying but
he/she is not sure about the direction of the movement.

V. Loss is limited to the extent of initial Payout.

VI. Potential Profit is unlimited in case there is a large movement.

VII. Long Greeks -Gamma, Vega

VIII. Short Greeks -Theta

3
Long Straddle (Payoff)

400
346 346
300

200
146 146
100
46 46
0
54 54
100
154 154
200

300 254 Spot Price 5500

Strike Price 5500
Call Price 145
Put Price 109
4
Short Straddle

I. Sell 1 ATM Call & Sell 1 ATM Put.

II. Payoff = -(C1+P1)

III. Initial Pay in is the combined Premium received on call & put option.

IV. Strategy is used when one does not expect huge movement in the
underlying in either direction.

V. Profit is limited to the extent of initial Pay in.

VI. Potential loss is unlimited in case there is a large movement.

VII. Short Greeks -Gamma, Vega

VIII. Long Greeks -Theta

5
Short Straddle (Pay off)

300 254

200
100
54 54
0
46 46
100
146
200
246 246
300
346 346
400
Spot Price 5500
Strike Price 5500
Call Price 145
Put Price 109
6
Long Strap
I. Buy 2 ATM Calls & Buy 1 ATM Put.

II. Payoff = 2C1+P1

III. Initial Payout is the combined Premium paid on calls & put option.

IV. Strategy is used when one expects huge movement in the underlying but
he/she is not sure about the direction of the movement.

V. At the same time one is more bullish than bearish thinking that there will
be breakout on upside.

VI. Loss is limited to the extent of initial Payout.

VII. Potential Profit is unlimited in case there is a large movement.

VIII. Long Greeks -Gamma, Vega

IX. Short Greeks -Theta

7
Long Strap (Payoff)

1,000

800 800

600

400 400

200 200

0 0 0

200
200 200
400 400

600 Spot Price 5500

Strike Price 5500
Call Price 145
Put Price 109
8
Short Strap
I. Sell 2 ATM Calls & Sell 1 ATM Put.

II. Payoff = -(2C1+P1)

III. Initial Pay in is the combined Premium received on calls & put option.

IV. Strategy is used when one does not expects huge movement in the
underlying.

V. At the same time one is more bearish than bullish thinking that there will
not any be breakout on upside.

VI. Profit is limited to the extent of initial Pay in.

VII. Potential Loss is unlimited in case there is a large movement.

VIII. Short Greeks -Gamma, Vega

IX. Long Greeks Theta

9
Short Strap (Payoff)

600

400 400

200 200 200

0 0 0

200 100 200

200
400

600

800 800
Spot Price 5500
1,000 Strike Price 5500
Call Price 145
Put Price 109 10
Long Strip
I. Buy 1 ATM Call & Buy 2 ATM Puts.

II. Payoff = C1+2P1

III. Initial Payout is the combined Premium paid on call & put options.

IV. Strategy is used when one expects huge movement in the underlying but
he/she is not sure about the direction of the movement.

V. At the same time one is more bearish than bullish thinking that there will
be breakout on downside.

VI. Loss is limited to the extent of initial Payout.

VII. Potential Profit is unlimited in case there is a large movement.

VIII. Long Greeks -Gamma, Vega

IX. Short Greeks -Theta

11
Long Strip (Payoff)

1,000

800 837

600

400 437

200 237 237

0 37 37

200
263
400 163 363
Spot Price 5500
600 Strike Price 5500
Call Price 145
Put Price 109
12
Short Strip
I. Sell 1 ATM Call & Sell 2 ATM Puts.

II. Payoff = -(C1+2P1)

III. Initial Pay in is the combined Premium received on call & put options.

IV. Strategy is used when one does not expects huge movement in the
underlying in either direction

V. At the same time one is more bullish than bearish and hence confident of
betting more against downside rather than upside.

VI. Profit is limited to the extent of initial Pay in.

VII. Potential loss is unlimited in case there is a large movement.

VIII. Short Greeks -Gamma, Vega

IX. Long Greeks -Theta

13
Short Strip

600

400 363

200 163
63
0 37 37
137
200 237
400

600

800 837
1,000
Spot Price 5500
Strike Price 5500
Call Price 145
Put Price 109
14
Long Strangle
I. Buy 1 OTM Call & Buy 1 OTM Put.

