A Note On Investment Strategies Involving Options

INTRODUCTION

Options on commodities have existed in different forms since 1860 for products including gold, wheat and tulip bulbs. However, large-scale manipulation by intermediaries and absence of standardized contracts resulted in investors incurring heavy losses due to which trading in commodity options were discontinued by many exchanges by 1968. But today options have become one of the most preferred derivative instruments among the investors.

Until 1973, trading in options on stocks was cumbersome as the contract was between the buyer and the seller, and the stock exchange played no major role. In 1973, options on stocks were traded for the first time in an organized stock exchange^[1] . The exchange also became a party to these contracts. Since then, there has been a significant growth in the options market with options being traded in several exchanges all over the world.

DEFINING THE TERMS

An option contract may involve taking a ‘long position'or a ‘short position'or both. An investor is said to have taken the long position when he/she has bought an option. On the other hand, an investor is said to have taken a short position when he/she has sold or written the option.

While discussing option contracts, it is important to understand some other terms that are often used. Strike or Exercise Price is the price at which the underlying asset would be bought at a particular date in the future. The date on which the option holder exercises his right to sell/buy the option is known as the Exercise Date while the date on which the option expires is known as Expiration Date.

Options can be categorized further according to the date of exercise. A European Option can be exercised only on the maturity date while an American Option can be exercised before or on the maturity date. A Bermudan Option is a combination of the American and European option and is exercisable only on certain specified days during its entire life. In Cash settled option buyer is paid the difference between the stock price and the exercise price (in the case of a call option) or between the exercise price and the stock price (in the case of a put option). In a Delivery settled option buyers take the delivery of the underlying security (in the case of a call option) or offers the delivery of the underlying security (in the case of a put option).

Options can be used by an investor to create a wide range of payoff functions. They help in achieving unique risk-return patterns, which cannot be achieved by taking investment positions in underlying assets. In this concept note, we illustrate in detail the various investment strategies using options.

INVESTMENT STRATEGIES INVOLVING OPTIONS

TABLE 1 IN, AT AND OUT OF THE MONEY OPTIONS

TABLE 2: PAYOFF FROM BUYING CALL OPTION (RS.)

TABLE 3: PAYOFF FROM SELLING A CALL OPTION (RS.)

TABLE 4: PAYOFF FROM BUYING OF PUT OPTION (RS.)

TABLE 5: PAYOFF FROM SELLING A PUT OPTION

TABLE 6: PAYOFF FROM BULL SPREAD USING CALLS

TABLE 7: PAYOFF FROM BEAR SPREAD USING CALLS

TABLE 8: PAYOFF USING BUTTERFLY SPREAD

TABLE 9: PAYOFF USING CONDOR SPREAD

TABLE 10: PAYOFF FROM LONG STRADDLE

TABLE 11: PAYOFF FROM LONG STRANGLE
 
TABLE 12: PAYOFF USING STRIPS

TABLE 13: PAYOFF USING STRAP
 
CONCLUSION

EXHIBIT I

ADDITIONAL READING & REFERENCES

^[1] Options on stocks were first traded on the Chicago Board Options Exchange.

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