Options Strategy VI ( Horizontal spreads )

We have already discussed what is a vertical spread. lets now discuss another options strategy

ie Horizontal Spreads..

In this strategy the strike price of the options remains the same whereas their expiry period differs.

As we already know options premium depends on time left for expiration of the option. ALL options have time value associated with them. As time passes by the premium of the options loses value. Also the closer you are to the expiration date the faster the value drops.

This spread takes advantage of this premium decay :) ( you can make money using options by using any situation ;) )


Let us take another example here :-0

Let's say we are now in the middle of July. We decide to perform a Horizontal Spread on a stock. For a particular strike price, let's say the August option has a premium of Rs4, and the September option has a premium of Rs4.50.

Now to make a horizontal spread , Sell the nearer option (in this case August), and buy the further option (in this case September). So you earn Rs 4.00 from the sale and spend Rs 4.50 on the purchase, netting you a Rs 0.50 cost. So your initial investment is Rs 0.50

Let's us assume august has come now and we are in the middle of august. The August option is fast approaching its expiration date, and the premium has dropped drastically, say down to Rs1.50. However, the September option still has another month's room, and the premium is still holding steady at Rs3.00.

At this point, we would close the spread position. We buy back the August option for Rs1.50, and sell the September option for Rs3.00. That gives us a profit of Rs1.50. When we deduct our initial cost of Rs0.50, we are left with a profit of Rs1.00.


That is basically how a Horizontal Spread works. The same technique can be used for Puts as well. Now Keep in mind that the price of stock has not moved at all and it remained the same.

To test this out take a stock whose price has remained the same( has not moved much) within the last two months and try paper trading on that stock and check it out. Poeple have been asking me to give some live examples. if i get time i will come out with some live examples too :)

Njoy reading.. more to come stay tuned ...

Option Strategy IV (Writing a Vertical Spread ..)

After a small break i am back with another very important options strategy. ie writing spreads.
I can see the no of people exceeded 1000 on the blog within a week and thats like crazy! So many people want to learn options ( :) ). But none has left a comment. I am not sure if this blog is helping anyone or not. So people pour in your comments..

Writing Spreads.
-----------------------

The Beauty of spread trading is that this can be used when the market is

1) in a BULL run
2) in a BEAR run
3) in a Static market

So it works most of the time. basically it reduces risk but also reduces profits as well.

In this technique you buy a option and sell the option at the same time ( ie call or put options).
The options have to be of the same type ( call or put ). A very simple example of this will be that you buy a call option on Ifci and sell the call option on ifci at the same time. Doing this is called spread trading.

By buying one option and selling another, you limit your risk, since you know the exact difference in either the expiration date or strike price (or both) between the two options. This difference is known as the spread, hence the name of this spread treading technique.

Spread option is based on various strategies. let us take a look at some simples ones

1) A Vertical Spread

It is a spread where the 2 options (the one you bought, and the one you sold) have the same expiration date, but differ only in strike price. For example, if you bought a Rs 60 June Call option and sold a Rs 70 June Call option, you have created a Vertical Spread.

Let's take a look at why you would do this.

Let's assume we have a stock IFCI that's currently priced at Rs 50. We think the stock will rise. However, we don't think the rise will be substantial, maybe just a movement of Rs 5.

We then initiate a Vertical Spread on this stock. We Buy a Rs 50 Call option, and Sell a Rs 55 Call option. Let's assume that the Rs 50 Call has a premium of Rs1 (since it's just In-The-Money), and the Rs 55 Call has a premium of Rs 0.25 (since it's Rs 5 Out-Of-The-Money).

So we pay Rs 1 for the Rs 50 Call, and earn Rs 0.25 off the Rs 55 Call, giving us a total cost of Rs 0.75.

Now here two things can happen.

1) The price of the IFCI stock goes to Rs 45. So we made a mistake and we will not exercise the options and both options will expire worthless. So we lose rs 0.75 we spend on buying and selling the option spread.

2) The price of the option rises to Rs 55 ( Voila! ) and now the 50$ call option is in the money so the premium may will rise to Rs 6 and the Rs 55 option call is JUST in the money so the premium will rise to Rs 1. Now we cant wait for expiration date as we didnt buy shares of IFCI to cover our sell option ( we had a NAKED call option ) so we need to buy a Rs 55 call option and sell the Rs 50 call option. So we will earn Rs 6 ( premium of Rs 50 call option ) - Rs 1 ( premium of Rs 55 call option ) - Rs 0.75 ( our initial expenditure ) = Rs 4.25

Now the question arises what happens if the stock price rises to Rs 60 ?

