Top 5 Option Trading Strategy for Beginners

Introduction

Along with the growth in Indian Stock market, option trading has become very popular within retail investors and traders. Over the period, Indian stock market is growing with participation from foreign investors as well as internal retail and institutional investors. We can expect further growth in coming days due to the economic development. With more and more participation in the market, option trading has come to forefront with significant volume. Recent SEBI reports confirms that a huge retail participation is seen in the option trading. One of the main reasons for extra ordinary interest within the retail traders for option trading is the possibility of potential high profit with limited risk and less capital requirement. However, option trading comes with certain risks that must be considered and mitigated specially for beginners.

Option is a risk management tool for investors to hedge their portfolio. Option can also be traded using some strategies to take advantage of the market situation. To do that a trader must have a solid understanding on option and its various strategies.

For beginner, it is important to start with some simple strategies that are less capital intensive, limited risk and easy to manage in case the trade goes wrong. Let us explore the top 5 option trading strategies that may be suitable for a beginner.

Understanding Option Trading in the Indian Context

Before we get into the option strategies, let us quickly recap what is an option and how it works. An option is a financial contract that gives the buyer the right to buy a call or put without any obligation to exercise that right. This contract is for some specific number of shares (lot size) and at a pre-determined price (strike price) on or before a specific date (expiry date). In India, options are exercised in European-style, meaning options can only be exercised on the expiry date.

Top 5 strategies for beginners to start option trading

1. Bull Call Spread

Bull call spread is essentially a bullish option trading strategy. It is also known as Call Debit Spread. To deploy this strategy, you need to buy a call option with a lower strike price and sell another call option with a higher strike price. The expiry date and number of lots must be same. This strategy is suitable for a trader who thinks that stock price of the underlying will rise, at the same time want to limit their risks in case their view goes wrong. However, in this strategy both risk and reward are limited.

When and why is it used?

A Bull Call Spread can be used:

• When you expect that the price of the underlying will increase at least moderately.
• When you want to reduce the cost of buying a call option, as you also have a selling leg.
• When you want to hedge your buy position for reducing potential loss.

Market Situation

A trader should consider this strategy in a moderately bullish market where the underlying asset is expected to rise but may not make a significant move.

How to Construct a Bull Call Spread?

To construct a Bull Call Spread, follow these steps:

• 1. Buy a Call Option with a lower strike price.
• 2. Sell a Call Option with a higher strike price.

Example:

Let’s assume the Nifty 50 is trading at ₹22,000. You are moderately bullish and expect the Nifty 50 to rise, but not beyond ₹22,500. You can construct a Bull Call Spread by:

• 1. Buying a 22,000 strike price call at a premium of say ₹100.
• 2. Selling a 22,500 strike price call at a premium of say ₹50.

This would cost you ₹100 (premium for buying the lower strike call) minus ₹50 (premium received from selling the higher strike call), so your net cost (or maximum loss) is ₹50 per lot.

Risk and Reward of a Bull Call Spread

Maximum Risk:

The maximum loss is limited to the net premium paid. In our example, this is ₹50 (₹100 – ₹50) per lot. This happens if the stock/index closes below the lower strike price (22,000) at expiration.

Maximum Reward:

The maximum profit is also limited to the difference between the strike prices minus the net premium paid. In our example, the strike price difference is ₹500 (₹22,500 – ₹22,000), and after subtracting the ₹50 premium, your maximum profit is ₹450 per lot.

Pay-off Diagram a Bull Call Spread

The pay-off of a Bull Call Spread looks like a rising slope that flattens once the price reaches the upper strike price. In this example 22,500

• If the underlying asset stays below the lower strike price (₹22,000 in this example), you incur the maximum loss (the premium paid).
• As the price of underlying asset rises, your profit also increases.
• Once the price hits the upper strike price (₹22,500), your profit is capped.

The pay-off chart: [Bull Call Spread]

Source: https://web.sensibull.com/

Summary

The Bull Call Spread is a very good option trading strategy when you anticipate a moderate rise in the underlying price and also want to limit your risk. By simultaneously buying and selling call options, you lower the cost of entry and cap your potential reward, making this an ideal strategy in mildly bullish market conditions.

2. Bear Put Spread

Bear put spread is obviously a bearish option trading strategy as the name suggest. It is also known as Put Debit Spread. To deploy this strategy, you need to buy a put option with a higher strike price and sell another put option with a lower strike price. The expiry date and number of lots must be same. This strategy is suitable for a trader who thinks that stock price of the underlying will fall, at the same time want to limit their risks in case their view goes wrong. However, in this strategy both risk and reward are limited.

