Authored by Divanshu Kapoor
Futures contracts can be used for three primary purposes based on a trader's risk profile and market view.
Hedging is a risk management strategy to offset potential losses from adverse price movements. A hedger's goal is not to profit, but to protect their underlying position.
Speculators take a view on the market's direction and use futures due to the significant leverage they offer. A small movement in the underlying price can lead to large profits or losses on the futures position.
Arbitrage is a risk-free profit strategy. It involves exploiting a temporary price discrepancy between the spot market and the futures market. The goal is to profit from the prices eventually converging at expiry.
Options offer non-linear payoffs, allowing for tailored risk-reward profiles. Let's explore some of the most common strategies.
Components: Long Stock + Long Put
Outlook: Bullish on the stock but concerned about potential downside risk.
Rules: The strategy acts as insurance. The put option sets a floor on your potential losses, while the stock retains unlimited upside. The cost of insurance is the put premium.
Components: Long Stock + Short Call
Outlook: Neutral to mildly bullish. Expects the stock to not rise significantly.
Rules: The trader earns premium income from selling the call, which reduces the cost basis of the stock. However, this caps the potential upside profit at the strike price. The strategy's downside is unlimited (just like holding the stock). The formula for maximum profit is: (Strike Price - Stock Purchase Price) + Premium Received
Bull Call Spread: Buy a Call (lower strike) + Sell a Call (higher strike). Used when moderately bullish. Both profit and loss are limited.
Max Profit: (Higher Strike - Lower Strike) - Net Premium Paid
Max Loss: Net Premium Paid
Bear Put Spread: Buy a Put (higher strike) + Sell a Put (lower strike). Used when moderately bearish. Both profit and loss are limited.
Max Profit: (Higher Strike - Lower Strike) - Net Premium Paid
Max Loss: Net Premium Paid
Long Straddle: Buy a Call + Buy a Put with the same strike price and expiry. Used when expecting high volatility but are unsure of the direction.
Max Profit: Unlimited
Max Loss: Net Premium Paid
Short Straddle: Sell a Call + Sell a Put with the same strike price and expiry. Used when expecting low volatility and are confident the price will stay in a narrow range.
Max Profit: Net Premium Received
Max Loss: Unlimited
Long Strangle: Buy a Call + Buy a Put with different strike prices and the same expiry. Used when expecting significant volatility, but with a lower initial cost than a straddle.
Max Profit: Unlimited
Max Loss: Net Premium Paid
Short Strangle: Sell a Call + Sell a Put with different strike prices and the same expiry. Used when expecting low volatility and are confident the price will stay within a defined range.
Max Profit: Net Premium Received
Max Loss: Unlimited
Components: Buy 1 Call at a low strike, Sell 2 Calls at a middle strike, Buy 1 Call at a high strike (where low < middle < high).
Outlook: Neutral. Bet on low volatility, expecting the stock to stay near the middle strike.
Rules: The strategy has limited profit and limited loss. The maximum profit is achieved if the stock closes exactly at the middle strike at expiry.
Max Profit: (Middle Strike - Low Strike) - Net Premium Paid
Max Loss: Net Premium Paid
Components: Sell a Put & Buy a Put below the current price. Sell a Call & Buy a Call above the current price.
Outlook: Neutral. Expects the price to stay within a specific range, profiting from time decay.
Rules: This is a limited-risk, limited-reward strategy. It's essentially a combination of a bear put spread and a bull call spread. The maximum profit is the net premium received.
Max Profit: Net Premium Received
Max Loss: (Difference between put strikes) - Net Premium Received
The principle of Put-Call Parity is a fundamental relationship that links the prices of a European call option, a European put option, the underlying asset, and a risk-free bond. Any deviation from this relationship creates a risk-free arbitrage opportunity.
The core no-arbitrage formula is: $C + PV(K) = P + S$
Rearranging this, we get the more common form: $C - P = S - PV(K)$
Where:
C = Price of the European call option
P = Price of the European put option
S = Spot price of the underlying asset
PV(K) = Present value of the strike price K, discounted from the expiry date at the risk-free rate.
Delta (Δ) is a Greek letter that measures the sensitivity of an option's price to a change in the underlying asset's price. For example, a call option with a delta of 0.5 will increase in price by about ₹0.50 for every ₹1 increase in the underlying stock's price.
A delta-neutral portfolio is constructed so that the overall delta is zero. This makes the portfolio's value insensitive to small movements in the underlying asset's price. Traders use this strategy to manage risk exposures from their options positions.
Authored with ❤️ by Divanshu Kapoor. Follow me on LinkedIn for more content.