Saturday, April 18, 2009

Options Lesson No 2….

Since the time I have started studying options I have become more and more impressed at them as investment tools of all seasons. Today I will discuss a strategy that I hope to put forward in layman’s words so that everyone understands it and can successfully implement it as far as possible.

The strategy is named Vertical Option Spread. Let us see who would like to use this strategy – It will be used by anyone who has had a loosing streak – anyone who takes whatever position and the market seems to be poised against him/her. Next is when can we use this strategy? Well this can be used when we are trending up, trending down or not trending. I am sure that you would have got it right. well it is true that you can use this strategy in – well almost all situations. The point still remains that you have to make sane decisions based on – let us say technicals. How much effort do I have to put in to make it work? Well if you are a habitual trader then you will be surprised how little time you have to put in. You have to study entry points then put in money and then wait for the eggs to hatch and that is about all. Then what is the catch? Well the catch is that firstly the gains are – depending upon strategy just about 8% to 15% and they are capped. Means that you will not make more than this in the best case scenario. Any other catch? well your losses are also capped at some points above the gains – but the good thing is that chances of your loosing are – let us say 20% or 25% of the times. Each strategy to give you money would take one expiry. So let us say we used this strategy and worked on the probabilities – then we have a good chance to get somewhere near 50-60% returns annually. Now if you are convinced that you need to know it then please continue reading ahead…

Strategy: What I will do is that I will now explain the strategy first and then see the other aspects. The strategy says – decide what side do you see the market going? Use technicals/your gut or anything. Then if you are bullish then sell a out of money put and buy a put one stop lower, on the other hand if you are bearish then sell out of money call and buy one call one stop higher.

Explanation: What we are doing effectively is that we are selling an out of money put/call and earning the difference of premium between the put/call sold and put/call bought. Let us see with and example:-

  • Market was at 3490 and I am convinced in my mind for what ever reason that the market will not go above 3500. So I sold the 3500 call at 102.1 and bought a 3600 call at 59 at the same time.
  • Now the three scenarios that come to play.
    • First scenario is that the markets will end the below 3500 (even a rupee) then what I earned out of selling the call is mine (102.1 X 50 = 5105) and I loose the 3600 call as worthless (59 X 50 = 2950). So my profit is 2155 minus the brokerage 215 = Rs 1940/-
    • Second scenario is that the market will end between 3500 and 3600 then my 3600 call will be nil and I will pay out the difference between the market closing and 3500. Let us assume that the market closed at 3599 then I loose 99 X 50 = 4950/- but remember I sold the 3500 call for 5105 and bought the 3600  call for 2950 – so I am carrying a profit of 1940/-. So the loss will be 4950 minus 1940 that is 3010/-
    • The third scenario is that the market will end up above 3600. In that case I will pay the same that I paid in the worst case of the scenario above. Let us take an example. Let us assume the market ends at 3700 then for the call I sold I pay out 3700 minus 3500 = 200 X 50 = 10,000/- . Now my 3600 call will be worth minimum 100 so I get 5,000/- and also add what I earned initially between selling and buying call = 1940/- So total loss is 10,000/- - (5,000/- + 1940) = 3,060/-

If you have seen and understood the above then it is time that we see how I can lower the margin of losses. Firstly and foremost –  if the call comes in money – square off your positions without thinking the loss in that case will always be less than 3,060/- Secondly if the market goes your way and tanks let us say 500 points – and technicals turn oversold – do this exercise for the puts also. In this case chances are very bright that you will see the market ending in-between somewhere and you will carry home money both ways. In the worst case the market can violate only one position and you will carry home nothing or a very small loss.

When would I use it? when the markets are overbought I will do this for calls and when oversold I will do this for Puts. In trending markets I will do this once or twice only. In range bond markets I will do this each time the markets touch either extreme of Bollinger bands (The markets do this exercise two to three times in a month)

It is time to see the returns now. My total investment for the positions is 24,000/- (calculated using ICICI direct) and max profit is 1940/- so in percentage terms as I said earlier it is just 8.08%. Not bad for a month. Nine winning months and three partially loosing months will give almost 50% return.

My last request – I too have been impatient – I too lost money due to greed and I am talking about a lot of money by my standards. I feel it is best that we keep our urge to trade as a compulsion everyday under check and we will go a long long way making money. If you like this do leave a comment. I have done away with the ratings of my articles on my blog so that is the only way I will know. It will just make me share such strategies over weekends in future.



Uma said...

great lesson! simple calculations n all

S S Cheema said...

thanks uma

Anonymous said...

Ecellant and lucidly explained. Please continue with other Strategies as well. I am in the process of learning Option and your bogspot offers excellant edcation. Thanking once again


r m said...

anyone who takes whatever position and the market seems to be poised against him/her.

Did you have me in mind? :)

Good strategy.

LICINDIA said...

cheemaji rachna here. good lesson on option. Will try with this strategy when i take postion in option. pls share more option trading strategy.

"In range bond markets I will do this each time the markets touch either extreme of Bollinger bands "

what is bollinger bands?

S S Cheema said...

Thanks veer, rm and rachna,
veer: I do intend discussing one odd strategy over weekends provided I have time. Running a bit busy.
rm: no I had me in mind when I said the quote you quoted - LOL
rachna: I discuss bollinger bands in every post I make - the explanation can be found here -