Derivatives

Derivatives are contracts whose value is derived from the value of an ‘underlying’ asset.
Derivative contracts are available on a wide range of ‘underlying’ assets, such as metals, energy
resources, Agri-commodities, and financial assets.

Reasons to trade in derivatives market

The benefits of trading in Derivatives are:

 Transfer risk to the person who is willing to accept it

 Opportunity to make profits with minimal amount of risk capital
 Lower transaction costs
 Provision for liquidity

Participants in the derivative market

There are generally three types of participants in the derivative market:

Hedgers
Hedgers use derivatives to reduce the risk associated with the prices of underlying assets.
Corporations, investing institutions and banks use derivative products to hedge or reduce their
exposures to market variables, such as interest rates, share values, bond prices, currency
exchange rates and commodity prices.

Speculators/Traders
Speculators try to predict the future movements in prices of underlying assets. Based on the
predictive view, they take positions in derivative contracts. Derivatives are preferred over
underlying assets for trading purpose, as they offer leverage, are less expensive, and are faster to
execute in size, owing to their high volume market.

Arbitrageurs
Arbitrage is a deal that produces profit by exploiting the difference in price of a product in two
different markets. Arbitrage originates when you purchase an asset cheaply in one location and
simultaneously arrange to sell it at a higher price in another location. Such opportunities are
unlikely to persist for very long, since other arbitrageurs would rush in, thus closing the price
gap.

Risks Faced by Participants in Derivative market

You should understand that derivatives, being leveraged instruments, are significantly more risky
than investing directly in the underlying real assets. Risks include Counter-party Risk i.e. default
by counter-party; Price Risk i.e. loss on position because of price move; Legal or Regulatory
Risk i.e. enforceability of contracts; and Operational Risk i.e. fraud, inadequate documentation,
improper execution, etc.

It may not be an appropriate avenue for someone of limited resources, trading experience and
low risk tolerance. You should carefully read the Model Risk Disclosure Document, given by the
broker at the time of signing the agreement.

Key Takeaways
 Derivatives are contracts that derive their value from underlying assets.
 Derivatives offer a number of benefits to the participants willing to trade in the product.
 Three main participants in the derivative market, hedgers, speculators and arbitrageurs.
 Since derivative is a leveraged instrument it can act as a double edged sword in some
cases.

Forward contract
A forwards contract is a customized contract between two parties to buy or sell an asset at a
specified price on a future date. Since forward contracts are not traded on a centralized exchange,
they are regarded as over the counter instruments, which also give rise to counter party default
risks. A forward contract settlement can occur in cash or on delivery basis. Since forward
contracts are non-standardized, it is of interest to those who wish to hedge by customizing the
contract to any commodity, amount or delivery date.

Futures contract
This is a standardized contract between two parties to buy or sell an asset at a specified time in
the future at a specified price. Futures are standardized exchange traded contracts. Futures’
trading is of interest to those who wish to:

 Speculate by taking a view on the market and buying or selling accordingly

 Prefer Price Risk Transfer through hedging
 Take advantage of the leverage offered by paying a small fraction of the total contract as
margin

Options
There are two basic types of Options - Call and Put. Call Option gives the buyer the right but not
the obligation to buy a specified amount of an underlying security at a specified price within a
specified time. On the other hand, a Put Option gives the buyer the right, but not the obligations
to sell a specified amount of an underlying security at a specified price within a specified time.
Option trading is of interest to those who wish to:

 Participate in the market without trading or holding a large quantity of stock

 Protect their portfolio by paying small premium amount

Future and Option Products Available in Indian Markets

Futures and Options contracts are traded on indices and on individual stocks. Popular indices
products available on the Indian stock exchanges are Nifty 50, CNX IT Index, Bank Nifty Index,
CNX Nifty Junior, CNX 100, Nifty Midcap 50, Mini Nifty and Long dated Options contracts on
Nifty 50.

Key Takeaways
 Forwards are customized contracts which can lead to counter party default.
 Futures were introduced to eliminate counter party default by standardizing the contract.
 Options are of two types - call and put.

Chapter 3 Future Contracts

Significance of Future Contract

This is an agreement made through an organized exchange to buy or sell a fixed amount of a
commodity or a financial asset, on a future date, at an agreed price. The clearing house,
associated with the exchange, guarantees settlement of these trades.

You can choose either to be a trader who buys futures contract and takes a long position, or a
trader who sells futures and takes a short position. The words buy and sell are figurative only
because no money or underlying asset changes hand, between buyer and seller, when the deal is
signed.

Scope of Futures in the Indian Market

NSE and BSE are the two main exchanges that offer future trading. Contracts are available for
different tenures (expiry). Typically, contracts are available for one, two or three months. You
can choose any of the three contracts, provided there is liquidity of the same underlying.
Remember the Following

 Last working Thursday is the date of expiry for the contracts of that particular month. If
the last Thursday is a holiday, the expiry is advanced by one day, i.e. Wednesday.
 Buyers and Sellers do not take or give delivery of the underlying.
 Profit and Losses are settled in cash.
 Since there is no delivery of underlying, you can trade in broad indices like NIFTY.
 You may choose to open a trade in future by paying a small portion (%) of the contract
value as Margin.
 The contract size and margin percentages are set by exchanges. In cash trading, the
settlement cycle is T+2 days; while in F &O, the trades are settled on T+1 day. If trade is
opened with a buy, such position is called as Long and if a trade is opened with a sell,
such position is called as Short.

Quotes Given on the NSE Website for Nifty Futures on Aug 28, 2017

Key Takeaways
Each futures contract has the following features-

Spot Price
This is the price at which an asset trades in the cash market. Underlying value of Nifty on Aug
28, 2017, was Rs. 9,913.4.

Equity Derivatives Watch

Futures Price
This is the price of the futures contract in the futures market. Nifty Future Price, on Aug 28
2017, was 9,919.15.

Equity Derivatives Watch

Expiration Day
This refers to the day on which a derivative contract ceases to exist. It is the last trading day of
the contract. On expiry date, all the contracts are compulsorily settled.

Equity Derivatives Watch

Contract Cycle
It is a period over which a contract trades. Futures contracts have a maximum of three-month
trading cycle - the near month (one), the next month (two) and the far month (three). New
contracts are introduced on the trading day following the expiry of the near month contracts. The
new contracts are introduced for three month duration. At any point in time, there will be three
contracts available for trading in the market i.e., one near month, one mid month and one far
month duration respectively.

Equity Derivatives Watch

Tick Size
It is the minimum move allowed in the price quotations. Exchanges decide the tick sizes on
traded contracts as part of contract specification. Tick size for Nifty futures is 5 paisa.

Contract Size and Contract Value

Futures contracts are traded in lots. To arrive at the contract value, we have to multiply the price
with contract multiplier/lot size/contract size.

Basis
The difference between the spot price and the futures price is called Basis. If the futures price is
greater than spot price, basis for the asset is considered to be negative. Similarly, if the spot price
is greater than futures price, basis for the asset is considered to be positive. Whatever the basis
is—positive or negative—it turns to zero, at maturity of the futures contract. This means that
there should not be any difference between futures price and spot price at the time of
maturity/expiry of contract.

Equity Derivatives Watch

On Aug 28, 2017, Nifty Spot Price was 9,913.4 and Nifty Aug Future Price was 9,919.5.
Therefore, current basis of Nifty is negative. But on Aug 31, 2017 i.e. expire day Nifty basis will
be zero.

Cost of Carry
Cost of Carry is the relationship between futures prices and spot prices. It measures the storage
cost (in commodity markets) plus the interest that is paid to finance or ‘carry’ the asset till
delivery. It does not include the income earned on the asset during the holding period. For equity
derivatives, cost of carry is the interest paid to finance the purchase, minus the dividend earned.
It is important to note that cost of carry will be different for different participants.

Contract Specifications
Contract specifications include the salient features of a derivative contract like contract maturity
and contract multiplier, also known as lot size, contract size, tick size, etc.

Price Band
Price Band is essentially the price range within which a contract is permitted to trade during a
day. The band is calculated with regard to previous day’s closing price of a specific contract. For
example, previous day’s closing price of a contract is Rs. 100 and price band for the contract is
10%, then the contract can trade between Rs. 90 and Rs. 110 for the next trading day.

Long Position
Outstanding/unsettled buy position in a contract is called “Long Position”. For instance, if Mr. X
buys 5 contracts on Nifty futures, then he would be long 5 contracts. Similarly, if Mr. Y buys 4
contracts on Pepper futures, then he would be long 4 contracts.

Short Position
Outstanding/unsettled sell position in a contract is called “Short Position”. For instance, if Mr. X
sells 5 contracts on Nifty futures, then he would be short 5 contracts on Nifty futures. Similarly if
Mr. Y sells 4 contracts on Pepper futures, then he would be short 4 contracts on pepper.

Open Position
Outstanding/unsettled derivative contracts, either in long (buy) or short (sell) positions are called
“Open Positions”. For instance, if Mr. X shorts 5 contracts on Infosys futures and longs 3
contracts on Reliance futures, he is said to be having open position, which is equal to short on 5
contracts on Infosys and long on 3 contracts of Reliance. Next day, if he buys 2 Infosys contracts
of same maturity, his open position would be short on 3 Infosys contracts and long on 3 Reliance
contracts.

Naked and Calendar Spread Positions

Naked position in futures market simply means a long or short position in any futures contract,
without having any position in the underlying asset. Calendar spread position is a combination of
two positions in futures on the same underlying, i.e. long on one maturity contract and short on a
different maturity contract. For instance, a short position in near month contract coupled with a
long position in far month contract is a calendar spread position. Calendar spread position is
computed with respect to the near month series and becomes an open position once the near
month contract expires or either of the offsetting positions is closed. A calendar spread is always
defined with regard to the relevant months.

Opening a Position
Opening a position means either buying or selling a contract, which increases a client’s open
position (long or short).

Closing a Position
A client is said to be closing a position if he sells a contract which he had bought before or he
buys a contract which he had sold earlier.

Initial Margin
This is the margin amount that a trader needs to pay to the Exchange to open a trade. Buyers
(long) and sellers (short) will be paying this margin. The margin percentage is specified by the
Exchange and these percentages could change within the tenure of the contract, in case of high
volatility.

Minimum Margin
Normally known as maintenance margin, it is the minimum margin that is blocked during the life
of the contract.

Convergence of Spot and Future Price

The logic for difference between spot and future is the time value of money and one of the
variables of time value is the number of days left in the contract. On the last day of the contract,
there is no time value left. Hence, the price of future contract and cash market will be same.
There could be many other market dynamics, which impact the prices during the last day/few
days of expiry.

Benefits of trading in Index Futures compared to any other

security
You can trade the ‘entire stock market’ by buying index futures instead of buying individual
securities with the efficiency of a mutual fund. The advantages of trading in Index Futures are:

 The contracts are highly liquid

 Index Futures provide higher leverage than any other stocks
 It requires low initial capital requirement
 It has lower risk than buying and holding stocks

Pay-off for Buyer of Futures contract: Long Futures

Let us say that a person goes long in ABC stock futures contract at Rs. 100. This means that he
has agreed to buy the underlying ABC stock at Rs. 100, on expiry. Now, if on expiry, the price of
the underlying (ABC stock) is Rs. 150, then this person will buy at Rs. 100, as per the ABC
stock futures contract and will immediately be able to sell the underlying in the cash market at
Rs. 150, thereby making a profit of Rs. 50.

Similarly, if the price of the underlying (ABC stock) falls to Rs. 70 at expiry, he would have to
buy at Rs. 100, as per the ABC stock futures contract. If he sells the same in the cash market, he
would only receive Rs. 70, translating into a loss of Rs. 30. This potential profit/loss at expiry,
when expressed graphically, is known as a pay off chart.

Short Futures Pay Off

As one person goes long, some other person has to go short, otherwise a deal will not take place.
The profits and losses for the short futures position will be exactly opposite of the long futures
position.

A short futures position makes profits when prices fall. If prices fall to 60 at expiry, the person
who has shorted at Rs.100 will buy from the market at 60 on expiry and sell at 100, thereby
making a profit of Rs. 40. This is shown in the given chart.

Pricing of Futures
The Cost of Carry Model is used for Future Pricing. It is defined as: F=S+C.

Herein, F=Future Price, S=Spot Price, and C=Holding Costs or Carry Costs

If F < S+C or F > S+C, arbitrage opportunities would exist, i.e. whenever the futures price moves
away from the fair value, there would be chances for arbitrage.

If ABC stock is quoted at Rs. 1,000 per share and the three months futures of ABC stock is
Rs.1070, then one can purchase ABC stock at Rs. 1000, in Spot, by borrowing @12% annum for
three months and selling ABC stock futures for three months, at Rs. 1070. Here, F=1000+36 =
1036.

Drawbacks of Trading in Futures

Futures carry the potential for unlimited risks and, hence, unlimited losses. In futures, there is an
obligation to honor the contract, irrespective of profit or loss.

Key Takeaways
 Futures are standardized contracts which are traded on the exchange platform.
 Through a futures contract we could either take a long position or a short position based
on our view.
 Margin- small portion of contract value you need to pay upfront.
 F &O trades are settled on T+1 day.
 Tick size for Nifty futures is 5 paisa.
 The difference between the spot price and the futures price is called Basis
 Outstanding/unsettled derivative contracts, either in long (buy) or short (sell) positions
are called Open Positions.
 Cost of Carry Model is used for Future Pricing. It is defined as: Future price = Spot price
+ Cost of carry

Margins
Two types of margins are determined daily: Initial Margin and Mark-to-Market Profit/Loss.
Initial margin on the future market is computed by using Value-at-Risk (VaR). Initial margin
amount, computed using VaR, is collected up-front from buyers and sellers.

At the time of initiating the futures position, margin is blocked in your trading account. The
initial margin is made up of two components i.e. SPAN margin and the Exposure Margin. Initial
Margin will be blocked in your trading account for the number of days you choose to hold the
futures trade. The value of initial margin varies daily as it depends on the futures price volatility.
Remember, Initial Margin = % of (Futures Price * Lot Size). Lot Size is fixed, but the futures
price varies every day.

Symbol NIFTY 31-Aug-17

Current Future Price 9,919
Lot Size 75
Contract Value (Future Price * Lot Size) 743,925
Initial Margin @ 5% 37,196
Exposure Margin @ 3% 22,317
Total Initial Margin (Rs) 59,513

Mark to Market
The daily settlement process is called Mark to Market. It provides for collection of losses that
have already occurred. The mark-to-market settlement is done in cash.

Mark to Market - Long Position

Assumption: Initial Margin is Rs. 59,500.

Beginning Funds Nifty Settlement Future Price Gain Ending

Day
Balance Deposited Close Price Change /Loss Balance
0 0 59,500 9900 742,500 0 0 59,500
1 59,500 0 9850 738,750 -50 -3,750 55,750
2 55,750 0 9750 731,250 -100 -7,500 48,250
3 48,250 0 9920 744,000 170 12,750 61,000
4 61,000 0 9945 745,875 25 1,875 62,875
5 62,875 0 9935 745,125 -10 -750 62,125
6 62,125 0 9950 746,250 15 1,125 63,250

Net Profit/ Loss From the trade = (63250-59500) = Rs. 3750

Mark to Market - Short Position

Assumption: Initial Margin is Rs. 59,500.

Beginning Funds Nifty Settlement Future Price Gain Ending

Day
Balance Deposited Close Price Change /Loss Balance
0 0 59,500 9900 742,500 0 0 59,500
1 59,500 0 9850 738,750 -50 3,750 63,250
2 63,250 0 9750 731,250 -100 -7,500 70,750
3 70,750 0 9920 744,000 +170 -12,750 58,000
4 58,000 0 9945 745,875 +25 -1,875 56,125
5 56,125 0 9935 745,125 -10 750 56,875
6 56,875 0 9950 746,250 +15 -1,125 55,750

Net Profit/Loss From the trade = (55,750- 59,500) = Rs. -3,750

Settlement of derivatives contracts

All the Futures and Options contracts are settled in cash on a daily basis and at the expiry or
exercise of the respective contracts as the case may be. As a trader, you can exit the future
position by taking an opposite position. Therefore, if you are a buyer, you have to sell the same
contract of the same quantity. On the other hand, if you are a seller, you need to buy the same
contract of same quantity. This process of exiting is also known as Square-off.

Once the position is squared off, you are free from all obligations and the contract ceases to
exist. If any position is not squared off, such positions are taken on the closing price of Stock
(not the future) of the expiry date. The closing price is the average price of the stock in the last
half an hour of trading.

Derivatives markets can be extremely volatile and there are no circuit breakers. Prices can move
up or down sharply, resulting in very favorable or unfavorable situations for you. Hence, you
need to monitor your positions regularly.

Key Takeaways
 Initial margin varies daily as it depends on the futures price volatility.
 Initial Margin = % of (Futures Price * Lot Size).
 Daily settlement process is called Mark to Market.
 Futures and Options contracts are settled in cash.
 Stock price movement in derivatives market can be extreme as there are no circuit filters.

Options
An Option is a contract that gives the right, but not the obligation, to buy or sell the underlying
asset on or before a stated date, at a stated price. The party taking a long position, i.e. buying the
option is called buyer/holder of the Option and the party taking a Short position, i.e. selling the
Option is called the seller/writer of the Option; the contract value and lots size are similar to
Futures.

Types of Options
There are two types of Options:

 Call Option
 Put Option

Options, which give you a right to buy the underlying asset, are called Call Options. On the other
hand, the Options that give you a right to sell the underlying asset are called Put Options.

Key features
Index Option

These Options have Index as the underlying asset. For example, options on Nifty, Sensex, Bank
Nifty etc.

Stock Option

These Options have individual stocks as the underlying asset. Examples include Options on
ONGC, NTPC, etc.

Buyer of an Option

The buyer of an Option has a right but not the obligation in the contract. For owning this right,
you pay a price to the seller of this right, called ‘option premium’.

Writer of an Option

The writer of an Option receives the Option premium and is thereby obliged to sell the asset if
the buyer of Option exercises his right.

Option Price/Premium

It is the price which you, as an Option buyer, pay to the Option seller.

Lot Size

Lot size is the number of units of underlying asset in a contract.

Expiration Day

This is the day on which a derivative contract ceases to exist. It is the last trading date of the
contract. The expiration day of Nifty contracts is Aug 31, 2017 in the following example.
Spot Price

It is the price at which the underlying asset trades in the spot market. Underlying stock value of
Nifty option was 9912 as on Aug 28, 2017.

Strike Price or Exercise Price

Strike price is the price per share for which the underlying security may be purchased or sold by
the Option holder. For e.g. when underlying value of NIFTY is 9912, then prices of 9900 Call
and 9900 Put is:

Underlying Expiry Date Option Type Strike Price Option Premium

NIFTY 31 Aug 2017 Call 9900 50.10

NIFTY 31 Aug 2017 Put 9900 33.15

Open Interest

As discussed in futures section, Open Interest is the total number of Option contracts outstanding
for an underlying asset.

