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Assignment One
Himanshu Ahire 13
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F&O Trading Strategies - Himanshu Ahire
Introduction 4
Hedgers 4
Speculators 5
Arbitrageurs 5
Market Players 6
The Exchanges 6
Financial Institution 6
Market Makers 6
Day traders 7
Premium Sellers 7
Spread Traders 7
Theoretical Traders 7
Long position 8
Short position 9
At-the-money 10
In-the-money 10
out-of-the-money 10
Trading Strategies 11
Bullish Strategies 11
Long call 11
Covered Calls 12
Protective Put 13
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F&O Trading Strategies - Himanshu Ahire
Naked Put 17
Bearish Strategies 18
Long Put 18
Naked Put 19
Put Back-spread 20
Neutral Strategies 23
Reversal 23
Conversion 24
The Collar 25
Long Straddle 26
Short Straddle 27
Long Strangle 28
Short Strangle 29
The Butterfly 30
Ratio Spread 31
Condor 32
Calendar Spread 33
Bibliography 34
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F&O Trading Strategies - Himanshu Ahire
Introduction
Derivatives are financial instruments which derives their value from underlying asset.
These underlying assets can be Shares, Bonds, Interest Rates, Market Volatility,
currencies & Commodities. Derivatives market can be OTC or Exchange Traded.
Primary goal of derivatives trading is to transfer underlying price risk from one party to
another. Hence derivatives helps mitigating risk from future uncertainties. Although main
objective of derivatives is to mitigate risk it can be used for profit making. Hence
Derivatives traders can be classified as
• Hedgers
• Speculators
• Arbitrageurs
Hedgers
Generally hedgers have substantial interest ( exposure ) in spot market. Hence they
participate in derivatives market to mitigate adverse price movement risk in spot market.
hedgers can take various positions in derivatives market based on their exposure in spot
market. Generally they take opposite position in derivatives market compare to spot
market. Hedging can also be used to protect existing future or options positions. For
Example following are option positions & their respective possible future/options hedge
positions.
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F&O Trading Strategies - Himanshu Ahire
Speculators
Speculators have profit motive. They tried to get benefit from market movement. They
bets on derivative position based on personal view. Generally they have high risk
appetite. Their main objective is to make quick gain by market movement. Because of
their one sided view there is possibility of large profit or Large loss.
Arbitrageurs
Arbitrageurs want to make risk-less profit. They tend to exploit market inefficiencies.
Generally In the market, future & options prices are closely related to respective underlying
spot market. For Example
But sometimes due to market inefficiencies there is some difference between spot market
& derivative markets.They can utilized these differences between spot market &
Derivatives market to make profit.
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F&O Trading Strategies - Himanshu Ahire
Market Players
With the possible exception of futures contracts, option trading is not a zero-sum game. In
other words, for every winner there doesn't have to be a loser. Therefore, because there
are so many different combinations and ways options can be hedged against each other.
The main defferance between spot & Derivatives market is that in derivatives trading there
are more players and multiple agendas.
• The Exchanges
• Financial Institution
• Market Makers
• Individual (Retail) Investors
The Exchanges
The exchange is a place where market makers and traders gather to buy and sell stocks,
options, bonds, futures, and other financial instruments.
Financial Institution
Financial institutions are professional investment management companies that typically fall
into several main categories: mutual funds, hedge funds, insurance companies, stock
funds. In each case, these money managers control large portfolios of stocks, options, and
other financial instruments.
Market Makers
Market makers are the traders on the floor of the exchanges who create liquidity by
providing two-sided markets. In each counter, the competition between market makers
keeps the spread between the bid and the offer relatively narrow. Nevertheless, it's the
spread that partially compensates market makers for the risk of willingly taking either side
of a trade. In general, there are four trading techniques that characterize how different
market makers trade options. Any or all of these techniques may be employed by the
same market maker depending on trading conditions.
• Day Traders
• Premium Sellers
• Spread Traders
• Theoretical Traders
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F&O Trading Strategies - Himanshu Ahire
Day traders
Day traders, on or off the trading screen, tend to use small positions to capitalize on intra-
day market movement. Since their objective is not to hold a position for extended periods,
day traders generally don't hedge options with the underlying stock. At the same time, they
tend to be less concerned about delta, gamma, and other highly analytical aspects of
option pricing.
Premium Sellers
Just like the name implies, premium sellers tend to
focus their efforts selling high priced options and
taking advantage of the time decay factor by
buying them later at a lower price. This strategy
works well in the absence of large, unexpected
price swings but can be extremely risky when
volatility skyrockets.
