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Management Paradise Guru
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Join Date: Jul 2010

We have considered above the profit/loss resulting to the investors with long and short positions in the call and put options. It is important to note that an investor need not take positions in naked options only or in a single option alone. In fact, a number of trading strategies involving options may be employed by the investors.

Options may be used on their own, in conjunction with the futures contracts, or in a strategy using the underlying instrument (equity stock, for example). One of the attractions of options is that they could be used for creating a very wide range of payoff functions. We now discuss some of the commonly used strategies.

To begin with, we may consider investment in a single stock option. The payoffs associated with a long or short call, and a long or short put option has already been discussed. A long call is used when one expects that the market would rise. The more bullish market sentiment or perception, the more out-of-the money option should one buy.

For the option buyer in this strategy, the loss is limited to the premium payable while the profit is potentially unlimited. On the other hand, the writer of a call has a mirror image position along the break-even line. The writer writes a call with the belief or expectation that the market would not show an upward trend.

In case of the put option, a long put would gain value as the underlying asset, the equity share price or the market index, declines. Accordingly, a put is bought when a decline is expected in the market. The loss for a put buyer is limited to the amount paid for the option if the market ends above the option exercise price.

The writer of a put option would get the maximum profit equal to the premium amount but would be exposed to loss should the market collapse. The maximum loss to the writer of a put option on an equity hare could be equal to the exercise price (since the stock price cannot be negative).

Thus, while selling of options may be used as a legitimate means of generating premium income and bought in the expectation of making profit from the likely bullish / bearish market sentiments, they may or may not be used alone. They may, however, be combined in several Ways without taking positions in the underlying assets or they might be used in conjunction with the underlying assets for purposes of hedging

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