Option Trading Strategies

Question

Explain the term Option Trading Strategies?

Answer 1

Introduction: Derivatives are one of the latest innovations in the financial world and they are often viewed as double edged swords since they possess the potential to improve the leverage of the portfolio. The deployment of leverage leads to magnification of gains when there is an upside in the market, but at the same time, losses are also magnified during times of downside. Derivative contracts can be primarily categorized into four main classes of forwards, swaps, futures, and OPTIONS. The first three types resemble each other on the grounds that these do not call for any cash outflow or exchange at the upfront. On the other hand, options call for cash exchange (in the form of option premium) at the start of the transaction. The former three contracts are obligatory in the sense that they have to be honored irrespective of the market conditions on expiry while options provide the right (and not the obligation) to the buyer of the option to exercise the contract. Due to these distinguishing aspects of options, they are the subject of this paper. The main notion that this thesis seeks to analyze is whether options can be deployed effectively to hedge the aggregate risk of the portfolio and make profits in the presence of arbitrage opportunities, or are these contracts risky like their counterparts.

The risk associated with naked options (i.e. those options which do not have a counter position in the market) cannot be underestimated; however, covered options possess the potential to yield significant returns (Naked Options, 2011). Strategies which combine options or stock positions with options can be used to minimize the aggregate risk of the investment portfolio, while providing scope for high returns at the same time. Thus, an investor can use covered options to make profits on the basis of one’s perception pertaining to the future trends in the markets. As a part of this report, various types of option trading strategies are analyzed that can be effectively deployed not just as a trading strategy to minimize the risk (Financial News, 2011), but also provide significant potential for unconstrained returns (like naked options).Such strategies can be based on the perceptions of the investors about the market. As such, a brief analysis is conducted of the option trading strategies which include straddle, bull & bear spread, as well as box spread. The payoffs are also determined along with the maximum losses which can accrue on account of each combination of options.