Spread Traders
Like other market makers, spread traders often
end up with large positions but they get there by
focusing on spreads. In this way, even the largest
of positions will be somewhat naturally hedged.
Spread traders employ a variety of strategies buying certain options and selling others to
offset the risk. Some of these strategies like reversals, conversions, and boxes are
primarily used by floor traders because they take advantage of minor price discrepancies
that often only exist for seconds. However, spread traders will use strategies like
butterflies, condors, call spreads, and put spreads that can be used quite effectively by
individual investors.
Theoretical Traders
By readily making two-sided markets, market makers often find themselves with
substantial option positions across a variety of months and strike prices. The same thing
happens to theoretical traders who use complex mathematical models to sell options that
are overpriced and buy options that are relatively underpriced. Of the four groups,
theoretical traders are often the most analytical in that they are constantly evaluating their
position to determine the effects of changes in price, volatility, and time.
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F&O Trading Strategies - Himanshu Ahire
The Pay-off of a futures contract on maturity depends on the spot price of the underlying
asset at the time of maturity and the price at which the contract was initially traded. There
are two positions that could be taken in a futures contract:
Long position
one who buys the asset at the futures price takes the long position. The pay-off for a long
position in a futures contract on one unit of an asset is:
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F&O Trading Strategies - Himanshu Ahire
Short position
one who sells the asset at the futures price takes the short position.
Short Pay-off = Future short position price - Future short position at Expiry
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F&O Trading Strategies - Himanshu Ahire
In-the-money Strike Price less than Spot Strike Price greater than
Price of underlying asset Spot Price of underlying
asset
Out-of-the-money Strike Price greater than Strike Price less than Spot
Spot Price of underlying Price of underlying asset
asset
At-the-money
An option is said to be 'at-the-money', when the option's strike price is equal to the
underlying asset price. This is true for both puts and calls.
In-the-money
A call option is said to be in-the-money when the strike price of the option is less than the
underlying asset price. For example, a Sensex call option with strike of 3900 is 'in-the-
money', when the spot Sensex is at 4100 as the call option has value.
The call holder has the right to buy a Sensex at 3900, no matter how much the spot
market price has risen. And with the current price at 4100, a profit can be made by selling
Sensex at this higher price.
out-of-the-money
On the other hand, a call option is out-of-the-money when the strike price is greater than
the underlying asset price. Using the earlier example of Sensex call option, if the Sensex
falls to 3700, the call option no longer has positive exercise value. The call holder will not
exercise the option to buy Sensex at 3900 when the current price is at 3700. (Please see
table)
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F&O Trading Strategies - Himanshu Ahire
Trading Strategies
Bullish Strategies
Long call
For aggressive investors who are bullish about the short-term prospects for a stock, buying
calls can be an excellent way to capture the upside potential with limited inside risk.
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F&O Trading Strategies - Himanshu Ahire
Covered Calls
For conservative investors, selling calls against a long stock position can be an excellent
way to generate income without assuming the risks associated with uncovered calls. In
this case, investors would sell one call contract for each 100 shares of stock they own.
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F&O Trading Strategies - Himanshu Ahire
Protective Put
For investors who want to protect the stocks in their portfolio from falling prices, protective
puts provide a relatively low-cost form of portfolio insurance. In this case, investors would
purchase one put contract for each 100 shares of stock they own.
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For bullish investors who want to a nice low risk, limited return strategy without buying or
selling the underlying stock, bull call spreads are a great alternative. This strategy involves
buying and selling the same number of calls at different strike prices to minimize both the
cash outlay and the overall risk.
• Max Profit = Strike Price of Short Call - Strike Price of Long Call - Net Premium Paid -
Commissions Paid
• Max Profit Achieved When Price of Underlying >= Strike Price of Short Call
• Max Loss = Net Premium Paid + Commissions Paid
• Max Loss Occurs When Price of Underlying <= Strike Price of Long Call
• Breakeven Point = Strike Price of Long Call + Net Premium Paid
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F&O Trading Strategies - Himanshu Ahire
For bullish investors who want a nice low risk, limited return strategy, bull put spreads are
another alternative. Like the bull call spread, the bull put spread involves buying and
selling the same number of put options at different strike prices. Since puts with the higher
strike are sold, the trade is initiated for a credit.
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For bullish investors who expect big moves in already volatile stocks, call back spreads
are a great limited risk, unlimited reward strategy. The trade itself involves selling a call (or
calls) at a lower strike and buying a greater number of calls at a higher strike price.
