Most Indian Nifty traders buy options. When you buy a nifty option you need to invest money. When you sell your options money is credited back to your account.

For example. If nifty is at 5600 and if call option of strike price 5600 is 100 and you want to buy one call, you will need to pay 100*50 = 5000.00 to your broker to buy the option at price 100. If you want to buy 2 lots you will need to pay double the amount: 100*50*2 = 10,000.00

There is one interesting point to be noted. I have been in touch with many option buyers in my life and what I have seen is that most of them have much more amount in their trading account, but only use a fraction of it when buying options. Most of it lay idle in their account. Well there is good news, now you can make that money work for you and make extra cash.

How?

Let us suppose Nifty is at 5500 and you expect it to go up in a few days. You can buy call options of nifty. Lets also assume that volatility is high, so the options are also priced high.

A 5500 call is at 120. So you need to pay 120*50 = 6000 to buy a call. Now to reduce the cost of buying this call you can do two things:

1. High Risk High Return Strategy: Very risky but highly rewarding. Should be done when you are highly assured of your opinion, else losses are unlimited.

The strategy: You can sell one ATM put. If 5500 put is also at 120. You will get Rs. 6000.00 when you sell this put. So virtually your call comes for free. If Nifty really starts to move up, you will make money BOTH on your call and your put. Humm great, isn’t it? But what if you were wrong? You will lose money on both calls and puts. Nothing comes for free. 🙂 And remember, your losses in the put sold will be unlimited, until you cover, if nifty keeps falling.

2. Medium Risk High Return Strategy: If you are not very sure of the nifty movement but still want to reduce the cost of your call, you can sell an OTM put. For example if you think nifty may not rise too much but may not fall too much either and will not certainly fall below 5200, you can then sell 5200 put. You may not get 6000, but you should get a percentage of it. For example if at that time 5200 put is at 20. You will get 20*50 = 1000. Your cost of buying the call will reduce by a thousand rupees.

Your max loss is Rs. 5000 if nifty does not fall below 5200.

3. Low Risk Low Return Strategy: This is the strategy used mostly by professionals. However here the returns are limited. Same view and you buy a 5500 call at 120, and to offset the cost you sell one 5600 call or a 5700 call depending on how much confident you are of the nifty movement.

Lets assume Nifty is at 5500 and 5500 call is at 120, 5600 call is at 85 and 5700 call is at 45.

What the pros do is this. If they are very certain of the upwards move, they will buy the 5500 call and sell the 5700 call. If they are not very certain, they will buy the 5500 call and sell the 5600 call.

Can you figure out why do they do this?

Ok. Let me explain. First let me explain a few things about this strategy. If nifty indeed starts to move up what do you think is going to happen? The 5500 call will increase in value, but 5600 and 5700 call will also increase in value. But 5500 call will increase more than 5600 and 5700 calls due to delta.

Now the trader will make money in 5500 call but will lose money in 5600 call or the 5700 call whichever he or she has sold. The same logic applies – the 5600 call will increase in value more than the 5700 call. So if someone has bought a 5500 call and sold a 5600 call and nifty moves up, they will make less profit than someone who has bought 5500 call and sold the 5700 call as 5700 will increase in value slower than 5600 call.

Hope its now clear why the pros sometimes sell a higher call and sometime sell a less higher call.

Note that the risk is reversed if the view was wrong – that is if nifty starts moving south. Since the 5600 call will lose value faster than 5700 call and the premium was also high – someone who had sold the 5600 call will lose less than someone who sold the 5700 call.

When professionals are very certain, they do not want miss a great opportunity to make money. They will buy ATM call and sell a far OTM call. When they are not they buy at ATM call and sell just the next level call.

The limitations: If the view was right and if the 5500 call was bought and 5600 call sold – any move above 5600 will not bring in any money as 5600 will lose money and effectively the profits will be capped/limited.

If the view was right and if the 5500 call was bought and 5700 call sold – any move beyond 5700 will not bring in profits as 5700 call will lose money. Effectively capping the profits at 5700 levels.

Note that the trader who sold 5600 call made less money because only after 100 points move his profits are capped, and the trader who sold the 5700 call made more because his profits are capped after nifty moves beyond 5700. Most traders will actually book their profits before a 200 point move. Similarly trader who sold 5600 call will lose less than the trader who sold the 5700 call as the premium received was more by the 5600 call seller.

These are some ways by which you can reduce the cost of buying an option. And its highly recommended. Unfortunately all tips providers almost always advise to buy naked options. This may look good when you are making profits, but when you start to lose money you will appreciate the value of hedging your options bought. Limited risk, limited reward strategy will always prove fruitful in the long run of your trading business.

Recently we discussed married put where you can buy puts if you feared that the stock you own may drop in the price in near future. If it does, you recover some of the losses from the profits gained from the puts.

What happens if your feelings are exactly the opposite? What if you feel if the stock you own may stay at the same level, be range bound, or may rise just a few percentage? Lets take an example. You hold 500 HDFC bank shares and your view is that for sometime (say a month) the stock is going to stay more or less where it is, or may be go up a little bit but not too much, or may head south but not too much. What do you do in such a situation? How do you make money?

Covered call is the answer. What is a covered call?

Covered call can be done when you feel the stock will not move much anywhere in the next 30 days. You should own the stock in cash equivalent to its F&O lot size. Yes a no movement in stock can also bring some money into your pockets. 🙂 Supposing you bought a stock at 16 and you feel it may be around the same place next few days – you can then just go and sell the 21 out of the money (OTM) call. If stock stays at the same place, or moves up, or goes a bit down you still make money. Please note that when you sell a call you receive cash. This means your cost of buying the stock goes down. So now you have a new break even which is below 16. After selling the call if the stock is anywhere above this new break-even on the expiry day you are in profit, else loss. Note that your loss is less than those traders who had the stock but did not sell the call.

Look at the image below to understand covered calls better:

Side Note: This happens in most months. If you study stock markets you will see that most stocks trade in a range for months. Huge movements like 10-20% come only in a couple of months in a year. Most of the times your stock will be 5%+/- in a 30 day range. So this strategy is great to make money in those 8-10 months when the stocks does nothing. In fact even if it moves up or goes down a bit, you will make money with covered calls.

Covered Call in Details

Selling covered calls is not selling naked options, they are covered by your stocks – so the chances of loss is very less. Interesting? Lets discuss more. Lets take another example.

Lets assume you bought 500 HDFC Bank shares at Rs. 650 a share (today’s closing rate). Today is 18th of September, 2013. Your view is that for the next one month or so, its going to remain almost at the same place, or go slightly up or down. You think that it may not cross 700. Using your shares as collateral you can sell October HDFC Bank 700 calls. Today at closing it was selling at 15.00.

