The stock market offers a wealth of opportunities for investors willing to explore advanced derivatives. One of the most exciting approaches is an option trading strategy that leverages multiple contracts to enhance both risk management and profit potential. In this post, we dive into various techniques—from combining options and writing covered calls to using spreads and straddles—that can elevate your option trading strategy in the Indian market.
Table of Contents
The Basics: Single Options to Combined Contracts
Traditionally, investors begin with simple positions: going long a call or a put, or shorting them. However, by combining options, you can refine your option trading strategy and potentially boost returns. For instance, if you own shares of a blue-chip company, you might write a covered call on every 100-share lot. Increasing your share holdings enables you to write calls at different strike prices and expiration dates. Techniques like ratio spreads—where you might hold 400 shares and write five calls to create a five-to-four ratio—help mitigate risk while augmenting income.
Advanced Techniques: Spreads in Your Option Trading Strategy
An option trading strategy truly becomes dynamic when you start exploring spreads. A spread involves simultaneously buying and selling options on the same underlying security with varying strikes or expirations. Let’s break down two popular spreads:
Bull Call Spread
A bull call spread is designed for a rising market. Imagine buying a call option at a specific strike price while selling another call at a higher strike price. Say, on a stock like Reliance Industries—you could buy a call at a strike of ₹2,000 and sell one at ₹2,050. The premium received from the sold call helps offset the cost of the bought call. If the stock price climbs above the higher strike, your losses on the short call are cushioned by gains on the long call, keeping risk minimal while capping profit potential.
Bear Spread
Conversely, a bear spread is ideal if you expect a stock’s price to decline. By using long puts and short puts with adjacent strikes, you set up a scenario where even if the price rises, the premium you received remains as net income. This spread structure forms a core part of an option trading strategy that prioritizes limited risk.
Notably, these spread techniques are flexible—you can also create a bull spread using puts or a bear spread with calls. The key is adjusting the strike prices to suit your market outlook, making your option trading strategy adaptable to both bullish and bearish market conditions.
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Diversifying with Straddles
Another advanced element of an option trading strategy is the straddle. This involves opening both a call and a put with the same strike price and expiration. Here’s how it works:
- Long Straddle:
When you expect a significant price move but are uncertain of the direction, a long straddle can be ideal. For example, if you anticipate a major move in a stock like Infosys, buying both the call and the put at the same strike price allows you to profit from volatility, regardless of direction. However, the underlying stock must move substantially beyond a “loss zone” for the strategy to be profitable. - Short Straddle:
In contrast, a short straddle involves selling both a call and a put. This position generates immediate premium income and is profitable if the stock price remains within a defined range. To reduce risk, many investors combine this with owning the underlying shares (turning part of it into a covered call), which can cushion against large moves.
Practical tips on Option Trading Strategy
Derivatives on indices like Nifty 50 or Bank Nifty—and on individual stocks—offer similar flexibility with one-point strike increments. This means you can craft an option trading strategy that provides access to fast-moving markets without the high costs and risks of direct futures trading.
- Start with What You Know:
Build your strategy by first using single options. Once comfortable, gradually combine options to diversify risk and profit potential. - Manage Risks with Covered Positions:
For instance, if you own shares of Tata Motors, writing covered calls can generate extra income while providing a buffer against moderate price declines. - Experiment with Spreads and Straddles:
Test these strategies in a simulated trading environment to understand how changes in strike prices and expirations impact your overall position. - Roll Options to Avoid Exercise:
Both calls and puts can be rolled to new strike prices or later expirations, providing flexibility in volatile market conditions.
Disclaimer: Readers to note that the strategy is given for educational purpose. Not meant to be any kind of recommendation for trading.
