A Guide to Option Trading Strategies for Beginners

Introduction

 

Options are contracts that give the buyer the right, but not the obligation, to buy (call option) or sell (put option) the underlying asset at a specified price on or before a specific date. They are a type of derivative since their value is dependent upon the price of the underlying asset.

 

Just like other derivatives, a trader can use options for hedging, speculative, and arbitrage purposes. But the thing that makes options trading much more attractive than trading other securities is that they provide the trader a plethora of options to express his/ her opinion of the markets and make money.

 

Options are divided into three groups, on the basis of their moneyness. Options’ Moneyness is a metric that determines if an option contract can profit if it is exercised immediately:

 

1. In The Money (ITM) Options: If the underlying security’s price is higher than the strike price, the call option is in the money. A put option, on the other hand, is in the money if the underlying security’s price is less than the strike price.

2. At The Money (ATM) Options: Both call and put options are at the money if the strike price and the underlying security’s price are equal.

3. Out of The Money (OTM) Options: If the underlying security’s price is lower than the strike price, a call option is out-of-the-money. A put option, on the other hand, is out-of-the-money if the underlying security’s price is higher than the strike price.

 

(Must check: What is Digital Money?)

 

A trader can bet on neutral positions along with bearish and bullish positions using options. This essentially means that a trader or a speculator can bet on the sideways movement of the markets. The markets don’t need to be trading in a direction for the trader to make money. 

 

Not just this, using options, a trader can also express the extent of the bullishness and bearishness of the trader. A moderately bullish trader can resort to a different strategy than a highly bullish trader and make money accordingly.

 

If a trader expects a one-sided move due to, let’s say, an event like results or budget upcoming, he can use an options strategy to profit even if he is not sure of the direction of the potential move.

 

Even though options provide alternatives, they are much riskier than other asset classes. Therefore, it is vital to understand the various option trading strategies that have predefined risk to avoid mishaps while using options

 

We’ll discuss a few widely-used option trading strategies in this blog. We look at bullish strategies- ideal for traders who see the market going up, bearish strategies- ideal for traders expecting the underlying security to go down, and neutral strategies- ideal for traders expecting the underlying security to remain in a range.

 

Before we continue, certain clarifications:

 

• As an example, all the strategies are based on Nifty 50. They can however be used on any stock/ index.

• The analysis was done on 2nd May 2021, Sunday. Therefore, the closing price of Nifty on 30th April which is 14,631, is taken as the current market price for the examples.

• The expiry date taken for the options is 27th May 2021, which is the monthly expiry for the May series. The monthly expiry is always on the last Thursday of the month.

• Opstra website is used to make the payoff charts of all the examples discussed below. 

 

What are Bullish Strategies?

 

1. Long Call: 

 

View on the underlying asset: Very bullish

Strategy: Buy call option

Risk: Limited to premium paid  

Reward: Unlimited

Breakeven: Strike price + premium paid

Criteria for profit: Close of the underlying asset on the expiry date is greater than strike price + premium paid

Example:

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Buy 14600 CE @Rs. 398.4

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2. Short Put: 

 

View on the underlying asset: Bullish

Strategy: Sell a put option

Risk: Unlimited

Reward: Limited to the premium received

Breakeven: Strike price - premium received

Criteria for profit: Close of the underlying asset on the expiry date is not less than strike price - premium or the option expires unexercised

Example:

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Sell 14600 PE @Rs. 334.95

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3. Call Spread:

 

View on the underlying asset: Moderately bullish

Strategy: Buy ITM call option and sell OTM call option

Risk: Limited to the net premium paid

Reward: Limited to the difference between the two strikes minus the net premium paid

Breakeven: Strike price of purchased call + net premium paid

Criteria for max profit: Both the options are exercised 

Criteria for max loss: Both the options are unexercised

Example:

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Buy 14400CE @Rs. 524.35, Sell 14800CE @Rs. 290

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4. Put Spread:

 

View on the underlying asset: Moderately bullish

Strategy: Sell OTM put option and buy further OTM put option

Risk: Limited to the difference between the two strikes minus net premium received

Reward: Limited to the net premium received

Breakeven: Strike price of sold put - net premium received

Criteria for max profit: Both the options are unexercised

Criteria for max loss: Both the options are exercised

Example:

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Sell 14600PE @Rs. 334.95, Buy 14500PE @Rs. 290.05

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What are Bearish Strategies?

