Short Call: Options Trading Strategy

BEARISH STRATEGIES

Short Call

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 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 advances in underlying prices. Although easy to execute it is a risky strategy since the seller of the Call is exposed to unlimited risk.

Market Scenario: Bearish

Risk: Unlimited

Reward: limited

BEP: Call Strike + Premium

EXAMPLE:
 

Entry:

SPOT

5100

                       

	STRIKE	PREMIUM
SELL CALL	5000	150

BEP = 5000 + 50 = 5150

On Exit if:

SPOT	CALL PAY-OFF	PREMIUM RECEIVED	STRATEGY PAY-OFF
4800	0	150	150
4900	0	150	150
5000	0	150	150
5100	-100	150	50
5150	-150	150	0
5200	-200	150	-50
5300	-300	150	-150
5400	-400	150	-250
5500	-500	150	-350

Short Call - Strategy Pay-Off

PROTECTIVE PUT: Options Trading Strategies

Protective Put (LONG STOCK + LONG PUT)

In this strategy, we purchase a stock since we feel bullish about it, but what if the price of the stock goes 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 price. The strike price can be the price at which you bought the stock (ATM strike price) or slightly below (OTM strike price).

Market Scenario: Bullish

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

Reward: Unlimited

BEP: Put Premium + Stock Price

EXAMPLE:
Entry:

STOCK

5100

                        

	STRIKE	PREMIUM
BUY PUT	5000	50

BEP = 5100 + 50 = 5150

On Exit if:

SPOT	STOCK	PUT PAY-OFF	STRATEGY PAY-OFF
4800	-300	150	-150
4900	-200	50	-150
5000	-100	-50	-150
5100	0	-50	-50
5150	50	-50	0
5200	100	-50	50
5300	200	-50	150
5400	300	-50	250
5500	400	-50	350

 

Protective Put - Strategy Pay-Off

 

 

Relationship Between Option Price and Its Variables

RELATIONSHIP BETWEEN OPTION PRICE AND ITS VARIABLES

Particulars	Call Option	Put Option
SPOT	POSITIVE	NEGATIVE
STRIKE	NEGATIVE	POSITIVE
TIME	NEGATIVE	NEGATIVE
VOLATILITY	POSITIVE	POSITIVE
RATE OF INTEREST	POSITIVE	NEGATIVE

Intrinsic Value, Time Value & Volatility

Intrinsic and Time value:

The option price, or premium, can be considered as the sum of two specific elements:
- Intrinsic Value
- Time Value

Intrinsic Value:
The intrinsic value of an option is the amount an option holder can realize by exercising the option immediately. Intrinsic value is always positive or zero. An out-of-the-money option has zero intrinsic value.
Intrinsic value of in-the-money call option = underlying price - strike price
Intrinsic value of in-the-money put option = strike price - underlying price

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

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

Time value decay curve

VOLATILITY:

The volatility of an option is a measure of the probability of the price movements of the underlying instrument. Volatility is normally expressed in annualized terms. The more volatile the underlying instrument, the greater the time value of the option will be. Volatility does not measure the direction of price change. This means that greater the uncertainty for an option seller higher is the premium he will charge to be compensated. Thus option prices increase as volatility rises and decrease as volatility falls.

Options Pricing

OPTIONS PRICING

There are mainly 5 factors, which affects the pricing of an Option.
1 Spot Price
2 Strike Price
3 Time to Maturity
4 Volatility
5 Rate of Interest