When a trader is completely bullish on the instrument, but wants to cap his downside risk. This Strategy gives unlimited profit on the upside and a limited loss on the downside.
The trader buys a Call option of the strike price, assuming that the instrument shall expire at or above the strike price at the time of its expiry.
Max Potential Profit: Unlimited
When: The stock price goes till infinity
Max Potential Loss: Net premium paid.
When: If stock expires at or below the strike price.
Breakeven at expiration: The strike price + Cost of the CE
Impact with passage of time
The CE(European Call Option) price reduces with the passage of time, assuming the instrument price remains constant. Hence time decay works against this strategy.
For example the trader is extremely bullish on Voltas and expects that Voltas would make a bull run in the coming month.
In order to capture the move, he has two options. He can take a long position in Voltas futures or he can buy a call option.Since taking positions in futures require significantly higher margin than buying options and also has a risk of unlimited losses, the trader decides to buy a CE. In this case his risk is limited as he will only pay the premium for the call option, and he will have unlimited profits if the position goes in his favor.
Voltas is currently trading at 420. The trader decides to buy 1 lot CE of strike price 430 of near month expiry, paying a premium of Rs. 3.6
Hence the breakeven price for this strategy shall be Rs. 433.6. Note that the CE shall itself be profitable after the price crosses 430 at the time of expiry, but as the trader has already paid Rs. 3.6 for the option, it needs to recover that cost in order for the strategy to turn up a profit.
Now let us consider different scenarios at the time of expiry.
Stock closes at Rs.440.
Profit= (Value of the CE-Net premium paid)*Lot Size
Value of the CE shall be current stock price-Strike Price
Hence Profit= (10-3.6)*2000
Stock Closes at Rs. 430
Stock closes at Rs. 420
Stock closes at Rs. 470
Thus, unlimited profit at a risk of Rs. 7200 !!
|Value of Spot at expiry||Lot Size||Strike Price||Net premium paid||Value of Option||P/L||Net P/L*LOT SIZE|