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Option Trading Strategy

SPECULATION: BEARISH SECURITY.

SELL CALLS OR BUY PUTS

Do you sometimes think that the nse india is going to drop? That you could make a profit by adopting a position on the market? Due to poor corporate results, or the instability of the government, many people feel that the stocks prices would go down. How does one implement a trading strategy to benefit from a downward movement in the market? Today, using options, you have two choices:

SELL CALL OPTIONS (OR)
BUY PUT OPTIONS

We have already seen the pay off a call option. The upside of the writer of the call option is limited to the option premium he receives upright for writing the option. His downside however is potentially unlimited. Suppose you have a hunch that the price of a particular security is going to fall in a months time. Your hunch proves correct and it does indeed fall, it is this commodity tips that you cash in on. When the price falls, the buyer of the call lets the call expire and you get to keep the premium. However, if your hunch proves to be wrong and the market soars up instead, what you lose is directly proportional to the rise in the price of the security.

Having decided to write a call, which one should you write? (Please refer table at page NO.74 which gives the premiums for one month calls and puts with different strikes). Given that there are market stock tips number of one month calls trading, each with a different strike price, the obvious question is, which strike should you choose, Let us take a take a look at call options with different strike prices. Assume that the current stock price is 1250, risk free rate is 12% per year and stock volatility is 30%. You could write the following options:

1.    A one month call with a strike of 1200
2.     A one month call with a strike of 1225
3.     A one month call with a strike of 1250
4.     A one month call with a strike of 1275
5.     A one month call with a strike of 1300.

Which of this options you write largely depends on how strongly you feel about the likelihood of the downward movement of prices and how much you are willing to lose should this downward movement not come about. There are five one month calls and five one month puts trading in the market. The call with a strike of 1200 is deep in the money and hence trades at a higher premium. The call with a strike of 1275 is out of the money and trades at a low premium. The call with a strike of 1300 is deep out of money. Its execution depends on the unlikely event that the stock will rise by more than 50 points on us take a expiration date. Hence writing this call is a fairly safe bet. There is a small probability that it may be in the money by expiration in which case the buyer exercises and the writer suffers losses to the extent that the price is above 1300. In the more likely event of the call expiring out of the money, the writer earns the premium amount of Rs.27.50.

As a person who wants to speculate on the hunch that the market may fall, you can also buy puts. As the buyer of puts you face an unlimited upside but a limited downside. If the price does fall, you profit to the extent the price falls below the strike of the put purchased by you. If however your hunch about a downward movement in the market proves to be wrong and the price actually rises, all you lose is the option premium. If for instance the security price rises to 1300 and you have bought a put with an exercise of 1250, you simply let the put expire. If however the price does fall to say 1225 on expiration date, you make a neat profit of Rs.25.

Having decided to buy a put, which one should you buy? Given that there are a number of one month puts trading, each with a different strike price, the obvious question is, which strike should you choose? This largely depends on how strongly you feel about the likelihood of the downward movement of the market. If you buy an at the money put, the option trading courses paid by you will be higher than if you buy an out of the money put. However the chances of an at the money put expiring in the money are higher as well.

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