Now here comes the less-risk-less-profit funda. Now If the stock price rises to Rs 60 then the premium of Rs 50 call option will be Rs 11 and of Rs 55 call option will be Rs 6 so again our net profit will be Rs 11 - Rs 6 - Rs 0.75 = Rs 4.25

So all you lose is your initial investment and you earn a limited profit.
So once both the calls are on the money we will earn profit equal to difference between the premium of the calls minus the initial investment.

So why not people always write such kind of spreads. Well this kind of spread works on moderately bullish stocks and also it requires a bull run for the stock. So this is also called bull call spread. Similarly, Bull Put Spreads, Bear Call Spreads and Bear Put Spreads are all based on the same technique and function quite the same. ( ? if you cant figure it out mail me at opt.trading@gmail.com for more information. first try it on your own )

Options Strategy IV ( Writing Covered Calls )

In The last post we studied about stradles. In this post we will study about more conservative strategy that is writing covered calls. This is for those moderate investors who dont have high risk apetite.

Writing covered calls works when the stock is moveing sideways and not at all volatile. So this strategy complements Stradles. May be you hear about some boring stocks, which dosent move most of the times. You can use this strategey on those stocks.

All we have learned in the last post was buying an option, for writing covered calls we will look into sellng those stock options. By writing covered calls we mean selling stock options to be exact.

While buying stock option means that you have the right to buy stocks, but you are niot obligated to actually buy the stock options. Conversely, if you sell a call option, you now have the obligation to sell the stock to the option buyer at the agreed upon price at the specified date.

Now you might feel now thats a big risky investment. And who would do that. But the best part is when you write an option you recive the premium instantly and you make profits. Then why dont everyone start writing options :) ??

Just remember what we learnt before :- An Open position is created when you buy an option and the position is closed when u sell the option. Similarly, when you Write options, you write the option to Open the Position, and you must Close the Position somehow, whether it's by letting the option expire worthless, or by buying the option back.

The more the stock options are in the money, higher is the stock pricein case of Calls options. So if you sell the stock option and the price of the stock goes below the option will not be exercised and it will expire.

Let take a simple example here :-

You sell a stock option of TCS @ Rs 100 strike price at a premium of Rs 5. Now if the price of the stock goes below 100 then the person who bought this option from you will not exercise the option and it will expire and you will earn Rs 5.

however suppose the stocks keeps on climbing and reached 110 now the person will exercise the option and you will have to buy TCS stock ( @ 110 Rs ) and sell it to the person for Rs 100 and you will have a huge loss ( assuming the contract was of 100 shares) ( So in the first para we defined we should pick stocks which are not volatile but move sideways !!! ) We say that you were called out.

Therefore, selling stock options on their own, also known as selling Naked or Uncovered options, is extremely risky.

Now to reduce this risk what you need to do is buy the stock while you write the options. So you dont have to buy the stocks again at a much higher price. Suppose you want sell a contract of TCS shares you need to buy 500 TCS shares ( assuming that in a single contract there are 500 shares) @ 95 Rs ie the current market price. By buying the shares, we eliminate the risk of having to buy the shares later at a higher price in case we get called out. This is called covering your call writing, ie. we just wrote a Covered Call.

Let us take TCS example once again. This time you also bought the TCS shares at the current price (Rs 95) to cover you call. Now again two things can happen ( as always ! ) the price went up or it came down.

1) Suppose the stock price becomes 90. So the the person who bought your option will not exercise his option and it will expire worthless. So you will earn Rs 5 the premium of the call. Also you will lose out Rs5 on the stock. So overall your profit will be 0. Also you still own the stock. If you compare with just buying the stock you would have lost Rs 5 on every TCS stock you own. So actually you have increased your loss tolerance by Rs 5 as even if the price of the TCS stock goes below 5 you still dont lose anything!. SO you can call that your break even level. As long as stock stays above that level you will be in profit. Now the problem comes if the stock goes below your tolerance level. you will start having losses. That's why we need to look at stable or moderately bullish stocks to consider for writing covered calls.This is important in the stock market, where stocks we buy usually don't go up the way we expect them to...

2) Now of the stock goes up by Rs 20 say it becomes 120. Now you will be called out. but now you own the stock at Rs 95 so you can easily sell the stock and earn a profit of Rs 20 + Rs 5 ( ie the premium ).

