sm_otsm

Preface Preface

The

The National Stock Exchange of INational Stock Exchange of I ndia Ltd. (NSE)ndia Ltd. (NSE) , set up in the year 1993, is today the, set up in the year 1993, is today the largest stock exchange in India and a preferred exchange for trading in equity, debt and largest stock exchange in India and a preferred exchange for trading in equity, debt and derivatives instruments by investors. NSE has set up a sophisticated electronic trading, derivatives instruments by investors. NSE has set up a sophisticated electronic trading, clearing and settlement platform and its infrastructure serves as a role model for the clearing and settlement platform and its infrastructure serves as a role model for the securities industry. The standards set by NSE in terms of market practices; products and securities industry. The standards set by NSE in terms of market practices; products and technology have become industry benchmarks and are being replicated by many other technology have become industry benchmarks and are being replicated by many other market participants. NSE has four broad segments Wholesale Debt Market Segment market participants. NSE has four broad segments Wholesale Debt Market Segment (commenced in June 1994), Capital Market Segment (commenced in November 1994) (commenced in June 1994), Capital Market Segment (commenced in November 1994) Futures and Options Segment (commenced June 2000) and the Currency Derivatives Futures and Options Segment (commenced June 2000) and the Currency Derivatives segment (commenced in August 2008). Various products which are traded on the NSE segment (commenced in August 2008). Various products which are traded on the NSE include, equity shares, bonds, debentures, warrants, exchange traded funds, mutual funds, include, equity shares, bonds, debentures, warrants, exchange traded funds, mutual funds, government securities, futures and options on indices & single stocks and currency futures. government securities, futures and options on indices & single stocks and currency futures. Today NSE’s share to the total equity market turnover in India averages around 72% Today NSE’s share to the total equity market turnover in India averages around 72% whereas in the futures and options market this share is around 99%.

whereas in the futures and options market this share is around 99%.

At NSE, it has always been our endeavour to continuously upgrade the skills and proficiency At NSE, it has always been our endeavour to continuously upgrade the skills and proficiency of the

of the Indian investor. Indian investor. Exchange-tradExchange-traded options form an ed options form an important class of derivativesimportant class of derivatives which have standardized contract features and trade on public exchanges, facilitating which have standardized contract features and trade on public exchanges, facilitating trading among investors. They provide settlement guarantee by the Clearing Corporation trading among investors. They provide settlement guarantee by the Clearing Corporation thereby reducing counterparty risk. Options can be used for hedging, taking a view on the thereby reducing counterparty risk. Options can be used for hedging, taking a view on the future direction of the market or for arbitrage. Options are also helpful for implementing future direction of the market or for arbitrage. Options are also helpful for implementing various trading strategies such as straddle, strangle, butterfly, collar etc. which can help in various trading strategies such as straddle, strangle, butterfly, collar etc. which can help in generating income for investors under various market conditions.

generating income for investors under various market conditions. This module is being introduced to explain so

This module is being introduced to explain some of the important and basic me of the important and basic OptionsOptions strategies. The module which would be of interest to traders, investors, students and strategies. The module which would be of interest to traders, investors, students and anyone interested in the options markets. However, it is advisable to have a good anyone interested in the options markets. However, it is advisable to have a good knowledge about the

knowledge about the basics of basics of Options or Options or cleaclear r the NCFM Derivatives Markets (Dealers)the NCFM Derivatives Markets (Dealers) Module before taking up this module. To get a better clarity on the strategies, it is important Module before taking up this module. To get a better clarity on the strategies, it is important to read the examples and the pay-off schedules. The pay-off schedules can be worked out to read the examples and the pay-off schedules. The pay-off schedules can be worked out using a simple excel spreadsheet for better understanding.

using a simple excel spreadsheet for better understanding.

We hope readers find this module a valuable addition which aids in understanding various We hope readers find this module a valuable addition which aids in understanding various Optio

O P T I O N S

O P T I O N S...3...3 1.

1. INTRODUCTION TO OPTIONSINTRODUCTION TO OPTIONS...3...3

1

1..11 OPTION TERMINOLOGYOPTION TERMINOLOGY ... 33 1

1..22 OPTIONS PAYOFFSOPTIONS PAYOFFS...4...4

1.2.1

1.2.1 Payoff profile of buyer of asset: Long assetPayoff profile of buyer of asset: Long asset...4...4

1.2.2

1.2.2 Payoff profile for seller of asset: Short assetPayoff profile for seller of asset: Short asset...5...5

1.2.3

1.2.3 Payoff profile for buyer of call options: Long callPayoff profile for buyer of call options: Long call ...5...5

1.2.4

1.2.4 Payoff profile for writer (seller) of call options: Short callPayoff profile for writer (seller) of call options: Short call...6 ...6 

1.2.5

1.2.5 Payoff profile for buyer of put options: Long putPayoff profile for buyer of put options: Long put ...7 ...7 

1.2.6

1.2.6 Payoff profile for writer (seller) of put options: Short putPayoff profile for writer (seller) of put options: Short put...8...8

STRATEGY

STRATEGY 1 : 1 : LONG CALLLONG CALL ...10...10 STRATEGY 2 :

STRATEGY 2 : SHORT CASHORT CA LLLL...12...12 STRAT

STRAT EGY 3 : EGY 3 : SYNSYN THETIC LONG CALLTHETIC LONG CALL...14...14 STRATEG

STRATEGY Y 4 : LONG PUT4 : LONG PUT...18.18 STRATEGY

STRATEGY 5 : 5 : SHORT PUTSHORT PUT ...20...20 STRAT

STRAT EGY 6 EGY 6 : : COVERED COVERED CALLCALL...22.22 STRATEGY

STRATEGY 7 : 7 : LONG COMBOLONG COMBO ...26...26 STRATEG

STRATEGY 8 : Y 8 : PROTECTIVPROTECTIV E E CALLCALL...28...28 STRAT

STRAT EGY 9 : EGY 9 : COVERED PUTCOVERED PUT...30...30 STRATEGY 10 : LONG STRADDLE

STRATEGY 10 : LONG STRADDLE...32...32 STRATEGY

STRATEGY 11 : 11 : SHORT STRADDLSHORT STRADDL EE...34...34 STRATEGY 12 : LONG STRANGLE

STRATEGY 12 : LONG STRANGLE...36...36 STRATEGY 13. SHORT STRA

STRATEGY 13. SHORT STRA NGNGLELE...38...38 STRATEGY 14. C

STRATEGY 14. COLLAOLLA RR...40...40 STRATEGY 1

STRATEGY 1 5. BULL CALL SPREAD STRATEGY5. BULL CALL SPREAD STRATEGY...43...43 STRATEG

STRATEGY Y 16. BULL P16. BULL P UT SPREAD STRATEGUT SPREAD STRATEGYY ...45...45 STRATEGY 17 :

STRATEGY 17 : BEAR CABEAR CA LL SPLL SP READ STRATEGYREAD STRATEGY...47...47 STRATEGY 18 :

STRATEGY 18 : BEABEA R PR P UT SPRUT SPR EAD STRATEGEAD STRATEGYY...49...49 STRATEGY 1

STRATEGY 1 9: 9: LONG CALL BUTTERFLYLONG CALL BUTTERFLY...51...51 STRATEGY 20

STRATEGY 20 : : SHORT CSHORT CALL BUTALL BUT TERFLYTERFLY...53...53 STRATEGY 21

STRATEGY 21 : : LONG CALL CONDORLONG CALL CONDOR ...55.55 STRATEGY 22 :

3

3

OPTIONS

OPTIONS

1.

