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Forex

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Strategy - BUY A CALL


  • Strategy Outlook
    Investor takes a view that the underlying will rise significantly in the short-term.
     
  • Implementation of this Strategy
    Call options are bought with a strike price determined by the extent of bullishness of the investor. The more bullish the investor is, the higher the strike price would be.
     
  • Upside Potential
    Profit potential is unlimited and rises as the underlying rises.
     
  • Breakeven Point at Expiry
    Strike price plus premium paid.
     
  • Downside Risk
    Limited to the premium paid. This maximum loss is incurred if the underlying on expiry is at or below the strike price of the call option bought.
     
  • Margin
    Not required.
     
  • Remarks
    If the underlying rises lesser than expected the value of the position will decrease as the time value of the option decreases as the expiry comes closer.

    When to buy a call?
     
  • Bullish Speculation with limited risk
    The primary motivation of this investor is to realize financial reward from an increase in price of the underlying security while restricting his losses in case of any adverse movement in the price.

    Experience and precision are keys to selecting the right option (expiration and/or strike price) for the most profitable result.

    In general, the more out-of-the-money the call is the more bullish the strategy, as higher increases in the underlying stock price are required for the option to reach the break-even point.
     
  • As Stock Substitute
    An investor who buys a call instead of purchasing the underlying stock considers the lower cost of purchasing a call option versus an equivalent amount of stock as a form of insurance. The uncommitted capital is "insured" against a decline in the price of the call option's underlying stock, and can be invested elsewhere. This investor is generally more interested in the number of shares of stock underlying the call contracts purchased, than in the specific amount of the initial investment - one call option contract for each 100 shares he wants to own. While holding the call option, the investor retains the right to purchase an equivalent number of underlying shares at any time at the predetermined strike price until the contract expires.

    An investor might purchase the call instead of the underlying security so that he is able to buy the underlying security at a reasonable price without taking the chance of missing out on an upward move in the underlying security.

    He might also want to do this if he had a large amount of cash coming in the near future, and had a smaller amount of cash available now. Feeling that a market movement upwards is about to occur and he doesn't want to miss out he would leverage his money now and buy the call.
     
  • Diversification
    Another investor may purchase calls if his portfolio consists of low volatile stocks, but he wants to take out a small percentage of his assets for trading in highly volatile stocks.

    He would then be participating in some higher risk securities while limiting his risk to a fixed amount.
     
  • Leverage
    A third type of investor may purchase call options as pure speculation. He may expect Satyam prices to increase and buy Satyam call option.

    If the expectation materializes, he will make much more profit than the investor who purchased Satyam shares with the same expectation and same capital.

    This facility to make a big profit from/on a small investment is the most attractive feature for a trader.
     

Strategy - SELL A PUT

  • Strategy Outlook
    Investor is certain that the market will not go down, but unsure about whether it will rise significantly in the short term.
     
  • Implementation of this Strategy
    Put options are sold with a strike price suited to the extent of bullish sentiments of the investor. If an investor is very bullish, then in-the-money puts would be sold.
    Generally out-of-money puts are sold in stocks where the investor is bullish on the stock.
     
  • Upside Potential
    Profit potential is limited to the premium received. The more the option is in-the-money, the greater is the premium received.
     
  • Breakeven Point at Expiry
    Strike price less premium.
     
  • Downside Risk
    Unlimited. Losses on the position will increase as the market rises. If the investor is not very certain of his view bearish spread might be a better alternative.
     
  • Margin
    Required.
     
  • Remarks
    If the price of the underlying security rises steadily or even remains stable as time passes this position is benefited, as the premium will fall with the time value getting eroded as expiry comes closer.
     
  • When to Write a Put?
    For bullish investors who are interested in buying a stock at a price below the current market price, selling naked put can be an excellent strategy.

    In this case, however, the risk is substantial because the writer of the option is obligated to purchase the stock at the strike price regardless of where the stock is trading.

    Using the same Satyam example stated above, if the investor expects the price of the share to rise he can earn the premium by selling the put option. This amount will reduce his cost of buying the stock.

    Warning:
    The put option writer can make huge losses if the price of the underlying decreases steeply.
    Hence, the writer should watch his position carefully and exit quickly to cut losses.
     

