Written By: Rhythm Garg
Now that we’ve explored the fundamental concepts of options trading and some basic strategies, it’s time to delve deeper into the world of advanced options trading. While beginner strategies offer a solid foundation, advanced techniques can significantly enhance your potential returns and risk management. These strategies require a more sophisticated understanding of options mechanics and market dynamics.
As Dan has now understood naked Option buying and selling, we will now teach him more complex strategies which uses combinations of these Call & Put Options
Spreads involve combining options on the same underlying and of the same type (call/ put) but with different strikes and maturities. These are limited profit and limited loss positions.
1. Bullish Vertical Spreads- This spread means you are Bullish on the market and will reap returns if the market goes up.
i. Bull call Spread: A bull call spread is a strategy that involves buying a call option with a lower strike price and selling a call option with a higher strike price, both with the same expiration date. It is a limited-profit, limited-loss strategy used when you’re moderately bullish on an underlying asset, like the Nifty 50 index.
Example 1, Let’s say Dan starts farming and plants 2 types of crops, he doesn’t want to risk everything on a single crop, so he decides to hedge his bets as he is optimistic yet cautious. He plants his main crop, a high-yield variety, but he also plants a smaller, less productive crop nearby. If the main crop thrives, he’ll reap a bountiful harvest. However, if a pest infestation or a sudden storm damages the main crop, the less productive crop will still provide some yield. It’s like planting two crops: the lower strike price call option is your main crop, and the higher strike price call option is your less productive crop.
If the underlying asset’s price rises significantly, the lower strike price call option will be more valuable, and you’ll profit from the difference between the two strike prices. However, if the price doesn’t rise as much, or even declines, your losses will be limited by the premium you received from selling the higher strike price call option.
Example 2, Suppose the current Nifty 50 index price is 23,500. You believe the index will rise moderately in the next few weeks. You could implement a Bull Call Spread strategy as follows:
– Buy a Call Option: Purchase a call option with a strike price of 23,500. This gives you the right to buy the Nifty 50 at 23,500.
– Sell a Call Option: Sell a call option with a higher strike price, say 24,000. This obligates you to sell the Nifty 50 at 24,000 if the option is exercised.
– Limited Loss: Your maximum loss is the net premium paid for the spread.
– Limited Profit: Your maximum profit is the difference between the strike prices minus the net premium paid.
– Reduced Volatility Risk: By buying and selling options, you’re partially hedging against adverse price movements.
– If Nifty 50 stays below 23,500 at expiration: Both options expire worthless, and your loss is limited to the net premium paid.
– If Nifty 50 rises to between 23,500 and 24,000: You’ll profit from the difference between the two strike prices, minus the net premium paid.
– If Nifty 50 rises above 24,000: Your profit is capped at the difference between the strike prices minus the net premium paid.
ii. Bull Put Spread: A bull put spread is a strategy involves selling a put option with a higher strike price and simultaneously buying a put option with a lower strike price, both with the same expiration date. It is a limited-risk, limited-reward strategy that can be used to generate income in a bullish or stable market.
Example 1 Dan is a farmer who expects a good harvest this year but is worried about a potential price drop in the market. He’s bullish on the price but wants to protect himself from a sudden decline.
– Selling the Insurance: Dan sells a “put option” to his neighbor. This essentially means he agrees to sell his crops to his neighbor John at a higher price if the market price drops significantly. In return, John pays him a small premium upfront.
– Buying a Safety Net: To limit his potential losses, Dan buys another “put option” from a different neighbour Smith, but at a lower price. This gives him the right to sell his crops to Smith at a lower price if the market price crashes severely.
– Good Harvest, Good Price: If the market price remains stable or increases, both “put options” expire worthless. Dan keeps the initial premium he received for selling the first put option, earning a small profit.
– Good Harvest, Lower Price: If the market price drops slightly, Dan can still sell his crops at the higher price from the first put option he sold, limiting his losses.
– Bad Harvest, Very Low Price: If the market price crashes significantly, Dan can use the second put option he bought to sell his crops at a slightly lower price, minimizing his losses.
Example 2, Suppose the current Nifty 50 index price is 24,000. You believe the index will either stay flat or rise slightly in the near future. To capitalize on this view, you can implement a Bull Put Spread strategy:
– Sell a Put Option: Sell a Put option with a strike price of 24,000. This means you’re obligated to buy the Nifty 50 at 24,000 if the option buyer chooses to exercise it. Let’s assume you receive a premium of ₹ 100 for selling this put option.