1. II NTRODUC

NTRODUCTION

TION TO

TO OPTI

OPTI ON

ON S

S

An

An optionoption is a is a contract written by a seller that conveys to the buyer the right contract written by a seller that conveys to the buyer the right — but not the— but not the obligation — to buy (in the case of a

obligation — to buy (in the case of a callcall option) or to sell (in the case of aoption) or to sell (in the case of a putput option) aoption) a particular asset, at a particular price (

particular asset, at a particular price (Strike price / Exercise priceStrike price / Exercise price) in future. In return for) in future. In return for granting the option, the seller collects a payment (the

granting the option, the seller collects a payment (the premiumpremium ) from the buyer. Exchange-) from the buyer. Exchange-traded options form an important class of

traded options form an important class of options which have standardized contract featuresoptions which have standardized contract features and trade on public

and trade on public exchanges, faciliexchanges, facilitating trading among tating trading among larglarg e e nnumber of umber of investors. Thinvestors. Theyey provide settlement guarantee by the Clearing Corporation thereby reducing counterparty provide settlement guarantee by the Clearing Corporation thereby reducing counterparty risk. Options can be used for hedging, taking a view on the future direction of the market, risk. Options can be used for hedging, taking a view on the future direction of the market, for arbitrage or for implementing strategies which can help in generating income for for arbitrage or for implementing strategies which can help in generating income for investors under various market conditions.

investors under various market conditions.

1.

1.1

1 OPTI

OPTION

ON TERMIN

TERMINOLOG

OLOGY

Y

•

• II n d e x o p t i o n sn d e x o p t i o n s:  :  These options have the index as the underlying. In India, they haveThese options have the index as the underlying. In India, they have a European style

a European style settlement. Eg. Nifty options, Mini Nifty options etc.settlement. Eg. Nifty options, Mini Nifty options etc.

•

• SSt o c k t o c k o p t i o n s :  o p t i o n s :  Stock options are options on individual stocks. A stock option contract givesStock options are options on individual stocks. A stock option contract gives the holder the right to buy or sell the underlying shares at the specified price. They have an the holder the right to buy or sell the underlying shares at the specified price. They have an American style settlement.

American style settlement. •

• Buyer of an option: Buyer of an option: The buyer of an option is the one who by paying the option premiumThe buyer of an option is the one who by paying the option premium buys the right but not the obligation to exercise his option on the seller/writer.

buys the right but not the obligation to exercise his option on the seller/writer. •

• W r i t e r / W r i t e r / s es el l el l er o f a n o p t i o n :  r o f a n o p t i o n :  The writer / seller The writer / seller of a call/put option is the one who receivesof a call/put option is the one who receives the

the opoptiotion pn preremiumium am and nd is thereby obligis thereby obliged to seled to sel l/buy tl/buy the assehe asse t if the bt if the buyer exuyer exerciserciseses on him.

on him. •

• CCall optall opt ion: ion: A call option gives the holder the right but not the obligation to buy an asset byA call option gives the holder the right but not the obligation to buy an asset by a

a cecertrtaiain datn date for e for a cera certain tain price.price. •

• Put option: Put option: A put option gives the holder the right but not the obligation to sell an asset byA put option gives the holder the right but not the obligation to sell an asset by a

a cercertaitain date fn date for a or a certain certain price.price. •

• OOp t i o n p r i cp t i o n p r i ce /e / p r e m i u m :  p r e m i u m :   Option price is the price which the option buyer pays to theOption price is the price which the option buyer pays to the option seller. It is also referred to as the option premium.

option seller. It is also referred to as the option premium.

•

• E x p i r a t i o n d a t e :  E x p i r a t i o n d a t e :  The date specified The date specified in the options contract is known in the options contract is known as the expirationas the expiration date, the exercise date, the strike date or the maturity.

date, the exercise date, the strike date or the maturity. •

• SSt rt r i k e p r i c e :  i k e p r i c e :  The price specified in the options contract is known as the strike price or theThe price specified in the options contract is known as the strike price or the exercise price.

exercise price. •

• A m e r i c a n o p t i o n s :  A m e r i c a n o p t i o n s :  American options are options that can be exercised at any time upto theAmerican options are options that can be exercised at any time upto the expiration date.

expiration date.

•

• E u r o p e a n o p t i o n s :  E u r o p e a n o p t i o n s :   European options are options that can be exercised only on theEuropean options are options that can be exercised only on the expiration date

•

• I n - t h e - m o n e y o p t i o n :  I n - t h e - m o n e y o p t i o n :  An in-the-money (ITM) option is an option that would lead to aAn in-the-money (ITM) option is an option that would lead to a positive cashflow to the holder if it

positive cashflow to the holder if it were exercised immediately. A call option on the indexwere exercised immediately. A call option on the index is said to be in-the-money when the current index stands at a level higher than the strike is said to be in-the-money when the current index stands at a level higher than the strike price (i.e. spot price > strike price). If the index is much higher than the strike price, the price (i.e. spot price > strike price). If the index is much higher than the strike price, the call is said to be deep ITM. In the case of a put, the put is ITM if the index is below the call is said to be deep ITM. In the case of a put, the put is ITM if the index is below the strike price.

strike price. •

• AAt -t - t h e - mt h e - m o n e y o n e y o p t i o n :  o p t i o n :  An at-the-An at-the-money (ATM) option is an option that would lead to zeromoney (ATM) option is an option that would lead to zero cashflow if it were

cashflow if it were exercised immediateexercised immediately. An option on the index is atly. An option on the index is at-the-money when the-the-money when the current index equals the strike price (i.e. spot price = strike price).

current index equals the strike price (i.e. spot price = strike price). •

• O u t - o f - t h e - m o n e y o p t i o n  O u t - o f - t h e - m o n e y o p t i o n  :: An out-of-the-money (OTM) option is an option that wouldAn out-of-the-money (OTM) option is an option that would lead to a negative cashflow if it were exercised immediately. A call option on the index is lead to a negative cashflow if it were exercised immediately. A call option on the index is out-of-the-money when the current index stands at a level which is less than the strike out-of-the-money when the current index stands at a level which is less than the strike price (i.e.

price (i.e. spot price spot price < strike price). If the index is much lower than the strike price, the call< strike price). If the index is much lower than the strike price, the call is said to be deep OTM. In the case of a put, the put is OTM if the index is above the is said to be deep OTM. In the case of a put, the put is OTM if the index is above the strike price.

strike price. •

• II ntrntr insic insic value of value of an option an option :: The option premium can be broken down into twoThe option premium can be broken down into two components - intrinsic value and time value. The intrinsic value of a call is the amount components - intrinsic value and time value. The intrinsic value of a call is the amount tthe he ooption is ption is ITM, if ITM, if it is ITit is ITM. M. If the call If the call is OTM, its is OTM, its intrinsic intrinsic value is zevalue is zero. Putting itro. Putting it another way, the intrinsic value of a call is

another way, the intrinsic value of a call is Max[0, (SMax[0, (Stt — K)]— K)] which means the intrinsicwhich means the intrinsic

value of a call is the greater of 0 or

value of a call is the greater of 0 or (S(Stt — K).— K). SimilSimilarly, the intrinsarly, the intrinsic value of a put isic value of a put is Max[0,Max[0,

K

K — S— Stt],i.e. the greater of 0 or],i.e. the greater of 0 or (K — S(K — Stt).). K is the strike price andK is the strike price and SStt is the spot price.is the spot price.