II. Payoff = C1+P1

III. Initial Payout is the combined Premium paid on call & put option.

IV. Strategy is used when one expects very huge movement in the underlying
but he/she is not sure about the direction of the movement.

V. Also, One wants to pay lesser premium as compared to straddle & is will
to bet on larger movement in either direction to make profits.

VI. Loss is limited to the extent of initial Payout.

VII. Potential Profit is unlimited in case there is a large movement.

VIII. Long Greeks -Gamma, Vega

IX. Short Greeks -Theta

15
Long Strangle (Payoff)

400

333 333
300

200

133 133
100

67 67
100

Spot Price 5500

200 167 167 167 Strike Price 5600
Call Price 98
Strike Price 5400
Put Price 69 16
Short Strangle
I. Sell 1 OTM Call & Sell 1 OTM Put.

II. Payoff = -(C1+P1)

III. Initial Pay in is the combined Premium received on call & put option.

IV. Strategy is used when one expects range bound markets.

V. Also, One is happy with a lesser premium as compared to straddle & is

willing to get higher security of larger movement in either direction
before he/she starts making losses.

VI. Profit is limited to the extent of initial Pay in.

VII. Potential loss is unlimited in case there is a large movement.

VIII. Short Greeks -Gamma, Vega

IX. Long Greeks -Theta

17
Short Strangle

200 167 167

100 67 67

0 33 33

100
133 133
200

300
333 333
400 Spot Price 5500
Strike Price 5600
Call Price 98
Strike Price 5400
Put Price 69 18
Long Butterfly Spread Using Call Options

I. Buy 1 ITM & 1 OTM Call & Sell 2 ATM Calls.

II. i.e .Buy Call with Lower Strike Price than spot & buy call with a higher
strike price than spot . & Sell 2 Calls with Strike Price equal to spot price.

III. Payoff = C1 +C2 -2C3

IV. Initial Payout is the Difference Between the Premiums

V. Strategy for a range bound market with low IV wherein you want to
protect downside either on upside or on down side.

VI. Loss is limited on the Downside to the extent of initial Payoff.

VII. Profit on the Upside is Capped based on ITM & OTM Calls bought.

19
Long Butterfly Spread Using Call Options (Payoff)

100 89 Spot Price 5500

80 Strike Price 5500
Call Price 145
Strike Price 5400
60
Call Price 203
Strike Price 5600
40 Call Price 98

20

0
S0 4900 5000 5100 5200 5300 5400 5500 5600 5700 5800 5900 6000
20 11 11 11 11

20
Long Butterfly Spread Using Put Options

I. Buy 1 ITM & 1 OTM Put & Sell 2 ATM Puts.

II. i.e .Buy Put with Lower Strike Price than spot & buy Put with a higher
strike price than spot . & Sell 2 Puts with Strike Price equal to spot price.

III. Payoff = P1 +P2 -2P3

IV. Initial Payout is the Difference Between the Premiums

V. Strategy for a range bound market with low IV wherein you want to
protect downside either on upside or on down side.

VI. Loss is limited on the Downside to the extent of initial Payoff.

VII. Profit on the Upside is Capped based on ITM & OTM Puts bought.

21
Long Butterfly Spread Using Put Options (Payoff)

100
88 Spot Price 5500
Strike Price 5500
80 Put Price 109
Strike Price 5400
Put Price 161
60
Strike Price 5600
Put Price 68
40

20

0
S0 4900 5000 5100 5200 5300 5400 5500 5600 5700 5800 5900 6000
12
20 12 12 12
22
Short Butterfly Spread Using Call Options

I. Sell 1 ITM & 1 OTM Call & Buy 2 ATM Calls.

II. i.e. Sell Call with Lower Strike Price than spot & Sell Call with a higher
strike price than spot . & Buy 2 Calls with Strike Price equal to spot price.

