Excellent Trading School - 20 - Applications of Options -2

Application of Options: While we looked at some applications of options contracts, like Hedging  in previous post, here we look at second application that is, Speculation:

Speculation: Bullish security, buy calls or sell puts

There are times when investors believe that security prices are going to rise. How does one implement a trading strategy to benefit from an upward movement in the underlying security. Using options there are two ways one can do this:

1. Buy call options; or

2. Sell put options

The downside to the buyer of the call option is limited to the option premium he pays for buying the option. His upside however is potentially unlimited. Suppose you have a hunch that the price of a particular security is going to rise in a months time. Your hunch proves correct and the price does indeed rise, it is this upside that you cash in on. However, if your hunch proves to be wrong and the security price plunges down, what you lose is only the option premium.

  

Speculation: Bearish security, sell calls or buy puts

Due to poor corporate results, or the instability of the government, many people feel that the stocks prices would go down. Today, using options, you have two choices:

1. Sell call options; or

2. Buy put options

The upside to the writer of the call option is limited to the option premium he receives upright for writing the option. His downside however is potentially unlimited. 

Suppose you have a hunch that the price of a particular security is going to fall in a month’s time. Your hunch proves correct and it does indeed fall, it is this downside that you cash in on. When the price falls, the buyer of the call lets the call expire and you get to keep the premium. However, if your hunch proves to be wrong and the market soars up instead, what you lose is directly proportional to the rise in the price of the security.

There are five one-month calls and five one-month puts trading in the market. The call with a strike deep in-the-money trades at a higher premium. The call with a strike which is out-of-the-money and trades at a low premium. Its execution depends on the unlikely event that the stock will rise by more than 50 points on the expiration date. Hence writing this call is a fairly safe bet. There is a small probability that it may be in-the-money by expiration in which case the buyer exercises and the writer suffers losses to the extent that the price is above strike price. In the more likely event of the call expiring out-of-the-money, the writer earns the premium amount.

As a person who wants to speculate on the hunch that the market may fall, you can also buy puts. As the buyer of puts you face an unlimited upside but a limited downside. If the price does fall, you profit to the extent the price falls below the strike of the put purchased by you.

If however your hunch about a downward movement in the market proves to be wrong and the price actually rises, all you lose is the option premium, so you simply let the put expire.

  

Bull spreads - Buy a call and sell another

There are times when you think the market is going to rise over the next two months, however in the event that the market does not rise, you would like to limit your downside. One way you could do this is by entering into a spread. Spread trading strategy involves taking a position in two or more options of the same type, that is, two or more calls or two or more puts. A spread that is designed to profit if the price goes up is called a bull spread.

This is basically done utilizing two call options having the same expiration date, but different exercise prices. The buyer of a bull spread buys a call with an exercise price below the current index level and sells a call option with an exercise price above the current index level. The spread is a bull spread because the trader hopes to profit from a rise in the index. The trade is a spread because it involves buying one option and selling a related option. Compared to buying the underlying asset itself, the bull spread with call options limits the trader’s risk, but the bull spread also limits the profit potential.

Payoff for a bull spread created using call options, one sold at Rs.40 and the other bought at Rs.80. The cost of setting up the spread is Rs.40 which is the difference between the call premium paid and the call premium received. The downside on the position is limited to this amount.

As the index moves above 3800, the position starts making profits (cutting losses) until the index reaches 4200. Beyond 4200, the profits made on the long call position get offset by the losses made on the short call position and hence the maximum profit on this spread is made if the index on the expiration day closes at 4200. Hence the payoff on this spread lies between 40 to 360. Somebody who thinks the index is going to rise, but not above 4200 would buy this spread. Hence he does not want to buy a call at 3800 and pay a premium of 80 for an upside he believes will not happen.

In short, it limits both the upside potential as well as the downside risk. The cost of the bull spread is the cost of the option that is purchased, less the cost of the option that is sold , shows the payoff from the bull spread. Broadly, we can have three types of bull spreads:

1. Both calls initially out-of-the-money.

2. One call initially in-the-money and one call initially out-of-the-money, and

3. Both calls initially in-the-money.

The decision about which of the three spreads to undertake depends upon how much risk the investor is willing to take. The most aggressive bull spreads are of type 1. They cost very little to set up, but have a very small probability of giving a high payoff.

  

Bear spreads - sell a call and buy another

There are times when you think the market is going to fall over the next two months. However in the event that the market does not fall, you would like to limit your downside. A spread trading strategy involves taking a position in two or more options of the same type, that is, two or more calls or two or more puts. A spread that is designed to profit if the price goes down is called a bear spread.

This is basically done utilizing two call options having the same expiration date, but different exercise prices.

 In a bear spread, the strike price of the option purchased is greater than the strike price of the option sold. The buyer of a bear spread buys a call with an exercise price above the current index level and sells a call option with an exercise price below the current index level. The spread is a bear spread because the trader hopes to profit from a fall in the index. The trade is a spread because it involves buying one option and selling a related option.

Compared to buying the index itself, the bear spread with call options limits the trader’s risk, but it also limits the profit potential. In short, it limits both the upside potential as well as the downside risk.

A bear spread created using calls involves initial cash inflow since the price of the call sold is greater than the price of the call purchased. Illustration 5.4 gives the profit/loss incurred on a spread position as the index changes. Figure 5.12 shows the payoff from the bear spread.

Broadly we can have three types of bear spreads:

1. Both calls initially out-of-the-money.

2. One call initially in-the-money and one call initially out-of-the-money, and

3. Both calls initially in-the-money.

The decision about which of the three spreads to undertake depends upon how much risk the investor is willing to take. The most aggressive bear spreads are of type 1. They cost very little to set up, but have a very small probability of giving a high payoff. As we move from type 1 to type 2 and from type 2 to type 3, the spreads become more conservative and cost higher to set up. Bear spreads can also be created by buying a put with a high strike price and selling a put with a low strike price.