•

• Time value of an option: Time value of an option:  The time value of an option is the difference between itsThe time value of an option is the difference between its premi

premium and its intrinsium and its intrinsic value. Both calls and putc value. Both calls and puts have s have time value. An option that is OTMtime value. An option that is OTM or ATM has only time value. Usually, the maximum time value exists when the option is or ATM has only time value. Usually, the maximum time value exists when the option is ATM. The longer the time to expiration, the greater is an option's time value, all else equal. ATM. The longer the time to expiration, the greater is an option's time value, all else equal. At expiration

At expiration, an option should have no time , an option should have no time value.value.

1.

1.2

2 OPTIONS

OPTIONS PA

PAYOFFS

YOFFS

The optionality characteristic of options results in a non-linear payoff for options. In simple The optionality characteristic of options results in a non-linear payoff for options. In simple words, it means that the losses for the buyer of an option are limited, however the profits words, it means that the losses for the buyer of an option are limited, however the profits are potentially unlimited. For a writer (seller), the payoff is exactly the opposite. His profits are potentially unlimited. For a writer (seller), the payoff is exactly the opposite. His profits are limited to the option premium, however his losses are potentially unlimited. These are limited to the option premium, however his losses are potentially unlimited. These non-linear payoffs are fascinating as they lend themselves to be used to generate various linear payoffs are fascinating as they lend themselves to be used to generate various payoffs by using combinations of options and the underlying. We look here at the six basic payoffs by using combinations of options and the underlying. We look here at the six basic payoffs (pay close attention to these pay-offs, since all the strategies in the book are payoffs (pay close attention to these pay-offs, since all the strategies in the book are derived out of

derived out of these basic payoffs).these basic payoffs).

1 . 2 . 1

1 . 2 . 1 P

Pa y o f f p r o f

a y o f f p r o f i l e

i l e o f b u y e r o f

o f b u y e r o f a s s

a s se t : L

e t : Lo n g a s

o n g a ss e t  

s e t  

In this basic position, an investor buys the underlying asset, ABC Ltd. shares for instance, In this basic position, an investor buys the underlying asset, ABC Ltd. shares for instance, for Rs. 2220, and sells it at a future date at an unknown price,

for Rs. 2220, and sells it at a future date at an unknown price, SStt.. Once it is purchased, theOnce it is purchased, the

investor is said to be "long" the asset. Figure 1.1 shows the payoff for a long position on investor is said to be "long" the asset. Figure 1.1 shows the payoff for a long position on ABC Ltd.

5

5

Figure 1.1 Payoff for investor who went Long ABC Ltd. at Rs. 2220Payoff for investor who went Long ABC Ltd. at Rs. 2220

The figure shows the profits/losses from a long position on ABC Ltd.. The investor bought ABC The figure shows the profits/losses from a long position on ABC Ltd.. The investor bought ABC Ltd.

Ltd. at Rat Rs. s. 2222220. 0. If tIf the share price goes up, he profhe share price goes up, he prof its. If tits. If the sharhe share price price fae falls he lls he losesloses..

1 . 2 . 2

1 . 2 . 2 P

Pa y o f f p r o f

a y o f f p r o f i l e

i l e f o r s e l l e

f o r s e l l er o f a

r o f as s

s se t : S

e t : Sh o r

h o r t a s s

t a s se t  

e t  

In this basic position, an investor shorts the underlying asset, ABC Ltd. shares for instance, In this basic position, an investor shorts the underlying asset, ABC Ltd. shares for instance, for Rs. 2220, and buys it back at a future date at an unknown price,

for Rs. 2220, and buys it back at a future date at an unknown price, SStt.. Once it is sold, theOnce it is sold, the

investor is said to be "short" the asset. Figure 1.2 shows the payoff for a short position on investor is said to be "short" the asset. Figure 1.2 shows the payoff for a short position on ABC Ltd..

ABC Ltd.. Figure

Figure 1.1.22 Payoff for investor who went Short ABC Ltd. at Rs. 2220Payoff for investor who went Short ABC Ltd. at Rs. 2220

The figure shows the profits/losses from a short position on ABC Ltd.. The investor sold ABC Ltd. The figure shows the profits/losses from a short position on ABC Ltd.. The investor sold ABC Ltd. at Rs. 2220. If the share price falls, he profits. If the share price rises, he loses.

at Rs. 2220. If the share price falls, he profits. If the share price rises, he loses.

1 . 2 . 3

1 . 2 . 3 P

Pa y o f f p r o f i l e f o r

a y o f f p r o f i l e f o r b u y e r o f c

b u y e r o f ca l l

a l l o p t

o p t i o n s :

i o n s : L o n g

L o n g c a

c al l  

l l  

A call option gives the buyer the right to buy the underlying asset at the strike price A call option gives the buyer the right to buy the underlying asset at the strike price specified in the option. The profit/loss that the buyer makes on the option depends on the specified in the option. The profit/loss that the buyer makes on the option depends on the

ABC L ABC Ltdtd ..

ABC L ABC Ltdtd ..

spot price of the underlying. If upon expiration, the spot price exceeds the strike price, he spot price of the underlying. If upon expiration, the spot price exceeds the strike price, he makes a profit. Higher the spot price, more is the profit he makes. If the spot price of the makes a profit. Higher the spot price, more is the profit he makes. If the spot price of the underlying is less than the strike price, he lets his option expire un-exercised. His loss in underlying is less than the strike price, he lets his option expire un-exercised. His loss in this case is

this case is the premium he the premium he paid for buying paid for buying the option. the option. Figure 1.3 gives the Figure 1.3 gives the payoff for thepayoff for the buyer of a three month call option (often referred to as long call) with a strike of 2250 buyer of a three month call option (often referred to as long call) with a strike of 2250 bought at a premium of 86.60.

bought at a premium of 86.60.

Figure 1.3

Figure 1.3 Payoff for buyer of call optionPayoff for buyer of call option

The figure shows the profits/losses for the buyer of a three-month Nifty 2250 call option. As can The figure shows the profits/losses for the buyer of a three-month Nifty 2250 call option. As can be seen, as the spot Nifty rises, the call option is in-the-money. If upon expiration, Nifty closes be seen, as the spot Nifty rises, the call option is in-the-money. If upon expiration, Nifty closes above the strike of 22

above the strike of 2250, the buyer 50, the buyer would exerciswould exercise his option and profit to the extent of thee his option and profit to the extent of the difference between the Nifty

difference between the Nifty-close and the strike price. The -close and the strike price. The profits possible on this profits possible on this option option areare potentially unlimi

potentially unlimited. However if Nifty falls ted. However if Nifty falls below the strike of 2250, he below the strike of 2250, he lets the option expire. Hislets the option expire. His losses are limited to the extent of the premium he paid for buying the option.

losses are limited to the extent of the premium he paid for buying the option.

