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Abstract

This paper examines the historical time-series performance of trading

strategies involving options on the S&P CNX Nifty 50 Index. Each option

strategy is examined over different maturities and money-ness, incorporating

transaction costs and margin requirements. An initial analysis was

constructed by assuming an individual position starting in 2002 and allowing

for a continuum of trading comparing historical performance via returns and

Sharpe Ratios as compared to the S&P CNX Nifty 50 as a benchmark. A second

analysis generated portfolios for a “typical” investor, using the past 10 years

to examine rates of return given certain trading restrictions. The analysis

revealed significant profitability in investing in certain option strategies, in

particular, market bullish strategy, especially long call and long call spread.

Keywords: Equity Options, Investment, S&P CNX Nifty 50, out the money

(OTM), at the money (ATM), in the money (ITM)

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Chapter 1

Introduction 1.1 Background

Option is a financial instrument which is extensively used in share markets, money

markets, and commodity markets to hedge the investment risks and acts as financial

leverage investment. Option is a kind of derivative instruments along with forwards,

futures and swaps, which are used for managing risk of the investors. Though

derivatives are theoretically risk management tools and leveraged investment tools,

most use them as speculative tools.

Most research in the field of option involves the theoretical and empirical estimation

of various option-pricing models and the role option play in hedging risk exposure.

Although very little attention has been dedicated to the effect options have from an

individual investor standpoint. Explicitly, what effect investing in option strategies

have on portfolio returns? The purpose of this study is to examine, from an

historical perspective, the return and risk to holding various option strategies from

a representative investor standpoint.

Our representative investor is considered different from an institutional investor,

since the individual is constraint with limited net worth and faces the burden of

higher transaction costs given bid-ask spreads, taxes and overall relative trade size.

The results are formulated and designed to provide investment strategies across

various level of risk aversion while maintaining a diversified portfolio. Hopefully,

the results will provide new insight into investment options that can actually be

utilized in today’s market.

The underlying asset to which the portfolio will be compared to is the Standard and

Poor’s CNX Nifty (Nifty 50), which is a capitalization –weighted index of 50 Blue-

Chip stocks. The S&P CNX Nifty 50 is typically used as the benchmark for the overall

performance of the market. From a theoretical point of view, investing directly into

the index would eliminate all non-systematic risk. In general, most managers who

are active in the market accept beating the market as a measure of positive

abnormal returns. As such, utilizing options on the index to examine various option

strategies, will allow the comparison relative to this benchmark for a wide array of

investor risk preferences.

This research further focuses on three types of individual investors: high-risk

aversion, medium-risk aversion, and low-risk aversion, where the medium risk

averse investor would accept the return and risk associated with the market. Each

strategy is compared and generated with the idea of classifying the strategy within a

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risk aversion class. It does not examine the reasons an investor falls into each

category, but the results should provide useful alternatives for each of the three

types of investors.

When discussing risk, it should be clear that this research is not trying to define risk

nor is it trying to discover riskless investments. The S&P CNX Nifty 50 Index’s level

of risk will be the baseline for the medium risk-averse investor. The highly risk

averse investor will have a low risk tolerance based primarily on lower standard

deviation of returns. Similarly, the low risk averse investor will have a higher risk

tolerance, which allows for high volatility in returns. Rates of return and Sharpe

ratios will be used in evaluating the strategies but only after classify the strategy to

an investor type based on the volatility of that strategy.

The options market today in India is liquid, low-transaction-cost, and penetrable

market. An individual investor, today, can easily trade small quantities of contracts

through a broker or an individual on-line brokerage account. The options market

today is nothing like it was ten years ago. Ten years ago the options market barely

existed and was primarily an institutional investment vehicle; the options market

had just become standardized, allowing an individual investor to invest in index

options but at extremely high costs and without out the fluidity of today’s market.

In today’s market, option prices instantly change in value as prices fluctuate in

underlying assets, according to market maker’s valuation estimates. The ease of

entry and exit is as fluid as trading exchange listed stocks. Gains and losses can be

easily magnified by the leverage options provide, and through the research, a

solution to maximize gains and realize the potential risk of losses will be highlighted

for each investor.

1.2 Rationale For The Study

The market price reduction of the share is called as downside risk of the investor.

The profit from the increase in the share price is known as upside potential. Option

strategies help the investors to cap the downside risk at the same time keep the

upside potential unlimited. This is the most desired need of the investors. Buying a

call option and selling a put option works well in the bull market, limiting the loss to

the premium paid but the upside potential in unlimited as market price increases.

Similarly, in a bearish situation, selling a call and buying a put are the strategies of

capping the downside risk. Apart from the above plain vanilla strategies, bull –

spread, bear – spread, calendar spreads, butterfly spreads, diagonal spreads,

straddle, strangle, strips, and straps are some of the famous strategies to cap the

downside risks up to any level required by the investors. This property makes the

option a unique tool for risk management and a preferred one.

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Option strategies can be used by the investors to bring down their risk from the

fluctuations in the market and can also use it to generate a significant return from it.

For example Bakshi and Kapadia (2003) and Coval and Shumway (2001) show that

selling puts and selling straddles on the S&P 500 offer unusually high returns for

their level of risk. For instance, Coval and Shumway show that shorting an at-the-

money, near-maturity straddle offered a return of 3.15 percent per week in their

sample. Although very little attention has been dedicated to the effect options have

from an individual investor standpoint. Explicitly, what effect investing in option

strategies have on portfolio returns? Some studies have been done in more

developed markets like U.S.A (United State of America) but there are no such studies

in Indian context as option market is still in its early stage. This study will try to

bridge this gap and will provide the answers to this question.

1.3 Objectives

The key objectives of the thesis are as follows:-

a) To find effect of writing or holding options have on individual’s portfolio

returns

b) To distinguish the option trading strategies on the basis of investors risk

appetite

c) To find out strategy that generates a significant return in Indian stock

exchange market

The results will provide new insight into investment options that can actually be

utilized in today’s market.

1.4 Data

The sample used for construction of portfolio consists of Index Options trading on

NSE which satisfy following conditions:

a) The options are European Options.

b) The period of analysis span from January 2002 until March 2012.

c) The option price used is the average of daily opening, mid and closing price

of the option.

d) The risk-free rates are obtained from the Reserve Bank of India.

e) The maturity period of options is 3-months but the position in strategies is

not established until 45, 37 and 30 days before the expiry so option prices

are taken accordingly. The positions are taken only on Thursday and if

Thursday is holiday then positions are taken prior to it.