If HDFC bank stays below 700 on the expiry day of October 2013, you pocket a cool Rs. 7,500.00 (15*500 = 7500) without actually investing anything. You still hold the same 500 shares of HDFC bank. 🙂

Even if you did not invest a single rupee while selling the call option (remember you sold using your stocks as collateral), you were still risking 3,25,000 that is the cost of buying the 500 shares of HDFC Bank. 500*650 = 3,25,000.

Lets calculate the ROI (return on investment).

Once you sell one HDFC Bank 700 Oct 2013 call at 15, you will immediately receive 15*500 = Rs. 7,500.00 in your trading account. You bought 500 HDFC Bank shares at 650 = 500*650 = 3,25,000. ((7500/325000)) * 100 = 2.30%. So your return on investment is almost 2% per month (since one and half months are left for Oct expiry – we assume its less than 2.30%). If you do this month after month you can make 25% or more on your investment of 3,25,000, which is approx Rs. 81,000.00 in one year. Yes there may be a couple of months where you may not make anything. Still even something slightly less that 81,000.00 in no small amount. Do you think HDFC bank will go up 10% every month? No, so the chances are making money are very high every month.

Isn’t it great? You keep the shares and still make a good 25% of it. If you are willing to take more risk, you can sell ATM calls and you may make more than 10% per month. But the winning months will reduce.

Well there is more to it. If HDFC Bank actually moves up but not beyond 700 on the expiry day, you keep entire premium you got for selling the call, plus you can sell your shares at 7.5% profit at 700. That’s double bonanza. Not only you made money from the calls sold, but also from selling your shares. Time for smiles :).

So where is the risk in Covered calls?

All good news till now. Time for some bad news.

1. What if HDFC shoots beyond 700? You start losing money in the sold call. However you do not lose anything till 715 – because you got 15 when you sold the call, beyond that there is a loss. But wait, you will still profit from the shares you bought. So essentially there is zero loss. Only problem is that beyond 715, you do not make any money. If there is a no-holds-bar rally in the stock, you will rue your decision to sell the call.

2. What happens if HDFC Bank falls? Yes you do keep the premium, but you make a loss in the shares you are holding. Of course if they are for long term, that’s great – but if you wanted to keep the shares for short term you have to sell them at a loss but you keep the premium you got from selling the call so your losses are slightly reduced.

No other loss in covered calls.

Covered calls is a great strategy if you hold a stock in your portfolio and want to keep it for a long time. If they fall, you keep the premium, else sell both your call and the stock to make sure you do not lose any money and re-enter the stock when it falls down.

One thing to keep in mind is that you need to keep the same number of stocks of that company as its futures shares. For HDFC bank it is 500 shares. If you buy a future of HDFC bank when its at 650 you get a leverage of 650*500 = Rs. 325,000. Therefore in my example I had taken 500 shares of HDFC bank.

You may have to pay only a fraction of that amount when you buy a future or sell a call, but your real risk is 325,000 that is 500 shares of HDFC bank.

Important note: If you do this with less number of shares than the leverage you get in futures, the math will not work and you may suffer losses. If the stock keep rising beyond the sold call, you may suffer huge losses as the numbers won’t match when you sell your shares to book profit. The loss on sold call will far exceed the profits made in selling the shares.

Short put is a strategy which can be played when you are bullish about nifty or any stock. If you think that Nifty will be go up you can either buy calls (long call) or short puts (sell puts). Most retailers almost always buy option and never sell. Its quite strange as option buyers mostly lose money. Your strategy should depend on market conditions and not just one single strategy.

Anyways coming back to the topic. If you think Nifty will move up you can short puts. If your view was right, your put will expire worthless and you can keep the premium. Of course if your view was wrong – you are at unknown risk till expiry or till the stock or index reaches zero. 🙂 Put cannot lose any further.

Have a look at the graph:

Its clear from the graph above that a put loss can be max when the stock reaches 0. A short put cannot lose more than that. However a short call can lose unlimited amount of money because the stock can rise to any level on the upside. In my course I teach how you can use this feature to your advantage.

Don’t be afraid of shorting puts, but have a plan like buying another put for protection. Yes you can buy calls as well if your view is bullish and it does have a limited risk. But the problem is buying options also comes at a risk. We will first discuss the short put and the difference between buying calls and shorting puts later.

Let suppose Nifty is at 5300 and you think that it may go up in the near future (you are bullish), you can short OTM puts. For example if you think Nifty may not go below 5200 this series as it has already come down a lot recently, then you can sell 5200 put. The lower you go, the safer you are, but the lesser premium you get. Low risk low returns, high risk high returns.

If Nifty does not go below 5200 as you had expected, you keep the premium. However if it keeps going down, your risk starts from 5200 minus the premium you got. For example if you got 100 as premium then your risk will start from 5200-100 = 5100.

Therefore it is always recommended that you should do a credit spread. Short 5200 put and buy 5100 or 5000 put. That way you will be not be on unlimited risk and you can breath easy even if Nifty is going against your view. Selling naked options is very risky. With credit spreads you know your max risk, and the best part is you are not on max risk from day one. If indeed nifty moves against your spread you can buy it back and sell another spread much lower – say for example 5000/4800. Chances are this time you will be successful. After all what are the chances that Nifty will close below 5000 within a month? You will get back your loss plus you may make some profit as well.

Of course you must make sure you are not taking a big loss, so before Nifty reaches an uncomfortable level you should buy back to close the spread. And if you think nifty will go even further down, you can wait for a couple of days to sell another spread. This will give you double benefits of going much lower and getting good premium. And don’t forget the losses you restricted because you acted sooner. If you keep waiting for things to reverse, that’s the worst decision you can ever take. Because in trading, hope never works. Period.

Yes nifty may revert back, but most of the times waiting for too long will make your losses bigger and impact your over all return in a year.

And one more thing – you should not wait till expiry. If you got 70-80% of return of a sold put or call you should close it as eventually you will find that a profitable position going back to a losing one. You do not want that. Don’t be cheap. Just close your profitable position, and be happy. Look for other opportunities.

Now coming to the difference between buying calls and selling puts. Both do the same job – giving you profits if Nifty goes up. On paper though buying calls is limited risk and unlimited profits, and shorting puts is limited profit and unlimited risk. However in reality both of them have some risk and some profit.

Example time. Lets suppose Nifty is at 5500 and you decided to short put and you got 100 as premium. Your friend decides to buy calls. Lets suppose 5500 call is also at 100. As a buyer probably he is looking for 10 points or 20 points profit. That is what most option buyers look for isn’t it? However you have decided that you will close your short put if Nifty reaches 5400 – that is your stop loss. Your friend will make his 20 point profit and exit. If nifty does not come back to 5500 in that series – your put will expire worthless and you keep all 100 points. Who made more?

Yes, if your view was wrong you are at unlimited risk so you can’t wait beyond 5400 and close your trade at a loss, however an option buyer may wait till the end of series to try his luck as he is at limited risk. If nifty turns and starts moving up, he can close at a profit. As you can see there is a trade off in both.

