DR. N.

BHASKARAN

Futures and Options (F&O)

Part 1 – General and about Futures

There is a whole world of financial securities other than stocks and bonds.
One of such securities is Derivatives, which are financial instruments whose
values are derived from the value of the underlying. Hence, they are called
derivative i.e. derive from something else. The underlying on which
derivative is based could be:

• Asset: e.g. stocks, bonds, mortgages, real estate, commodities, real

estate properties.

• Index: e.g. stock market indices, Consumer Price Index, Foreign

Currencies and interest rates

• Other items: e.g. Weather (yes- you will derivatives written on rain!!)

For example - a derivative on a stock derive its value from the value of
underlying stock! There are three main types of derivatives:
o Forwards (similar to Futures),
o Options and
o Swaps.

Futures are very similar to Forwards except for the fact that Futures are
traded on exchange while Forwards are traded over the counter (OTC). This
article focuses only on Futures (F) and Options (O). F&O or any reference to
it, it means Futures & Options.

Why do we need derivatives?

Derivatives are used to either
1. Hedge the risk i.e. lessen the risk which may arise due to changes in
the value of underlying. This is known as hedging.
2. Increase the profit arising from the changes in the value of underlying
in the direction they expect or guess. This is known as speculation.

Hence, there should not be any misconception that derivatives or F&O are
used only by speculators to make money. These are extremely useful
financial instruments which are used by corporate or individuals to mitigate
their risk. But unfortunately same instruments can be used by speculators to
make money. One simple example is nuclear energy. People can use it to
generate 1000s of MW of energy for peaceful purpose whereas others can
use the same nuclear energy to make nuclear bombs for mass destruction. Is
it fair to blame nuclear energy for this? We cannot. So if you want to blame
someone, blame speculators and not derivatives.

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How hedging works?

Assuming that you are not speculator, I will focus on how futures or future
contracts are used for hedging. Suppose I am a petroleum distributor whose
job is to sell petroleum products such as Petrol and Diesel in the market
while you are an airline owner, say Mr.Vijay Mallya. I am in the business of
selling petroleum while you are a net buyer of petroleum products. I will be
concerned with drop in prices of petroleum because that would hurt my
revenues and profit margin. This is because I am selling petrol, right. While
you, an airline owner, would be concerned with any increase in prices of
petroleum because it would increase your costs. Thus we two have a
common concern uncertainty in the price of petroleum products.
To reduce our risk and buy a peace of mind, we will sit together and fix a
price of petroleum to be sold in the future. Thus, I have reduced the risk of
prices going down while you have reduced the risk of prices going up. This is
called hedging.

F&O Market in the US and India

It is a fact that the volume of F&O trade is much more than volume of
stocks trade in the world. This shows the sheer popularity of F&O
instruments among investors. In the US, futures are traded primarily on CME
(Chicago Mercantile Exchange), which is the largest financial derivatives
exchange in the United States and most diversified in the world. CMEs
currency market is the world’s largest regulated marketplace for foreign
exchange (FX) trading. In the US, Options are traded on CBOE (Chicago
Board Options Exchange).
In India Futures and Options are traded on both BSE and NSE. The market
hasn’t developed to its potential yet due to lot of political and regulatory
issues. Hence, the size of derivatives market is much smaller in India as
compared to those in developed worlds.

Forward Contract vs. Futures Contract

While futures and forwards are both contracts to deliver an asset at a fixed
(pre-arranged) price on a future date, they are different in following
respects: (Source: Derivatives India)
Features Forward Contracts Future Contracts
Operational Mechanism Traded Over The Counter Traded on exchange
(OTC) and NOT on
exchange
Contract Specifications Extremely customized; Standardized contracts
differs from trade to trade
Counterparty Risk High because of default Less risky because only margins
risk are settled
Liquidation Profile Poor liquidity due to Very high because contracts are
customized products customized
Price Discovery Poor; as markets are Better because market is on a
fragmented common platform of an
exchange

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Futures
Let us now focus only on Future contracts, which are an agreement between
two parties to buy or sell an asset (underlying) at a given point of time in
the future. They are standardized contract i.e. an agreement, traded on a
futures exchange, to buy or sell a standardized quantity of a specified
commodity of standardized quality at a certain date in the future, at a price
(the futures price) determined by the parties involved. The future date is
called the delivery date or final settlement date. The official price of the
futures contract at the end of a day\'s trading session on the exchange is
called the settlement price for that day of business on the exchange.

I have assumed that no cash settlement was done between the two parties.
A futures contract gives the holder the obligation to make or take delivery
under the terms of the contract. Also both parties of a futures contract
must fulfill the contract on the settlement date it is legally binding. The
seller delivers the underlying asset to the buyer, or, if it is a cash-settled
futures contract, then cash is transferred from the futures trader who
sustained a loss to the one who made a profit. Money lost and gained by
each party on a futures contract are equal and opposite. In other words, a
future trading is a zero-sum game.

Future prices are not definitive statements of prices in the future. In fact
they are not even necessarily predictions of the future. But they are
important pieces of information about the current state of a market, and
futures contracts are powerful tools for managing risks.

Terminology
I will discuss a few terms that are often associated with derivatives. They
are following:
“Underlying”: It is the asset or index on which a derivative is written. For
example a futures index has the underlying as an index.

“Delivery Date”: This is the date at which the underlying will be delivered
by the seller to the buyer. It is also known as final settlement date.

“Future Price”: This is the agreed upon or prearranged price determined

by the instantaneous equilibrium between the forces of supply and demand
among competing buy and sell orders on the exchange at the time of the
purchase or sale of the contract. Simply, the price prearranged between the
seller and the buyer.

