Strategies using Equity futures and Equity options

LEARNING OBJECTIVES:

• Uses of Trading Strategies

• Calendar spreads using futures
• Spread strategies using options
• Straddles and Strangles
• Collar and Butterfly Spread
• Covered calls and Protective Puts
• Arbitrage using options
• Delta-hedging using options
• Interpreting Open Interest and Put-Call ratio

USES OF ENTERING INTO TRADING STRATEGIES

1. Risk Management:
Options strategies are widely used for risk management purposes, allowing traders and investors
to protect their portfolios from adverse price movements in the underlying asset.
For example, buying put options can provide downside protection by allowing traders to profit
from a decline in the price of the underlying asset, thereby offsetting potential losses in their long
stock positions.

2. Enhanced Returns:
Options strategies can be employed to enhance returns and improve risk-adjusted performance.
By combining options positions with stock holdings or other assets, traders can create strategies
that offer the potential for higher returns while managing downside risk.

3. Income Generation:
Options strategies such as covered calls, cash-secured puts, and credit spreads are designed to
generate income from options premiums.
By selling options contracts, traders can collect premiums and earn regular income, regardless of
whether the underlying asset's price moves.

4. Speculation:
Options provide traders with the ability to speculate on the direction of price movements in the
underlying asset.
Strategies such as long calls, long puts, and straddles allow traders to profit from anticipated price
movements without having to invest in the underlying asset itself.
5. Volatility Trading:
Options strategies can be used to profit from changes in implied volatility levels.
Volatility-based strategies, such as straddles, strangles, and iron condors, are designed to
capitalize on expected changes in volatility, regardless of the direction of price movements.

6. Capital Preservation:
Options strategies can help preserve capital by providing downside protection or limiting potential
losses in volatile markets.
Strategies such as protective puts, collars, and ratio spreads enable traders to establish
predefined risk levels and protect their portfolios from adverse market conditions.

7. Portfolio Diversification:
Incorporating options strategies into a portfolio can enhance diversification and reduce overall
portfolio risk. By adding non-correlated assets or strategies, investors can improve risk-adjusted
returns and minimize exposure to specific market factors.

8. Flexibility and Customization:

Options offer a high degree of flexibility and customization, allowing traders to tailor strategies to
their specific objectives, risk tolerance, and market outlook.
Traders can choose from a wide range of options strategies and adjust parameters such as strike
prices, expiration dates, and position sizes to meet their individual needs.

9. Leverage: Options allow traders to gain exposure to a larger position in the underlying asset
with a smaller upfront investment compared to trading the asset itself. This leverage amplifies
potential returns but also increases risk.

10. Tax Efficiency: Options trading may offer tax advantages compared to trading the underlying
asset directly. For example, certain options strategies may allow traders to defer or reduce
taxes on capital gains.

11. Portfolio Rebalancing: Options strategies can be used to rebalance portfolios by adjusting
exposure to different asset classes or sectors. For example, covered call writing can be
employed to trim overweight positions or generate income from holdings that have
appreciated.

12. Event Protection: Options can provide protection against unexpected events such as earnings
announcements, economic data releases, or geopolitical developments. Strategies like
straddles or strangles allow traders to profit from significant price movements resulting from
such events.

13. Arbitrage Opportunities: Sophisticated traders and institutional investors may use options
strategies to exploit pricing inefficiencies or mispricings between options contracts, the
underlying asset, and related securities. Arbitrage strategies aim to capture profits from these
discrepancies.

14. Tail Risk Hedging: Options strategies can be used to hedge against extreme or tail risk events
 that may result in significant portfolio losses. Tail risk hedging strategies, such as long-dated
put options or put spreads, provide insurance-like protection against market downturns.

15. Income Enhancement: Options strategies can be employed to enhance income from existing
portfolios or assets. For example, covered call writing on dividend-paying stocks can increase
income through premiums while still allowing investors to participate in potential stock price
appreciation.

16. Asset Allocation: Options can be used as part of an overall asset allocation strategy to manage
risk exposure and optimize portfolio returns. By incorporating options positions alongside
traditional assets like stocks and bonds, investors can achieve a more diversified and balanced
portfolio.

Overall, options strategies play a crucial role in options trading by providing traders with a
versatile toolkit to manage risk, speculate on market movements, generate income, and preserve
capital. By understanding the objectives and risk-return profiles of different strategies, traders can
effectively navigate the options market and achieve their investment goals.

BREAKEVEN POINT:

In derivatives trading, the breakeven point refers to the price level at which the trader neither
makes a profit nor incurs a loss on their position. Understanding the breakeven point is essential
for traders as it helps them assess the risk and potential reward associated with their trades. The
breakeven point varies depending on the type of derivative instrument and the trading strategy
employed.

Basic Example:
A trader buys a call option on a stock with a strike price of ₹500 and pays a premium of ₹20 per
share. The trader is bullish on the stock and expects its price to rise.

Breakeven Point = Strike Price + Premium Paid

Breakeven Point = ₹500 (Strike Price) + ₹20 (Premium Paid)
Breakeven Point = ₹520

Here's how the breakeven point is determined in some common derivatives trading scenarios:

Options Trading:
For options trading, the breakeven point for call options is calculated by adding the premium paid
to the strike price of the option. For put options, it is calculated by subtracting the premium paid
from the strike price.

Futures Trading:
In futures trading, the breakeven point is determined by the difference between the entry price
and the current market price, adjusted for transaction costs.
For long futures positions, the breakeven point is the entry price plus transaction costs. For short
futures positions, it is the entry price minus transaction costs.

Spread Trading:
In spread trading, which involves trading two or more related derivative contracts simultaneously,
the breakeven point is determined by the price difference between the two contracts.
For example, in a bull call spread where a trader buys a call option with a lower strike price and
sells a call option with a higher strike price, the breakeven point is the strike price of the long call
option plus the net premium paid.
Similarly, in a bear put spread where a trader buys a put option with a higher strike price and sells
a put option with a lower strike price, the breakeven point is the strike price of the long put option
minus the net premium paid.

Options Strategies:
For more complex options strategies like straddles, strangles, butterflies, and condors, the
breakeven point is determined by the combined effect of multiple options contracts involved in
the strategy.

Traders can calculate the breakeven point for these strategies by considering the strike prices and
premiums of the individual options contracts and analyzing their combined payoff at expiration.
In summary, the breakeven point in derivatives trading depends on various factors such as the
type of derivative instrument, the trading strategy employed, transaction costs, and market
conditions. Traders should carefully calculate and monitor the breakeven point to assess the risk
and potential reward of their trades and make informed decisions accordingly.