III. Pay in = 2C3 C1-C2

IV. Initial Payin is the Difference Between the Premiums

V. Strategy for a directional market with high IV wherein you want to make
money either on upside or on down side.

VI. Profit is limited on the upside to the extent of initial Payoff invested at
risk free rate.

VII. Loss on the downside is Capped based on ITM & OTM Calls bought.

23
Short Butterfly Spread Using Call Options (Payoff)

NET PAYOFF
100
47 47
50

0
53 53
50

100
Spot Price 5500
150 153 Strike Price 5500
Call Price 145
200 Strike Price 5300
Call Price 274
Strike Price 5700
Call Price 63

24
Short Butterfly Spread Using Put Options

I. Sell 1 ITM & 1 OTM Put & Buy 2 ATM Puts.

I. i.e. Sell Put with Lower Strike Price than spot & Sell Put with a higher
strike price than spot . & Buy 2 Puts with Strike Price equal to spot price.

II. Pay in = 2P3 P1-P2

III. Initial Payin is the Difference Between the Premiums

IV. Strategy for a directional market with high IV wherein you want to make
money either on upside or on down side.

V. Profit is limited on the upside to the extent of initial Payoff invested at

risk free rate.

VI. Loss on the downside is Capped based on ITM & OTM puts bought.

25
Short Butterfly Spread Using Put Options (Payoff)

NET PAYOFF
100
48 48 48 48
50
52 52
0

50

100

150 152 Spot Price 5500

Strike Price 5500
200 Put Price 109
Strike Price 5300
Put Price 40
Strike Price 5700
Put Price 226
26
Long Condor Using Call Options

I. Buy 1 ITM & 1 OTM Call & Sell 1 ITM Call with strike price higher than
the one bought & sell 1 OTM call with strike price lower than the 1
bought.

II. Payoff = C1 +C4 C2 C3

III. Initial Payout is the Difference Between the Premiums

IV. Strategy for a range bound market with low IV wherein you want to
protect downside either on upside or on down side.

V. Loss is limited on the Downside to the extent of initial Payoff.

VI. Profit on the Upside is Capped based on ITM & OTM Calls bought.

27
Long Condor Using Call Options (Payoff)

NET PAYOFF
100 Spot Price 5500
Strike Price 5500
80 77 Call Price 145
77
Strike Price 5400
60 Call Price 203
Strike Price 5600
40 Call Price 98
Strike Price 5300
20 Call Price 274

0
S0 5000 5100 5200 5300 5400 5500 5600 5700 5800 5900 6000 6100
20 23 23 23 23 23 23 23 23 23 23
23
40

28
Long Condor Using Put Options

I. Buy 1 ITM & 1 OTM Put & Sell 1 ITM Put with strike price lower than the
one bought & sell 1 OTM put lower with strike price lower than the 1
bought.

II. Payoff = P1 +P4 P2 P3

III. Initial Payout is the Difference Between the Premiums

IV. Strategy for a range bound market with low IV wherein you want to
protect downside either on upside or on down side.

V. Loss is limited on the Downside to the extent of initial Payoff.

VI. Profit on the Upside is Capped based on ITM & OTM Puts bought.

29
Long Condor Using Put Options (Payoff)

NET PAYOFF
Spot Price 5500
100
Strike Price 5500
80 Put Price 109
77 77 Strike Price 5400
60 Put Price 161
Strike Price 5600
40
Put Price 68
20 Strike Price 5300
Put Price 40
0
S0 5000 5100 5200 5300 5400 5500 5600 5700 5800 5900 6000 6100
20
23 23 23 23 23 23 23 23 23 23 23
40

30
Facts to remember about Volatility Spreads

I. In case of Long Volatility Spreads one is always long on Gamma, Vega &
short on Theta.

II. Direction is irrelevant as long as price action is sufficient enough to

recover the initial cost.

III. While making long volatility Spreads one should be careful about the
Implied Volatilities ()in option pricings.

IV. The above point is important as one will only make money provided there
is sufficiently large movement to offset his/her initial cost.

V. Also one must remember as per efficient market hypothesis, the events
such as State/Central Government Results, Union Budgets, Individual
Company Results , Credit Policies etc will already be discounted by the
markets & will be reflected in option prices.