Some people like me, like to sell, but some like to buy. That is not important. What is important is what nifty does after you put on the trade.

Married or Protective puts are helpful when you want to protect the profits made from a stock, but do not want to sell it as of now to lock in the profits.

Married or Protective puts are also helpful when you bought shares and fear that the stock value may fall – but for some reason you do not want to sell the stock. Married puts will help in case the stock actually falls.

Here is a graph of married puts. If stock falls below “A” the protective puts will save the investor from losses in the stock.

Let me now explain in details.

You hold quite a lot of shares of a company and some bad news comes in about the company or about equities in general and you fear that your shares’ value may now tank. What do you do? You have two options:

1. Sell the shares at a loss, or
2. Buy ATM/OTM put of the same company.

Option 1 is pretty easy, but mostly you will lose money. Remember markets get the news before retail investors like us get. So even before you can trade, the markets will price the shares of the company you own at appropriate levels which almost always means you will be at a loss or may be breaking even (if you bought the shares at a great price.)

Even if you are not in a loss, one thing is pretty sure you lost a great amount of profits that you could have made had you sold the shares when they were at a higher level. Unfortunately greed came in and you kept it on hold. 🙂 Well don’t worry, it happens with everyone. Nothing to feel guilty about it. If you are still in profit, my advice is that you should get out, and re-enter at a lower levels. The problem is how on earth you know if it will ever go more down and where to re-enter?

Timing the market is extremely difficult if not impossible. (Actually impossible, but they say nothing is impossible so 🙂

You can however protect further downside of the stock by a simple strategy called married puts. Which takes us to the second option. Buy ATM/OTM put of the same company.

Note: Married puts are useful if you have a lot at stake in that particular stock, at least 2-3 lakhs or equivalent to its leverage in futures and options. For example right at the time of writing this article HDFC Bank is trading at Rs. 588.00 and let us suppose you bought 500 shares of HDFC Bank at 590.00. So your total investment is 500*590 = Rs. 295,000.00. The markets are falling – especially the banking sector. You fear that HDFC Bank may also fall and so you may suffer a loss, but you want to hold the stock and don’t want to sell right now and not lose money too.

You can then buy a put option of HDFC Bank to protect your losses from the downfall. Now if HDFC Bank falls, you need not worry as the put you bought will also increase in value and you can sell it at an appropriate level to realize a profit. Now your buying cost of HDFC Bank will come down due to this profit.

Three things can happen when in a married put strategy:

1. Prices moves down: You profit from the put bought. Your cost of buying the stock comes down.
2. Prices remain at the same level: Put expires worthless. You lose the premium paid to buy it. (Worst situation.)
3. Prices move up: You profit on the stocks bought. However you lose money on the puts bought. If prices move beyond the breakeven point you will make money. The premium paid to buy the puts should be added to the cost of buying stock. This is your breakeven point. Anything beyond that is your profit.

Great. But what is the risk?

The risk is if HDFC Bank shares stays at the same level or move up. The worst situation is when they stay at the same level. Your puts will expire worthless and you will lose whatever you paid as premium to buy them. If the shares move up, you will gain some from the up move but your puts will get lower in value as the stock price moves upwards. But after your breakeven points you should be in profits.

When is a married put helpful?

You should go for married put when you are certain that the stock price of the company you hold shares in will fall in value. And you should also know the maximum risk you are wiling to take. To make married puts work its best, it is best to buy ATM or just OTM puts. If you buy too far OTM puts they may be cheap but will not increase in value fast and may actually expire worthless even if the share price drops. This will be a double whammy. You lose money in shares and you will also lose money you invested in puts as well. As in joke they will become divorced puts. 🙂 Rather your expression will be 🙁

Yes taking a married put decision can bring rewards, but the risk is definitely there. You may ask why not sell futures of the same company when the stock price is going down.

Yes you may be right. Yes there are no premiums to pay and the cash also comes from the collateral from the same shares. You can use your collateral to buy options as well but at least you know your max loss when buying options. In futures you have no idea as it can be unlimited loss, so using collateral money in not a good idea.

Selling future is a better option if the stock price stays there or goes down. However what happens if there is some good news and the stock opens gap up the next day morning? You will make money in stocks you hold, but lose the same amount of money in the future. Your buying cost of the stock will go up. Unfortunately you will have to pay this as MTM (mark to margin) and if you don’t have cash your broker may sell some of your shares to pay for the losses you incurred in the future. Not a good situation to be in.

With married puts you know exactly how much you are going to lose. And if your view was wrong you may actually sell the put and restrict your losses.

It is your call, but experts always say married puts not married futures. So there is something to it.

Important Note: If you are not sure of the movement or if you think there will not be a significant drop in the share value do not attempt a married put. You may lose the premium you paid.

If you have a bullish or a bearish view in Nifty, here are some tips to help you make most money in a Nifty trend. Before reading please understand that this article is written for people with some knowledge about futures and options. As Nifty does not have any stock, it is only apparent that we use futures and options to give some tips on making the most money. If you have no knowledge of futures and options – please get some knowledge before reading this article.

Here we go.

1. You can buy Nifty futures if you are bullish or sell futures if bearish. A future will go up or down 1:1 in the same ratio as Nifty. Yes it does have a premium. But in any case it increases 1 point with every 1 point raise in Nifty and decreases 1 point in every 1 point decrease in Nifty. So even if it has a premium, you need not worry. You should realize a profit of almost 100 points if nifty actually raises or falls 100 points from the point you bought/sold the future. If your view was wrong, your losses will also be the same.

Well whenever you are trading you must keep in mind that you will not be right 100% of the time. In fact it is nearly impossible to be right more than 60% of the time. Here is where it is important that you hedge your position even if you are absolutely sure of the move. Since the derivatives gives you a huge leverage, doesn’t it make sense to use some of it to protect your losses to some extend?

These financial instruments are dangerous if not used wisely. You should be willing to sacrifice a percentage of your profits for the sake of protection. If you are wrong, which you will be many times during the course of your trades in one year, your protections will keep you in the game. Moreover with futures your timing has to be excellent. If your view was right but you timed it wrong, you will still end up putting a stop loss to your contract. For example if you were looking at 20 points profit or 20 points loss. You could hit a stop-loss only to see that Nifty actually moved in the direction you predicted. There will be heart burn, but then you have already lost it and there is nothing you can do to reverse it.So how to take on the ride?

There are two ways to do it.

ONE – If you have bought futures, simultaneously buy a slightly OTM (out of the money) put, and if you have sold a future, buy a slightly OTM call. Now you are protected at least to some extend. Remember this – this strategy WONT work if you wait till expiry. In fact in real world of trading you should not wait till expiry at all. If you have made a profit, move on to next trade. Why wait till expiry?