“Standardization”: Futures contracts ensure their liquidity by being highly

standardized, usually by specifying:

™ The underlying asset or instrument. This could be anything from a

barrel of crude oil to a short term interest rate.

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™ The type of settlement, either cash settlement or physical

settlement.
™ The amount and units of the underlying asset per contract. This can
be the notional (fictional) amount of bonds, a fixed number of barrels
of oil, units of foreign currency, the notional amount of the deposit
over which the short term interest rate is traded, etc.
™ The currency in which the futures contract is quoted.
™ The grade of the deliverable. In the case of bonds, this specifies
which bonds can be delivered. In the case of physical commodities,
this specifies the quality of the underlying goods
™ The delivery month
™ The last trading date

Types of Futures Contracts

There are a large number of futures contracts trading on future exchanges
around the world. I have highlighted characteristics of each major group of
contracts:

Agricultural Commodities
This category is the oldest group of futures contracts. It includes all widely
used grains such as wheat, soybeans, corn and rice. Additionally, futures are
traded actively on Cocoa, coffee, orange juice, sugar, cotton, wool, wood,
and cattle.

Equities
Futures are actively traded on individual stocks as well as index. These are
generally cash settled i.e. no exchange of stocks happens between the
contracted parties; only the party which loose (prices of stocks move against
them) gives money to the party which wins. Stock index futures have been
quite popular in the market. These contracts are generally indices of a
combination of stocks.

Natural Resources
Futures contracts are actively traded on metals and natural resources.
Metals include gold, silver, copper, aluminum etc while natural resources
include crude.

Foreign Currencies
There is a very large market of futures contract traded on foreign currencies
because a large number of multinational companies are concerned about
the volatility (changes) in the value of currencies of different countries
where they sell or buy their products. Most popular currencies are Japanese
Yen (¥), British Pound (£), Euro () and Swiss Franc (CHF).

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Disadvantages of futures or derivatives

Remember, I gave you an example of Petroleum distributor (me) and airline
owner (you). I will be concerned with the drop in prices of petro products
while you will be worried about a rise in the prices. Let’s say the current
price of petro is Rs. 50 per liter. I think the prices will fall further from Rs.
50 to 40 while you think US might attack Iran and hence prices will go up
from Rs. 50 to 60. So you want to fix a price little higher from today’s price
(but less than what you expect it to be in 3 months) which is favorable to
both of us as per our own calculations and predictions. Two of us decide to
exchange 100 liters of petro 3 months later on March 24, 2009 at a price of
Rs. 55.

Now, imagine US didn’t attack Iran and global economy sink further. Hence,
on May 24, 2009 price of petro products drop to Rs. 45. Here, I, the seller,
will sell you petro at a price of Rs. 55 even though the market price is Rs. 45
per liter. Thus, I will make money while you lose it.

Hence, the biggest disadvantage of futures is that one of the parties

involved will not be able to take advantage of favorable movement in price
i.e. if you have not entered into a futures contract with me, you could have
bought petro at Rs. 45 (market price) instead of Rs. 55.

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Part 2 – Options

As you may know, I covered derivatives, types of derivatives, hedging and

futures concepts in the previous article. I also explained the concept of
Future Contracts and its uses. Many of our readers had some questions
regarding my first article. I have tried to answer those questions with best
of my abilities. You can find those questions at the bottom of this article.
Here in Part 2, I am going to discuss another very important derivative
called Options. The trading market for Option is so huge and exciting that it
commands a dedicated article on itself.

*Options*
An option is a contract where the buyer has the right (depends on buyer to
execute it), but not the obligation (legally bonded) to buy or sell an
underlying asset (a stock or index) at a specific price on or before a certain
date. An option is a security, just like a stock or bond, and constitutes a
binding legal contract with strictly defined terms and conditions.

*Futures Vs Options*
Remember from the previous part, Futures are contracts where both the
buyer and the seller have the obligation to honor the contract whereas
option does not involve any obligation for both the parties. A contract is a
zero sum game i.e. one party will book loss while the other take home the
profit. If the contract is futures, the losing party will pay the winning party.
However, in options, the buyer will decide whether to execute the contract.
You will understand this by the following example.

Let say there is a contract between you and me which says that I will buy
one kg of gold at Rs. 1,000 per gm from you on March 1st, 2009. I am the
buyer of this contract and you are the seller. So we will either go for cash
settlement or you have to deliver the gold to me. Now suppose on the date
of settlement i.e. March 1st, 2009, price of gold is Rs. 500 per gram. Thus,
the market price of gold on March 1st, 2009 is lower than the contract
price.

If the contract were Futures, I would have to buy the gold from you because
I have the obligation to do so. Hence, I will pay you Rs.1,000 per gm and you
will deliver me the gold. Hence, you make profit while I book loss. Good for
you, Bad for me!!

However, if the contract were an Option, I would not have executed it i.e.
would not have bought the gold from you. I would have let the contract
expire (i.e. do nothing and wait till March 1st, 2009 passes by). How can I do
so? I can do it because Options gives me (the buyer) the right and not the
obligation to buy it. Thus, an option would protect me from any adverse
movement in the price of underlying asset.

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In an option, seller has no right because he is compensated by the buyer by

paying option premium. Thus, the buyer of an option contract has the right
but the seller of option contract has the obligation to honor the option.

So you may now be wondering that why on earth somebody will ever buy a
futures contract when options contract are better. We must know that
option has a premium attached to it which is called Options Premium. This
is the amount that a buyer of option contract has to pay the seller of the
option contract in exchange for higher flexibility and protection against
adverse price movement in the value of underlying. Thus, if I have to buy an
option contract from you, I will pay a premium to the seller i.e. you.