Option Premium
Intrinsic Value

Option premium, consists of two components - intrinsic value and time value.

For an Option, intrinsic value refers to the amount by which an Option is in the money, i.e. the
amount an Option buyer will realize, before adjusting for premium paid, if he exercises the
Option instantly.

Therefore, only in-the-money Options have intrinsic value whereas at-the-money and out-of-the-
money Options have zero intrinsic value. The intrinsic value of an Option can never be negative.
Thus, for call Option, which is in-the-money, intrinsic value is the excess of spot price (S) over
the exercise price (X).

Intrinsic value of a Call Option can be calculated as S-X, with a possible minimum value of zero
because no one would like to exercise his right under no advantage condition. Similarly, for Put
Option which is in-the-money, intrinsic value is the excess of exercise price (X) over the spot
price (S). Thus, intrinsic value of Put Option can be calculated as X-S, with minimum possible
value of zero.
Time Value

It is the difference between premium and intrinsic value, if any, of an Option. ATM and OTM
Options will have only time value because the intrinsic value of such Options is zero.

Option Greeks
Delta

Delta measures the change in Option price for a unit change in the price of underlying. So if my
delta is 0.46, it shows that for each unit increase/decrease in underlying, Option price will
increase/decrease by 0.46.

Important points for Delta:

 Delta of Call Option is always positive and Delta of Put Option is always negative.
 When you buy Call Option, Delta is positive and when you sell Call Option, Delta is
negative.
 When you buy Put Option, Delta is negative and when you sell Put Option, Delta is
positive.
 Call Delta ranges from 0 to 1 and Put Delta ranges from 0 to -1
 Total of absolute value of call Delta and put Delta always comes to 1

Gamma

Gamma measures the change in Delta with respect to per unit change in underlying. If Gamma
value is 0.0008, it shows that the next move in Delta will be 0.0008 if underlying changes by 1.
So Gamma shows what will be the next change in Delta with respect of change in underlying.

Important points for Gamma:

 Gamma of Option is always positive.

 Gamma of Call and Put Option is same.
 Gamma is highest at ATM & decreases as Underlying moves away.
 Call Delta ranges from 0 to 1 and Put Delta ranges from 0 to -1
 Gamma of Future is 0.

Vega

Vega measures the change in Options price per unit change in volatility. A Vega value of 6.87
shows that for every unit increase in volatility, Option price will increase by 6.87. Thus, Vega
shows effect of volatility on Option price.
Theta

Theta measures the change in Option price per day change in time to expiry. If Theta is -3.87, it
signifies that for each day passing towards expiry, the Options price will decrease by 3.87.

Rho

Rho measures the change in Option price per unit change in interest rate. A Rho value of 2
shows that for every unit increase in interest rate, Option price will change by 2. Rho is inversely
related to puts and directly related to calls.

In the Money (ITM) option

A Call Option is said to be ITM when spot price is higher than strike price. A Put Option is said
to be ITM when spot price is lower than strike price.

For example, last traded price of different ITM Calls and Puts, when underlying Nifty is trading
at 9912, are as follows:

Strike Price LTP of Calls

9900 51.8

9850 85.3

9800 128.9

9750 171.4

9700 217.75

9650 262.05

LTP of
Strike Price
Puts

9950 57.35

10000 92.55

10050 133.95

10100 179.75
10150 235.1

10200 279.35

At the Money (ATM) Option

At-The-Money is a situation where an Option’s strike price is same as the price of the underlying
security. Both the Call and Put Options are simultaneously At-The-Money. At-The-Money
Options have no intrinsic value, but it may still have time value.

Out of the Money (OTM) Option

Call Option is said to be OTM, when spot price is lower than strike price. And a Put Option is
said to be OTM when spot price is higher than strike price.

For example, last traded price of different OTM Calls and Puts, when underlying Nifty is trading
at 9912, are as follows:

Strike Price LTP of Calls

9950 28.65

10000 14.3

10050 6.45

10100 3.15

10150 1.6

10200 1

LTP of
Strike Price
Puts

9900 34.35

9850 20.25

9800 12.9

9750 7.9
9700 5.25

9650 3.05

Difference between ITM, ATM and OTM

Exercise of Options

In case of American option, buyers can exercise their Option any time before the maturity of
contract. All these Options are exercised with respect to the settlement value/closing price of the
stock on the day of exercise of Option.

Payoff Diagram
Long Call Payoff

On Aug 28, 2017, Nifty was trading at 9912. Assume that you buy a Call Option with strike
price of 9900 at a premium of Rs. 52 with expiry date Aug 31, 2017.

Scenario Analysis at various expiry levels:

Spot Closing at Expiry

Instrument Action Strike Premium No of Lots 9600 9700 9800 9900 10000 10100 10200

Call Buy 9900 52 1 -52 -52 -52 -52 48 148 248

Long Put Payoff

On Aug 28, 2017, Nifty is at 9912. Assume that you buy a Put Option with strike price of 9900
at a premium of Rs.34 with expiry date Aug 31, 2017.
Scenario Analysis at various expiry levels:

Spot Closing at Expiry

Instrument Action Premium Strike No of Lots 9600 9700 9800 9900 10000 10100 10200

Put Buy 9900 34 1 266 166 66 -34 -34 -34 -34

Opening a Position

An opening transaction is one that adds or creates a new trading position. It can be either a
purchase or a sale. With respect to an Option transaction, we will consider both:

 Opening purchase – This is done with the purchasing intention of creating or increasing a
long position in a given series of Options.
 Opening sale – This is done with the selling intention of creating or increasing a Short
position in a given series of Options.

Closing a Position

A Closing transaction is one that reduces or eliminates an existing position by an appropriate

offsetting purchase or sale. This is also known as “squaring off” your position. With respect to an
Option transaction:

 Closing purchase – This is done with the purchasing intention of reducing or eliminating
a short position in a given series of Options. This transaction is frequently referred to as
“covering” a short position.
 Closing sale – This is done with the selling intention of reducing or eliminating a long
position in a given series of Options.

You cannot close out a long call position by purchasing a Put or any other similar transaction. A
closing transaction for an Option involves the sale of an Option contract with the same terms.
Leverage

You, as an Option buyer, pay a relatively small premium for market exposure in relation to the
contract value. This is known as Leverage. You can see large percentage gains from
comparatively small, favorable percentage moves in the underlying equity. Leverage also has
downside implications. If the underlying price does not rise/falls during the lifetime of the
Option, Leverage can magnify your percentage loss.

Risk Return

Long Premium paid Unlimited

Short Unlimited Premium received

A Long Option position has limited risk (premium paid) and unlimited profit potential. A Short
Option position has unlimited downside risk, but limited upside potential (to the extent of
premium received).

Option Trading Strategies

Option Strategies

Options trading, in particular, has many advantages and there are plenty of reasons why this form
of trading is worthy of consideration for anyone looking to trade in the market ,even if it is
slightly more complex subject to learn than direct equity trading.

We will look at some of the benefits of for trading in the options market and why it is can be
such a good idea.

Leverage

One of the primary reasons for trading in the options markets is the benefit of leverage that a
trader receives. It is possible to make significant profits without necessarily having large sums of
cash. In simple terms we can make use of leverage to get more trading power from the capital we
have.

Risk & Reward

Options trading can offer a much better risk versus reward ratio if the right trading strategies are
employed. Through the wide range of option strategies we place different orders and limit our
risk, which may not be possible by simply buying and selling stocks. As we learn about the
various options strategies in the following section we will understand the power of the tool when
it comes to handling risk.
Flexibility & Versatility

One of the most appealing elements of options is the flexibility that they offer. When we trade in
the cash market there are limitations involved, we can either buy the stock or sell its. But in the
options market there are trading strategies based on the prevailing situation and trend in the
market.

 Bullish Option Strategies

 Bearish Option Strategies
 Neutral Option Strategies
 Volatility Option Strategies

Key Takeaways
 There are two types of Options - Call Option and Put Option.
 Call Option is bought when view is bullish.
 Put Option is bought when view is bearish.
 Buyer of Option pays the Option premium.
 Writer of the Option receives the Option premium.
 Only ITM Options have intrinsic value.
 Time value is the difference between premium and intrinsic value.
 Delta measures the change in Option price for a unit change in the price of underlying.
 Gamma measures the change in Delta with respect to per unit change in underlying.
 Vega measures the change in Options price per unit change in volatility.
 Theta measures the change in Option price per day change in time to expiry.
 Rho measures the change in Option price per unit change in interest rate.
 All option strategies use basic Call and Put Options.

Bullish Option Strategies

Bullish options trading strategies are used when options trader expects the underlying assets to
rise. It is very important to determine how much the underlying price will move higher and the
timeframe in which the rally will occur in order to select the best options strategy. The simplest
way to make profit from rising prices using options is to buy calls. However, buying call is not
necessarily the best way to make money in moderately or mildly bullish market. Following are
the most popular bullish strategies that can be used depend upon different scenarios.

 Long Call Strategy

 Short Put Strategy
 Bull Put Spread
 Long Call Ladder Strategy
 Covered Call Strategy
  Call Back –Spread Strategy
 Stock Repair Strategy
 Call Ratio Spread

How to make profit using bullish option trading strategies?

Long Call
When to initiate a Long call?

Long call is best used when you expect the underlying asset to increase significantly in a
relatively short period of time. It would still benefit if you expect the underlying asset to rise
slowly. However, one should be aware of the time decay factor, because the time value of call
will reduce over a period of time as you reach near to expiry.

Why to use the Long call

This is a good strategy to use because downside risk is limited only up to the premium/cost of the
call you pay, no matter how much the underlying asset drops. It also gives you the flexibility to
select risk to reward ratio by choosing the strike price of the options contract you buy.

Strategy Buy/Long Call Option

Market Outlook Extremely Bullish

Breakeven at expiry Strike price + Premium paid

Risk Limited to premium paid

Reward Unlimited

Margin required No

Let’s try to understand with an Example:

Current ABC Ltd Price 8200

Strike price 8200

Premium Paid (per share) 60

BEP (strike Price + Premium paid) 8260

 Lot size 75

Suppose the stock of ABC Ltd is trading at Rs. 8,200. A call option contract with a strike price of
Rs. 8,200 is trading at Rs. 60. If you expect that the price of ABC Ltd will rise significantly in
the coming weeks, and you paid Rs. 4,500 (75*60) to purchase single call option covering 75
shares. So, as expected, if ABC Ltd rallies to Rs. 8,300 on options expiration date, then you can
sell immediately in the open market for Rs. 100 per share. As each option contract covers 75
shares, the total amount you will receive is Rs. 7,500. Since you had paid Rs. 4,500 to purchase
the call option, your net profit for the entire trade is, therefore Rs. 3,000. For the ease of
understanding, we did not take into account commission charges.

Analysis Of Long Call Strategy:

Long call strategy limits the downside risk to the premium paid which is coming around Rs. 60
per share in the above example, whereas potential return is unlimited if ABC Ltd moves higher
significantly. It is perfectly suitable for traders who don’t have a huge capital to invest but could
potentially make much bigger returns than investing the same amount directly in the underlying
security.

Short Put Options Trading Strategy

What is short put option strategy?

A short put is the opposite of buy put option. With this option trading strategy, you are obliged to
buy the underlying security at a fixed price in the future. This option trading strategy has a low
profit potential if the stock trades above the strike price and exposed to high risk if stock goes
down. It is also helpful when you expect implied volatility to fall, that will decrease the price of
the option you sold.

When to initiate a short put?

A short put is best used when you expect the underlying asset to rise moderately. It would still
benefit if the underlying asset remains at the same level, because the time decay factor will
always be in your favour as the time value of put will reduce over a period of time as you reach
near to expiry. This is a good option trading strategy to use because it gives you upfront credit,
which will help to somewhat offset the margin.

Strategy Short Put Option

Market Outlook Bullish or Neutral

Breakeven at expiry Strike price - Premium received

Risk Unlimited

Reward Limited to premium received

Margin required Yes

Let’s try to understand with an Example:

Current Nifty Price 8300

Strike price 8200

Premium received (per share) 80

BEP (strike Price - Premium paid) 8120

Lot size 75

Suppose Nifty is trading at Rs. 8300. A put option contract with a strike price of 8200 is trading
at Rs. 80. If you expect that the price of Nifty will surge in the coming weeks, so you will sell
8200 strike and receive upfront profit of Rs.6,000 (75*80). This transaction will result in net
credit because you will receive the money in your broking account for writing the put option.
This will be the maximum amount that you will gain if the option expires worthless. If the
market moves against you, then you should have a stop loss based on your risk appetite to avoid
unlimited loss.
So, as expected, if Nifty Increases to 8400 or higher by expiration, the options will be out of the
money at expiration and therefore expire worthless. You will not have any further liability and
amount of Rs.6000 (75*80) will be your maximum profit. If Nifty goes against your expectation
and falls to 7800 then the loss would be amount to Rs.24000 (75*320). Following is the payoff
schedule assuming different scenarios of expiry. For the ease of understanding, we did not take
into account commission charges and Margin.

Analysis of Short Put Option Trading Strategy

A short put options trading strategy can help in generating regular income in a rising or sideways
market but it does carry significant risk and it is not suitable for beginner traders. It’s also not a
good strategy to use if you expect underlying assets to rise quickly in a short period of time;
instead one should try long call trade strategy.

Bull Put Spread

What is Bull Put Spread Option strategy?

A Bull Put Spread involves one short put with higher strike price and one long put with lower
strike price of the same expiration date. A Bull Put Spread is initiated with flat to positive view
in the underlying assets.

When to initiate Bull Put Spread

Bull Put Spread Option strategy is used when the option trader believes that the underlying assets
will rise moderately or hold steady in the near term. It consists of two put options – short and
long put. Short put’s main purpose is to generate income, whereas long put is bought to limit the
downside risk.
How to Construct the Bull Put Spread?

Bull Put Spread is implemented by selling At-the-Money (ATM) Put option and simultaneously
buying Out-the-Money (OTM) Put option of the same underlying security with the same expiry.
Strike price can be customized as per the convenience of the trader.

Probability of making money

A Bull Put Spread has a higher probability of making money as compared to Bull Call Spread.
The probability of making money is 67% because Bull Put Spread will be profitable even if the
underlying assets holds steady or rise. While, Bull Call Spread has probability of only 33%
because it will be profitable only when the underlying assets rise.

Strategy Sell 1 ATM Put and Buy 1 OTM Put

Market Outlook Neutral to Bullish

Motive Earn income with limited risk

Breakeven at expiry Strike Price of Short Put - Net Premium received

Risk Difference between two strikes - premium received

Reward Limited to premium received

Margin required Yes

Let’s try to understand with an example:

Nifty Current spot price (Rs) 9300

Sell 1 ATM Put of strike price (Rs) 9300

Premium received (Rs) 105

Buy 1 OTM Put of strike price (Rs) 9200

Premium paid (Rs) 55

Break Even point (BEP) 9250

Lot Size 75
 Net Premium Received (Rs) 50

Suppose Nifty is trading at Rs.9300. If Mr. A believes that price will rise above 9300 or hold
steady on or before the expiry, so he enters Bull Put Spread by selling 9300 Put strike price at
Rs.105 and simultaneously buying 9200 Put strike price at Rs.55. The net premium received to
initiate this trade is Rs.50. Maximum profit from the above example would be Rs.3750 (50*75).
It would only occur when the underlying assets expires at or above 9300. In this case, both long
and short put options expire worthless and you can keep the net upfront credit received that is
Rs.3750 in the above example. Maximum loss would also be limited if it breaches breakeven
point on downside. However, loss would be limited to Rs.3750(50*75).

For the ease of understanding, we did not take in to account commission charges. Following is
the payoff chart and payoff schedule assuming different scenarios of expiry.

The Payoff Schedule:

On Expiry Nifty closes Payoff from Put Sold 9300 Payoff from Put Bought 9200 Net Payoff
at (Rs) (Rs) (Rs)

8800 -395 345 -50

8900 -295 245 -50

9000 -195 145 -50

9100 -95 45 -50

9200 5 -55 -50

9250 55 -55 0

9300 105 -55 50

9400 105 -55 50

9500 105 -55 50

9600 105 -55 50

9700 105 -55 50

Payoff diagram

Impact of Options Greeks:

Delta: Delta estimates how much the option price will change as the stock price changes. The
net Delta of Bull Put Spread would be positive, which indicates any downside movement would
result in loss.

Vega: Bull Put Spread has a negative Vega. Therefore, one should initiate this strategy when the
volatility is high and is expected to fall.

Theta: Time decay will benefit this strategy as ATM strike has higher Theta as compared to
OTM strike.

Gamma: This strategy will have a short Gamma position, so any downside movement in the
underline asset will have a negative impact on the strategy.

How to manage Risk?

A Bull Put Spread is exposed to limited risk; hence carrying overnight position is advisable.

Analysis of Bull Put Spread Options strategy:

A Bull Put Spread Options strategy is limited-risk, limited-reward strategy. This strategy is best
to use when an investor has neutral to Bullish view on the underlying assets. The key benefit of
this strategy is the probability of making money is higher as compared to Bull Call Spread.
Long Call Ladder Options Strategy
A Long Call Ladder is the extension of bull call spread; the only difference is of an additional
higher strike sold. The purpose of selling the additional strike is to reduce the cost. It is limited
profit and unlimited risk strategy. It is implemented when the investor is expecting upside
movement in the underlying assets till the higher strike sold. The motive behind initiating this
strategy is to rightly predict the stock price till expiration and gain from time value.

When to initiate a Long Call Ladder

A Long Call Ladder spread should be initiated when you are moderately bullish on the
underlying assets and if it expires in the range of strike price sold then you can earn from time
value factor. Also another instance is when the implied volatility of the underlying assets
increases unexpectedly and you expect volatility to come down then you can apply Long Call
Ladder strategy.

How to construct a Long Call Ladder?

A Long Call Ladder can be created by buying 1 ITM call, selling 1 ATM call and selling 1 OTM
call of the same underlying security with the same expiry. Strike price can be customized as per
the convenience of the trader i.e. A trader can initiate the following trades also: Buy 1 ATM Call,
Sell 1 OTM Call and Sell 1 far OTM Call.

Strategy Buy 1 ITM Call, Sell 1 ATM Call and Sell 1 OTM Call

Market Outlook Moderately bullish

Upper Breakeven Total strike price of short call - Strike price of long call - Net premium paid

Lower Breakeven Strike price of long call + Net Premium Paid

Limited to premium paid if stock falls below lower breakeven.

Risk
Unlimited if stock surges above higher breakeven.