– Buy a Put Option: Simultaneously, you buy a put option with a lower strike price, say 23,600. This gives you the right to sell the Nifty 50 at 23,600. The premium for this put option is ₹ 50.
– Net Premium Received: ₹ 100 (from selling the put) – ₹50 (from buying the put) = ₹ 50
– Limited Risk: Your maximum loss is capped at the difference between the strike prices (₹ 400) minus the net premium received (₹ 50), which is ₹ 350.
– Limited Profit: Your maximum profit is the net premium received, which is ₹ 50.
– Income Generation: If the Nifty 50 stays above 24,000 at expiration, both options expire worthless, and you keep the ₹ 50 net premium.
Nifty at Expiration:
– Above 24,000: Both options expire worthless. Profit = ₹ 50 (net premium)
– Between 23,600 and 24,000: Both options expire worthless. Profit = ₹ 50 (net premium)
– Below 23,600: You exercise your long put (right to sell at 23,600). Loss is limited to the difference between strike prices (₹ 400) minus net premium (₹ 50) = ₹ 350
2. Bearish Vertical Spreads- This spread means you are Bearish on the market and will reap returns if the market goes down.
iii. Bear Call Spread: A Bear Call spread is a strategy which involves selling a call option with a lower strike price and simultaneously buying a call option with a higher strike price, both with the same expiration date. It is a limited-risk, limited-reward strategy that can be used to generate income in a bearish or stable market.
Example 1 Dan is an orchard owner who fears bumper crop of apples this year, leading to a potential drop in apple prices. He’s bearish on the apple market but wants to limit his losses.
– Selling the Right to Buy Cheap: Dan “sells a call option” to his neighbour John. This means he agrees to sell his apples to his neighbour John, at a lower price if the market price rises significantly. In return John pays the Dan a small premium upfront.
– Buying Insurance Against an Apple Price Surge: To limit his potential losses if the apple price unexpectedly surges, the Dan “buys a call option” from another neighbour Liam, but at a higher price. This gives him the right to buy apples from this neighbour Liam, at a higher price if the market price skyrockets.
– Low Prices, Good Outcome: If the apple price remains low or declines, both “call options” expire worthless. The Dan keeps the initial premium he received for selling the first call option, earning a small profit.
– Stable Prices, Neutral Outcome: If the apple price remains stable, both “call options” expire worthless, and the Dan keeps the initial premium.
– High Prices, Limited Loss: If the apple price surges significantly, Dan is obligated to sell his apples at the lower price from the first call option he sold to John. However, he can limit his losses by buying apples at the higher price from the second call option he bought from Liam.
Example 2, Suppose the current Nifty 50 index price is 23,600. You believe the index will either stay flat or fall slightly in the near future. To capitalize on this view, you can implement a Bear Call Spread strategy:
– Sell a Call Option: You sell a call option with a lower strike price of 23,600. This means you’re obligated to sell the Nifty 50 at 23,600 if the option buyer chooses to exercise it. Let’s assume you receive a premium of ₹ 120 for selling this put option.
– Buy a Call Option: Simultaneously, you buy a call option with a higher strike price, say 23,800. This gives you the right to buy the Nifty 50 at 23,800. The premium for this put option is ₹ 50.
– Net Premium Received: ₹ 120 (from selling the call) – ₹ 50 (from buying the call) = ₹ 70
– Limited Risk: Your maximum loss is capped at the difference between the strike prices (₹ 200) minus the net premium received (₹ 70), which is ₹ 130.
– Limited Profit: Your maximum profit is the net premium received, which is ₹ 70.
– Income Generation: If the Nifty 50 stays below 23,600 at expiration, both options expire worthless, and you keep the ₹ 70 net premium.
Nifty at Expiration:
– Below 23,600: Both options expire worthless. Profit = ₹ 70 (net premium)
– Between 23,600 and 23,800: You’re obligated to sell the Nifty 50 at 23,600. Loss is limited to the difference between strike prices (₹ 200) minus net premium (₹ 70) = ₹ 130.
– Above 23,600: You exercise your long call (right to buy at 23,800). Loss is limited to the difference between strike prices (₹ 200) minus net premium (₹ 70) = ₹ 130
iv. Bear Put Spread: A Bear Put spread is a strategy which involves involves selling a put option with a lower strike price and simultaneously buying a put option with a higher strike price, both with the same expiration date. This Strategy is employed when you anticipate a moderate decline or expect the price of the underlying asset to remain relatively unchanged.
Example 1 Dan is a farmer who is concerned about an upcoming storm that could damage his crops. He’s bearish on the potential outcome and wants to protect himself from potential losses.