*Options Vs Stocks*
In order for you to better understand the benefits of trading options you
must first understand some of the similarities and differences between
options and stocks.

Similarities:
9 Listed Options are securities, just like stocks.
9 Options trade like stocks, with buyers making bids and sellers
making offers.
9 Options are actively traded in a listed market, just like stocks.
They can be bought and sold just like any other security.

Differences:
9 Options are derivatives, unlike stocks (i.e, options derive their
value from something else, the underlying security).
9 Options have expiration dates, while stocks do not.
9 There is not a fixed number of options, as there are with stocks
available e.g. there could tens or even hundreds of options
written on the same stock
9 Stockowners have a share of the company, with voting and
dividend rights. Options convey no such rights.

Remember these options are not issued or written by companies who stocks
act as underlying asset. These options are generally written by brokers or
traders for investors.

Options Terminology
Options Premium
An option Premium is the price of the option that a buyer pays to purchase
the contract from the seller.

Strike Price
The Strike (or Exercise) Price is the price at which the underlying security
(in this case, XYZ) can be bought or sold as specified in the option contract
from the seller. The strike price also helps to identify whether an option is
In-the-Money, At-the-Money, or Out-of-the-Money when compared to the
price of the underlying security.

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Expiration Date
The Expiration Date is the day on which the option is no longer valid and
ceases to exist.

Classes of Options
There are two classes of options American Option and European Option.

The key differences are:

1. American option can be exercised before the expiration while a European

option is exercised only on the expiration date.
2. Dividends can be issued by the underlying stock in an American option
while it is not the case in European option

Types of Options
There are only two types of options: Call option and Put option. In this
article we will discuss only European options i.e. options which can not be
executed before the agreed upon date.

Call Options
A Call Option is an option to buy a stock (underlying) at a specific price on a
certain date. The buyer of call option holds the rights while the seller has
the obligation to honor the contract. The buyer of a call option enters the
contract assuming that the value of underlying will increase in future and
benefit him. The seller thinks otherwise i.e. the stock price will not go up
and hence the buyer will not execute the contract. So he (seller) will keep
the option premium to himself that would be his profit. Hence, the buyer
will execute the contract only when the market price of underlying stock is
higher than the strike price.

Example 1
I bought a call option from you with the following feature: Underlying is an
Infosys Stock, Exercise price is Rs. 1100 and expiration period is Jan 24,
2009. Option premium is Rs. 100 per underlying stock and the option is
written on only 1 stock.

How call option helps me (the buyer) in realizing profits. Let us assume that
the stock price on Jan 24, 2009 is Rs. 1250. Thus, I will execute the call
option and you will sell the stock to me for Rs. 1100 and NOT at the current
price. I will take that stock from you and sell it for Rs. 1250 in the open
market and book a profit of Rs. 1250 - Rs. 1100 - Rs. 100 (Option premium) =
Rs. 50.

Now look at my return on investment and NOT on amount of investment. My

return on investment (ROI) is = (Profit * 100 / Total Cost or investment) %
= 50*100/100 = 50%

Compare this to someone who invested in Infosys stock and NOT in the
option. If he bought the stock at Rs. 1000 and sold for Rs. 1250 in the

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market, his profit would be = (Profit * 100 / Total Cost or investment) % =

(250* 100 /1000) = 25%

Isn’t it great One golden rule of investment - Don’t measure your profit or
loss based on absolute value of profit or loss but on return on investment
(ROI).

Remember this. The buyer of a call option will execute the contract only
when the market price of the underlying stock will be higher than the strike
price of the stock. This is because the buyer will buy the stock from the
seller at a lower cost and sell in the open market to book the difference as
profit. However, if the market price of underlying stock is less than that of
the exercise price, the buyer will let the option expire. In the above
example, if the stock price of Infosys on Jan 24, 2009 were Rs. 1090, I will
not exercise the contract! Thus, my only loss would be Rs. 100, the option
premium that I paid to the seller (you).

Put Options
Put options are options to sell a stock at a specific price on a certain date.
Put options mean right to sell. It is just the opposite of a call option. The
buyer of a put option holds the right to sell while the seller has the
obligation to buy. Here, the buyer assumes that the price of underlying
asset will go down in future and he will benefit from the put option. Hence,
the buyer of a put option will execute the contract only when the market
price of underlying stock is lower than the strike price.

Profit realization for the buyer - When do you make profit by selling
something Only when you buy something for X amount and sell it for Y
amount where Y>X. Or, you sell someone a product at a price higher than
the market price. Why will someone buy a product at a price higher than
the market price? He will do it only when he has signed a contract to do so.
This is put option which protects and benefits its buyer from any downward
movement in the stock price.

State of an option
In-the-Money option
This is when strike price is less than the market price for a call option or the
strike price is more than the market price for a put option.

At-the-money
This is when strike price is equal to the market price.

Out-of-the-money
This is when the strike price is more than the market price for the call
option while the strike price is less than the market price for the put option.

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How to read an option traded listed on an exchange? If you read any

business newspaper you may find quotations like this:

INFOSYSTCH Jan 29 CA 1,020.00 51.00 51.00 50.00 51.00

What does this mean? It simply means it is an option with

1. Underlying as Infosys stock
2. Jan 29 is the expiry date
3. To BUY (because it is a call) Infosys stock - CA is Call Option
4. 1020.00 is the Strike Price
5. The numbers (51.00, 51.00, 50.00, 51.00) shown after the strike are
High price, low price, previous close and last price respectively.

