Option Trading Strategies With Real Examples

INTRODUCTION:- Currency options are derivative instrument, which give buyer of the option the right but not the obligation to execute a spec...

INTRODUCTION:-

Currency options are derivative instrument, which give buyer of the option the right but not the obligation to execute a specified transaction in the underlying currency pair. It gives the buyer the flexibility to execute settlement of option or not. These are different from other derivatives like forwards and futures in a way that it provides downside protection against risk and also an upside benefit from favorable movement in the underlying exchange rates.

Since the person has the right to buy or sell the foreign currency but not the obligation. It can let the option expire by not exercising its right, in case the exchange rate moves in its favour thereby making the profits. It would not have made had it hedged through currency forwards or currency futures.

However, the above advantage does not come free because the above feature currency options generally cost more than other tools of hedging. The other advantage offered by options are flexibility in selecting the exchange rate at which a currency can be bought or sold unlike for forwards or futures in which there is only one exchange rate.

There are two types of currency options i.e. CALL & PUT as elucidated below:

Profit/Loss from an option – The profit/loss arising from currency options under various circumstances are as under:


Intrinsic and Time value: -

The option price or premium can be considered as the sum of two specific elements: intrinsic value and time value.

Intrinsic value:
The intrinsic value of an option is the amount an option holder can realize by exercising the option immediately. Intrinsic value is always positive zero. An out-of-the-money option has zero intrinsic value.

Intrinsic value of in-the-money call option = Spot price – Exercise price 
Intrinsic value of in-the-money put option = Exercise price – Spot price 

Time value:
Time value of an option is the value over and above intrinsic value that the market on the option. It can be considered as the value of the continuing exposure to the movement in the underlying product price that the option provides. The price that the market puts on this time value depends on a number of factors: time to expiry, volatility of the underlying product price, risk free interest rates and expected dividends.

Time to expiry:
Time has value, since the longer the option has to go until expiry. The more opportunity there is for the underlying price to move to a level such that the option becomes in-the-money. Generally the longer the time to expiry, the higher the option’s time value. As expiry approaches, the value of an option tends to zero and the rate of time decay accelerates.

OPTION TRADING STRATEGIES:-


The following data related to particular strategies is of TCS-March 2016.

BULL SPREAD STRATEGY:

Purpose of Strategy:-
The strategy is useful if investor is expecting rise in the market. 

Formulation of Strategy:- 
The investor will purchase a call option with an exercise price E1, and write another call option with an exercise price E2, with the same maturity date. 
(E2 > E1) 

Outcome of Strategy:-
The strategy will provide maximum limited profit, if spot price goes beyond to the investors and have maximum limited loss if the price falls below E1. 

Example: 
S0 = Rs. 2276.65 
E1 = Rs. 2300 Call Option - Rs. 42.65 Premium – BUY 
E2 = Rs. 2350 Call Option - Rs. 23.85 Premium - WRITE 
Lot Size = 200 
Net Premium = (3,760.00)



BEAR SPREAD STRATEGY:-

Purpose of Strategy:- 
The strategy is useful when investor is expecting fall in the market. 

Formulation of the Strategy:- 
The strategy can be used by purchasing a call option with an exercise price E2  and writing another call option with an exercise price E1. 
(E2 > E1) 

Outcome of the Strategy:- 
The strategy will provide maximum limited profit if price goes below. Similarly it provides maximum limited loss if price goes above. 

Example: 
S0 = Rs. 2276.65 
E1 = Rs. 2200 – Call Option - Rs. 104.40 Premium – WRITE 
E2 = Rs. 2250 – Call Option - Rs. 69.85 Premium – BUY 
Lot Size = 200 
Net Premium = 6,910.00 



BUTTERFLY STRATEGY:-

Purpose of Strategy:- 
The Butterfly spread strategy is useful to an investor if he expects that market is likely to remain same in near future. 

Formulation of the Strategy:- 
The Butterfly strategy can be created by purchasing a call option with an exercise price E1, he will purchase another call option with an exercise price E3, and simultaneously two (2) call options will be written with an exercise price E2. 
(E3 > E2 > E1) 

Outcome of the strategy:- 
The strategy will provide the benefit if on the day of settlement price is near to E2. Similarly sharp movement happens in either direction than it provides maximum limited loss. 

Example: 
S0 = Rs. 2276.65 
E1 = Rs. 2250 – Call Option - Rs. 69.85 Premium – BUY 
E2 = Rs. 2300 – Call Option - Rs. 42.60 Premium – WRITE (2) 
E3 = Rs. 2350 – Call Option - Rs. 23.85 Premium – BUY 
Lot Size = 200 
Net Premium = (1,680.00) 



STRADDLE STRATEGY:-

Purpose of Strategy:- 
When it is expected a significant change in market but not sure about its direction. 

Formulation of the strategy:- 
The straddle strategy can be formulated by purchasing a call option and put option all with the same exercise price with same maturity date. 

Outcome of the strategy:-
The strategy will provide unlimited profit if significant change happens in either direction, else it will provide limited loss. 

Example: 
S0 = Rs. 2276.65 
E1 = Rs. 2250 – Call Option - Rs. 69.85 Premium – BUY 
E1 = Rs. 2250 – Put Option - Rs. 42.50 Premium – BUY 
Lot Size = 200 
Net Premium = (22,470.00) 




STRAP STRATEGY:-

Purpose of Strategy:- 
When an investor is expecting upside in the near future but in the same time he anticipates a little chances that market may down. 

Formulation of the Strategy:-The strategy will be formulated by purchasing two (2) call option and one put option all with same exercise price with same maturity date. 

Outcome of the Strategy:- 
The strategy will provide sharp upside profit if market goes up, similarly if market moves down than it provides a little profit. 

Example: 
S0 = Rs. 2276.65 
E1 = Rs. 2300 – Call Option - Rs. 42.65 Premium – BUY (2) 
E1 = Rs. 2300 – Put Option - Rs. 60.25 Premium – BUY 
Lot Size = 200 
Net Premium = (29,110.00)




STRIP STRATEGY:-

Purpose of Strategy:- 
The purpose of the strategy is to design a strategy for an investor if chances of down side are more than upside. 

Formulation of the Strategy:- 
The strategy should be formulated by purchasing two (2) put options and one call option all with same exercise price and same expiry date. 

Outcome of the Strategy:- 
The strategy will provide unlimited sharp profit if market moves down and a little profit if market goes up. 

Example: 
S0 = ?2276.65 
E = ? 2250 – Call Option - ? 69.85 Premium – BUY 
E = ? 2250 – Put Option - ? 42.50 Premium – BUY (2) 
Lot Size = 200 
Net Premium = (38,070.00) 



Conclusion:

By applying various option strategies an investor can have different returns. As investors are rational and decision maker the selection of strategy depends upon the rationalization of an investor.

Because different investor can have different perception about the market movement like some investors can be bullish about market while at same time some can have bearish look towards the market at same time others can have neutralized the perception about market movement.

But, by applying option strategy an investor can reduce or limit their risk in order to get significant return. Like bullish investor can apply bull spread strategy as willing to take limited profit by limited risk with lower investment. While same can apply straddle strategy to get higher return with little higher risk.

Author Bio:

This Article is created and written by Brijesh Dave (MBA Finance)  and also a professional article writer for finance and economics blogs. He is also specialized to write article on Stock Market. He described here option trading strategies with real examples of TCS March 2016. Contact him on Yahoo Mail and Facebook.

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