Calls in a Bearish Strategy

Another option for a bearish investor is to go short on a call with the intent to purchase it back in the future. By selling a call, you have a net short position and needs to be bought back before expiration and cancel out your position.
For this an investor needs to write a call option. If the market price falls, long call holders will let their out-of-the-money options expire worthless, because they could purchase the underlying asset at the lower market price.

The investor's profit potential is limited because the trader's maximum profit is limited to the premium received for writing the option.
Here the loss potential is unlimited because a short call position holder has an obligation to sell if exercised, he will be exposed to potentially large losses if the market rises against his position.
The investor breaks even when the market price equals the exercise price: plus the premium. At any price greater than the exercise price plus the premium, the trader is losing money. When the market price equals the exercise price plus the premium, the trader breaks even.
An increase in volatility will increase the value of your call and decrease your return.
When the option writer has to buy back the option in order to cancel out his position, he will be forced to pay a higher price due to the increased value of the calls.

Puts in a Bearish Strategy

When you purchase a put you are long and want the market to fall. A put option is a bearish position. It will increase in value if the market falls. An investor with a bearish market outlook shall buy put options. By purchasing put options, the trader has the right to choose whether to sell the underlying asset at the exercise price. In a falling market, this choice is preferable to being obligated to buy the underlying at a price higher.

An investor's profit potential is practically unlimited. The higher the fall in price of the underlying asset, higher the profits.
The investor's potential loss is limited. If the price of the underlying asset rises instead of falling as the investor has anticipated, he may let the option expire worthless. At the most, he may lose the premium for the option.
The trader's breakeven point is the exercise price minus the premium. To profit, the market price must be below the exercise price. Since the trader has paid a premium he must recover the premium he paid for the option.
An increase in volatility will increase the value of your put and increase your return. An increase in volatility will make it more likely that the price of the underlying instrument will move. This increases the value of the option.

Bullish Put Spread Strategies In Options

A vertical Put spread is the simultaneous purchase and sale of identical Put options but with different exercise prices. To "buy a put spread" is to purchase a Put with a higher exercise price and to write a Put with a lower exercise price. The trader pays a net premium for the position.
To "sell a put spread" is the opposite: the trader buys a Put with a lower exercise price and writes a put with a higher exercise price, receiving a net premium for the position.
An investor with a bullish market outlook should sell a Put spread. The "vertical bull put spread" allows the investor to participate to a limited extent in a bull market, while at the same time limiting risk exposure.

To put on a bull spread, a trader sells the higher strike put and buys the lower strike put.
The bull spread can be created by buying the lower strike and selling the higher strike of either calls or put. The difference between the premiums paid and received makes up one leg of the spread.
The investor's profit potential is limited. When the market price reaches or exceeds the higher exercise price, both options will be out-of-the-money and will expire worthless. The trader will realize his maximum profit, the net premium
 The investor's potential loss is also limited. If the market falls, the options will be in-the-money. The puts will offset one another, but at different exercise prices.
The investor breaks-even when the market price equals the lower exercise price less the net premium. The investor achieves maximum profit i.e. the premium received, when the market price moves up beyond the higher exercise price (both puts are then worthless).
An example of a bullish put spread.
Lets us assume that the cash price of the scrip is Rs 100. You now buy a November put option on a scrip with a strike price of Rs 90 at a premium of Rs 5 and sell a put option with a strike price of Rs 110 at a premium of Rs 15.
The first position is a short put at a higher strike price. This has resulted in some inflow in terms of premium. But here the trader is worried about risk and so caps his risk by buying another put option at the lower strike price. As such, a part of the premium received goes off and the ultimate position has limited risk and limited profit potential. Based on the above figures the maximum profit, maximum loss and breakeven point of this spread would be as follows:
Maximum profit = Net option premium income or net credit
                             = 15 - 5 = 10
Maximum loss = Higher strike price - Lower strike price - Net premium received
                          = 110 - 90 - 10 = 10
Breakeven Price = Higher Strike price - Net premium income
                               = 110 - 10 = 100

Bullish Call Spread Strategies In Options

A vertical call spread is the simultaneous purchase and sale of identical call options but with different exercise prices.
To "buy a call spread" is to purchase a call with a lower exercise price and to write a call with a higher exercise price. The trader pays a net premium for the position.
To "sell a call spread" is the opposite, here the trader buys a call with a higher exercise price and writes a call with a lower exercise price, receiving a net premium for the position.
An investor with a bullish market outlook should buy a call spread. The "Bull Call Spread" allows the investor to participate to a limited extent in a bull market, while at the same time limiting risk exposure.

To put on a bull spread, the trader needs to buy the lower strike call and sell the higher strike call. The combination of these two options will result in a bought spread. The cost of Putting on this position will be the difference between the premium paid for the low strike call and the premium received for the high strike call.
The investor's profit potential is limited. When both calls are in-the-money, both will be exercised and the maximum profit will be realised. The investor delivers on his short call and receives a higher price than he is paid for receiving delivery on his long call.