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f) Each of the strategies was evaluated over three levels of money-ness; Out-of-

the money (OTM), at-the money (ATM), and in-the money (ITM). The

strategies are all based on leveraging and investing in the S&P CNX Nifty 50

Index.

The data were obtained from Bloomberg Data Base (Courtesy: Navam Capital)

1.5 Limitation of the Study

The study is limited to National Stock Exchange and limited to index options, which

are traded from January 2002 till March 2012 for some strategies and for some

strategies period of analysis span from October 2007 till March 2012 due to

unavailability of data, as the trades in BSE has been less than one percentage

compare to NSE trade.

1.6 Organization of the Study

Chapter 2 briefly reviews the literature related to testing methodologies used in

past empirical studies on equity option strategies for an individual investor.

Chapter 3 contains a detailed description of methodology used in the analysis and

its relevance. This is followed by the results of the study.

Chapter 4 contains the discussion of results.

Chapter 5 contains a brief summary and conclusions of the study.

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Chapter 2

Literature Review

This section contains two subsections. The first subsection discusses the theoretical

details whereas the second subsection most commonly used methodology used for

testing equity option strategies for individual investors and the empirical findings

from a number of studies related to the markets all around the world.

2.1 Option Overview

Option is a financial instrument whose value depends upon the value of the

underlying assets. Option itself has no value without underlying assets. Option gives

the right to the buyer either to sell or to buy the specified underlying assets for a

particular price (Exercise / Strike price) on or before a particular date (expiration

date). If the right is to buy, it is known as “call option” and if the right is to sell, it is

called as “put option”. The buyer of the option has the right but no obligation either

to buy or to sell. The option buyer has to exercise the option on or before the

expiration date, otherwise, the option expires automatically at the end of the

expiration date. Hence, options are also known as contingent claims.

Such an instrument is extensively used in share markets, money markets, and

commodity markets to hedge the investment risks and acts as financial leverage

investment. Option is a kind of derivative instruments along with forwards, futures

and swaps, which are used for managing risk of the investors. Though derivatives

are theoretically risk management tools and leveraged investment tools, most use

them as speculative tools.

Though the derivatives were very old as early as 1630s, the exchange traded

derivative market was introduced during 1970s. 1973 marked the creation of both

the Chicago Board Options Exchange and the publication of the most famous

formula in finance, the option-pricing model of Fischer Black and Myron Scholes.

These events revolutionized the investment world in ways no one could imagine at

that time. The Black-Scholes model, as it came to be known, set up a mathematical

framework that formed the basis for an explosive revolution in the use of

derivatives. Chicago Board Options Exchange (CBOE) was founded as first United

States of America (USA) options exchange and trading begins on standardized, listed

options. April 26, the first day of trading sees 911 contracts traded on 16 underlying

stocks. During 1975, computerized price reporting was introduced and Options

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Clearing Corporation was formed. The Black-Scholes model was adopted for pricing

options in CBOE. In the year 2005, CBOE’s options contract volume was an all-time

record of 468,249,301 contracts (up 30% over the previous year), and the notional

value of this volume was more than US$1.2 trillion.

In 1983, the Chicago Board Options Exchange decided to create an option on an

index of stocks. Though originally known as the CBOE 100 Index, it was soon turned

over to Standard and Poor's and became known as the S&P 100, which remains the

most actively traded exchange-listed option.

Options have the most peculiar property of capping the downside risk at the same

time keeping the unlimited upside potential. Furthermore, the importance of the

option trading and the requirement of its correct pricing are far more critical and

useful in decision making, which are narrated below.

First, prices in an organized derivatives market reflect the perception of market

participants about the future and lead the prices of underlying to the perceived

future level. The prices of derivatives converge with the prices of the underlying at

the expiration of the derivative contract. Thus derivatives help in discovery of future

as well as current prices. Second, the derivatives market helps to transfer risks from

those who have them but may not like them to those who have an appetite for them.

Third, derivatives, due to their inherent nature, are linked to the underlying cash

markets. With the introduction of derivatives, the underlying market witness higher

trading volumes, because more players participated who would not otherwise

participate for lack of an arrangement to transfer risk. Fourth, the speculative trades

shift to a more controlled environment of derivatives market. In the absence of an

organized derivatives market, speculators trade in the underlying cash markets.

Margining, monitoring and surveillance of the activities of various participants

become extremely difficult in these kinds of mixed markets. Fifth, an important

incidental benefit that flows from derivatives trading is that it acts as a catalyst for

new entrepreneurial activity. The derivatives have a history of attracting many

bright, creative, well-educated people with an entrepreneurial attitude. They often

energize others to create new businesses, new products and new employment

opportunities, the benefit of which are immense. Finally, derivatives markets help

increase savings and investment in the long run. Transfer of risk enables market

participants to expand their volume of activity.

In India, derivatives trading was introduced Index Futures Contracts from June

2000 and stock option trading in July 2001 grown very fast to reach an average daily

turnover of derivatives at NSE, at Rs.33,745 crores during May 2006 as against cash

markets turnover of about Rs.9202.15 crores (as on May 2006), which indicates the

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importance of the derivatives. Normally, the derivative turnover is three to four

times the cash market turnover in India.

Option, being one of the derivatives is a unique type of hedging tool. Black – Scholes

formula after mesmerize the western countries also entered into in Indian option

market.

2.1.1 Option Pricing:

The price of the option is determined by many methods like binomial method, Black

Scholes option pricing formula, Volatility jump model etc. out of which the Black

Scholes option pricing model is most popular and widely used throughout the

world.

The variables and the parameters that determine the call option price are

diagrammatically given in Figure 1.1.

Future is uncertain and must be expressed in terms of probability distributions. The

probability distribution of the price at any particular future time is not dependent

on the particular path followed by the price in the past. This states that the present

price of a stock impounds all the information contained in a record of past prices. If

the weak form of market efficiency were not true, technical analysts could make

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above-average returns by interpreting charts of the past history of stock prices.

There is very little evidence that they are in fact able to get above-average returns.

It is competition in the marketplace that tends to ensure that weak-form market

efficiency holds. There are many, many investors watching the stock market closely.

Trying to make a profit from it, leads to a situation where a stock price, at any given

time, reflects the information in past prices. Assume that it was discovered a

particular pattern in stock prices, which always gave a 65% chance of subsequent

steep price rises. Investors would attempt to buy a stock as soon as the pattern was

observed, and demand for the stock would immediately rise. This would lead to an

immediate rise in its price and the observed effect would be eliminated, as would

any profitable trading opportunities.

