Derivatives

The term ‘Derivative’ stands for a contract whose price is derived from or is dependent upon
an underlying asset. The underlying asset could be a financial asset such as currency, stock
and market index, an interest bearing security or a physical commodity.

Types of Derivative Contracts

Derivatives comprise four basic contracts namely Forwards, Futures, Options and Swaps.
Over the past couple of decades several exotic contracts have also emerged but these are
largely the variants of these basic contracts.
1. Forward Contracts: These are promises to deliver an asset at a pre- determined date in
future at a predetermined price. Forwards are highly popular on currencies and interest
rates. The contracts are traded over the counter (i.e. outside the stock exchanges, directly
between the two parties) and are customized according to the needs of the parties. Since
these contracts do not fall under the purview of rules and regulations of an exchange, they
generally suffer from counterparty risk i.e. the risk that one of the parties to the contract
may not fulfill his or her obligation.

2 Futures Contracts: A futures contract is an agreement between two parties to buy or

sell an asset at a certain time in future at a certain price. These are basically exchange
traded, standardized contracts. The exchange stands guarantee to all transactions and
counterparty risk is largely eliminated.
Futures contracts are available on variety of commodities, currencies, interest rates, stocks
and other tradable assets. They are highly popular on stock indices, interest rates and
foreign exchange.

3 Options Contracts: Options give the buyer (holder) a right but not an obligation to buy
or sell an asset in future. Options are of two types - calls and puts. Calls give the buyer the
right but not the obligation to buy a given quantity of the underlying asset, at a given price
on or before a given future date. Puts give the buyer the right, but not the obligation to sell
a given quantity of the underlying asset at a given price on or before a given date. One can
buy and sell each of the contracts.

4 Swaps: Swaps are private agreements between two parties to exchange cash flows in the
future according to a prearranged formula. They can be regarded as portfolios of forward
contracts. The two commonly used swaps are:
• Interest rate swaps: These entail swapping only the interest related cash flows between
the parties in the same currency.
• Currency swaps: These entail swapping both principal and interest between the parties,
with the cash flows in one direction being in a different currency than those in the opposite
direction.
Types of Derivatives:

Participants in a Derivative Market

The derivatives market is similar to any other financial market and has following three
broad categories of participants:
• Hedgers: These are investors with a present or anticipated exposure to the underlying
asset which is subject to price risks. Hedgers use the derivatives markets primarily for price
risk management of assets and portfolios.
• Speculators: These are individuals who take a view on the future direction of the
markets. They take a view whether prices would rise or fall in future and accordingly buy or
sell futures and options to try and make a profit from the future price movements of the
underlying asset.
• Arbitrageurs: They take positions in financial markets to earn riskless profits. The
arbitrageurs take short and long positions in the same or different contracts at the same
time to create a position which can generate a riskless profit

Futures Terminology

• Spot price: The price at which an underlying asset trades in the spot market.
• Futures price: The price that is agreed upon at the time of the contract for the delivery
of an asset at a specific future date.
• Contract cycle: It is the period over which a contract trades. The index futures contracts
on the NSE have one-month, two-month and three-month expiry cycles which expire on the
last Thursday of the month. Thus a January expiration contract expires on the last Thursday
of January and a February expiration contract ceases trading on the last Thursday of
February. On the Friday following the last Thursday, a new contract having a three-month
expiry is introduced for trading.
• Expiry date: is the date on which the final settlement of the contract takes place.
• Contract size: The amount of asset that has to be delivered under one contract. This
is also called as the lot size.
• Basis: Basis is defined as the futures price minus the spot price. There will be a different
basis for each delivery month for each contract. In a normal market, basis will be positive.
This reflects that futures prices normally exceed spot prices.
• Cost of carry: Measures the storage cost plus the interest that is paid to finance the
asset less the income earned on the asset.
• Initial margin: The amount that must be deposited in the margin account at the time a
futures contract is first entered into is known as initial margin.
• Marking-to-market: In the futures market, at the end of each trading day, the margin
account is adjusted to reflect the investor’s gain or loss depending upon the futures closing
price. This is called marking-to-market.
• Maintenance margin: Investors are required to place margins with their trading
members before they are allowed to trade. If the balance in the margin account falls below
the maintenance margin, the investor receives a margin call and is expected to top up the
margin account to the initial margin level before trading commences on the next day.

