Market Strategies. Navin Bafna Investment Banking Jan 2008

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1 Market Strategies Using Options Navin Bafna Investment Banking Jan 2008

2 SEGMENTS CAPITAL MARKET CASH FUTURES & OPTIONS FUTURES OPTIONS ONE TWO THREE MONTH CALL PUT

3 OPTIONS CALL PUT

4 CALL PUT The buyer of the option has the right, but not the obligation to buy an agreed quantity of a particular underlying instrument from the seller of the option at a certain time (the expiration date) for a certain price (the strike price). The seller (or"writer") is obligated to sell the commodity or financial instrument should the buyer so decide. The buyer pays a fee (called a premium) for this right. A put option is a financial contract between two parties, the seller (writer) and the buyer of the option. The put allows its buyer the right but not the obligation to sell a commodity or financial instrument (the underlying instrument) to the writer (seller) of the option at a certain time for a certain price (the strike price). The writer (seller) has the obligation to purchase the underlying asset at that strike price, if the buyer exercises the option.

5 TERMS TO REMEMBER STRIKE PRICE SPOT PRICE PREMIUM TERM MARKET SENTIMENT

6 USING OPTIONS MARKET STRATEGIES Bullish Bearish Neutral Volatile

7 IMPORTANT Straddle Buy/Sell both the options at same strike price Buy Long Straddle Sell Short Straddle Strangle Buy/Sell both the options at different strike price Buy Long Strangle Sell Short Strangle

8 BULLISH Buy Call Sell Put Bull Spread Diagonal Spread

9 BUY CALL Strategy View Investor thinks that the market will rise significantly in the short-term.. Strategy Implementation Call options are bought with a strike price of a. The more bullish the investor is, the higher the strike price should be. Upside Potential Profit potential is unlimited and rises as the market rises. Breakeven Point at Expiry Strike price plus premium Downside Risk Limited to the premium paid -incurred if the market at expiry is at, or below, the strike a Margin Not required

10 SELL PUT Strategy View Investor is certain that the market will not go down, but unsure/unconcerned about whether it will rise. Strategy Implementation Put options are sold with a strike price a. If an investor is very bullish, then in-the-money puts would be sold. Upside Potential Profit potential is limited to the premium received. The more the option is in-the-money, the greater the premium received. Breakeven Point at Expiry Strike price less premium Downside Risk Loss is almost unlimited. High risk strategy Potential huge losses incurred if the market crashes. Margin Always required

11 BULL SPREAD Strategy View Investor thinks that the market will not fall, but wants to cap the risk. Conservative strategy for one who thinks that the market is more likely to rise than fall Strategy Implementation Call option is bought with a strike price of a and another call option sold with a strike of b, producing a net initial debit, OR Put option is bought with a stike of a and another put sold with a strike of b, producing a net initial credit. Upside Potential Limited in both cases Calls: difference between strikes minus initial debit Puts: net initial credit Maximum profit if market at expiry is above the higher strike. Downside Risk Limited in both cases - Calls: net initial debit Puts: difference between strikes minus initial credit Maximum loss if at expiry market is below the lower strike. Margin Possibility for margin requirements to be off-set

12 DIAGONAL SPREAD Strategy View Investor thinks that the market will be weak in the short-term, but then rally later. Strategy Implementation A near-dated call option is sold, and a longerdated, further out-of-the-money call option is bought. Upside Potential Unlimited, if the bought option is held after the short option expires (the position then becomes a straight-forward buy call). If the position is closed at expiry of the near option, maximum profit will accrue if the market is at the level of the sold strike. Downside Risk Limited to the difference in strikes plus/minus the initial debit/credit when establishing the spread Margin Yes, but off-set may apply. Comment There is a risk of the sold options being called (i.e. being exercised

13 BEARISH Buy Put Sell Call Bear Spread Diagonal Spread Put Hedge

14 BUY PUT Strategy View Investor thinks that the market will fall significantly in the short-term.. Strategy Implementation Put option is bought with a strike price of a. The more bearish the investor is, the lower the strike price should be. Upside Potential Profit potential is unlimited (well, not really unlimited of course as the market can not fall below zero). Breakeven Point at Expiry Strike price minus premium paid. Downside Risk Limited to the premium paid -incurred if at expiry the market is at or above the strike a Margin Not required