A wining trade may become a losing one in few hours of trading, let alone days. Today you are winner, tomorrow the same trade may be losing – so why keep yourself on the tenterhooks till the expiry day? You also save time and unlock trading cash once you book a small profit. Waiting till expiry is a foolish move. You will rarely win in the stock market if you trade derivatives and take it to expiry. Expiry day is also too volatile, and you wont have anytime left to do anything. You will be left praying if a wining trade suddenly goes against you. And praying to win in the stock market is another topic.

When you achieve your target, just close the trade. Agreed you will have to take a loss in your protection. But it will give you enough strength to stay in the trade if its going against you. Depending on how far OTM you have bought, at least you will keep getting back some of you losses from these options. Yes you will lose money if you were right in these options – but this is a limited loss and your profits from the futures will surpass this loss.

Buy the same number of lots as that of the futures. Yes if you are too far OTM or you are getting options at a very low cost (low volatility), you can buy a few extra. You wont believe if you were absolutely wrong (a strong move against your trade) – the extra options will actually bring in more profits than your losses in futures. But you got to do some math before buying protection. 20% of your profit target should be good enough. Do not spend too much on buying protection. Remember if you are right you should be rewarded for it. The protections will eat away your profits. So use your brain, do some math before buying protection.

TWO – This one is more popular. If you have bought a future, you can sell at OTM call. Now if your view was right, you will make money in your future buy, but you will lose some in your sold call option. But if you were wrong, you will recover some from the profits you will make in selling your call option. However if you are right, your profits are limited. Why? Because the losses in sold call, will offset the profits you make in the future. Lets take an example.

Suppose Nifty is at 5700 and the trend is bullish. So you buy a future and sell a 5800 Call. Lets suppose 5800 call is at 50. Now if Nifty expires at 5800, you will make 100 points from future and since 5800 call will also expire worthless, you will make 100+50 = 150 points. Now lets suppose Nifty expires at 5900. You make 200 points from future, but you make a 50 point loss in the short call. Your total profit stands at 200-50 = 150 points. That’s your max profit. However since you have bought futures, you losses are unlimited. If nifty keeps going down, your max profit from sold calls is 50 only, but you will keep losing money in futures. Your breakeven is at 5650 – after that losses are unlimited. (Nifty expiry just used as explanation. You shouldn’t bother going till expiry.)

Here is a tip: What about combining ONE and TWO? If you are bullish, buy a future, sell a call and buy a OTM put from the money you got from selling the call. You must be thinking wow what a great idea. Well everything comes at a cost. Here your max profit will be even less than the option TWO as if you are right, you will make money from the future, but lose on the short call and the bought put. Since you cannot buy deep OTM puts as they wont make sense, you may have to put money from your pocket to buy that put. What will be your payoff? Exact calculation is not possible but lets suppose you got 50 from selling call and you had to pay 50 to buy puts. If Nifty expires at 5800, you make 100 points from future, 50 from sold calls but you lost 50 form buying puts. Your total profit is 100 points. However if put was costlier than call, you need to subtract the difference from the profits. And that is you max profit. However in this strategy your losses are not unlimited.

If your view was wrong and Nifty closed at 5600, and supposing you had bought 5600 puts for 70. You will lose 100 points in the future, your put will also expire worthless but you make 50 points from the short call. Your loss -100-70+50 = -120. This is also your maximum loss. Your max loss is greater that your max profits. 🙂 Well as you can see everything in trading comes at a cost.

Similarly the above strategy can be inverted if the trend is bearish. You will then sell a future and buy a call or sell a put or both. The rest is self explanatory.

Important Note: If you have not hedged your position in futures than it is important you play with a strict stop loss. Buying or selling future is a unlimited profit and unlimited loss strategy. Also you should make sure you take maximum profit. So do not put a target. If your target is reached go for a trailing stop-loss as much as possible. This way if market goes up even after hitting your target you will not miss out on future profits. However if there is a gap down opening you may rue your decision of not exiting and booking profits. It depends on the market conditions. If you think market may go even further you may go with a trailing stop-loss. There can be a gap up opening as well. But if you are in doubt, its better to take the profit and exit.

2. You can buy calls if the trend is bullish or buy puts if its bearish. This one the is most sought after trade done by retail traders in India. Why? Because its easy to do and its cheap. But is it really cheap? We will discuss. But of course it is simple. If the trend is bullish you buy nifty calls and buy puts if the trend is bearish. You buy low sell high. Isn’t it the simplest way of making money from stocks? This is one single reason that attracts traders. Everybody wants to buy low and sell high. Therefore this trading strategy is very popular. Search for nifty trading tips in Google and you will see ads full of nifty option tips. They will be much more than ads of futures. Why? Because someone with even Rs. 5,000 in their trading account can buy options. And they know they can get money from you. However for futures trading you need more money in your account – at least Rs. 20,000.00.

Buying options is also a limited risk, unlimited profit strategy. This again appeal to traders. It can actually be sold by tips providers. Cheap, limited risk, unlimited profits – wow sounds so good. But is it really? No its not. The problem with this strategy is the theta time decay. When you buy options you are running against time and volatility. Your view has to be correct from the time you bought the options. Even if nifty stays in the same place, you will lose money. Even if your view was right but the pace is slow and volatility drops, the value of your options will drop. So in reality the limited risk and unlimited profits is only on paper. As soon as you buy options your premium is at risk of melting down to zero (0.05 actually :))

How to hedge this? If you have bought calls then you should sell calls. So even if your bought options melts away, you will realize some profit from sold options. Unfortunately not many traders do this. If you make money from the bought options, the sold OTM options will not lose much. But if your bought options expire worthless, your sold options will expire worthless too and you will recover some money from them. However your profits will be limited, as the sold options will start losing money, if your bought options are making money and vice versa. Your losses are also capped at the money used to buy options. You cannot lose more than money used to buy options minus money got from sold options.

3. You can sell puts if the trend is bullish and sell calls if the trend is bearish. This strategy is mostly done by institutional investors and hedge fund managers. As you all know selling options is a limited profit and unlimited risk strategy. Therefore most retail investors stay away from it. However it is not as bad as it looks on the paper. You can always buy back your options if you get into losses. Where is the unlimited loss? In that sense even futures buying or selling is unlimited loss on paper. But retailers do trade in futures. However just like futures, selling naked options is very risky.

How to hedge it? Best way to hedge is to sell a credit spread. You sell a OTM option and buy the same number of even further OTM options. If you do so, there will be credit in your account. This is a limited profit and limited loss strategy. Credit spreads and iron condors are very popular in the west as they are easy to mange. Most of the times a credit spread will expire worthless and you make money by doing nothing for a whole month. Great? Read this – trouble starts if the trend goes against you. Moreover the risk-reward ratio is very bad in credit spreads. Two bad spreads can eat away many months of profits. Therefore here too you should put a stop loss if the spread reaches a level you are not comfortable with. As you can see every strategy comes with their own pros and cons.

