Advanced Option Trading Strategies for Indian Stock Markets

In our previous chapter, we discussed the basic aspects of options trading, learning about terms like strike price and expiry date and foundational strategies like the Covered Call and Protective Put. While these initial concepts are essential for a good understanding of space and trading success, it is a good idea to look further into more sophisticated trading manoeuvres.

In this chapter, we will look at advanced options and trading strategies. They are a level up from basic strategies that equip traders to handle standard market conditions with moderate risk. These advanced strategies open new possibilities that align with specific market behaviours and intricate trader objectives. Apart from speculating potential profits, these advanced methods also provide dynamic solutions for risk management across diverse market scenarios.

You can also use these as tools to maximise gains from market movements or protect yourself against potential downturns.  

Below are the advanced option trading strategies that you can use:

Bull Call Spread

You must have heard about bull markets, which are characterised by a positive market sentiment where the prices are rising. The Bull Call Spread is a strategic approach in options trading that is particularly attractive in bullish market conditions. It consists of the trader simultaneously purchasing call options at a lower strike price and selling an equal number of call options at a higher strike price where both have the same expiration date. This strategy is structured to benefit from a moderate rise in the price of the underlying asset. By buying and selling call options, traders put a limit to their maximum loss to the net premium paid for the positions. They also set a clear upper limit to potential gains, which are realised if the stock price reaches or exceeds the higher strike price at expiration.

For example, consider a trader who opts to implement a Bull Call Spread on stock XYZ, which is currently trading at ₹3,750. The trader buys call options with a strike price of ₹3,750 and sells call options with a strike price of ₹4,500, both set to expire in one month. The cost incurred from buying the call options is partially offset by the income from selling the call options, reducing the overall investment and risk. If the price of XYZ rises above ₹4,500, the maximum profit is capped at the difference between the strike prices minus the net premium paid. However, if XYZ fails to rise above ₹3,750, the trader's loss is limited to the net premium.

Thus, by using this strategy, traders can manage their risk exposure while setting themselves up to profit from predicted market movements. 

Bull Put Spread

Another strategic option in a bullish environment is the Bull Put Spread. It is employed in moderately bullish markets and allows traders to benefit from the premiums collected on options. It is executed by selling put options at a higher strike price and simultaneously buying put options at a lower strike price, with both options set to expire at the same time. This approach minimises the initial investment and risk because the premiums received from the sold puts help offset the cost of the purchased puts. 

The profit of this strategy is maximum when the underlying asset stays above the higher strike price as it allows the puts sold to expire worthless and hence enables the trader to retain the full premium.

Consider a practical scenario with stock XYZ, trading at ₹750. A trader might deploy a Bull Put Spread by selling put options at a ₹700 strike price and buying puts at a ₹650 strike price, both set to expire in one month. If XYZ stays above ₹700, the trader keeps the premium from the puts sold. This setup not only provides a clear profit margin but also limits potential losses at the difference between the strike prices minus the net premium received, should the stock price fall unexpectedly.

Strategies for Low Volatility

• Long Call Butterfly

After exploring strategies employed in bullish environments, you must be wondering about those when the market volatility is low. Long Call Butterfly is a popular strategy in such situations. 

This strategy involves buying one in-the-money call option, selling two at-the-money call options, and buying one out-of-the-money call option, all of which share the same expiration date. The essence of the Long Call Butterfly is to earn profits when the stock price at expiration is very close to the strike price of the at-the-money calls sold. The setup aims to limit financial exposure while targeting a specific price range for maximum profitability.

• Case Study of Long Call Butterfly

For instance, if a trader anticipates that stock ABC, currently priced at ₹500, will remain stable, they might establish a Long Call Butterfly. This could involve buying a call at ₹480, selling two calls at ₹500, and buying another call at ₹520. The ideal scenario here is for ABC's price to hover around ₹500 at expiration, allowing the trader to maximise gains from the premiums of the sold calls, balanced against the cost of the calls purchased. This strategy's risks and rewards are tightly confined and thus provide a controlled, strategic approach to trading under specific market conditions.

• Short Call Butterfly

The Short Call Butterfly strategy is another strategy in scenarios with similarly low volatility. It, however, employs a different positioning of options trades and aims to profit from the premium decay as long as the stock price does not move significantly. It involves selling one in-the-money call, buying two at-the-money calls, and selling one out-of-the-money call. The purpose behind the seemingly complex strategy is to collect premiums on the options sold, which are maximised if the stock price remains near the at-the-money strike price at expiration.

The ideal conditions for a Short Call Butterfly are when the market is expected to have minimal volatility and remain around a specific price level. This setup benefits from the decay of time value on the options sold, especially as the expiration date approaches. The risks in a Short Call Butterfly come from significant movements in the stock price, either upward or downward, beyond the strikes of the options sold. These movements can lead to unlimited losses. Thus, it is very important to manage the position actively and possibly employ stop-loss orders to mitigate potential losses.

• Case Study of Short Call Butterfly

For example, if the same stock is trading at ₹1000, the trader might sell a call at ₹980, buy two calls at ₹1000, and sell a call at ₹1020. This position earns the trader premium income from the sold calls. If the stock price remains around ₹1000 as expiration approaches, the premiums from the sold calls are retained as profit. However, if the stock price moves significantly above ₹1020 or below ₹980, the strategy could face substantial losses.

Note: Both the Long Call Butterfly and the Short Call Butterfly require precise market forecasting and careful setup to optimise the outcomes. These strategies are particularly favoured by traders who anticipate little to no movement in the underlying asset's price and are comfortable with the complex risk management they necessitate.

Risks and Considerations

While advanced trading strategies provide traders with opportunities to maximise gains, they are not free of risks. In fact, there may sometimes be unlimited losses. It is, thus, important to get a hedge against market downturns and other loss-making conditions. Below are some risks and considerations that traders can keep in mind. By taking these risks and considerations into account, traders can more effectively employ advanced options strategies to enhance their trading outcomes while managing the associated risks.

Risks

• Premium Loss: If the market moves contrary to expectations, there's a risk of losing the entire premium paid for the options.
• Market Volatility: Unexpected shifts in market conditions can lead to significant financial losses, particularly if the strategies are not well-hedged.
• Complex Execution: The intricate setup and requirements for successful execution can lead to mistakes, especially under fast-changing market conditions.
• Unlimited Losses: Certain strategies like the Short Call Butterfly have the potential for unlimited losses if the market moves significantly beyond the targeted price range without adequate protective measures.

Considerations

• Market Analysis: Perform thorough research and continuous monitoring of market trends to align strategies with current conditions.
• Risk Management Strategy: Establish clear guidelines for risk tolerance and use hedging techniques to manage potential losses.
• Use of Stop-Loss Orders: Implement stop-loss orders to automatically limit losses when the market moves unfavourably.
• Strategy Adjustment: Be prepared to adjust positions in response to market movements to minimise losses and potentially capitalise on unexpected changes.
• Knowledge of Strategy Conditions: Understand the optimal conditions for each strategy to ensure they are employed under suitable market scenarios to enhance the likelihood of success.

Wrapping Up

The options trading strategies from basic to advanced work for different market scenarios. This reflects the nuanced nature of options trading and shows how traders can profit in any kind of market environment. Each strategy serves distinct objectives, from maximising gains to robust risk management, and offers traders the right ways to tackle the complexities of the financial markets. It is, however, important for traders to be mindful of risk and manage it well, given that trades can go either way.