Now let is again take point 1) where you still own the stock. Now you can again sell another option on the same lot of TCS stocks and earn the premium. So you can earn a cool monthly income by writing stock options. Unless you r unlucky enough and the stock price goes lower and lower. Now if the stock price goes higher you again earn profits!!

This is how investors write covered calls to generate a monthly income. This strategy usually earns about 3% to 15% a month. Not bad for a strategy that's almost risk-free! I hope you know Mr Gujral and heard about his trading academy. His tangline is 'Earn 30-40K / month without risking your capital". This is how this is done ;)

However, do note that if you are unlucky enough to choose to buy a stock that keeps falling lower and lower, no strategy is going to help you! (Unless you buy a Put option on that stock to reduce your losses :) (? try to figure this out yourself )).

Note :- Also suppose you own a stock which is not moving at all. You can start writing covered calls on that option and start earning montly income. And hopefully you get called out soon so you can get some profits out of that dead stock and invest it elsewhere.

Options Strategy III

Now we know how we trade options in the market. So let us learn another strategy .



Straddles and Straddle Strategy :-



Well its a general mis conception that poeple can only make money by predicting whether market will go up or go down in medium term or a stock will go up or go down in near future.

Now what if you know that a court case is pending or a order is pending for a company which could go either ways. You are not in a position to guess what will happen. It can go either ways. But you are sure that either ways the stock will ''Move'' Either it will go up or it will go down whatever be the outcome.



In an ideal world, we would like to be able to clearly predict the direction of a stock. However, in the real world, it's quite difficult. On the other hand, it's relatively easier to predict whether a stock is going to move



So if you know that the stcok price will be volatile in a short term you can make money using this strategy. This is how it works.



To initiate a Straddle, you will buy a Call and Put of a stock with the same expiration date and strike price. For example, let us assume annual report is SAIL is comming and you r not sure that how the results will be but you are sure the stock will not remain flat but will move in either direction.



We would initiate a Straddle for company SAIL by buying a August Rs 120 Call as well as a August Rs120 Put. Now the first thing which will come to your mind is why the hell would you buy both. (You buy a call when u think the price will go up while you would buy a put when the price will go down.) But here you just know that the price will be volatile.





Now Two things can happen when the results for SAIL are out



1) The results are good and the stock moves northwards. In this Case PUToption will be worthless but your CALL option will be IN THE MONEY so the premium of the CALL option will raise and you can now sell the CALL option and make profits.



2) The results are BAD and the stock price dives southwards. In this case you CALL option will be worthless but you will earn profits on your PUT option.





Let us take the same SAIL example



We would initiate a Straddle for company SAIL by buying a August Rs 120 Call as well as a August Rs120 Put Option. Now the premium for the Call option is Rs 0.75 ( it is less as this is OUT OF MONEY option ( the current price of stock is less that the strike price ) ) and the premium for Put option is Rs 3.00 ( as this is IN THE MONEY option ( the current price of stock is less that the strike price)). So your total investment is Rs 3.75 ( 0.75 + 3) for both options.



Now after the results the stock price rises to Rs 122 in two days. Now your call option of Rs 120 will be IN THE MONEY ( why ? try to figure this out yourself and write in the comments if you dont understand ) and your PUT option will be OUT of money. So the premium of the call and out options will change.



Let us put this in a table.


XYZ Day 1 Day 3

Stock Price Rs118 Rs122
Rs120 Call In-The-Money Out Rs2 In Rs7
Rs 120 Call Premium Rs0.75 RS8.00
Rs 120 Put In-The-Money In Rs2 Out Rs7
Rs 120 Put Premium Rs3.00 Rs0.25
Total Option Value Rs3.75 Rs8.25
Profit - Rs3.75 Rs 4.50



You could have just bought a basic Call option and earned a greater profit. But you didn't know which direction the stock price would go. If SAILS report is BAD , the price could have dropped Rs 10 , making your Call worthless and causing you to lose your entire investment. A Straddle strategy is more conservative and will profit whether the stock goes up or down.



if this is such a good strategy why dont everyone makes money out of this strategy ???

Well the downside is if the price dosent move for a long time your both calls will become worthless and you will lose your investment completely!



Also the premium you paid for your investment in SAIL will keep on decreasing as time goes on. The premiums for this months CALL/PUT options will be cheaper than the premiums of next month. So if the price dosen't move the premiums of both the options will become cheaper and will eat away your profit. So the bottom line is this strategy is ONLY useful when there is volatility in the market or that specific stock.