However when nifty is in a clear trend you should go with the trend. Do not go against it, or else you will lose money. And if you have good strategy in place with hedging making money in nifty in a trend is not that difficult.

Hedging any trade is very important. If you love to take Nifty Future trade in a trend I highly recommend my course where in the directional strategy you will learn how you can hedge Futures with options. If you are right you will make money – but you make money taking a Future trade anyway if you are right. So whats so great about the strategy in my course? It is that you can make money even if you were WRONG in your Nifty Future trade. Yes if you were wrong the options’ delta increases more than the Future delta and you can make money. For that to happen Nifty or the stock has to move fast against your trade. For more information please read about the course.

If you do some research online or even ask an expert, you will find that a lot of people and experts advise against buying out-of-money (OTM) options. The reason is plain and simple. They say it has more chances of expiring worthless so you may also lose your money. They should be sold not bought. Well they are right. More often than not out of the money options expire worthless. Is that the only reason you should not buy them?

I do not agree – to some extend. If you have a well thought out strategy you can make a good profit out of them. Also out of money options have other importance too – else why are they traded? Let me put some points outright to explain:

1) OTM options are great for protection: If you have read about credit spreads, you will understand the value of buying OTM options for protection. If a spread is going against you, it is the OTM option that will bring profits and minimize your unlimited losses. In fact it is due to out of the money options that you may sleep well in the night knowing very well your max loss. Buying OTM options will limit your losses. OTM options have the same job on the iron condors as well. Buying out of the money options can be a lifesaver if you have sold in the money options.

2) OTMs double money very fast: Agreed, its easier said than done. But in my three years of experience in trading, I have seen hundreds of out of the money options doubling in value in days. (You feel bad thinking why you did not invest, isn’t it? But that’s a different topic.) I am sure you must have experienced too.

I have seen an option going from 1.00 to 3.75 in one day. Yes an increase of 375% in one day. No in-the-money option can ever match that even if there is a huge move in the underlying. But please never buy so deep out-of-money option. This is just an example that happens very rarely.

You see percentage wise, it is the out-of-money options that increase in value fast – by the way, they don’t decrease that fast. Why? Because the max they can decrease is to 0.05. If 30 days are left for expiry, an OTM with the value 2 – how fast do you think its going to decrease? Because they have nothing but time value left, the deep out-of-money options cannot decrease very fast if enough time is left. Yes enough time should be left – and that is a very important factor. I will explain later why.

3) Who is waiting till expiry anyway? Did you make any meaning out of that? If you didn’t I will explain.

Read this is important. When experts say you shouldn’t buy out-of-money options they are referring to the expiry. Yes its true that OTM options mostly expire worthless, so if you plan to wait till expiry then you are doing a huge mistake. Do not buy out-of-money options to hold till expiry. You will lose all your premium paid. Experts are right – out-of-money options expire worthless 80% of the time. But my point is who is waiting till expiry?

Let me give you a live example. Today 26-July-2013, I bought NIFTY AUG13 6400 CE (call option) for 3.5. My max loss capacity I have determined is Rs. 3500. (Note that I am not putting a lot of money at risk as this option will 90% expire worthless, I cannot be greedy.) I have bought 20 lots. Here is the math: 3.5*20*50 = Rs. 3500.00.

Nifty today closed at around 5886. There is a lot of time for the August 2013 series to expire. I need not worry. And moreover I have made up my mind not to lose more than 2500 in this trade. If this option reaches 1.00, I will close this trade. However what are the chances that this option will only decrease in value for the next few trading sessions? For that 1) Nifty has to keep going down and 2) volatility has to also keep going down. Even if Nifty goes slightly down, but volatility rises – I can make a profit.

My target is 5.5. if Nifty goes up by even 50-60 points or volatility rises I can achieve that. The profit I make is Rs. 2000.00. I am risking Rs. 2500.00 to make 2000. Isn’t that fair?

I will not update with what happened to this particular trade as it is not important. But what is important is that when you buy out of money options you should keep the following strategy in mind:

1. Never buy very deep out-of-money option. As explained earlier please do not be greedy and buy too deep out-of-money options. Yes they may also increase in value but for that the underlying has to move very fast.

2. Give your option enough time and room to increase in value. Do not buy a out of the money option in its last week of expiry. You will rarely make a profit. If you keep your stop-loss very small you are most likely to lose money every time.

3. Sometimes be prepared to lose 100% of your option premium – as you may not get time to close the trade (a huge jump against your trade) and you may not get back a comfortable amount. In that case leave the option till expiry, who knows the trend will change and you may get your money back, or you may even be in profit. Remember the first point, you should have enough time for it.

4. Do not buy options too often. Usually option buyers lose money. Yes if 80% of options expire worthless, it means option sellers are making money. Do proper research before even thinking of buying an option. Lots of people have lost lot of money buying options. This point goes for at the money (ATM), in the money (ITM) or out of the money (OTM) options. If you want to buy anyway – you should have a clear stop loss or profit booking price in your mind. You should place it in your system if you think the option price may reach there on that day.

Now you must be thinking why I bought this option? Because right now Nifty is in a bull run and it fell 200 points in three days. I am sure it will try to climb some points up in the next few days and I should get my target. No technical analysis here – just pure speculation – with risking only Rs. 2500.00. Hope you get the idea.

4. Do not spend a lot of money on buying out of the money options. As you can see I put in less that half percentage of my trading capital into buying these OTM options. Even if they expire worthless – I will not lose much. My next trade can make me money.

Remember these points and just don’t ignore out of the money options – sometimes they carry gold with them. Spot them. 🙂

A lot of Indian retail option traders buy options in the hope of making money, sorry I was wrong actually they buy options in the hope of making a lot of money (unlimited profits).

Here is one real example of how a trader lost more than 40 lakhs buying options looking for that home-run which never happened. Actually home-run never happens because people book profits much earlier and let the losses run.

Unlimited profits is actually a trap. How many of you have actually made even one trade of unlimited profits? I mean what is unlimited profits? Buying an option for 10 and selling it for 100? Has anyone done that? Or you book your profits much before that? Maybe when its up 20% or 30%. So where are unlimited profits? Please do not fall for such a trap.

Unlimited profits is nothing but another name of GREED. And greedy option traders never make money. Ask me, I was one of those greedy traders. But the stock markets took a lot of money from me to make me realize greed is bad in stock markets.

Similarly unlimited loss is also a trap. Do you think an option seller will leave his sold option open if its losing money? No. But lets leave that topic for another article.

However option buyers have an excuse and that is they think option buying is “limited loss unlimited income strategy”. Yes it is. But the problem is they book profits at 10 points and leave the losses open in the hope the trade will reverse. Unfortunately the option expire worthless. All money gone. Where is the profit?

Option buyers have to get 3 things right:

1. Their timing and direction of the stock price,
2. Their view of the movement and how far the stock travels,
3. Time and volatility.