Pricing Futures:
Pricing of futures contract is very simple. Using the cost-of-carry logic, we calculate the fair
value of a futures contract. Every time the observed price deviates from the fair value,
arbitragers would enter into trades to capture the arbitrage profit. This in turn would push
the futures price back to its fair value. The cost of carry model used for pricing futures is
given below:

where:
r Cost of financing (using continuously compounded interest rate)
T Time till expiration in years
e 2.71828

Example: Security XYZ Ltd trades in the spot market at Rs. 1150. Money can be invested at
11% p.a. The fair value of a one-month futures contract on XYZ is calculated as follows:
Variation in spot and future price over time

Application of Futures Contracts

 Risk Management: Long security, sell futures
 Speculation (Bullish): Buy futures
 Speculation (Bearish): Sell futures
 Arbitrage (Overpriced futures): Buy spot, sell futures
 Arbitrage (Underpriced futures): Sell spot, buy futures
 Hedging using stock index futures

OPTIONS
An option is a contract written by a seller that conveys to the buyer the right — but not the
obligation — to buy (in the case of a call option) or to sell (in the case of a put option) a
particular asset, at a particular price (Strike price / Exercise price) in future. In return for
granting the option, the seller collects a payment (the premium) from the buyer. Exchange
traded options form an important class of options which have standardized contract features
and trade on public exchanges, facilitating trading among large number of investors. They
provide settlement guarantee by the Clearing Corporation thereby reducing counterparty
risk. Options can be used for hedging, taking a view on the future direction of the market,
for arbitrage or for implementing strategies which can help in generating income for
investors under various market conditions.
OPTION TERMINOLOGY

Index options: These options have the index as the underlying. In India, they have a
European style settlement. Eg. Nifty options, Mini Nifty options etc.
Stock options: Stock options are options on individual stocks. A stock option contract
gives the holder the right to buy or sell the underlying shares at the specified price. They
have an American style settlement.
Buyer of an option: The buyer of an option is the one who by paying the option premium
buys the right but not the obligation to exercise his option on the seller/writer.
Writer / seller of an option: The writer / seller of a call/put option is the one who
receives the option premium and is thereby obliged to sell/buy the asset if the buyer
exercises on him.
Call option: A call option gives the holder the right but not the obligation to buy an asset
by a certain date for a certain price.
Put option: A put option gives the holder the right but not the obligation to sell an asset
by a certain date for a certain price.
Option price/premium: Option price is the price which the option buyer pays to the
option seller. It is also referred to as the option premium.
Expiration date: The date specified in the options contract is known as the expiration
date, the exercise date, the strike date or the maturity.
Strike price: The price specified in the options contract is known as the strike price or the
exercise price.
American options: American options are options that can be exercised at any time upto
the expiration date.
European options: European options are options that can be exercised only on the
expiration date itself.
In-the-money option: An in-the-money (ITM) option is an option that would lead to a
positive cashflow to the holder if it were exercised immediately. A call option on the index is
said to be in-the-money when the current index stands at a level higher than the strike
price (i.e. spot price > strike price). If the index is much higher than the strike price, the
call is said to be deep ITM. In the case of a put, the put is ITM if the index is below the
strike price.
At-the-money option: An at-the-money (ATM) option is an option that would lead to
zero cashflow if it were exercised immediately. An option on the index is at-the-money
when the current index equals the strike price (i.e. spot price = strike price).
Out-of-the-money option: An out-of-the-money (OTM) option is an option that would
lead to a negative cashflow if it were exercised immediately. A call option on the index is
out-of-the-money when the current index stands at a level which is less than the strike
price (i.e. spot price < strike price). If the index is much lower than the strike price, the call
is said to be deep OTM. In the case of a put, the put is OTM if the index is above the strike
price.
Intrinsic value of an option: The option premium can be broken down into two
components - intrinsic value and time value. The intrinsic value of a call is the amount the
option is ITM, if it is ITM. If the call is OTM, its intrinsic value is zero. Putting it another way,
the intrinsic value of a call is Max[0, (St — K)] which means the intrinsic value of a call is
the greater of 0 or (St — K). Similarly, the intrinsic value of a put is Max[0, K — St],i.e. the
greater of 0 or (K — St). K is the strike price and St is the spot price.
Time value of an option: The time value of an option is the difference between its
premium and its intrinsic value. Both calls and puts have time value. An option that is OTM
or ATM has only time value. Usually, the maximum time value exists when the option is
ATM. The longer the time to expiration, the greater is an option's time value, all else equal.
At expiration, an option should have no time value.
OPTIONS PAYOFFS
The optionality characteristic of options results in a non-linear payoff for options. In simple
words, it means that the losses for the buyer of an option are limited; however the profits
are potentially unlimited. For a writer (seller), the payoff is exactly the opposite. His profits
are limited to the option premium; however his losses are potentially unlimited.