Strategy - BULLISH SPREAD


  • Strategy Outlook
    Investor takes the view that the underlying security will not fall, but wants to cap the risk. Conservative strategy for one who thinks that the market is more likely to rise than fall.
     
  • Implementation of this Strategy
    Call option is bought with a lower strike price and another call option sold with a higher strike, producing a net initial debit,OR Put option is bought with a lower strike and another put sold with a higher strike, producing a net initial credit.
     
  • Upside Potential
    Limited in both cases - Calls: difference between strikes minus initial debit Puts: net initial credit Maximum profit is when the underlying security at expiry is at or above the higher strike.
     
  • Downside Risk
    Limited in both cases - Calls:net initial debit
    Puts: difference between strikes minus initial credit
     
  • Margin
    Margin requirements may be off-set.
     
  • Remarks
    Time value erosion not too significant due to the balanced position..
    When to use a Bullish Spread ?
     
  • Moderately Bullish
    An investor often employs the bullish call spread in moderately bullish market environments and wants to capitalize on a modest advance in price of the underlying stock.

    Say the investor expects the security XYZ currently quoting at 170 to advance to around 177 - 180 level at the most, it would be far more attractive to enter into a bull spread than buy an outright call.

    Effectively he shall be buying the 170-strike price call of XYZ at Rs. 7 but his cost in this position shall be reduced to the extent of the premium received in the sale of the 180-strike price XYZ call at Rs 4. His break even in this case is 173 and his maximum profit is achieved at 180.
     
  • Risk Reduction
    An investor will also turn to this spread when there is discomfort with either the cost of purchasing and holding the long call alone, or with the conviction of his bullish market opinion.
     
  • The Benefit
    The bull call spread can be considered a doubly hedged strategy. The price paid for the call with the lower strike price is partially offset by the premium received from writing the call with a higher strike price.

    Thus, the investor's investment in the long call, and the risk of losing the entire premium paid for it, is reduced or hedged.

    On the other hand, the long call with the lower strike price caps or hedges the financial risk of the written call with the higher strike price.

    If the investor is assigned an exercise notice on the written call and must sell an equivalent number of underlying shares at the strike price, those shares can be purchased at a predetermined price by exercising the purchased call with the lower strike price.

    As a trade-off for the hedge it offers, this written call limits the potential maximum profit for the strategy
     
  • Warning:
    The investor needs to keep an eye on this spread. If the underlying security moves up in price too steeply, too quickly, the time value premium of the short call could rise substantially. If this happens, that call may need to be bought back early. Also, if the price of the underlying security rises too high, the short call may go in the money. The trader should be aware of this and buy the call back before it is exercised.

    Again if this strategy is implemented with American style options, there is a risk or premature assignment on the short option position and it may even result in a net loss or unanticipated cash outflow.  

Strategy - DIAGONAL SPREAD


  • Strategy Outlook
    Investor takes a view that the underlying security will be weak in the short-term but will rally later.
     
  • Implementation of this Strategy
    A call option with near month expiry is sold, and a higher strike call option with farther month expiry is bought.
     
  • Upside Potential
    Unlimited, if the long option position is held after the short option expires (the position then becomes a simple buy call).
    If the position is closed at expiry of the near option, maximum profit will accrue if the underlying is at the level of the sold strike.
     
  • Downside Risk
    Limited to the difference in strikes plus/minus the initial debit/credit when establishing the spread.
     
  • Margin
    Yes, but off-setting may apply.
     
  • Remarks
    There is a risk of the sold options being called (i.e. being exercised).

    When to enter into a Diagonal Spread ?
    The diagonal spread is entered into when there is a firm long term bullish view of the underlying security but the investor would prefer to cash in on any immediate subdued movement of the underlying security.

    This could be in anticipation of any favourable corporate news/earnings report that could be profitably employed.

    The fast time decay in case of near month option could also be a temptation to enter into this strategy while simultaneously buying of an longer expiry out-of-money call option.

    Warning: The strategy has substantial risk in the near term. Though spread margins are lower initially, the expiry of the near term option leads to a naked exposure to the long term option which then becomes near.