INFOSYSTCH Feb 26 PA 1,020.00 35.00 35.00 52.00 35.00

It simply means it is an option to SELL (because it is a put) Infosys stock with

similar details.

Table1: Representation of rights and obligations

CALL PUT
BUYER Right but not the obligation
Right but not the obligation to buy
(Long) to sell
SELLER
Obligation to sell Obligation to buy
(Short)

Common terminology – people who buy options are also called \"holders\" or
are considered to be “Long” on option and, those who sell options are also
called \"writers\" or are considered as “Short” on option.

Remember this:
Long > Buy
Short > Sell (Selling the right to someone else is like buying obligation for
oneself)

Call option > Right to buy

Put option > Right to sell (Selling the right to someone else is like buying
obligation for oneself)

Long call > Buy the right to buy

Short call > Sell the right to buy (Selling the right to someone else is like
buying obligation for oneself)

Long put > Buy the right to sell

Short put > Sell the right to sell (Selling the right to someone else is like
buying obligation for oneself)

Hence, if I buy a call option, I will say I am Long Call or I am a Call Holder.
People who buy options have a right to exercise.

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When a Call is exercised, Call holders may buy stock at the strike price from
the Call seller, who is required to sell stock at the strike price to the Call
holder. When a Put is exercised, Put holders (buyers) may sell stock at the
strike price to the Put seller, who is required to buy stock at the strike price
from the Put holder. Neither Call holders nor Put holders are obligated to
buy or sell; they simply have the rights to do so, and may choose to exercise
or not to exercise based upon their own judgment.

Let us discuss example 1 from the point of view of put option in the next
example.

Example 2
I bought a put option from you with the following feature: Underlying is an
Infosys Stock, Exercise price is Rs. 1100 and expiration period is Jan 24,
2009. Option premium is Rs. 100 per underlying stock and the option is
written on only 1 stock. The current price of Infosys stock is say, Rs. 1050.

How put option helps me (the buyer) in realizing profits and protecting my
interests. Let us assume that the stock price on Jan 24, 2009 is Rs.950.
Thus, I will execute the put option and you will buy the stock from me at Rs.
1100 and NOT at the current price which is Rs. 900. Thus, my profit is Rs.
1100 Rs. 950 Rs. 100 (Option premium) = Rs. 50. Now look at my return on
investment and NOT on amount of investment. My return on investment
(ROI) is = (Profit * 100 / Total Cost or investment) % = 50*100/100 = 50%

Compare this to someone who invested in Infosys stock and NOT in the
option. The value of Infosys stocks has come down from Rs. 1050 to Rs.950;
hence, his profit would be
= (Profit * 100 / Total Cost or investment) %
= (-100* 100 /1000) = - 10% i.e. a loss of 5%.

*Gain, Loss and Breakeven Table

Calls Puts
Long Short Long Short
Maximum
Infinite Premium Limited
gain
Maximum loss Premium Infinite
Market price = Strike Price + Market Price = Strike Price -
Breakeven
Premium Premium

Potential Benefits of Options

• Greater return for smaller amount invested
• Less risk
• Less initial investment
• Diversify portfolio

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These previous examples introduced how options can provide investors with
more alternatives, allowing them to specify, precisely, the amount of risk
they are willing to take in their holdings. If used on a 1-to-1 basis with the
underlying shares, then options can be used to invest in stocks with limited
risk, to insure stock investments held, or to set levels of market exposure
consistent with one\'s investment strategy.

Options can also be used as alternatives to stock investments (one option for
each 100 shares), giving investors the ability to profit from favorable market
moves just as if they held the underlying security, but with lower potential
risk due to a lower initial investment.

Test your skills

1. __________ option conveys the right to Buy.
A. Call
B. Put

2. ________ option conveys the right to Sell.

A. Call
B. Put

3. Long on an option means_____.

A. Buy
B. Sell

4. For a call option when the strike price is more than the market price, it is
____.
A. In-the-money
B. At-the-money
C. Out-of-the-money

5. For a put option when the strike price is less than the market price, it is
____.
A. In-the-money
B. At-the-money
C. Out-of-the-money

6. The buyer of a call option will exercise the option when ____.
A. Strike price is higher than the market price
B. Strike price is lower than the market price
C. Strike price is equal to the market price

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Part 3 – Option Strategies

Let us refresh our memory on Options which was covered in earlier parts.

Options are financial instruments that give the buyer the right to buy (for a
call option) or sell (for a put option) the underlying security at some specific
point of time in the future (European Option), which is fixed in advance i.e.
when the option is written. Call options increase in value as the underlying
stock increases in value. Likewise put options increase in value as the
underlying stock decreases in value.

In this part we will discuss some most commonly used options strategies.
These strategies depend on whether investors are growth-oriented or
conservative, or short-term aggressive traders.

Options are generally used to speculate on the movement of the price of

underlying asset or hedge an existing position or investment. An option
strategy is implemented by combining one or more option positions and
possibly an underlying stock position. Options strategies can favor
movements in the underlying stock that are bullish, bearish, neutral, event
driven and stock combination. The option positions used can be long and/or
short positions in calls and/or puts at various strikes.

Before we begin our discussion, I would like to explain few important terms
used extensively in options:

Options Premium
An option Premium is the price of the option that a buyer pays to purchase
the contract from the seller.

Strike Price
The Strike (or Exercise) Price is the price at which the underlying security
(in this case, XYZ) can be bought or sold as specified in the option contract
from the seller. The strike price also helps to identify whether an option is
In-the-Money, At-the-Money, or Out-of-the-Money when compared to the
price of the underlying security.

Expiration Date
The Expiration Date is the day on which the option is no longer valid and
ceases to exist.

