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Derivative

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Forex

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Strategy - COVERED CALL WRITING

  • Strategy Outlook
    Investor thinks that the market will be rise moderately in the short-term.
     
  • Implementation of this Strategy
    A futures contract is bought and an at the money call option with similar expiry is sold.
     
  • Upside Potential
    Limited to the difference between 'strike + premium received' and 'futures buying price'. For maximizing returns with corresponding increase in risk, a deep-in-the-money call should be sold.
     
  • Downside Risk
    Unlimited after the 'futures purchase price - premium received' level, which should be taken as a stop loss level. The other alternative in that case will be to cover the call sold and selling of a fresh in-the-money call. Another alternative in limiting risks could be the simultaneous buying of a deep-out-of-money put which helps in protecting from a sudden fall in prices. However this will raise the stop loss level by the amount spent in buying the put.
     
  • Margin
    Yes, but off-setting applies.
     
  • Remarks
    There is a risk of loss if the futures price falls below the stop loss level as arrived by above.

    When to enter into a covered call writing?
    The covered call writing is entered into when there is moderate bullishness about the underlying.
    The fast time decay in case of near month option could also be a temptation to enter into this strategy.
     
  • Warning:
    The strategy has substantial risk attached if the prices fall below the stop loss level.
    There is a risk of loss if the futures price falls below the stop loss level as arrived by above.
     

Strategy - LONG STRADDLE


  • Strategy Outlook
    Investor thinks that the market will move significantly but is unsure of the direction.
     
  • Implementation of this Strategy
    A call option and a put option with similar strike prices and expiry are bought.
     
  • Upside Potential
    Unlimited. The movement in either direction has to be substantial in the first place to cover the premiums paid on both the options and thereby to generate profits.
     
  • Downside Risk
    Limited to the extent of premiums paid on both the legs. Maximum loss occurs when the underlying's price is similar to the strike price of the call and put option bought on expiry.
     
  • Margin
    No
     
  • Remarks
    This strategy is advisable when heavy volatility is expected in the underlying but the expected direction is uncertain. This strategy should be used with caution in case of stocks already witnessing heavy volatility, where the premiums traded will already be on a higher side thereby restricting the profit potential.

    When to enter into a long straddle?
    Long straddle is used when heavy volatility is expected but the surrounding uncertainty has made the direction uncertain.
    In the converse case where the volatility in the underlying is expected to be low, one can go for a short straddle i.e., sell a call and a put with similar strike prices and expiry.
     
  • Warning:
    The strategy may not be profitable when the volatility in the underlying price is already high resulting into high premiums, which raises the break even point on both the sides.