– Selling Insurance Against Minor Damage: The farmer “sells a put option” to his neighbor John. This means he agrees to sell his crops to John at a slightly lower price if the storm causes minor damage. In return, John pays Dan a small premium upfront.
– Buying Insurance Against Major Damage: To limit his potential losses if the storm causes significant damage, Dan “buys a put option” from another neighbor Liam, but at a much lower price. This gives him the right to sell his crops to Liam at a significantly lower price if the damage is severe.
– No Storm, Good Outcome: If the storm doesn’t materialize or causes minimal damage, both “put options” expire worthless. Dan keeps the initial premium he received for selling the first put option, earning a small profit.
– Minor Storm, Neutral Outcome: If the storm causes minor damage, both “put options” expire worthless, and Dan keeps the initial premium.
– Major Storm, Limited Loss: If the storm causes significant damage, Dan is obligated to sell his crops at the slightly lower price from the first put option he sold to John, However, he can limit his losses by selling his damaged crops at the much lower price from the second put option he bought from Liam.
Example 2, Suppose the current Nifty 50 index price is 23,900. You anticipate the index to either decline or remain relatively unchanged in the near future. To capitalize on this view, you can implement a Bear Put Spread strategy.
– Sell a Put Option: You sell a put option with a lower strike price, say 23,500. This means you’re obligated to buy the Nifty 50 at 23,500 if the option buyer chooses to exercise it. Let’s assume you receive a premium of ₹ 100 for selling this put option.
– Buy a Put Option: Simultaneously, you buy a put option with a higher strike price, say 23,700. This gives you the right to sell the Nifty 50 at 23,700. The premium for this put option is ₹ 50.
– Net Premium Received: ₹ 100 (from selling the put) – ₹ 50 (from buying the put) = ₹ 50
– Limited Risk: Your maximum loss is capped at the difference between the strike prices (₹ 200) minus the net premium received (₹ 50), which is ₹ 150.
– Limited Profit: Your maximum profit is the net premium received, which is ₹ 50.
– Income Generation: If the Nifty 50 stays Above 23,500 at expiration, both options expire worthless, and you keep the ₹ 50 net premium.
Nifty at Expiration:
– Above 23,500: Both options expire worthless. Profit = ₹ 50 (net premium)
– Between 23,500 and 23,700: You’re obligated to buy the Nifty 50 at 23,500. Loss is limited to the difference between strike prices (₹ 200) minus net premium (₹ 50) = ₹ 150.
– Below 23,700: You exercise your long put (right to sell at 23,700). Loss is limited to the difference between strike prices (₹ 200) minus net premium (₹ 50) = ₹ 150
3. Horizontal Spreads– A horizontal spread, also known as a calendar spread or time spread, is an options trading strategy that involves buying and selling options contracts on the same underlying asset with the same strike price but different expiration dates. This strategy aims to profit from the time decay (theta) of options as they approach their expiration.
Types of Horizontal Spreads
– Bull Calendar Spread: Involves buying a long-term call option and selling a short-term call option.
– Bear Calendar Spread: Involves buying a long-term put option and selling a short-term put option.
– Buy a Long-Term Option: You purchase an option contract with a later expiration date. This gives you the right to buy (call) or sell (put) the underlying asset at the specified strike price until the later expiration date.
– Sell a Short-Term Option: Simultaneously, you sell an option contract with an earlier expiration date on the same underlying asset and at the same strike price. This obligates you to sell (call) or buy (put) the underlying asset at the strike price if the option buyer exercises it before the earlier expiration date.
4. Diagonal Spreads – A diagonal spread is an advanced options trading strategy that combines elements of both vertical spreads and calendar spreads. It involves buying and selling options contracts on the same underlying asset, but with different strike prices and different expiration dates.
Types of Diagonal Spreads
– Bull Call Diagonal Spread: Buy a long-term call option and sell a short-term call option with a lower strike price.
– Bear Call Diagonal Spread: Buy a long-term call option and sell a short-term call option with a higher strike price.
– Bull Put Diagonal Spread: Buy a long-term put option and sell a short-term put option with a lower strike price.
– Bear Put Diagonal Spread: Buy a long-term put option and sell a short-term put option with a higher strike price.
– Buy a Long-Term Option: You purchase an option contract (call or put) with a later expiration date.
– Sell a Short-Term Option: Simultaneously, you sell an option contract (of the same type – call or put) with an earlier expiration date and a different strike price.
Mastering these advanced option strategies can significantly enhance your trading arsenal in all bullish, bearish, and stagnant market, but always prioritize risk management and thorough research.