Trading strategies
Beta hedging with index futures, covered calls, protective puts, bull and bear spreads, straddles, strangles…
A strategy is just two or more of the positions from chapters 3 and 4 held together. The exam gives you the legs and asks for maximum profit, maximum loss or break-even, or it gives you a view (mildly bullish, expecting a big move either way) and asks which strategy fits. This chapter works each common structure with numbers so the shapes become familiar.
Hedging a portfolio with index futures
A diversified equity portfolio moves with the market in proportion to its beta. To neutralise market risk for a period, sell enough index futures that a market fall is offset by futures gains.
| Portfolio value | ₹1,80,00,000 |
| Portfolio beta | 1.2 |
| Nifty futures 24,000 × lot 75 = contract value | ₹18,00,000 |
| Contracts to sell = 1.2 × 1,80,00,000 ÷ 18,00,000 | 12 |
| Nifty falls 5% to 22,800: portfolio falls 1.2 × 5% = 6% | −₹10,80,000 |
| Futures gain = 12 × 75 × (24,000 − 22,800) | +₹10,80,000 |
| Net change | ₹0 |
If the number comes out fractional, round to the nearest whole contract; the exam accepts that the hedge is then slightly over or under. To reduce beta only partly, say from 1.2 to 0.6, sell (1.2 − 0.6) × portfolio ÷ contract value, which is 6 contracts here. To increase exposure, buy futures. The hedge removes market risk, not stock-specific risk, and it also removes the upside for as long as it is on.
Covered call and protective put
A covered call is a long stock position plus a short call on the same stock. The premium adds income; in return the holder gives up gains above the strike. It suits a holder who expects the stock to go nowhere or rise modestly. A protective put is a long stock plus a long put. It is insurance: the holder pays a premium and in return has a floor under the position at the strike. It suits a holder who wants to stay invested through an event but cap the downside.
| Hold 1 lot of a stock bought at ₹1,000. Covered call: sell 1,050 call at ₹20. Protective put: buy 950 put at ₹15 | Profit per share |
| Stock at 900: covered call 900 − 1,000 + 20; protective put 950 − 1,000 − 15 | −80 and −65 |
| Stock at 1,000: covered call +20; protective put −15 | +20 and −15 |
| Stock at 1,050: covered call 50 + 20; protective put 50 − 15 | +70 and +35 |
| Stock at 1,200: covered call capped at 50 + 20; protective put 200 − 15 | +70 and +185 |
Covered call: maximum profit = (K − purchase price) + premium = ₹70; break-even = purchase price − premium = ₹980. Protective put: maximum loss = (purchase price − K) + premium = ₹65; break-even = purchase price + premium = ₹1,015; upside unlimited.
Vertical spreads: bull and bear
A spread buys one option and sells another of the same type and expiry but a different strike. Selling the second leg cuts the cost and caps the profit. A bull call spread buys a lower-strike call and sells a higher-strike call; a bull put spread does the same with puts for a net credit. A bear put spread buys a higher-strike put and sells a lower-strike put; a bear call spread is the credit version. For a debit spread, maximum loss is the net premium paid and maximum profit is the strike difference less that premium.
| Buy 24,000 call at ₹200, sell 24,300 call at ₹90; net debit per unit | ₹110 |
| Expiry at 23,800: both expire worthless | −110 (max loss) |
| Expiry at 24,110: 24,000 call worth 110, net 110 − 110 | 0 (break-even) |
| Expiry at 24,300: 300 − 0 − 110 | +190 (max profit) |
| Expiry at 24,600: 600 − 300 − 110; per lot = 190 × 75 | +190, ₹14,250 |
A bear put spread works the same way in reverse: buy a 24,000 put at ₹180 and sell a 23,700 put at ₹80 for a net debit of ₹100; maximum profit is 300 − 100 = ₹200 at or below 23,700 and break-even is 24,000 − 100 = 23,900.
Straddle, strangle and calendar spread
A long straddle buys a call and a put at the same strike and expiry. It profits from a large move in either direction and loses the combined premium if the underlying stays put. A long strangle buys an OTM call and an OTM put with different strikes; cheaper, but it needs a bigger move. Short straddles and strangles are the mirror image: they collect premium betting on a quiet market and carry unlimited risk. A calendar spread sells a near-month option and buys a far-month option at the same strike; it earns the faster time decay of the near month and gains if the underlying stays near the strike until the near expiry.
| Straddle: buy 24,000 call at ₹200 and 24,000 put at ₹180; cost | ₹380 |
| Straddle break-evens = 24,000 ± 380 | 23,620 and 24,380 |
| Straddle at expiry 24,000: both worthless | −380 (max loss) |
| Straddle at expiry 24,800: call 800 − 380 | +420 |
| Strangle: buy 24,300 call at ₹90 and 23,700 put at ₹80; cost | ₹170 |
| Strangle break-evens = 24,300 + 170 and 23,700 − 170 | 24,470 and 23,530 |
One last pattern: the exam likes to ask which strategy has limited profit and limited loss (spreads), limited loss and unlimited profit (long options, straddles, protective put), or limited profit and unlimited loss (short options, covered call on the downside is limited by the stock going to zero, naked short straddle). Sort every strategy into one of these buckets as you revise.
Remember
- Beta hedge: contracts to sell = beta × portfolio value ÷ (index futures price × lot). Round to whole contracts.
- Covered call = long stock + short call: extra income, upside capped at strike plus premium.
- Protective put = long stock + long put: a floor at the strike, cost is the premium, upside kept.
- Bull call spread: buy lower strike, sell higher; max loss = net debit, max profit = strike gap − debit, BEP = lower strike + debit.
- Straddle buys call and put at one strike; strangle uses two OTM strikes. Break-evens are strike ± total premium paid.
- Calendar spread sells the near month and buys the far month at the same strike to harvest faster near-term time decay.