Exploring Common Options Strategies

Options strategies can be likened to placing various types of bets based on how you expect a
stock’s price to move. Here’s a detailed, layman-friendly guide to some common options
strategies:

1. Straddle

A Straddle is like betting on a horse to either win or lose dramatically, but not stay in the
middle.

• What It Is: You buy both a call option (betting the stock will go up) and a put option
(betting it will go down) with the same strike price and expiration date.
• When to Use: Use this when you expect significant movement in the stock price but
are unsure of the direction.
• Example:
o If a stock is trading at ₹1,000, you buy a ₹1,000 call and a ₹1,000 put.
o If the stock moves to ₹1,200, the call option gains value.
o If it drops to ₹800, the put option gains value.
o If it stays around ₹1,000, you might lose the premiums paid for both options.

2. Strangle

A Strangle is like betting that a horse will finish either far ahead or far behind, but not in the
middle.

• What It Is: You buy an out-of-the-money (OTM) call option (strike price above
current price) and an out-of-the-money put option (strike price below current price).
• When to Use: Use this when you expect a big move but want to spend less money.
• Example:
o If the stock is at ₹1,000, you buy a ₹1,100 call and a ₹900 put.
o You profit if the stock moves above ₹1,100 or below ₹900.
o If it stays between ₹900 and ₹1,100, you lose the premiums paid.

3. Iron Condor

An Iron Condor is like betting that a horse will finish within a specific range, not too high or
too low.

• What It Is: You sell an in-the-money (ITM) call and put option (closer to current
price) and buy further out-of-the-money call and put options to limit risk.
• When to Use: Use this when you expect the stock to stay within a specific range.
• Example:
 o If the stock is at ₹1,000, you might sell a ₹900 put and a ₹1,100 call, and buy a
₹800 put and a ₹1,200 call.
o You profit if the stock stays between ₹900 and ₹1,100.
o Losses are limited if the stock moves outside ₹800 or ₹1,200.

4. Butterfly Spread

A Butterfly Spread is like betting that a horse will finish very close to a specific position,
neither too high nor too low.

• What It Is: You buy one option at a lower price, sell two options at a middle price,
and buy one option at a higher price, all with the same expiration date.
• When to Use: Use this when you expect little movement in the stock.
• Example:
o If the stock is at ₹1,000, you might buy a ₹900 call, sell two ₹1,000 calls, and
buy a ₹1,100 call.
o Maximum profit if the stock stays near ₹1,000.
o Limited loss if it moves too far from ₹1,000.

5. Covered Call

A Covered Call is like renting out your car while you’re not using it, making extra money,
but agreeing to sell it if someone wants to buy it at a higher price.

• What It Is: You sell a call option on a stock you already own.
• When to Use: Use this to generate extra income if you don’t expect the stock to rise
significantly.
• Example:
o If you own a stock at ₹1,000, you sell a ₹1,100 call option.
o You earn the premium from selling the option.
o If the stock rises above ₹1,100, you sell it at ₹1,100, keeping the premium.

6. Protective Put

A Protective Put is like buying insurance for your car – you’re protecting your investment if
something goes wrong.

• What It Is: You buy a put option on a stock you own to protect against a decline.
• When to Use: Use this to hedge against potential losses.
• Example:
o If you own a stock at ₹1,000, you buy a ₹900 put.
o If the stock drops to ₹800, you can still sell it for ₹900 using the put.
7. Collar

A Collar is like using a combination of safety gear – a helmet and knee pads – to limit how
much you can get hurt.

• What It Is: You buy a put option to limit downside risk and sell a call option to limit
upside potential.
• When to Use: Use this to protect against significant losses while capping gains.
• Example:
o Own a stock at ₹1,000.
o Buy a ₹900 put to limit losses.
o Sell a ₹1,100 call to cap gains but earn the premium.

8. Calendar Spread

A Calendar Spread is like making two bets on the same horse in different races – one in a
short race and one in a longer race.

• What It Is: You buy and sell options with the same strike price but different
expiration dates.
• When to Use: Use this when you expect little movement in the short term but more
movement later.
• Example:
o If the stock is at ₹1,000, you might sell a ₹1,000 call expiring in one month
and buy a ₹1,000 call expiring in three months.
o You profit if the stock stays around ₹1,000 in the short term.

9. Diagonal Spread

A Diagonal Spread is like betting on a horse in different races with slightly different odds.

• What It Is: You buy and sell options with different strike prices and different
expiration dates.
• When to Use: Use this to take advantage of time and price movement.
• Example:
o If the stock is at ₹1,000, you might sell a ₹1,100 call expiring in one month
and buy a ₹1,200 call expiring in three months.
o Profits from both time decay and expected movement.

Factors Affecting Option Premiums

1. Intrinsic Value:
Intrinsic value is the actual, built-in value of an option if exercised right now.

• Example:
o For a call option, if a stock is ₹1,200 and you have a ₹1,000 call, the intrinsic
value is ₹200.
o For a put option, if a stock is ₹800 and you have a ₹1,000 put, the intrinsic
value is ₹200.