2.1.2 Option and the Stock Market

The derivatives make the stock market more efficient. The spot, future and option

markets are inextricably linked. Since it is easier and cheaper to trade in derivatives,

it is possible to exploit arbitrage opportunities quickly, and keep the prices in

alignment. Hence these markets help ensure that prices of the underlying asset

reflect true values.

Options can be used in a variety of ways to profit from a rise or fall in the underlying

asset market. The most basic strategies employ put and call options as a low capital

means of garnering a profit on market movements, known as leveraging. Option

route enable one to control the shares of a specific company without tying up a large

amount of capital in the trading account. A small portion of money say, 20%

(margin) is sufficient to get the underlying asset worth 100 percentages. Options

can also be used as insurance policies in a wide variety of trading scenarios. One,

probably, has insurance on his / her car or house because it is the responsible act

and safe thing to do. Options provide the same kind of safety net for trades and

investments already committed, which is known as hedging.

Options can provide leverage. This means an option buyer can pay a relatively small

premium for market exposure in relation to the contract value (usually 100 shares

of underlying stock). An investor can see large percentage gains from comparatively

small, favorable percentage moves in the underlying index. Leverage also has

downside implications. If the underlying stock price does not rise or fall as

anticipated during the lifetime of the option, leverage can magnify the investment’s

percentage loss. Options offer their owners a predetermined, set risk. However, if

the owner’s options expire with no value, this loss can be the entire amount of the

premium paid for the option. An uncovered option writer, on the other hand, may

face unlimited risk.

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The amazing versatility that an option offers in today's highly volatile markets is

welcome relief from the uncertainties of traditional investing practices. Options can

be used to offer protection from a decline in the market price of available underlying

stocks or an increase in the market price of uncovered underlying stock. Options can

enable the investor to buy a stock at a lower price, sell a stock at a higher price, or

create additional income against a long or short stock position. One can also uses

option strategies to profit from a movement in the price of the underlying asset

regardless of market direction.

There are three general market directions: market up, market down, and market

sideways. It is important to assess potential market movement when you are placing

a trade. If the market is going up, you can buy calls, sell puts or buy stocks. Does one

have any other available choices? Yes, one can combine long and short options and

underlying assets in a wide variety of strategies. These are some of the strategies

that limit your risk while taking advantage of market movement.

Table 2.1

Bullish Limited Risk Strategies

Bullish Unlimited Risk Strategies

Bearish Limited Risk Strategies

Bearish Unlimited Risk Strategies

Buy Call Buy Stock Buy Put Sell Stock Bull Call Spread Sell Put Bear Put Spread Sell Call Bull Put Spread Covered Call Bear Call Spread Covered Put

Table 2.2

Neutral Limited Risk Strategies Neutral Unlimited Risk Strategies Long Straddle Short Straddle Long Strangle Short Strangle Long Butterfly Long Condor

2.1.3 Option Strategies (An overview on “Strategies to be tested”)

1. LONG CALL

If upon expiration, the spot price exceeds the strike price, he makes a profit. Higher the spot

price more is the profit he makes. If the spot price of the underlying is less than the strike

price, he lets his option expire un-exercised. His loss in this case is the premium he paid for

buying the option. Market Expectation: Market Bullish/Volatility Bullish

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Volatility: The option value will increase as volatility increases (good) and will fall as

volatility falls (bad).

Time Decay: As each day passes the value of the option erodes.

2. SHORT CALL

A call option gives the buyer the right to buy the underlying asset at the strike price

specified in the option. For selling the option, the writer of the option charges a premium.

The profit/loss that the buyer makes on the option depends on the spot price of the

underlying. Whatever is the buyer's profit is the seller's loss. If upon expiration, the spot

price exceeds the strike price, the buyer will exercise the option on the writer. Hence as the

spot price increases the writer of the option starts making losses. Higher the spot price

more is the loss he makes. If upon expiration the spot price of the underlying is less than the

strike price, the buyer lets his option expire un-exercised and the writer gets to keep the

premium.

Market Expectation: Market Bearish/ Volatility Bearish

Volatility: The option value will increase as volatility increases (bad) and will decrease as

volatility decreases (good).

Time Decay: As each day passes the value of the option erodes (good).

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3. LONG PUT

A put option gives the buyer the right to sell the underlying asset at the strike price

specified in the option. The profit/loss that the buyer makes on the option depends on the

spot price of the underlying. If upon expiration, the spot price is below the strike price, he

makes a profit. Lower the spot price more is the profit he makes. If the spot price of the

underlying is higher than the strike price, he lets his option expire un-exercised. His loss in

this case is the premium he paid for buying the option.

Market Expectation: Market Bearish/Volatility Bullish

Volatility: The option value will increase as volatility increases (good) and will fall as

volatility falls (bad).

Time Decay: As each day passes the value of the option erodes (bad).

4. SHORT PUT

A put option gives the buyer the right to sell the underlying asset at the strike price

specified in the option. For selling the option, the writer of the option charges a premium.

The profit/loss that the buyer makes on the option depends on the spot price of the

underlying. Whatever is the buyer's profit is the seller's loss. If upon expiration, the spot

price happens to be below the strike price, the buyer will exercise the option on the writer.

If upon expiration the spot price of the underlying is more than the strike price, the buyer

lets his option un-exercised and the writer gets to keep the premium.

Market Expectation: Market Bullish/Volatility Bearish

Volatility: The option value will increase as volatility increases (bad) and will decrease as

volatility decreases (good).

Time Decay: As each day passes the value of the option erodes (good).

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5. LONG STRADDLE

A Straddle is a volatility strategy and is used when the stock price / index is expected to

show large movements. This strategy involves buying a call as well as put on the same stock

/ index for the same maturity and strike price, to take advantage of a movement in either

direction, a soaring or plummeting value of the stock / index. If the price of the stock / index

increases, the call is exercised while the put expires worthless and if the price of the stock /

index decreases, the put is exercised, the call expires worthless. Either way if the stock /

index show volatility to cover the cost of the trade, profits are to be made. With Straddles,

the investor is direction neutral. All that he is looking out for is the stock / index to break

out exponentially in either direction.

Market Expectation: Market neutral/Volatility bullish

Volatility: The option value will increase as volatility increases which is good for both

options. Alternatively a decrease in volatility will be bad for both options.

Time Decay: As each day passes the value of the option erodes (bad).

6. SHORT STRADDLE

A Short Straddle is the opposite of Long Straddle. It is a strategy to be adopted when the

investor feels the market will not show much movement. He sells a Call and a Put on the

same stock / index for the same maturity and strike price. It creates a net income for the

investor. If the stock / index do not move much in either direction, the investor retains the

Premium as neither the Call nor the Put will be exercised. However, in case the stock / index

moves in either direction, up or down significantly, the investor’s losses can be significant.