In-the-Money option (ITM)

The option is said to be in-the-money option when the strike price (SP) is
less than the market price (MP) of the underlying asset for a call option or
the strike price is more than the market price for a put option.

i.e. SP < MP For Call option

SP > MP For Put option

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At-the-money option (ATM)

The option is said to be at-the-money option when strike price is equal to
the market price of the underlying asset.

i.e. SP = MP For both Put and Call option

Out-of-the-money option (OTM)

This is when the strike price is more than the market price of the underlying
asset for call option while the strike price is less than the market price for
the put option.

i.e. SP > MP For Call option

SP < MP For Put option

Time Decay
Generally, the longer the time remaining until an option's expiration, the
higher its premium will be. This is because the longer an options lifetime,
greater is the possibility that the underlying share price might move so as to
make the option in-the-money. All other factors affecting an options price
remaining the same, the time value portion of an options premium will
decrease (or decay) with the passage of time. Note: This time decay
increases rapidly in the last several weeks of an options life. When an option
expires in in-the-money, it is generally worth only its intrinsic value.

Intrinsic Value
For call options, this is the difference between the underlying stock's price
and the strike price. For put options, it is the difference between the strike
price and the underlying stock's price. In the case of both puts and calls, if
the respective difference value is negative, the intrinsic value is given as
zero.

Volatility
Volatility is the tendency of the underlying security's market price to
fluctuate either up or down. It reflects a price changes magnitude; it does
not imply a bias toward price movement in one direction or the other. Thus,
it is a major factor in determining an options premium. The higher the
volatility of the underlying stock, the higher the premium because there is a
greater possibility that the option will move in-the-money. Generally, as the
volatility of an underlying stock increases, the premiums of both calls and
puts overlying that stock increase, and vice versa.

Leverage
Options can provide leverage. This means an option buyer can pay a
relatively small premium for market exposure in relation to the contract
value (usually 100 shares of underlying stock). An investor can see large
percentage gains from comparatively small, favorable percentage moves in

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the underlying equity. Leverage also has downside implications. If the

underlying stock price does not rise or fall as anticipated during the lifetime
of the option, leverage can magnify the investments percentage loss.
Leverage is like a magnifying force it magnifies both the upside gain as well
as downside loss.

Now, let’s begin our discussion on various options strategies.

Bullish Strategies
Bullish options strategies are employed when the options trader expects the
underlying stock price to move upwards. It is necessary to assess how high
the stock price can go and the time frame in which the rally will occur in
order to select the optimum trading strategy.

Stocks seldom go up by leaps and bounds. Moderately bullish options traders

usually set a target price for the Bull Run and utilize bull spreads to reduce
cost. (It does not reduce risk because the options can still expire worthless.)
While maximum profit is capped for these strategies, they usually cost less
to employ for a given nominal amount of exposure. The bull call spread and
the bull put spread are common examples of moderately bullish strategies.

Mildly bullish trading strategies are options strategies that make money as
long as the underlying stock price does not go down by the options
expiration date. These strategies may provide a small downside protection
as well. Writing out-of-the-money covered calls is a good example of such a
strategy.

Long Call
This is the most common option trading among investors.

How to design: Buy 1 call.

Margins: No
Market Outlook: Bullish. Investors believe that the share price will rise well
above the strike price. The more bullish your view the further out of the
money you can buy to create maximum leverage.
Profit: The profit increases as the market rises. The break-even point (BEP)
will be the options strike price plus the premium (OP) paid for the option
i.e.
BEP = Strike Price + OP.
Loss: The maximum loss is the premium paid for the option. Any point
between the strike prices A, and the break-even point you will make a loss
although not the maximum loss.
Volatility: The option value will increase as volatility increases (good) and
will fall as volatility falls (bad).
Time Decay: As each day passes the value of the option erodes.

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Short Put
How to design: Sell 1 put.
Margins: Yes
Market Outlook: Bullish. The share price will not fall below the strike price.
If it does you are obligated to buy at the strike price, or buy the option back
to close.
Profit: The maximum profit is the premium you sold the option for. The
break-even point will be the options strike price, minus the premium
received for the option.
Loss: The maximum loss is the strike price less the premium received.
Volatility: The option value will increase as volatility increases (bad) and
will decrease as volatility decreases (good).
Time Decay: As each day passes the value of the option erodes (good).

Bull Call Spread

How to design: Buy an at-the-money call option while simultaneously Sell a
higher striking out-of-the-money call option of the same underlying security
and the same expiration month.
Margins: No
Market Outlook: Bullish. The share price will expire above the higher strike
price and not below the lower strike price. The strategy provides protection
if your view is wrong.
Profit: The maximum profit is limited to the difference between the strike
prices of two options less the cost of the spread i.e. net premium paid.
Loss: The maximum loss is also limited to the cost of the spread (Calls). The
bull call spread strategy will result in a loss if the stock price declines at
expiration. Maximum loss cannot be more than the initial debit taken to
enter the spread position.
Volatility: You are not affected by volatility.
Time Decay: It depends on the underlying share price, if it is below lower
strike price, then time decay works against you. If it is above higher strike
price, then it works for you.

Example: Suppose ABC stock is trading at Rs. 420 in June. An options trader
executes a bull call strategy by buying a JUL 400 call (it means call put
option has the strike price of Rs. 400 and will expire in the last week of
July) for Rs. 3,000 (option premium) and selling a JUL 450 call for Rs. 1,000.
The net debit (or investments) to trader (i.e. he paid to enter this strategy)
to enter the trade is Rs. 2,000.