Reward Limited (expiry between upper and lower breakeven)

Margin required Yes

Let’s try to understand with an example:

Nifty Current spot price (Rs) 9100

Buy 1 ITM call of strike price (Rs) 9000

 Premium paid (Rs) 180

Sell 1 ATM call of strike price (Rs) 9100

Premium received (Rs) 105

Sell 1 OTM call of strike price (Rs) 9200

Premium received (Rs) 45

Upper breakeven 9270

Lower breakeven 9030

Lot Size 75

Net Premium Paid (Rs) 30

Suppose Nifty is trading at 9100. An investor Mr. A thinks that Nifty will expire in the range of
9100 and 9200 strikes, so he enters a Long Call Ladder by buying 9000 call strike price at
Rs.180, selling 9100 strike price at Rs.105 and selling 9200 call for Rs.45. The net premium paid
to initiate this trade is Rs.30. Maximum profit from the above example would be Rs.5250
(70*75). It would only occur when the underlying assets expires in the range of strikes sold.
Maximum loss would be unlimited if it breaks higher breakeven point. However, loss would be
limited up to Rs.2250(30*75) if it drops below the lower breakeven point.

For the ease of understanding, we did not take in to account commission charges. Following is
the payoff chart and payoff schedule assuming different scenarios of expiry.
The Payoff chart:

The Payoff Schedule

Payoff from 1 ITM Call Payoff from 1 ATM Payoff from 1 OTM
On Expiry NIFTY Net Payoff
Bought Calls Sold Call Sold
closes at (Rs)
(9000) (Rs) (9100) (Rs) (9200) (Rs)

8600 -180 105 45 -30

8700 -180 105 45 -30

8800 -180 105 45 -30

8900 -180 105 45 -30

9000 -180 105 45 -30

9030 -150 105 45 0

9100 -80 105 45 70

9200 20 5 45 70

9270 90 -65 -25 0

9300 120 -95 -55 -30

9400 220 -195 -155 -130

9500 320 -295 -255 -230

9600 420 -395 -355 -330

9700 520 -495 -455 -430

9800 620 -595 -555 -530

Impact of Options Greeks:

Delta: At the time of initiating this strategy, we will have a short Delta position, which indicates
any significant upside movement, will lead to unlimited loss.

Vega: Long Call Ladder has a negative Vega. Therefore, one should buy Long Call Ladder
spread when the volatility is high and expects it to decline.

Theta: A Long Call Ladder will benefit from Theta if it moves steadily and expires in the range
of strikes sold.

Gamma: This strategy will have a short Gamma position, which indicates any significant upside
movement, will lead to unlimited loss.

How to manage Risk?

A Long Call Ladder is exposed to unlimited risk; it is advisable not to carry overnight positions.
Also, one should always strictly adhere to Stop Loss in order to restrict losses.

Analysis of Long Call Ladder Options strategy:

A Long Call Ladder spread is best to use when you are confident that an underlying security will
not move significantly and will stays in a range of strike price sold. Another scenario wherein
this strategy can give profit is when there is a decrease in implied volatility.

What Is Covered Call Options Trading Strategy?

A covered call options trading strategy is an Income generating strategy which can be initiated
by simultaneously purchasing a stock and selling a call option. It can also be used by someone
who is holding a stock and wants to earn income from that investment. Generally, the call option
which is sold will be out-the-money and it will not get exercised unless the stock price increases
above the strike price.

How should you use the covered call Options Trading strategy?

Choosing between strikes involves a trade-off between priorities. An investor can select higher
out-the-money strike price and preserve some more upside potential. However, more out-the-
money would generate less premium income, which means that there would be a smaller
downside protection in case ofstock decline. The expiration month reflects the time horizon of
his market view.

Strategy Buy Stock & Sell call option

Market Outlook Neutral to moderately bullish

Breakeven(Rs.) at expiry Stock price paid-premium received

Maximum Risk Stock price paid-call premium

Reward Limited

Margin required Yes

Let’s try to understand the Covered Call Options Trading Strategy with an Example:
Current ABC Ltd Price Rs. 8500

Strike price Rs. 8700

Premium Received (per share) Rs. 50

BEP (strike Price - Premium paid) Rs. 8450

Lot size (in units) 100

Let us consider the following scenario: Mr. X has purchased 100 shares of ABC Ltd. for Rs.8500
and simultaneously sells a call option with a strike price of Rs.8700 for Rs.50 which means that
Mr. X does not think that price of ABC Ltd will rise above Rs.8700 till expiry. Thus, the net
outflow to Mr. X is (Rs.8500-Rs.50) Rs.8450.

The upside profit potential is limited to the premium received from the call option sold plus the
difference between the stock purchase price and its strike price.

In the above example, if stock price surges above the 8700 level, then the maximum profit would
be calculated as:(8700-8500 +50)*100 = (250*100) = Rs. 25,000. If the stock price stays at or
below Rs.8700, the call option will not get exercised and Mr. X can retain the premium of Rs.
50, which is an extra income.

For the ease of understanding, concepts such as commission, dividend, margin, tax and other
transaction charges have not been included in the above example.

Any increase in volatility will have a neutral to negative impact as the option premium will
increase, while a decrease in volatility will have a positive effect. Time decay will have a
positive effect.

Analysis of Covered Call trading Strategy:

The covered call strategy is best used when an investor wishes to generate income in addition to
any dividends from shares of stocks he or she owns. However, it may not be a very profitable
strategy for an investor whose main interest is to gain substantial profit and who wants to protect
downside risk.

What is Call Backspread?

The Call Backspread is reverse of call ratio spread. It is bullish strategy that involves selling
options at lower strikes and buying higher number of options at higher strikes of the same
underlying stock. It is unlimited profit and limited risk strategy.

When to initiate the Call Backspread

The Call Backspread is used when an option trader thinks that the underlying asset will
experience significant upside movement in the near term.

How to construct the Call Backspread?

 Sell 1 ITM/ATM Call

 Buy 2 OTM Call

The Call Backspread is implemented by selling one In-the-Money (ITM) or At-the-Money

(ATM) call option and simultaneously buying two Out-the-Money (OTM) call options of the
same underlying asset with the same expiry. Strike price can be customized as per the
convenience of the trader.

Strategy Call Backspread

Market Outlook Significant upside movement

Upper Long call strikes + Difference between long and short strikes -/+ net premium received
Breakeven or paid

Lower
Strike price of Short call +/- net premium paid or received
Breakeven

Risk Limited

Reward Unlimited (when Underlying price > strike price of buy call)

Margin required Yes

Let’s try to understand with an Example:

NIFTY Current market Price Rs 9300

Sell ATM Call (Strike Price) Rs 9300

Premium Received (per share) Rs 140

Buy OTM Call (Strike Price) Rs 9400

 Premium Paid (per lot) Rs 70

Net Premium Paid/Received 0

Upper BEP 9500

Lower BEP 9300

Lot Size 75

Suppose Nifty is trading at Rs.9300. If Mr. A believes that price will rise significantly above Rs
9400 on or before expiry, then he initiates Call Backspread by selling one lot of 9300 call strike
price at Rs.140 and simultaneously buying two lot of 9400 call strike price at Rs.70. The net
premium paid/received to initiate this trade is zero. Maximum profit from the above example
would be unlimited if underlying assets break upper breakeven point. However, maximum loss
would be limited to Rs.7,500 (100*75) and it will only occur when Nifty expires at 9400.

For the ease of understanding, we did not take in to account commission charges. Following is
the payoff schedule assuming different scenarios of expiry.

The Payoff Schedule:

On Expiry NIFTY Net Payoff from 9300 Call Net Payoff from 9400 Call Bought Net Payoff
closes at Sold (Rs) (Rs) (2Lots) (Rs)

9000 140 -140 0

9100 140 -140 0

9200 140 -140 0

9300 140 -140 0

9350 90 -140 -50

9400 40 -140 -100

9450 -10 -40 -50

9500 -60 60 0

9600 -160 260 100

9700 -260 460 200

9800 -360 660 300

9900 -460 860 400

The Payoff Graph:

Impact of Options Greeks:

Delta: If the net premium is received from the Call Backspread, then the Delta would be
negative, which means even if the underlying assets falls below lower BEP, profit will be the net
premium received.

If the net premium is paid then the Delta would be positive which means any upside movement
will result into profit.

Vega: The Call Backspread has a positive Vega, which means an increase in implied volatility
will have a positive impact.

Theta: With the passage of time, Theta will have a negative impact on the strategy because
option premium will erode as the expiration dates draws nearer.

Gamma: The Call Backspread has a long Gamma position, which means any major upside
movement will benefit this strategy.
How to manage risk?

The Call Backspread is exposed to limited risk; hence one can carry overnight position.

Analysis of Call Backspread:

The Call Backspread is best to use when an investor is extremely bullish because investor will
make maximum profit only when stock price expires above higher (bought) strike.

What is Stock Repair strategy?

As the name suggests, the Stock Repair strategy is an alternative strategy to recover from loss
that a stock has suffered due to fall in price. The Stock Repair strategy helps in recovering losses
with just a moderate rise in the price of the underlying stock.

Why to Initiate Stock Repair strategy?

Stock Repair strategy is initiated to recover from the losses and exit from loss making position at
breakeven of the underlying stock.

Who can initiate Stock Repair strategy?

A Stock Repair strategy should be implemented by investors who are looking forward to average
their position by buying additional stocks in cash when the underlying stock price is falling.
Instead of buying additional stock in cash one can apply stock repair strategy.

Stock Repair strategy?

A Stock Repair strategy should be initiated only when the stock that you are holding in your
portfolio has corrected by 10-20% and only if you think that the underlying stock will rise
moderately in near term.

How to Construct the Stock Repair strategy?

 Buy 1 ATM call

 Sell 2 OTM calls

Stock Repair strategy is implemented by buying one At-the-Money (ATM) call option and
simultaneously selling two Out-the-Money (OTM) call options strikes, which should be closest
to the initial buying price of the same underlying stock with the same expiry.

Strategy Long Stock, Buy 1 ATM Call and Sell 2 OTM Call

Market Outlook Mildly Bullish

 Motive Recover loss with limited risk

Break even (Strike price of buy call + strike of sell call + net premium paid)/2

Risk Net premium paid, Drop in price of holding stock

Reward Average of difference between strike price-net premium paid

Margin required Yes

Let’s try to understand with an example:

DISHTV earlier Bought at Rs 100

Quantity bought 7000

DISHTV Current spot price (Rs) 90

Buy 1 ATM Call of strike price (Rs) 90

Premium paid (Rs) 5

Sell 2 OTM Call of strike price (Rs) 100

OTM call price per lot (Rs) 2

Premium received (Rs) (2*2) 4

Break even 95.5

Lot Size 7000

Net Premium paid (Rs) 1

For example, an investor Mr. A had bought 7000 shares of DISHTV at Rs.100 in April but the
price of DISHTV has declined to Rs.90, resulting in to notional loss of Rs.70,000. Mr. A thinks
that price will rise from this level so rather than doubling the quantity at current price, here he
can initiate the Stock Repair strategy. This can be initiated by buying one May 90 call for Rs.5
and selling two May 100 call for Rs.2 each. The net debit paid to enter this spread is Rs.1
amounting to Rs.7000, which will be the maximum loss from repair strategy that Mr. A will face
if DISHTV falls below Rs.90.

If DISHTV expires at 80 level then both the calls would expire worthless, resulting in loss of the
debit paid of Rs.7000 as the net cost to initiate Stock Repair strategy is Rs.1 per lot. Had Mr A
doubled his position at 90 level then he would have lost Rs.70,000 (10*7000). This shows he is
much better off by applying this strategy.

If DISHTV expires at 100 level then this would be the best case scenario where maximum profit
will be achieved. May 90 call bought would result in to profit of Rs.5 where as May 100 call sold
will expire worthless resulting in to gain of Rs.4. Net gain would be Rs.63,000 (9*7000).

Followings are the two scenarios assuming Mr A has implemented the Stock Repair strategy
whereas Mr B has doubled his position at lower level. For the ease of understanding, we did not
take in to account commission charges.

Stock Repair Normal Averaging

Payoff from Payoff from Payoff from

DISHTV Net payoff Doubling down Net Payoff
stock holding at Repair stock holding at
expires at of Mr. A position payoff of Mr. B
Rs 100 Strategy Rs 100

70 (2,10,000) 7,000 (2,17,000) (2,10,000) (1,40,000) (3,50,000)

80 (1,40,000) 7,000 (1,47,000) (1,40,000) (70,000) (2,10,000)

90 (70,000) 7,000 (77,000) (70,000) 0 (70,000)

100 0 63,000 63,000 0 70,000 70,000

110 70,000 (7,000) 63,000 70,000 1,40,000 2,10,000

Comparison:
Mr. A initiated stock repair strategy Mr. B Doubled his position at lower level

Only margin money is required to initiate Full amount has to be paid in cash for
Margin
stock repair strategy taking delivery of stock

Interest Loss (1
1,50,000*0.08/12=1000 630000*0.08/12= 4200
month)

It involves high risk when the stock price

Risk Risk associated is limited
falls

Brokerage paid to initiate position is higher

Brokerage Brokerage in Options is comparatively less.
as compared to Options.
The Payoff chart:

Analysis of Stock Repair strategy:

The Stock Repair strategy is suitable for an investor who is holding a losing stock and wants to
reduce breakeven at very little or no cost. This strategy helps in minimizing the loss at very low
cost as compared to "Doubling Down" of position.

Call Ratio Spread Explained

What is Call Ratio Spread?

The Call Ratio Spread is a premium neutral strategy that involves buying options at lower strikes
and selling higher number of options at higher strikes of the same underlying stock.
When to initiate the Call Ratio Spread

The Call Ratio Spread is used when an option trader thinks that the underlying asset will rise
moderately in the near term only up to the sold strikes. This strategy is basically used to reduce
the upfront costs of premium paid and in some cases upfront credit can also be received.

How to construct the Call Ratio Spread?

 Buy 1 ITM/ATM Call

 Sell 2 OTM Call

The Call Ratio Spread is implemented by buying one In-the-Money (ITM) or At-the-Money
(ATM) call option and simultaneously selling two Out-the-Money (OTM) call options of the
same underlying asset with the same expiry. Strike price can be customized as per the
convenience of the trader.

Strategy Call Ratio Spread

Market Outlook Moderately bullish with less volatility

Upper Difference between long and short strikes + short call strikes +/- premium received or
Breakeven paid

Lower
Strike price of long call +/- Net premium paid or received
Breakeven

Risk Unlimited

Reward Limited (when Underlying price = strike price of short call)

Margin required Yes

Let’s try to understand with an Example:

NIFTY Current market Price 9300

Buy ATM Call (Strike Price) 9300

Premium Paid (per share) 140

Sell OTM Call (Strike Price) 9400

Premium Received 70
Net Premium Paid/Received 0

Upper BEP 9500

Lower BEP 9300

Lot Size 75

Suppose Nifty is trading at Rs.9300. If Mr. A believes that price will rise to Rs.9400 on expiry,
then he enters Call Ratio Spread by buying one lot of 9300 call strike price at Rs.140 and
simultaneously selling two lot of 9400 call strike price at Rs.70. The net premium paid/received
to initiate this trade is zero. Maximum profit from the above example would be Rs.7500
(100*75). For this strategy to succeed the underlying asset has to expire at 9400. In this case
short call option strikes will expire worthless and 9300 strike will have some intrinsic value in it.
However, maximum loss would be unlimited if it breaches breakeven point on upside.

For the ease of understanding, we did not take in to account commission charges. Following is
the payoff schedule assuming different scenarios of expiry.

The Payoff Schedule:

On Expiry NIFTY Net Payoff from 9300 Call Net Payoff from 9400 Call Sold Net Payoff
closes at Bought (Rs) (Rs) (2Lots) (Rs)

8900 -140 140 0

9000 -140 140 0

9100 -140 140 0

9200 -140 140 0

9300 -140 140 0

9350 -90 140 50

9400 -40 140 100

9450 10 40 50

9500 60 -60 0

9600 160 -260 -100

9700 260 -460 -200

9800 360 -660 -300

9900 460 -860 -400

The Payoff Graph:

Impact of Options Greeks:

Delta: If the net premium is received from the Call Ratio Spread, then the Delta would be
negative, which means slight upside movement will result into loss and downside movement will
result into profit.

If the net premium is paid then the Delta would be positive which means any downside
movement will result into premium loss, whereas a big upside movement is required to incur
loss.

Vega: The Call Ratio Spread has a negative Vega. An increase in implied volatility will have a
negative impact.

Theta: With the passage of time, Theta will have a positive impact on the strategy because
option premium will erode as the expiration dates draws nearer.
Gamma: The Call Ratio Spread has short Gamma position, which means any major upside
movement will impact the profitability of the strategy.

How to manage risk?

The Call Ratio Spread is exposed to unlimited risk if underlying asset breaks higher breakeven;
hence one should follow strict stop loss to limit loses.

Analysis of Call Ratio Spread:

The Call Ratio Spread is best to use when an investor is moderately bullish because investor will
make maximum profit only when stock price expires at higher (sold) strike. Although investor
profits will be limited if the price does not rise higher than expected sold strike.

1 2 3 4 5 6 7 8 9 10

Bearish Option Strategies

Bearish Option Trading strategy is best used when an options trader expects the underlying
assets to fall. It is very important to determine how much the underlying price will move lower
and the timeframe in which the rally will occur in order to select the best option strategy. The
simplest way to make profit from falling prices using options is to buy put options. Following are
the most popular bearish strategies that can be used in different scenarios.

 Long Put
 Short Call Strategy
 Put Ratio Strategy
 Bear Call Strategy
 Bear Put Strategy
 Put Back - spread Strategy
 Long Put Ladder Strategy

Bearish Options Trading strategies for Falling Markets

Long Put Options Trading

When should you initiate a Long Put Options Trade?

A Long Put strategy is best used when you expect the underlying asset to fall significantly in a
relatively short period of time. It would still benefit if you expect the underlying asset to fall
gradually. However, one should be aware of the time decay factor, because the time value of put
will reduce over a period of time as you reach near expiry.

Why should you use Long Put?

This is a good strategy to use because the downside risk is limited only up to the premium/cost of
the put you pay, no matter how much the underlying asset rises. It also gives you the flexibility
to select the risk to reward ratio by choosing the strike price of the options contract you buy. In
addition, Long Put can also be used as a hedging strategy if you want to protect an asset owned
by you from a possible reduction in price.

Strategy Buy/Long Put Option

Market Outlook Extremely Bearish

Breakeven at expiry Strike price - Premium paid

Risk Limited to premium paid

Reward Unlimited

Margin required No

Let’s try to understand with an example:

Current Nifty Price Rs.8200

Strike price Rs.8200

Premium Paid (per share) Rs.60

BEP (Strike Price - Premium paid) Rs.8140

Lot size (in units) 75

Suppose Nifty is trading at Rs.8200. A put option contract with a strike price of Rs 8200 is
trading at Rs.60. If you expect that the price of Nifty will fall significantly in the coming weeks,
and you paid Rs.4,500 (75*60) to purchase a single put option covering 75 shares.

As per expectation, if Nifty falls to Rs.8100 on options expiration date, then you can sell
immediately in the open market for Rs 100 per share. As each option contract covers 75 shares,
the total amount you will receive is Rs 7,500 (100*75). Since, you had paid Rs.4,500 (60*75) to
purchase the put option, your net profit for the entire trade is therefore Rs.3,000. For the ease of
understanding, we did not take into account commission
How to manage risk?