Calendar spread
Calendar spread refers to the arbitrage between futures contracts of different expiration
months. In this strategy, the arbitrageur buys and sells the futures contracts of two
different months. To execute this strategy, the arbitrageur must identify which contract
to buy or sell. The principal rule of arbitrage is that one must buy the underpriced contract
and sell the overpriced one. Hence, the arbitrageur needs to compute the fair price of
both futures contracts and compare these with the traded prices, to decide which
contract is overpriced and which one is underpriced.
For example, suppose that a stock is traded at Rs.120 and the near-month futures and
mid-month futures are traded at Rs.121.30 and Rs.121.50. Suppose further that the
interest rate is around 8% p.a.
Now the fair price of the near-month futures works out to 120* e0.08*1/12 which is 120.80
while the fair price of the mid-month futures is 120* e0.08*2/12, i.e., 121.61. As per the fair
price computation, the difference between the prices of both futures contracts should
ideally be around 81 paise, but currently this difference has narrowed to just 20 paise.
This means that the near-month futures contract is overpriced relative to the mid-month
futures contract. Hence the arbitrageur will short the near-month futures contract at Rs
121.30 and go long the mid-month futures contract at Rs 121.50. This is done because
sooner or later, the difference in the prices of the two futures contracts (i.e., the spread)
is expected to come back to the fair difference. The arbitrageur makes a profit when the
actual spread returns to the fair spread and then he unwinds both the positions.
Case 1: The stock price closes at Rs.122 on the expiry date of the near-month futures
contract and the mid-month futures contract trades at Rs.122.82:
Near-month futures price: 122
Loss on near-month futures: 121.30 – 122 = 0.70
Mid-month futures price: 122.82
Gain on mid-month futures: 1.32 (=122.82 – 121.50)
Net gain on the calendar spread: Rs 0.62 ( = 1.32 - 0.70)
Case 2: The stock price closes at 120 on the expiry date of near-month futures and the
mid-month futures contract trades at Rs.120.80:
Near-month futures price: 120
Gain on near-month futures: 121.30 – 120 = 1.30
Mid-month futures price: 120.80
Loss on mid-month futures: 0.70 (=121.50 - 120.80).
Net gain on the calendar spread: Rs 0.60 ( = 1.30 - 0.70)
The above example shows that calendar spreads are typically low risk - low return
strategies. The return is low because the arbitrageur is simply trying to capture the small
amount of mispricing in the prices of the pair of futures contracts. There is no directional
bet involved in calendar spreads. The risk is low because the arbitrageur takes opposite
positions in both contracts. Hence, the arbitrageur is protected from large losses,
regardless of whether the stock price rises or declines.
In practice, calendar spread arbitrage opportunities are difficult to find. Index and stock
futures contracts are quite liquid, and a large number of buyers and sellers continuously
track these futures prices. As a result, any instances of mispricing are spotted quickly, and
arbitrageurs rapidly exploit these arbitrage opportunities so that the mispricing
disappears within a very short timeframe. For the calendar spread arbitrage to make the
anticipated profit, it is essential that the long and short positions must be entered
simultaneously and squared up at the same instant. Any delay in execution of the other
leg of the transaction after the first leg has been executed, will reduce the profitability or
may even lead to losses.
COMMONLY USED STRATEGIES – SHORT NOTES

1. Straddle:
A straddle is an options strategy where a trader simultaneously buys both a call
 option and a put option with the same strike price and expiration date.
This strategy is used when the trader expects a significant price movement in the
underlying asset but is uncertain about the direction of the movement.
Profits are realized if the price of the underlying asset moves significantly in either
direction, surpassing the combined cost of the call and put options.
2. Strangle:
A strangle is similar to a straddle but involves buying out-of-the-money call and
put options with different strike prices but the same expiration date.
This strategy is used when the trader expects a significant price movement in the
underlying asset but is unsure about the direction of the movement.
Profits are realized if the price of the underlying asset moves significantly in either
direction, surpassing the combined cost of the call and put options.

3. Bull Call Spread:

A bull call spread is an options strategy where a trader simultaneously buys a call
option and sells another call option with a higher strike price but the same
expiration date.
This strategy is used when the trader expects moderate upside movement in the
price of the underlying asset.
Profits are limited to the difference in strike prices minus the initial cost of
establishing the spread, and losses are limited to the initial cost of the spread.

4. Bear Put Spread:

A bear put spread is an options strategy where a trader simultaneously buys a put
option and sells another put option with a lower strike price but the same
expiration date.
This strategy is used when the trader expects moderate downside movement in
the price of the underlying asset.
Profits are limited to the difference in strike prices minus the initial cost of
establishing the spread, and losses are limited to the initial cost of the spread.

5. Covered Call:
A covered call is an options strategy where a trader holds a long position in the
underlying asset and sells a call option on the same asset.
This strategy is used when the trader is neutral to moderately bullish on the
underlying asset's price and wants to generate income from the option premium.
 Profits are limited to the strike price of the call option plus the premium received,
while losses are cushioned by the ownership of the underlying asset.

6. Collar:
A collar is an options strategy where a trader simultaneously holds a long position
in the underlying asset, sells a call option, and buys a put option on the same
asset.
This strategy is used to protect against downside risk in the underlying asset while
limiting upside potential.
Profits are limited to the strike price of the call option plus the premium received,
while losses are limited by the ownership of the put option.

7. Butterfly:
A butterfly is an options strategy where a trader combines a bull spread and a
bear spread using either call options or put options with three different strike
prices but the same expiration date.
This strategy is used when the trader expects minimal movement in the price of
the underlying asset.
Profits are maximized if the price of the underlying asset settles at the middle
strike price at expiration, and losses are limited to the initial cost of establishing
the spread.

8. Protective Put:
A protective put is an options strategy where a trader holds a long position in the
underlying asset and buys a put option on the same asset to protect against
downside risk.
This strategy is used when the trader is bullish on the underlying asset's price but
wants to hedge against potential losses.
Profits are unlimited on the long position in the underlying asset, and losses are
limited to the strike price of the put option minus the premium paid.

These options strategies offer traders a variety of ways to manage risk, generate
income, and capitalize on market movements based on their outlook and
objectives.

CLASSIFICATION:
The most common trading strategies using options include spreads, straddles and
strangles. Let us consider each of these strategies using numerical examples.
Spreads involve combining options on the same underlying and of same type (call/ put)
but with different strikes and maturities. These are limited profit and limited loss
positions. They are primarily categorized into three sections as:
• Vertical Spreads
• Horizontal Spreads
• Diagonal Spreads
Vertical Spreads
Vertical spreads are created by using options having same expiry date but different strike
prices. Further, these can be created either using calls as combination or puts as
combination. These can be further classified as:
• Bullish Vertical Spread
o Using Calls
o Using Puts
• Bearish Vertical Spread
o Using Calls
o Using Puts