1 . 2 . 4

1 . 2 . 4 P

Pa y o f f p r o f i l e

a y o f f p r o f i l e f o r w

f o r w r i t

r i t e r

e r (( s e l l e

s e l l er ) o f c

r ) o f ca l l

a l l o p t i o n s : S

o p t i o n s : Sh o r t c a l l  

h o r t c a l l  

A call option gives the buyer the right to buy the underlying asset at the strike price A call option gives the buyer the right to buy the underlying asset at the strike price specified in the option. For selling the option, the writer of the option charges a premium. specified in the option. For selling the option, the writer of the option charges a premium. The profit/loss that the buyer makes on the option depends on the spot price of the The profit/loss that the buyer makes on the option depends on the spot price of the underlying. Whatever is the buyer's profit is the seller's loss. If upon expiration, the spot underlying. Whatever is the buyer's profit is the seller's loss. If upon expiration, the spot price exceeds the strike price, the buyer will exercise the option on the writer. Hence as the price exceeds the strike price, the buyer will exercise the option on the writer. Hence as the spot price increases the writer of the option starts making losses. Higher the spot price, spot price increases the writer of the option starts making losses. Higher the spot price, more is the loss he makes. If upon expiration the spot price of the underlying is less than more is the loss he makes. If upon expiration the spot price of the underlying is less than the strike price, the buyer lets his option expire un-exercised and the writer gets to keep the strike price, the buyer lets his option expire un-exercised and the writer gets to keep the premium. Figure 1.4 gives the payoff for the writer of a three month call option (often the premium. Figure 1.4 gives the payoff for the writer of a three month call option (often referred to as short call) with a strike of 2250 sold at a premium of 86.60.

7

7

Figure 1.1.44 Payoff for writer of call optionPayoff for writer of call option The figure shows the

The figure shows the profits/losses for the seller of a profits/losses for the seller of a threethree--momonth Nifty 2250 call option. As thenth Nifty 2250 call option. As the spot Nifty rises,

spot Nifty rises, the call option is in-thethe call option is in-the--money and the writer starts making lossmoney and the writer starts making losses. If upones. If upon expiration, Nifty closes above the strike of 2250, the buyer would exercise his option on the wr expiration, Nifty closes above the strike of 2250, the buyer would exercise his option on the wr iteriter who would suffer a loss to the extent of the difference between the Nifty-close and the strike who would suffer a loss to the extent of the difference between the Nifty-close and the strike price. The loss that can

price. The loss that can be incurred by the writer of be incurred by the writer of the option is potentially the option is potentially unlimunlimited, ited, wherewhereasas the maximum profit is limited to the extent of the up-front option premium of Rs.86.60 charged by the maximum profit is limited to the extent of the up-front option premium of Rs.86.60 charged by him.

him.

1 . 2 .

1 . 2 .5

5 P

Pa y o f f p r o f i l

a y o f f p r o f i le

e f o r b u y e r o f

f o r b u y e r o f p u t o p t i o n s :

p u t o p t i o n s : L o

L on g p u t  

n g p u t  

A put option gives the buyer the right to sell the underlying asset a

A put option gives the buyer the right to sell the underlying asset at the strike price specified in thet the strike price specified in the option. The profit/loss tha

option. The profit/loss that the buyer makes on the t the buyer makes on the option depends on the spot option depends on the spot price of price of thethe underlying. If upon expiration, the spot price is below the

underlying. If upon expiration, the spot price is below the strike price, he makes a profit. strike price, he makes a profit. Lower theLower the spot price, more is the profit he makes. If the spot price of the underlying is higher than the strike spot price, more is the profit he makes. If the spot price of the underlying is higher than the strike price, he lets his option

price, he lets his option expire unexpire un--exercised. His loss in thiexercised. His loss in this case is the premium he paid s case is the premium he paid forfor buying the

buying the option. Figure option. Figure 1.5 gives the payoff for the buyer of a three month put option (often1.5 gives the payoff for the buyer of a three month put option (often referred to as long put) with a strike of 2250 bought at a premium of 61.70.

Figure

Figure 1.1.55 Payoff for buyer of put optionPayoff for buyer of put option The figure shows the profits/losses for

The figure shows the profits/losses for the buyer of a the buyer of a threethree--month Nifty 2250 put option. As can bemonth Nifty 2250 put option. As can be seen, as the

seen, as the spot Nifty falls, spot Nifty falls, the put option the put option is in-this in-the-e-money. If upon expirmoney. If upon expiration, Nifty closation, Nifty closes belowes below the strike of 2250, the buyer would exercise his option and profit to the extent of the difference the strike of 2250, the buyer would exercise his option and profit to the extent of the difference between the strike price and Nifty-close. The profits possible on this option can be as high as the between the strike price and Nifty-close. The profits possible on this option can be as high as the strike price. However if Nifty rises above the strike of 2250, he lets the option expire. His losses strike price. However if Nifty rises above the strike of 2250, he lets the option expire. His losses are limited to the extent of the premium he paid for buying the option.

are limited to the extent of the premium he paid for buying the option.

1 . 2 .

1 . 2 .6

6 P

Pa y o f f

a y o f f p r o f i l e

p r o f i l e f o r w

f o r w r i t e r

r i t e r (( s e

s el l e r ) o f p u t o p t i o n s :

l l e r ) o f p u t o p t i o n s : S

Sh o r t p u t  

h o r t p u t  

A put option gives the buyer the right to sell the underlying asset at the strike price A put option gives the buyer the right to sell the underlying asset at the strike price specified in the option. For selling the option, the writer of the option charges a premium. The specified in the option. For selling the option, the writer of the option charges a premium. The profit/loss that the buyer makes on the option depends on the spot price of the underlying. profit/loss that the buyer makes on the option depends on the spot price of the underlying. Whatever is the buyer's profit is the seller's loss. If upon expiration, the spot price happens to be Whatever is the buyer's profit is the seller's loss. If upon expiration, the spot price happens to be below the strike price, the buyer will exercise the option on the writer. If upon expiration the spot below the strike price, the buyer will exercise the option on the writer. If upon expiration the spot price of the underlying is more than the strike price, the buyer lets his option un-exercised and price of the underlying is more than the strike price, the buyer lets his option un-exercised and the writer gets to keep the premium.

the writer gets to keep the premium. Figure 1.6 gives the Figure 1.6 gives the payoff for the writer of payoff for the writer of a three montha three month put option (often referred to as short put) with a strike of 2250 sold at a premium of 61.70. put option (often referred to as short put) with a strike of 2250 sold at a premium of 61.70.

