Futures & Options 101: Choosing the Best Option Strategy

Ambiguity with choosing the best option strategy

Exchange-traded options have become the buzzword among the investor’s these days. Started trading in 1973 from CBOE, options, however, grew significantly in the last decade only. A testimony of this can be understood from the fact that the total volume of options contracts traded on U.S grew to 2 billion in 2006 as against 507 million in 1999 as per the data compiled by the Chicago Board of Options Exchange .

Simply stated, an option is a contract that gives right to the investor to buy or sell specified quantity of the underlying security at a predetermined strike price on or before expiration date. The option becomes worthless, if not exercised, before the end of expiration date.

Exchange-traded options is an important class of derivatives having standardized contract features and which can be traded on public exchanges, facilitating trading among investors. Options can be used for hedging by predicting the future direction of the market after analyzing the microeconomics and macroeconomic conditions affecting the industry and the market or for arbitrage. In short, option strategies range from simple to complex which can be used either to make money or save money invested in stocks if market condition doesn’t favor the stock trading.

Options trading, in general, is a riskier investment for a naive investor. One main reason behind this could be attributed to the fact that the naive investors do not fully understand the concept of leverage. Moreover, options trading is relatively more complex than equity and futures trading, so market participants take more time to be comfortable, and develop skills and systems to cope with options trading.

Contrary to the common belief if managed and used properly, options can have less risk than an equivalent position in stock . This is where choosing the best strategy comes into picture and a financial advisory firm with sound experience in derivative trading can help reduce ambiguity to a great extent.

However, choosing the best strategy is a tedious and the most challenging task for an option trader as no single trading strategy works in all types of markets. There are many popular option trading strategies each having its own set of risk and reward. Those claiming one strategy being superior over other simply mean that they have a preference to a particular risk-reward profile.

So, two things are important while choosing the best option strategy; first, one must take into account of how much risk the investor is willing to take and second deciding on which risk-reward profile will suit investor the most under a given a market condition.

As already said, each strategy has its own set of risk and reward. Below are a few common strategies with its potential reward and risk.

Strategy Risk Reward
Long Call/ Buy Call Limited to the premium Unlimited
Short Call/Sell Call Unlimited Limited to the premium
Long Put/Buy Put Limited to the Premium Unlimited
Short Put/Sell Put Unlimited Limited to the premium
Covered Call/Buy Stock + Sell Call maximum risk = Stock Price Paid – Call Premium Limited to (Call Strike Price – Stock Price paid) + Premium received
Covered Put (Short Stock + Short Put Option) also called as Synthetic Long Put Unlimited  Maximum is (Sale Price of the Stock – Strike Price) + Put Premium
Long Straddle Limited to the Premium Unlimited
Short Straddle Unlimited Limited to the Premium
Synthetic Long Call/ Buy Stock, Buy Put Losses limited to Stock price + Put Premium – Put Strike price Unlimited 

Likewise, there are a number of option strategies each work under different market condition with its own set of risk and reward.

The first step in choosing the best strategy is analyzing the current market condition and perform a detailed analysis of how the market is going to behave; upward, downward or neutral during the expiration period. Based on the given market condition, decide the best option strategy which matches with the risk reward profile of the investor as each strategy has its own sets of risk and reward.

However, choosing the best strategy is half work done only, applying the best strategy to exchange traded options is equally important. Then, purchase the specific stock option on the company you decided to invest and then wait for the underlying stock to reach target price and then exercise your option to buy or sell the stock at the current market prices. You can however allow the option to expire if it doesn’t reach the expected price in order to reduce risk to a minimum.

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 Manish Kumar | T A Pai Management Institute, Manipal

Read Manish’s earlier article on option strategies: Yield Enhancement Strategy using covered calls

Follow Manish here at manishkumar@insideiim.com

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