Bullish Vertical Spread using Calls

A bull call spread is created when the underlying view on the market is positive or bullish,
but the trader would also like to reduce the cost of his position. So, he takes one long call
position with a lower strike price and sells a call option with a higher strike. As the lower
strike call costs more than the premium earned by selling a higher strike call, the position
involves a net cash outflow to begin with. Secondly, as the higher strike call is sold, all
gains on the long call beyond the strike price of the short call get negated by losses on the
short call. To capture more profits from his long call, the trader can short a call with as
high a strike price as possible. However, this will result in his cost coming down only
marginally, as the higher strike calls will fetch lesser and lesser premium.
For example, a trader is bullish on the market and decides to go long on 17500 strike call
option by paying a premium of Rs 185. He does not expect the market to rise above 17800,
and so he shorts a 17800 call option and receives a premium of Rs 61. His net payoff for
various price moves (after adjusting the premium paid or received) will be as follows:
Option Call Call
Long/Short Long Short
Strike 17500 17800
Premium 185 61
Spot 17500
 Index P&L P&L Net gain
value at long call short call
expiry
17100 -185 61 -124
17200 -185 61 -124
17300 -185 61 -124
17400 -185 61 -124
17500 -185 61 -124
17600 -85 61 -24
17700 15 61 76
17800 115 61 176
17900 215 -39 176
18000 315 -139 176

BULL CALL SPREAD

Long call Short call Net gain

400

300

200

100

0
17100 17300 17500 17700 17900 18100
-100

-200

-300

As can be seen from the above payoff chart, it is a limited profit and limited loss position.
Maximum profit in this position is Rs. 176 and maximum loss is Rs.124. The break-even
point for this spread is 17624. This is obtained by adding the net premium paid (i.e., 185-
61=124) to the lower strike price, i.e. 17500 + 124.
Bullish Vertical Spread using Puts
Here again, the view on the market is bullish and hence, the trader would like to short a
put option. If the index goes up, the trader will end up with the premium on sold puts.
However, in case of a fall in the index, the trader will face the risk of unlimited losses. In
order to put a floor to his downside, he may buy a put option with a lower strike. While
this would reduce his overall upfront premium, the benefit is the embedded insurance
against unlimited potential loss on short put. This is a net premium receipt strategy.
Let us see this with the help of an example, where the trader goes short a put option of
strike 17500 and receives a premium of Rs 125 and goes long a put option of strike 17000
and pays a premium of Rs 34:
Option Put Put
Long/Short Short Long
Strike 17500 17000
Premium 125 34
Spot 17500

Index values P&L short P&L long Net gain

at expiry put put
16800 -575 166 -409
16900 -475 66 -409
17000 -375 -34 -409
17100 -275 -34 -309
17200 -175 -34 -209
17300 -75 -34 -109
17400 25 -34 -9
17500 125 -34 91
17600 125 -34 91
17700 125 -34 91
17800 125 -34 91

BULL PUT SPREAD

Short put Long put Net gain

300
200
100
0
-10016800 17000 17200 17400 17600 17800
-200
-300
-400
-500
-600
-700

As can be seen from the chart above, this is a limited profit and limited loss position.
Maximum profit in this position is Rs 91 (the difference between the premium received
and paid) and maximum loss is Rs 409. The break-even point for this position is 17409.
This is obtained by deducting the net premium received (i.e., 125-34=91) from the higher
strike price, i.e., 17500.
Bearish Vertical Spread using calls
Here, the trader is bearish on the market and so he shorts a low strike call with a high
premium. The risk in a naked short call is that if prices rise, losses could be unlimited. So,
to prevent his unlimited losses, he also goes long a higher strike call costing a smaller
premium. Thus, in this strategy, he starts with a net inflow.
Let us see this with the help of the following table:
Option Call Call
Long/Short Long Short
Strike 17800 17500
Premium 61 185
Spot 17500

Index values P&L P&L Net gain

at expiry long call short call
17100 -61 185 124
17200 -61 185 124
17300 -61 185 124
17400 -61 185 124
17500 -61 185 124
17600 -61 85 24
17700 -61 -15 -76
17800 -61 -115 -176
17900 39 -215 -176
18000 139 -315 -176

BEAR CALL SPREAD

Long call Short call Net gain

300
200
100
0
17100 17200 17300 17400 17500 17600 17700 17800 17900 18000
-100
-200
-300
-400

As can be seen from the picture above, this is a limited profit and limited loss position.
Maximum profit in this position is Rs 124 (net premium received) and maximum loss is Rs
176. The break-even point for this position is 17624.
Bearish Vertical Spread using puts
Here, again the trader is bearish on the market and so goes long in one put option by
paying a premium. Further, to reduce his cost, he shorts another low strike put and
receives a premium.
For example, if a trader goes long in a put option of strike 17500 and pays a premium of
Rs 125 and at the same time to reduce his cost, shorts a 17000 strike put option and earns
a premium of Rs 34, his net profits/ losses would be as under:
Option Put Put
Long/Short Short Long
Strike 17000 17500
Premium 34 125
Spot 17500

Index values P&L P&L Net gain

at expiry short put long put
16800 -166 575 409
16900 -66 475 409
17000 34 375 409
17100 34 275 309
17200 34 175 209
17300 34 75 109
17400 34 -25 9
17500 34 -125 -91
17600 34 -125 -91
17700 34 -125 -91
17800 34 -125 -91

BEAR PUT SPREAD

Short put Long put Net gain

700
600
500
400
300
200
100
0
-10016800 16900 17000 17100 17200 17300 17400 17500 17600 17700 17800
-200
-300

As can be seen from the picture above, it is a limited profit and limited loss position.
Maximum profit in this position is Rs 409 and maximum loss is Rs 91. The break-even point
for this position is 17409.
Horizontal Spread
A horizontal spread involves options of the same type, having the same strike price, but
different expiry dates. This is also known as time spread or calendar spread. Here, it is not
possible to draw the payoff chart as the expiry dates of the underlying options are
different. The rationale for horizontal spreads is that these two options would have
different time values and the trader believes that the difference between the time values
would shrink or widen. This is essentially a bet on the narrowing or widening of the
difference in the premium of the two options.
Diagonal spread
Diagonal spread involves a combination of options on the same underlying but different
expiry dates as well as different strikes. Again, as the two options in the spread have
different maturities, it is not possible to draw payoff diagrams. These are much more
complicated in nature and in execution. These strategies are more suitable for the OTC
market than for the exchange-traded markets.
Straddles
This strategy involves two different types of options (call and put) with the same strike
prices and same maturity. A long straddle position is created by buying a call and a put
option of the same strike and same expiry date whereas a short straddle is created by
shorting a call and a put option of same strike and same expiry date.
Let us say a stock is trading at Rs 6,000 and premiums for ATM call and put options are Rs
257 and Rs 136 respectively.
Long Straddle
If a person buys both a call and a put at these prices, then his maximum loss will be equal
to the sum of these two premiums paid, which is equal to Rs 393 ( = 257 + 136). Any price
movement from here in either direction would first result in that person recovering his
premium and then making a profit. This strategy is undertaken when the trader is not
certain of the direction in which the stock will move in the near future, but he expects a
significant movement in the stock price, either upwards or downwards.
Now, let us analyse his position on various market moves. Let us say the stock price falls
to 5300 at expiry. Then, his payoffs from the strategy would be:
Long Call: - 257 (market price is below strike price, so option expires worthless)
Long Put: - 136 - 5300 + 6000 = 564
Net Flow: 564 – 257 = 307
As the stock price keeps moving down, loss on long call position is limited to premium
paid, whereas profit on long put position keeps increasing.
Now, consider that the stock price shoots up to 6700.
Long Call: - 257 – 6000 + 6700 = 443
Long Put: - 136
Net Flow: 443 – 136 = 307
As the stock price keeps moving up, loss on long put position is limited to premium paid,
whereas profit on long call position keeps increasing.Thus, it can be seen that the
strategy yields profits for huge swings in either direction. However, there would be a
band within which the position would result into losses. This position would have two
Break even points (BEPs) and they would lie at “Strike – Total Premium” and “Strike +
Total Premium”. Combined pay-off may be shown as follows:
Option Call Put
Long/Short Long Long
Strike 6000 6000
Premium 257 136
Spot 6000

