Page 80 - DMGT513_DERIVATIVES_AND_RISK_MANAGEMENT

Unit 7: Option Strategies and Pay-offs

1. Bullish Strategies Notes
2. Bearish Strategies and
3. Neutral Strategies.

7.1 Bullish Strategies

Seven kinds of bullish option strategies are discussed below. They are:

1. Long Call
2. Short Put
3. Covered Call

4. Protective Put
5. Call Bull Spread
6. Put Bull Spread
7. Straps
1. Long Call (Buy Call): A long call is simply the purchase of one call option. A long call
option is the simplest way to benefit if we believe that the market will make an upward
move and is the most common choice among first time investors. Being long a call option
means that we will benefit if the stock/future rallies, however, our risk is limited on the
downside if the market makes a correction.

From the graph (Figure 7.1) we can see that if the stock/future is below the strike price at
expiration, our only loss will be the premium paid for the option. Even if the stock goes
into liquidation, we will never lose more than the option premium that we paid initially
at the trade date. Not only will our losses be limited on the downside, we will still benefit
infinitely if the market stages a strong rally.

!
Caution A long call has unlimited profit potential on the upside.
When you are very bullish, buy a call option. When you are very bullish on the market as
a whole, buy a call option on indices (Nifty/Sensex). When you are very bullish on a
particular stock, buy a call option on that stock. The more bullish you are, the more out of
the money (higher strike price) should be the option you buy. No other position gives you
as much leveraged advantage in a rising market with limited downside.

Maximum Loss: Limited to the premium paid up front for the option.
Maximum Gain: Unlimited as the market rallies.
When to use: When we are bullish on market direction and also bullish on market volatility.

Upside potential: The price of the option increases as the price of the underlying rises. You
can book profit by selling the same option at higher price whenever you think that the
underlying price has come to the level you expected. At expiration the break-even
underlying price is the strike price plus premium paid for buying the option.
Downside risk: your loss is limited to the premium you have paid. The maximum you can
lose is the premium, if the underlying price is below the strike price at expiry of the
option.

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