If ABC stock goes up and trades at Rs. 460 on expiration in July, both the
call options expire in-the-money (because market price is more than the
strike price). However, the trader will earn profit on JUL 400 call (because
he is the buyer) but he will loose money in JUL 450 (because he is the seller

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of that call) Intrinsic value of JUL 400 call= (Market price - Strike price) No.
of underlying stocks
= (Rs. 460- Rs. 400) 100 = Rs. 6,000
Intrinsic value of JUL 450 call= (Market price - Strike price) No. of
underlying stocks
= (Rs. 460- Rs. 450) 100 = Rs. 1,000

Hence, the traders net profit to the trader is equal to Rs. 6,000-1,000 = Rs.
5,000
Subtracting the initial debit of Rs. 2,000, the options trader's net profit
comes to Rs. 5,000-2,000 = Rs. 3,000.

If the price of stock ABC goes down to Rs. 380 on expiration, both the
options expire worthless. The trader will loose his investment of Rs.2,000,
which is also his maximum possible loss.

Bearish Strategies
Bearish options strategies are the mirror image of bullish strategies. They
are employed when the options trader expects the underlying stock price to
move downwards. It is necessary to assess how low the stock price can go
and the time frame in which the decline will happen in order to select the
optimum trading strategy.

Stock prices only occasionally make steep downward moves. Moderately

bearish options traders usually set a target price for the expected decline
and utilize bear spreads to reduce cost. While maximum profit is capped for
these strategies, they usually cost less to employ. The bear call spread and
the bear put spread are common examples of moderately bearish strategies.

Mildly bearish trading strategies are options strategies that make money as
long as the underlying stock price does not go up by the options expiration
date. These strategies may provide a small upside protection as well. .

Long Put
How to design: Buy 1 ATM put.
Margins: No
Market Outlook: Bearish. Investors believe the share price will expire well
below the strike price. It is used to profit from an expected fall in a share.
This strategy is commonly used to provide protection to stocks held in your
portfolio. If the share price falls, the profit from the Put will offset the loss
on the Share.
Profit: The maximum profit is limited to the strike price less the cost of the
option (Option Premium), as the share can only fall as low as zero.
Loss: The maximum loss is equal to the amount of premium paid for the
option.
Volatility: The option value will increase as volatility increases (good) and
will fall as volatility falls (bad).

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Time Decay: As each day passes the value of the option erodes (bad).

Short Call
How to design: Sell 1 call.
Margins: Yes
Market Outlook: Bearish. The share price will expire below the strike price
A. If it does you will get to keep the option premium.
Profit: The maximum profit is the premium you sold the option. The break-
even point will be the options strike price A, plus the premium received for
the option.
Loss: The maximum loss for this trade is unlimited.
Volatility: The option value will increase as volatility increases (bad) and
will decrease as volatility decreases (good).
Time Decay: As each day passes the value of the option erodes (good).

Bear Call Spread

A bear call spread is a limited profit, limited risk options trading strategy
that can be used when the options trader is moderately bearish on the
underlying security.
How to design: Buy 1 OTM Call (higher strike price) and Sell 1 ITM Call
option (lower strike price) on the same underlying security expiring in the
same month.
Margins: Yes
Market Outlook: Bearish. The options trader thinks that the price of the
underlying asset will go down moderately in the near term.
Profit: The maximum profit is limited to the difference net premium
received i.e. the premium received for the short call minus the premium
paid for the long call.
Loss: The maximum loss is also limited to the difference in the strike price
of two options -Net Premium. If the stock price rise above the strike price of
the higher strike call at the expiration date, then the bear call spread
strategy suffers a maximum loss equals to the difference in strike price
between the two options minus the original credit taken in when entering
the position.
Volatility: You are not affected by volatility.
Time Decay: It depends on the underlying share price, if it is below A, then
time decay works for you. If it is above B, then it works against you.

Example: Suppose ABC stock is trading at Rs. 380 in June. An options trader
executes a bear call spread by buying a JUL 400 call (it means call put
option has the strike price of Rs. 400 and will expire in the last week of
July) for Rs. 1,000 (option premium) and selling a JUL 350 call for Rs. 3,000.
The net credit to trader (i.e. he receives Rs. 2000 to enter this strategy)
taken to enter the trade is Rs. 2,000.

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If ABC stock goes up and trades at Rs. 420 on expiration in July, both the
call options expire in-the-money (because market price is more than the
strike price). However, the trader will earn profit on JUL 400 call (because
he is the buyer) but he will loose money in JUL 350 (because he is the seller
of that call and has to pay the buyer).
Intrinsic value of JUL 400 call= (Market price - Strike price) No. of
underlying stocks
= (Rs. 420- Rs. 400) 100 = Rs. 2,000
Intrinsic value of JUL 350 call= (Market price - Strike price) No. of
underlying stocks
= (Rs. 420- Rs. 350) 100 = Rs. 7,000

Hence, the traders net loss is equal to Rs. 7,000-2,000 = Rs. 5,000.
Subtracting the initial credit of Rs. 2,000, the options trader's net loss
comes to Rs. 5,000-2,000 = Rs. 3,000.

On expiration in July, if ABC stock drops to Rs. 340, both the JUL 350 call
and the JUL 400 call expires worthless and the bear call spread trader
pockets his profit which is equal to the initial credit of Rs. 2,000

Neutral Strategies
Neutral strategies in options trading are employed when the options trader
does not know whether the underlying stock price will rise or fall. Also
known as non-directional strategies, they are so named because the
potential to profit does not depend on whether the underlying stock price
will go upwards or downwards. Rather, the correct neutral strategy to
employ depends on the expected volatility of the underlying stock price.