So this is a risky strategy and should be carefully adopted and only when the expected

volatility in the market is limited. If the stock / index value stays close to the strike price on

expiry of the contracts, maximum gain, which is the Premium received is made.

Market Expectation: Market neutral/Volatility bearish

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Volatility: The option value will decrease as volatility decreases which is good for both

options. Alternatively an increase in volatility will be bad for both options.

Time Decay: As each day passes the value of the option erodes (good).

7. LONG STRANGLE

A Strangle is a slight modification to the Straddle to make it cheaper to execute. This

strategy involves the simultaneous buying of a slightly out-of-the-money (OTM) put and a

slightly out-of-the-money (OTM) call of the same underlying stock / index and expiration

date. Here again the investor is directional neutral but is looking for an increased volatility

in the stock / index and the prices moving significantly in either direction. Since OTM

options are purchased for both Calls and Puts it makes the cost of executing a Strangle

cheaper as compared to a Straddle, where generally ATM strikes are purchased. Since the

initial cost of a Strangle is cheaper than a Straddle, the returns could potentially be higher.

However, for a Strangle to make money it would require greater movement on the upside or

downside for the stock / index than it would for a Straddle. As with a Straddle, the strategy

has a limited downside (i.e. the Call and the Put premium) and unlimited upside potential.

Market Expectation: Market neutral/volatility bullish

Volatility: The option value will increase as volatility increases which is good for both

options. Alternatively a decrease in volatility will be bad for both options.

Time Decay: As each day passes the value of the option erodes (bad).

8. SHORT STRANGLE

A Short Strangle is a slight modification to the Short Straddle. It tries to improve the

profitability of the trade for the Seller of the options by widening the breakeven points so

that there is a much greater movement required in the underlying stock / index, for the Call

and Put option to be worth exercising. This strategy involves the simultaneous selling of a

slightly out-of-the-money (OTM) put and a slightly out-of-the-money (OTM) call of the same

underlying stock and expiration date. This typically means that since OTM call and put are

sold, the net credit received by the seller is less as compared to a Short Straddle, but the

break even points are also widened. The underlying stock has to move significantly for the

Call and the Put to be worth exercising. If the underlying stock does not show much of a

movement, the seller of the Strangle gets to keep the Premium.

Market Expectation: Market neutral/volatility bearish

Volatility: The option value will decrease as volatility decreases which is good for both

options. Alternatively an increase in volatility will be bad for both options.

Time Decay: As each day passes the value of the option erodes (good).

9. BULL CALL SPREAD STRATEGY: BUY CALL OPTION, SELL CALL OPTION

A bull call spread is constructed by buying an in-the-money (ITM) call option, and selling

another out-of-the-money (OTM) call option. Often the call with the lower strike price will

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be in-the-money while the Call with the higher strike price is out-of-the-money. Both calls

must have the same underlying security and expiration month. The net effect of the strategy

is to bring down the cost and breakeven on a Buy Call (Long Call) Strategy. This strategy is

exercised when investor is moderately bullish to bullish, because the investor will make a

profit only when the stock price / index rise. If the stock price falls to the lower (bought)

strike, the investor makes the maximum loss (cost of the trade) and if the stock price rises

to the higher (sold) strike, the investor makes the maximum profit.

Market Expectation: Market Bullish/Volatility Neutral

Volatility: You are not affected by volatility.

Time Decay: It depends on the underlying share price, if it is below A, then time decay

works against you. If it is above B, then it works for you.

10. BULL PUT SPREAD STRATEGY: SELL PUT OPTION, BUY PUT OPTION

A bull put spread can be profitable when the stock / index is either range bound or rising.

The concept is to protect the downside of a Put sold by buying a lower strike Put, which acts

as insurance for the Put sold. The lower strike Put purchased is further OTM than the higher

strike Put sold ensuring that the investor receives a net credit, because the Put purchased

(further OTM) is cheaper than the Put sold. This strategy is equivalent to the Bull Call

Spread but is done to earn a net credit (premium) and collect an income. If the stock / index

rise, both Puts expire worthless and the investor can retain the Premium. If the stock /

index falls, then the investor are breakeven is the higher strike less the net credit received.

Provided the stock remains above that level, the investor makes a profit. Otherwise he could

make a loss. The maximum loss is the difference in strikes less the net credit received. This

strategy should be adopted when the stock / index trend is upward or range bound.

Market Expectation: Market bullish/Volatility Neutral

Volatility: You are not affected by volatility.

Time Decay: It depends on the underlying share price, if it is below A, then time decay

works against you. If it is above B, then it works for you.

11. BEAR CALL SPREAD STRATEGY: SELL ITM CALL, BUY OTM CALL

The Bear Call Spread strategy can be adopted when the investor feels that the stock / index

are either range bound or falling. The concept is to protect the downside of a Call Sold by

buying a Call of a higher strike price to insure the Call sold. In this strategy the investor

receives a net credit because the Call he buys is of a higher strike price than the Call sold.

The strategy requires the investor to buy out-of-the-money (OTM) call options while

simultaneously selling in-the-money (ITM) call options on the same underlying stock index.

This strategy can also be done with both OTM calls with the Call purchased being higher

OTM strike than the Call sold. If the stock/index falls both call will expire worthless and the

investor can retain the net credit. If the stock/index rises then the breakeven is the lower

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strike plus the net credit. Provided the stock remains below that level, the investor makes a

profit. Otherwise he could make a loss. The maximum loss is the difference in strikes less

the net credit received.

12. BEAR PUT SPREAD STRATEGY: BUY PUT, SELL PUT

This strategy requires the investor to buy an in-the-money (higher) put option and sell an

out-of-the-money (lower) put option on the same stock with the same expiration date. This

strategy creates a net debit for the investor. The net effect of the strategy is to bring down

the cost and raise the breakeven on buying a Put (Long Put). The strategy needs a Bearish

outlook since the investor will make money only when the stock price / index fall. The

bought Puts will have the effect of capping the investor’s downside. While the Puts sold will

reduce the investors costs, risk and raise breakeven point (from Put exercise point of view).

If the stock price closes below the out-of-the-money (lower) put option strike price on the

expiration date, then the investor reaches maximum profits. If the stock price increases

above the in-the-money (higher) put option strike price at the expiration date, then the

investor has a maximum loss potential of the net debit.

