In the Options module, we talked about various aspects related to Options. For those who went through it, we hope that we were successful in helping the reader understand the diverse facets of Options, starting right from the basic elements before moving to more advanced and critical areas. Meanwhile, for those who haven’t yet completed the Options module, we highly recommend you go through it before proceeding with this module. We assume that the reader has a good understanding of various concepts related to Options that we have discussed previously.
Before beginning ourdiscussion on various Option Strategies, we thought that it would be a good idea to refresh some of the key Option-related concepts that we discussedover the last several chapters. This will help one in recollecting the key terms that are worth knowing before going throughthe Option Strategies. We shall concludethis chapter by talking about what all strategies we intend to discuss in thecoming chapters. So, let us get started.
An option is a derivative contract that gives the holder of the instrument (i.e. the buyer) the right, but not an obligation, to buy or sell an underlying asset at a certain fixed price on or before a pre-determined date.
There are two types of Options, namely Call option and Put Option. A Call option is an option that gives the buyer a right, but not an obligation, to buy an underlying asset at a certain fixed price on or before a pre-determined date. A Put option is an option that gives the buyer a right, but not an obligation, to sell an underlying asset at a certain fixed price on or before a pre-determined date.
The pre-agreed price at which the asset will be exchanged on or before the pre-determined date is called the strike price or the exercise price.
Option price is the price that the buyer must pay to the seller to acquire the right to the option contract. Option price is composed of two components, time value and intrinsic value.
Intrinsic Value is the In-the-Money component of an option price. An option that is At-the-Money or Out-of-the-Money has no intrinsic value.
Time Value is the additional premium that an option buyer must pay to the option seller to compensate the option seller for taking the ‘time’ risk. The greater the time to expiration, the greater would be the time value, and vice versa.
An American option is an option that can be exercised at any time up to the expiry of the option contract.
A European option is an option that can be exercised only on the expiry day of the option contract. All options that are traded on Indian exchanges are European-type options.
The type of option
The underlying price
The strike price
Time to expiration
Dividend (in case the underlying is a stock)
The term Delta comes from the Greek symbol ‘Δ’. It measures the rate of change in an option price based on a 1-point change in the price of the underlying. Put it simply, Delta measures the speed at which the price of an option changes for a change in the underlying price.
The term Gamma comes from the Greek symbol ‘Γ’. It measures the rate of change in Delta based on a 1-point change in the price of the underlying. Put it simply, Gamma measures the pace at which the Delta changes for a change in the underlying price.
The term Vega is commonly denoted using the symbol ‘K’. It measures the change in an option price based on a 1-point change in the underlying’s implied volatility (or IV). Put it simply, Vega measures the sensitivity of an option price to changes in volatility of the underlying.
The term Theta comes from the Greek symbol ‘Θ’. It measures the change in option price based on a change in the time to expiration. Put it simply, Theta measures the rate at which the option price loses its value due to the element of time decay.
The term Rho comes from the Greek symbol ‘ρ’. It measures the rate of change in an option price based on a change in the risk-free interest rate. Put it simply, Rho measures the sensitivity of an option price to changes in interest rate.
Volatility is the rate at which the price of an asset fluctuates over time. The higher the volatility, the higher is the magnitude of the fluctuation in price, and vice versa.
Standard Deviation, denoted by the Greek letter σ, measures the amount of dispersion around the mean, where mean is the average of the observations within the data set over the past ‘n’ periods.
Historical volatility measures the dispersion around the mean for daily returns on an annualized, percentage basis. It measures how volatile the movements in prices have been over the specified period.
Implied volatility is used to measure future volatility. It is based on what market participants imply the volatility of the underlying will be over the remaining life of an option contract.
Volume refers to the total number of contracts that are created over the course of the day. For instance, a volume of 100 represents 100 contracts have been traded on a particular option during the day.
Open interest refers to total number of option contracts that have been created but have not yet been closed out. In other words, it refers to the total number of open option positions till date.
Put Call ratio is a ratio showing the open interest of Put options relative to the open interest of Call options. Occasionally, volume is also used in place of open interest.
VIX is usually expressed as the 30-day implied volatility of index options that are traded on an exchange. It is a very commonly used measure of risk and tells a lot about the prevailing risk sentiment in the market. VIX and the underlying instrument tend to move in the opposite direction.