Option Strategies II

I Request you to read all the posts from the begining :)

Trading Options :-


In All the above posts we have learnt about buying the the options, exercise the options, or letting the option to expire.

When u go and buy an options that means your opening a position. Following are the ways to close an option :-

1) Exercise the option
2) Let the option expire

We have already learnt about these two in previous posts. The last one is ( most popular )

3) Sell the option.

Buying and selling option is same as buying and selling stocks. You Buy the options in the market where other poeple will also buy and sell options. So there will be Bid and ask prices as there are in Stocks. When u buy any stock option that means you have an OPEN POSITION ( remember this term ) in the stock. When u sell your option that means you have CLOSED your POSITION in the option. Another important term is OPEN INTEREST.

OPEN INTEREST :-

This simply means the no of OPEN positions for the option in the market.

Lets take an example here :-

You buy an option on the 1st of August for the HINDALCO when the stock was trading at Rs 160.00. We buy the August option with a strike price of Rs170.00, at a premium of Rs 0.75 You now have an Open Position on the Hindalco Rs170 August Call option.

Let's assume that a week later, on the 8th of August, the price for the Hindalco stock has gone up to Rs 180.00. That means your option is now In-The-Money by Rs10, since your strike price is Rs 170 and the current value is Rs180, allowing you to theoretically exercise the option and buy the stock at Rs 170, and immediately sell it at Rs170 for a Rs10 profit. (Remember that since you are trading American Options, you can exercise anytime before expiration day.)

However, a more convenient method (and cheaper too, since you don't have to spend the $20 to buy the stock), would be to sell the option to someone else. Since the option is now In-The-Money, its premium would have risen quite a bit too, say to RS4.50. That is the price you can sell the option at. You don't have to worry about finding someone to buy the option from you . The American options market ( Remember that American Options have nothing to do with America its just an type of option which was discussed earlier ) has Market Makers who will maintain market liquidity, i.e. they will make sure all buyers will find corresponding sellers, and vice versa.

So you will sell the Call Option at Rs4.50. Since you initially paid RS0.75 for the option premium, you have just made a profit of Rs4.50 - RS0.75 = RS3.75. In case you were wondering, that's a 400% profit on our Rs0.75 investment !!!

But be aware of the fact that you could have lost your entire Rs 0.75 if the stock price of Hindalco would have gone below 160!!!

Leave comments... or mail me at optrading@rediffmail.com

There is more to come this is just a start so stay tuned..

Option Strategies I

Hedging :-

Poeple generally buy options to hedge thier investments.
Suppose you have bought a stock which u thought will rise in 6 months time. But there is uncertainty that the price might drop. So what you can so is buy an insurance for your investment at a premium. To do this you but a put call option for the same stock.

Lets take an example :-

You Bought 1000 GMR infra stocks at 690 Rs and you assume that it would go upto 1000 Rs in 6 months. Now to prtotect your investment you buy a Put call at strike price 600 ( You buy a put call when u think the price will drop ) for 1000 shares at an premium of 5000Rs.

Now after 6 months two things can happen

1) GMR stock shoots up and reaches 1000Rs. Now you have made a profit of 310*1000 so you will not exercise your put option and you will lose your money. ie only 5000Rs

2) GMR stock price drops to 500 Rs SO you would lose 190*1000 Rs. But as you have a put option you can sell those shares at 600 and your loss will be only 90*1000 + 5000 ( premium paid for put option ) .

So from the above example you can see by investing 5000 Rs in a put option you can limit your losses...

Frequently used terms in options

Premium - The premium is the amount that you pay up front for the option. This amount is once-off and non-refundable.

Strike Price - The strike price is the amount that you agree to pay for the stock at a later date.

Underlying Stock - The underlying stock is the stock for which you are purchasing the option.

Exercising Options - . By exercising an option, you are using your right to buy, and actually purchasing the underlying stock.

Expiration Date - The expiration date is the last day for you to exercise your option. If you don't exercise it by then, your option will expire worthless. In the United States, the expiration date is the 3rd Friday of the month. So if you have a June option, that option will expire on the 3rd Friday of June.

American Options - American options are options (not limited by any geographic boundaries) that allow you to exercise the options at any time until the expiration date.

European Options - European options are options (not limited by any geographic boundaries) that allow you to exercise the options at only the expiration date. Do check with your local Options Exchange which form of options are used in your country.

Contract - Option trading is carried out in numbers of contracts. One contract equates to 100 underlying shares. If you buy one call option contract, you are buying the right to buy 100 shares of the underlying stock.