13. LONG CALL BUTTERFLY: SELL 2 ATM CALL OPTIONS, BUY 1 ITM CALL

OPTION AND BUY 1 OTM CALL OPTION

A Long Call Butterfly is to be adopted when the investor is expecting very little movement in

the stock price / index. The investor is looking to gain from low volatility at a low cost. The

strategy offers a good risk / reward ratio, together with low cost. A long butterfly is similar

to a Short Straddle except your losses are limited. The strategy can be done by selling 2 ATM

Calls, buying 1 ITM Call, and buying 1 OTM Call options (there should be equidistance

between the strike prices). The result is positive incase the stock / index remains range

bound. The maximum reward in this strategy is however restricted and takes place when

the stock / index is at the middle strike at expiration. The maximum losses are also limited.

14. SHORT CALL BUTTERFLY: BUY 2 ATM CALL OPTIONS, SELL 1 ITM CALL

OPTION AND SELL 1 OTM CALL OPTION

A Short Call Butterfly is a strategy for volatile markets. It is the opposite of Long Call

Butterfly, which is a range bound strategy. The Short Call Butterfly can be constructed by

Selling one lower striking in-the-money Call, buying two at-the-money Calls and selling

another higher strike out-of-the-money Call, giving the investor a net credit (therefore it is

an income strategy). There should be equal distance between each strike. The resulting

position will be profitable in case there is a big move in the stock / index. The maximum risk

occurs if the stock / index is at the middle strike at expiration. The maximum profit occurs if

the stock finishes on either side of the upper and lower strike prices at expiration. However,

this strategy offers very small returns when compared to straddles, strangles with only

slightly less risk.

17

15. LONG CALL CONDOR: BUY 1 ITM CALL OPTION (LOWER STRIKE), SELL 1 ITM

CALL OPTION (LOWER MIDDLE), SELL 1 OTM CALL OPTION (HIGHER MIDDLE), and

BUY 1 OTM CALL OPTION (HIGHER STRIKE)

A Long Call Condor is very similar to a long butterfly strategy. The difference is that the two

middle sold options have different strikes. The profitable area of the payoff profile is wider

than that of the Long Butterfly The strategy is suitable in a range bound market. The Long

Call Condor involves buying 1 ITM Call (lower strike), selling 1 ITM Call (lower middle),

selling 1 OTM call (higher middle) and buying 1 OTM Call (higher strike). The long options

at the outside strikes ensure that the risk is capped on both the sides. The resulting position

is profitable if the stock / index remains range bound and shows very little volatility. The

maximum profits occur if the stock finishes between the middle strike prices at expiration.

16. SHORT CALL CONDOR: SHORT 1 ITM CALL OPTION (LOWER STRIKE),

LONG 1 ITM CALL OPTION (LOWER MIDDLE), LONG 1 OTM CALL OPTION

(HIGHER MIDDLE), SHORT 1 OTM CALL OPTION (HIGHER STRIKE)

A Short Call Condor is very similar to a short butterfly strategy. The difference is that the

two middle bought options have different strikes. The strategy is suitable in a volatile

market. The Short Call Condor involves selling 1 ITM Call (lower strike), buying 1 ITM Call

(lower middle), buying 1 OTM call (higher middle) and selling 1 OTM Call (higher strike).

The resulting position is profitable if the stock / index shows very high volatility and there

is a big move in the stock / index. The maximum profits occur if the stock / index finish on

either side of the upper or lower strike prices at expiration.

2.2 Empirical Findings

Hamernik (2005) examined the historical time-series performance of seventeen

trading strategies involving options on the S&P 500 Index. In particular, seventeen

separate strategies are examined over multiple time-horizons and holding periods.

The selection of these strategies is in-line with the most popular option strategies as

per the Chicago Board of Option Exchange and similar to those examined by Santa-

Clara and Saretto (2005). . Each option strategy is examined over different

maturities and money-ness, incorporating transaction costs and margin

requirements. An initial analysis was constructed by assuming a theoretical option

starting in 1970 and allowing for a continuum of trading comparing historical

performance via returns and Sharpe Ratios as compared to the S&P 500 as a

benchmark. A second analysis generated portfolios for a “typical” investor, using the

past 34 years and 10 years to examine rates of return given certain trading

restrictions.

Each strategy was ranked by the standard deviation and the Sharpe ratio. The

standard deviation of the S&P 500 was used as a baseline for determining each

18

investor category. A medium risk averse investor’s strategies ranged from the S&P

500’s standard deviation to half its value. The highly risk averse investor’s

strategies were all strategies with half the standard deviation of the S&P 500’s

standard deviation or less. The low risk averse investor’s strategies were all the

strategies with standard deviations greater than the S&P 500’s. All 17 strategies

were evaluated despite the outcome of their standard deviation and Sharpe ratio

analysis under the Empirical Results. All the strategies were evaluated at the three

levels of money-ness and over the two levels of maturity. Then each position was

compared on a 34-year run and a 10-year run of a baseline portfolio constructed of

investing in the S&P 500 Index. Of note, the buying Put was extremely successful in

the one-year investments over the last 10 years because of the recession and

massive market decline. The leverage shows a direct reflection as to the

profitability of the position. The more leverage the more profitable buying a put

was. Because of the recession from 2000 until 2002, the results of the strategy

could be considered unrepresentative of the general market. The 34-year run of the

one-year investments shows a drastically different picture; however, the 30-day

strategy shows the buying OTM puts as a highly profitable investment over the 10-

year and 34-year runs. The OTM put is a highly profitable strategy; however, the

percentage of the time the investment is profitable would pale and hinder even most

of the truly low risk averse investors. In the one-year strategies, the OTM put is

profitable around 20% of the time due to the long period and depth of the market

decline from 2000 until 2003.

Despite the large market decline in the latter part of the experiment and due to the

length of the periods the experiment was conducted over, a significant number of

the strategies proved to be profitable above the S&P 500. In fact, almost a full third

of the strategies investigated provided returns higher than that of the S&P 500.

In the study done by Hamernik (2005), he concluded for many of the strategies the

additional risks in investing in the options are not out weighted by the potential

profits. The low risk averse strategies that are profitable have dramatic downside

potential. The most significant strategy investigated based on astounding returns

and ability for the individual investor to establish the position has to be the ATM

Synthetic Stock. A young investor has the ability to absorb large short-term losses to

receive the eventually huge gains. The risks of the ATM Synthetic Stock have shown

to be very rewarding in the long run; therefore, the individual investor that has the

time to benefit from long upward trends in the market that can be maximized from

the leverage afforded in the Synthetic Stock.