Examples of neutral strategies are:

Short Straddle
How to design: Sell 1 at-the-money Call and Sell 1 at-the-money Put of the
same underlying stock, striking price and expiration date simultaneously.
Margins: Yes
Market Outlook: Neutral. The share price will expire around the strike
price. If it does you will get to keep the option premium from both sold
options. This strategy is also used if your view is that volatility will
decrease.
Profit: The maximum profit is the combined total premium you received for
the sale of the options. One break-even point (Upper BEP) will be the strike
price plus the combined options premium received. The other break-even
point (Lower BEP) will be the strike price minus the combined options
premium received.
Loss: The maximum loss for this trade is unlimited on the upside and limited
on the downside to the strike price, as the share cant fall below zero.

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Volatility: The option value will decrease as volatility decreases which is

good for both options. Alternatively an increase in volatility will be bad for
both options.
Time Decay: As each day passes the value of the option erodes (good).

Example: Suppose ABC stock is trading at Rs. 400 in June. An options trader
executes a short straddle by selling a JUL 400 put (it means put option has
the strike price of Rs. 400 and will expire in the last week of July) for Rs.
2,000 (option premium) and a JUL 450 call for Rs.2,000. The net credit to
enter the trade is Rs. 4,000, which is also his maximum possible profit
(because the trader is selling these options and getting premium).

If ABC stock goes up and trades at Rs. 500 on expiration in July, the JUL 400
put will expire worthless (because market price is more than the strike
price) but the JUL 400 call expires in-the-money (because market price is
greater than the strike price) and has an intrinsic value of : Rs. 10,000
(Intrinsic value of call = (Market price - Strike price) No. of underlying
stocks).
= (Rs. 500- Rs. 400) 100 = Rs. 10,000
Subtracting the initial credit of Rs. 4,000, the options trader's loss comes to
Rs. 10,000-4,000 = Rs. 6,000 (because trader has to pay Rs.10,000 to the
buyer of call option).

On expiration in July, if ABC stock is still trading at Rs. 400, both the JUL
350 put and the JUL 450 call expire worthless and the options trader gets to
keep the entire initial credit of Rs. 4,000 taken to enter the trade as profit.

Short Strangle
How to design: Sell 1 out-of-the-money Call and Sell 1 out-of-the-money
Put of same expiration date and same underlying stock but different strike
price.
Margins: Yes
Market Outlook: Neutral. The share price will expire between the strike
prices A and B. If it does you will get to keep the option premium from both
sold options. This strategy is also used if your view is that volatility will
decrease.
Profit: The maximum profit is the combined total premium you received for
the sale of the options. One break-even point (Lower BEP) will be the strike
price of short put minus the net options premium received. The other break-
even point (Upper BEP) will be the strike price of short call plus the net
options premium received.
Loss: The maximum loss for this trade is unlimited on the upside and limited
on the downside to the strike price, as the share cant fall below zero.
Volatility: The option value will decrease as volatility decreases which is
good for both options. Alternatively an increase in volatility will be bad for
both options.

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Time Decay: As each day passes the value of the option erodes (good).

Example: Suppose ABC stock is trading at Rs. 400 in June. An options trader
executes a short strangle by selling a JUL 350 put (it means put option has
the strike price of Rs. 350 and will expire in the last week of July) for Rs.
1000 (option premium) and a JUL 450 call for Rs. 1000. The net credit to
enter the trade is Rs. 2000, which is also his maximum possible profit
(because the trader is selling these options and getting premium).

If ABC stock goes up and trades at Rs. 500 on expiration in July, the JUL 350
put will expire worthless (because market price is more than the strike
price) but the JUL 450 call expires in-the-money (because market price is
greater than the strike price) and has an intrinsic value of : Rs. 5000
(Intrinsic value of call = (Market price - Strike price) No. of underlying
stocks).
= (Rs. 500- Rs. 450) 100 = Rs. 5000
Subtracting the initial credit of Rs. 2000, the options trader's loss comes to
Rs. 5000-2000 = Rs. 3000 (because trader has to pay Rs. 5000 to the buyer of
call option).

On expiration in July, if ABC stock is still trading at Rs. 400, both the JUL
350 put and the JUL 450 call expire worthless and the options trader gets to
keep the entire initial credit of Rs. 2000 taken to enter the trade as profit.

Long Put Butterfly

A long butterfly is similar to Short Straddle except the fact that loss is
limited.
How to design: Buying 1 in-the-money Put and 1 out-of-the-money Put +
Selling 2 at-the-money Puts
All these options must have same underlying stock and expiration dates.
The strike price differs for these three puts (1 for ATM, 1 for OTM and 1 for
ITM).
Margins: Yes
Market Outlook: Neutral. Investor thinks that the underlying stock will not
rise or fall much by expiration (i.e. when the investor is bearish on
volatility.
Profit: The maximum gain for the long put butterfly is attained when the
underlying stock price remains unchanged at expiration. At this price, only
the highest striking put expires in the money.
The maximum profit for this trade is limited to the strike price of (ATM -
ITM) - Net premium paid for the spread.
There are 2 break-even points for the long put butterfly position.
The breakeven points can be calculated using the following formulae.
Upper Breakeven Point = Strike Price of Highest Strike Long Put – Net
Premium Paid
Lower Breakeven Point = Strike Price of Lowest Strike Long Put + Net
Premium Paid

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Loss: The maximum loss is = Net Premium Paid + Commissions Paid

Volatility: The option value will decrease as volatility decreases which is
generally good for the strategy. Alternatively an increase in volatility will be
generally bad for the strategy.
Time Decay: As each day passes the value of the option erodes (good). Most
of the decay will occur in the final month before expiry.