More to come... soon

What is Call and Put ?

In the previous example we bought an option hoping that the price will go up. This type of option is called a call option.

One main reason why people like options is that they can make money both ways. if price of stock falls then also you can make money using options and when the price of the stock increases then also you can make money using options. In the last example we made money when the stock price went up.

This is the not the same for stocks when u buy them. you can only make money when stock prices increase ( we are not taking short sell into account here as most poeple dont do that )

There are different kind of options in the market to suit the investor. If you think the price of the stock will go down in future you can buy a put option which is opposite the call option.

Always Remember CALL means BUY, PUTS means SELL.

So Put option means that you can sell the share for a certain price at a certain time.

Let us take the same example here also.

Suppose current price of INFOSYS shares is Rs 2000 / share.

Now you think the price of INFOSYS share will decrease to 1500 Rs / share after 6 months.
So you buy a contract with exchange to sell 1000 Infosys Shares at 1800 Rs after six months ( such price is set by using several parameters which we will come to at later stages. ) The price of the contract is suppose 5000 rs again. So you pay 5000 rs to Exchange and buy the right to sell 1000 Infosys shares "@ 1800 / share.

1) INFOSYS bags some BIG projects and its profitability increases and revenue increases and the share price shoots up to 3000 Rs after 6 months so 1000 shares are worth 30,00,000 rs now. Now the value of the contract is 18,00,000 Lacs only so if you "exercise'' your contract you will lose money. So you dont use your option and it expires so you lose 5000 Rs


2) INFOSYS profits drop and it dosent bag any new projects and rupee rises further the price drops to 1500 Rs. So infosys Shares are worth only 15,00,000 Lacs rs If you ''exercise'' the option now you can sell Infosys Shares for 18,00,000 where as you can buy from the market for 15,00,000 Rs . So your gain is 18,00,000 - 15,00,000 Lac Rs ie 3 Lacs Rs

So from the last two posts you can figure it out the money you lose in options is the money you invested to buy those options, But your profit potential is umlimited...

So, to repeat the difference between Calls and Puts, you would buy a Call option if you expect the stock in question to go up, and you would buy Put options if you expect the stock to go down.

More posts to come...

What is an Option ?

I have started getting lot of mails so let me first tell you few things :-

1) It will take time for you to learn options. It will take few months. So dont think that you can learn option in a day and start trading them :)

2) Have patience, Dont just start looking for tips to buy options. All those tips are useless. No one will give you free tips ;) You have to use your own intelligence.

3) Options are risky, Yes they are but then investing in equity is also risky. So you have to learn them , practice with some dummy transactions for some time. If you think you can handle them after that you can start trading them.

4) The successful use of options requires a willingness to learn what they are, how they work, and what risks are associated with particular options strategies. Individuals seeking expanded investment opportunities in today's markets will find options trading challenging, often fast moving, and potentially rewarding.

5) Lastly i will not be liable if you lose money in options ;). Its your money so use it wisely




If you buy an option it gives you the right to buy the underlying asset at a specified time for a specific price.

Eg :- Suppose you want to buy 1000 BHEL shares ( at 2000 / share ) you need to shell out 1000 * 2000 Rs = 20,00,000 ie 20 lac Rs. But you dont have such huge amount of money.
You make a contract with exchange that you will buy 2000 Shares of BHEL in 6 months time.

Exchange says that after evaluating BHEL price will increase to 2500 after 6 months so we will sell at that price if you want to buy it now. So you agree and say ok we can have a contract worth 25,000,000

But as a promise you need to do a down paymemt ( aka premium ) of 5000 rs for the contract ( as you can run away ;).

So you spend 5000 Rs and earn a right to buy 1000 BHEL shares in 6 months time.

So after 6 months no matter what the market value of BHEL share is you have the right to buy BHEL share @ 2500 rs / share.

Now two things can happen.

1) BHEL bags some BIG projects and its profitability increases and revenue increases and the share price shoots up to 3000 Rs after 6 months so 1000 shares are worth 30,00,000 rs now.
But you already have right to buy 1000 Shares for 25 lac Rs . So you can ''exercise'' your option and earn 5 Lacs profit

2) BHEL profits drop and it dosen't bag any new projects and the price drops to 1500 Rs. So if you ''exercise'' the option now you may lose money. So Instead you dont use the option and let it expire. So you only lose only 5000Rs you paid for the option.

So This is a simple example how options works. Next article will explain you the terms used in options trading

Happy Investing...