STRATEGIES:
STRATEGY 1: LONG CALL
Buying a call is the most basic of all options strategies. It constitutes the first options trade
for someone already familiar with buying / selling stocks and would now want to trade
options. Buying a call is an easy strategy to understand. When you buy it means you are
bullish. Buying a Call means you are very bullishand expect the underlying stock / index to
rise in future.

When to Use: Investor is very bullish on the stock / index.

Risk: Limited to the Premium. (Maximum loss if market expires at or below the option
strike price).
Reward: Unlimited

Breakeven: Strike Price + Premium

STRATEGY 2: SHORT CALL

The seller of the option feels the underlying price of a stock / index is set to fall in the
future.

When to use: Investor is very aggressive and he is very bearish about the stock /index.

Risk: Unlimited

Reward: Limited to the amount of premium

Break-even Point: Strike Price + Premium

STRATEGY 3: SYNTHETIC LONG CALL: BUY
STOCK, BUY PUT
In this strategy, we purchase a stock since we feel bullish about it. But what if the price of
the stock went down. You wish you had some insurance against the price fall. So buy a Put
on the stock. This gives you the right to sell the stock at a certain price which is the strike
price. The strike price can be the price at which you bought the stock (ATM strike price) or
slightly below (OTM strike price).

When to use: When ownership is desired of stock yet investor is concerned about near-
term downside risk. The outlook is conservatively bullish.

Risk: Losses limited to Stock price + Put Premium – Put Strike price

Reward: Profit potential is unlimited.

Break-even Point: Put Strike Price + Put Premium + Stock Price – Put Strike Price

STRATEGY 4 : LONG PUT

A long Put is a Bearish strategy. To take advantage of a falling market an investor can buy
Put options.
When to use: Investor is bearish about the stock / index.

Risk: Limited to the amount of Premium paid. (Maximum loss if stock / index expires at or
above the option strike price).

Reward: Unlimited

Break-even Point: Stock Price – Premium

STRATEGY 5 : SHORT PUT

Selling a Put is opposite of buying a Put. An investor buys Put when he is bearish on a
stock. An investor Sells Put when he is Bullish about the stock – expects the stock price to
rise or stay sideways at the minimum.
When to Use: Investor is very Bullish on the stock / index. The main idea is to make a
short term income.
Risk: Put Strike Price – Put Premium.
Reward: Limited to the amount of Premium received.
Breakeven: Put Strike Price – Premium
STRATEGY 6 : COVERED CALL
You own shares in a company which you feel may rise but not much in the near term (or at
best stay sideways). You would still like to earn an income from the shares. The covered call
is a strategy in which an investor Sells a Call option on a stock he owns (netting him a
premium). The Call Option which is sold in usually an OTM Call. The Call would not get
exercised unless the stock price increases above the strike price. Till then the investor in the
stock (Call seller) can retain the Premium with him. This becomes his income from the
stock. This strategy is usually adopted by a stock owner who is Neutral to moderately
Bullish about the stock.

When to Use: This is often employed when an investor has a short-term neutral to
moderately bullish view on the stock he holds. He takes a short position on the Call option
to generate income from the option premium. Since the stock is purchased simultaneously
with writing (selling) the Call, the strategy is commonly referred to as “buy-write”.

Risk: If the Stock Price falls to zero, the investor loses the entire value of the Stock but
retains the premium, since the Call will not be exercised against him.
So maximum risk = Stock Price Paid – Call Premium
Upside capped at the Strike price plus the Premium received. So if the Stock rises beyond
the Strike price the investor (Call seller) gives up all the gains on the stock.

Reward: Limited to (Call Strike Price – Stock Price paid) + Premium received

Breakeven: Stock Price paid - Premium Received

STRATEGY 7 : LONG COMBO : SELL A PUT,

BUY A CALL
A Long Combo is a Bullish strategy. If an investor is expecting the price of a stock to move
up he can do a Long Combo strategy. It involves selling an OTM (lower strike) Put and
buying an OTM (higher strike) Call. This strategy simulates the action of buying a stock (or
a futures) but at a fraction of the stock price. It is an inexpensive trade, similar in pay-off to
Long Stock, except there is a gap between the strikes (please see the payoff diagram). As
the stock price rises the strategy starts making profits.