When and why is it used?

A Bear Put Spread can be used:

• When you expect that the price of the underlying will decrease at least moderately.
• When you want to reduce the cost of buying a put option, as you also have a selling leg.
• When you want to hedge your buy position for reducing potential loss.

Market Situation:

A trader should consider this strategy when his view is moderately bearish where the underlying asset is expected to fall but may not make a significant downside move.

How to Construct a Bear Put Spread?

To create a Bear Put Spread, follow these steps:

• 1. Buy a Put Option at a higher strike price.
• 2. Sell a Put Option at a lower strike price.

Example:

Assume Nifty 50 is currently trading at ₹19,000. You expect price to fall further.
You could construct a Bear Put Spread as follows:

• Buy a 19,000 strike price put at a premium of ₹120.
• Sell a 18,500 strike price put at a premium of ₹70.

Your net cost (or maximum loss) will be ₹50 per lot (₹120 premium paid minus ₹70 premium received).

Risk and Reward of Bear Put Spread

Maximum Risk:

The maximum loss is always limited to the net premium paid. Here, the maximum loss is ₹50 per lot. This will happen when the price of the underlying stays above the higher strike price (₹19,000 in this case).

Maximum Reward:

The maximum profit is limited to the difference between the strike prices minus the net premium paid. Here, the strike price difference is ₹500 (₹19,000 – ₹18,500), and after subtracting the premium cost of ₹50, the maximum profit would be ₹450 per lot.

The maximum profit is limited to the difference between the strike prices minus the net premium paid. Here, the strike price difference is ₹500 (₹19,000 – ₹18,500), and after subtracting the premium cost of ₹50, the maximum profit would be ₹450 per lot.

Pay-off Diagram a Bear Put Spread

The pay-off structure for a Bear Put Spread is a downward slope that flattens once the price hits the lower strike price.

• If the asset price remains above the higher strike price (₹19,000 in our example), you incur the maximum loss (the premium paid).
• As the price drops below the higher strike, your profit increases.
• Once the asset reaches or falls below the lower strike price (₹18,500), the profit is capped.

The pay-off chart: [Bear Put Spread]

Source: https://web.sensibull.com/

Summary

The Bear Put Spread is a good option trading strategy to consider in moderately bearish markets where you expect a fall in the underlying price at the same time want to limit your risk. By simultaneously buying and selling put option, you lower the cost of entry and cap your potential reward, making this an ideal strategy in mildly bearish market conditions.

3. Covered Call

Covered Call is an easy option trading strategy for beginners where no adjustment is required even if your view goes wrong. You can deploy this strategy only when you already hold certain shares, for e.g. TCS. All you need to do is sell an OTM call option of TCS. The shares you hold acts as ‘cover’ against the risk of selling call option.
The primary goal of this strategy is to generate additional earnings from the premium received by selling the call option, in addition to holding the shares and their price appreciation. You can make profit when price of TCS remains below the strike price of the call sold at expiration.
When the TCS price goes beyond the strike price of the call sold, you will have to sell your shares at that strike price. However, you still receive the premium.

When and why is it used?

A Covered Call can be used:

• When your view is neutral to mildly bullish on the stock that you already have. You don’t expect a significant upside move in its price.
• When you want to generate some extra money from your stock holdings by selling an OTM call option.
• When you are ready to sell your stocks in case the call option is exercised meaning the price of reaches the strike price of the call sold.

Market Situation:

Covered Call will work best in sideways or mildly bullish market. If you think that your stock will move up but not significantly, then this strategy allows you to earn from both stock holding and the premium received from selling the call.

How to Construct a Covered Call?

To construct a Covered Call, follow these steps:

• 1. Buy and hold the stock: First, you need to own the stock in your portfolio. Number of stocks should be equal to the lot size of that stock.
• 2. Sell a Call Option: You then sell a call option with a strike price above the current market price where you believe that price will not reach by the expiry.

Example:

Let’s say you own shares of Reliance, say currently trading at ₹2,500 per share. You believe the stock won’t rise much beyond ₹2,600 in the near term (within the expiry). You sell a call option with a strike price of ₹2,600, receiving a premium of ₹50 per share.

Risk and Reward of a Covered Call

Maximum Risk:

• The risk lies in the stock price dropping. If Reliance’s price falls, the premium you earned from the option sale provides some cushion, but your overall position will lose value when price moves down significantly.
• If the stock falls to ₹2,400, you still lose ₹100 per share, but the ₹50 premium reduces your loss to ₹50 per share.