CMP Long Call Long Put Net Flow

5000 -257 864 607
5100 -257 764 507
5200 -257 664 407
5300 -257 564 307
5400 -257 464 207
5500 -257 364 107
5600 -257 264 7
5700 -257 164 -93
5800 -257 64 -193
5900 -257 -36 -293
6000 -257 -136 -393
6100 -157 -136 -293
6200 -57 -136 -193
6300 43 -136 -93
6400 143 -136 7
6500 243 -136 107
6600 343 -136 207
6700 443 -136 307
6800 543 -136 407
6900 643 -136 507
7000 743 -136 607
It may be noted from the table and picture, that the maximum loss of Rs. 393 would occur
to the trader if the underlying expires at the strike price of the options viz. 6000. Further,
as long as the underlying stock expires between 6393 and 5607, he would always incur a
loss which would depend on the level of underlying. His profit would start only after
recovery of his total premium of Rs. 393 in either direction, and that is the reason for the
two breakeven points in this strategy.
Short Straddle
This would be the exact opposite of long straddle. Here, the trader’s view is that the price
of underlying would not move much or remain stable. So, he sells a call and a put so that
he can profit from the premiums. As the position of short straddle is just opposite of long
straddle, the payoff chart would be just inverted, so what was a loss for the long straddle
would become a profit for the short straddle. The details of the position are as follows:
Option Call Put
Long/Short Short Short
Strike 6000 6000
Premium 257 136
Spot 6000
CMP Short Call Short Put Net Flow
5000 257 -864 -607
5100 257 -764 -507
5200 257 -664 -407
5300 257 -564 -307
5400 257 -464 -207
5500 257 -364 -107
5600 257 -264 -7
5700 257 -164 93
5800 257 -64 193
5900 257 36 293
6000 257 136 393
6100 157 136 293
6200 57 136 193
6300 -43 136 93
6400 -143 136 -7
6500 -243 136 -107
6600 -343 136 -207
6700 -443 136 -307
6800 -543 136 -407
6900 -643 136 -507
7000 -743 136 -607
It is clear that this strategy is a limited profit and unlimited loss strategy and should be
undertaken with significant care. Further, it will incur a substantial loss for the trader if
the market moves significantly in either direction – up or down.
Strangles
This outlook of this strategy is similar to that of a straddle, but the implementation,
aggression and cost are different.
Long Strangle
As in case of straddle, the outlook here (for the long strangle position) is that the market
will move substantially in either direction, but while in a straddle, both options have the
same strike price, strangles are constructed using different strike prices. Also, both the
options (call and put) in this case are out-of-the-money and hence the premium paid is
low.
Let us say the cash market price of a stock is 6100. The 6200 strike call is available at Rs
145 and 6000 put is trading at a premium of Rs 140. Both these options are out-of-the-
money.
If a trader goes long both these options, then his maximum cost would be equal to the
sum of the premiums of both these options. This would also be his maximum loss in worst
case situation. However, if the stock starts moving in either direction, his loss would
remain the same for some time and then reduce. And, beyond a point (BEP) in either
direction, he would make money. Let us see this with various price points.
If spot price falls to 5700 on maturity, his long put would make profits while his long call
option would expire worthless.
Long Call: - 145
Long Put: - 140 - 5700 + 6000 = 160
Net Position: 160 - 145 = 15
As the stock price continues to go down, the long put position will become more and more
profitable and the long call’s loss would be limited to the premium paid.
In case the stock price rises to 6800 at expiry, the long call would become profitable and
long put would expire worthless.
Long Call: - 145 - 6200 + 6800 = 455
Long Put: - 140
Net Position: 455 - 140 = 315
The payoff chart for long strangle is shown below:
Option Call Put
Long/Short Long Long
Strike 6200 6000
Premium 145 140
Spot 6100

CMP Long Call Long Put Net Flow

5100 -145 760 615
5200 -145 660 515
5300 -145 560 415
5400 -145 460 315
5500 -145 360 215
5600 -145 260 115
5700 -145 160 15
5800 -145 60 -85
5900 -145 -40 -185
6000 -145 -140 -285
6100 -145 -140 -285
6200 -145 -140 -285
6300 -45 -140 -185
6400 55 -140 -85
6500 155 -140 15
6600 255 -140 115
6700 355 -140 215
6800 455 -140 315
6900 555 -140 415
7000 655 -140 515
7100 755 -140 615
In this position, the maximum profit for the trader would be unlimited in both the
directions – up or down and maximum loss would be limited to Rs. 285, which would
occur if the underlying expired at any price between 6000 and 6200. The position would
have two BEPs at 5715 and 6485. The trader would always incur a loss until the underlying
crosses either of these prices.
Short Strangle
This is exactly opposite to the long strangle and involves a short position in two out-of-
the-money options (call and put). The outlook, like in the short straddle, is that the
underlying price will remain stable over the life of options. Payoffs for this position will be
exactly opposite to that of a long strangle position. As always, the short position will make
money, when the long position is in a loss and vice versa.
Option Call Put
Long/Short Short Short
Strike 6200 6000
Premium 145 140
Spot 6100

CMP Short Call Short Put Net Flow

5100 145 -760 -615
5200 145 -660 -515
5300 145 -560 -415
5400 145 -460 -315
5500 145 -360 -215
5600 145 -260 -115
5700 145 -160 -15
5800 145 -60 85
5900 145 40 185
6000 145 140 285
6100 145 140 285
6200 145 140 285
6300 45 140 185
6400 -55 140 85
6500 -155 140 -15
6600 -255 140 -115
6700 -355 140 -215
6800 -455 140 -315
6900 -555 140 -415
7000 -655 140 -515
7100 -755 140 -615
In this position, the maximum loss for the trader would be unlimited in both the directions
– up or down and the maximum profit would be limited to Rs. 285, which would occur if
the underlying expired at any price between 6000 and 6200. Again, the short strangle
would have two BEPs at 5715 and 6485. The trader would always make a profit until the
underlying crosses either of these prices.
Covered call
This strategy is used to generate extra income from existing holdings in the cash market.
If an investor has bought a stock and intends to hold it for some time, then he would like
to earn some income on the stockholding, without selling the stock. This would help to
reduce his cost of acquisition. So how does an investor continue to hold on to the stock,
earn income and reduce acquisition cost?
Suppose that an investor buys a stock in the cash market at Rs. 1590 and sells a call option
with a strike price of 1600, thereby earning Rs. 10 as premium. If the stock price rises
above Rs. 1590, he makes a profit in the cash market but starts losing in the option trade.
For example, if the stock price rises to 1640:
Long Cash: Profit of 1640 – 1590 = 50
Short Call: – 1640 + 1600 + 10 = –30
Net Position: 50 – 30 = 20
If the stock drops below Rs.1590, he loses in the cash market, but gets to keep the
premium as income. For example, if the stock price falls to Rs.1520,
Long Cash: 1520 – 1590 = -70
Short Call: + 10 (The call holder will not exercise his right as he can buy the stock from the
market at a price lower than strike, and so he will let the option expire and the seller gets
to keep the premium.)
Net Position: -70 + 10 = -60
Therefore, the combined position of long stock and short call would generate the payoff
as defined in the table and picture below:
Long Stock 1590
Strike Price 1600
Premium 10