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Figure 1.1.66 Payoff for writer of put optionPayoff for writer of put option

The figure shows the profits/losses for the seller of a three-month Nifty 2250 put option. As the The figure shows the profits/losses for the seller of a three-month Nifty 2250 put option. As the spot Nifty falls, the put option is in-the-money and the writer starts making losses. If upon spot Nifty falls, the put option is in-the-money and the writer starts making losses. If upon expiration, Nifty closes belo

expiration, Nifty closes below the strike w the strike of 2250, the buyer would eof 2250, the buyer would exercise his option on thexercise his option on the writer who would suffer a loss to the extent of the difference between the strike price and writer who would suffer a loss to the extent of the difference between the strike price and Nifty-close. The loss that can be incurred by the writer of the option is a maximum extent of the close. The loss that can be incurred by the writer of the option is a maximum extent of the strike price (Since the worst that can happen is that the asset price can fall to zero) whereas strike price (Since the worst that can happen is that the asset price can fall to zero) whereas the maximum profit is limited to the extent of the up-front option premium of Rs.61.70 charged the maximum profit is limited to the extent of the up-front option premium of Rs.61.70 charged by him.

by him.

Let us now

STRATEGY

STRATEGY 1 :

1 : LON

LON G C

G CAL

AL L

L

For aggressive investors who are very bullish about the prospects for a stock / index, buying For aggressive investors who are very bullish about the prospects for a stock / index, buying calls can be an

calls can be an excellent way to capture the excellent way to capture the upside potential with limited downside riskupside potential with limited downside risk..

Buying a call is the most basic of  Buying a call is the most basic of  all options strategies. It all options strategies. It constitutes the first options trade constitutes the first options trade for someone already familiar with for someone already familiar with buying / selling stocks and would buying / selling stocks and would now want to trade options. Buying now want to trade options. Buying a call is an easy strategy to a call is an easy strategy to understand. When you buy it understand. When you buy it means you are bullish. Buying a means you are bullish. Buying a Call means you are very bullish Call means you are very bullish and expect the underlying stock / and expect the underlying stock / index to rise in future.

index to rise in future. When to Use:

When to Use: Investor is veryInvestor is very bullish

bullish on the stock / index.on the stock / index. Risk:

Risk: Limited to the Premium.Limited to the Premium. (Maximum loss if market expires (Maximum loss if market expires at or below the option strike at or below the option strike price).

price). Reward:

Reward: UnlimitedUnlimited Breakeven:

Breakeven: Strike Strike Price Price ++ Premium

Premium

Example Example

Mr. XYZ is bullish on Nifty on 24

Mr. XYZ is bullish on Nifty on 24tt hh June, when theJune, when the Nifty is

Nifty is at at 4191.10. 4191.10. He buys He buys a call a call option woption w ith aith a strike pric

strike price of Rs. 4600 at a e of Rs. 4600 at a premium of premium of Rs. 36.Rs. 36.35,35, expiring on 31

expiring on 31stst July. If the Nifty goes aboveJuly. If the Nifty goes above 4636.35, Mr. XYZ will make a net profit (after 4636.35, Mr. XYZ will make a net profit (after deducting the premium) on exercising the option. deducting the premium) on exercising the option. In case the Nifty stays at or falls below 4600, he In case the Nifty stays at or falls below 4600, he can forego t

can forego the option (it he option (it ww ill expire worthless) will expire worthless) w ithith a maximum loss of the premium.

a maximum loss of the premium. Strategy : Buy Call Option

Strategy : Buy Call Option Current

Current Nifty Nifty index index 4191.14191.100

Call

Call Option Option Strike Strike Price Price (Rs.) (Rs.) 46004600 Mr.

Mr. XYZ XYZ Pays Pays Premium Premium (Rs.) (Rs.) 36.3536.35 Break Even Point

Break Even Point (Rs.) (Strike Price (Rs.) (Strike Price + Premium) + Premium) 4636.35 4636.35

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ANALYSIS: This strategy limits the downside risk to the extent of premium paid by Mr.This strategy limits the downside risk to the extent of premium paid by Mr. XYZ

XYZ (Rs. (Rs. 36.336.35). B5). But the potential return is unlimited in case of rise ut the potential return is unlimited in case of rise in in NiftNifty. y. A long A long callcall option is the simplest way to benefit if you believe that the market will make an upward option is the simplest way to benefit if you believe that the market will make an upward move and is the most common choice among first time investors in Options. As the stock move and is the most common choice among first time investors in Options. As the stock price / index rises the long Call moves into profit more and more quickly.

price / index rises the long Call moves into profit more and more quickly. The payoff schedule

The payoff schedule

On expiry Nifty On expiry Nifty closes at

closes at

Net

Net Payoff Payoff from from CallCall Option (Rs.) Option (Rs.) 4100.00 4100.00 -36.35-36.35 4300.00 4300.00 -36.35-36.35 4500.00 4500.00 -36.35-36.35 4636.35 4636.35 00 4700.00 4700.00 63.6563.65 4900.00 4900.00 263.65263.65 5100.00 5100.00 463.65463.65 5300.00 5300.00 663.65663.65

The payoff chart (Long Call) The payoff chart (Long Call)

STRATEGY 2

STRATEGY 2 :

: SHORT CAL

SHORT CAL L

L

When you buy a Call you are hoping that the underlying stock / index would rise. When When you buy a Call you are hoping that the underlying stock / index would rise. When you expect the underlying stock / index to fall you do the opposite. When an investor is you expect the underlying stock / index to fall you do the opposite. When an investor is very bearish about a stock / index and expects the prices to fall, he can sell Call options. very bearish about a stock / index and expects the prices to fall, he can sell Call options. This position offers limited profit potential and the possibility of large losses on big This position offers limited profit potential and the possibility of large losses on big advances in underlying prices. Although easy to execute it is a risky strategy since the advances in underlying prices. Although easy to execute it is a risky strategy since the seller of the Call is exposed to unlimited risk.

seller of the Call is exposed to unlimited risk.

1.

1.

A Call option means an Option A Call option means an Option to buy. Buying a Call option to buy. Buying a Call option means an investor expects the means an investor expects the underlying price of a stock / underlying price of a stock / index to rise in future. Selling a index to rise in future. Selling a Call option is just the opposite Call option is just the opposite of buying a Call option. Here the of buying a Call option. Here the seller of the option feels the seller of the option feels the underlying

underlying price price of of a a stock stock // index is set to fall in the future. index is set to fall in the future. When to use:

When to use: Investor is veryInvestor is very aggressive and he is

aggressive and he is veryvery bearish

bearish about the stock /about the stock / index.

index. Risk:

Risk: UnlimitedUnlimited Reward:

Reward: Limited to the amountLimited to the amount of premium

of premium

Break-even Point:

Break-even Point: Strike PriceStrike Price + Premium

+ Premium

Example: Example:

Mr. XYZ is bearish about Nifty and expects it to Mr. XYZ is bearish about Nifty and expects it to fall.fall. He sells a Call option with a strike price of Rs. 2600 He sells a Call option with a strike price of Rs. 2600 at a premium of Rs. 154, when the current Nifty is at at a premium of Rs. 154, when the current Nifty is at 2694. If the Nifty stays at 2600 or below, the Call 2694. If the Nifty stays at 2600 or below, the Call option w

option w ill not be exercised by the buyer of ill not be exercised by the buyer of the Callthe Call and Mr. XYZ can retain the entire premium of Rs. and Mr. XYZ can retain the entire premium of Rs. 154.