Santa-Clara and Saretto (2004) investigated the risk and return of a wide variety of

trading strategies involving options on the S&P 500. We consider naked and covered

19

positions, straddles, strangles, and calendar spreads, with different maturities and

levels of money-ness. Overall, they found that strategies involving short positions in

options generally compensate the investor with very high Sharpe ratios, which are

statistically significant even after taking into account the non-normal distribution of

returns. Furthermore, they found that the strategies’ returns are substantially

higher than warranted by asset pricing models. They also found that the returns of

the strategies could only be justified by jump risk if the probability of market

crashes were implausibly higher than it has been historically. They concluded that

the returns of option strategies constitute a very good deal. However, exploiting this

good deal is extremely difficult. They found that trading costs and margin

requirements severely condition the implementation of option strategies. Margin

calls force investors out of a trade precisely when it is losing money.

They conducted a systematic analysis of the risks and returns of option strategies

focusing in particular on the impact that margin requirements and transaction costs

have on the execution of these strategies. They considered naked and covered

positions, straddles, strangles, and calendar spreads, with different maturities and

levels of money-ness. They used data on S&P 500 options from January of 1985 to

December of 2002 which is a much longer data set than used in previous studies and

encompasses a variety of market conditions. They concluded that the high returns of

option strategies cannot be explained as compensation for their risk. However, they

found that transaction costs and margin requirements greatly reduce the

profitability of option strategies. Consistent with the arguments of Shleifer and

Vishny (1997) and Liu and Longstaff (2004) about the limits to arbitrage, their

findings explain why the good deals in options prices have not been arbitraged

away. Finally, they found evidence that margin requirements may have been set too

high by the options exchanges relative to the actual risk of the option positions. This

suggests that there is scope for the exchanges to improve the efficiency of option

markets by changing the way margin requirements are calculated.

Bakshi and Kapadia (2003) and Coval and Shumway (2001) show that selling puts

and selling straddles on the S&P 500 offer unusually high returns for their level of

risk. For instance, Coval and Shumway show that shorting an at-the-money, near-

maturity straddle with zero beta offered a return of 3.15 percent per week in their

sample. Even though the volatility of the strategy was as high as 19 percent per

week, the strategy still provided an annualized Sharpe ratio of 1.19, which is more

than double the historic Sharpe ratio on the stock market. It is especially puzzling

that Sharpe ratios are so high even for delta-neutral (and even crash-neutral)

strategies that by construction are not directionally exposed to the stock market.

These strategies are mostly exposed to volatility risk which is a risk that does not

20

exist in meaningful net supply in the economy and would therefore not seem to

warrant a large premium.

To summarize it has been found out from the previous studies conducted in

developed markets like U.S.A. (on S&P 500) that by investing in certain option

strategies an individual investor can generate a decent return from it. Although

there is not much of literature available in this field, especially in Indian context, as

option (derivative) market is in its early stage. This study will be an attempt to

bridge this gap and will try to put some light on it.

21

Chapter 3

Methodology

To test, I used the Bloomberg Database on NSE S&P CNX Nifty 50 Option price

quotes. I examined the returns of European-style call and put options on S&P CNX

Nifty 50 index over a ten-year period, from January 2002 to March 2012. I focused

on the monthly returns of S&P CNX Nifty 50 options as our base case. The Index

closing price is taken as proxy for the index value at that particular day. The Index

price is then rounded off to multiple of 100 as to get the strike price for the index

options as strike prices of index options are multiple of 100. Then on the basis of

the strategy strike price were chosen to establish a position.

The method used for calculating option returns is as follows. For each option

required I identified the closing price. I took options which are to expire during the

following calendar month, and therefore are roughly between 25 and 50 days to

expiration. For every strategy I assumed that I am establishing the positions 45, 37

and 30 days before the expiration of the options. The positions are hold till the

expiration of the option contracts. Our monthly results only use prices observed on

Thursdays as the option in NSE (National Stock Exchange) expires on last Thursday

of that month and if the last Thursday is a holiday then it expires on last Wednesday.

The new position in strategy is also established on Thursday itself.

This research’s intent is to find investment opportunities that can outperform the

S&P CNX Nifty 50 based on risk and rates of return. Therefore, a control group

portfolio was created by investing the monthly investment amount straight into the

S&P CNX Nifty Index every month to establish a baseline performance for all

portfolios. The rates of return are determined by the value in the account at the end

of the period compared to the total amount invested during the entire period.

Each strategy is evaluated over three levels of maturity for the analysis. The three

theoretical maturities are 45 days, 37 days, and 30 days. Each of the theoretical

maturity is held as closely as possible to the number of days it specifies that is

option is held till expiry.

Finally, the margin requirements for selling the Index or writing options were

determined using the National Stock Exchange (NSE) minimum requirements

formula.

Margin = Leverage * (Premium Proceeds + .2* Aggregate Contract Value – Amount

OTM)

22

Many brokerages require higher margin requirements, but the market minimum

was used to create consistency in the research.

For each of the positions, the rates of return, the standard deviation of returns and

the Sharpe ratio was calculated. The rates of return were determined using the cost

of the position’s establishment as the base compared to the total profit or loss. The

standard deviation was determined using all executions; no outliers or exclusion of

any data points was made. Both the rates of return and the standard deviations

were then annualized.

Sharpe Ratio:

The Sharpe ratio or Sharpe index or Sharpe measure or reward-to-variability

ratio is a measure of the excess return (or risk premium) per unit of deviation in an

investment asset or a trading strategy, typically referred to as risk (and is

a deviation risk measure).

Where R is the asset return, Rf is the return on a benchmark asset, such as the risk free rate of return, E[R-Rf] is the expected value of the excess of the asset return over the benchmark return, and is the standard deviation of the excess of the asset return.

The Sharpe ratio is used to characterize how well the return of an asset

compensates the investor for the risk taken, the higher the Sharpe ratio numbers

the better. When comparing two assets each with the expected return E[R} against

the same benchmark with return Rf, the asset with the higher Sharpe ratio gives

more return for the same risk. Investors are often advised to pick investments with

high Sharpe ratios.

Each strategy was then ranked by the standard deviation and the Sharpe ratio. The

standard deviation of the S&P CNX Nifty 50 was used as a baseline for determining

each investor category. A medium risk averse investor’s strategies ranged from the

S&P CNX Nifty 50’s standard deviation to half its value. The highly risk averse

investor’s strategies were all strategies with half the standard deviation of the S&P

CNX Nifty 50’s standard deviation or less. The low risk averse investor’s strategies

were all the strategies with standard deviations greater than the S&P CNX Nifty 50’s.