15 SELL CALL Strategy View Investor is certain that the market will not rise and is unsure/unconcerned whether it will fall. Strategy Implementation Call option is sold with a strike price of a. If the investor is very certain of his view then at-themoney options should be sold, if less certain, then out-of-the-money ones should be sold. Upside Potential Limited to the premium received -received if the market at expiry is at, or below, the option strike. Downside Risk Unlimited Losses on the position will worsen as the market rises. [If the investor likes the idea of the strategy, but not the downside risk, they might be interested in a bear spread]. Margin Always required

16 BEAR SPREAD Strategy View Investor thinks that the market will not rise, but wants to cap the risk. Conservative strategy for one who thinks that the market is more likely to fall than rise Strategy Implementation Call option is sold with a strike price of a and another call option bought with a strike of b, producing a net initial credit, OR Put option is sold with a stike of a and another put bought with a strike of b, producing a net initial debit. Upside Potential Limited in both cases - Calls: net initial credit Puts: difference between strikes minus initial debit Maximum profit if market at expiry is below the lower strike. Downside Risk Limited in both cases - Calls: difference between strikes minus initial credit Puts: net initial debit Maximum loss if at expiry market is above the higher strike. Margin Possibility for margin requirements to be off-set

17 DIAGONAL SPREAD Strategy View Investor thinks that the market will be flat or rise only slightly in the short-term, but will then fall later. Strategy Implementation Sell a near-dated put option and buy a longer dated out-of-the-money put. Upside Potential Large, if the bought option is held after the short option expires (the position then becomes a straight-forward buy put). If the position is closed at expiry of the near option, maximum profit will accrue if the market is at the level of the sold strike. Downside Risk Limited to the difference in strikes plus/minus the initial debit/credit when establishing the spread Margin Yes, but limited.

18 PUT HEDGE - Hold stock, Buy Put Strategy View Investor holds stock and is worried about a market fall. Put options can be bought to protect the value of the stock position, while not preventing the position to benefit in the event of a market rise. Strategy Implementation Put options are bought with a strike price of a. The number of put options bought will depend on the bearishness of the investor and the size of the stock holding. Upside Potential Profit potential is unlimited, being the ordinary return on the stock minus the fixed premium paid for the put option. Downside Risk Potentially limited, (depending on the hedge ratio initially applied) The gains on the put options -as the market falls -will off-set the stock losses. Margin Not required

19 Neutral & Volatile Sell Straddle Sell Strangle Long Butterfly Calendar Spread Covered Call Buy Straddle Buy Strangle Short Butterfly

20 Long Butterfly Strategy View Investor thinks that the market will not be volatile, but wants to cap the downside risk.. Strategy Implementation Call option with low strike bbought and 2 call options with medium strike asold and call option with high strike cbought. (The same position can be created with puts, but is less common). Upside Potential Limited -to the difference between the lower and middle strikes minus the net debit of establishing the spread Downside Risk Limited to the initial net debit of establishing the spread Margin Margin could be possible.

21 Short Butterfly Strategy View Investor mildly thinks that the market will be volatile. Strategy Implementation Call option is sold with strike b, two call options are bought with strike aand a call option is sold with strike c.[a similar position can be created with puts]. Upside Potential Limited to initial credit received. Downside Risk Limited to the difference between the lower and middle strikes minus the initial spread credit. Margin Off-set may be available.

22 CALENDAR SPREAD Strategy View Investor thinks that the market will be weak in the shortterm, but rally in the longer-term. Strategy Implementation Near dated call option is sold, and a longer-dated call option with the same strike is bought. [If the investor holds the opposite view, then a comparable strategy can be constructed with puts]. Upside Potential Large, if the bought option is held after the short option expires (the position then becomes a straight-forward buy call). If the position is closed at expiry of the near option, maximum profit will accrue if the market is at the level of the sold strike. Breakeven Point at Expiry Strike price plus premium Downside Risk Limited to the initial debit incurred for establishing the spread.. Margin Off-set may be available.

23 Real Options ESSAR Hutch Vodafone IDFC Hutch India

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