31
Section 2:
Time Spreads

32
Calendar Spreads Using Call/Put Options

I. Sell 1 ATM Call with lower maturity & buy 1 ATM Call with higher maturity.

II. Payoff = CT2-CT1

III. Initial Payout is the Difference Between the Premiums

IV. Strategy for a range bound market.

V. Loss is limited to the extent of initial Payoff.

VI. Profit on the Upside is Capped.

VII. Long Greek- Theta

VIII. Short Greek- Gamma ,Vega

33
Calendar Spreads Using Call Options
100
Spot Price 5500
80 Strike Price 5500
74
Call Price (1 month) 145
60
Call Price (2 months) 217
40

20 24
8
0
13
20 21
32
40 38
60 54
68 64
80

The above profit diagram is constructed assuming remains the same for both the
options on the date when the option with lesser time to maturity expires & option
with higher time to maturity is sold on the same day.
34
Calendar Spreads Using Put Options

Spot Price 5500

100
Strike Price 5500
80 Call Price (1 month) 109
74
60 Call Price (2 months) 144
40
35
20 24
8
0
20 21
28 32
40
60 54
68
80

The above profit diagram is constructed assuming remains the same for both
the options on the date when the option with lesser time to maturity expires &
option with higher time to maturity is sold on the same day.
35
Section 3:
Ratio Spreads

36
Bull Ratio Spread Using Call Options

I. Buy ITM or ATM Call & Sell 2 OTM Calls. (Ratio 1:2, could be changed)

II. i.e .Buy Call with Lower Strike Price & higher premium & Sell 2 Calls with
Higher Strike Price & Lower Premium

III. Payoff = C1-2C2

IV. Initial Payout is the Difference Between the two Premiums is close to 0

V. Bullish Strategy with range capped at a higher end where the call is sold.

VI. Loss is limited on the Downside to the extent of initial Payoff, however
unlimited losses in case the expiry occurs significantly above higher strike
price.

VII. Profit on the Upside is Capped and is maximum at a strike price for which
calls are sold.

37
Bull Ratio Spread Using Call Options
Spot Price 5500
Strike Price 5500
250 Call Price 145
Strike Price 5700
200 Call Price 63
181
150
100
81 81
50
0
19 19 19 19 19
50 S0 4900 5000 5100 5200 5300 5400 5500 5600 5700 5800 5900 6000

100
119
150
200
219
250
38
Bear Ratio Spread Using Put Options

I. Buy ITM or ATM Put & Sell 2 OTM Puts. (Ratio 1:2 could be changed)

II. i.e .Buy Put with higher Strike Price & higher premium & Sell 2 puts with
Lower Strike Price & Lower Premium

III. Payoff = P1-2P2

IV. Initial Payout is the Difference Between the two Premiums is close to 0

V. Bearish Strategy with range capped lower strike for which put is sold.

VI. Loss is limited on the Upside to the extent of initial Payoff, however
unlimited losses in case the expiry occurs significantly below lower strike
price for which puts are sold.

VII. Profit on the downside is Capped and is maximum at a strike price for
which puts are sold.
39
Bear Ratio Spread Using Put Options

Spot Price 5500

200 174 Strike Price 5400
Put Price 69
150 Strike Price 5200
Put Price 22
100
74
74
50

0
26 26 26 26 26
50

100
126
150

40
Section 4:
Diagonal Spreads

41
Diagonal Spreads

I. All the spreads created so far, We have assumed Long Position in 1 or

more Calls/ Puts and short position in 1 or more Calls/Puts.

II. In case of Directional Spreads Strike Prices were different but time to
maturity was same for all the options

III. In case of Time spreads Strike Prices were same but time to expiry was
different.

IV. In case of Diagonal Spreads both these variables i.e. Strike Prices & Time
to expiry are different for both the options in the consideration.

