INTRODUCTION TO CALL OPTIONS AND PUT OPTION

An option contract is an agreement between two parties to buy/sell an asset (stock or futures contract as an example) at a fixed price and fixed date in the future.

It is called an option because the buyer is not obliged to carry out the transaction. If, over the life of the contract, the asset value decreases, the buyer can simply elect not to exercise his/her right to buy/sell the asset.

There are two types of option contracts - Call options and Put options. A Call option gives the buyer the right to buy the underlying asset, while a Put option gives the buyer the right to sell the underlying asset.

EXAMPLE
A simple example: Peter buys a Call option contract from Sarah. The contract states that Peter will buy 100 Microsoft shares from Sarah on the 5th May for $25. The current share price for Microsoft is $30.

Note: this is an example of a Call option as it gives Peter the right to buy the underlying asset.

If the share price of Microsoft is trading above $25 on the 5th May, then Peter will exercise the option and Sarah will have to sell him Microsoft shares for $25. With Microsoft trading anywhere above $25 Peter can make an instant profit by taking the shares from Sarah at the agreed price of $25 and then selling the shares on the open market for whatever the current share price is and making a profit.

The $25 value, which is stated in the agreement, is referred to as the Exercise (or Strike) Price. This is the price at which the asset will be exchanged. The date (in this case 5th May) is known as the Expiry (or Maturity) Date. This date is the deadline for the option contract. At this date, the option buyer is to decide if a transaction of the underlying asset is to occur.

Outcomes: Let's imagine that at the expiration date, Microsoft is trading at $30, then Peter will buy the shares from Sarah at the agreed $25 and then he can sell them back on the open market for $30 and make an instant $5.

Alternatively, if Microsoft is trading at $20, then buying the shares from Sarah at $25 is too expensive as he can buy them on the open market for $20 and save $5. In this situation, Peter would choose not to exercise his right to buy the shares and let the options contract expire worthless. His only loss would be the amount that he paid to Sarah when he bought the contract, which is called the Option Premium more on that a little later. Sarah would, however, keep the option premium received from Peter as her profit.

In the real world of exchange traded options, transactions don't really take place between two people. The process of Novation actually removes the identity of who is on the other side of the trade. You simply Buy or Sell an option contract from the exchange without knowing who is on the other side

Birth of the Modern Option

In 1973, the modern financial options market came into existence. The Chicago Board of Trade (CBOT) opened the Chicago Board Options Exchange (CBOE).

The CBOE instituted a new "exchange traded options contract". This contract was standardized in its terms and conditions. An options buyer and seller no longer had to sit down and negotiate terms of the contract every time he or she sought to buy an option. Thus, the CBOE could publish quoted options prices for the first time, and could establish a market maker system to make sure that there was a secondary or resell market for options.

At the same time, the Options Clearing Corporation was formed to make sure that the contract would be honored by all members. Lastly, the whole process came under the regulatory control of the Securities and Exchange Commission.

Thus, the trading of the modern option, "exchange traded options contract" had begun. On the first day the contracts traded, April 26, 1973, a total of 911 contracts were traded.

Since that time, options trading has grown enormously. In 2007, there were over 2.8 billion contracts cleared by the Options Clearing Corporation.

Options are now widely traded in variety of financial instruments: from stocks and bonds to exchange-traded funds, commodities and currency futures.

Next, we will take a closer look at what options are, why they are so popular and why every trader and investors should include them as part of their trading/investing toolkit.

John Emery has been a professional trader for more than a decade, trading in stocks, options and stock indexes on a daily basis. A former proprietary trader, Emery has written numerous articles for TradingMarkets over the years on topics ranging from trading basics to his own trading methods and strategies. Emery uses options both to trade and as a risk reduction tool.

OPTIONS TERMINOLGY

Call option: A call option gives the holder the right but not the obligation to buy
an asset at a certain date for a certain price.

Put option: A put option gives the holder the right but not the obligation to sell
an asset by a certain date for a certain price.

Index options: These options have the index as the underlying. In India, they
have a European style settlement. E.g. Nifty options, Mini Nifty options, etc.

Stock options: Stock options are options on individual stocks. A stock option
contract gives the holder the right to buy or sell the underlying shares at the specified price. They have an American style settlement.