CMP Stock Call Net

1490 -100 10 -90
1500 -90 10 -80
1510 -80 10 -70
1520 -70 10 -60
1530 -60 10 -50
1540 -50 10 -40
1550 -40 10 -30
1560 -30 10 -20
1570 -20 10 -10
1580 -10 10 0
1590 0 10 10
1600 10 10 20
1610 20 0 20
1620 30 -10 20
1630 40 -20 20
1640 50 -30 20
1650 60 -40 20
1660 70 -50 20
1670 80 -60 20
1680 90 -70 20
1690 100 -80 20
From the table and the payoff chart we can see that the net position of a covered call
strategy looks like ‘short put’ with a strike of 1600. This is because the covered call
restricts the ‘upside’ or gains from the position while leaving a scope for unlimited losses.
Hence, the covered call is called a ‘synthetic short put’ position.
If at that point of time, a 1600 strike put is available at any price other than Rs.20 (let us
say Rs.17), an arbitrage opportunity exists, where the trader can create a synthetic short
put position (covered call), earn a Rs. 20 premium and use the proceeds to buy a 1600 put
for Rs.17, thereby making a risk-free profit of Rs.3. Indeed, one needs to also provide for
frictions in the market like brokerage, taxes, administrative costs, funding costs, etc.
The most important factor in this strategy is the strike of the sold call option. If the strike
price is close to the prevailing price of the underlying stock, it would fetch higher premium
upfront but would lock the potential gain from the stock early. And, if the strike price is
too far from the current price of underlying, while it would fetch low upfront premium, it
would provide for a longer ride of money on the underlying stock. One must decide on
this subject based on one’s view on the stock price and the choice between upfront
premium from the option and a potential gain from the movement of the underlying.
A simple perspective on the choice of strike price for the covered call is that, till the time
the cash market price does not reach the pre-determined exit price, the long cash position
can be used to sell calls of that target strike price. As long as the stock price stays below
that target price (let’s say 1600 in our case), we can write call option of 1600 strike and
keep earning the premium. The moment 1600 is reached in the spot market, we can sell
in the cash market and also cover the short call position.
Collar
A collar strategy is an extension of the covered call strategy. Readers may recall that in
case of covered call, the downside risk remains for falling prices; i.e. if the stock price
moves down, losses keep increasing (covered call is similar to short put). To put a floor to
this downside, we go long a put option, which essentially eliminates the downside of the
short underlying/futures (or the synthetic short put).
In our example, we had assumed that a trader goes long a stock at 1590 and shorts a call
option with a strike price of 1600 and receives Rs. 10 as premium. In this case, the BEP
was 1580. If the stock price fell below 1580, loss could be unlimited whereas if price rose
above 1600, the profit was capped at Rs. 20.
To limit the downside, let us say, we now buy an out-of-the-money put option of strike
1580 by paying a small premium of Rs. 7.
Now, if price of underlying falls to 1490 on maturity:
Long Stock: -1590 + 1490 = -100
Short Call: 10
Long Put: -7 – 1490 + 1580 = 83
Net Position: -100 + 10 + 83 = - 7 (in case of covered call this would have been -90)
If price rises to 1690 on maturity:
Long Stock: -1590 + 1690 = 100
Short Call: 10 – 1690 +1600 = - 80
Long Put: - 7
Net Position: 100 – 80 – 7 = 13 (in case of covered call this would have been + 20)
Combined position (i.e. long underlying, short call and long put) is as follows:
Long Stock 1590 Long Put 1580
Short Call 1600 Premium 7
Call Premium 10

CMP Long Stock Short Call Long Put Net

1490 -100 10 83 -7
1500 -90 10 73 -7
1510 -80 10 63 -7
1520 -70 10 53 -7
 1530 -60 10 43 -7
1540 -50 10 33 -7
1550 -40 10 23 -7
1560 -30 10 13 -7
1570 -20 10 3 -7
1580 -10 10 -7 -7
1590 0 10 -7 3
1600 10 10 -7 13
1610 20 0 -7 13
1620 30 -10 -7 13
1630 40 -20 -7 13
1640 50 -30 -7 13
1650 60 -40 -7 13
1660 70 -50 -7 13
1670 80 -60 -7 13
1680 90 -70 -7 13
1690 100 -80 -7 13

It is important to note here that while the long put helps in reducing the downside risk, it
also reduces the maximum profit, which a covered call would have generated. Also, the
BEP has moved higher by the amount of premium paid for buying the out-of-the-money
put option.
Butterfly Spread
As a collar is an extension of the covered call, a butterfly spread is an extension of the
short straddle. We may recollect that a short straddle has an unlimited downside, if the
underlying moves significantly in either direction. To limit this downside, the trader buys
one out-of-the-money call and one out-of-the-money put along with the short straddle.
This results in a position with a pictorial payoff, which looks like a butterfly and so this
strategy is called “Butterfly Spread”.
A butterfly spread can be created with only calls, only puts or combinations of both calls
and puts. Here, we are creating this position with the help of only calls. To do so, the
trader must take the following positions in three options with different strikes and the
same maturity dates:
Long Call 1 with strike of 6000 and premium paid Rs. 230
Short Call 2 with strike of 6100 and premium received Rs. 150
Long Call 3 with strike of 6200 and premium paid of Rs. 100
Short Call 2 with strike of 6100 and premium received Rs. 150
Let us see what happens if on the expiry the stock price is:
• Less than or equal to 6000
• Equal to 6100
• More than or equal to 6200
Case I: Price at 6000
Long Call 1: -230
Short Call 2: 150
Long Call 3: - 100
Short Call 2: 150
Net Position: -230 + 150 – 100 + 150 = -30
For any price lower than 6000, all calls will be out-of-the-money so nobody will exercise.
Hence buyers will lose the premium and sellers/ writers will get to keep the premium. In
all these situations, the trader’s loss would be a flat Rs. 30.
Case II: Price at 6100
Long Call 1: - 230 – 6000 + 6100 = - 130
Short Call 2: 150
Long Call 3: - 100
Short Call 2: 150
Net Position: - 130 + 150 – 100 + 150 = 70
This is the maximum possible profit for this position. Both the short calls earn the
premium for the trader. This entire premium is retained by the trader for all prices less
than or equal to 6100.
Case III: Price at 6200 or higher
Long Call 1: - 230 – 6000 + 6200 = - 30 (This will keep increasing as price rises)
Short Call 2: 150 – 6200 + 6100 = 50 (This will start getting losses as price increases)
Long Call 3: - 100
Short Call 2: 150 – 6200 + 6100 = 50 (This will start getting losses as price increases)
Net Position: - 30 + 50 – 100 + 50 = - 30
From 6200 or higher, the long calls will start making money for the trader whereas the
short calls will be in losses. The net payoff of all 4 options would always be equal to –30.
Following table and picture explain this position:
Option Call Call Call Call
Long/Short Long Short Long Short
Strike 6000 6100 6200 6100
Premium 230 150 100 150
Spot 6100