V. These are typically used for ranges in which one is willing for profits.

42
Diagonal Spreads Using Call Options

I. Sell 1 ATM Call with lower maturity & buy 1 ITM Call with higher maturity.

II. Payoff = CT2-CT1

III. Initial Payout is the Difference Between the Premiums

IV. Strategy for a range bound market with positive bias.

V. Loss is limited to the extent of initial Payoff.

VI. Profit on the Upside is Capped but no loss even if the market rallies
substantially.

VII. Long Greek- Theta

VIII. Short Greek- Gamma ,Vega

43
Diagonal Spreads Using Call Options

Spot Price 5500

Strike Price 5500
100 Call Price (1 month) 145
Strike Price 5400
74
Call Price (2 months) 275
50
29
12 8 6 5
0
S0

4900
5000
5100
5200
5300
5400
5500
5600
5700
5800
5900
6000
6100
6200
6300
6400
37
50
74
100
123
150

44
Section 5:
Options Beta ()

45
Options Beta
I. Options Beta = (% Change in the option price)/(% change in the Spot Price)
II. i.e. = ((C2-C1)/C1)/((S2-S1)/S1)
i.e. = * S1/C1 (Same can be seen in case of Put Options)
III. Since S1/C1 is grater than 1 because of the risk & leverage is always
greater than .
IV. Options is a measure of the risk taken. Higher the risk taken higher will be
the .
V. OTM Options are more risky as compared to ATM or ITM options
VI. So, OTM Options >= ATM Options >= ITM Options
VII. In case of Puts will be negative in sign but similar in nature as in case of
Calls.

46
Section 6:
Pair Trading

47
What is Pair Trading?

I. Pair Trading is a process wherein trader Sells one security which is

overpriced & buys another security which is underpriced.

II. The above mentioned overpricing/under pricing is in context of another

based on combined historical performance of 2 securities and not in
absolute terms.

III. The 3 most common types of Pair Trading strategies are

A. Statistical arbitrage
B. Relative fundamental
C. Risk arbitrage

IV. The one most commonly used by traders is Statistical Arbitrage.

48
Statistical Arbitrage

I. Market neutral long/short strategy i.e. Equal Gross Long & Short Exposure
in such a way Net Long/Short position is ideally 0 or very close to it.

II. Select equity pairs which have exhibited high correlation in price
movements in the past.
A. Generally Stocks from same sector
B. A stock from a particular sector & an index of the same sector.
C. A Stock & Market Index

III. Enter into a trade when the price ratio of an equity pair is significantly
deviated from its long run equilibrium level. ( Generally 3 months or 6
months)

IV. Unwind the trade when the price ratio returns to its equilibrium.

49
Mean Reversion Behaviour

I. Statistical arbitrage is premised on the existence of mean reversion

behaviour which will correct the mispricing and restore an equity pairs price
ratio to its long run equilibrium.

II. High correlation does not necessarily lead to mean reversion.

III. The price ratio of an equity pair exhibits mean reversion behaviour if it
fluctuates around a mean level.

IV. Co-integration is a statistical measure for mean reversion

50
Correlation v/s Co-Integration

I. The correlation coefficient is a measure of the degree of linear relationship

between two variables, usually labeled X and Y. In equity pair trading,
correlation is measured by price returns of two stocks..

II. The high correlation is a essential for pair trading it is not sufficient to
execute a pair trade.

III. Co-integration and correlation are related, but different concepts.

IV. Two variables are said to be having co-integration property only when they
have a reversion to mean property.

V. This reversion to mean property was discovered by Robert F. Engle and Clive
W.J. Granger in 1987.

51
Importance of Co-Integration

I. If the 2 variables i.e. Security/ An index show an Mean reversion behavior

historically, Typically over a 3 to 6 months period then they are said to be co-
integrated.

II. If there is significant deviation from the mean in such a case then based on
the historical standard deviation one can execute a pair trade with a fair
degree of conviction.

III. Also, Please do remember pair trades, just like any other trades are executed
with targets, time frames and trailing stop-losses in mind.

