An option is a right to buy or sell an asset without the obligation. Therefore when you buy the option you get this right without the obligation. That will not come for free and for that you need to pay a price which is called the option premium. When you read options prices in the trading terminal or the newspaper options page, you are actually reading about the premiums on these options. Options have different strikes and that makes them an extremely flexible product. Unlike futures that are linear (losses and profits are unlimited), options are not linear. The pay-off for the buyer of the option and seller of the option are very different. A buyer of an option has limited risk and unlimited return potential. The seller of the option has limited return potential but unlimited risk. That is what makes options unique and also interesting.
Options can not only be used in isolation they can also be used in combinations with futures and options. Such combinations are called hybrids. Let us try and understand about the use of options strategies for bullish markets; meaning markets that are trending upwards. Trading options in bull markets call for a unique set of strategies to be applied to make the best of the situation. Let us look at 4 such bull market options strategies..
Trading bullish markets with a naked call option..
This is the simplest use of options in a bullish market. A call option is a right to buy a stock or an index without the obligation to buy. That means you will pay the premium to get the right without the obligation. That premium is your option price and represents the maximum loss that you will incur in the transaction. Let us understand that better with a live example.
Investor ViewInvestor ActionInvestor pay-offHas a bullish view on Reliance Industries and expects the stock to go up from Rs.960 to Rs.1050 during the monthInvestor buys Reliance 980 Call option in February 2018 contract by paying a premium of Rs.22CMP (940) - Loses Premium
CMP (970) – Loses Premium
CMP (1000) – Net Loss of Rs.2
CMP (1050) – Net Profit of Rs.48
In the above scenario it is clear that the break-even point for the naked long call option is Rs.1002 (strike price of Rs.980 + premium of Rs.22). It is only after the price level of Rs.1002 that the trader starts to make net profit. Below Rs.980, the trader is indifferent as he loses his entire premium irrespective of the price. Above Rs.980 he starts to recover his premium cost and keeps recovering it till the breakeven point of Rs.1002. It is only post this point that he starts making profits.
Trading bullish market with insurance via protective put strategy..
A protective put is also a bullish strategy but it comes with a built in insurance. The problem with buying naked options is that you end up paying a huge premium and more often than not it is difficult to recover the premium amount. An alternate strategy could be protective put where you buy futures and protect it by purchasing a lower put option. In the Reliance example, if you can buy Reliance Futures at Rs.960 and protect yourself with a 950 put option at Rs.12, then your maximum risk is still Rs.22 as in the case of the naked option. But then your breakeven point is Rs.972 as at that point you will cover the cost of the put option too. Remember, when you buy futures here is higher margin payable and also you are subject to payment of mark to market margins. But this strategy essentially brings down your breakeven point.
Moderately bullish strategy via covered call strategy..
What do you do if you are moderately bullish on a stock? In the Reliance case you do not Reliance to go up to Rs.1050 but only up to 990. In that case you buy Reliance Futures at Rs.960 and the sell the Reliance 990 call option at Rs.10. This effectively reduces your cost of acquiring Reliance by Rs.10 and your new effective purchase price is Rs.950. On the upside you earn maximum profit on this strategy at Rs.990. After that whatever you gain on the futures is lost on the short call option. But it needs to be remembered that this strategy has open risk on the downside below Rs.950. That is a risk you need to be conscious of.
Moderately bullish strategy via Bull call spread strategy..
The downside of the covered call strategy is that the downside risk is open. That problem can be resolved using a covered call. This is also a moderately bullish strategy. What you do in this case is you buy a lower strike call and sell a higher strike call. So your maximum loss is limited to your net premium. In the case of Reliance, you can buy a 960 call option at Rs.25 and sell a 990 call option at Rs.10. Your maximum loss will be the net cost of Rs.15. This is an improvement on the covered call strategy in the sense that the downside risk is also covered.
In a nutshell, there are unique option strategies that you can employ under different market conditions and under different market views. That is how you can make the best of options.