CMP Long Call 1 Short Call 2 Long Call 3 Short Call 2 Net Flow
5100 -230 150 -100 150 -30
5200 -230 150 -100 150 -30
5300 -230 150 -100 150 -30
5400 -230 150 -100 150 -30
5500 -230 150 -100 150 -30
5600 -230 150 -100 150 -30
5700 -230 150 -100 150 -30
5800 -230 150 -100 150 -30
5900 -230 150 -100 150 -30
6000 -230 150 -100 150 -30
6100 -130 150 -100 150 70
6200 -30 50 -100 50 -30
6300 70 -50 0 -50 -30
6400 170 -150 100 -150 -30
6500 270 -250 200 -250 -30
6600 370 -350 300 -350 -30
6700 470 -450 400 -450 -30
6800 570 -550 500 -550 -30
6900 670 -650 600 -650 -30
7000 770 -750 700 -750 -30
7100 870 -850 800 -850 -30
 1000
Butterfly Spread Payoff

800

600

400

200
P/ L (Rs.)

-200

-400

-600

-800

Long Call 1 Short Call 2 Long Call 3 Short Call 2 Net Flow
-1000

Cost of creating butterfly spread: -230 + 150 – 100 + 150 = - 30

Lower BEP = 6000 + 30 = 6030
Higher BEP = 6200 – 30 = 6170
This position can also be created with the help of only puts or a combination of calls and
puts. To create this position from puts, you need to buy one highest strike option, sell two
middle strike options and then again buy one lowest strike option. And, to create this
position from combination of calls and puts, you must buy one call at lowest strike, sell
one call at middle strike, buy one put at highest strike and sell one put at middle strike.
This is a limited profit and limited loss strategy.
Hedging with options:
Options are known for providing an insurance against unexpected movements in the
underlying price. If an investor has plans to buy a stock at some date in the future, buying
a call option on the stock enables him to lock in the purchase price for the stock today.
Thus, the investor is protected against a surprise rally in the stock price. Hence, buying a
call option enables the call holder to ‘insure’ against large and surprise upside movement
in the stock price.
For example, suppose that an investor expects to receive some money from a maturing
fixed deposit at the end of the month and plans to buy 1500 shares of a company at that
time. The risk faced by the investor is that the stock price might rise a lot by end of the
month, making it difficult for him to buy the planned number of shares. The investor can
protect himself from the risk of a rally in the stock price by buying a call option on the
stock today. Suppose that the stock price today is Rs.463 and the investor buys a near-
month call option with a strike price of 460 at a premium of Rs.19. Now suppose that the
stock price on the expiry date has risen to Rs.520. In this case, the rise in the call premium
would compensate the investor for the rise in the stock price. However, if the stock price
falls to Rs.430 on the expiry date, the investor would buy the stock at the market price
which is cheaper than exercising the option. In this way, buying a call option protects the
investor from a sudden rise in the price of the stock that he is planning to buy in the
future.
Similarly, buying a put option enables an investor to protect his portfolio against
unexpected downward movements in the underlying price.
Protective Put
This is a hedged position. Any investor, long in the cash market, always runs the risk of a
fall in prices and thereby reduction of portfolio value and MTM losses. A mutual fund
manager, who is anticipating a fall, can either sell his entire portfolio or he can short
futures to hedge his portfolio. In both cases, he is out of the market, as far as profits from
upside are concerned. What can be done to remain in the market, reduce losses but gain
from the upside? Buy insurance!
By buying put options, the fund manager is effectively taking a bearish view on the market
and if his view turns to be correct, he will make profits on the long put, which will be
useful to wipe out the MTM losses in the cash market portfolio.
Let us say an investor buys a stock in the cash market at Rs 1600 and at the same time
buys a put option with strike of 1600 by paying a premium of Rs 20.
Now, if prices fall to Rs 1530 from here:
Long Cash: Loss of 70 (i.e., 1530 - 1600 = - 70)
Long Put: Profit of 50 (i.e., – 20 – 1530 + 1600 = 50)
Net Position: -20
For all falls in the market, the long put will be profitable, and the long stock position will
be loss-making, thereby reducing the overall losses only to the extent of premium paid (if
strikes are different, losses will be different from premium paid).
In case prices rise to 1660:
Long Cash: Profit of 60 (i.e., 1660 – 1600 = 60)
Long Put: Loss of 20
Net Position: 60 – 20 = 40
As the stock price keeps rising, the profits of the hedged position will keep rising. This is
because while the maximum loss in the long put is equal to the premium paid, the profits
in the long stock position keep increasing. The combined position would look like this:
Long Cash 1600
Strike Price 1600
Premium 20

CMP Long Cash Long Put Net Flow

1500 -100 80 -20
1510 -90 70 -20
1520 -80 60 -20
1530 -70 50 -20
1540 -60 40 -20
1550 -50 30 -20
1560 -40 20 -20
1570 -30 10 -20
1580 -20 0 -20
1590 -10 -10 -20
1600 0 -20 -20
1610 10 -20 -10
1620 20 -20 0
1630 30 -20 10
1640 40 -20 20
1650 50 -20 30
1660 60 -20 40
1670 70 -20 50
1680 80 -20 60
1690 90 -20 70
1700 100 -20 80
 150
Protective Put Payoff

100

50
P/ L (Rs.)

0
1500 1510 1520 1530 1540 1550 1560 1570 1580 1590 1600 1610 1620 1630 1640 1650 1660 1670 1680 1690 1700

-50

-100

CMP (Rs.)
-150

A protective put payoff is similar to that of a long call. This is because a protective put
position offers the scope of unlimited gains with a limited loss, which is also the payoff
profile of a long call position. Hence the protective put is called a ‘synthetic long call’
position.