52
Practical Example

I. Short Sun Pharma - long Dr. Reddy

II. Potential upside 10.5% return on gross exposure (~`4m).

III. The preceding six months has seen Sun Pharma outperform Dr. Reddy by ~19.8%.

IV. The current price ratio is trading 2.01 STD DEV above its trailing 6-M mean of ~0.276 (in
excel)

V. We expect this mispricing to correct given co-integration exhibited over the sample time
frame. Our assumed trading span would be a 30-day period. An intermediate target of
0.276 would yield 10.8%.

VI. A stop loss of 0.32 (-4.4% on GEP) must be maintained for the trade implying a risk reward
ratio of 1:2.4.

VII. Rupee Neutral Trade: Sell 13lots of Sun Pharma & Buy 10 lots of Dr. Reddy (approx).

53
Tendency of Mean Reversion (Dr Reddy Sun Pharma)

1900
1850 540
1800 520
1750 500
1700
1650 480
1600 460
1550 440
1500
1450 420
1400 400

DrReddy

SUNPHARMA

54
 0.24
0.25
0.26
0.27
0.28
0.29
0.30
0.31
0.32
0.33
Date
16-Dec-10
28-Dec-10
06-Jan-11
17-Jan-11
27-Jan-11
07-Feb-11
16-Feb-11
25-Feb-11
09-Mar-11
18-Mar-11
29-Mar-11
07-Apr-11
20-Apr-11
02-May-11
11-May-11
20-May-11
31-May-11
Tendency of Mean Reversion (Dr Reddy Sun Pharma Price Ratio)

Average
Long Term
Actual Ratio

55
Mean Itself can change over a period of time

5.30
4.80
4.30
3.80
Current Ratio
3.30
2.80 Long Term Average
2.30
1.80
28-Nov-05

19-Nov-10
Date

05-Mar-08

15-May-09
29-Sep-09
18-Feb-10
08-Jul-05

19-Apr-06

22-Oct-07

07-Jul-10
07-Jun-07

25-Jul-08
17-Dec-08

06-Apr-11
30-Aug-06

23-Aug-11
16-Jan-07

11-Jan-12
As can be seen from the above graph long term graph of Infosys & TCS 6 month
mean itself can deviate significantly so Stop Loss is a must for a Pair Trade.

56
Section 7:
Value at Risk

57
Value at Risk ( How bad the things can get?)

Value at Risk (VaR) is the maximum loss that can incur at a

specified confidence level.

VaR is an attempt to provide a single number summarizing the

total risk in a portfolio of Financial Assets for decision makers.

E.G. We are X percent certain that we will not lose more than Y
Rupees in the next N days.

58
Calculation of VaR

VaR is usually calculated for one day.

N Day VaR= 1-Day VaR * Sqrt(N)

59
Methods used for calculation of VaR

Historical Simulation

Model based Approach

60
Historical Simulation

Past data is used as a guide to what might happen in future.

All the market variables are identified.

Market data for the same is taken for last 500 days.

This provides for 500 alternative scenarios for what will happen
between today & tomorrow.

Then estimate percent changes for each variable assuming the

same % changes as on day 1( 500 days before); as on day 2( 499
days before) and so on.

61
Historical Simulation

For each of these combinations calculate the value of the

portfolio.

The changes in the value of the portfolio are then serially ranked..

For a data of 500 scenario the 5th worst case is the one day 99%
VaR.

N Day VaR= 1-Day VaR * Sqrt(N)

Each day VaR is updated using latest 500 day data.

62
Model Based Approach

Also known as variance-covariance approach.

Uses value of per day rather than a year.

per day = per year/ Sqrt (252) assuming there are 252 trading
days.

Example Rs. 2 Cr worth Infosys

Example Rs. 4 Cr. worth Reliance.

Combined Portfolio of the above 2 securities. ( In class)

63
Linear Model

The above examples were simple examples of Linear Model.

Suppose we have a portfolio P consisting of N number of assets

with amount i being invested in asset i. (1<= i<=n) .

P = from i=1 to i= n , i * xi

The above said Linear model can be extended to options as well.

In case of options * share price will replace the plane share price
as in case of simple non derivative instrument portfolio.

64
Other Approaches

Quadratic Model.

Monte Carlo Simulation

(Hull- Page No- 378-81)

65
THANK YOU