Most Popular Options Strategies To Bank On

Options trading is one of the most aggressive ways to participate in the equity markets. But while the potential looks awesome, traders often falter while selecting the most appropriate options trading strategies that can give the best risk-adjusted returns. Geyatee Deshpande highlights some of the most popular options strategies for both the bearish and bullish view on the underlying

Options traders make for an important community in the equity markets. The reason is that options trading has begin to increase in popularity judging by the volumes on options contracts, whether index options or stock options. In India, around 80 per cent of derivatives trading happens in the options market and the rest in futures. Options are attractive derivatives instruments because they are cost-efficient, have high profit potential, are less risky and most importantly, there are multiple options strategies available that can be used according to market moods and swings. Many participants find options trading lucrative as there are multiple strategies available to exploit the market conditions profitably. 

In other words, there is an options strategy if you have a bullish view on the markets. For a bearish view there are different strategies that can be exploited and if your view is that of consolidation in the markets there are different sets of options trading strategies that can be adopted. This flexibility and variety of options strategies available is one of the most important factors why derivatives traders are attracted towards options trading. And while it is true that derivatives traders are attracted to options trading owing to the variety in strategies available, this very availability of multiple strategies in options trading is also one of the reasons why options traders do not make money consistently in the markets.

What is this means is that very often traders are likely to adopt a wrong strategy that can lead to losses. Most beginners lack the understanding of the basic concepts of options trading and tend to adopt an options trading strategy that is too complex. The selection of an options trading strategy is crucial for profitable outcome. It is important that one keeps the strategies as simple as possible. Complication is never profitable. It is also important to categorise yourself as an ‘options day trader’ or ‘positional options trader’.

Day Trading in Options

One of the biggest problems while trading options is the decay in time value. When a trader opts to buy and sell options on an intraday basis, understanding the impact of time value on options prices becomes even more relevant and often will determine whether the trade is profitable. It is advisable that options traders, when going for intraday options bets, use options with as little time value as possible. Also, it may be wise to opt for those options where the delta is as close to ‘one’ as possible.

When it comes to day trading, if the chances of profitability have to improve, it makes sense to go for a near month, in-the-money options of highly liquid stocks. Why in-themoney? That’s because in-the-money options have the least amount of time value and have the greatest delta when compared to out-of-the-money or for that matter at-the-money options. Traders should also note that more popular the underlying stock, the smaller the bid-ask spread will be. 

Popular Options Strategy

Once the trader has done the required homework and classified himself as a day trader or a positional trader, the focus should be on understanding the underlying market trend and whether the target stock or index is trending. To understand the underlying trend, technical analysis can be useful while price volume breakout, put-call ratio and open interest data can come handy while doing so.

Put Call Ratio

Understanding the ‘put call ratio’ and interpreting the ratio can be instrumental for options traders. Traders may have noticed that the average value for the put call ratio is not 1.00 as equity options traders almost always buy more calls than puts. The average ratio is often less than 1.00 for stock options. The put call ratio is nothing but the ratio of puts purchased versus the purchase of calls for the underlying. A ratio of close to 1.00 or greater indicates a bearish sentiment. Traders have to keep a tab on whether a higher number of puts have been bought compared to the calls, which would suggest that a higher number of traders are betting against the underlying and hence the general outlook can be bearish.

Similarly, when the put call ratio is near 0.50 or lesser, it suggests that the sentiment is bullish. Traders should also note that put call ratio can be used as a contrarian indicator. An extremely high put call ratio reading can be termed bullish as it points towards an over-bearish crowd and vice versa. It is worth mentioning here that the analysis of put call ratio for stock options and that for the index options should vary. It is a common practice for fund managers to buy index put options in order to protect their portfolios. This leads to a higher put call ratio for index options than the stock options.

Bearish View

As discussed, before applying any options strategy it is important that the trader has a view on the underlying security. After conducting a thorough market analysis, let’s say the trader has a bearish view on the underlying. In such cases, two of the most popular options trading strategies are bearish put or bear call spread. Here, both the strategies can generate profits if the stock prices move in the intended direction and the trader has already taken a bearish position. However, it is important to understand which strategy is optimum when the prices fall and you have a bearish view on the market.

Whenever the traders view is that the markets or the underlying will trade moderately bearish, instead of using outright naked put options it is advisable that the trader opt for a bear call spread strategy, which is also known credit spread strategy. This strategy involves selling ITM call options and buying OTM call options. It’s a two-legged options strategy. Bear call spread strategy is to be used when the markets have rallied considerably and hence the call options premiums have swelled while there is ample time to expiry. A trader should note that volatility should also be favourable. In this strategy there is net credit because one sells deep ITM call options and purchases OTM call options. 