Buyer of an option: The buyer of an option is the one who by paying the option
premium buys the right but not the obligation to exercise his option on the seller/writer.

Writer / seller of an option: The writer / seller of a call / put option is the one
who receives the option premium and is thereby obliged to sell/buy the asset if the buyer exercises on him.

Option price/premium: Option price is the price which the option buyer pays
to the option seller. It is also referred to as the option premium.

Expiration date: The date specified in the options contract is known as the
expiration date, the exercise date, the strike date or the maturity.

Strike price: The price specified in the options contract is known as the strike
price or exercise price.

American options: American options are options that can be exercised at any
time up to the expiration date.

European options: European options are options that can be exercised only on
the expiration date itself.

In-the-money option: An in-the-money (ITM) option is an option that would

lead to a positive cash-flow to the holder if it were exercised immediately. A call option on the index is said to be in-the-money when the current index stands at a level higher than the strike price (i.e. spot price > strike price). If the index is much higher than the strike price, the call is said to be deep ITM. In the case of a put, the put is ITM if the index is below the strike price.

At-the-money option: An at-the-money (ATM) option is an option that would

lead to zero cash-flow if it were exercised immediately. An option on the index is at-the-money when the current index equals the strike price (i.e. spot price = strike price).

Out-of-the-money option: An out-of-the-money (OTM) option is an option that would lead to a negative cash-flow if it were exercised immediately. A call option on the index is out-of-the-money when the current index stands at a level which is less than the strike price (i.e. spot price < strike price). If the index is much lower than the strike price, the call is said to be deep OTM. In the case of a put, the put is OTM if the index is above the strike price.

Intrinsic value of an option: The option premium can be broken down into two components intrinsic value and time value. The intrinsic value of a call is the amount the option is ITM, if it is ITM. If the call is OTM, its intrinsic value is zero. Putting it another way, the intrinsic value of a call is Max [0, (St K)] which means the intrinsic value of a call is the greater of 0 or (St K). Similarly, the intrinsic value of a put is Max [0, K St], i.e. the greater of 0 or (K St). K is the strike price and St is the spot price.

Time value of an option: The time value of an option is the difference between its premium and its intrinsic value. Both calls and puts have time value. An option that is OTM or ATM has only time value. Usually, the maximum time value exists when the option is ATM. The longer the time to expiration, the greater is an options time value, all else equal.

Practically,

Option Premium = Intrinsic Value + Time Value

OPTION GREEK

When learning Option Greeks there are four words you need to know. These words are delta, gamma, theta and vega. Option Greeks are measurements of risk that explain several variables that influence option prices. Before we can begin understanding what Option Greeks are, we should first understand the factors which influence the change in the price of an option. Then we can better understand how this fits in with the Option Greeks. Here are the 3 main factors that influence the change in the price of an option:

1: Volatility Amount
If you are long in the option, increases in volatility are normally positive for both calls and puts. However, an increase in volatility is typically negative if you are the writer of the option.

2: Changes in the time to expiration

If an option gets nearer to the expiration time it will become more and more negative and the profit potential will be become less and less. The nearer the option is to expiration, the faster the time value evaporates. Another way of saying this is that the rate of loss of time value for an option with three months left to expiration is faster than that of an option with six months remaining. Time is running out for the option to get in-the-money (when the strike price is less than the market price of the underlying security). The less time, the less value. The closer and closer options get to expiration, the less chance there is that it will happen, and there are generally fewer buyers and more sellers.

3: When the underlying asset changes in price

If a holder of an option has a call option, an increase in the price of the underlying asset is typically a positive situation. If you have a put option and there is a decrease in the price of the underlying instrument this is typically a positive situation. There is another influence which is interest rates. A lot of the time these are less important. With interest rates being higher this means that the call options will be more expensive and the put options will be less expensive. Once you understand the influences that change the price of an option you can then, advance to learning about the Option Greeks

1: Delta
A option delta is the sensitivity of an options theoretical value to a change in the price of the underlying stock or entity. Delta is described as the price relationship or the amount of change in price of the underlying entity to the option based on 1 point, or a dollar price move. Delta values range from -100 to 0 for put options and from 0 to 100 for calls, or -1 to 0 and 0 to 1, if you use the more commonly used expression in decimals. If the underlying entity moves $1 higher and the option follows penny for penny, the option has a delta of 1, which is the case for an in-the-money-option option. If the option increases in value only 50 cents for each dollar gained by the underlying entity, the delta is 50 or 50 percent.