The investors's potential loss is limited. At the most, the investor can lose is the net premium. He pays a higher premium for the lower exercise price call than he receives for writing the higher exercise price call.
The investor breaks even when the market price equals the lower exercise price plus the net premium. At the most, an investor can lose is the net premium paid. To recover the premium, the market price must be as great as the lower exercise price plus the net premium.
An example of a Bullish call spread:
Let's assume that the cash price of a scrip is Rs 100 and you buy a November call option with a strike price of Rs 90 and pay a premium of Rs 14. At the same time you sell another November call option on a scrip with a strike price of Rs 110 and receive a premium of Rs 4. Here you are buying a lower strike price option and selling a higher strike price option. This would result in a net outflow of Rs 10 at the time of establishing the spread.
Now let us look at the fundamental reason for this position. Since this is a bullish strategy, the first position established in the spread is the long lower strike price call option with unlimited profit potential. At the same time to reduce the cost of puchase of the long position a short position at a higher call strike price is established. While this not only reduces the outflow in terms of premium but his profit potential as well as risk is limited. Based on the above figures the maximum profit, maximum loss and breakeven point of this spread would be as follows:
Maximum profit = Higher strike price - Lower strike price - Net premium paid
                              = 110 - 90 - 10 = 10
Maximum Loss = Lower strike premium - Higher strike premium
                             = 14 - 4 = 10
Breakeven Price = Lower strike price + Net premium paid
                               = 90 + 10 = 100

Put Options in a Bullish Strategy

An investor with a bullish market outlook can also go short on a Put option. Basically, an investor anticipating a bull market could write Put options. If the market price increases and puts become out-of-the-money, investors with long put positions will let their options expire worthless.

By writing Puts, profit potential is limited. A Put writer profits when the price of the underlying asset increases and the option expires worthless. The maximum profit is limited to the premium received. However, the potential loss is unlimited. Because a short put position holder has an obligation to purchase if exercised. He will be exposed to potentially large losses if the market moves against his position and declines.The break-even point occurs when the market price equals the exercise price: minus the premium. At any price less than the exercise price minus the premium, the investor loses money on the transaction. At higher prices, his option is profitable.An increase in volatility will increase the value of your put and decrease your return. As an option writer, the higher price you will be forced to pay in order to buy back the option at a later date , lower is the return.

Call Options in a Bullish Strategy

An investor with a bullish market outlook should buy call options. If you expect the market price of the underlying asset to rise, then you would rather have the right to purchase at a specified price and sell later at a higher price than have the obligation to deliver later at a higher price.

The investor's profit potential buying a call option is unlimited. The investor's profit is the the market price less the exercise price less the premium. The greater the increase in price of the underlying, the greater the investor's profit.
The investor's potential loss is limited. Even if the market takes a drastic decline in price levels, the holder of a call is under no obligation to exercise the option. He may let the option expire worthless.
The investor breaks even when the market price equals the exercise price plus the premium.
An increase in volatility will increase the value of your call and increase your return. Because of the increased likelihood that the option will become in- the-money, an increase in the underlying volatility (before expiration), will increase the value of a long options position. As an option holder, your return will also increase.
A simple example will illustrate the above:
Suppose there is a call option with a strike price of Rs 2000 and the option premium is Rs 100. The option will be exercised only if the value of the underlying is greater than Rs 2000 (the strike price). If the buyer exercises the call at Rs 2200 then his gain will be Rs 200. However, this would not be his actual gain for that he will have to deduct the Rs 200 (premium) he has paid.
The profit can be derived as follows
Profit = Market price - Exercise price - Premium
Profit = Market price – Strike price – Premium.
                 2200 – 2000 – 100 = Rs 100

The Time Value and Other Elements of an Option Price

The Time Value of an Option
Generally, the longer the time remaining until an option’s expiration, the higher its premium will be. This is because the longer an option’s lifetime, greater is the possibility that the underlying share price might move so as to make the option in-the-money. All other factors affecting an option’s price remaining the same, the time value portion of an option’s premium will decrease (or decay) with the passage of time.
Note: This time decay increases rapidly in the last several weeks of an option’s life. When an option expires in-the-money, it is generally worth only its intrinsic value.


Volatility
Volatility is the tendency of the underlying security’s market price to fluctuate either up or down. It reflects a price change’s magnitude; it does not imply a bias toward price movement in one direction or the other. Thus, it is a major factor in determining an option’s premium. The higher the volatility of the underlying stock, the higher the premium because there is a greater possibility that the option will move in-the-money. Generally, as the volatility of an under-lying stock increases, the premiums of both calls and puts overlying that stock increase, and vice versa.
Higher volatility=Higher premium
Lower volatility = Lower premium


Interest rates
In general interest rates have the least influence on options and equate approximately to the cost of carry of a futures contract. If the size of the options contract is very large, then this factor may take on
some importance. All other factors being equal as interest rates rise, premium costs fall and vice versa. The relationship can be thought of as an opportunity cost. In order to buy an option, the buyer must either borrow funds or use funds on deposit. Either way the buyer incurs an interest rate cost. If interest rates are rising, then the opportunity cost of buying options increases and to compensate the buyer premium costs fall. Why should the buyer be compensated? Because the option writer receiving the premium can place the funds on deposit and receive more interest than was previously anticipated. The situation is reversed when interest rates fall – premiums rise. This time it is the writer who needs to be compensated.