Trading Strategy – Neutral and Volatile Strategies

NEUTRAL AND VOLATILE STRATEGIES

Can we summaries the earlier discussions on Option Trading Strategies?

In our previous discussions, we covered Bullish and Bearish Strategies. We also discussed Covered Calls in detail. We now turn to Option Strategies which you can apply if you are Neutral or if you believe the market will turn Volatile.

What does Neutral mean?

Neutral means you believe that the index or scrip in question is likely to remain wherever it is, or that the movement is not likely to be significant. For example, if the Sensex is around 3,200 now and you believe that the Sensex will stay around this level in the next two weeks, you are said to be Neutral.

What does Volatile mean?

A volatile view will imply that you believe the market will definitely move either upwards or downwards, but you are not sure which way the movement will occur. You are however quite sure that the market will not stay where it is. In this sense, a Volatile view is quite the opposite of the Neutral view.

What strategies can be applied to these situations?

The most common strategies to both situations are Straddles and Strangles.

What is a Straddle?

A Straddle is a strategy where you buy a Call Option as well as a Put Option on the same underlying scrip (or index) for the same expiry date for the same strike price. For example, if you buy a Satyam July Call Strike Price 240 and also buy a Satyam July Put Strike Price 240, you have bought a Straddle.

As a buyer of both Call and Put, you will pay a Premium on both the transactions. If the Call costs Rs 12 and the Put Rs 9, your total cost will be Rs 21.

When will I buy a Straddle?

You will buy a Straddle if you believe that Satyam will become volatile. Its current price is say Rs 240, but you think it will either rise or fall significantly. For example, you could believe that Satyam could rise right upto Rs 300 or fall upto Rs 200 in the next fortnight or so.

Why should it fluctuate so much?

There could be various situations which might warrant heavy movement. For example, during Budget time, a favourable proposal might impact the price favourably and if nothing favourable is proposed, the price could fall significantly. An Indian company could be considering collaborations with a major foreign company. If the collaboration were to happen, the price could rise, and if it were not to happen, the price could fall.

An Indian company might be expecting a huge order from a foreign company. The market might be awaiting news on this front. While a positive development might result in a price rise, a negative development might dampen the prices.

Some companies might face huge lawsuits. The decision could significantly impact prices any which direction.

In all these cases, you are sure that the price will either move up or move down, but you are not clear which way.

How will the Straddle help me?

Let us continue the above example. You have bought the Call and the Put and spent Rs 21. The current price and the strike price are the same Rs 240. Your profile will be determined as under:

Satyam Closing Price Profit on Call Profit on Put Initial Cost Net Profit
200 0 40 21 19
210 0 30 21 9
220 0 20 21 -1
230 0 10 21 -11
240 0 0 21 -21
250 10 0 21 -11
260 20 0 21 -1
270 30 0 21 9
280 40 0 21 19

Thus you make maximum profit if the price falls significantly to Rs 200 or rises significantly to Rs 280. You will make a maximum loss of Rs 21 (your initial cost) if the price remains wherever it currently is.

What are the other implications of Straddle?

As a buyer of the Straddle, you will pay initially for both the Call and the Put. You need not place any margins as you are a buyer of both Options. If time passes and the scrip remains at or around the same price (in this case Rs 240), you will find that the Option Premia of both the Call and the Put will decline (Time Value of Options decline with passage of time). Hence, you will suffer losses.

When will I sell a Straddle?

You bought a Straddle because you thought the scrip will become volatile. Conversely, the seller of the Straddle would believe that the scrip will act neutral. The seller will believe that the price of Satyam will stay around Rs 240 in the next fortnight or so. Accordingly, he will sell both the Call and the Put.

If the price indeed remains around Rs 240, he will make a maximum gain of Rs 21. If the price were to move up or down, he will make a lower gain as he will have to pay either on the Call (if it moves up) or on the Put (if it moves down).

What is the break even point of the Straddle?

The Straddle has two break even points viz. the Strike Price plus both Premia and the Strike Price minus both Premia. In the above example, the two break even points are Rs 261 (240 + 21) and Rs 219 (240 – 21). As seen earlier, the break even points are the same for the buyer and the seller.

What are the other implications for the seller?

As a seller, he will receive the Premia of Rs 21 on day one. He will have to place margins on both the Options and hence these requirements could be fairly high. If time passes and the scrip stays around Rs 240, the seller will be happy as the Option values will decline and he can buy back these Options at a lower level. On the other hand, if the scrip moves, he should be careful and think of closing out early.

What is a Strangle?

A Strangle is a slightly safer Strategy in the sense that you buy a Call and a Put but at different strike prices rather than one single strike price as in the case of a Straddle. For example, you could buy a Satyam Put Strike 220 and a Satyam Call Strike 260 at prices of Rs 5 and Rs 6 respectively. This would cost you Rs 11 and you would have a Volatile view on the scrip.

The lower cost would however imply a wider break even and you would make profit only if the Scrip moves up or down by a wider margin.

The profit potential is provided in this table:

Satyam Closing Price Profit on Call Profit on Put Initial Cost Net Profit
200 0 20 11 9
210 0 10 11 -1
220 0 0 11 -11
230 0 0 11 -11
240 0 0 11 -11
250 0 0 11 -11
260 0 0 11 -11
270 10 0 11 -1
280 20 0 11 9

The two break even points here would be worked out as lower strike minus the two premia and higher strike plus the two premia respectively. In this case, the break even points are Rs 209 (220 – 11) and Rs 271 (260 + 11).

We will discuss the finer points of these strategies in the next Article.

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