Each strategy was then categorized into this groups based on the condition

mentioned above.

23

Chapter 4

Results

The first phase of the experiment established the strategies position as described in

the Chapter 3. The option strategies were tested for different level of money-ness

and for different time to maturity. Some of the strategies were evaluated for the

period span from January 2002 to March 2012 and some were evaluated for a short

period span from October 2007 to March 2012 due to unavailability of the data. The

Table 4.1 shows the strategy and time frame in which it was evaluated.

Table 4.1

Strategy Span of Analysis Long Call (ATM) January 2002-March 2012 Long Call (ITM) January 2002-March 2012 Long Call (OTM) January 2002-March 2012 Long Put (ATM) January 2002-March 2012 Long Put (ITM) January 2002-March 2012 Long Put (OTM) January 2002-March 2012 Short Straddle January 2002-March 2012

Short Strangle (ITM) October 2007-March 2012 Long Butterfly (Call) January 2002-March 2012 Long Butterfly (Put) January 2002-March 2012

Long Call Spread (ITM) January 2002-March 2012 Long Call Spread (ATM) January 2002-March 2012 Long Call Spread (OTM) January 2002-March 2012 Short Put Spread (ATM) January 2002-March 2012 Short Put Spread (ITM) January 2002-March 2012 Short Put Spread (OTM) January 2002-March 2012

Long Condor (Call) October 2007-March 2012 Long Condor (Put) October 2007-March 2012

Long Calendar Spread (Call) January 2002-March 2012 Long Calendar Spread (Put) January 2002-March 2012

Table 4.2 displays the annualized rate of return and annualized standard deviation

of S&P CNX Nifty 50 as this was set as the benchmark. The strategies having return

greater than that of S&P CNX Nifty 50 represents that strategy has outperformed the

index in the period considered whereas strategies having return less than that of

index represents index has outperformed that particular strategy in the period

considered in this research. The strategies having standard deviation higher than

that of index represents risk involved in it is greater than that of risk involved in

investing in market whereas strategies with standard deviation less than that of

24

index represents risk involved in that strategies are less than the risk persisting in

the market.

Table 4.2

Index Rate of Return (%) Standard Deviation (%) S&P CNX Nifty 50 28.57 25.9161

Table 4.3 displays the probability of having positive returns and number of times

the strategy generated positive returns for investor in the span of analysis.

Table 4.3

Strategy % Profitable Times Profitable Long Call (ATM) 44.08 41 Long Call (ITM) 51.08 47 Long Call (OTM) 30.26 23 Long Put (ATM) 32.63 31 Long Put (ITM) 33.75 27 Long Put (OTM) 26.31 20 Short Straddle 50.55 46

Short Strangle (ITM) 67.92 36 Long Butterfly (Call) 28.33 17 Long Butterfly (Put) 29.31 17

Long Call Spread (ITM) 63.86 53 Long Call Spread (ATM) 58.90 43 Long Call Spread (OTM) 44.07 26 Short Put Spread (ATM) 58.57 41 Short Put Spread (ITM) 47.619 30 Short Put Spread (OTM) 64 54

Long Condor (Call) 25.49 13 Long Condor (Put) 21 11

Long Calendar Spread (Call) 58.75 47 Long Calendar Spread (Put) 70.37 57

(ATM: at the money, ITM: in the money, OTM: out the money)

Table 4.4 displays the annualized rate of return, annualized standard deviation and

sharpe ratio for the strategies tested. The high risk averse strategies have standard

deviation half of the S&P CNX Nifty 50 whereas medium risk averse investors have

standard deviation same as that of S&P CNX Nifty and the low risk averse investors

have standard deviation less than that of S&P CNX Nifty Index. The medium risk

averse strategies all have standard deviations less than or equal to the S&P CNX

NIFTY 50. The theory behind the choice of the limits of the standard deviation is the

25

medium risk averse investor is willing to accept the average market risk

represented by the standard deviation of the S&P CNX NIFTY 50. Therefore, a

medium risk averse investor would seek lower standard deviations of at least the

S&P CNX NIFTY 50 but not as low as the highly risk averse investor seeking

protection of wealth rather than possible creation of it.

Table 4.4

Strategy Rate of Return Standard Deviation Sharpe Ratio Long Call (ATM) 1783.37% 544.03% 3.267 Long Call (ITM) 1059.7% 408.51% 2.58 Long Call (OTM) 1093.7% 780.81% 1.393 Long Put (ATM) -09.22% 583.98% -0.026 Long Put (ITM) -87.62% 507.2% -0.18 Long Put (OTM) -82.39% 601.35% -0.147 Short Straddle -11.62% 56.33% -0.313 Short Strangle

(ITM) 13.52% 46.75% 0.16

Long Butterfly (Call)

-0.69% 4% -1.55

Long Butterfly (Put)

1.875% 5.825% -0.72

Long Call Spread (ITM)

25.02% 17.68% 1.075

Long Call Spread (ATM)

90% 74.90% 1.12

Long Call Spread (OTM)

59.15% 79.22% 0.671

Short Put Spread (ATM)

23% 18.5% 0.94

Short Put Spread (ITM)

16.484% 21% 0.4986

Short Put Spread (OTM)

21.8% 27.51% 0.57

Long Condor (Call) -3.89% 8.256% -1.1974 Long Condor (Put) -2.75% 7.27% -1.203

Long Calendar Spread (Call)

-77.36% 58.13% -1.55

Long Calendar Spread (Put)

41.217% 42.445% 0.83

(ATM: at the money, ITM: in the money, OTM: out the money)

The empirical finding suggests that Long call strategy at all level of money-ness and

at different maturity generates a high return for the investors. But having a very

26

high level of risk involved in this strategy, it is restricted to low risk averse

investors. The high risk averse investors will not find the strategy in accordance

with their risk appetite. Long put irrespective of level of money ness is not the

strategy to invest in. It has in some periods shown very high returns but that were

the periods of financial crisis. In general this strategy consistently generated

negative returns for the investors. As option is a zero-sum game short put strategy

can be beneficial for the individual investor but again this strategy is restricted to

low risk averse investors. In general naked (Long Call or Short Call) call and naked

put (Long Put or Short Put) is restricted to low risk averse investors since they show

high fluctuations in their returns. However, the call options no matter the money-

ness and maturity has a high probability of having a positive payoff as compared to

long put which has a very low probability of showing a positive payoff and this

strategy is for a few period is profitable and that to most of that during the famous

financial crisis of 2008. The ATM, ITM and OTM Long call rates of return edge out

the S&P CNX Nifty 50 in 10-year run. The highly risk averse investor is going to seek

the best possible rates of return for his risk tolerance and these three strategies

provide very equitable solutions.