5.3 Arbitrage using options: Put-call parity

We have seen how it is possible to execute arbitrage strategies whenever the traded price
of a futures contract deviates from its fair or theoretical price. In the same manner,
arbitrage is possible whenever the traded price of an option deviates from its fair price.
Such arbitrage is based on an important principle known as ‘put-call parity’. It simply
states the relationship between calls and puts with the same strike price and time to
maturity. It can be stated as below:
𝑐 + 𝑋 ∗ 𝑒−𝑟𝑡 = 𝑝 + 𝑆0
In this formula, c and p denote the premium for the call and put options, X is the strike
price of the options, 𝑆0 is the spot price of the underlying, r is the rate of interest and t is
the time to expiry of the options.
What this formula means is that if we know the price of the underlying stock or asset and
also the price of a call option on this asset, we can derive the ‘fair’ or ‘theoretical’ price of
a put option on the same underlying asset having the same strike price and expiry date as
the call option. Further, if the traded price of the put option is different from this
derivedfair price, there is an arbitrage opportunity to make a risk-free profit. Note
that the put- call parity principle is only applicable to European options.
For example, suppose that a stock is trading at Rs.1251 and a call option with a strike
priceof Rs.1240 and expiring after 1 month is quoting at Rs.47.50. Assume that the
interest rate is 8% p.a. What should be the fair price of a one-month put option on the
stock withthe same strike price?
Substituting the numbers in the put-call parity formula, we can derive the fair price of
theput option as Rs.28.26. Now suppose that the put is being traded in the market at
Rs.23.15. It means that the put is underpriced, thus creating an arbitrage opportunity.
What will the arbitrageur do?
The arbitrageur will buy the put and the stock, (paying out Rs.23.15 and Rs.1251) and
simultaneously short the call option for Rs.47.50. This leaves him with a net cash
outflowof Rs.1226.65 (=1251+23.15-47.50). Assume that the arbitrageur can borrow
this amountat 8% p.a.
Now, suppose that the stock rises to Rs.1275 on expiry date. The arbitrageur will sell
theshares held by him for Rs.1275. The put bought by him will expire worthless. The
short call position will be in-the-money and lead to a loss of Rs.35 for the arbitrageur.
The borrowing will grow to Rs.1234.86 (=1226.65*exp(0.08*1/12)) and will have to be
repaid.The net cash inflow will thus be 1275-35-1234.86 = Rs.5.14, which is equal to
thedifference between the fair price and traded price of the put.
If the stock falls to Rs.1200 on the expiry date, the short call will expire worthless. The
arbitrageur will sell his stock at Rs.1200, but the long put will result in a payoff of
Rs.40. After repayment of borrowing of Rs.1234.86, the arbitrageur will again be left
with a netgain of Rs.5.14.
The above example shows how the principle of put-call parity can be used to find
arbitrage opportunities between call and put options on the same underlying stock
and having the same strike price and expiry dates. However, these strategies are
difficult to execute, because they involve the simultaneous buying and selling of the
stock, the put and the call. Any delay in executing one leg of the strategy will lead to
the arbitrageur notbeing able to capture the anticipated arbitrage gain. Also, if the
arbitrageur is unable to execute one leg of the transaction after the other leg has
already been executed, he will be left with a naked long or short position, which can
expose him to large losses.

Delta-hedging
Delta of theoption measures the sensitivity of the option value to a given small change
in the price of the underlying asset. Hence, if the delta of a call option is 0.6, it means
that a change of Rs 1 in the underlying stock price will lead to a change of Rs 0.60 in the
price of the option.Option traders use the concept of delta to hedge their portfolio of
option positions. This will be clear from the following example.
The delta hedging process involves several steps to create and maintain a delta-
neutral portfolio, effectively managing the risk associated with changes in the price
of the underlying asset. Here's a detailed overview of the delta hedging process:
1. Identify Options Position: The first step in delta hedging is to identify the options
position that needs to be hedged. This could be a long or short position in call
options, put options, or a combination of both.
2. Calculate Delta: Calculate the delta of each options contract in the portfolio. Delta
represents the sensitivity of the options price to changes in the price of the
underlying asset. For call options, delta is typically positive, while for put options,
delta is typically negative.
3. Determine Hedge Ratio: Determine the hedge ratio by comparing the delta of the
options position to the delta of the underlying asset. The hedge ratio indicates the
number of shares of the underlying asset needed to hedge against changes in the
options position.
4. Establish Hedge Position: Based on the hedge ratio, establish a hedge position in
the underlying asset to offset the delta exposure of the options position. If the
options position has a positive delta (long call options), the hedge position would
involve selling (shorting) shares of the underlying asset. If the options position has
a negative delta (long put options), the hedge position would involve buying
shares of the underlying asset.
5. Monitor Portfolio: Continuously monitor the portfolio to track changes in the
price of the underlying asset and the options position. As the price of the
underlying asset changes, the delta of the options position will also change,
necessitating adjustments to the hedge position to maintain delta neutrality.
6. Adjust Hedge Position: If the delta of the options position increases (decreases),
adjust the hedge position by buying (selling) additional shares of the underlying
asset to increase (decrease) delta exposure and maintain delta neutrality.
7. Rebalance Portfolio: Regularly rebalance the portfolio by adjusting the hedge
position to ensure that it remains delta neutral. This may involve buying or selling
shares of the underlying asset and/or adjusting options positions as needed to
align with changes in market conditions.
8. Evaluate Effectiveness: Periodically evaluate the effectiveness of the delta
hedging strategy in managing portfolio risk. Assess the impact of changes in the
price of the underlying asset on the overall portfolio value and determine whether
adjustments to the hedge position are necessary.
By following these steps, investors and traders can implement a delta hedging
strategy to effectively manage the risk associated with changes in the price of the
underlying asset and maintain a delta-neutral portfolio. Delta hedging helps mitigate
directional price risk in options positions, providing greater stability and predictability
in portfolio returns.

Suppose that a stock is trading at Rs.100 and a trader takes a short position in 10 ATM
calloptions on this stock. Assume that the options have a lot size of 50. Now suppose
that thedelta of this call option is 0.50. It means that a one rupee change in the stock
price will cause the call price to change by 50 paise.
Since the trader has sold the calls, he is at risk from a rise in the stock price. To hedge
thisrisk, the trader must go long in the underlying stock. But what should be the size
of the long stock position? This is decided based on the option delta. If the stock price
moves upby 1 rupee, the loss on the trader’s short call position would be 0.50*50*10
= Rs 250. Thetrader’s long position in stock futures should compensate for the loss in
the option position.
Remember that a stock futures contract has a delta of roughly one, because the
futures price goes hand in hand with the spot price. As the lot size is 50, it means that
the tradermust go long in 5 futures contracts. Since the delta of a futures contract is
equal to one, the long position in 5 lots of futures has a delta of 1*5*50 = 250. The
delta of the 10 lots of short call is -0.5*10*50 = -250. Hence the delta of the combined
position (short call andlong futures) is equal to zero. This position is called a ‘delta-
neutral’ position. What this means is that the combined position of short 10 lots of
calls and long 5 lots of futures contracts is not affected by any small changes in the
stock price. The key word here is ‘small’ changes.
The option delta changes with any change in the price of the underlying stock. So, if
the stock price rises from 100 to 110, the call delta may rise from 0.50 to 0.60. In that
case, the trader will need to increase his long position in futures so as to keep the
portfolio delta-neutral. He will now have to go long in one more lot of futures so that
the long futures position is now 6 lots. This will again make the combined position
delta-neutral.
In this way, the trader must keep buying or selling futures contracts in order to
maintainthe delta of the combined position near zero. This process is known as ‘delta
hedging’. Itis the option trader’s way of managing the risk of his short option position.