2: Gamma
This is the sensitivity of an options delta to a change in the price of the underlying entity. In other words, gamma measures the rate of change of delta in relation to the change in the price of the underlying entity. From this information you can make a more informed decision on predicting how much can be made or lost based on the movement of the underlying position.

3: Theta
This is the sensitivity of an options theoretical value to a change in the amount of time to expiration.

4:Vega
Vega refers to the sensitivity of an options theoretical value to a change in volatility. It measures the risk exposure to changes in implied volatility and tells traders how much an options price will rise or fall as the volatility of the option varies.

FOUR BASIC OPTIONS POSITIONS

Call Options
(1) Call options give the holder (buyer) the right (but not the obligation) to buy the underlying asset at the strike price any time until the expiry date. (2) Call options obligate the writer (seller) to sell the underlying asset at the strike price any time until the expiry date. Note: the writer has the exact opposite position in comparison to the holder, this is because they are on opposite sides of the same contract.

Put Options
(3) Put options give the holder (buyer) the right (but not the obligation) to sell the underlying asset at the strike price any time until the expiry date. (4) Put options obligate the writer (seller) to buy the underlying asset at the strike price any time until the expiry date. Note: the writer has the exact opposite position in comparison to the holder, this is because they are on opposite sides of the same contract

Summary of the Four Basic Options Positions Holder (Buyer) Call Options Put Options Right to Buy Right to Sell Writer (Seller) Obligation to Sell Obligation to Buy

HOW TO APPROACH OPTIONS

For a trader to become successful at trading options he/she will have to become disciplined and focused and will need to stay in touch with the outside world and current events. An investor will need to have some sort of way or method of forecasting the price of the underlying stock to have good success in this game.

Investors and trader must become clued into reality. It is not possible to win all the time and nor is it possible for everyone to have the same amount of success as other traders. It is unrealistic for everyone to achieve the exact same results as the best traders. This is just pointing out a few obvious pieces of information.

Many professional traders make sure that they have more winners than losers. They have many trades that only break even or lose a little and they have some others that are winners. Their trading plans incorporate the possibility that not all trades will be successful.

When a beginner option trader is designing out a trading plan they should take into account that many trades will be unsuccessful. Being real about your chances will allow them to design a workable system that makes more profits from the winners than the losers. As an option trader, you will need to get a good handle on your money management to succeed in this game. Sometimes this can be a dynamic process where you need to update from time to time.

An options trader must take their trading seriously. If a trader is not in the mood on one particular day, that is fine. Just make sure that when you head is in the wrong place, that you dont start making trades, otherwise you can have heart stopping losses.

Many option traders have said that traders should never be afraid of selling to soon. If an investors goals have been met almost right away, some experts recommended that they should stick to the rules they have set out for themselves in their trading system. If the objective of the investor good hit, many investors would encourage them to consider taking their profits.

Who Trades Options?

Two broad categories of players exist in the option markets: risk seekers and risk avoider's.

Risk seeker
A risk seeker, also known as a speculator, is the type of trader that is trying to profit from a prediction in market direction. A speculator will have his or her own method of analysing the market and then use the options market to make a bet on his/her analysis.

Risk avoider
A risk avoider, also known as a hedger is in the market because s/he is trying to transfer risk to the speculator. A hedger will use the option market to create insurance for his/her physical position against an adverse market movement.

Options Trading
As an options trader you will need to learn how to judge price movements or volatility for the underlying stock. With stock options, the trader should consider the exchange on which the stock trades. The volatility of a stock and the volatility of the options on that stock are very much influenced by the volatile state of the overall exchange.

Often times, calm markets calm down volatile stocks. However, an individual stock can often be very volatile in the calmest of markets. There are can be many reasons why this may be the case, but these can be sometimes a good candidate for a short term option trade.