Maximum Reward:

The maximum profit is limited to the premium received plus the stock’s price appreciation up to the strike price.

• In our example, if Reliance’s price rises to ₹2,600, you make ₹100 per share from the stock price increase (₹2,600 – ₹2,500), plus ₹50 from the option premium, for a total profit of ₹150 per share.
• If the stock rises above ₹2,600, you will still have to sell it at ₹2,600 (since you sold the call option) but keep the ₹50 premium.

Pay-off Diagram a Covered Call

The pay-off chart of a Covered Call shows limited upside potential and some downside protection due to the premium received from selling the call. It is similar to Bull Call Spread.

• If the stock price stays below the strike price (₹2,600 in our example), you keep the premium and benefit from holding the stock in addition to the premium received.
• If the stock price rises above the strike price, you are obligated to sell your stock at the strike price, capping your profit with stock price rise and premium received.
• If the stock price falls, your losses are cushioned by the premium received.

The pay-off chart: [Covered Call]

Source: www.simplysafedividends.com/

Summary

Covered Call is a popular option trading strategy among traders who are holding some stocks and want to generate income by selling OTM call option of that stock. This strategy is particularly useful in markets where you expect moderate upward movement but want to make the most of your existing holdings.

4. Cash-Secured Put

Cash-Secured Put is another easy option trading strategy that beginner can execute. It is used when you want to buy certain stocks e.g. TCS, but want to buy it at a lower price than current market price. To do that you sell a put option of TCS where strike price is lower than the current market price. As option seller you have the obligation to buy the stock when the price reaches the strike price you sold. You must have sufficient cash in your account to buy that stock. Primary goal is to earn extra income from the premium but ready to buy the stock if the price falls below the strike price.
This strategy is called “cash-secured” because you have enough cash to buy the stock.

When and why is it used?

A Cash-Secured Put is used when:

• You are bullish to neutral on the stock. You believe that the price will stay the same or rise slightly, but you’re also willing to buy the stock at a lower price.
• You want to generate income from the premium received for selling the put option.
• You are willing to buy the stock if it falls to a specific, lower price (the strike price).

Market Situation:

This strategy works best in sideways to slightly bullish markets. If you believe the stock will not fall significantly, this allows you to earn the premium from selling the put, and, if the price drops, you acquire the stock at a discounted price.

How to Construct a Cash-Secured Put?

To construct a Cash-Secured Put, follow these steps:

• 1. Sell a Put Option: You sell a put option on a stock that you are willing to buy if the price drops to the strike price.
• 2. Hold Cash: Set aside enough cash to buy the underlying stock if the put is exercised.

Example:

Let’s say TCS is trading at ₹4,000 per share. You are interested in buying TCS, but only if the price drops to ₹3,800. You can sell a put option with a ₹3,800 strike price, receiving a premium of say ₹50 per share. You must keep enough cash in your account to buy the stock if the option is exercised (₹3,800 x 175 shares = ₹6,65,000). TCS Lot size (quantity)=175. In case it is not exercised, you earn a profit equal to premium (50 x 175 shares = ₹8,750)

Risk and Reward of a Cash-Secured Put

Maximum Risk:

• The maximum loss occurs if the stock price drops significantly. If TCS falls well below ₹3,800, you will still be obligated to buy it at the strike price of ₹3,800, regardless of how low the market price goes. However, the premium you received will offset some of the loss.
• For example, if TCS falls to ₹3,700, your effective cost is ₹3,750 (₹3,800 – ₹50 premium), and you incur a loss of ₹50 per share.

Maximum Reward:

• The maximum profit is limited to the premium received for selling the put option.
• In this example, you received ₹50 per share, so the total profit would be ₹5,000 (₹50 x 175 shares) if TCS stays above ₹3,800, and the option expires worthless.

Pay-off Diagram a Cash-Secured Put

The pay-off chart for a Cash-Secured Put is relatively straightforward. The risk is mitigated by the fact that you’re prepared to buy the stock at a lower price, but your profit potential is limited to the premium received.

• If the stock stays above the strike price (₹3,400 in our example), you keep the premium as profit.
• If the stock price drops below the strike price, you will be assigned the stock, and your loss depends on how much further the stock price falls.

The pay-off chart: [Cash-Secured Put]

Source: https://medium.com/

Summary

Cash-Secured Put is an option trading strategy, ideal for traders who are willing to buy the underlying stock at a specific price below the current market price while generating an extra income in case price does not fall to that desired lower level. It is a good strategy to consider when market is neutral to mildly bullish. By selling the put, you either keep the premium as profit if the stock stays above the strike price or acquire the stock at a discounted price.

