A step-by-step guide to creating a successful options strategy, beginning with the basic terminologies like premium, lot size, expiration day, spot price, and strike price. The guide covers evaluating the expectation for the underlying stock, determining the strike price, the option time frame, and option premium while considering market conditions.
Options trading can be a powerful tool for investors to take advantage of market movements and capitalise on price changes in underlying stocks. As you already know by now, an option is a derivative contract that gives the right, but not an obligation, to buy/sell the underlying asset on or before a stated date at a stated price. The party who takes a long position is said to be buying the option is known as the buyer/holder of the option, and the one who takes a short position is said to be selling the option and is regarded as the seller/writer of the option.
Creating your first options strategy may be somewhat intimidating, especially if you are a beginner. In this article, we will guide you through the process of creating a successful options strategy by highlighting the key factors to keep in mind. But before we jump into it, let’s quickly recap some basic options terminologies.
- Premium: The price which the buyer of the options pays to the options seller.
- Lot Size: The total number of units of the underlying assets in a contract. The lot size of a NIFTY options contract is 75 shares.
- Expiration Day: The day on which a derivative contract ceases to exist which is the last trading day. It is typically the last Thursday of the expiry month, but if it is a holiday, then it expires one day before the last Thursday.
- Spot price: The price at which the underlying asset trades in the stock market.
- Strike Price/Exercise Price: The price per share for which the underlying security is purchased or sold by the option holder.
Let’s now go through the steps involved in creating your first options strategy.
Steps to Create an Options Strategy
Evaluate your expectation for the underlying stock
The first step in creating your first options strategy is determining your expectation for the underlying stock. This will influence the type of options contract that you will take on. If you think the stock price will increase, you have two options: buy a call option or sell a put option. If you think the stock price will stay stable, you can sell a call or put option. If you think the stock price will decrease, your options are to buy a put option or sell a call option. It is, however, important to ensure that your prediction is in sync with the strike price.
Determine the strike price
When buying an option, it’s important to consider the strike price. The option remains valuable only if the stock price closes the option’s expiration period in the money; that means either above or below the strike price. For call options, it’s above the strike; for put options, it’s below the strike.
When selecting the strike price, you should choose a price that reflects where you predict the stock will be during the option’s lifetime. A good rule of thumb is to choose a strike price that is slightly below the current market price if you think the stock price will go up, slightly above if you think the stock price will go down, and at the current market price if you think the stock price will stay stable.
Determine the option time frame
The next step is determining the option time frame, also known as the expiration. Choose an expiration date that gives you enough time for your prediction to materialise but not so much time that the option becomes too expensive to trade.
Consider the option premium
When buying an option, you must pay a premium, which is the option’s price. The option premium comprises two parts: intrinsic value and time value. The intrinsic value is the amount the option is in the money. The time value is the amount the option is worth due to the potential for the stock price to move before the expiration date. When creating your first options strategy, it’s important to consider the option premium and how it affects your overall returns. A higher premium can lead to higher returns but also increases your risk.
Evaluate the market conditions
Finally, it is important to evaluate the market conditions. This includes considering factors such as current market trends, economic conditions, and events that may affect the stock price. It is also important to consider the volatility of the stock and the option. A highly volatile stock can lead to large price swings, which can significantly impact your options strategy.
Let’s use the example of buying call options to illustrate how to create your first options strategy. Let’s say you believe that ABC’s stock price, which is currently trading at Rs. 80, will increase soon. Based on your prediction, you buy a lot of its call options that expire in 90 days and have a strike price of Rs. 100. Now, you patiently wait for your returns to come in.
But, all is not hunky dory in the financial markets. Imagine the situation when the expiration day arrives, and before you know it, the options lose their value. You correctly predicted that the stock price of ABC would increase, and you bought a call option with a strike price of Rs. 100. Unfortunately, although your intuition was right and the market price of ABC was Rs. 96 after 90 days, you still lost money.
This scenario is common for inexperienced traders who are new to options trading. It is important to remember that options trading is not a guarantee of profits, and there is always a risk of losing money. To avoid this situation, it’s crucial to understand how options trading works and to have a solid strategy in place.
Creating a Multi-legged Strategy on uTrade Algos
Now that you have a fairly good understanding of creating an options strategy, you can go one step further and extract the benefits of a multi-legged strategy. Here is a step-by-step guide on creating a three-legged iron butterfly options strategy using uTrade Algos.
- Start by selecting the custom form and name the portfolio, say ‘Iron Butterfly’ in this case.
- Select the underlying asset, such as NIFTY.
- Buy 1 ITM put option with a strike price of 9500, sell 1 ATM put option with a strike price of 10,000 and 1 ATM call option with a strike price of 10,000 each, and buy 1 OTM call option with a strike price of 10,500 each.
- Choose the expiry date to be on the 22nd of the current month and set the weekly offset to 0, meaning that you want to select the nearest expiry.
- Define exit parameters such as setting a target of a 5% profit and a stop loss of 3%.
- Choose when to execute the strategy, here we can punch in Mondays and Tuesdays.
- Save the portfolio, backtest the strategy, view the payoff curve and analyse the results.
Creating an options strategy might appear to be complex, especially if you are just beginning to trade, but with these steps, you are bound to become a pro at it very soon. So, go ahead and start making your first options strategy. uTrade Algos is always there to make your life easier.
Options trading can be a powerful tool for investors to take advantage of market movements and capitalise on price changes in underlying stocks.
Premium, lot size, expiration day, spot price, and strike price/exercise price are important basic options terminologies.
To create your first options strategy, you need to evaluate your expectation for the underlying stock, determine the strike price, option time frame, option premium, and evaluate the market conditions.
It’s crucial to have a solid strategy in place when trading options, and to be aware of the potential risk of losing money.