I should have written 6 actually, but that would have scared option buyers. 🙂

Lets discuss them one by one.

1. Their timing and direction of the stock price:

Option buyer timing has to be perfect when they buy options. As soon as they buy a call option, the stock has to go up. If they buy a put option, the stock has to go down for them to make money.

Let me take an example. At the time of writing this article Nifty is at 6050 (a 1.25% up-move from yesterdays close). Now a call buyers view might be that Nifty might move further 20-50 odd points up. He buys a Nifty JUL13 call option strike price 6000 currently at 78. Now what I mean by the timing has to be right is that Nifty has to go up from here from the time he bought the call option. It’s already 3.20 pm – we are ten minutes away from close.

The buyer may have a target of 10 or 20 points and since ATM options generally have a delta of .50, it is assumed that Nifty has to go up 20 points from here for him to make 10 points profit or has to go up 40 points for him to make 20 points. Note that .50 delta means every 1 point move in Nifty will add .50 points in the ATM call. Similarly .50 we be deducted from the ATM call if Nifty moves down.

What do you think are his chances of success. Forget about what the technical analysis says. Just think about a figure of the success rate. 50%? Yes it is and in that case his probability of winning has already reduced by 50%.

So when you are buying options – your timing has to be right – absolutely right. The stock or the index has to move in the direction of your option from the moment you buy until you book profit.

2. Their view of the movement and how far the stock travels:

If a stock is moving up, or going down – chances are it will continue to do so for sometime and then the trend will change. The problem is we don’t know when. Today Nifty went only up, and closed almost at its peak at 6040 (the 6000 call we bought is already at a loss). The point is the option buyer’s view should be correct and it should hold for quite some time for him to book profits. Remember that time is also eating away the premiums of the options bought. His race is against time too. The stock has to move pretty quickly in the direction the buyer predicted, so that he hits the profit.

Unfortunately most of the times their view is right but timing is wrong. They still lose money. For example, you are thinking that Nifty will move up from here and you bought at call. If your target is 10 points your stop-loss should be also 10 points. What if Nifty hits your stop loss and then starts its upwards journey again? Your view of the movement was right, but in the long term not in the short term but you lost anyway because you cannot keep waiting to see your options expire worthless. If they do you will lose all the money you paid as premium. You have to take a stop loss at some point even if your view was right.

Seeing this many option buyers increase their stop loss points to 20 or 30 points. And increase their target to 20 points too. Can you get the idea? The more money they are losing the more money they are putting at risk. Do you think this is a good idea? Well it may work if you buy more time. Explanation is below. However there are no guarantees.

Another example. What if Nifty stays in a tight range for quite a few days? Only 7 calendar days are left for expiry. Time is eating away your premiums almost 10% a day on an average. Even if your view was right, you will have to take a stop loss just because your premiums were melting away.

So your view of how far the stock will travel, and timing both have to be correct to make a profit when buying options. Chances of success? 50%.

Combining 1 and 2. The chances of success of an option buyer is 25%.

3. Time and Volatility:

If the above 2 were not enough, the option buyers have one more major issue – their prediction of the movement has to come within a specified time else the option premium will melt away. Of course especially for call buyers, when the stock moves up, volatility goes down. For call buyers this can be killing.

They will be frustrated to see that their prediction was right, timing was also right, speed was also right but somehow the options worth is not increasing because the volatility is decreasing.

Lets discuss in details. Just like stocks, no one can predict volatility. Jumps in volatility in the range of 3%-10% are quite common. A 5% jump in volatility can bring in significant changes in the price of an option. Volatility is a friend of an option buyer if it increases, but enemy if it decreases. Usually when the market is trending up the volatility decreases. It also decreases if markets remain calm and stagnant. But they can also increase if it goes up especially when predicting gets difficult. However one thing is for sure, when market falls fast, volatility increases, because there is fear in the markets.

The point here is and I think everyone knows it, if volatility decreases the option values also decreases. So your timing may be right, your view may also be right, but if volatility crunches after you have bought an option – chances are you will still be making a loss. How bad is that?

I have myself witnessed many times call option getting reduced in value even after an increase in the stock price. It will be really frustrating to see your option going down in value even after your view was right and the timing excellent.

Now the big question. How many times can you get all of the 3 points correct? Don’t be disappointed. You can, it is not that every time you will fail. But the failures will be more than the winners and therefore you will not be able to make money buying options.

One thing more. Most retail traders buy ATM (at the money) options. In technical sense, ATM options are the costliest. Why? Because they have the most time value. They have zero intrinsic value and therefore all they are buying is time. If the stock does not move – the option will become worthless. If they buy OTM (out of the money) options, the stock has to travel very far and with high speed for OTM buyers to be successful. How many times will they be successful?

Combining 1, 2 and 3 we can see that the chances of option buyer being successful is only 12.5%. Which means they lose money 8 or more times out of 10 times they trade on an average.

So what you should do when you want to buy options?

1. Buy time too: You should give your options enough time to succeed. For example if you give yourself 60 days of time instead of 30 days – you have a lot of time to make a profit. Agreed 60 days options are costlier, but they give you a chance to succeed. However since you have given yourself time you should also now give the options more room to perform. For example a 20-25 point stop loss and a 40-50 point profit booking whichever comes first. Note that the profit points are double than the losses.

2. Buy when volatility is low: Agreed you cannot time volatility, but if you someday see the volatility has droped considerably, you may go ahead and buy options. When volatility will increase you can realize a profit.

3. Don’t be greedy: Keep booking profits at regular intervals or just keep a trailing stop-loss of profits. Don’t get greedy thinking to book profits when the option price will double. They do happen but sadly you don’t know if your option will double or not. You should look at points and book your profit when it arrives.

Final word: You got to take a call. Sometimes buying options is good. For example when you are sure a stock price will move in any direction sharply, in that case selling options is suicidal. In such a situation you should buy call and put options and wait for the price move and book your profits – still if volatility drop you will lose money.

However under normal market conditions – buying options will not make you money in the long run!

Note: If you are tired of buying options and losing money, I advise you to take my course. I do not promise that you will make 100% returns every month or even a year. But I can promise you that 3-5% a month is possible. I will explain to you very conservative strategies. You will know exactly when to enter and when to exit and book profit. For more information read this or contact me.

Iron condors is my favorite strategy to trade nifty options month after month. Well if you want to know the winning percentage – its close to 70%. But what’s more important is how to handle the 30% losses. If you are willing to take less profits you can also trade iron condors with 90% winning probability – and that’s the best strategy for beginners.

First thing first – What is an Iron Condor?

An iron condor is a trade of two credit spreads – one on a call option and one on the put option – sold on any underlying for the same month. Since I always trade on nifty, henceforth all my examples will be restricted to nifty only.

If you don’t know what credit spreads are, this article will help you to know about credit spreads. Read that first and then come back here.