 

1. Long Put: 

 

View on the underlying asset: Very bearish

Strategy: Buy put option

Risk: Limited to premium 

Reward: Unlimited

Breakeven: Strike price - premium paid

Criteria for profit: Close of the underlying asset on the expiry date is less than strike price - premium paid

Example:

---

Buy 14600 PE @Rs. 334.95

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2. Short Call: 

 

View on the underlying asset: Bearish

Strategy: Sell call option

Risk: Unlimited

Reward: Limited to the premium received

Breakeven: Strike price + premium received

Criteria for max profit: Close of the underlying asset on the expiry date is not more than strike price + premium and the option expires unexercised

Criteria for loss: Close of the underlying asset on the expiry date is more than strike price + premium and the option expires exercised

Example:

---

Sell 14600 CE @Rs. 398.4

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3. Call Spread:

 

View on the underlying asset: Moderately bearish

Strategy: Sell ITM call option and Buy OTM call option

Risk: Limited to the difference between the two strikes minus the net premium received

Reward: Limited to the net premium received

Breakeven: Strike price of sold call + net premium received

Criteria for max profit: Both the options are unexercised 

Criteria for max loss: Both the options are exercised

Example:

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Sell 14500CE @Rs. 457.34, Buy 14700CE @Rs. 342.35

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4. Put Spread:

 

View on the underlying asset: Moderately bearish

Strategy: Buy ITM Put option and Sell OTM Put option

Risk: Limited to the net premium paid

Reward:  Limited to the difference between the two strikes minus net premium paid

Breakeven: Strike price of bought put - Net premium paid

Criteria for max profit: Both the options are exercised

Criteria for max loss: Both the options are unexercised

Example:

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Buy 14700PE @Rs. 377.65, Sell 14500PE @Rs. 290.05

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What are Neutral Strategies?

 

1. Long Straddle: 

 

View on the underlying asset: Significant volatility

Strategy: Buy a call option and a put option of the same strike price

Risk: Limited to premium paid  

Reward: Unlimited

Breakeven: Upper breakeven: strike price of call bought + net premium paid, lower breakeven: strike price of put bought - net premium paid

Criteria for profit: One of the options is exercised

Criteria for max loss: Both the options are unexercised

Example:

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Buy 14600 CE @Rs. 398.4, Buy 14600 PE @Rs. 334.95

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2. Short Straddle: 

 

View on the underlying asset: Little volatility

Strategy: Sell call and put option of the same strike price

Risk: Unlimited

Reward: Limited to the premium received

Breakeven: Upper breakeven: strike price of call sold + net premium received, lower breakeven: strike price of put sold - net premium received

Criteria for max profit: Both the options are unexercised 

Criteria for loss: One of the options is exercised

Example:

---

Sell 14600 CE @Rs. 398.4, Sell 14600 PE @Rs. 334.95

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3. Long Strangle:

View on the underlying asset: Significant volatility

Strategy: Buy OTM Call and Put option

Risk: Limited to the premium paid

Reward: Unlimited 

Breakeven: Upper breakeven: strike price of call + net premium paid, lower breakeven: strike price of put - net premium paid

Criteria for profit: One of the options is exercised 

Criteria for max loss: Both the options are unexercised

Example:

---

Buy 14700CE @Rs. 342.35, Buy 14500PE @Rs. 290.05

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4. Short Strangle:

 

View on the underlying asset: Little volatility

Strategy: Sell OTM call and put option

Risk: Unlimited

Reward: Limited to the net premium received

Breakeven: Upper breakeven: strike price of call + net premium received, lower breakeven: strike price of put - net premium received

Criteria for max profit: Both the options are unexercised

Criteria for max loss: One of the options is exercised

Example:

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Buy 14700CE @Rs. 342.35, Buy 14500PE @Rs. 290.05

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Conclusion

 

In this blog, we went through some of the option trading strategies used by traders all over the world to make profits in all types of market conditions.

 

Multiple other option trading strategies can be made to tweak the conditions as per one’s expectations of the future market movement. Options are used along with other financial securities like stocks, futures, and bonds to form multiple other types of option trading strategies as well.