154.

Strategy :

Strategy : Sell Call Sell Call OptionOption Current

Current Nifty Nifty index index 26942694 Call

Call Option Option Strike Strike Price Price (Rs.) (Rs.) 26002600 Mr.

Mr. XYZ XYZ receives receives Premium Premium (Rs.) (Rs.) 151544 Break Even Point (Rs.)

Break Even Point (Rs.) (Strike Price + (Strike Price + Premium)* Premium)* 2754 2754

* Breakeven Point is from the point of Call Option Buyer. * Breakeven Point is from the point of Call Option Buyer.

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2.

2.

ANALYSIS:

ANALYSIS: This strategy is used when an investor is very aggressive and has a strongThis strategy is used when an investor is very aggressive and has a strong expectation of a price fall (and certainly not a price rise). This is a risky strategy since as expectation of a price fall (and certainly not a price rise). This is a risky strategy since as the stock price / index rises, the short call loses money more and more quickly and losses the stock price / index rises, the short call loses money more and more quickly and losses can be significant if the stock price / index falls below the strike price. Since the investor can be significant if the stock price / index falls below the strike price. Since the investor does not own the underlying stock that he is shorting this strategy is also called Short does not own the underlying stock that he is shorting this strategy is also called Short Naked Call.

Naked Call.

The payoff schedule The payoff schedule

On expiry On expiry Nifty closes at Nifty closes at

Net Payoff from Net Payoff from the Call Options the Call Options (Rs.) (Rs.) 2400 2400 1515 44 2500 2500 1515 44 2600 2600 1515 44 2700 2700 5454 2754 2754 00 2800 2800 --4646 2900 2900 -146-146 3000 3000 -246-246

The payoff chart (

STRATEGY 3

STRATEGY 3 :

: SYN

SYN THETI

THETI C

C LON

LON G C

G CAL

AL L:

L: BUY

BUY

ST

STOCK,

OCK, BUY

BUY P

P UT

UT

In this strategy, we purchase a stock since we feel bullish about it. But what if the price of  In this strategy, we purchase a stock since we feel bullish about it. But what if the price of  the stock went down. You wish you had some insurance against the price fall. So buy a Put the stock went down. You wish you had some insurance against the price fall. So buy a Put on the stock. This gives you the right to sell the stock at a certain price which is the strike on the stock. This gives you the right to sell the stock at a certain price which is the strike price. The strike price can be the price at which you bought the stock (ATM strike price) or price. The strike price can be the price at which you bought the stock (ATM strike price) or sl

slightly below ightly below (OTM strike price).(OTM strike price).

In case the price of the stock rises you get

In case the price of the stock rises you get the full benefit of the price rise. In case the pricethe full benefit of the price rise. In case the price of the stock falls, exercise the Put Option (remember Put is a right to sell). You have capped of the stock falls, exercise the Put Option (remember Put is a right to sell). You have capped your loss in this manner because the Put option stops your further losses.

your loss in this manner because the Put option stops your further losses. It is a strategyIt is a strategy with a limited loss and (after subtracting the Put premium) unlimited profit (from the stock with a limited loss and (after subtracting the Put premium) unlimited profit (from the stock price rise). The result of this strategy looks like a Call Option Buy strategy and therefore is price rise). The result of this strategy looks like a Call Option Buy strategy and therefore is called a Synthetic Call!

called a Synthetic Call!

But the strategy is

But the strategy is not Buy Call Option (Strategy 1). Here you have taken an exposure to annot Buy Call Option (Strategy 1). Here you have taken an exposure to an underlying stock with the aim of holding it and reaping the benefits of price rise, dividends, underlying stock with the aim of holding it and reaping the benefits of price rise, dividends, bonus rights etc. and at the same time insuring against an adverse price movement.

bonus rights etc. and at the same time insuring against an adverse price movement.

In simple buying of a Call Option, there is no underlying position in the stock but is entered In simple buying of a Call Option, there is no underlying position in the stock but is entered into only to take advantage of price movement in the underlying stock.

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When to use: WhenWhen ownership is desired of  ownership is desired of  stock yet investor is stock yet investor is concerned about near-term concerned about near-term downside risk. The outlook downside risk. The outlook is

is conservativconservatively ely bullish.bullish. Risk:

Risk: Losses Losses limited limited toto Stock price + Put Premium Stock price + Put Premium – Put Strike price

– Put Strike price R e w a r d :

R e w a r d : Profit potential isProfit potential is unlimited.

unlimited.

Break-even Point:

Break-even Point: PutPut Strike Pr

Strike Price + ice + Put PremiumPut Premium + Stock

+ Stock Price Price – – Put StrikePut Strike Price

Price

Example Example

Mr. XYZ is bullish about ABC Ltd stock. He buys ABC Mr. XYZ is bullish about ABC Ltd stock. He buys ABC Ltd. at current market price of R

Ltd. at current market price of R s. 4000 on 4s. 4000 on 4tt hh July. ToJuly. To protect against fall in the price of ABC Ltd. (his risk), protect against fall in the price of ABC Ltd. (his risk), he buys an ABC Ltd. Put option w

he buys an ABC Ltd. Put option w ith a strike price Rs.ith a strike price Rs. 3900 (OTM) at a premium of Rs. 143.80 expiring on 3900 (OTM) at a premium of Rs. 143.80 expiring on 31st July.

31st July. Strategy :

Strategy : Buy Stock + Buy PBuy Stock + Buy P ut Optionut Option Buy Stock

Buy Stock (Mr. XYZ pays) (Mr. XYZ pays)

Current Market Price of  Current Market Price of  ABC

ABC Ltd. Ltd. (Rs.)(Rs.)

4000 4000

Strike

Strike Price Price (Rs.) (Rs.) 39003900 Buy Put Buy Put (Mr. XYZ pays) (Mr. XYZ pays) Premium (Rs.) Premium (Rs.) 143.80 143.80 Break Even Point (Rs.)

Break Even Point (Rs.) (Put Strike Price + Put (Put Strike Price + Put Premium + Stock Price – Premium + Stock Price – Put Strike Price)*

Put Strike Price)*

4143.80 4143.80

* Break Even is from the point of view of Mr. XYZ. He has to * Break Even is from the point of view of Mr. XYZ. He has to recover the cost of the Put Option purchase price + the recover the cost of the Put Option purchase price + the stock price to break even.

Example : Example :

ABC Ltd. is trading at Rs. 4000 on 4

ABC Ltd. is trading at Rs. 4000 on 4thth July.July. Buy 100 shares of the Stock at Rs. 4000 Buy 100 shares of the Stock at Rs. 4000

Buy 100 July Put Options with a Strike Price of Rs. 3900 at a premium of Rs. 143.80 per Buy 100 July Put Options with a Strike Price of Rs. 3900 at a premium of Rs. 143.80 per put.

put.