A Long Put is a limited risk and unlimited reward strategy. So carrying overnight position is
advisable but one can keep stop loss to restrict losses due to opposite movement in the
underlying assets and also time value of money can play spoil sports if underlying assets doesn’t
move at all.

Conclusion:

A Long Put is a good strategy to use when you expect the security to fall significantly and
quickly. It also limits the downside risk to the premium paid, whereas the potential return is
unlimited if Nifty moves lower significantly. It is perfectly suitable for traders who don’t have a
huge capital to invest but could potentially make much bigger returns than investing the same
amount directly in the underlying security.

Short Call Strategy Explained

Short Call Strategy:

What is Short Call strategy?

A Short Call means selling of a call option where you are obliged to buy the underlying asset at a
fixed price in the future. This strategy has limited profit potential if the stock trades below the
strike price sold and it is exposed to higher risk if the stock goes up above the strike price sold.

When to initiate a Short Call?

A Short Call is best used when you expect the underlying asset to fall moderately. It would still
benefit if the underlying asset remains at the same level, because the time decay factor will
always be in your favour as the time value of Call option will reduce over a period of time as you
reach near to expiry. This is a good strategy to use because it gives you upfront credit, which will
help you to somewhat offset the margin. But by initiating this position you are exposed to
potentially unlimited losses if underlying assets goes dramatically high in price.

How to construct a Short Call?

A Short Call can be created by selling 1 ITM/ATM/OTM call of the same underlying asset with
the same expiry. Strike price can be customized as per the convenience of the trader.

Strategy Short Call Option

Market Outlook Neutral to Bearish

Motive Earn income from selling premium

Breakeven at expiry Strike price + Premium received

Risk Unlimited

Reward Limited to premium received

Margin required Yes

Probability 66.67%
Let’s try to understand with an Example:
NIFTY Current market Price 9600

Sell ATM Call (Strike Price) 9600

Premium Received 110

BEP (Rs.) 9710

Lot Size 75

Suppose Nifty is trading at Rs.9600. A Call option contract with a strike price of 9600 is trading
at Rs.110. If you expect that the price of Nifty will fall marginally in the coming weeks, then you
can sell 9600 strike and receive upfront premium of Rs.8,250 (110*75). This transaction will
result in net credit because you will receive money in your broking account for writing the Call
option. This will be the maximum amount that you will gain if the option expires worthless.

So, as per expectation, if Nifty falls or remains at 9600 by expiration, therefore the option will
expire worthless. You will not have any further liability and amount of Rs.8,250 (110*75) will
be your profit. The probability of making money is 66.67% as you can profit in two scenarios: 1)
when price of underlying asset falls. 2) When price stays at same level.

Loss will only occur in one scenario i.e. when the underlying asset moves above the strike price
sold.

Following is the payoff schedule assuming different scenarios of expiry. For the ease of
understanding, we did not take into account commission charges and Margin.

On Expiry Nifty closes at Net Payoff from Sell Buy (Rs.)

9300 110

9400 110

9500 110

9600 110

9700 10

9710 0

9800 -90
9900 -190

10000 -290

10100 -390

10200 -490

Payoff Diagram:

Impact of Options Greeks:

Delta: Short Call will have a negative Delta, which indicates any rise in price will have a
negative impact on profitability.

Vega: Short Call has a negative Vega. Therefore, one should initiate Short Call when the
volatility is high and expects it to decline.
Theta: Short Call will benefit from Theta if it moves steadily and expires at or below strike sold.

Gamma: This strategy will have a short Gamma position, which indicates any significant upside
movement, will lead to unlimited loss.

How to manage Risk?

A Short Call is exposed to unlimited risk; it is advisable not to carry overnight positions. Also,
one should always strictly adhere to Stop Loss in order to restrict losses.

Analysis:

A Short Call strategy can help in generating regular income in a falling or sideways market but it
does carry significant risk and it is not suitable for beginner traders. It’s also not a good strategy
to use if you expect underlying assets to fall quickly in a short period of time; instead one should
try Long Put strategy.

Put Ratio Spread Explained

What is Put Ratio Spread?

The Put Ratio Spread is a premium neutral strategy that involves buying options at higher strike
and selling more options at lower strike of the same underlying stock.

When to initiate the Put Ratio Spread

The Put Ratio Spread is used when an option trader thinks that the underlying asset will fall
moderately in the near term only up to the sold strike. This strategy is basically used to reduce
the upfront costs of premium and in some cases upfront credit can also be received.

How to construct the Put Ratio Spread?

 Buy 1 ITM/ATM Put

 Sell 2 OTM Put

The Put Ratio Spread is implemented by buying one In-the-Money (ITM) or At-the-Money
(ATM) put option and simultaneously selling two Out-the-Money (OTM) put options of the
same underlying asset with the same expiry. Strike price can be customized as per the
convenience of the trader.

Strategy Put Ratio Spread

Market Outlook Moderately bearish with less volatility

 Upper
Long put strike (-/+) Net premium paid or received
Breakeven

Lower Short put strike - Difference between Long and Short strikes (-/+) premium received or
Breakeven paid

Risk Unlimited

Reward Limited (when underlying price = strike price of short put)

Margin required Yes

Let’s try to understand with an Example:

NIFTY Current market Price Rs 9300

Buy ATM Put (Strike Price) Rs 9300

Premium Paid (per share) Rs 140

Sell OTM Put (Strike Price) Rs 9200

Premium Received Rs 70

Net Premium Paid/Received Rs 0

Upper BEP 9300

Lower BEP 9100

Lot Size 75

Suppose Nifty is trading at Rs.9300. If Mr. A believes that price will fall to 9200 on expiry, then
he can initiate Put Ratio Spread by buying one lot of 9300 put strike price at Rs.140 and
simultaneously selling two lot of 9200 put strike price at Rs 70. The net premium paid/received
to initiate this trade is zero. Maximum profit from the above example would be Rs.7500
(100*75). It would only occur when the underlying asset expires at 9200. In this case, short put
options strike will expire worthless and 9300 strike will have some intrinsic value in it. However,
maximum loss would be unlimited if it breaches breakeven point on downside.

For the ease of understanding, we did not take in to account commission charges. Following is
the payoff schedule assuming different scenarios of expiry.
The Payoff Schedule:
On Expiry NIFTY Net Payoff from 9300 Put Net Payoff from 9200 Put Sold (Rs) Net Payoff
closes at Bought (Rs) (2Lots) (Rs)

8700 460 860 -400

8800 360 660 -300

8900 260 460 -200

9000 160 -260 -100

9100 60 -60 0

9150 10 40 50

9200 -40 140 100

9250 -90 140 50

9300 -140 140 0

9350 -140 140 0

9400 -140 140 0

9450 -140 140 0

9500 -140 140 0

The Payoff Graph:

Impact of Options Greeks:

Delta: If the net premium is received from the Put Ratio Spread, then the Delta would be
positive, which means any upside movement will result into marginal profit and any major
downside movement will result into huge loss.

If the net premium is paid, then the Delta would be negative, which means any upside movement
will result into premium loss, whereas a big downside movement is required to incur huge loss.

Vega: The Put Ratio Spread has a negative Vega. An increase in implied volatility will have a
negative impact.

Theta: With the passage of time, Theta will have a positive impact on the strategy because
option premium will erode as the expiration dates draws nearer.

Gamma: The Put Ratio Spread has short Gamma position, which means any major downside
movement will affect the profitability of the strategy.

How to manage Risk?

The Put Ratio Spread is exposed to unlimited risk if underlying asset breaks lower breakeven
hence one should follow strict stop loss to limit losses.
Analysis of Put Ratio Spread:

The Put Ratio Spread is best to use when investor is moderately bearish because investor will
make maximum profit only when stock price expires at lower (sold) strike. Although your profits
will be none to limited if price rises higher.

Bear Call Option Trading Strategy

What is a Bear Call Spread Option strategy?

A Bear Call Spread is a bearish option strategy. It is also called as a Credit Call Spread because it
creates net upfront credit at the time of initiation. It involves two call options with different strike
prices but same expiration date. A bear call spread is initiated with anticipation of decline in the
underlying assets, similar to bear put spread.

When to initiate a Bear Call Spread Option strategy?

A Bear Call Spread Option strategy is used when the option trader expects that the underlying
assets will fall moderately or hold steady in the near term. It consists of two call options – short
and buy call. Short call’s main purpose is to generate income, whereas higher buy call is bought
to limit the upside risk.

How to construct the Bear Call Spread?

Bear Call Spread can be implemented by selling ATM call option and simultaneously buying
OTM call option of the same underlying assets with same expiry. Strike price can be customized
as per the convenience of the trader.

Probability of making money

A Bear Call Spread has a higher probability of making money. The probability of making money
is 67% because Bear Call Spread will be profitable even if the underlying assets holds steady or
falls. While, Bear Put Spread has probability of only 33% because it will be profitable only when
the underlying assets fall.

Strategy Sell 1 ATM call and Buy 1 OTM call

Market Outlook Neutral to Bearish

Motive Earn income with limited risk

Breakeven at expiry Strike Price of short Call + Net Premium received

Risk Difference between two strikes - premium received

 Reward Limited to premium received

Margin required Yes

Let’s try to understand with an example:

Nifty Current spot price (Rs) 9300

Sell 1 ATM call of strike price (Rs) 9300

Premium received (Rs) 105

Buy 1 OTM call of strike price (Rs) 9400

Premium paid (Rs) 55

Break Even point (BEP) 9350

Lot Size 75

Net Premium Received (Rs) 50

Suppose Nifty is trading at Rs.9300. If Mr. A believes that price will fall below 9300 or holds
steady on or before the expiry, so he enters Bear Call Spread by selling 9300 call strike price at
Rs.105 and simultaneously buying 9400 call strike price at Rs.55. The net premium received to
initiate this trade is Rs.50. Maximum profit from the above example would be Rs.3750 (50*75).
It would only occur when the underlying assets expires at or below 9300. In this case both long
and short call options expire worthless and you can keep the net upfront credit received.
Maximum loss would also be limited if it breaches breakeven point on upside. However, loss
would also be limited up to Rs.3750(50*75).

For the ease of understanding, we did not take in to account commission charges. Following is
the payoff chart and payoff schedule assuming different scenarios of expiry.

The Payoff Schedule:

On Expiry Nifty closes Net Payoff from Call Sold 9300 Net Payoff from Call Bought 9400 Net Payoff
at (Rs) (Rs) (Rs)

8900 105 -55 50

9000 105 -55 50

9100 105 -55 50

9200 105 -55 50

9300 105 -55 50

9350 55 -55 0

9400 5 -55 -50

9500 -95 45 -50

9600 -195 145 -50

9700 -295 245 -50

9800 -395 345 -50

Bear Call Spread’s Payoff Chart:

Impact of Options Greeks:

Delta: The net Delta of Bear Call Spread would be negative, which indicates any upside
movement would result in to loss. The ATM strike sold has higher Delta as compared to OTM
strike bought.
Vega: Bear Call Spread has a negative Vega. Therefore, one should initiate this strategy when
the volatility is high and is expected to fall.

Theta: The net Theta of Bear Call Spread will be positive. Time decay will benefit this strategy.

Gamma: This strategy will have a short Gamma position, so any upside movement in the
underline asset will have a negative impact on the strategy.

How to manage Risk?

A Bear Call is exposed to limited risk; hence carrying overnight position is advisable.

Analysis of Bear Call Options strategy:

A Bear Call Spread strategy is limited-risk, limited-reward strategy. This strategy is best to use
when an investor has neutral to bearish view on the underlying assets. The key benefit of this
strategy is the probability of making money is higher.

What Is A Bear Put Spread Options Trading Strategy?

A Bear Put Spread strategy involves two put options with different strike prices but the same
expiration date. Bear Put Spread is also considered as a cheaper alternative to long put because it
involves selling of the put option to offset some of the cost of buying puts.

When To Initiate A Bear Put Spread Options Trading?

A Bear Put Spread strategy is used when the option trader thinks that the underlying assets will
fall moderately in the near term. This strategy is basically used to reduce the upfront costs of
premium, so that less investment of premium is required and it can also reduce the affect of time
decay. Even beginners can apply this strategy when they expect security to fall moderately in
near the term.

How To Construct The Bear Put Spread?

 Buy 1 ITM/ATM Put

 Sell 1 OTM Put

Bear Put Spread is implemented by buying In-the-Money or At-the-Money put option and
simultaneously selling Out-The-Money put option of the same underlying security with the same
expiry.

Strategy Buy 1 ITM/ATM put and Sell 1 OTM put

Market Outlook Moderately Bearish

 Breakeven at expiry Strike price of buy put - Net Premium Paid

Risk Limited to Net premium paid

Reward Limited

Margin required Yes

Let’s try to understand Bear Put Spread Options Trading with an example:
Nifty current market price Rs.8100

Buy ATM Put (Strike Price) Rs.8100

Premium Paid (per share) Rs.60

Sell OTM Put (Strike Price) Rs.7900

Premium Received Rs.20

Net Premium Paid Rs.40

Break Even Point (BEP) Rs.8060

Lot Size (in units) 75

Suppose Nifty is trading at Rs.8100. If you believe that price will fall to Rs.7900 on or before the
expiry, then you can buy At-the-Money put option contract with a strike price of Rs.8100, which
is trading at Rs.60 and simultaneously sell Out-the-Money put option contract with a strike price
of Rs.7900, which is trading at Rs.20. In this case, the contract covers 75 shares. So, you paid
Rs.60 per share to purchase single put and simultaneously received Rs.20 by selling Rs.7900 put
option. So, the overall net premium paid by you would be Rs 40.

So, as expected, if Nifty falls to Rs.7900 on or before option expiration date, then you can square
off your position in the open market for Rs 160 by exiting from both legs of the trade. As each
option contract covers 75 shares, the total amount you will receive is Rs 15,000 (200*75). Since,
you had paid Rs.3,000 (40*75) to purchase the put option, your net profit for the entire trade is,
therefore Rs.12,000 (15000-3000). For the ease of understanding, we did not take in to account
commission charges.

Following is the payoff schedule assuming different scenarios of expiry.

The Payoff Schedule:
On Expiry NIFTY closes at Net Payoff from Put Buy (Rs) Net Payoff from Put Sold (Rs) Net Payoff (Rs)

7500 540 -380 160

7600 440 -280 160

7700 340 -180 160

7800 240 -80 160

7900 140 20 160

8000 40 20 60

8100 -60 20 -40

8200 -60 20 -40

8300 -60 20 -40

8400 -60 20 -40

8500 -60 20 -40

8600 -60 20 -40

8700 -60 20 -40

Bear Put Spread’s Payoff Chart:

The overall Delta of the bear put position will be negative, which indicates premiums will go up
if the markets go down. The Gamma of the overall position would be positive. It is a long Vega
strategy, which means if implied volatility increases; it will have a positive impact on the return,
because of the high Vega of At-the-Money options. Theta of the position would be negative.

Analysis of Bear Put Spread strategy:

A Bear Put Spread strategy is best to use when an investor is moderately bearish because he or
she will make the maximum profit only when the stock price falls to the lower (sold) strike.
Also, your losses are limited if price increases unexpectedly higher.

Put Backspread Explained - Back Spread Options Strategy

What is Put Backspread?

The Put Backspread is reverse of Put Ratio Spread. It is a bearish strategy that involves selling
options at higher strikes and buying higher number of options at lower strikes of the same
underlying asset. It is unlimited profit and limited risk strategy.

When to initiate the Put Backspread

The Put Backspread is used when an option trader believes that the underlying asset will fall
significantly in the near term.

How to construct the Put Backspread?

 Sell 1 ITM/ATM Put

 Buy 2 OTM Put

The Put Backspread is implemented by selling one In-the-Money (ITM) or At-the-Money

(ATM) put option and buying two Out-the-Money (OTM) put options simultaneously of the
same underlying asset with the same expiry. Strike price can be customized as per the
convenience of the trader.

Strategy Put Backspread

Market Outlook Significant downside movement

Upper
Strike price of short put -/+ premium paid/ premium received
Breakeven

Lower Long put strike - Difference between Long and Short strikes (-/+) premium received or
Breakeven paid

Risk Limited

Reward Unlimited (when Underlying price < strike price of buy put)

Margin required Yes

Let’s try to understand with an Example:

NIFTY Current market Price Rs 9300

Sell ATM Put (Strike Price) Rs 9300

Premium received (Rs) 140

Buy OTM Put (Strike Price) Rs 9200

Premium paid (per lot) Rs 70

Net Premium Paid/Received Rs 0

Upper BEP 9300

Lower BEP 9100

Lot Size 75

Suppose Nifty is trading at Rs.9300. If Mr. A believes that price will fall significantly below
9200 on or before expiry, then he can initiate Put Backspread by selling one lot of 9300 put
strike price at Rs.140 and simultaneously buying two lot of 9200 put strike price at Rs.70. The
net premium paid/received to initiate this trade is zero. Maximum profit from the above example
would be unlimited if underlying asset breaks lower breakeven point. However, maximum loss
would be limited to Rs.7,500 (100*75) and it will only occur when Nifty expires at 9200.

For the ease of understanding, we did not take in to account commission charges. Following is
the payoff schedule assuming different scenarios of expiry.

The Payoff Schedule:

On Expiry NIFTY Net Payoff from 9300 Put Net Payoff from 9200 Put Bought Net Payoff
closes at Sold (Rs) (Rs) (2Lots) (Rs)

8700 -460 860 400

8800 -360 660 300

8900 -260 460 200

9000 -160 260 100

9100 -60 60 0

9150 -10 -40 -50

9200 40 -140 -100

9250 90 -140 -50

9300 140 -140 0

9350 140 -140 0

9400 140 -140 0

9450 140 -140 0

9500 140 -140 0

The Payoff Graph:

Impact of Options Greeks:

Delta: If the net premium is paid, then the Delta would be negative, which means any upside
movement will result into premium loss, whereas a big downside movement would result in to
unlimited profit. On the other hand, If the net premium is received from the Put Backspread, then
the Delta would be positive, which means any upside movement above higher breakeven will
result into profit up to premium received.

Vega: The Put Backspread has a positive Vega, which means an increase in implied volatility
will have a positive impact.

Theta: With the passage of time, Theta will have a negative impact on the strategy because
option premium will erode as the expiration dates draws nearer.
Gamma: The Put Backspread has a long Gamma position, which means any major downside
movement will benefit this strategy.

How to manage Risk?

The Put Backspread is exposed to limited risk; hence one can carry overnight position.

Analysis of Put Backspread:

The Put Backspread is best to use when investor is extremely bearish because investor will make
maximum profit only when stock price expires at below lower (bought) strike.

Long Put Ladder Strategy Explained

A Long Put Ladder is the extension of Bear Put spread; the only difference is of an additional
lower strike sold. The purpose of selling the additional strike is to reduce the cost of premium. It
is limited profit and unlimited risk strategy. It is implemented when the investor is expecting
downside movement in the underlying assets till the lower strike sold. The motive behind
initiating this strategy is to rightly predict the stock price till expiration and gain from time value.