This theory states that as the expiration approaches, there is a tendency for the price of the underlying asset to gravitate towards the strike price where the largest number of option contracts will expire worthless. In other words, Maximum Pain is that point (strike price) on the Option Chain that would cause the least amount of loss to option writers and the maximum loss to option buyers.
In this Module, we will discuss several Option strategiesstarting right from the simple, single-legged strategies before proceeding to more complex, multi-legged strategies. Unlike futures, where only a limited number of strategies can be deployed, Options open up the door for creating a multitude of different strategies using various combinations of the four basic strategies - long Call, short Call, long Put, and short Put. In some strategies, options are even combined with the underlying instrument. The type of strategies that could be created using options depends on various factors, such as the trader’s risk and reward profile (risk averse vs. risk taker), view of the underlying asset (bullish, bearish, or neutral), view about volatility (high volatility or low volatility), objective of the trader (capital appreciation,regular income, or hedging) etc.
We shall discuss each Option strategy in detail and shall devote one chapter to each strategy, wherein we shall cover various aspects of the strategy from both long perspective and short perspective. For instance, there will be one chapter devoted to buying and selling a naked Call option, one chapter devoted to buying and selling a naked Put option, one chapter devoted to buying and selling a Straddle, and so forth. Once a reader goes through and understands each of these strategies, he or she can also use them as a reference at any point in time.
While knowing these strategies will provide the reader with key inputs, we would like to caution that these strategies are not a holy grail to making money. One must know which strategy to use when and under what market conditions. One must have a view on the underlying, for instance, before taking an option position. If this view does not pan out as expected, then there is a possibility that the option strategy might turn out to be futile. Hence, one must also know when the accept that an option strategy has gone wrong and be prepared to exit the trade, if necessary. Even though some option strategies have limited risk, risk management is still important. After all, return of capital should be of foremost priority than return on capital.
Again, before starting with the discussion of Option strategies, we would suggest the reader to go through the Options Modules that we covered earlier. Also, having a knowledge of Fundamental and Technical analysis would be beneficial, given that one needs to have a view on the underlying before deploying an option strategy.
The major strategies that we intend to cover over the course of the next several chapters are as mentioned below:
|Bullish Strategies||Bearish Strategies||Neutral Strategies|
|Long Call||Short Call||Long Call Butterfly|
|Short Put||Long Put||Short Call Butterfly|
|Covered Call||Covered Put||Long Put Butterfly|
|Synthetic Call||Synthetic Put||Short Put Butterfly|
|Bull Call Spread||Bear Call Spread||Long Iron Butterfly|
|Bull Put Spread||Bear Put Spread||Short Iron Butterfly|
|Collar||Bull Put Ladder||Long Call Condor|
|Diagonal Call||Ratio Put Backspread||Short Call Condor|
|Diagonal Put||Long Put Condor|
|Bear Call Ladder||Short Put Condor|
|Ratio Call Backspread||Long Iron Condor|
|Calendar Call||Short Iron Condor|
|Calendar Put||Long Straddle|
|Bull Call Ladder|
|Bear Put Ladder|
In all, there are a total of 39 strategies that we intend to cover. Also, we have divided Option strategies into three parts: bullish, bearish, and neutral. Bullish strategies are those strategies that benefit when the price of the underlying goes up. Bearish strategies are those strategies that benefit when the price of the underlying goes down. Neutral strategies are those strategies that benefit when the price of the underlying goes in any direction, subject to certain conditions of the concerned individual strategy. Again, as stated earlier, we shall devote one chapter to each strategy, wherein we shall cover various aspects of the strategy from both long perspective and short perspective.
Long Call and Short Call24 Lessons
In this chapter, we shall discuss two of the most basic option strategies: Long Call and Short Call . We shall talk about the various aspects of the two strategies including payoff, Greeks, and examples.
Long Put and Short Put15 Lessons
In this chapter, we shall discuss two of the most basic option strategies: Long Put and Short Put. We shall talk about the various aspects of the two strategies including payoff, Greeks, and illustrations with examples.In this chapter, we shall discuss two of the most basic option strategies: Long Put and Short Put. We shall talk about the various aspects of the two strategies including payoff, Greeks, and illustrations with examples.
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