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F&O Trading Strategies - Himanshu Ahire
Naked Put
For bullish investors who are interested in buying a stock at a price below the current
market price, selling naked puts can be an excellent strategy. In this case, however, the
risk is substantial because the writer of the option is obligated to purchase the stock at the
strike price regardless of where the stock is trading.
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F&O Trading Strategies - Himanshu Ahire
Bearish Strategies
Long Put
For aggressive investors who have a strong feeling that a particular stock is about to move
lower, long puts are an excellent low risk, high reward strategy. While risk is limited to the
initial investment, the profit potential is unlimited.
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F&O Trading Strategies - Himanshu Ahire
Naked Put
Selling naked calls is a very risky strategy which should be utilized with extreme caution.
By selling calls without owning the underlying stock, you collect the option premium and
hope the stock either stays steady or declines in value. If the stock increases in value this
strategy has unlimited risk.
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F&O Trading Strategies - Himanshu Ahire
Put Back-spread
For aggressive investors who expect big downward moves in already volatile stocks,
backspreads are great strategies. The trade itself involves selling a put at a higher strike
and buying a greater number of puts at a lower strike price. As the stock price moves
lower, the profit potential is unlimited.
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F&O Trading Strategies - Himanshu Ahire
For investors who maintain a generally negative feeling about a stock, bear spreads are a
nice low risk, low reward strategies. This trade involves selling a lower strike call, usually
at or near the current stock price, and buying a higher strike, out-of-the-money call. This
spread profits when the stock price decreases and both calls expire worthless.
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F&O Trading Strategies - Himanshu Ahire
For investors who maintain a generally negative feeling about a stock, bear spreads are
another nice low risk, low reward strategy. This trade involves buying a put at a higher
strike and selling another put at a lower strike. Like bear call spreads, bear put spreads
profit when the price of the underlying stock decreases.
• Max Profit = Strike Price of Long Put - Strike Price of Short Put - Net Premium Paid -
Commissions Paid
• Max Profit Achieved When Price of Underlying <= Strike Price of Short Put
• Max Loss = Net Premium Paid + Commissions Paid
• Max Loss Occurs When Price of Underlying >= Strike Price of Long Put
• Breakeven Point = Strike Price of Long Put - Net Premium Paid
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F&O Trading Strategies - Himanshu Ahire
Neutral Strategies
Reversal
Primarily used by floor traders, a reversal is an arbitrage strategy that allows traders to
profit when options are underpriced. To put on a reversal, a trader would sell stock and use
options to buy an equivalent position that offsets the short stock.
• Profit = Sale Price of Underlying - Strike Price of Call/Put + Put Premium - Call
Premium
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F&O Trading Strategies - Himanshu Ahire
Conversion
Primarily used by floor traders, a conversion is an arbitrage strategy that allows traders to
profit when options are overpriced. To put on a conversion, a trader would buy stock and
use options to sell an equivalent position that offsets the long stock.
• Profit = Strike Price of Call/Put - Purchase Price of Underlying + Call Premium - Put
Premium
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F&O Trading Strategies - Himanshu Ahire
The Collar
For bullish investors who want to nice low risk, limited return strategy to use in conjunction
with a long stock position, collars are a great alternative. In this case, the collar is created
by combining covered calls protective puts.
• Max Profit = Strike Price of Short Call - Purchase Price of Underlying + Net Premium
Received - Commissions Paid
• Max Profit Achieved When Price of Underlying >= Strike Price of Short Call
• Max Loss = Purchase Price of Underlying - Strike Price of Long Put - Net Premium
Received + Commissions Paid
• Max Loss Occurs When Price of Underlying <= Strike Price of Long Put
• Breakeven Point = Purchase Price of Underlying + Net Premium Paid
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F&O Trading Strategies - Himanshu Ahire
Long Straddle
For aggressive investors who expect short-term volatility yet have no bias up or down (i.e.,
a neutral bias), the long straddle is an excellent strategy. This position involves buying
both a put and a call with the same strike price, expiration, and underlying. The potential
loss is limited to the initial investment. The potential profit is unlimited as the stock moves
up or down.
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F&O Trading Strategies - Himanshu Ahire
Short Straddle
For aggressive investors who don't expect much short-term volatility, the short straddle
can be a risky, but profitable strategy. This strategy involves selling a put and a call with
the same strike price, expiration, and underlying. In this case, the profit is limited to the
initial credit received by selling options. The potential loss is unlimited as the market
moves up or down.