Net

Net Debit Debit (payout(payout) ) Stock Stock Bought Bought + + Premium Premium PaidPaid Rs. 4000 + Rs. 143.80

Rs. 4000 + Rs. 143.80 Rs.

Rs. 4,14,380/-Maximum

Maximum Loss Loss Stock Stock Price Price + + Put Put Premium Premium – – Put Put StrikeStrike Rs. 4000 + Rs. 143.80 – Rs. 3900 Rs. 4000 + Rs. 143.80 – Rs. 3900 Rs. 24,380

Rs. 24,380 Maximum

Maximum Gain Gain Unlimited Unlimited (as (as the the stock stock rises)rises)

Breakeven

Breakeven Put Put Strike Strike + + Put Put Premium Premium + + Stock Stock Price Price – – Put Put StrikeStrike Rs. 3900 + Rs. 143.80 + Rs. 4000 – Rs. 3900

Rs. 3900 + Rs. 143.80 + Rs. 4000 – Rs. 3900 = Rs. 4143.80

= Rs. 4143.80

The payoff schedule The payoff schedule

ABC Ltd. closes at ABC Ltd. closes at (Rs.) on expiry (Rs.) on expiry

Payoff from the Payoff from the Stock (Rs.) Stock (Rs.)

Net Payoff from the Net Payoff from the Put Option ( Put Option ( Rs.)Rs.) Net Payoff  Net Payoff  (Rs.) (Rs.) 3400. 3400.00 00 --600.0600.00 0 356.20356.20 -243.80-243.80 3600. 3600.00 00 --400.0400.00 0 156156 .2.200 -243.80-243.80 3800. 3800.00 00 --200.0200.00 0 --43.8043.80 -243.80-243.80 4000. 4000.00 00 0 0 -143.80-143.80 -143.80-143.80 4143. 4143.80 80 143.80 143.80 -143.80-143.80 00 4200. 4200.00 00 200.00 200.00 -143.80-143.80 56.2056.20 4400. 4400.00 00 400.00 400.00 -143.80-143.80 256.20256.20 4600. 4600.00 00 600.00 600.00 -143.80-143.80 456.20456.20 4800. 4800.00 00 800.00 800.00 -143.80-143.80 656.20656.20

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ANALYSIS: This is a low risk strategy. This is a strategy which limits the loss in case of fallThis is a low risk strategy. This is a strategy which limits the loss in case of fall in market but the potential profit remains unlimited when the stock price rises. A good in market but the potential profit remains unlimited when the stock price rises. A good strategy when you buy a stock for medium or long term, with the aim of protecting any strategy when you buy a stock for medium or long term, with the aim of protecting any down

downside riskside risk. . The pay-off The pay-off resembles a Call Option buy and is therefore resembles a Call Option buy and is therefore called as Syntheticcalled as Synthetic Long Call.

Long Call.

The payoff chart (

The payoff chart ( Synthetic Long CallSynthetic Long Call

))

+

+

=

=

Buy Stock

ST

STRA

RA TEG

TEGY

Y 4 :

4 : LON

LON G P

G P UT

UT

Buying a Put is the opposite of buying a Call. When you buy a Call you are bullish about the Buying a Put is the opposite of buying a Call. When you buy a Call you are bullish about the sto

stock ck / inde/ inde xx. . When an investor iWhen an investor is bearish, he can buy a Put optios bearish, he can buy a Put option. A Put Option gives then. A Put Option gives the buyer of the Put a right to sell the stock (to the Put seller) at a pre-specified price and buyer of the Put a right to sell the stock (to the Put seller) at a pre-specified price and thereby limit his risk.

thereby limit his risk.

A long Put is a A long Put is a Bearish

Bearish strategy. Tostrategy. To take advantage of a take advantage of a falling market an falling market an investor can buy Put investor can buy Put options. options. When to use: When to use: Investor is bearish Investor is bearish about the stock / about the stock / index.

index. Risk:

Risk: Limited to theLimited to the amount of Premium amount of Premium paid. (Maximum loss if  paid. (Maximum loss if  stock / index expires stock / index expires at or above the option at or above the option strike price).

strike price). Reward:

Reward: UnlimitedUnlimited Break-even Point: Break-even Point: Stock Price - Premium Stock Price - Premium

Example: Example:

Mr. XYZ is bearish on Nifty on 24

Mr. XYZ is bearish on Nifty on 24tt hh June, when theJune, when the Nifty is

Nifty is at at 2694. 2694. He buys He buys a a Put option with a strikePut option with a strike price Rs. 2600 at a premium of Rs. 52, expiring on price Rs. 2600 at a premium of Rs. 52, expiring on 31

31stst July. If the Nifty goes below 2548, Mr. XYZ willJuly. If the Nifty goes below 2548, Mr. XYZ will make a profit on exercising the option. In case the make a profit on exercising the option. In case the Nifty rises above 2600, he can forego the option (it Nifty rises above 2600, he can forego the option (it will expire worthless) with a maximum loss of the will expire worthless) with a maximum loss of the premium.

premium.

Strateg

Strateg y : y : Buy PBuy P ut Optionut Option Current

Current Nifty Nifty index index 26942694 Put

Put Option Option Strike Strike Price Price (Rs.) (Rs.) 26002600 Mr.

Mr. XYZ XYZ Pays Pays Premium (Rs.) Premium (Rs.) 5252 Break Even Point (Rs.)

Break Even Point (Rs.) (Strike Price -

(Strike Price - PremPremiumium))

2548 2548

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ANALYSIS: A A bearish bearish investor investor can can profit frprofit from declining stom declining stock price by buock price by buying Pying Puts. uts. HeHe limits his risk to the amount of premium paid but his profit potential remains unlimited. This limits his risk to the amount of premium paid but his profit potential remains unlimited. This is one of the widely used strategy when an investor is bearish.

is one of the widely used strategy when an investor is bearish. The payoff schedule

The payoff schedule

On expiry Nifty On expiry Nifty closes at

closes at

Net Payoff from Net Payoff from Put

Put Option (Rs.)Option (Rs.) 2300 2300 2424 88 2400 2400 1414 88 2500 2500 4848 2548 2548 00 2600 2600 --5252 2700 2700 --5252 2800 2800 --5252 2900 2900 --5252

The payoff chart

S

STRATEGY 5

TRATEGY 5 :

: S

SHORT P

HORT P UT

UT

Selling a Put is opposite of buying a Put. An investor buys Put when he is bearish on a Selling a Put is opposite of buying a Put. An investor buys Put when he is bearish on a stock. An investor Sells Put when he is

stock. An investor Sells Put when he is B u l l i s hB u l l i s h about the stock – expects the stock price toabout the stock – expects the stock price to rise or stay sideways at the minimum. When you sell a Put, you earn a Premium (from the rise or stay sideways at the minimum. When you sell a Put, you earn a Premium (from the buyer of the Put). You have sold someone the right to sell you the stock at the strike price. buyer of the Put). You have sold someone the right to sell you the stock at the strike price. If the stock price increases beyond the strike price, the short put position will make a profit If the stock price increases beyond the strike price, the short put position will make a profit for the sell

for the seller by er by the amount of the amount of the premium, since the the premium, since the buyer will not exercbuyer will not exercise the Put optionise the Put option and the Put seller can

and the Put seller can retain the Premium (which retain the Premium (which is his is his maximum profit). maximum profit). But, if the stockBut, if the stock price decreases below the strike price, by more than the amount of the premium, the Put price decreases below the strike price, by more than the amount of the premium, the Put selle

seller r will lose monewill lose money. y. The potential loss being unlimited (until The potential loss being unlimited (until the stock price the stock price fall to zero).fall to zero).