For example, for executing a bear call spread strategy on SBI which is trading at Rs 207 per share, the following can be done:

Sell IMT call options with strike price of Rs 180;
call premium = Rs 30.

Buy OTM call options with strike price of Rs 220;
call premium = Rs 5.

Here, the net credit will be Rs 30 – Rs 5 = Rs 25.

A bear call spread strategy can be executed using OTM strike prices as well and it is not required that we have to sell ITM call options only. In this strategy, higher the difference between the two selected strikes (spread), larger is the profit potential. A trader has to ensure for a bear call spread strategy so that all the strikes belong to the same underlying and have the same expiry series while ensuring that each leg involves the same number of options. A bear call spread strategy is used when the call options premiums are more attractive than put options.

In this strategy, both the profits and losses are capped. One must remember that both ITM selling and OTM buying should happen simultaneously. The key highlights of a bear call spread strategy are:

✓Breakeven = Lower strike price + Net credit.
✓Maximum profit = Net credit.
✓Maximum loss = Spread – Net credit.
✓Net credit = Premium received – Premium paid. 

As per this strategy, the selection on strikes is crucial and the decision should be made based on the time to expiry. Timing is crucial while trading in equities; similarly, the bear call spread should be executed only when the trader expects the volatility to increase. 

Naked Put Options

Put options can be purchased when there is expectation of a drastic fall in the underlying stock or the index. Traders will find it extremely easy to execute this strategy as unlike the other two leg strategies, here the mathematics is simple. Bear call spread is used when the underlying is expected to be moderately bearish while the put options are purchased when the confidence level is high. This confidence relates to the theory that the underlying will either crash or fall by a good percentage point so as to justify the put premium paid. Also, according to this strategy, the losses are limited but there is no upper limit for profit potential. 

Bullish View

Buying naked call options is one of the most popular options strategies adopted by options traders. However, it is not the only strategy that can help you make money when the underlying asset is expected to increase in price. Whenever there are expectations about an increase in prices but not a rally, a bull put spread is one of the best strategies that can be adopted. Similar to bull call spread, it is a two-leg strategy and has a similar sort of pay-off. However, a bull call spread is a net debit strategy whereas bull put spread is a net credit strategy. In other words, when one executes the trade there is positive cash flow and the trader will receive the amount. 

Let’s understand this better. In a bull put spread strategy one needs to buy OTM put options while selling deep ITM put options. One may choose other strike options as well and need not stick to selling deep ITM put options. For example, let’s say a trader is moderately bullish on SBI and expects the stocks to inch up by 10 per cent in one month or on the last day of expiry. Assuming that SBI is trading at Rs 200 per share, a trader sells 210 put options at Rs 15 while buying a 190 put options by paying an options premium of Rs 5. In this case there is a net credit in favour of the trader’s account of Rs 10 per lot. 

As there is net credit involved, bull put spread strategy is one of the most popular strategies when the trader is moderately bullish on the underlying. This strategy produces optimal profits when the markets have declined considerably and therefore the put premiums are rich, the volatility is on the higher side and there is plenty of time to the expiry. Some of the simple basics that the trader needs to keep in mind are that options with different strike prices need to be of the same underlying and the options should carry the same expiry dates. Also, always remember that each leg of the options strategy should carry the same number of options. 

For example, if the trader is planning to execute a bull put spread strategy with SBI as underlying, equal number of ITM put options should be sold matching the number of OTM put options being purchased. The key highlights of the bull put spread strategy are: 

✓Maximum profit = Net credit.
✓Maximum loss = Spread – Net credit.
✓Breakeven = Higher strike price – Net credit.
✓Higher the spread, bigger the profit potential. 

Conclusion

Deciding about which options strategy to use is the key when it comes to options trading. There are numerous complex strategies available for traders to choose from which leads to confusion. Traders must use naked put options when extremely bearish and use bear call spread when moderately bearish. When extremely bullish, naked call options is best while bullish put spread is advantageous when the trader is moderately bullish on the underlying. Sticking to a simple strategy can work in the best interest of the trader, especially when most options traders do not know the risks of writing options.

Writing options or selling options carry risks similar to that of futures. The risks are unlimited while doing so. Wise use of derivatives (options) data and timing is important to be successful in options trading. It is also very important to first understand what sort of an options trader you are – are you an intraday trader or a positional trader – because the adoption of any particular strategy will also depend upon your timeframe for the trade. Also, what strike options should be used depends on how much time is left for the options expiry. Such minute details need to be well planned before implementing any options trading strategy.