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F&O Trading Strategies - Himanshu Ahire
Long Strangle
For aggressive investors who expect short-term volatility yet have no bias up or down (i.e.,
a neutral bias), the long strangle is another excellent strategy. This strategy typically
involves buying out-of-the-money calls and puts with the same strike price, expiration, and
underlying. The potential loss is limited to the initial investment while the potential profit is
unlimited as the market moves up or down.
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F&O Trading Strategies - Himanshu Ahire
Short Strangle
For aggressive investors who don't expect much short-term volatility, the short strangle
can be a risky, but profitable strategy. This strategy typically involves selling out-of-the-
money puts and calls with the same strike price, expiration, and underlying. The profit is
limited to the credit received by selling options. The potential loss is unlimited as the
market moves up or down.
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The Butterfly
Ideal for investors who prefer limited risk, limited reward strategies. When investors expect
stable prices, they can buy the butterfly by selling two options at the middle strike and
buying one option at the higher and lower strikes. The options, which must be all calls or
all puts, must also have the same expiration and underlying.
• Max Profit = Strike Price of Short Call - Strike Price of Lower Strike Long Call - Net
Premium Paid - Commissions Paid
• Max Profit Achieved When Price of Underlying = Strike Price of Short Calls
• Max Loss = Net Premium Paid + Commissions Paid
• Max Loss Occurs When Price of Underlying <= Strike Price of Lower Strike Long Call
OR Price of Underlying >= Strike Price of Higher Strike Long Call
• Upper Breakeven Point = Strike Price of Higher Strike Long Call - Net Premium Paid
• Lower Breakeven Point = Strike Price of Lower Strike Long Call + Net Premium Paid
•
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F&O Trading Strategies - Himanshu Ahire
Ratio Spread
For aggressive investors who don't expect much short-term volatility, ratio spreads are a
limited reward, unlimited risk strategy. Put ratio spreads, which involve buying puts at a
higher strike and selling a greater number of puts at a lower strike, are neutral in the sense
that they are hurt by market movement.
• Max Profit = Strike Price of Short Call - Strike Price of Long Call + Net Premium
Received - Commissions Paid
• Max Profit Achieved When Price of Underlying = Strike Price of Short Calls
• Maximum Loss = Unlimited
• Loss Occurs When Price of Underlying > Strike Price of Short Calls + ((Strike Price of
Short Call - Strike Price of Long Call + Net Premium Received) / Number of
Uncovered Calls)
• Loss = Price of Underlying - Strike Price of Short Calls - Max Profit + Commissions
Paid
• Upper Breakeven Point = Strike Price of Short Calls + (Points of Maximum Profit /
Number of Uncovered Calls)
• Lower Breakeven Point = Strike Price of Long Call +/- Net Premium Paid or Received
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F&O Trading Strategies - Himanshu Ahire
Condor
Ideal for investors who prefer limited risk, limited reward strategies. The condor takes the
body of the butterfly - two options at the middle strike - and splits between two middle
strikes. In this sense, the condor is basically a butterfly stretched over four strike prices
instead of three.
• Max Profit = Strike Price of Lower Strike Short Call - Strike Price of Lower Strike Long
Call - Net Premium Paid - Commissions Paid
• Max Profit Achieved When Price of Underlying is in between the Strike Prices of the 2
Short Calls
• Max Loss = Net Premium Paid + Commissions Paid
• Max Loss Occurs When Price of Underlying <= Strike Price of Lower Strike Long Call
OR Price of Underlying >= Strike Price of Higher Strike Long Call
• Upper Breakeven Point = Strike Price of Highest Strike Long Call - Net Premium
Received
• Lower Breakeven Point = Strike Price of Lowest Strike Long Call + Net Premium
Received
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F&O Trading Strategies - Himanshu Ahire
Calendar Spread
Calendar spreads are also known as time or horizontal spreads because they involve
options with different expiration months. Because they are not exceptionally profitable on
their own, calendar spreads are often used by traders who maintain large positions.
Typically, a long calendar spread involves buying an option with a long-term expiration and
selling an option with the same strike price and a short-term expiration.
The maximum possible profit for the neutral calendar spread is limited to the premiums
collected from the sale of the near month options minus any time decay of the longer term
options. This happens if the underlying stock price remains unchanged on expiration of the
near month options.
The maximum possible loss for the neutral calendar spread is limited to the initial debit
taken to put on the spread. It occurs when the stock price goes down and stays down until
expiration of the longer term options.
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Bibliography
www.nseindia.com
http://www.theoptionsguide.com/
http://en.wikipedia.org/wiki/Main_Page
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