When to initiate a Long Put Ladder

A Long Put Ladder should be initiated when you are moderately bearish on the underlying asset
and if it expires in the range of strike price sold then you can earn from time value and delta
factor. Also, another instance is when the implied volatility of the underlying asset increases
unexpectedly and you expect volatility to come down then you can apply Long Put Ladder
strategy.

How to construct Long Put Ladder

A Long Put Ladder can be created by buying 1 ITM Put, selling 1 ATM Put and selling 1 OTM
Put of the same underlying security with the same expiry. Strike price can be customized as per
the convenience of the trader. A trader can also initiate the Short Put Ladder strategy in the
following way - buy 1 ATM Put, Sell 1O TM Put and Sell 1 Far OTM Put.

Strategy Buy 1 ITM Put, Sell 1 ATM Put and Sell 1 OTM Put

Market Outlook Moderately bearish

Upper Breakeven Strike price of long Put - Net Premium Paid

Lower Breakeven Addition of two sold Put strikes - Strike price of long Put + Net premium paid

Risk Limited to premium paid if stock goes above higher breakeven.

 Unlimited if stock falls below lower breakeven.

Reward Limited (expiry between upper and lower breakeven)

Margin required Yes

Let’s try to understand with an example:

Nifty Current spot price (Rs) 9400

Buy 1 ITM Put of strike price (Rs) 9500

Premium paid (Rs) 180

Sell 1 ATM Put of strike price (Rs) 9400

Premium received (Rs) 105

Sell 1 OTM Put of strike price (Rs) 9300

Premium received (Rs) 45

Upper breakeven 9470

Lower breakeven 9230

Lot Size 75

Net Premium Paid (Rs) 30

Suppose Nifty is trading at 9400. An investor Mr. A feels that Nifty will expire in the range of
9400 and 9300 strikes, so he enters a Long Put Ladder by buying 9500 Put strike price at Rs.180,
selling 9400 strike price at Rs.105 and selling 9300 Put for Rs.45. The net premium paid to
initiate this trade is Rs.30. Maximum profit from the above example would be Rs.5250 (70*75).
It would only occur when the underlying assets expires in the range of strikes sold. Maximum
loss would be unlimited if it breaks lower breakeven point. However, loss would be limited up to
Rs.2250 (30*75) if Nifty surges above the higher breakeven point.

For the ease of understanding, we did not take in to account commission charges. Following is
the payoff chart and payoff schedule assuming different scenarios of expiry.
The Payoff chart:

The Payoff Schedule:

On Expiry NIFTY Payoff from 1 ITM Put Payoff from 1 ATM Puts Payoff from 1 OTM Put Net Payoff
closes at Bought (9500) (Rs) Sold (9400) (Rs) Sold (9300) (Rs) (Rs)

8800 520 -495 -455 -430

8900 420 -395 -355 -330

9000 320 -295 -255 -230

9100 220 -195 -155 -130

9200 120 -95 -55 -30

9230 90 -65 -25 0

9300 20 5 45 70

9400 -80 105 45 70

9470 -150 105 45 0

9500 -180 105 45 -30

9600 -180 105 45 -30

9700 -180 105 45 -30

9800 -180 105 45 -30

Impact of Options Greeks:

Delta: At the time of initiating this strategy, we will have a short Delta position, which indicates
any significant downside movement, will lead to unlimited loss.

Vega: Long Put Ladder has a negative Vega. Therefore, one should buy Long Put Ladder spread
when the volatility is high and expects it to decline.

Theta: A Long Put Ladder will benefit from Theta if it moves steadily and expires in the range
of strikes sold.

Gamma: This strategy will have a short Gamma position, which indicates any significant
downside movement, will lead to unlimited loss.

How to manage Risk?

A Long Put Ladder is exposed to unlimited risk; hence it is advisable not to carry overnight
positions. Also, one should always strictly adhere to Stop Loss in order to restrict losses.

Analysis of Long Put Ladder Strategy:

A Long Put Ladder spread is best to use when you are confident that an underlying security will
move marginally lower and will stay in a range of strike price sold. Another scenario wherein
this strategy can give profit is when there is a decrease in implied volatility.

1 2 3 4 5 6 7 8 9 10

Neutral Option Strategies

Neutral Option Strategy is made use of when the trader expects the volatility in the market to
decline after a sharp spike. The trader expects the stock to trade in a narrow range and expects
the option premium of call and put options to decline. Following are the most popular strategies
that can be used when the market is expected to trade range bound with a decline in volatility.

 Short Strangle Strategy

 Short Straddle Strategy
 Long Call Butterfly Strategy
 Short Iron Butterfly Strategy
 Long Call Condor Strategy
  Long Call Calendar Spread Strategy

How to make Profit in a Sideways Market: Short Strangle

strategy
How to make Profit in a Sideways Market: Short Strangle strategy

A Short Strangle strategy consists of one short call with higher strike price and one short put
with lower strike price. It is established for a net credit and generates profit only when the
underlying stock expires between two strikes sold. Every day that passes without large
movement in the underlying assets will benefit this strategy due to time erosion. Volatility is a
vital factor and it can adversely affect a trader’s profits in case it goes up.

When to initiate a Short Strangle strategy?

A Short Strangle strategy should only be used when you are very confident that the security
won’t move in either direction because the potential loss can be substantial if that happens. This
strategy can also be used by advanced traders when the implied volatility goes abnormally high
and the call and put premiums may be overvalued. After initiating Short Strangle, the idea is to
wait for implied volatility to drop and close the position at a profit. Inversely, this strategy can
lead to losses in case the implied volatility rises even if the stock price remains at same level.

How to construct a Short Strangle strategy?

A Short Strangle strategy is implemented by selling Out-the-Money Call option and

simultaneously selling Out-the-Money Put option of the same underlying security with the same
expiry. Strike price can be customized as per convenience of the trader but the call and put
strikes must be equidistant from the spot price.

Strategy Sell OTM Call and Sell OTM Put

Market Outlook Neutral or very little volatility

Motive Earn income from selling option premium

Upper
Strike price of short call + Net Premium received
Breakeven

Lower
Strike price of short put - Net Premium received
Breakeven

Risk Unlimited
 Limited to Net Premium received (when underlying assets expires in the range of call
Reward
and put strikes sold)

Margin
Yes
required

Let’s try to understand with an example:

Nifty Current spot price Rs 8800

Sell OTM Call Strike Price Rs 9000

Premium Received (per share) Rs 40

Sell OTM Put Strike price Rs 8600

Premium Received (per share) Rs 30

Upper breakeven 9070

Lower breakeven 8530

Lot Size 75

Suppose Nifty is trading at 8800. An investor, Mr A is expecting very little movement in the
market, so he enters a Short Strangle by selling 9000 call strike at Rs.40 and 8800 put for Rs.30.
The net upfront premium received to initiate this trade is Rs.70, which is also the maximum
possible reward. Since this strategy is initiated with a view of no movement in the underlying
security, the loss can be substantial when there is significant movement in the underlying
security. The maximum profit will be limited to the upfront premium received, which is around
Rs.5250 (70*75) in the example cited above. Another way by which this strategy can be
profitable is when the implied volatility falls.

For the ease of understanding, we did not take into account commission charges. Following is
the payoff chart and payoff schedule assuming different scenarios of expiry.
The Payoff Chart:

The Payoff Schedule:

On Expiry NIFTY closes at Net Payoff from Call Buy (Rs) Net Payoff from Put Buy (Rs) Net Payoff (Rs)

8300 40 -270 -230

8400 40 -170 -130

8500 40 -70 -30

8530 40 -40 0

8600 40 30 70

8700 40 30 70

8800 40 30 70

8900 40 30 70
9000 40 30 70

9070 -30 30 0

9100 -60 30 -30

9200 -160 30 -130

9300 -260 30 -230

Impact of option Greeks:

Delta: A Short Strangle has near-zero delta. Delta estimates how much an option price will
change as the stock price changes. When the stock price trades between the upper and lower
wings of Short Strangle, call Delta will drop towards zero and put Delta will rise towards zero as
the expiration date draws nearer.

Vega: A Short Strangle has a negative Vega. This means all other things remain the same,
increase in implied volatility will have a negative impact.

Theta: With the passage of time, all other things remain same, Theta will have a positive impact
on the strategy, because option premium will erode as the expiration dates draws nearer.

Gamma: Gamma estimates how much the Delta of a position changes as the stock prices
changes. Gamma of the Short Strangle position will be negative as we are short on options and
any major movement on either side will affect the profitability of the strategy.

How to manage risk?

Since this strategy is exposed to unlimited risk, it is advisable not to carry overnight positions.
Also, one should always strictly adhere to Stop Loss in order to restrict losses.

Analysis of Short Strangle strategy:

A Short Strangle strategy is the combination of short call and short put and it mainly profits from
Theta i.e. time decay factor if the price of the security remains relatively stable. This strategy is
not recommended for amateur/beginner traders, because the potential losses can be substantial
and it requires advanced knowledge of trading.

How to make Profit in a Neutral Market: Short Straddle

Option Strategy
A Short Straddle strategy is a race between time decay and volatility. Every day that passes
without movement in the underlying assets will benefit this strategy from time erosion. Volatility
is a vital factor and it can adversely affect a trader’s profits in case it goes up.

When to initiate a Short Straddle Options Trading Strategy?

A short options trading straddle strategy can be used when you are very confident that the
security won’t move in either direction because the potential loss can be substantial if that
happens. This strategy can also be used by advanced traders when the implied volatility goes
abnormally high for no obvious reason and the call and put premiums may be overvalued. After
selling straddle, the idea is to wait for implied volatility to drop and close the position at a profit.
Inversely, this strategy can lead to losses in case the implied volatility rises even if the stock
price remains at same level.

How to Construct a Short Straddle Options Trading Strategy?

A short straddle is implemented by selling at-the-money call and put option of the same
underlying security with the same expiry.

Strategy Sell ATM Call and Sell ATM Put

Market Outlook Neutral or very little volatility

Motivation Earn income from selling option premium

Upper
Strike price of short call + Net Premium received
Breakeven

Lower
Strike price of short call + Net Premium received
Breakeven

Risk Unlimited

Limited to Net Premium received (when underlying assets expires exactly at the strikes
Reward
price sold)

Margin required Yes

Let’s try to understand with an example:

Nifty Current spot price Rs.8800

Sell ATM Call & Put(Strike Price) Rs.8800

 Premium received (per share) Call Rs.80

Put Rs.90

Upper breakeven Rs.8970

Lower breakeven Rs.8630

Lot Size(in units) 75

Suppose, Nifty is trading at 8800. An investor, Mr. A is expecting no significant movement in

the market, so he enters a Short Straddle by selling a FEB 8800 call strike at Rs.80 and FEB
8800 put for Rs.90. The net upfront premium received to initiate this trade is Rs.170, which is
also the maximum possible reward. Since this strategy is initiated with a view of no movement in
the underlying security, the loss can be substantial when there is significant movement in the
underlying security. The maximum profit will be limited to the upfront premium received, which
is around Rs.12750 (170*75) in the example cited above. Another way by which this strategy
can be profitable is when the implied volatility falls.

For the ease of understanding, we did not take into account commission charges. Following is
the payoff chart and payoff schedule assuming different scenarios of expiry.

The Payoff Chart:

The Payoff Schedule:
On Expiry NIFTY closes at Net Payoff from Call Sell (Rs) Net Payoff from Put Sell (Rs) Net Payoff (Rs)

8300 80 -410 -330

8400 80 -310 -230

8500 80 -210 -130

8600 80 -110 -30

8630 80 -80 -0

8700 80 10 70

8800 80 90 170

8900 -20 90 70

8970 -90 90 0

9000 -120 90 -30

9100 -220 90 -130

9200 -320 90 -230

9300 -420 90 -330

Impact of Options Greeks:

Delta: Since we are initiating ATM options position, the Delta of call and put would be around
0.50.

 8800 CE Delta @ 0.5, since we are short, the delta would be -0.5.
 8800 PE Delta @-0.5, since we are short, the delta would be +0.5.
 Combined delta would be -0.5+0.5=0.

Delta neutral in case of Short Straddle suggests profit is capped. If the underlying assets move
significantly, the losses would be substantial.

Gamma: Gamma of the overall position would be Negative.

Vega: Short Straddle Strategy has a negative Vega. Therefore, one should initiate Short Straddle
only when the volatility is high and expects to fall.
Theta: Time decay is the sole beneficiary for the Short Straddle trader given that other things
remain constant. It is most effective when the underlying price expires around ATM strike price.

How to manage risk?

Since this strategy is exposed to unlimited risk, it is advisable not to carry overnight positions.
Also, one should always strictly adhere to Stop Loss in order to restrict losses.

Analysis of Short Straddle Option Trading Strategy:

A Short Straddle Option Trading Strategy is the combination of short call and short put and it
mainly profits from Theta i.e. time decay factor if the price of the security remains relatively
stable. This strategy is not recommended for amateur/beginner traders, because the potential
losses can be substantial and it requires advanced knowledge of trading.

Long Call Butterfly Options Strategy

A Long Call Butterfly is implemented when the investor is expecting very little or no movement
in the underlying assets. The motive behind initiating this strategy is to rightly predict the stock
price till expiration and gain from time value with limited risk.

When to initiate a Long Call Butterfly?

A Long Call Butterfly spread should be initiated when you expect the underlying assets to trade
in a narrow range as this strategy benefits from time decay factor. However, unlike Short
Strangle or Short Straddle, the potential risk in a Long Call Butterfly is limited. Also, when the
implied volatility of the underlying assets increases unexpectedly and you expect volatility to
come down, then you can apply Long Call Butterfly strategy.

How to construct a Long Call Butterfly?

A Long Call Butterfly can be created by buying 1 ITM call, buying 1 OTM call and selling 2
ATM calls of the same underlying security with the same expiry. Strike price can be customized
as per the convenience of the trader; however, the upper and lower strike must be equidistant
from the middle strike.

Strategy Buy 1 ITM Call, Sell 2 ATM Call and Buy 1 OTM Call

Market Outlook Neutral on market direction & Bearish on volatility

Upper Breakeven Higher Strike price of buy call - Net Premium Paid

Lower Breakeven Lower Strike price of buy call + Net Premium Paid
 Risk Limited to Net Premium Paid

Reward Limited (Maximum profit is achieved when market expires at middle strike)

Margin required Yes

Let’s try to understand with an example:

Nifty Current spot price (Rs) 8800

Buy 1 ITM call of strike price (Rs) 8700

Premium paid (Rs) 210

Sell 2 ATM call of strike price (Rs) 8800

Premium received (Rs) 300 (150*2)

Buy 1 OTM call of strike price (Rs) 8900

Premium paid (Rs) 105

Upper breakeven 8885

Lower breakeven 8715

Lot Size 75

Net Premium Paid (Rs) 15

Suppose Nifty is trading at 8800. An investor Mr A thinks that Nifty will not rise or fall much by
expiration, so he enters a Long Call Butterfly by buying a March 8700 call strike price at Rs.210
and March 8900 call for Rs 105 and simultaneously sold 2 ATM call strike price of 8800 @150
each. The net premium paid to initiate this trade is Rs.15, which is also the maximum possible
loss. This strategy is initiated with a neutral view on Nifty hence it will give the maximum profit
only when there is no movement in the underlying security. Maximum profit from the above
example would be Rs.6375 (85*75). The maximum profit would only occur when underlying
assets expires at middle strike. Maximum loss will also be limited if it breaks the upper and
lower break-even points i.e. Rs.1125 (15*75). Another way by which this strategy can give profit
is when there is a decrease in implied volatility.

For the ease of understanding, we did not take in to account commission charges. Following is
the payoff chart and payoff schedule assuming different scenarios of expiry.
The Payoff chart:

The Payoff Schedule:

On Expiry NIFTY Net Payoff from 1 ITM Net Payoff from 2 ATM Net Payoff from 1 OTM Net Payoff
closes at Call Bought (Rs) Calls Sold (Rs) Call Bought (Rs) (Rs)

8200 -210 300 -105 -15

8300 -210 300 -105 -15

8400 -210 300 -105 -15

8500 -210 300 -105 -15

8600 -210 300 -105 -15

8700 -210 300 -105 -15

8715 -195 300 -105 0

8800 -110 300 -105 85

8885 -25 130 -105 0

8900 -10 100 -105 -15

9000 90 -100 -5 -15

9100 190 -300 95 -15

9200 290 -500 195 -15

9300 390 -700 295 -15

9400 490 -900 395 -15

Impact of Options Greeks before expiry:

Delta: The net delta of a Long Call Butterfly spread remains close to zero.

Vega: Long Call Butterfly has a negative Vega. Therefore, one should buy Long Call Butterfly
spread when the volatility is high and expect to decline.

Theta: It measures how much time erosion will affect the net premium of the position. A Long
Call Butterfly will benefit from theta if it expires at middle strike.

Gamma: This strategy will have a long gamma position.

How to manage Risk?

A Long Call Butterfly is exposed to limited risk, so carrying overnight position is advisable but
one can keep stop loss to further limit losses.

Analysis of Long Call Butterfly strategy:

A Long Call Butterfly spread is best to use when you are confident that an underlying security
will not move significantly and will stay in a range. Downside risk is limited to net debit paid,
and upside reward is also limited but higher than the risk involved.

Short Iron Butterfly Options Strategy

A Short Iron Butterfly strategy is implemented when an investor is expecting very little or no
movement in the underlying assets. The motive behind initiating this strategy is to rightly predict
the stock price till expiration and gain from time value. It is a limited risk and a limited reward
strategy, similar to Long Call Butterfly strategy. A Short Iron Butterfly could also be considered
as a combination of Bear Call Spread and Bull Put Spread.

When to initiate a Short Iron Butterfly?

A Short Iron Butterfly spread is best to use when you expect the underlying assets to trade in a
narrow range as this strategy benefits from time decay factor. Also, when the implied volatility
of the underlying assets increases unexpectedly and you expect volatility to come down, then
you can apply Short Iron Butterfly strategy.

How to construct a Short Iron Butterfly?

A Short Iron Butterfly can be created by selling 1 ATM call, buying 1 OTM call, selling 1 ATM
put and buying 1 OTM put of the same underlying security with the same expiry. Strike price can
be customized as per the convenience of the trader; however, the upper and lower strike must be
equidistant from the middle strike.