5.4 Interpreting open interest and put-call ratio for trading strategies
Before we end this chapter, let us understand some basic terms associated with
futuresand options and how these can be used for deciding a trading strategy.
Open Interest: This refers to the number of positions that have been opened by
marketparticipants and not yet closed. For example, if the May index futures
contract has an open interest of 2,56,000 contracts, it means that market participants
have bought or sold2,56,000 contracts till date and all these positions are yet to be
 closed.
Total Traded Quantity or traded volume: This is the total number of contracts that
have been traded or changed hands during the day. If the traded volume of May index
futurestoday is 2,00,000 contracts, it refers to the number of contracts traded today.
Put-call ratio: This is the ratio of trading volume of put options to call options. The ratio
iscalculated either on the basis of options trading volumes or on the basis of their
open interest.
Traders also consider the changes in the put-call ratio for deciding their option trading
strategy. If the put open interest for an index options contract is 8000 and the call
open interest is 12000, the put-call ratio is computed as:
PCR = 8000/12000 = 0.67.
The put-call ratio is generally treated as a contrarian indicator. If the PCR is less than
one,it means that the open interest of calls exceeds that of puts. It also means that
option traders prefer to sell more calls than puts. This indicates that option sellers do
not expectthe index to rise in the near future. Thus, a PCR less than one signals a
bearish trend. A PCR greater than one, say 1.25, means that the open interest of puts
is higher than that of calls. This is taken as a bullish signal, because it shows that option
sellers do not expecta fall in the market.

RELATIONSHIP BETWEEN OI & PRICE and the market inference.

Open interest (OI) and price in financial markets are interrelated, and understanding
their relationship can provide valuable insights for traders and analysts. Open interest
refers to the total number of outstanding contracts in a futures or options market at
any given point in time. It represents the number of contracts that have been opened
and not yet offset by closing trades. Traders can decide whether to buy or sell futures based
on changes in the open interest and the futures price. There are four possible scenarios and the
trading strategy would differ accordingly. Here's how the relationship between open
interest and price typically works:

1. Trend Confirmation: In general, when the price of an asset is increasing along with a
rise in open interest, it suggests that the current trend is likely to continue. This is
because increasing open interest indicates that new money is flowing into the market,
supporting the price movement. If the futures price is rising and open interest of the
futures contract is also increasing,it signals a bullish trend. Traders usually prefer to
go long the futures in such situations. This stage is called LONG BUILDUP
2. Trend Reversal: Conversely, when the price of an asset is increasing but open interest
is decreasing, it may signal a potential trend reversal. This divergence suggests that
the current price movement is not supported by new positions being opened in the
 market, possibly indicating weakening investor sentiment. It usually indicates that
existing short positions are being squared up. This stage is called SHORT COVERING.
3. If the futures price is declining but open interest is increasing, it indicates a bearish
trend. Traders usually tend to go short on the futures in sucha scenario. This stage is
called as SHORT BUILDUP.
4. If the futures price is declining and open interest is also declining, it usually means that
existing long positions are being squared up. This stage is called as LONG UNWINDING
5. Liquidity and Volatility: High levels of open interest often coincide with increased
liquidity and trading activity in the market. This can lead to greater price volatility as
more market participants engage in buying and selling activities. Conversely, low
open interest may result in thinner trading volumes and potentially wider bid-ask
spreads.
Options Market: In options markets, changes in open interest can provide insights into
potential future price movements. For example, a significant increase in open interest
for call options may suggest bullish sentiment, while a rise in open interest for put
options could indicate bearish sentiment.
Contract Rollover: In futures markets, open interest tends to decline as contracts
approach their expiration date due to traders rolling their positions forward to the next
contract month. A significant increase or decrease in open interest during this period
may reflect changes in market sentiment or expectations about future price
movements.
Consolidation Periods: During periods of consolidation or range-bound trading, open
interest may remain relatively stable as traders take offsetting positions or remain on
the sidelines. Changes in open interest during these periods can provide clues about
potential breakouts or trend reversals.
Overall, while open interest alone does not determine price direction, analyzing its
relationship with price movements can help traders identify market trends, gauge
investor sentiment, and make more informed trading decisions. It is important to
consider open interest in conjunction with other technical and fundamental factors to
gain a comprehensive understanding of market dynamics.

MAX PAIN THEORY

The Max Pain theory is rooted in the options market, where investors trade contracts that
give them the right to buy (call options) or sell (put options) an underlying asset at a
predetermined price (strike price) on or before a specified expiration date. Option prices are
influenced by various factors, including the price of the underlying asset, time to expiration,
volatility, and interest rates.

Key Concepts:
Open Interest and Max Pain Strike: Open interest refers to the total number of outstanding
options contracts at a specific strike price for a given expiration date. The Max Pain theory
focuses on identifying the strike price with the highest open interest, known as the Max Pain
strike. This strike price is often seen as a point of interest because it represents the level at
which the most options contracts are held by traders.

Options Expiration: The Max Pain theory primarily applies to options contracts nearing
expiration. As the expiration date approaches, options traders make decisions about
whether to exercise their contracts or let them expire worthless. At expiration, options
contracts are settled based on the price of the underlying asset. For call options, contracts
are profitable if the underlying asset's price is above the strike price, while for put options,
contracts are profitable if the underlying asset's price is below the strike price.

Options Sellers' Incentives: Options sellers, also known as writers, have an incentive to keep
the price of the underlying asset close to the Max Pain strike price. This is because options
sellers profit when options contracts expire worthless, as they keep the premiums received
from selling the contracts. By influencing the price of the underlying asset towards the Max
Pain strike, options sellers can maximize their profits by ensuring that the maximum number
of options contracts expire out of the money.

Max Pain Price Calculation: The Max Pain price is the theoretical price at which the total
value of options contracts expiring out of the money is maximized. It represents the price
level at which option buyers experience the maximum financial loss or “pain.” Traders can
calculate the Max Pain price by analyzing the open interest of options contracts across
different strike prices and determining the price level at which the total value of expiring
options is highest.

Limitations and Considerations:

Market Efficiency: Critics of the Max Pain theory argue that markets are efficient and that
attempts to manipulate prices to achieve the Max Pain strike would be quickly arbitraged
away. They believe that option prices reflect all available information and that there is no
systematic manipulation of prices by options sellers.

Imperfect Predictive Power: While the Max Pain theory provides insights into options
market dynamics, it is not a precise predictor of future price movements. Market conditions
can change rapidly, and the relationship between open interest, options prices, and the
underlying asset's price may not always follow the Max Pain scenario.

Risk Management: Traders who use the Max Pain theory in their trading strategies should
exercise caution and employ proper risk management techniques. Options trading involves
inherent risks, including the risk of loss of capital, and traders should only use the Max Pain
theory as one of many tools in their trading arsenal.