Example: Suppose ABC stock is trading at Rs. 400 in June. An options trader
executes a long put butterfly by selling a JUL 300 put (it means put option
has the strike price of Rs. 300 and will expire in the last week of July) for
Rs. 1,000 (option premium), writing 2 July 400 puts for Rs. 2,000 and a JUL
500 call for Rs. 5,000. The net debt taken to enter the trade is Rs. 4,000,
which is also his maximum possible profit (because the trader is selling
these options and getting premium).

If ABC stock is still trading at Rs. 400 on expiration in July, the JUL 400 and
JUL 300 put will expire worthless (because market price is more than the
strike price) but the JUL 500 pull has intrinsic value of Rs. 5000: Intrinsic
value of put = (Strike price - Market price) No. of underlying stocks
= (Rs. 500- Rs. 400) 100 = Rs. 10,000

Subtracting the initial credit of Rs. 4,000, the options trader's profit comes
to Rs. 10,000-4,000 = Rs. 6,000 (because trader is selling stocks at a higher
rate than the market price).

Maximum loss results when the stock is trading below Rs. 300 or above Rs.
500. At Rs. 500, all the options expire worthless. Below Rs. 300, any "profit"
from the two long puts will be neutralized by the "loss" from the two short
puts. In both situations, the long put butterfly trader suffers maximum loss
which is equal to the initial debit taken to enter the trade.

Event Driven
Event driven strategies in options trading are employed when the options
trader is expecting some events which will influence the prices of underlying
asset. In general, they benefit from the volatility in the price of stocks.

Long Straddle
How to design: Buy 1 ATM Call and Buy 1 ATM Put simultaneously at the
same underlying stock, striking price and expiration date.
Market Outlook: An investor may take a long straddle position if he thinks
the market is highly volatile, but does not know in which direction it is going
to move. If volatility increase, both bought options will increase in value.
Profit: The maximum profit for this trade is unlimited on the upside and
limited on the downside to the strike price, as the share cant fall below
zero.
Loss: The maximum loss for this trade is the premium paid to buy both
options.

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Volatility: The option value will increase as volatility increases which is

good for both options. Alternatively a decrease in volatility will be bad for
both options.
Time Decay: As each day passes the value of the option erodes (bad).

Example: Suppose ABC stock is trading at Rs. 400 in June. An options trader
executes a long straddle by buying a JUL 400 put (it means put option has
the strike price of Rs. 400 and will expire in the last week of July) for Rs.
2,000 (option premium) and buying a JUL 400 call for Rs. 2,000. The net
debt taken to enter the trade is Rs. 4,000, which is also his maximum
possible loss (because the trader is investing money to buy these options
from the seller).

If ABC stock is still trading at Rs. 500 on expiration in July, the JUL 400 put
will expire worthless but JUL 400 call expires in the money (because market
price is more than the strike price which is good for buyer of a call option).
Intrinsic value of call= (Market price - Strike price) No. of underlying stocks
= (Rs. 500- Rs. 400) 100 = Rs. 10,000

Subtracting the initial credit of Rs. 4,000, the options trader's profit comes
to Rs. 10,000-4,000 = Rs. 6,000 (because trader is buying stocks at a lower
rate than the market price).

On expiration in July, if ABC stock is still trading at Rs. 400, both the JUL
400 put and the JUL 400 call expires worthless and the long straddle trader
suffers a maximum loss which is equal to the initial debit of Rs. 4,000

Long Strangle
How to design: Buy 1 OTM Call and Buy 1 OTM Put of different strike price
but the same underlying stock and expiration date.
Market Outlook: The owner of a long strangle makes a profit if the
underlying price moves far enough way from the current price, either above
or below. Thus, an investor may take a long strangle position if he thinks the
underlying security is highly volatile, but does not know which direction it is
going to move.
Profit: The maximum profit for this trade is unlimited on the upside and
limited on the downside to the strike price A, as the shares cant fall below
zero. A large gain for the long strangle option strategy is possible when the
underlying stock price makes a very strong move either upwards or
downwards at expiration.
Loss: The maximum loss for this trade is the premium paid to buy both
options.
Volatility: The option value will increase as volatility increases which is
good for both options. Alternatively a decrease in volatility will be bad for
both options.
Time Decay: As each day passes the value of the option erodes (bad).

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Example: Suppose ABC stock is trading at Rs. 400 in June. An options trader
executes a long strangle by buying a JUL 350 put (it means put option has
the strike price of Rs. 350 and will expire in the last week of July) for Rs.
1,000 (option premium) and buying a JUL 450 call for Rs. 1,000. The net
debt taken to enter the trade is Rs. 2,000, which is also his maximum
possible loss (because the trader is investing money to buy these options
from the seller).

If ABC stock goes up and trades at Rs. 500 on expiration in July, the JUL 350
put will expire worthless but JUL 450 call expires in-the-money (because
market price is more than the strike price which is good for buyer of a call
option).
Intrinsic value of call= (Market price - Strike price) No. of underlying stocks
= (Rs. 500- Rs. 450) 100 = Rs. 5,000

Subtracting the initial credit of Rs. 2,000, the options trader's profit comes
to Rs. 5,000-2,000 = Rs. 3,000 (because trader is buying stocks at a lower
rate than the market price).

On expiration in July, if ABC stock is still trading at Rs. 400, both the JUL
350 put and the JUL 450 call expires worthless and the long strangle trader
suffers a maximum loss which is equal to the initial debit of Rs. 2,000

Conclusion
There is around hundreds of different options strategies. However, my idea
was to cover only selected few simple options to educate you.

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