Strategy Sell 1 ATM Call, Buy 1 OTM Call, Sell 1 ATM Put and Buy 1 OTM Put

Market Outlook Neutral on market direction & Bearish on volatility

Motive Earn from time value with limited risk

Upper Breakeven Short Option (Middle) Strike price + Net Premium Received

Lower Breakeven Short Option (Middle) Strike price - Net Premium Received

Risk Limited

Reward Limited to premium received

Margin required Yes

Let’s try to understand with an example:

Nifty Current spot price (Rs) 9200

Sell 1 ATM Call of strike price (Rs) 9200

Premium received (Rs) 70

 Buy 1 OTM Call of strike price (Rs) 9300

Premium paid (Rs) 30

Sell 1 ATM Put of strike price (Rs) 9200

Premium received (Rs) 105

Buy 1 OTM Put of strike price (Rs) 9100

Premium paid (Rs) 65

Upper breakeven 9280

Lower breakeven 9120

Lot Size 75

Net Premium Received (Rs) 80

Suppose Nifty is trading at 9200. An investor, Mr. A thinks that Nifty will not rise or fall much
by expiration, so he enters a Short Iron Butterfly by selling a 9200 call strike price at Rs.70,
buying 9300 call for Rs.30 and simultaneously selling 9200 put for Rs.105, buying 9100 put for
Rs.65. The net premium received to initiate this trade is Rs.80, which is also the maximum
possible gain. This strategy is initiated with a neutral view on Nifty hence it will give the
maximum profit only when the underlying assets expire at middle strike. The maximum profit
from the above example would be Rs.6,000 (80*75). The maximum loss will also be limited to
Rs.1,500 (20*75), if it breaks the upper and lower break-even points. Another way by which this
strategy can give profit is when there is a decrease in implied volatility.

For the ease of understanding, we did not take into account commission charges. Following is
the payoff chart and payoff schedule assuming different scenarios of expiry.
The Payoff chart:

The Payoff Schedule:

On Expiry Net Payoff from 1 Net Payoff from 1 Net Payoff from 1 Net Payoff from 1 Net
NIFTY closes ITM Call Bought OTM Call Sold (Rs) ATM Put bought OTM Put sold (Rs.) Payoff
at (Rs) 9200 9300 (Rs) 9200 9100 (Rs)

8800 70 -30 -295 235 -20

8900 70 -30 -195 135 -20

9000 70 -30 -95 35 -20

9100 70 -30 5 -65 -20

9120 70 -30 25 -65 0

9200 70 -30 105 -65 80

9280 -10 -30 105 -65 0

9300 -30 -30 105 -65 -20

9400 -130 70 105 -65 -20

9500 -230 170 105 -65 -20

9600 -330 270 105 -65 -20

Impact of Options Greeks before expiry:

Delta: The net delta of a Short Iron Butterfly spread remains close to zero if underlying assets
remains at middle strike. Delta will move towards -1 if the underlying assets expire above the
higher strike price and Delta will move towards 1 if the underlying assets expire below the lower
strike price.

Vega: Short Iron Butterfly has a negative Vega. Therefore, one should initiate Short Iron
Butterfly spread when the volatility is high and is expected to fall.

Theta: With the passage of time, if other factors remain the same, Theta will have a positive
impact on the strategy.

Gamma: This strategy will have a short Gamma position, so the change in underline asset will
have a negative impact on the strategy.

How to manage Risk?

A Short Iron Butterfly is exposed to limited risk compared to reward, so carrying overnight
position is advisable.

Analysis of Short Iron Butterfly strategy:

A Short Iron Butterfly spread is best to use when you are confident that an underlying security
will not move significantly and will stay in a range. Downside risk is limited to the net premium
received, and upside reward is also limited but higher than the risk involved. It provides a good
reward to risk ratio.
Long Call Condor Options Trading Strategy
Long Call Condor options trading strategy

A Long Call Condor is similar to a Long Butterfly strategy, wherein the only exception is that
the difference of two middle strikes sold has separate strikes. The maximum profit from condor
strategy may be low as compared to other trading strategies; however, a condor strategy has high
probability of making money because of wider profit range.

When to initiate a Long Call Condor

A Long Call Condor spread should be initiated when you expect the underlying assets to trade in
a narrow range as this strategy benefits from time decay factor.

How to construct a Long Call Condor?

A Long Call Condor can be created by buying 1 lower ITM call, selling 1 lower middle ITM
call, selling 1 higher middle OTM call and buying 1 higher OTM calls of the same underlying
security with the same expiry. The ITM and OTM call strikes should be equidistant.

Strategy Buy 1 ITM Call, Sell 1 ITM Call, Sell 1 OTM Call and Buy 1 OTM Call

Market Outlook Neutral on market direction and Bearish on volatility

Motive Anticipating minimal price movement in the underlying assets

Upper Breakeven Higher Strike price - Net Premium Paid

Lower Breakeven Lower Strike price + Net Premium Paid

Ris> Limited to Net premium paid

Reward Limited (Maximum profit is achieved when underlying expires between sold strikes)

Margin required Yes

Let’s try to understand with an example:

Nifty Current spot price 9100

Buy 1 deep ITM call of strike price (Rs) 8900

Premium paid (Rs) 240

 Sell 1 ITM call of strike price (Rs) 9000

Premium received (Rs) 150

Sell 1 OTM call of strike price (Rs) 9200

Premium received (Rs) 40

Buy 1 deep OTM call of strike price (Rs) 9300

Premium paid (Rs) 10

Upper breakeven 9240

Lower breakeven 8960

Lot size 75

Net premium paid 60

Suppose Nifty is trading at 9100. An investor Mr. A estimates that Nifty will not rise or fall
much by expiration, so he enters a Long Call Condor and buys 8900 call strike price at Rs.240,
sells 9000 strike price of Rs.150, sells 9200 strike price for Rs 40 and buys 9300 call for Rs.10.
The net premium paid to initiate this trade is Rs.60, which is also the maximum possible loss.
This strategy is initiated with a neutral view on Nifty hence it will give the maximum profit only
when there is little or no movement in the underlying security. Maximum profit from the above
example would be Rs.3000 (40*75). The maximum profit would only occur when underlying
assets expires in the range of strikes sold.

In the mentioned scenario, maximum loss would be limited up to Rs.4500 (60*75) and it will
occur if the underlying assets goes below 8960 or above 9240 strikes at expiration. If the
underlying assets expires at the lowest strike then all the options will expire worthless, and the
debit paid to initiate the position would be lost. If the underlying assets expire at highest strike,
all the options below the highest strike would be In-the-Money. Furthermore, the resulting profit
and loss would offset and net premium paid would be lost.

For the ease of understanding of the payoff schedule, we did not take in to account commission
charges. Following is the payoff schedule assuming different scenarios of expiry.

The Payoff Schedule:

On Expiry Net Payoff from 1 Net Payoff from Net Payoff from 1 Net Payoff from 1 Net
NIFTY Deep ITM Call 1 ITM Call sold OTM Call sold deep OTM call Payoff
closes at bought (Rs) 8900 (Rs) 9000 (Rs) 9200 bought (Rs) 9300 (Rs)
8600 -240 150 40 -10 -60

8700 -240 150 40 -10 -60

8800 -240 150 40 -10 -60

8900 -240 150 40 -10 -60

8960 -180 150 40 -10 0

9000 -140 150 40 -10 40

9100 -40 50 40 -10 40

9200 60 -50 40 -10 40

9240 100 -90 0 -10 0

9300 160 -150 -60 -10 -60

9400 260 -250 -160 90 -60

9500 360 -350 -260 190 -60

9600 460 -450 -360 290 -60

The Payoff Graph:

Impact of Options Greeks before expiry:

Delta: If the underlying asset remains between the lowest and highest strike price the net Delta
of a Long Call Condor spread remains close to zero.

Vega: Long Call Condor has a negative Vega. Therefore, one should initiate Long Call Condor
spread when the volatility is high and expect to decline.

Theta: A Long Call Condor has a net positive Theta, which means strategy will benefit from the
erosion of time value.

Gamma: The Gamma of a Long Call Condor strategy goes to lowest values if it stays between
sold strikes, and goes higher if it moves away from middle strikes.

Analysis of Long Call Condor spread strategy

A Long Call Condor spread is best to use when you are confident that an underlying security will
not move significantly and stays in a range of strikes sold. Long Call Condor has a wider sweet
spot than the Long Call Butterfly. But there is a tradeoff; this is a limited reward to risk ratio
strategy for advance traders.

Long Call Calendar Spread

A Long Call Calendar Spread is initiated by selling one call option and simultaneously buying a
second call option of the same strike price of underlying assets with a different expiry. It is also
known as Time Spread or Horizontal Spread. The purpose of this strategy is to gain from Theta
with limited risk, as the Time Decay of the near period expiry will be faster as compared to the
far period expiry. As the near period option expires, far month call option would still have some
premium in it, so the option trader can either own the far period call or square off both the
positions at same time on near period expiry.

When to initiate a Long Call Calendar Spread?

A Long Call Calendar Spread can be initiated when you are very confident that the security will
remain neutral or bearish in near period and bullish in longer period expiry. This strategy can
also be used by advanced traders to make quick returns when the near period implied volatility
goes abnormally high as compared to the far period expiry and is expected to cool down. After
buying a Long Calendar Spread, the idea is to wait for the implied volatility of near period expiry
to drop. Inversely, this strategy can lead to losses in case the implied volatility of near period
expiry contract rises even if the stock price remains at same level.

How to construct a Long Call Calendar Spread?

A Long Call Calendar Spread is implemented by selling near month at-the-money/out-the-money

call option and simultaneously buying far month at-the-money/out-the-money call option of the
same underlying assets.

Strategy Buy far month ATM/OTM call and sell near month ATM/OTM call.

Market
Neutral to positive movement.
Outlook

Motive Hopes to reduce the cost of buying far month call option.

Risk Limited to the difference between the premiums.

Limited if both the positions squared off at near period expiry. Unlimited if far period call
Reward
option hold till next expiry.

Margin
Yes
required
Let’s try to understand with an example:
Nifty Current spot price 9000

Sell near month ATM call strike price Rs. 9000

Premium received (per share) Rs. 180

Buy far month ATM call strike price Rs. 9000

Premium paid (per share) Rs. 250

Lot size (in units) 75

Suppose Nifty is trading at 8800. An investor, Mr. A is expecting no significant movement in

near month contract, so he enters a Long Call Calendar Spread by selling near month strike price
of 9000 call at Rs.180 and bought 9000 call for Rs.250. The net upfront premium paid to initiate
this trade is Rs.70, which is also the maximum possible loss. The idea is to wait for near month
call option to expire worthless by squaring off both the positions in near month expiry contract or
reduce the cost of far month buy call by setting off the profit made from the near month call
option. Another way by which this strategy can be profitable is when the implied volatility of the
near month falls.

For the ease of understanding, we did not take into account commission charges. Following is
the payoff chart of the expiry.
The Payoff Schedule on near period expiry date:
Near period expiry if Net Payoff from near Theoretical Payoff from far Net Payoff at near
NIFTY closes at period Call sold (Rs.) period call Buy (Rs.) period expiry (Rs.)

8700 180 -190 -10

8800 180 -160 20

8900 180 -120 60

9000 180 -70 110

9100 80 -10 70

9200 -20 +60 40

9300 -120 140 20

9400 -220 230 10

9500 -320 330 10

Following is the payoff schedule till far expiry, where maximum loss would be limited up to 320
Rs (250+70), Rs.70 is from near expiry and Rs.250 is the premium of far month call bought.
Maximum profit would be unlimited since far month call bought will have unlimited upside
potential.

Net Combined Payoff Schedule on next period expiry date:

NIFTY closing price on Near Theoretical Payoff from far Net Payoff at near Net Payoff at Far
and Far period expiry period call Buy (Rs.) period expiry (Rs.) period expiry (Rs.)

8700 -250 -10 -260

8800 -250 20 -230

8900 -250 60 -190

9000 -250 110 -140

9100 -150 70 -80

9200 -50 40 -10

9300 50 20 70

9400 150 10 160

9500 250 10 260

The Payoff Graph

Impact of option Greeks:

Delta: The net Delta of a Long Call Calendar will be close to zero or marginally positive. The
negative Delta of the near month short call option will be offset by positive Delta of the far
month long call option.

Vega: A Long Call Calendar has a positive Vega. Therefore, one should buy spreads when the
volatility of far period expiry contract is expected to rise.
Theta: With the passage of time, if other factors remain same, Theta will have a positive impact
on the Long Call Calendar Spread in near period contract, because option premium will erode as
the near period expiration dates draws nearer.

Gamma: Gamma estimates how much the Delta of a position changes as the stock prices
changes. The near month option has a higher Gamma. Gamma of the Long Call Calendar Spread
position will be negative till near period expiry, as we are short on near period options and any
major upside movement till near period expiry will affect the profitability of the spreads.

How to manage risk?

A Long Call Calendar spread is exposed to limited risk up to the difference between the
premiums, so carrying overnight position is advisable but one can keep stop loss on the
underlying assets to further limit losses.

Analysis of Long Call Calendar Spread strategy

A Long Call Calendar Spread is the combination of short call and long call option with different
expiry. It mainly profits from Theta i.e. Time Decay factor of near period expiry, if the price of
the security remains relatively stable in near period. Once the near period option has expired, the
strategy becomes simply long call, whose profit potential is unlimited.

Volatility Option Strategies

Volatility Option Strategies are made use by traders when they expect huge swing in the price of
the underlying asset in either direction. The trader tends to bet on the surge in volatility rather
than the trend. Following are the most popular strategies that can be used when the volatility is
expected to spike in the underlying asset.

 Long Strangle Strategy

 Long straddle Strategy
 Short Put Ladder Strategy
 Short Call Ladder Strategy
 Long Iron Butterfly Strategy
 Short Call Condor Strategy
 Short Call Butterfly Strategy

How to make Profit in a Volatile Market at low cost - Long

Strangle Option Strategy
A Long Strangle strategy is one of the simplest trading strategies, which can be used to make
profit in an extremely volatile market. A Long Strangle is a slight modification of the Long
Straddle strategy and also cheaper to execute as both the calls and puts are Out-the-Money. It can
generate good returns when the price of an underlying security moves significantly in either
direction. It means that you don’t have to forecast the trend of the market, but you have to bet on
the volatility.

When to initiate a Long Strangle?

If you believe that an underlying security is going to make a move because of any events, such as
budget, monetary policy, earning announcements etc, then you can buy OTM call and OTM put
option. This strategy is known as Long Strangle.

How to construct a Long Strangle Option strategy?

Long Strangle is implemented by buying Out-the-Money call option and simultaneously buying
Out-the-Money put option of the same underlying security with the same expiry. Strike price can
be customized as per convenience of the trader but the call and put strikes must be equidistant
from the spot price.

Strategy Buy OTM Call and Buy OTM Put

Market Outlook Significant volatility in underlying movement

Motive Capture a quick increase in implied volatility/ big move in underlying assets

Upper Breakeven Strike price of Long call + Net Premium Paid

Lower Breakeven Strike price of Long put - Net Premium Paid

Risk Limited to Net premium paid

Reward Unlimited

Margin required Limited to the premium paid

Let's try to understand with an example:

Nifty Current spot price Rs 8800

Buy OTM Call Strike Price Rs 9000

Premium Paid (per share) Rs 40

BUY OTM Put Strike price Rs 8600

Premium Paid (per share) Rs 30

 Upper breakeven 9070

Lower breakeven 8530

Lot Size 75

Suppose, Nifty is trading at 8800. An investor Mr A is expecting a significant movement in the

market, so he enters a Long Strangle by buying 9000 call strike at Rs 40 and 8600 put for Rs 30.
The net premium paid to initiate this trade is Rs 70, which is also the maximum possible loss.
Since this strategy is initiated with a view of significant movement in the underlying security, it
will give the maximum loss only when there is very little or no movement in the underlying
security, which comes around Rs 70 in the above example. Maximum profit will be unlimited if
it breaks the upper and lower break-even points. Another way by which this strategy can give
profit is when there is an increase in implied volatility. Higher implied volatility can increase
both call and put’s premium.

For the ease of understanding, we did not take in to account commission charges. Following is
the payoff schedule assuming different scenarios of expiry.

The Payoff Schedule:

On Expiry NIFTY closes at Net Payoff from Call Buy (Rs) Net Payoff from Put Buy (Rs) Net Payoff (Rs)

8300 -40 270 230

8400 -40 170 130

8500 -40 70 30

8530 -40 40 0

8600 -40 -30 -70

8700 -40 -30 -70

8800 -40 -30 -70

8900 -40 -30 -70

9000 -40 -30 -70

9070 30 -30 0

9100 60 -30 30
9200 160 -30 130

9300 260 -30 230

Impact of Option Greeks:

Delta: The net delta of a Long Strangle remains close to zero. The positive delta of the call and
negative delta of the put are nearly offset by each other.

Vega: A Long Strangle has a positive Vega. Therefore, one should buy Long Strangle spreads
when the volatility is low and expect it to rise.

Theta: With the passage of time, if other factors remain same, Theta will have a negative impact
on the strategy, because option premium will erode as the expiration dates draws nearer.

Gamma: Gamma estimates how much Delta of a position changes as the stock prices changes.
Gamma of the Long Strangle position will be positive since we have created long positions in
options and any major movement on either side will benefit this strategy.
How to manage risk?

A Long Strangle is exposed to limited risk up to premium paid, so carrying overnight position is
advisable but one can keep stop loss to further limit losses.

Analysis of Long Strangle spread strategy

A Long Strangle spread strategy is best to use when you are confident that an underlying security
will move significantly in a very short period of time, but you are unable to predict the direction
of the movement. Maximum loss is limited to debit paid and it will occur if the underlying stocks
remain between the two buying strike prices, whereas upside reward is unlimited.

How Long Straddle Option Trading Strategy can be used for

making profits in a volatile market?
A Long Straddle Options Trading is one of the simplest options trading strategy which involves a
combination of buying a call and buying a put, both with the same strike price and expiration.
Long Straddle option strategy can be used to make profit in a volatile market. It can generate
good returns when the price of an underlying security moves significantly in either direction. It
means that you don’t have to forecast the trend of the market, but you have to bet on the
volatility.

When should you initiate a Long Straddle Option Trading?

If you believe that an underlying security is going to make a move because of events such as
budget, monetary policy, earning announcements, etc., and also implied volatility should be at
normal or at below average level, then you can buy call & put option. This strategy is known as
long straddle trading.

How should you construct a Long Straddle Option Strategy?

Long straddle options strategy is implemented by buying at-the-money call option and
simultaneously buying at-the-money put option of the same underlying security with the same
expiry.

Strategy Buy ATM Call and Buy ATM Put

Market Outlook Significant volatility in underlying movement

Upper Breakeven Strike price of buy call + Net Premium Paid

Lower Breakeven Strike price of long put - Net Premium Paid

Risk Limited to Net premium paid

 Reward Unlimited

Margin required No

Let’s try to understand this with an example:

Nifty Current spot price Buy ITM/ATM Call+ Sell OTM Call

Buy ATM Call & Put (Strike Price) Rs. 8800

Premium Paid (per share) Call Rs. 80

Premium Paid (per share) Put Rs. 90

Upper breakeven Rs. 8970

Lower breakeven Rs. 8630

Lot Size (in units) 75

Suppose, Nifty is trading at 8800. An investor, Mr. A is expecting a significant movement in the
market, so he enters a long straddle by buying a FEB 8800 call strike at Rs. 80 and FEB 8800 put
for Rs. 90. The net premium paid to initiate this trade is Rs. 170, which is also the maximum
possible loss. Since this strategy is initiated with a view of significant movement in the
underlying security, it will give the maximum loss only when there is no movement in the
underlying security, which comes around Rs. 170 in the above example. The maximum profit
will be unlimited if it breaks the upper and lower break-even points. Another way by which this
options trading strategy can give profit is when there is an increase in implied volatility. Higher
implied volatility can increase both call and put’s premium.