The low risk averse investor is willing to accept greater risks for potentially greater

returns. The low risk averse strategies are those with the higher standard

deviations. The low risk averse investments for this experiment were the strategies

with standard deviations higher than the S&P CNX Nifty 50’s. Although some low

risk averse strategies may have had negative Sharpe ratios, the Table 4.4 display

some investments with incredible rates of returns; thus the significant difference

between the strategies recommended for the low risk averse investor and those

strategies with very high rates of return.

Buying the butterfly and condor position, no matter the money-ness and maturity is

not a viable position to invest for individual investor with a view of generating

returns. These strategies have a negative payoff and are most of the times

unprofitable. They have a very low probability of generating positive returns that is

around 25-26% in average.

Despite the large market decline in the latter part of the experiment and due to the

length of the periods the experiment was conducted over, a significant number of

the strategies proved to be profitable above the S&P CNX Nifty 50. In fact, almost a

full third of the strategies investigated provided returns higher than that of the S&P

CNX Nifty 50. Table 4.5 displays the percent times each strategy was profitable, the

number times over the period it was profitable, the rates of return, and how much

that rates of return beat the corresponding period’s S&P CNX Nifty 50 return.

27

Table 4.5

Strategy % Profitable Times Profitable Rate of Return Difference (Strategy-

Index Return)

Long Call (ATM) 44.08 41 1783.37% 1754.8% Long Call (ITM) 51.08 47 1059.7% 1031.13% Long Call (OTM) 30.26 23 1093.7% 1065.13% Long Put (ATM) 32.63 31 -09.22% -37.79% Long Put (ITM) 33.75 27 -87.62% -116.19% Long Put (OTM) 26.31 20 -82.39% -110.96% Short Straddle 50.55 46 -11.62% -40.19%

Short Strangle (ITM) 67.92 36 13.52% -15.05% Long Butterfly (Call) 28.33 17 -0.69% -29.26% Long Butterfly (Put) 29.31 17 1.875% -26.695%

Long Call Spread (ITM) 63.86 53 25.02% -3.55% Long Call Spread (ATM) 58.90 43 90% 61.43% Long Call Spread (OTM) 44.07 26 59.15% 30.58% Short Put Spread (ATM) 58.57 41 23% -5.57% Short Put Spread (ITM) 47.619 30 16.484% -12.086% Short Put Spread (OTM) 64 54 21.8% -6.77%

Long Condor (Call) 25.49 13 -3.89% -32.46% Long Condor (Put) 21 11 -2.75% -31.32%

Long Calendar Spread (Call)

58.75 47 -77.36% -105.93%

Long Calendar Spread (Put)

70.37 57 41.217% 12.647%

(ATM: at the money, ITM: in the money, OTM: out the money)

Each of the strategy is being categorized into three groups in accordance to

individual investor risk appetite based on the annualized standard deviation of the

respective strategy as shown in Table 4.6.

Table 4.6

High Risk Averse Investor Medium Risk Averse Investor Low Risk Averse Investor Long Butterfly (Put) Short Put Spread (OTM) Calendar Put Spread Long Butterfly (Call) Call Spread (ITM) Calendar Call Spread Long Condor (Call) Short Put Spread (ITM) Call Spread (OTM) Long Condor (Put) Put Spread (ATM) Short Straddle Call Spread (ITM) Short Straddle Short Strangle (ITM) Short Put Spread (ITM) Call Spread (ATM) Long Call and Put all level

of money-ness

28

The results suggests that by investing in strategies which have market expectations

of market bullish/volatility bullish in nature in general generates high return for

investors in Indian market rather than strategies which have market expectation of

market neutral or volatility neutral or even market bearish in the long run. This

suggests that the Indian market is been volatile in the period considered and the

result matches with the theory which says if the market is volatile strategies like

long call, long call spread generates profit for the investors. As theory suggest that

strategies like short straddle, short call should show negative returns if the market

is volatile which is consistent with the result obtained. The findings also suggest that

option strategies can be used as risk hedging tool to reduce the exposure in the

market depending on the choice of the investors. Investors can significantly reduce

their risk through investing in option strategies.

The finding suggests that there is a scope for individual investor irrespective of their

risk appetite to invest in option strategies in Indian market. An individual investor

which is high risk averse can gain a decent return if not high returns by investing in

option strategies which have low standard deviation (low fluctuations in their

returns). A key finding of the study is the return that a high risk individual investor

can generate by investing in option strategies. As option market (derivative market)

is still in its early stage and is growing quickly there is lot of scope for the individual

investor to grab this opportunity.

29

Figures below show the returns of some of the strategies tested, at different level of

money-ness.

Figure 4.1 – shows the return of Long Call Options

Figure 4.2 – shows the return of Long Put Options

30

Figure 4.3 – shows the return of Long Call Spread

Figure 4.4 – shows the return of Short Put Spread

31

Chapter 5

Conclusion

The overall theory that investing in options is a risky choice has been demonstrated

to be false. Some of the strategies evaluated do demonstrate ways for an investor to

significantly reduce risk while not sacrificing the returns he may be seeking in the

long run. Options have an allure for the low risk averse investor and the speculator;

potentially huge profits for very little investment. The effects of speculating and

taking risks in the long run can easily be disastrous if the investment strategy is not

fully investigated. An investor is not “speculating” in the market if he truly

understands his risks/reward potential, knows his percentile chances of

profitability, and has a disciplined investment approach. A disciplined investor can

take significant risks to lead towards the significant payoff that should accompany

those risks.

The strategies discussed in Chapter 2 show that for each investor’s risk tolerance

there is an appropriate strategy. Surprisingly, the medium risk averse investor’s

best strategy is the buy and hold strategy within the index. Buy the index and hold

it. This simple strategy has proven to be tough to outperform throughout the whole

experiment. For the low risk averse investor, potentially huge gains are possible but

the losses that accompany those risks can be very intimidating.

For many of the strategies the additional risks in investing in the options are not out

weighted by the potential profits. The low risk averse strategies that are profitable

have dramatic downside potential. The most significant strategy investigated based

on astounding returns and ability for the individual investor to establish the

position has to be the long call spread (At the Money) and long call. The strategy

with a bullish expectation is a good strategy in case of Indian market.

Hopefully, the results will provide new insight into investment options that can actually be

utilized in today’s market.

32

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Hamernik R.C., 2005, Equity Option Strategy

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