Tuesday, February 26, 2013

Excellent Trading School - 29 - Frequently Asked Questions about Options Contracts - Part 5 (Options Strategies)


Question: What are Strip and Strap strategies?
Answer: These strategies are quite similar to Straddle. The only difference is that unlike straddle, call and put options are not bought in equal numbers.

In Strip strategy, the number of puts bought or sold is double that of call options.
In Strap, the number of calls bought or sold is double that of put options.

You buy strip when you expect sharp movement in the prices of the underlying but are a little biased towards downward movement, so you buy more put than call options. 

Likewise while buying strap you are little biased towards upward movement, you buy more call than put options.

You sell strip when you expect the price to fluctuate in a narrow range but you also believe that in case the price moves beyond the range, it would move upward, so you sell more put than call options.

Likewise while selling strap you are a little biased toward downward movement of the underlying price in case it breaks the range.

Question: I believe that the underlying will fluctuate in a narrow range but am not very sure of it moving sharply in either direction. What should be my strategy? What is the upside potential and downside risk? What happens as time passes?
Answer: When you believe that the underlying will fluctuate in a narrow range but are not very sure of it moving sharply in either direction, Long Butterfly is the best strategy.
Strategy implementation: buy one in-the-money call, sell two at-the-money calls and buy one out-of-the-money call option. The same strategy can be implemented using put options also. It is difficult to execute four transactions simultaneously. As such there is execution risk involved.
Upside potential: the profit is limited to the extent of the difference between the lower and middle strike prices minus initial debit.
Downside risk: the loss is limited to the extent of initial debit.
Time decay characteristic: time works against.

Question: I am not sure of the direction and am fairly certain that the underlying is going to rise or fall sharply. What strategy should I follow? What is the upside potential and downside risk? What happens as time passes?
Answer: When you are not so sure that the underlying index or stock will rise or fall sharply and are not certain about the direction, Short Butterfly is the best strategy. Strategy implementation: sell one in-the-money call, buy two at-the-money calls and sell one out-of-the-money call option. The same strategy can be implemented using put options also. It is difficult to execute four transactions simultaneously. As such there is execution risk involved.
Upside potential: the profit is limited to the extent of initial credit received.
Downside risk: the loss is limited to the extent of the difference between the lower and middle strike prices minus initial credit received.
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