Narach Investment

OPTIONS TRADING STRATEGIES IN A BULL MARKET


Whether the stock market and the stocks traded in them are in a bullish trend or bearish mode both the Call options and Put options are available to an investor. Keeping this in view and that the stock market were to be in a bull run, the investor would be able to utilize the Call options in a bullish Call spread strategy or the Put option in a bullish Put spread strategy.

Call options in a bullish strategy: An investor with a bullish market outlook should buy Call options. If the market price of the underlying asset is expected to rise, then the investor would rather have the right to purchase at a specified price and sell later at a higher price.

The investor's profit potential while buying a Call option is unlimited. Of course, the profit would be the market price of the underlying less the exercise price and less the premium paid by him. So, greater the increase in the price of the underlying asset, the greater would be the investor's profit. On the flip side, the investor's potential loss is limited; as even if there were to be drastic decline in price levels of the underlying asset, the holder of the Call option would be under no obligation to exercise the option and would allow it to expire worthless.

The investor breaks even when the market price equals the exercise price plus the premium paid. An increase in the volatility would increase the value of the Call option and also increase the investor's return. This would be because of the increased likelihood that the Call option would become in-the-money with an increase in the volatility of the price of the underlying asset before expiration; and would increase the value of the long options position. As an option holder, the investor's return would also increase.

To illustrate the above, let's say there is a Call option with a strike price of ₹2,000.00 and the option premium is ₹100.00. The option would be exercised only if the value of the underlying asset is greater than ₹2,000.00 (that is, the strike price). If the buyer were to exercise the Call option at ₹2,200.00, then his gain would be ₹200.00. However, this would not be his actual gain; for which he would be required to deduct the ₹100.00 (that is, the premium) he had paid earlier. The profit would be derived as follows:

Profit = Market Price − Exercise Price − Premium = ₹2,200.00 − ₹2,000.00 − ₹100.00 = ₹100.00

Put options in a bullish strategy: An investor with a bullish market outlook can also go short on a Put option. Basically, an investor anticipating a bull market could write Put options. If the market price of the underlying asset increases and the Puts become out-of-the-money, the investors with the long Put option positions would let their options expire worthless; while the Put option writer would get to keep the premium received earlier, and would be his gain.

By writing Puts, the profit potential is limited. A Put writer profits when the price of the underlying asset increases and the option expires worthless. The maximum profit to the option writer would be limited to the premium received. However, the potential loss in this case would be unlimited, as the short put option holder has an obligation to purchase if exercised; and he would be exposed to potentially large losses if the price of the underlying asset were to move against his position and decline.

The breakeven point occurs when the market price of the underlying asset equals the exercise price minus the premium. At any price less than the exercise price minus the premium, the investor would lose money on the transaction; at higher prices his option would be profitable. An increase in volatility would increase the value of the Put and decrease the investor's return. As an option writer, the higher the price you would be required to pay in order to buy back the option at a later date, lower would be the return.

Bullish Call spread strategies: A vertical Call spread is the simultaneous purchase and sale of identical Call options but with different exercise prices. So, to "buy a Call spread" is to purchase a Call with a lower exercise price and to write a Call option with a higher exercise price. The investor would pay a net premium for the position. To "sell a Call spread" is the opposite; here the investor buys a Call with a higher exercise price and writes a Call with a lower exercise price while receiving a net premium for the position.

An investor with a bullish market outlook would buy a Call spread; as the "Bull Call spread" allows the investor to participate to a limited extent in a bull market, while at the same time limiting his risk exposure.

To put on a Bull spread, the investor needs to buy the lower strike price Call and sell the higher strike price Call. The combination of these two options would result in a bought spread. The cost of putting on this position would be the difference between the premium paid for the lower strike price Call and the premium received for the higher strike price Call.

The investor's profit potential is limited. When both the Calls are in-the-money, both would be exercised and the maximum profit would be realized. The investor would deliver on his short Call and receive a higher price than he paid for receiving delivery on his long Calls. The investor's potential loss is limited; at the most he would lose the net premium. As the investor pays a higher premium for the lower exercise price Call than he receives for writing the higher exercise price Call. The investor would breakeven when the market price of the underlying asset equals the lower exercise price plus the net premium.