For the ease of understanding, we did not take into account commission charges. Following is
the payoff schedule assuming different scenarios of expiry.

The Payoff Schedule:

On Expiry NIFTY closes at Net Payoff from Call Buy (Rs) Net Payoff from Put Buy (Rs) Net Payoff (Rs)

8300 -40 270 230

8400 -40 170 130

8500 -40 70 30
8530 -40 40 0

8600 -40 -30 -70

8700 -40 -30 -70

8800 -40 -30 -70

8900 -40 -30 -70

9000 -40 -30 -70

9070 30 -30 0

9100 60 -30 30

9200 160 -30 130

9300 260 -30 230

Analysis of Long Straddle Options Trading Spread Strategy

A Long Straddle Spread Strategy is best to use when you are confident that an underlying
security will move significantly in a very short period of time, but you are unable to predict the
direction of the movement. Downside loss is also limited to net debit paid, whereas upside
reward is unlimited.

Short Put Ladder Strategy Explained

Short Put Ladder Strategy

A Short Put Ladder is the extension of Bull Put spread; the only difference is of an additional
lower strike bought. The purpose of buying the additional strike is to get unlimited reward if the
underlying asset goes down.
When to initiate a Short Put Ladder

A Short Put Ladder should be initiated when you are expecting big movement in the underlying
asset, favoring downside movement. Profit potential will be unlimited when the stock breaks
lower strike price. Also, another opportunity is when the implied volatility of the underlying
asset falls unexpectedly and you expect volatility to go up then you can apply Short Put Ladder
strategy.

How to construct Short Put Ladder?

A Short Put Ladder can be created by selling 1 ITM Put, buying 1 ATM Put and buying 1 OTM
Put of the same underlying asset with the same expiry. Strike price can be customized as per the
convenience of the trader. A trader can also initiate the Short Put Ladder strategy in the
following way - Sell 1 ATM Put, Buy 1 OTM Put and Buy 1 Far OTM Put.

Strategy Sell 1 ITM Put, Buy 1 ATM Put and Buy 1 OTM Put

Market
Significant movement (lower side)
Outlook

Upper
Strike price of Short Put - Net Premium Received
Breakeven

Lower
Addition of two Long Put strikes - Strike Price of Short Put + Net Premium Received
Breakeven

Risk Limited (expiry between upper and lower breakeven).

Limited to premium received if stock surges above higher breakeven Unlimited if stock
Reward
falls below lower breakeven.

Margin
Yes
required

Let's try to understand with an example:

Nifty Current spot price (Rs) 9400

Sell 1 ITM Put of strike price (Rs) 9500

Premium received (Rs) 180

Buy 1 ATM Put of strike price (Rs) 9400

 Premium paid (Rs) 105

Buy 1 OTM Put of strike price (Rs) 9300

Premium paid (Rs) 45

Upper breakeven 9470

Lower breakeven 9230

Lot Size 75

Net Premium Received (Rs) 30

Suppose Nifty is trading at 9400. An investor Mr. A is expecting a significant movement in the
Nifty with a slightly more bearish view, so he enters a Short Put Ladder by selling 9500 Put
strike price at Rs 180, buying 9400 strike price at Rs 105 and buying 9300 Put for Rs 45. The net
premium received to initiate this trade is Rs 30. Maximum loss from the above example would
be Rs 5250 (70*75). It would only occur when the underlying asset expires in the range of strikes
bought. Maximum profit would be unlimited if it breaks lower breakeven point. However, profit
would be limited up to Rs 2250(30*75) if it moves above the higher breakeven point.

For the ease of understanding, we did not take in to account commission charges. Following is
the payoff chart and payoff schedule assuming different scenarios of expiry.

The Payoff chart:

The Payoff Schedule:
On Expiry Payoff from 1 ITM Put Payoff from 1 ATM Puts Payoff from 1 OTM Put Net Payoff
NIFTY closes at sold (9500) (Rs) Bought (9400) (Rs) Bought (9300) (Rs) (Rs)

8700 -620 595 555 530

8800 -520 495 455 430

8900 -420 395 355 330

9000 -320 295 255 230

9100 -220 195 155 130

9200 -120 95 55 30

9230 -90 65 25 0

9300 -20 -5 -45 -70

9400 80 -105 -45 -70

9470 150 -105 -45 0

9500 180 -105 -45 30

9600 180 -105 -45 30

9700 180 -105 -45 30

9800 180 -105 -45 30

Impact of Options Greeks:

Delta: At the initiation of trade, Delta of the Short Put Ladder will be negative, indicating of a
decent profit potential if the underlying asset moves lower.

Vega: Short Put Ladder has a positive Vega. Therefore, one should initiate Short Put Ladder
spread when the volatility is low and expects it to rise.

Theta: A Short Put Ladder has negative Theta position and therefore it will lose value due to
time decay as the expiration approaches.
Gamma: This strategy will have a long Gamma position, which indicates any significant
downside movement, will lead to unlimited profit.

How to manage Risk?

A Short Put Ladder is exposed to limited loss; hence it is advisable to carry overnight positions.

Analysis of Short Put Ladder Strategy:

A Short Put Ladder is best to use when you are confident that an underlying security will move
significantly lower. Another scenario wherein this strategy can give profit is when there is a
surge in implied volatility. It is a limited risk and an unlimited reward strategy only if movement
comes on the lower side or else reward would also be limited.

Short Call Ladder Options Strategy

A Short Call Ladder is the extension of Bear Call spread; the only difference is of an additional
higher strike bought. The purpose of buying the additional strike is to get unlimited reward if the
underlying asset moves up.

When to initiate a Short Call Ladder?

A Short Call Ladder spread should be initiated when you are expecting big movement in the
underlying assets, favoring upside movement. Profit potential will be unlimited when the stock
breaks highest strike price. Also, another opportunity is when the implied volatility of the
underlying assets falls unexpectedly and you expect volatility to go up then you can apply Short
Call Ladder strategy.

How to construct a Short Call Ladder

A Short Call Ladder can be created by selling 1 ITM call, buying 1 ATM call and buying 1 OTM
call of the same underlying asset with the same expiry. Strike price can be customized as per the
convenience of the trader. A trader can also initiate the Short Call Ladder strategy in the
following way - Sell 1 ATM Call, Buy 1 OTM Call and Buy 1 Far OTM Call.

Strategy Sell 1 ITM Call, Buy 1 ATM Call and Buy 1 OTM Call

Market
Significant moment (higher side)
Outlook

Upper Higher Long call strike price + Strike difference between short call and lower long call -
Breakeven Net premium received

Lower Strike price of Short call + Net Premium Received

 Breakeven

Risk Limited (expiry between upper and lower breakeven).

Limited to premium received if stock falls below lower breakeven. Unlimited if stock
Reward
surges above higher breakeven.

Margin
Yes
required

Let's try to understand with an example:

Nifty Current spot price (Rs) 9100

Sell 1 ITM call of strike price (Rs) 9000

Premium received (Rs) 180

Buy 1 ATM call of strike price (Rs) 9100

Premium paid (Rs) 105

Buy 1 OTM call of strike price (Rs) 9200

Premium paid (Rs) 45

Upper breakeven 9270

Lower breakeven 9030

Lot Size 75

Net Premium Received (Rs) 30

Suppose Nifty is trading at 9100. An investor Mr. A is expecting a significant movement in the
Nifty with slightly more bullish view, so he enters a Short Call Ladder by selling 9000 call strike
price at Rs 180, buying 9100 strike price at Rs 105 and buying 9200 call for Rs 45. The net
premium received to initiate this trade is Rs 30. Maximum loss from the above example would
be Rs 5250 (70*75). It would only occur when the underlying assets expires in the range of
strikes bought. Maximum profit would be unlimited if it breaks higher breakeven point.
However, profit would be limited up to Rs 2250(30*75) if it drops below the lower breakeven
point.
For the ease of understanding, we did not take in to account commission charges. Following is
the payoff chart and payoff schedule assuming different scenarios of expiry.

The Payoff chart:

The Payoff Schedule:

On Expiry Payoff from 1 ITM Call Payoff from 1 ATM Calls Payoff from 1 OTM Call Net Payoff
NIFTY closes at sold (9000) (Rs) Bought (9100) (Rs) Bought (9200) (Rs) (Rs)

8600 180 -105 -45 30

8700 180 -105 -45 30

8800 180 -105 -45 30

8900 180 -105 -45 30

9000 180 -105 -45 30

9030 180 -105 -45 0

9100 80 -105 -45 70

9200 -20 -5 -45 -70

9270 -90 65 25 0

9300 -120 95 55 30

9400 -220 195 155 130

9500 -320 295 255 230

9600 -420 395 355 330

9700 -520 495 455 430

9800 -620 595 555 530

Impact of Options Greeks:

Delta: At the initiation of the trade, Delta of short call condor will be negative and it will turn
positive when the underlying asset moves higher.

Vega: Short Call Ladder has a positive Vega. Therefore, one should initiate Short Call Ladder
spread when the volatility is low and expects it to rise.

Theta: A Short Call Ladder has negative Theta position and therefore it will lose value due to
time decay as the expiration approaches.

Gamma: This strategy will have a long Gamma position, which indicates any significant upside
movement, will lead to unlimited profit.
How to manage Risk?

A Short Call Ladder is exposed to limited loss; hence it is advisable to carry overnight positions.
However, one can keep stop Loss in order to restrict losses.

Analysis of Short Call Ladder Options strategy:

A Short Call Ladder spread is best to use when you are confident that an underlying security will
move significantly. Another scenario wherein this strategy can give profit is when there is a
surge in implied volatility. It is a limited risk and an unlimited reward strategy if movement
comes on the higher side.

Long Iron Butterfly Options Strategy

A Long Iron Butterfly is implemented when an investor is expecting volatility in the underlying
assets. This strategy is initiated to capture the movement outside the wings of options at
expiration. It is a limited risk and a limited reward strategy. A Long Iron Butterfly could also be
considered as a combination of bull call spread and bear put spread.

When to initiate a Long Iron Butterfly

A Long Iron Butterfly spread is best to use when you expect the underlying assets to move
sharply higher or lower but you are uncertain about direction. Also, when the implied volatility
of the underlying assets falls unexpectedly and you expect volatility to shoot up, then you can
apply Long Iron Butterfly strategy.

How to construct a Long Iron Butterfly?

A Long Iron Butterfly can be created by buying 1 ATM call, Selling 1 OTM call, buying 1 ATM
put and selling 1 OTM put of the same underlying security with the same expiry. Strike price can
be customized as per the convenience of the trader; however, the upper and lower strike must be
equidistant from the middle strike.

Strategy Buy 1 ATM Call, Sell 1 OTM Call, Buy 1 ATM Put and Sell 1 OTM Put

Market Outlook Movement above the highest or lowest strike

Motive Profit from movement in either direction

Upper Breakeven Long Option (Middle) Strike price + Net Premium Paid

Lower Breakeven Long Option (Middle) Strike price - Net Premium Paid

Risk Limited to Net Premium Paid

 Reward Higher strike-middle strike-net premium paid

Margin required Yes

Let’s try to understand with an example:

Nifty Current spot price (Rs) 9200

Buy 1 ATM call of strike price (Rs) 9200

Premium paid (Rs) 70

Sell 1 OTM call of strike price (Rs) 9300

Premium received (Rs) 30

Buy 1 ATM put of strike price (Rs) 9200

Premium paid (Rs) 105

Sell 1 OTM put of strike price (Rs) 9100

Premium received (Rs) 65

Upper breakeven 9280

Lower breakeven 9120

Lot Size 75

Net Premium Paid (Rs) 80

Suppose Nifty is trading at 9200. An investor Mr A thinks that Nifty will move drastically in
either direction, below lower strike or above higher strike by expiration. So he enters a Long Iron
Butterfly by buying a 9200 call strike price at Rs 70 , selling 9300 call for Rs 30 and
simultaneously buying 9200 put for Rs 105, selling 9100 put for Rs 65. The net premium paid to
initiate this trade is Rs 80, which is also the maximum possible loss.

This strategy is initiated with a view of movement in the underlying security outside the wings of
higher and lower strike price in Nifty. Maximum profit from the above example would be Rs
1500 (20*75). Maximum loss will also be limited up to Rs 6000 (80*75).

For the ease of understanding of the payoff, we did not take in to account commission charges.
Following is the payoff chart and payoff schedule assuming different scenarios of expiry.
The Payoff chart:

The Payoff Schedule:

On Expiry Net Payoff from 1 Net Payoff from 1 Net Payoff from 1 Net Payoff from 1 Net
NIFTY closes ITM Call Bought OTM Call Sold (Rs) ATM Put bought OTM Put sold (Rs.) Payoff
at (Rs) 9200 9300 (Rs) 9200 9100 (Rs)

8800 -70 30 295 -235 20

8900 -70 30 195 -135 20

9000 -70 30 95 -35 20

9100 -70 30 -5 65 20

9120 -70 30 -25 65 0

9200 -70 30 -105 65 -80

9280 10 30 -105 65 0

9300 30 30 -105 65 20

9400 130 -70 -105 65 20

9500 230 -170 -105 65 20

9600 330 -270 -105 65 20

Impact of Options Greeks before expiry:

Delta: The net Delta of a Long Iron Butterfly spread remains close to zero if underlying assets
remain at middle strike. Delta will move towards 1 if underlying expires above higher strike
price and Delta will move towards -1 if underlying expires below the lower strike price.

Vega: Long Iron Butterfly has a positive Vega. Therefore, one should buy Long Iron Butterfly
spread when the volatility is low and expect to rise.

Theta: With the passage of time, if other factors remain same, Theta will have a negative impact
on the strategy.

Gamma: This strategy will have a long Gamma position, so the change in underline assets will
have a positive impact on the strategy.

How to manage Risk?

A Long Iron Butterfly is exposed to limited risk but risk involved is higher than the net reward
from the strategy, one can keep stop loss to further limit the losses.

Analysis of Long Iron Butterfly strategy:

A Long Iron Butterfly spread is best to use when you are confident that an underlying security
will move significantly. Another way by which this strategy can give profit is when there is an
increase in implied volatility. However, this strategy should be used by advanced traders as the
risk to reward ratio is high.

Short Call Condor Options Trading Strategy

A Short Call Condor is similar to Short Butterfly strategy. The only exception is that the
difference of two middle strikes bought has different strikes.

When to initiate a Short call condor?

A Short Call Condor is implemented when the investor is expecting movement outside the range
of the highest and lowest strike price of the underlying assets. Advance traders can also
implement this strategy when the implied volatility of the underlying assets is low and you
expect volatility to go up.

How to construct a Short Call Condor?

A Short Call Condor can be created by selling 1 lower ITM call, buying 1 lower middle ITM
call, buying 1 higher middle OTM call and selling 1 higher OTM calls of the same underlying
security with the same expiry. The ITM and OTM call strikes should be equidistant.

Strategy Sell 1 ITM Call, Buy 1 ITM Call, Buy 1 OTM Call and Sell 1 OTM Call

Market Outlook Significant volatility above higher and lower strikes

Motive Anticipating price movement in the underlying assets

Upper Breakeven Highest strike price - Net credit

Lower Breakeven Lowest strike price + Net credit

Risk Limited (if expires above lower breakeven point and vice versa)

Reward Limited to Net premium received

Margin required Yes

Let’s try to understand with an example:

Nifty Current spot price 9100

Sell 1 ITM call of strike price (Rs) 8900

Premium received (Rs) 240

Buy 1 ITM call of strike price (Rs) 9000

Premium paid (Rs) 150

 Buy 1 OTM call of strike price (Rs) 9200

Premium paid (Rs) 40

Sell 1 OTM call of strike price (Rs) 9300

Premium received (Rs) 10

Upper breakeven 9240

Lower breakeven 8960

Lot Size 75

Net premium received 60

Suppose Nifty is trading at 9100. An investor Mr. A estimates that Nifty will move significantly
by expiration, so he enters a Short Call Condor and sells 8900 call strike price at Rs 240, buys
9000 strike price of Rs 150, buys 9200 strike price for Rs 40 and sells 9300 call for Rs 10. The
net premium received to initiate this trade is Rs 60, which is also the maximum possible reward.
This strategy is initiated with a view of significant volatility on Nifty hence it will give the
maximum profit only when there is movement in the underlying security below 8900 or above
9200. Maximum profit from the above example would be Rs 4500 (60*75). The maximum profit
would only occur when underlying assets expires outside the range of upper and lower
breakevens. Maximum loss would also be limited to Rs 3000 (40*75), if it stays in the range of
higher and lower breakeven.

For the ease of understanding of the payoff schedule, we did not take in to account commission
charges. Following is the payoff schedule assuming different scenarios of expiry.

The Payoff Schedule:

On Expiry Net Payoff from 1 Net Payoff from 1 Net Payoff from 1 Net Payoff from 1 Net
NIFTY Deep ITM Call Sold ITM Calls Bought OTM Call bought deep OTM Call sold Payoff
closes at (Rs) 8900 (Rs) 9000 (Rs) 9200 (Rs.) 9300 (Rs)

8600 240 -150 -40 10 60

8700 240 -150 -40 10 60

8800 240 -150 -40 10 60

8900 240 -150 -40 10 60

8960 180 -150 -40 10 0

9000 140 -150 -40 10 -40

9100 40 -50 -40 10 -40

9200 -60 -50 -40 10 -40

9240 -100 90 0 10 0

9300 -160 150 60 10 60

9400 -260 250 160 -90 60

9500 -360 350 260 -190 60

9600 -460 450 360 -290 60

The Payoff Graph:

Impact of Options Greeks before expiry:

Delta: If the underlying asset remains between the lowest and highest strike price the net Delta of
a Short Call Condor spread remains close to zero.

Vega: Short Call Condor has a positive Vega. Therefore, one should buy Short Call Condor
spread when the volatility is low and expect to rise.

Theta: Theta will have a negative impact on the strategy, because option premium will erode as
the expiration dates draws nearer.
Gamma: The Gamma of a Short Call Condor strategy goes to lowest if it moves above the
highest or below the lowest strike.

Analysis of Short Call Condor spread strategy

A Short Call Condor spread is best to use when you are confident that an underlying security will
move outside the range of lowest and highest strikes. Unlike straddle and strangles strategies risk
involved in short call condor is limited.

Short Call Butterfly Option Trading Strategy

A Short Call Butterfly is implemented when an investor is expecting volatility in the underlying
assets. This strategy is initiated to capture the movement outside the wings of the options at
expiration. It is a limited risk and a limited reward strategy.

When to initiate a Short Call Butterfly?

Short Call Butterfly can generate returns when the price of an underlying security moves
moderately in either direction. It means that you don’t have to forecast the trend of the market,
but you have to bet on volatility. When the implied volatility of the underlying assets is low and
you expect volatility to shoot up, then you can apply Short Butterfly Strategy.

How to construct a Short Call Butterfly?