In short in credit spreads, one near option is sold and the further OTM option is bought for insurance. Since the sold option has more points, a credit is done to your account. You actually buy the OTM option from the money you get by selling the near option. That is why the number of sold options should be equal to the bought options.

Now what if you think in this month nifty will not close beyond 6000 and not fall below 5500? you can sell an iron condor for that month. You can sell a credit spread on 6000 call by selling 6000 call and buying either 6100 call or 6200 call according to your risk capacity. Similarly you can sell a 5500 put and buy 5400 or 5300 put as per your risk. Remember the more gap you give between the sold and the bought options – the more money you make but more risky your iron condor becomes. Justified, isn’t it?

How to do it? Ok let me take a live example from one of my trades:

This trade was done in the month of May 2013. My view was that nifty will not go beyond 6000 and not go below 5700 in the May 2013 series. So I sold an iron condor for lets suppose four lots (I trade more lots but this is to simplify). Here are the details:

1. Buy 6100 Call Option: 31.70 * 100 (2 lots) = -3170 (debit)
2. Sell 6000 Call Option: 65.90 * 100 (2 lots) = 6590 (credit)
3. Buy 5600 Put Option: 12.75 * 100 (2 lots) = -1275 (debit)
4. Sell 5700 Put Option: 23.45 * 100 (2 lots) = 2345 (credit)

Here the profit and loss graph of an Iron Condor:

You can see in the graph that profit and loss is limited in Iron Condor. But the risk in the Iron condor is more than the reward you get. However Iron Condors are profitable most of the times. The rest of the times the risk needs to be managed aggressively. If you take my course I will tell you exactly how I manage the risk much better than how most traders manage it. I actually take a trade that is successful 95% of the times after my Iron condor hits a stop loss. This ensures I get back losses made in the Iron Condor trade plus I end up making a small profit because I double the lot in the second strategy.

Ok, lets get back to the strategy I was discussing in this article.

Net Credit in my account: 6590+2345-3170-1275 = Rs. 4490.00

Now lets calculate the ROI if I win.

For 6000 call and 5700 put option sold investment required: 15000*4 (lots) = 60000.00

For options bought= 3170+1275 = 4445.00

So 60000.00 + 4445.00 = 64,445.00 – this is approx cash locked in my account for this trade for margin money.

If all of the options expire worthless I keep 4490.

ROI: (4490/64450) * 100 = 6.96% in 30 days – not bad!

Now lets calculate the losses:

If Nifty expires at 6100: -3170-3410-1275+2345 = -5510

If Nifty expires at 6200: 6830-13410-1275+2345 = -5510

If Nifty expired at 6300: 16830-23410-1275+2345= -5510

If Nifty expires at 5600: -3170+6590-1275-7655 = -5510

If Nifty expires at 5500: -3170+6590+8725-17655 = -5510

Loss ROI = (5510/64450) * 100 = 8.54%

It means my maximum loss in this trade is 5510 wherever nifty closes and maximum profit is 4490 if it closes between 6000 and 5700. Does that makes sense? Yes it does if I risk 8.54% of my capital to make 6.96% in 30 days.

Now this discussion will get even interesting. What happens if my view goes for a toss and nifty starts to move in one direction and my real fears come true? Well it did and that is the reason I took this month’s example. A loosing one and not an easy win. 🙂

As soon as put the trade on 26-Apr-2013 – nifty started to rise – a worst case scenario. Nifty was already in a bull run since 9-Apr-2013 from touching of a low of 5487. It had reached almost 5900 when I put on the trade. I thought it wont raise any further or start to fall soon. As you can see I got more premiums from my calls than my puts. When nifty or any stock is rising the system makes the calls costlier and vice verse. This I done to make an even field for buyers and sellers. If the sellers are not getting a good premium for selling options why would they sell in the first place?

Long story short – my short call was in trouble and I had to adjust or get out or hedge my position to make sure I at least do not lose a lot on my trade.

How to adjust an iron condor?

We will come later to what I did, but lets first discuss what you can do when your iron condor is in danger:

1. The most common option done by traders – rollover the condor one step up if the underlying is going up – or roll down if its going down. In my case I should close the 6000/6100 leg and sell/buy the 6100/6200 calls. Depending on profits I should also close my puts and bring them up one position to make more money. However please note that this should be done early as otherwise it will get costly to close the condor. Idea is to lose less and make more.

2. Close the losing leg in small loss (in my case the sold call) and let the other leg expire worthless. Note that the bought calls will bring in some money and offset the losses. So I don’t lose 5510 – my max loss. I lose much less. In reality if your losses are less than you can make from the leg that expires worthless you make money and not lose it. Though your ROI will be less. However the problem with this strategy is that what if nifty nose dives back in the opposite direction after you close the losing leg?

3. Take a small loss before it escalates. Close the condor before you smell trouble. You can put on the condor again and get your money back.

4. Buy more OTM calls or puts depending on which leg is in trouble. However the same problem exists here – what if nifty starts heading south?

As you can see all the above three adjustments to iron condors come with their own risk. However one thing is clear – you should take action before you start losing a lot of money. Even though you know your maximum risk but why wait if you can recover the same money in that month and lose nothing?

If you actually lose nothing in that 30% of the times when an iron condor is in trouble – you will see that in a year your investments have bought in around 30-50%. And that is very good.

Now you would like to know what I did? I closed my call leg for a small loss of around 1000 and sold 6300/6400 JUNE call option. Technically this is not a iron condor as I shifted to next month, but its all fair in the game as I have to do what will make me money. The put ones expired worthless in may and I waited for nifty to go down. It did and I closed the June credit spread at a good profit. Nifty started to go down after reaching 6146. My profits actually exceeded my max profit but it took a little more time and patience. Yes patience is important in any trade. Nothing happens in a day or even two. You have to have patience while trading. Eventually the win will come.

As you can see iron condors can be profitable even if your view is wrong. And since one leg is guaranteed to make money, will expire worthless – you can use some strategy to make sure you come out winner of the other leg. However its easier said than done. What if nifty would have kept creeping up? My losses would have been much more than my max loss.

Another thing you should keep in mind when trading iron condors is that you should go as far deep OTM as possible if that makes sense. The further you go, the probability of wining be more. It depends on how experienced you are. A 700 points wide iron condor will have a 80-90% probability.

One more point: Sometime volatility will drop after you have traded an iron condor – and you will be in good profit in few days. In that case don’t wait till expiry – just book your profits. Whats wrong in making 2% in 10 days? You can make the rest in the remaining days. These small profits will add up to big profits in a year.

Happy Trading.

I had done a nifty credit spread a few days back so I will be discussing a live example with you. BTW credit spreads is my favorite strategy. I mostly do them every month and occasionally naked selling only if the markets gives me a great opportunity. If you do not know what a credit spread is here is an explanation.