Sometimes volatility can affect lots of traders negatively. Often times this there can be volatility that strikes down very harsh on a lot of traders very suddenly. Other times it can involve volatility (whether it is higher or lower) which is negative for traders that can build up very gradually and incrementally until it soon begins to sweep up more and more traders in its sights.

Volatility is a very important factor for many market analytic tools for helping to predict fair market value of options. It also plays a big role in the key indices you study to get a fix on market trends.

As an options trader it is important that you are aware of the 2 basic types of stock exchanges in order to get a good comprehension and understanding of their impact on the volatility of the underlying asset you trade.

The first and oldest type of exchange involves having a physical trading floor where buyers and sellers meet via their representative brokerage firms.

Many people think of this as being an auction where people call out a bid and ask for offers on the floor of the exchange. This metaphor will help you to understand somewhat how prices are set.

Some examples of these types of exchanges are Chicago Board of Options Exchange (CBOE), Pacific Stock Exchange (PSE), Midwest Stock Exchange (MWSE), Philadelphia Stock Exchange (PHLX), New York Stock Exchange (NYSE), and American Stock Exchange (AMEX)

The second basic type of stock exchange is the electronic or screen-based, as in computer monitor, exchanges.

The type of exchange the underlying stock trades on goes back to volatility and which type of exchange has a propensity to be more or less volatile. This type of information that can affect volatility can be very important for an option trader to know.

FEATURES OF OPTION

1.

High flexible:

On one hand, option contracts are high ly standardized and so they can be traded only in organized exchanges. Such option instrument cannot be made flexible according to the requirement of the writer as well as the user. On the other hand, there are also privately arranged options, which can be, traded Over the Counter. These instruments can be made according to the requirements of the writer and user. Thus, it combines the feature of futures as well as forward contracts.

2.

Down Payment:

The option holder must pay a certain amount called premium for holding the right of exercising the option. This is considered to be the consideration for the contract. If the option holder does not exercise will be deduction from the total payoff in calculating the net payoff due to the option holder.

3.

Settlement:

No money or commodity or shares is exchanged when the contract is written. Generally this option contract terminates either at the time of exercising the option holder or maturity whichever is earlier. So, settlement is made only when the option holder exercises his option. Suppose the option is not exercised till maturity, then the agreement automatically lapses and no settlement is required.

4.

Non-Linearity:

Unlike futures and forward, on option contract does not posses the property of linearity. It means that the option holders profit, when the value of the underlying assets moves in one direction is not equal to his loss when its value moves in the opposite direction by the same amount. In short, profit and losses are not symmetrical under an option contract. This can be illustrated by means of an illustration: Mr. A purchased a two month call option on rupee at Rs100=3.35$. Suppose, the rupee appreciates within two months by 0.05 $ per one hundred rupees, then the market price would be Rs.100= 3.40$. If the option holder Mr. A exercises his option, he can purchases at the rate mentioned in the option i.e., Rs100=3.35$. He gets a payoff at the rate of 0.05$per every one hundred rupees. On the other hands, if the exchanges rate moves in the opposite direction by the same amount and reaches a level of Rs100=3.30$, the option contract, the gain is not equal to the loss.

5.

No Obligation to Buy or Sell:

In all option contracts, the option holder has a right to buy or sell underlying assets. He can exercise this right at any time during the currency of the contract. But, in no case, he is under an obligation to buy or sell. If he does not buy or sell, the contract will be simply lapsed.

Option Types

The Options can be classified into following types

1: Exchange-traded options.

Exchange-traded options (also called "listed options") are a class of exchangetraded derivatives. Exchange traded options have standardized contracts, and are settled through a clearing house with fulfillment guaranteed by the Options Clearing Corporation (OCC). Since the contracts are standardized, accurate pricing models are often available. Exchange-traded options include

stock options, bond options and other interest rate options stock market index options or, simply, index options and options on futures contracts.

2: Over-the-counter.

Over-the-counter options (OTC options, also called "dealer options") are traded between two private parties, and are not listed on an exchange. The terms of an OTC option are not standardized.They are customized in nature. Option types commonly traded over the counter include 1 Interest rate options, 2 Currency cross rate options

3 Option Styles: An option style refers to whether the option contract can be exercised before the expiration date or not. .There are differnt types of option style they are as follow;

American Option
These option can be exercised on a day between option purchase date and the expiration date.Thus, these option have as many exercise dates as there are in the days till expiration.