2. Time Value:

Time value is the extra cost of an option because of the time remaining until it expires.

• Example:
o If a stock is ₹1,000 and a call option with a strike price of ₹1,100 is worth ₹30,
but the intrinsic value is ₹0, the ₹30 is entirely time value.

3. Volatility:

Volatility reflects how much the stock price is expected to move. Higher volatility increases
the option's price because of the higher chance of significant price changes.

4. Interest Rates:

Interest rates impact the cost of holding options, especially for longer-term options. Higher
rates increase call option premiums and decrease put option premiums.

5. Dividends:

Dividends paid on the underlying stock can reduce call option prices and increase put option
prices.

6. Theta Decay:

Theta decay is the rate at which an option loses its value as it approaches expiration. The
closer to expiration, the faster the decay, especially for at-the-money (ATM) options.

Hedging in Options Trading: Understanding Put-Call Parity

Hedging with options is a way to protect your investments against adverse price movements.
A crucial concept in this context is Put-Call Parity.

What is Put-Call Parity?

Put-Call Parity links the prices of European call and put options on the same underlying asset
with the same strike price and expiration date. It shows that holding a call option and cash
equivalent to the strike price (or bond) is equivalent to holding a put option and the
underlying stock.
Mathematical Formula: C−P=S−K×e−rTC - P = S - K \times e^{-rT}C−P=S−K×e−rT
Where:

• CCC = Price of the call option

• PPP = Price of the put option
• SSS = Current price of the underlying stock
• KKK = Strike price of the options
• rrr = Risk-free interest rate
• TTT = Time to expiration

Simplified Version: C−P=S−KC - P = S - KC−P=S−K (When ignoring interest rates and

dividends for simplicity.)

Key Insight: This formula shows that the difference in the price of a call and a put option is
equal to the difference between the current stock price and the strike price.

How Put-Call Parity Helps in Hedging

1. Creating Synthetic Positions:

Put-Call Parity can help you create synthetic positions to hedge your investments. For
example:

• Synthetic Long Stock:

o Create a position equivalent to holding the stock by buying a call option and
selling a put option with the same strike price.
o Why: Mimics stock ownership without buying the stock.
o Example:
▪ If a stock is at ₹1,000, buy a ₹1,000 call and sell a ₹1,000 put.
▪ This position behaves like owning the stock.
• Synthetic Short Stock:
o Create a position equivalent to shorting the stock by buying a put option and
selling a call option with the same strike price.
o Why: Protects against or profits from a stock's decline without shorting it
directly.
o Example:
▪ If the stock is at ₹1,000, buy a ₹1,000 put and sell a ₹1,000 call.
▪ This position benefits from a drop in the stock price.

Example of Put-Call Parity:

Let’s say a stock is priced at ₹1,000, and you find the following option prices:

• A call option with a strike price of ₹1,000 costs ₹50.

• A put option with the same strike price costs ₹30.

Using put-call parity: C−P=S−KC - P = S - KC−P=S−K 50−30=1,000−1,00050 - 30 = 1,000 -

1,00050−30=1,000−1,000
This confirms the relationship holds (assuming no dividends and interest rates).

Hedging Strategies Using Put-Call Parity

1. Protective Put (Insurance for Stocks):

• What It Is: Buy a put option on a stock you own.

• How It Helps: Limits the downside risk of your stock falling below the strike price.
• Example:
o You own a stock at ₹1,000.
o Buy a ₹900 put option.
o If the stock drops to ₹800, you can still sell it for ₹900 using the put.

2. Covered Call (Income from Stocks):

• What It Is: Sell a call option on a stock you own.

• How It Helps: Earns extra income from the option premium, but you might have to
sell your stock if the price rises above the strike price.
• Example:
o You own a stock at ₹1,000.
o Sell a ₹1,100 call option.
o You earn the premium and agree to sell the stock if it goes above ₹1,100.

3. Collar (Protective Range):

• What It Is: Combine a protective put with a covered call.

• How It Helps: Limits downside risk and caps upside potential, creating a range
within which you are protected.
• Example:
o Own a stock at ₹1,000.
o Buy a ₹900 put to limit losses.
o Sell a ₹1,100 call to cap gains but earn the premium.

4. Synthetic Long Stock:

• What It Is: Create a position similar to owning the stock by buying a call and selling
a put at the same strike price.
• How It Helps: Mimics stock ownership without buying the actual stock.
• Example:
o If the stock is at ₹1,000, buy a ₹1,000 call and sell a ₹1,000 put.
o Profit from stock-like movements without holding the stock.

5. Synthetic Short Stock:

• What It Is: Create a position similar to shorting the stock by buying a put and selling
a call at the same strike price.
• How It Helps: Protects against or profits from a stock's decline without shorting it
directly.
• Example:
o If the stock is at ₹1,000, buy a ₹1,000 put and sell a ₹1,000 call.
o Profit from a fall in stock price without shorting it directly.