To illustrate the above, let's assume that the market price of the underlying asset is ₹100.00 and the investor buys a Nov Call option with a strike price of ₹90.00 and pays a premium of ₹14.00. At the same time, the investor sells another Nov Call option on the underlying asset with a strike price of ₹110.00 and receives a premium of ₹4.00. This would result in a net outflow of ₹10.00 at the time of establishing the spread.

Now, let us look at the fundamental reason for this position. Since this is a Bullish strategy, the first position established in the spread is the long lower strike price Call option with unlimited profit potential. At the same time, to reduce the cost of purchase of the long position a short position at a higher Call strike price is established. While this would not only reduce the outflow in terms of premium, but both his profit potential as well as risk are limited. Based on the above figures the maximum profit, maximum loss and the breakeven point of this spread would be as follows:

Maximum Profit = Higher strike price − Lower strike price − Net premium paid = ₹110.00 − ₹90.00 − ₹10.00 = ₹10.00

Maximum Loss = Lower strike premium − Higher strike premium = ₹14.00 − ₹4.00 = ₹10.00

Breakeven Price = Lower strike price + Net premium paid = ₹90.00 + ₹10.00 = ₹100.00

Bullish Put spread strategies: A vertical Put spread is the simultaneous purchase and sale of identical Put options but with different exercise prices. To "buy a Put spread" is to purchase a Put option with a higher exercise price and simultaneously write a Put with a lower exercise price. The investor would pay a net premium for the position. To "sell a Put spread" would be the opposite; where the investor would buy a Put with a lower exercise price while simultaneously writing a Put with a higher exercise price, receiving a net premium for the position.

An investor with a bullish market outlook would sell a Put spread. The "vertical Bull Put spread" allows the investor to participate to a limited extent in a bull market, while at the same time limiting his risk exposure.

To put on a Bull spread, an investor sells the higher strike Put and buys the lower strike Put. The Bull spread can be created by buying the lower strike and selling the higher strike of either the Calls or the Puts. The difference between the premiums paid and received make up one leg of the spread.

Again, the investor's profit potential would be limited. When the market price of the underlying asset reaches or exceeds the higher exercise price, both options would be out-of-the-money and would expire worthless; and the investor would realize his maximum profit, that is the net premium. The investor's potential loss would be limited. If the market price of the underlying asset were to fall, the options would be in-the-money; and the Puts would offset one another, but at different exercise prices. The investor's breakeven would be when the market price of the underlying asset equals the lower exercise price less the net premium paid earlier.

To illustrate the above, let's say that the market price of the underlying asset is ₹100.00. The investor buys a Nov Put option on the underlying asset with a strike price of ₹90.00 at a premium of ₹5.00; and sells a Nov Put option with strike price of ₹110.00 at a premium of ₹15.00.

The first position is a short put at a higher strike price. This would result in some inflow in terms of premium. But, here the investor is worried about risk and so caps his risk by buying another Put option at a lower strike price. As such, a part of the premium received is paid out to provide for the second position; and the ultimate position would have limited risk with limited profit potential. Based on the above figures the maximum profit, maximum loss and breakeven point of this spread would be as follows:

Maximum Profit = Net option premium income (or net cost) = ₹15.00 − ₹5.00 = ₹10.00

Maximum Loss = Higher strike price − Lower strike price − Net premium received = ₹110.00 − ₹90.00 − ₹10.00 = ₹10.00

Breakeven Point = Higher strike price − Net premium income = ₹110.00 − ₹10.00 = ₹100.00

We would strongly recommend that the investor first study these investment instruments along with the above listed strategies; conduct dry runs with pen and paper; understand the nuances of the dynamics of the underlying security and the connectivity between the various risks that he or she would be taking on during the pendency of a futures or options position held by him. The strategies provided here are academic in nature; and the information should be used by investors who are aware of the risks inherent in investing and trading in options in the equity markets amongst other financial instruments. Narach Investment accepts no liability whatsoever for any loss arising from the use of this website and its contents.