European option
These option can be exercised on the expiration date only.Thus, these option have single expiration date,which is same as expiration date.

Bermudan option
These type of option instead of having single exercise date has a set of predetermined discrete exercise dates and the option can be exercised on those dates only.They are commonly use in interest rate and foreign exchange markets

The most popular index option markets are:

Symbol Country Description

KOSPI

Korea

KOSPI 200 Index Options

DAX

Germany

DAX 30 Index Options

SPX

USA

S&P 500 Index Options

NDX

USA

NASDAQ 100 Index Options

OEX

USA

S&P 100 Index Options

HSI

Hong Kong

Hang Seng Index Options

N225

Japan

Nikkei 225 Index Options

FTSE

UK

FTSE 100 Index Options

Factors affecting pricing of an Option

The current price of the underlying is obviously a very important factor that determines the price of an Option. Also the strike price of the contract is another key factor that affects the price of an Option. The time to expiry is again another important factor that affects the price of an Option. The intrinsic value of an option represents the amount of an option that is in-themoney (ITM). Note that OTM and ATM options have no intrinsic value. In short all the Greeks affect the pricing of an option contract as described elaborately later in this chapter.

Price of underlying
The price of the underlying is the key factor that determines the price of an option. The price of an option premium for a given strike price will undergo change based on the price of the underlying stock. The closer the market price is to the strike price, the rate of change will be the highest. For strike prices farther away from the market price, the rate of change of option premium will be lower.

Strike Price
Strike price is the contracted price that would be exchanged in the event of the exercise of the option by the buyer of the contract. Hence strike price plays a vital role in determining the price of an option contract. The exercise price will remain the same throughout the life of an option contract and will not undergo any change. However, in the case of a stock split there would be change in the strike price.

Time to Expiry
With more time there is more uncertainty. More the time to expiry, greater are the chances that there would be fluctuation in the price of the underlying to the advantage of one of the parties to the contract. Hence more the time, higher would be the time value of the premium. The options price is directly related to the time remaining till the expiration of the option contract. The buyer of an option stands to gain if the option contract finishes in-the-money and greater are the chances that it would do so if there is more time to expiry. It should be noted that as the time to expiration of the option contract decreases, the value of the option would erode.

If an investor buys an option that is three months away from expiration, it will be more expensive than a similar option that is only five days from expiration. All options exhibit time decay and are wasting assets. In other words, as time passes, option contracts lose value. If the investor buys an option that is three months away from expiration and hold it until there are only five days until expiration, there will be a significant premium loss due to time depreciation assuming the price of the underlying is more or less constant.

Rate of Interest
The cost of carry would depend upon the risk-free rate of interest in the market concerned. The higher the interest rate, the higher the call option price and lower the put option price. The lower the interest rate, the lower the call option price and higher the put option price.

Volatility of underlying
Volatility is the standard deviation of the price of the underlying over a defined period of time. If a market becomes more volatile, the premium for option contracts would go up. Someone who bought options earlier would be benefited to the detriment of someone who previously sold options. Buying options prior to such volatility expansion has a high probability of success. Higher the volatility more would be the premium of options.

OPTIONS STRATEGIES

STRATEGY 1: LONG CALL

For aggressive investors who are very bullish about the prospects for a stock / index, buying calls can be an excellent way to capture the upside potential with limited downside risk. Buying a Call Option is the basic of all Option strategies. It is an easy strategy to understand. When you buy a Call Option it means you expect the stock / index to rise in the future. When to Use: Investor is very aggressive and he is very bullish about the stock/ index Risk: Limited to the premium paid. Reward: Unlimited Break-even Point: Strike Price + Premium. Example: Mr. XYZ is bullish on Nifty on 24th June, when the Nifty is at 4191. He buys a call options with a strike price of `4600 at a premium of `36, expiring on 31 st July. If the Nifty goes above 4636, Mr. XYZ will make a net profit (after deducting the premium) on exercising the option. In case the Nifty stays at or falls below 4600, he can forego the option (it will expire worthless) with a maximum loss of the premium.

