Using options to play a bullish equity market..

Indian equity derivatives markets have grown by leaps and bounds over the last 15 years since futures and options were first introduced in India. One market that has really developed rapidly in the last few years is the Options market. Options represent a right to buy or sell an asset without the responsibility. A right to buy is referred to as a call option while a right to sell is called a put option. So typically, when I expect markets to go up, I will buy a call option and when I expect the markets to go down I will buy a put option.
 
Remember, in options there is a subtle difference between the buyer and the seller of an option. The buyer has the right but no responsibility, while the seller of the option has the responsibility but not the right. The maximum profits in case of an option buyer can be unlimited but the maximum loss will be limited to the option premium paid. On the other hand, in case of an option seller the maximum profit will be limited to the premium received but the maximum loss will be unlimited. It is this interaction between the buyers and sellers of options that actually creates an options market.
 
How do you use options when you are bullish on the market; that is you either expect to go up marginally or substantially? This bullishness can be applied to stocks or even in the index. Interestingly, options offer a variety of strategies to play a bullish market
 
You can buy a plain vanilla call option
This is the simplest of options strategies where you just buy a plain vanilla call option. Assume that the stock price of RIL is currently quoting at Rs.1420. You can buy an Rs.1450 call option in the current series by paying a premium of Rs.25. This is the maximum loss that you will incur irrespective of how low the stock price goes. Your profits on RIL will start after you have covered the cost of the option premium. Assume that that price of RIL has now moved up to Rs.1500. That means you must be making a profit of Rs.25 after covering your cost of the option. But in reality the actual value of the option will be higher as it will also factor in the time value of money. Assume that the RIL 1450 call option is trading at Rs.70, and then you can reverse your position by selling the call option and booking a profit of Rs.45 (70-25) on your call option position.
 
You can create a protective put
A protective put is a simple strategy created by combining a future and a put option or a cash market position and an option. In a protective put also you are bullish on the stock but you just want to protect your downside risk in the event of any volatility risk. The put option is purchased at a lower strike than your futures purchase price. Your loss on the downside will be the gap between your future price and the put option strike plus the premium irrespective of how low the stock price goes. On the upside, the profit on futures is unlimited after your cost of put options is covered. Such combination strategies are called hybrids in F&O.
 
You can create a bull call spread
In a simple call option and in a protective put position, you are very bullish on the stock or the index. But what if you are moderately bullish on the stock? You can opt for a bull call spread, wherein you buy a call option of a lower strike and sell a call option of a higher strike. So to create a bull call spread on Infosys you will buy the 940 call option at Rs.50 and sell the 1000 call option at Rs.30. In this case, your maximum losses on the strategy will Rs.20 (50-30) while your maximum profit will be Rs.40 (difference of strikes less the net cost). You must use this strategy only when you are moderately bullish on the stock. In that case the premium received on the option sold reduces the cost of buying the lower option.
 
You can create a covered call strategy..
A covered call strategy is slightly more risky and you need to be cautious about that. In a covered call you buy the futures and sell a higher call option. The premium received on the call option sold reduces your cost of holding the futures and thus you can make profits even with a marginal movement in the futures. If you bought TCS futures at Rs.2350 and sold Rs.2450 strike call at Rs.45 then your profitable up to a upper limit of Rs.2495 and neutral after that. But you need to be conscious of the downside risk in this strategy. If the stock crashes sharply, then you just have the cover of the option premium received. So this strategy must be implemented only if you are confident of the stock not falling sharply and it is better to use this strategy with a stop loss.
 
You can sell put options
This is not exactly a bullish strategy but it is more of an anti-bearish strategy. For example, if you are positive on a strong price support for HPCL due to its proposed merger with ONGC then what do you do? One way is to sell a lower put option on HPCL. Basically you are betting that HPCL will not fall below a certain price. You are not taking any view on the upside. Remember, this is an open position so if the price of HPCL falls sharply then your losses can be unlimited. You need to be conscious of the same.
 
Options are wonderful trading products; not just because losses are limited but also because they offer the facility to tweak and combine and create unique strategies for very specific outlooks and uses.