An option credit spared is a position when the nearer strike option is sold and the further out of the money (OTM) option is bought for protection. Ideally they both should be of the same stock or index and of the same lot size and of the same months (some people create credit spreads with different months but that is entirely different subject. This article deals with same month credit spreads). Since the nearer option is sold – the difference of the amount between the sold and the bought option is “credited” to your account. Therefore the name – Credit Spreads.

Confusing? Ok let me give an example to help you understand.

Lets suppose nifty is at 5800. It has already fallen 200 points recently and you think a re-bounce may happen anytime soon. Even if it falls a bit further you do not think that it will go below 5600 this month. What do you do? You sell (short) one lot (or more) of the PUT at 5600. Now as you know shorting options can be very risky, to protect yourself from a great downfall you buy the same number of lots you sold at the strike price of 5500 or 5400 as per your risk. Now if nifty goes for a free fall you will realize some profit from the options you bought limiting your losses to a certain extend in the short options.

But then, how do you profit?

If both the options expire worthless you keep the premium. That is your maximum profit. Do not worry about losing the premium you paid for buying the options – you will profit anyway because the sold options will also expire worthless. Remember they were costlier than the ones you bought so the premium you received should be more than what you paid to buy the options.

Lets take a real example – a trade I did. As on June 12, 2013 Nifty closed at 5760. In the last 30 days Nifty made a high of almost 6200 and since May 30, 2013 Nifty is continuously falling from a high of 6133.75. This is a fall of almost 6% in 12 days. Yes Nifty can fall a bit further – but certainly from some point it will rebound. I don’t know from where, but eventually it should. (Even if it doesn’t I don’t have much to lose – I will explain why).

The VIX (volatility index) was also on the higher end. Note that option prices are directly proportional to volatility. If VIX is high option prices will also be priced higher. Tomorrow if volatility drops the same options will lose their value. (In that case I can actually profit tomorrow itself and close my positions. However I am not in a hurry.) For those who want some more info on volatility here is a para taken from http://www.moneycontrol.com/indian-indices/india-vix-36.html:

Volatility Index is a measure of market’s expectation of volatility over the near term. Volatility is often described as the “rate and magnitude of changes in prices” and in finance often referred to as risk. Volatility Index is a measure, of the amount by which an underlying Index is expected to fluctuate, in the near term, (calculated as annualized volatility, denoted in percentage e.g. 20%) based on the order book of the underlying index options.

India VIX is a volatility index based on the NIFTY Index Option prices. From the best bid-ask prices of NIFTY Options contracts, a volatility figure (%) is calculated which indicates the expected market volatility over the next 30 calendar days.

Since the volatility was high I was getting a good price on July 5500 PE (put option). I got it at 45. Now you tell me what are the chances that after falling 6% in 12 days Nifty will fall another 5% and more? Slim. But one can’t predict markets, so protection is important – very very important. Here is what I did:

1. Short (sold) to open Nifty July 5500 PE at 45*400 (8 lots) = Rs. 18000.00 (credit in my account)
2. Long (bought) to open Nifty July 5300 PE at 20*400 (8 lots) = Rs. 8000.00 (debit from my account)

Total credit = 18000 – 8000 = Rs. 10,000.00.

ROI: 45 days are left for expiry. Total money invested is 1,30,000.00. Absolute return is 7.69%. it comes to almost 5% return in a month. Of course, I need to get out in a profit.

Here is the profit and loss graph of Credit Spreads:

By seeing the image I hope you can understand that profit and loss in a credit spread is always limited.

Now coming to my trade. As you can see I got a credit, the trade is called “Credit Spread”. This can be done either in calls or in puts. You just have to sell the option with the higher value and buy the option with the lower value to get a credit in your account.

Credit spread usually have a success rate of 80%. But here is a cliche – one losing trade can eat profits of many months. Therefore its important to adjust your credit spreads if your short leg is in trouble – and it does happens believe me – more often than you can think of.

Why I did a trade in July month and not June month. Only 15 days are left for expiry of this month so I would have not got a good credit at 5500 puts. (June 5500 PE is at 13.05) plus if Nifty starts moving down fast I will have no time to adjust my credit spread. It made sense to play the next month options.

Profits are limited, what about the losses?

Good question. You see losses are limited too since I have bought 5300 puts for protection. The difference between the prices of the options will be my maximum loss. Lets take an example. What happens if Nifty closed at 5200 in July expiry:

1. 5500 PE = 300 (5500-5200 = 300) I had received 45 so ((45-300)*400) = -102000.00

2. 5300 PE = 100 (5300-5200 = 100) I had paid 20 so ((100-20)*400) = 32000

32,000 -1,02,000.00 = -70,000.00 this is my maximum loss. However my profits are only 10,000.00. As you can see even if I make profit for 7 months – just one month loss will offset my profits. Therefore I should adjust my spread if Nifty gets closer to my shorted puts i.e… 5500. and I have to do it much before I enter a huge loss.

Lets see how we adjust our credit spread if it really comes to that. Luckily I did not have to adjust my spreads as Nifty never came close to my short puts. 🙂 (BTW if I had to, I would have taken a small loss in my credit spread and rolled it down 200 points if Nifty had fallen sharply near 5500 very fast as soon as I opened my spreads. If nifty closed above my new position I will have no profit or no loss or some profit / loss depending on the trade. But I would have certainly avoided a huge loss as explained earlier. And further I keep a record of my trades so if anytime I adjust my spreads I will update this post with a real adjustment of credit spreads.)

Here is a update: On July 04, 2013 I closed my credit spread.

I bought July 5500 PE (remember I had sold it earlier) at 16.00, and
I sold July 5500 PE (remember I had bought it earlier for protection) at 4.50.

Lets calculate my profit or loss:

Sold July 5500 PE (8 lots): (45 -16) * 400 = 11,600.00 (profit)
Bought July 5300 PE (8 lots): (4.50 – 20) * 400 = -6200.00 (loss)
Total Profit: 11,600.00 – 6200.00 = 5,400.00

Some people might be thinking why I bought the protection. My profit would have been great. Yes you are right, but falls are steeper, even before you know you can incur huge losses. With this small price for insurance at least I can sleep better in night. You don’t want to make money without sleeping, do you?

Lets calculate return on investment.

Total cost of opening the spread: 1,30,000.00

Absolute returns: (5400/130000.00) * 100 = 4.15% in 20 days.

Note that I could have close my spread a few days back when Nifty went near 5900 and got even better profits in less days – but these things keep happening in trading. You never get the best price. Ultimately its the profits that matters. 🙂

Also I did not wait for the expiry. Why? Because I am already getting a good profit and a full month is left for expiry. A winning trade can become a losing trade some day, who knows. So its better to close the spread when you have realised a good profit from it and release your locked for margin cash for opening another spread or doing any other trade.

Hope this article has helped you to understand credit spreads. If you want to know anything please ask in the comments section below.