When to Use:

When to Use: InvestorInvestor is very

is very B u l l i s hB u l l i s h on theon the stock / index. The main stock / index. The main idea is to make a short idea is to make a short term income.

term income. Risk:

Risk: Put StrikPut Strike Price e Price –– Put Premium.

Put Premium. Reward:

Reward: Limited to theLimited to the amount of Premium amount of Premium received.

received. Breakeven:

Breakeven: Put StrikePut Strike Price - Premium

Price - Premium

Example Example

Mr. XYZ is bullish on Nifty w

Mr. XYZ is bullish on Nifty w hen it is at 4191.10. He sells ahen it is at 4191.10. He sells a Put option with a strike price of Rs. 4100 at a premium of  Put option with a strike price of Rs. 4100 at a premium of  Rs. 170.50 expiring on 31

Rs. 170.50 expiring on 31stst July. If the Nifty index staysJuly. If the Nifty index stays above 4100,

above 4100, he will gain the amount of premhe will gain the amount of prem ium as the ium as the PutPut buyer won’t exercise his option. In case the Nifty falls buyer won’t exercise his option. In case the Nifty falls below 4100, Put buyer w

below 4100, Put buyer w ill exercill exercise the option and the Mr.ise the option and the Mr. XYZ will start losing money. If the Nifty falls below XYZ will start losing money. If the Nifty falls below 3929.50, which is the breakeven point, Mr. XYZ will lose 3929.50, which is the breakeven point, Mr. XYZ will lose the premium and mo

the premium and mo re depending on the extent of the fallre depending on the extent of the fall in Nifty.

in Nifty. Strategy :

Strategy : Sell Put OpSell Put Op tiontion Current

Current Nifty Nifty index index 4191.4191.1010 Put

Put Option Option Strike Strike Price Price (Rs.) (Rs.) 41004100 Mr.

Mr. XYZ XYZ receives receives Premium Premium (Rs.) (Rs.) 170.5170.5 Break Even Point (Rs.)

Break Even Point (Rs.) (Strike Price - Premium)* (Strike Price - Premium)*

3929.5 3929.5

* Breakeven Point is from the point of Put Option Buyer. * Breakeven Point is from the point of Put Option Buyer.

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The payoff schedule

On expiry Nifty On expiry Nifty Closes at Closes at Net Payoff  Net Payoff  from the Put from the Put Option (Rs.) Option (Rs.) 3400.00 3400.00 -529.50-529.50 3500.00 3500.00 -429.50-429.50 3700.00 3700.00 -229.50-229.50 3900.00 3900.00 -29.50-29.50 3929.50 3929.50 00 4100.00 4100.00 170.50170.50 4300.00 4300.00 170.50170.50 4500.00 4500.00 170.50170.50

The payoff chart (Short Put) The payoff chart (Short Put)

A N A L Y S I S

A N A L Y S I S: Selling Puts can lead to regular income in a rising or range bound markets. But it: Selling Puts can lead to regular income in a rising or range bound markets. But it should be done carefully since the potential losses can be significant in case the price of the stock should be done carefully since the potential losses can be significant in case the price of the stock  / index falls. This strategy can be

STRATEGY 6

STRATEGY 6 :

: COVERED CAL

COVERED CAL L

L

You own shares in a company whi

You own shares in a company which you feel ch you feel may rise but not may rise but not mucmuch in the near term (or ath in the near term (or at best stay sideways). You would still like to earn an income from the shares. The covered call best stay sideways). You would still like to earn an income from the shares. The covered call is a strategy in which an investor Sells a Call option on a stock he owns (netting him a is a strategy in which an investor Sells a Call option on a stock he owns (netting him a premium). The Call Option which is sold in usually an OTM Call. The Call would not get premium). The Call Option which is sold in usually an OTM Call. The Call would not get exercised unless the stock price increases above the strike price. Till then the investor in the exercised unless the stock price increases above the strike price. Till then the investor in the stock

stock (Call (Call seller) seller) can retain the Pcan retain the P remium wremium with himith him. This becomes his income from the. This becomes his income from the stock. This strategy is usually adopted by a stock owner who is

stock. This strategy is usually adopted by a stock owner who is Neutral to moderatelyNeutral to moderately Bullish

Bullish about the stock.about the stock.

An investor buys a stock or owns a stock which he feel is good for medium to long term but An investor buys a stock or owns a stock which he feel is good for medium to long term but is neutral or bearish for the near term. At the same time, the investor does not mind exiting is neutral or bearish for the near term. At the same time, the investor does not mind exiting the stock at a certain price (target price). The investor can sell a Call Option at the strike the stock at a certain price (target price). The investor can sell a Call Option at the strike price at which he

price at which he would be fine ewould be fine e xiting the stock xiting the stock (OTM strike). By selling the Call Option the(OTM strike). By selling the Call Option the investor earns a Premium. Now the position of the investor is that of a Call Seller who owns investor earns a Premium. Now the position of the investor is that of a Call Seller who owns the underlying stock. If the stock price stays

the underlying stock. If the stock price stays at at or or below the strike below the strike priceprice, the Call Bu, the Call Buyeryer (refer to Strategy 1) will not exercise the Call. The Premium is retained by the investor. (refer to Strategy 1) will not exercise the Call. The Premium is retained by the investor.

In case the stock price goes above the strike price, the Call buyer who has the right to buy In case the stock price goes above the strike price, the Call buyer who has the right to buy the stock at the strike price

the stock at the strike price will exercise the Call option. The Call seller (twill exercise the Call option. The Call seller (t he investor) whohe investor) who has to sell the stock to the Call buyer, will sell the stock at the strike price. This was the has to sell the stock to the Call buyer, will sell the stock at the strike price. This was the price which the Call sel

price which the Call seller (the investor) was anyway ler (the investor) was anyway interested in exiting the interested in exiting the stock and nowstock and now exits at that price. So besides the strike price which was the target price for selling the exits at that price. So besides the strike price which was the target price for selling the stock, the Call seller (investor) also earns the Premium which becomes an additional gain stock, the Call seller (investor) also earns the Premium which becomes an additional gain for him. This strategy is called as a Covered Call strategy because the Call sold is backed by for him. This strategy is called as a Covered Call strategy because the Call sold is backed by a stock owned by the Call Seller (investor). The income increases as the stock rises, but a stock owned by the Call Seller (investor). The income increases as the stock rises, but gets capped after the stock reaches the strike price. Let us see an example to understand gets capped after the stock reaches the strike price. Let us see an example to understand the Covered Call strategy.