A Short Call Butterfly can be created by selling 1 ITM call, buying 2 ATM call and selling 1
OTM call of the same underlying security with the same expiry, giving the trader a net credit to
enter the position. Strike price can be customized as per convenience of the trader but the upper
and lower strikes must be equidistant from the middle strike.

Strategy Sell 1 ITM Call, Buy 2 ATM Call and Sell 1 OTM Call

Market Outlook Movement on or above the sold strike price & Bullish on volatility

Motive Attempt to correctly predict the movement in underlying assets in either direction

Upper Breakeven Higher Strike price of short call Net Premium Received

Lower Breakeven Lower Strike price of short call + Net Premium Received

Risk Limited (Maximum loss only if expires at middle strike)

Reward Limited to Net premium received

Margin required Yes

Let’s try to understand with an Example:
Nifty Current spot price (Rs) 8800

Sell 1 ITM call of strike price (Rs) 8700

Premium received (Rs) 210

Buy 2 ATM call of strike price (Rs) 8800

Premium paid (Rs) 300(150*2)

Sell 1 OTM call of strike price (Rs) 8900

Premium received (Rs) 105

Upper breakeven 8885

Lower breakeven 8715

Lot Size 75

Net premium received (Rs) 15

Suppose Nifty is trading at 8800. An investor Mr A enters a Short Call Butterfly by selling 8700
call strike price at Rs 210 and 8900 call for Rs 105 and simultaneously bought 2 ATM call strike
price of 8800 150 each. The net premium received to initiate this trade is Rs 15, which is also the
maximum possible reward. This strategy is initiated with a view of moderate movement in Nifty
hence it will give the maximum profit only when there is movement in the underlying security
either below lower sold strike or above upper sold strike. Maximum loss from the above example
would be Rs 6375 (85*75) if it expires at middle strike. The maximum profit would only occur
when underlying assets expires below 8700 or above 8900 i.e. Rs 1125 (15*75). Another way by
which this strategy can give profit is when there is an increase in an implied volatility. For the
ease of understanding, we did not take in to account commission charges. Following is the
payoff chart and payoff schedule assuming different scenarios of expiry.
The Payoff Chart:

The Payoff Schedule:

On Expiry NIFTY Net Payoff from 1 ITM Net Payoff from 2 ATM Net Payoff from 1 OTM Net Payoff
closes at Call Bought (Rs.) Calls Sold (Rs.) Call Bought (Rs.) (Rs.)

8200 210 -300 105 15

8300 210 -300 105 15

8400 210 -300 105 15

8500 210 -300 105 15

8600 210 -300 105 15

8700 210 -300 105 15

8715 195 -300 105 0

8800 110 -300 105 -85

8885 25 -130 105 0

8900 10 -100 105 15

9000 -90 100 5 15

9100 -190 300 -95 15

9200 -290 500 -195 15

9300 -390 700 -295 15

9400 -490 900 -395 15

Impact of Options Greeks before expiry:

Delta: The net delta of a Short Call Butterfly spread remains close to zero.

Vega: The Short Call Butterfly has a positive Vega. Therefore, one should buy Short Call
Butterfly spread when the volatility is low and expect to rise.

Theta: With the passage of time, if other factors remain same, “Theta” will have a negative
impact on the strategy, because option premium will erode as the expiration dates draws nearer.

Gamma: The Short Call Butterfly will have a short gamma when it is initiated.

How to manage risk?

A Short Call Butterfly requires experience in trading, because as expiration approaches small
movement in underlying stock price can have a higher impact on the price of a Short Call
Butterfly spread. Therefore, one should always follow strict stop loss in order to restrict losses.

Analysis of Short Call Butterfly spread strategy

A Short Call Butterfly spread is best to use when you are confident that an underlying security
will move in either direction. This is a limited reward to risk ratio strategy for advance traders.

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Chapter 10 Futures Pricing Formula

How is the price of a stock determined in the futures market?

A futures contract is nothing more than a standardized forwards contract. The price of a futures
contract is determined by the spot price of the underlying asset, adjusted for time and dividend
accrued till the expiry of the contract.

When the futures contract is initially agreed to, the net present value must be equal for both the
buyer and the seller else there would be no consensus between the two.

This difference in price between the futures price and the spot price is called the “basis or
spread”.
The futures pricing formula is used to determine the price of the futures contract and it is the
main reason for the difference in price between the spot and the futures market. The spread
between the two is the maximum at the start of the series and tends to converge as the settlement
date approaches. The price of the futures contract and its underlying asset must necessarily
converge on the expiry date.

The spot future parity i.e. difference between the spot and futures price arises due to variables
such as interest rates, dividends, time to expiry, etc. It is a mathematical expression to equate the
underlying price and its corresponding futures price.

According to the futures pricing formula:

Futures price = (Spot Price*(1+rf))- Div)
Where,
Spot Price is the price of the stock in the cash market.
rf = Risk free rate (T Bill/ Government securities)
d – Dividend paid by the company

A key point to take note of is ‘r’ is the risk free interest that we can earn for the entire year but
since the future contracts expires in 1, 2 or 3 months, we require to adjust the formula
proportionately.

Futures price = Spot price * [1+ rf*(x/365) – d]

x = number of days to expiry

One can take the RBI’s 91 or 182 days Treasury bill as a proxy for the short term risk free rate.
The ongoing rate can be referred from RBI’s website. The prevailing rate in the market for 91
and 182 day t bill is ~6.68% and ~6.92% respectively.

Fair Value vs. Futures Price

Sometimes we observe that there is a difference in price between the value calculated through
the futures pricing formula (fair value) and value trade in the market (futures price). The futures
price may be different from the fair value due to the short term influences of supply and demand
for the futures contract. A large deviation between the two could result in an arbitrage
opportunity assuming that the futures price will eventually revert back to the fair value.

Let us consider a practical example to understand the concept better.

We will calculate the futures price of ITC through the pricing formula and compare it with the
current futures price in the market.

The spot price of ITC is 302.55 as of 9/8/2018

The stock has not declared any dividend in the current August series.
August series expiry is on 30th i.e last Thursday of the month.

There are 22 days for expiry 30-9 (taking both the days into consideration)

What should ITC’s current month futures contract be priced at?

Futures price = 302.55* [1+6.68 %( 22/365)] – 0

Futures price =303.7

Solving the above equation, we obtain the futures price of 303.7, which is called its fair value.
However, the actual price in the market, of ITC Aug Futures is 303.5, which is called its market
price.

The price difference between the fair value and prevailing market price occurs due to supply
/demand, liquidity as well as factors such as transaction charges, taxes and margins. But on most
occasions, the theoretical future price would match the market price.

Similarly, we could determine the future price for the mid month and far month contracts.
Mid month calculation (September series)

Spot Price =302.65

Div =0

Days to expiry =22+28 (22 days of Aug series +28 days of Sep series)

Futures Price = 302.65 * [1+ 6.68%( 50/365)] – 0

= 305.4

Far month calculation (October series)

Spot Price =302.65

Div =0

Days to expiry =22+28 +28 (22 days of Aug series +28 days of Sep series+28 days of
October Series)
Futures price = 302.65 * [1+ 6.68%( 78/365)] – 0>

= 307.04

There is a difference of Rs. 2.66 between the fair value and the market price. This is due to the
low liquidity that is present. There are hardly any contracts of ITC October Futures which are
traded in the market, hence the premium.

Premium /Discount

If the price of the security is trading higher in the futures market vs. spot price (which is usually
the case) then the futures price is said to be at a premium. While it is said to be trading at a
discount if the futures price is less vs. the spot price. We will now see how a trader can benefit if
there is a major difference in the price of security in the cash and futures market.

Arbitrage

An arbitrage is known as simultaneous buying and selling of securities, currency, or

commodities in different markets or in derivative forms in order to take advantage of differing
prices for the same asset.
Here we will see how arbitrage strategies can be made use of when there is a difference in price
between the spot market and the futures market.

It is considered a riskless strategy as the gains are locked right at the start and thereafter, it does
not matter in which direction the asset moves.

Consider a scenario where Infosys -

Spot = 1380
Rf – 6.68%
Days to expiry (x) = 22
div = 0
Having this information we calculate the future price using the mathematical formula as earlier
Futures price = 1380*(1+6.68 %( 22/365)) – 0
= 1385.55
This is nearly the rate at which it is trading in the futures market at present

But what if Infosys Aug Futures is trading at 1410 drastically deviating from its theoretical price.

According to the formula there should ideally be only a Rs5 difference between the spot and
future price. But if a huge gap is witnessed due to supply demand imbalances, an arbitrage
opportunity arises.
How can a trader benefit in such a scenario?

Clearly Infosys is trading above its fair value, and according the arbitrage strategy, we sell the
expensive asset and purchase the cheaper one. In this case, we will sell Infosys futures and
purchase the same quantity of shares in the cash market, knowing that by the end of the series the
price of the futures and spot will converge.

Sell Infosys Futures at 1410

Since the lot size of Infosys is 600 we purchase 600 shares of Infosys in the cash market at 1380.

Once we have executed the trade at the expected price you have locked in the spread. So
irrespective of where the market goes by expiry, profit is guaranteed. The strategy requires us to
square off our positions before expiry i.e. we would have to buy Infosys in the futures market
and sell the 600 shares in the cash market.

This arbitrage strategy between the spot and futures market is known as cash and carry arbitrage.

Pay-off of cash and carry arbitrage

Expiry Value Spot Trade P&L (Long) Futures Trade P&L (Short) Net P&L

1390 1390 – 1380 = +10 1410 – 1390 = +20 +10 + 20 = +30

Similarly, if the stock is trading at discount in the futures market compared to its spot price, we
can implement the reverse cash and carry arbitrage strategy. In this strategy it is required that
the trader already has shares in his DP equal to or more than the lot size or its multiple.

Here the trader purchases the future contract and sells the stock in the cash market. At the time of
expiry, a reverse trade has to be executed, as we had seen in the cash and carry arbitrage.

Example: Price of Infosys in cash market 1380

Price of Infosys August Futures 1352.

Clearly, the stock is trading at a discount to its fair value, which has been calculated through the
mathematical formula and which had come up to 1385.

Hence, in order to take benefit of the situation, the trader sells 600 shares of Infosys (or multiples
of 600 lot size) in the cash market and purchase the proportionate quantity of Infosys in futures
market. In this strategy too, the spread is locked right at the start, and hence, it does not matter at
what price the stock ends on expiry.

Pay-off of reverse cash and carry arbitrage

 Expiry Value Spot Trade P&L (Short) Futures Trade P&L (Long) Net P&L

1390 1380 – 1390 = -10 1390 – 1352 = +38 -10 + 38 = +28

Through these two examples we see how a trader can benefit if there is a price difference in the
spot and futures market.

Arbitrage: Arbitrage is the process of simultaneous buy and sale of shares in order to profit from
difference in the price of underlying assets. It is the process of exploiting risk free return which
arises due to price differences. Arbitrage opportunity exists because of market inefficiencies.
Cash And Carry: Cash and Carry arbitrage is a combination of long position in underlying
assets and short position in underlying futures. Cash and carry arbitrage occurs when market is in
"Contango", which means the future prices of an underlying asset are higher than the current
spot price. To initiate cash and carry arbitrage, the difference between spot price and future price
should be reasonably high enough to cover transaction cost, financing cost as well as to earn
profit. As expiration date approaches nearby, prices of spot and future converge and liquidation
of position can be done at that time.

In order to exploit the risk free return, the arbitrageur/ trader will have to carry the asset until the
expiration date of future contract. Therefore, this strategy would be profitable only if the cash
flow from future at expiration exceeds the acquisition cost and carrying cost on long asset
position.

Let’s try to understand with the help of example of DHFL.

Cash market price (as on 25th April 2017) (S) Rs 422

June Futures (Expiry on 29th June 2017) (F) Rs 430
Contract size 3000
Fair value is measured by the formula F= S*(1+R)^n
Rate of Interest 9% (p.a.)
Time to expiry (n) 65 days
Amount borrowed Rs 12,66,000 (422*3000)
Cost of Borrowing {0.09*(65/365)} 1.6%
Basis Future price-spot price

Expected future price (F) = 422*(1+9%) ^(65/365)

Therefore, in above case F= 428.53

Current future price= 430

Hence, we can see that there is an arbitrage opportunity.

Risk free Arbitrage = Rs 1.47 (430-428.53)

To take the advantage of this mis-pricing, an arbitrageur/ trader may borrow Rs 12,66,000 at an
interest rate of 9% p.a. and buy 3000 shares of DHFL in cash market at Rs 422 and sell 1 lot of
DHFL Futures contract at Rs 430.

Cost of borrowing in Rs [(1266000)*(9%*(65/365))]= 20,291

Gains from price difference between futures and spot= Rs 24,000

This would result in to net arbitrage opportunity of Rs 24,000-20291= Rs 3,709

Scenario analysis:

Case 1: DHFL rises to 435, at expiry

Profit on underlying (cash) = (435-422)*3000= Rs 39,000

Loss on futures = (435-430)*3000= (Rs 15,000)

Gross Gain on Arbitrage= Rs 24,000

Cost of borrowing: Rs 20,291

Net gain from arbitrage: Rs.3,709.

Case 2: DHFL falls to 415, at expiry

Loss on underlying (cash) = (422-415)*3000= (Rs 21,000)

Profit on Futures= (430-415)*3000= Rs 45,000

Gross Gain on Arbitrage= Rs 24,000

Cost of borrowing: Rs 20,291

Net gain from arbitrage: Rs.3,709.

To round up, in any cash and carry arbitrage, the moment you lock in your position, your profit
is fixed depending upon the arbitrage opportunity. This is also called risk free arbitrage because
your profit is secured irrespective of underlying price movement.

Whenever futures are trading at a substantial discount to spot, a reverse cash and carry arbitrage
opportunity arises.
Article

Reverse Cash and Carry arbitrage

22 May 2017 Nilesh Jain

Reverse Cash and Carry arbitrage is a combination of short position in underlying asset (cash)
and long position in underlying future. It is initiated when future is trading at a discount as
compared to cash market price. In other words, the cash market price is trading higher as
compared to future. The arbitrageur/ trader can take position by selling his delivery of stocks in
cash and simultaneously buying futures of same underlying assets of equal quantity. A trader
must have delivery in that particular stock when there is such an opportunity available in the
market.

Reverse cash and carry arbitrage occurs when market is in "Backwardation", which means
future contracts are trading at a discount to the spot price.
Let’s try to understand with the help example of CEATLTD as on 26th APRIL 2017:

As we can see in the above illustration from 5paisa terminal there was a price difference between
cash market price and May futures price of Rs 60.

Cash market price (as on 26th April 2017) (S) Rs 1570

May Futures (Expiry on 29th May 2017) (F) Rs 1510
Contract size 700
Rate of Interest 9% (p.a.)
Time to expiry (n) 29 days
Amount received from selling Delivery of CEAT Rs 10,99,000 (1570*700)
Margin required to sell futures Rs 1,37,595
Free cash available Rs 9,61,405
Fair value is measured by the formula S= F/(1+R)^n
Lending rate 0.72%
Basis Spot price-Future price

Free cash available to lend will be Rs 10,99,000 - Rs 1,37,595 = Rs 9,61,405

Gain from amount lend is Rs 6,874.71 (9,61,405*(0.09^(29/365)))

S= 1510/(1+0.09)^(29/365)

Fair Value of spot price (S)= 1500

Current spot price= 1570

Hence, we can see that there is an arbitrage opportunity.

Risk free Arbitrage=Rs 70 (1570-1500)

To take advantage from this mispricing, trader/arbitrageur will buy futures at Rs 1510 and sell
CEATLTD in cash market at Rs 1570. This would result in gross arbitrage profit of Rs 42,000
(60*700). And income received from lended amount would be Rs 6874.71, so Net arbitrage
profit would be Rs 48,874.71.

Scenario analysis:

Case 1: CEATLTD rises to 1620, at expiry

Loss on underlying (cash) = (1620-1570)*700= (Rs 35,000)

Profit on futures = (1620-1510)*700= Rs 77,000

Gross Gain on Arbitrage= Rs 42,000

Inflow from lending: Rs 6874.71

Net gain from arbitrage: Rs 48,874.71

Case 2: CEATLTD falls to 1450, at expiry

Profit on underlying (cash) = (1570-1450)*700= Rs 84,000

Loss on Futures= (1510-1450)*700= (Rs 42,000)

Gross Gain on Arbitrage= Rs 42,000

Inflow from lending: Rs 6874.71

Net gain from arbitrage: Rs 48,874.71

To round up, in any reverse cash and carry arbitrage, the moment you trigger this arbitrage, your
profit is fixed depending upon the arbitrage opportunity. This is also called risk free arbitrage
because your profit is secured irrespective of underlying price movement.

Whenever future price of an underlying asset are higher than the current spot price, a cash and
carry arbitrage opportunity arises.
Example of Cash-and-Carry Arbitrage

Consider the following example of a reverse cash-and-carry-arbitrage. Assume an asset currently

trades at $104, while the one-month futures contract is priced at $100. In addition, monthly
carrying costs on the short position (for example, dividends are payable by the short seller)
amount to $2. In this case, the trader or arbitrageur would initiate a short position in the asset at
$104, and simultaneously buy the one-month futures contract at $100. Upon maturity of the
futures contract, the trader accepts delivery of the asset and uses it to cover the short position in
the asset, thereby ensuring an arbitrage or riskless profit of $2.

The term "riskless" is not 100% correct as there are still risks that carrying costs can increase,
such as the brokerage firm raising its margin rates. However, the risk of any market movement,
which is the major component in any regular long or short trade, is mitigated by the fact that
once the trade is set in motion, the only event is the delivery of the asset against the futures
contract. There is no need to access either side of the trade in the open market at expiration.

Reverse cash and carry arbitrage is performed when the futures is trading at a discount to the
cash market price.

Lets assume the following data:

Cash market price: Rs.100

December futures price: Rs.90

This reflects a negative cost of carry which is bound to reverse to positive at some point in time
during contract's life and this reversal is an opportunity for traders to execute reverse cash and
carry arbitrage.

Lets assume a contract multiplier for futures contract on Stock A is 200 shares. To execute
reverse cash and carry, arbitrageur will buy one Dec Fut at Rs.90 and sell 200 shares of Stock A
at Rs.100 in cash market. This would result in the arbitrage profit of Rs. 2000 (200 X Rs.10).
Position of the arbitrager in various scenarios of stock price would be as follows:

Case I: Stock rises to Rs. 110

Loss on underlying = (110 - 100) x 200 = Rs. 2000
Profit on futures = (110 - 90) x 200 = Rs. 4000
Net gain out of arbitrage = Rs. 2000
Case II: Stock falls to Rs. 85
Profit on underlying = (100 - 85) x 200 = Rs. 3000
Loss on futures = (90 - 85) x 200 = Rs. 1000
Net gain out of arbitrage = Rs. 2000

On maturity, when the futures price converges with the spot price of underlying, the arbitrageur
is in a position to buy the stock back at the closing price/ settlement price of the day.