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C. Raja Rajeshwari

I buy options and sell them when I am in-the-money. I have been making small profits. My friend tells me that I could also make money by buying one type of option and selling another. How do I go about this? - Ranganathan

Unlimited profits: If you buy both put and call, you make money on either an uptrend or a decline in the underlying stock price.

The payoff with this long call and long put would be unlimited profit, limited loss.

# The call is profitable on uptrend in the stock above the call's strike.

# The put is profitable on a decline in the underlying stock price below the put's strike.

# Buying both a call and a put is used in times of high volatility, to profit from an uptrend or a downtrend in the stock.

# As you are buying two options, the outflow for the purchase would be substantial.

# If the underlying stock does not move or if the movements are flat, the loss is the premium paid.

For instance, assume that the spot is currently at Rs 160. You purchase a 170 call (out-of-the-money) for Rs 5 and a 150 put (out-of-the-money) for Rs 7.

If the stock moves in a narrow range of Rs 158-162, neither the call nor the put turns in-the-money.

The loss is limited to the premiums paid - Rs 12 (Rs 5+Rs 7)

Combinations: You could buy one option and sell another depending upon the directional view on the underlying stock.

Bearish combination: A long position (buy) on the put combined with a short position (sell) in a call, would be profitable if the stock price declines lower than the put's strike.

Cost factor: The premium received from the short call is used for the purchase of the long put. Hence, the upfront outlay is lower when compared with buying both a put and a call.

For instance, the spot is currently at Rs 490.The 510 call (out-of-the-money) would cost Rs 9 and the 460 put costs Rs 5 (out-of-the-money).

The premium received from writing a call (Rs 9) is used to fund the purchase of the put (Rs 5).

The net amount you receive is Rs 4 (Rs 9-Rs 5).

In case you had wanted to buy both the put and the call, the outflow would have been Rs 14.

Stock price rises: The loss is unlimited, as there is a short position in the call. In case the spot rises above 510, then the call becomes in-the-money; the chances of the call being assigned to you are high.

On assignment, you have to pay the difference between the strike price and the spot price. For instance, if the spot rises to Rs 520, you pay the difference of Rs 10 (520-510).

The loss would be Rs 6 (Rs 10 - premium received Rs 4).

Break-even point: The combination is at no profit - no loss when the underlying is at Rs 514; if the call is assigned to you when the spot is at this break-even level, the outflow would be Rs 4 (514-510).

This, adjusted with the net premium received of Rs 4, would leave you in a no loss-no profit situation.

Decline in stock price: If the spot declines below Rs 460, then the put becomes in-the-money. For instance, if the stock declines to Rs 450, then the put is in-the-money by Rs 10.

To take profits, either square off (by selling a put) or exercise your put, whichever is higher.

On assignment, you receive the difference between the strike price and the spot (Rs 10).

On selling the put, you may receive more than the put's intrinsic value, which is the difference between the strike and the spot price.

Bullish combination: In case you are bullish on the underlying stock, then a long position on a call (buy) combined with a short position on a put would reap profits.

# This combination makes profits on increases in the spot price above the call strike price.

For instance, if you have a long position (buy) in a 510 call (cost Rs 9) and a short position (sell) in 460 put (cost Rs 5). Then the outflow would the difference on the premium received and the premium paid - Rs 4.

In case the spot rises to Rs 520, then the call is in-the-money. The call can be exercised or squared-off to realise profits.

# As you have created this combination with a net debit of Rs 4, the break-even point is at Rs 514 (the call strike plus the premium paid), if you exercise. You would receive Rs 4, if you exercise the call.

This, adjusted with the Rs 4 paid for setting up the position, would leave you in a no profit-no loss situation.

In case you choose to square-off by selling in the open market, then the break-even point would be lower than Rs 514 as the call would fetch you more than the intrinsic value of the call (spot-strike).

# If the stock declines, the put becomes in-the-money. In such a case, the chances of the put being assigned to you are high.

For instance, if the stock price declines to Rs 450, then the loss would be the difference between the strike price and the spot price on assignment - Rs 10.

Note: As there is short position in both the combinations, margins have to be maintained. In addition, there are unlimited profits, if the directional view on the underlying is correct. —

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