Strategy : Buy Call Option Current Nifty index Call Option Mr. XYZ Pays Strike Price (`) Premium (`) Break Even Point (`) (Strike Price + Premium) 4600 36 4636 4191

The payoff schedule:On expiry Nifty closes at Net payoff from Call option (`) 4100 4300 4500 4636 4700 4900 5100 5300 -36 -36 -36 0 64 264 464 664

The payoff profile:-

Long Call
120 100 80 60 40 20 0 -20 -40 -60 Nifty Profit 4000 4300 4636 4700 4900

Analysis
This strategy limits the downside risk to the extent of premium paid. But the potential return is unlimited in case of rise in Nifty. A long call option is the simplest way to benefit if you believe that the market will make an upward move. As the stock price / index rises, the long Call moves into profit more and more quickly.

STRATEGY 2: SHORT CALL

When you buy a Call you are hoping that the underlying stock / index would rise. When you expect the underlying stock / index to fall you do the opposite. When an investor is very bearish about a stock / index and expects the prices to fall, he can sell Call options. This position offers limited profit potential and the possibility of large losses on big advances in underlying prices. Although easy to execute it is a risky strategy since the seller of the call is exposed to unlimited risk. Selling a Call option is the just the opposite of buying a Call option. Here the seller of the option feels the underlying price of the stock / index to fall in the future. When to Use: Investor is very aggressive and he is very bearish about the stock/ index. Risk: Unlimited. Reward: Limited to the amount of the premium. Break-even Point: Strike Price + Premium. Example: Mr. XYZ is bearish about Nifty and expects it to fall. He sells a Call option with a strike price of `2600 at a premium of `154, when the current Nifty is at 2694. If the Nifty stays at 2600 or below, the Call option will not be exercised by the buyer of the option and Mr. XYZ can retain the entire premium of `154.

Strategy : Sell Call Option Current Call Option Mr.XYZ receives Break Even Point (`) (Strike Price + Premium) 2754 Nifty 2694 2600 154

index Strike Price (`) Premium (`)

The Payoff schedule :-

On expiry Nifty closes at

Net payoff from Call option (`)

2400 2500 2600 2700 2754 2800 2900 3000

154 154 154 54 0 -46 -146 -246

The payoff profile:-

Short Call
200 150 100 50 0 -50 -100 -150 -200 -250 -300 -350

2400

2600

2754

2900

3000

Nifty

Profit

Analysis
This strategy is used when an investor is very aggressive and has a strong expectation of a price fall (and certainly not a price rise). This is a risky strategy since as the stock price / index rises, the short call loses money more and more quickly and losses can be significant if the stock price / index fall below the strike price.

STRATEGY 3: LONG PUT

Buying a Put is opposite of buying a Call. When an investor buys a Call option, he is bullish on the stock / index. If an investor is bearish, he can buy a Put option. A Put option gives a right to the seller to sell the stock (to the Put seller) at a predetermined price and thereby limiting his risk.

A Long Put is a Bearish strategy. To take advantage of a falling market an investor can buy Put options. When to Use: Investor is bearish about the stock / index. Risk: Limited to the amount of Premium paid. (Maximum loss if stock / index expire at or above the option strike price.) Reward: Unlimited. Break-even Point: Stock Price Premium.

Example: Mr. XYZ is bearish on Nifty on 24th June, when Nifty is at 2694. He buys a Put option with a strike price of `2600 at a premium of `52 expiring on 31 st July. If the Nifty goes below 2548, Mr. XYZ will make a profit on exercising the option. In case the Nifty rises above 2600, he can forego the option (it will expire worthless) with a maximum loss of the premium.

Strategy : Buy Put Option Current Nifty index Put Option Mr. XYZ Pays Break Even Point (`) (Strike Price Premium) 2548 Strike Price (`) Premium (`) 2694 2600 52

The payoff schedule:-

On expiry Nifty closes at 2300 2400 2500 2548 2600 2700 2800 2900

Net Payoff from Put Option (`) 248 148 48 0 -52 -52 -52 -52

The payoff profile:-

Long Put
300 250 200 150 100 50 0 -50 -100 Nifty Profit 2300 2400 2548 2700 2800

Analysis
A bearish investor can profit from declining stock price by buying Puts. He limits his risk to the amount of premium paid but his profit potential remains unlimited. This is one of the widely used strategy when an investor is bearish.