5. Long Straddle

A straddle is formed when a call and a put option is bought or sold at the same strike price for the same expiry. As the name suggest ‘long straddle’ which means buying (long) simultaneously a call option and a put option both with the same strike price and expiry date. This option trading strategy gives profit when there is a significant price movement on either side. Strategy is profitable when there is a large swing in price quickly due to volatility.

When and why is it used?

A Long Straddle is used when:

• You expect a big move in the price of the underlying asset, but you’re uncertain about the direction.
• The market may react strongly to an upcoming event like earnings reports, economic announcements etc. for which market volatility will increase.
• You want to profit from a sharp increase or decrease in price and don’t want to bet on a specific direction up or down.

Market Situation:

This strategy works best in markets that are expected to experience high volatility. If you believe that a stock or index will undergo a major price swing due to impending news, policy changes, or results, but you’re not sure whether the move will be upward or downward, a Long Straddle can be effective.

How to Construct a Long Straddle?

To construct a Long Straddle, follow these steps:

• 1. Call Option: Buy a call option generally at ATM strike price.
• 2. Put Option: Buy a put option at ATM strike price with same expiry date.

Example:

Assume Reliance is trading at ₹2,500, and you expect Reliance price will make a big move but you are not sure about the direction. So you buy both call and put at ATM:

1. Call option of strike ₹2,500 for premium ₹80.
2. Put option of strike ₹2,500 for premium ₹70.
So your total cost (premium) is ₹150 per share (₹80 for call + ₹70 for put).

Risk and Reward of a Long Straddle

Maximum Risk:

The maximum loss is equal to the total premium paid. So it will be always limited. In this case, ₹150 per share (₹80 for call + ₹70 for put) if stock price is exactly at 2500 at the time of expiration.

Maximum Reward:

The maximum profit is unlimited when price continuously move on any direction up or down. On upside, call option will give profit but put will give limited loss and vice-versa.

• In case Reliance price increases to ₹2,700, the call option will be valuable (₹200 per share), but the put option expires worthless. So, your net profit is ₹50 per share (₹200 – ₹150 as premium).
• In case Reliance price decreases to ₹2,300, the put option will be valuable (₹200 per share), but the call expires worthless. Again, your profit is ₹50 per share (₹200 – ₹150 as premium).

Pay-off Diagram a Long Straddle

The pay-off chart for a Long Straddle is a -shape, with the maximum loss at the strike price and unlimited profit potential as the stock price moves either up or down.

• If the underlying asset stays close to the strike price, you incur the maximum loss (the premiums paid).
• If the asset moves significantly in either direction, you begin to make a profit once the price moves far enough to cover the cost of total premiums.

The pay-off chart: [Long Straddle]

Source: https://web.sensibull.com/

Summary

Long Straddle is suitable when you expect very high volatility and major price swings in the market but not sure about the direction. By buying both a call and a put option at ATM, you can make profit from big mov in either direction. However, the only risk is losing the premiums if the price doesn’t move enough.

Option Trading Tips and Key Takeaways for Beginners

• Start Small: Start with small positions till you understand how option market works and behaviour of option with change in market situation.
• Use Paper Trading: It is always better to try option trading using a practice account. This helps to practice without losing the real money.
• Understand Option Greeks: Understand the impact of option Greeks (Delta, Gamma, Theta, and Vega) Each Greek has different impact on your position.
• Track Volatility: Market often gets volatile due to various reasons. This leads to fluctuation of price and can impact option.
• Be Aware of Lot Size: Options are traded in specific lot sizes for each stock. This means bigger the lot size bigger the loss due to big price move. Make sure you understand position sizing.
• Expiry Dates: In NSE option expires on the last Thursday of every month. In addition of monthly expiry, NSE has weekly expiries for indices. Keep track of these dates.
• Stay Informed: Keep an eye on the latest market news, events especially quarterly results, any important policy change. These can significantly influence stock and option prices.
• Understand Tax Implications: Options trading has specific tax implications in India in addition to cost of trading. So, consult with appropriate authority to avoid unwanted surprises.

Conclusion

Option trading can be a profitable business, but it requires good knowledge, sufficient practice, and discipline. Five strategies mentioned here provide a solid foundation for beginners to start their options trading journey. Remember, while these strategies are considered beginner-friendly, all trading strategies carries some risk. It is important to thoroughly understand each of the option trading strategy before implementing it with real money.