STRATEGY 4: SHORT PUT

An investor sells Put when he is Bullish about the stock. When you sell a Put, you earn a Premium (from the buyer of the Put). You have sold someone the right to sell you the stock at the strike price. If the stock price increases beyond the strike price, the short put position will make a profit for the seller by the amount of the premium, since the buyer will not exercise the Put option and the Put seller can retain the Premium (which is his maximum profit). But, if the stock price decreases below the strike price, by more than the amount of the premium, the Put seller will lose money.

When to Use: Investor is very Bullish about the stock / index. The main idea is to make short term income. Risk: Unlimited. Reward: Limited to the amount of Premium received. Break-even Point: Put Strike - Premium. Example: Mr. XYZ is bullish on Nifty when it is 4190.10. He sells a Put option with a strike price of `4100 at a premium of `170 expiring on 31 st July. If the Nifty index stays above 4100, he will gain the amount of premium as a Put buyer wont exercise his option. In case the Nifty falls below 4100, Put buyer will exercise the option and Mr. XYZ will start losing money. If the Nifty falls below 3930, which is the breakeven point, Mr. XYZ will lose the premium and more depending on the extent of the fall in Nifty.

Strategy : Sell Put Option Current Nifty index Put Option Mr. XYZ receives Break Even Point (`) (Strike Price Premium) 3930 Strike Price (`) Premium (`) 4191.10 4100 170

The payoff schedule:On expiry Nifty Closes at 3400 3500 3700 3900 3930 4100 4300 4500 Net Payoff from the Put Option (`) -530 -430 -230 -30 0 170 170 170

The payoff profile:-

Short Put
300 200 100 0 -100 -200 -300 -400 -500 -600 Nifty Profit 3400 3700 3930 4300 4600

Analysis
Selling Puts can lead to regular income in a rising or range bound markets. But it should be done carefully since the potential losses can be significant in case the price of the stock / index falls. This strategy can be considered as an income generating strategy.

STRATEGY 5: LONG COMBO

A Long Combo is a Bullish strategy. If an investor is expecting the price of a stock to move up he can do a Long Combo strategy. It involves selling an OTM (lower strike) Put and buying an OTM (higher strike) Call. This strategy simulates the action of buying a stock (or a futures) but at a fraction of the stock price. It is an inexpensive trade, similar in pay-off to Long Stock, except there is a gap between the strikes (please see the payoff diagram). As the stock price rises the strategy starts making profits. Let us try and understand Long Combo with an example.

When to Use: Investor is Bullish on the stock.

Risk: Unlimited (Lower Strike price + Net Debit)

Reward: Unlimited.

Break-even Point: Higher Strike Price + Net Debit

Example: A stock ABC Ltd is trading at `450. Mr. XYZ is bullish on the stock. But he does not want to invest `450. He does a Long Combo. He sells a Put option with a strike price of `400 at a premium of `1 and buys a Call option with a strike price of `500 at premium of `2. The net cost of the strategy (net debit) is `1.

Strategy : Sell a Put + Buy a Call ABC Ltd. Sells Put Mr. XYZ Buys Call recd Mr. XYZ pays Current Market Price (`) Strike Price (`) Premium (`) Strike Price (`) Premium (`) Net Debit (`) Break Even Point (`) (Higher Strike + Net Debit) The payoff schedule:ABC Ltd. closes at ( `) 700 650 600 550 501 500 450 400 350 300 250 Net Payoff Net Payoff from Net Payoff the Call purchased 198 (`) 148 98 48 -1 -2 -2 -2 -2 -2 -2 ( `) 199 149 99 49 0 -1 -1 -1 -51 -101 -151 450 400 1.00 500 2.00 1.00 501

from the Put Sold (`) 1 1 1 1 1 1 1 1 -49 -99 -149

For a small investment of `1 (net debit), the returns can be very high in a

Long Combo, but only if the stock moves up. Otherwise the potential losses can also be high.

The payoff chart (Long Combo)

+ Sell put Buy call

= Long Combo