When to Use: Investor is Bullish on the stock.

Risk: Unlimited (Lower Strike + net debit)

Reward: Unlimited

Breakeven: Higher strike + net debit

STRATEGY 8 : PROTECTIVE CALL /

SYNTHETIC LONG PUT
This is a strategy wherein an investor has gone short on a stock and buys a call to hedge.
This is an opposite of Synthetic Call (Strategy 3). An investor shorts a stock and buys an
ATM or slightly OTM Call. The net effect of this is that the investor creates a pay-off like a
Long Put, but instead of having a net debit (paying premium) for a Long Put, he creates a
net credit (receives money on shorting the stock). In case the stock price falls the investor
gains in the downward fall in the price. However, incase there is an unexpected rise in the
price of the stock the loss is limited.

When to Use: If the investor is of the view that the markets will go down (bearish) but
wants to protect against any unexpected rise in the price of the stock.

Risk: Limited. Maximum Risk is Call Strike Price – Stock Price + Premium

Reward: Maximum is Stock Price – Call Premium

Breakeven: Stock Price – Call Premium

STRATEGY 9 : COVERED PUT
This strategy is opposite to a Covered Call. A Covered Call is a neutral to bullish strategy,
whereas a Covered Put is a neutral to Bearish strategy. You do this strategy when you feel
the price of a stock / index is going to remain range bound or move down. Covered Put
writing involves a short in a stock / index along with a short Put on the options on the stock
/ index.

When to Use: If the investor is of the view that the markets are moderately bearish.

Risk: Unlimited if the price of the stock rises substantially

Reward: Maximum is (Sale Price of the Stock – Strike Price) + Put Premium

Breakeven: Sale Price of Stock + Put Premium

STRATEGY 10 : 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.
When to Use: The investor thinks that the underlying stock / index will experience
significant volatility in the near term.

Risk: Limited to the initial premium paid.

Reward: Unlimited

Breakeven:
Upper Breakeven Point = Strike Price of Long Call + Net Premium Paid
Lower Breakeven Point = Strike Price of Long Put - Net Premium Paid

STRATEGY 11 : 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 does not move much in either direction, the investor retains
the Premium as neither the Call nor the Put will be exercised. However, incase the stock /
index moves in either direction, up or down significantly, the investor’s losses can be
significant.

When to Use: The investor thinks that the underlying stock / index will experience very
little volatility in the near term.

Risk: Unlimited

Reward: Limited to the premium received

Breakeven:
Upper Breakeven Point = Strike Price of Short Call + Net Premium Received
Lower Breakeven Point = Strike Price of Short Put - Net Premium Received
STRATEGY 12 : 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.

When to Use: The investor thinks that the underlying stock / index will experience very
high levels of volatility in the near term.

Risk: Limited to the initial premium paid

Reward: Unlimited

Breakeven:
Upper Breakeven Point = Strike Price of Long Call + Net Premium Paid
Lower Breakeven Point = Strike Price of Long Put - Net Premium Paid

STRATEGY 13. 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.

When to Use: This options trading strategy is taken when the options investor thinks that
the underlying stock will experience little volatility in the near term.

Risk: Unlimited

Reward: Limited to the premium received

Breakeven:
Upper Breakeven Point = Strike Price of Short Call + Net Premium Received
Lower Breakeven Point = Strike Price of Short Put - Net Premium Received

STRATEGY 14. COLLAR

A Collar is similar to Covered Call (Strategy 6) but involves another leg – buying a Put to
insure against the fall in the price of the stock. It is a Covered Call with a limited risk. So a
Collar is buying a stock, insuring against the downside by buying a Put and then financing
(partly) the Put by selling a Call.
When to Use: The collar is a good strategy to use if the investor is writing covered calls to
earn premiums but wishes to protect himself from an unexpected sharp drop in the price of
the underlying security.
Risk: Limited

Reward: Limited

Breakeven: Purchase Price of Underlying – Call Premium + Put Premium

STRATEGY 15. 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
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.

When to Use: Investor is moderately bullish.

Risk: Limited to any initial premium paid in establishing the position. Maximum loss occurs
where the underlying falls to the level of the lower strike or below.
Reward: Limited to the difference between the two strikes minus net premium cost.
Maximum profit occurs where the underlying rises to the level of the higher strike or above
Break-Even-Point (BEP): Strike Price of Purchased call + Net Debit Paid

STRATEGY 16. 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 an 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.
When to Use: When the investor is moderately bullish.

Risk: Limited. Maximum loss occurs where the underlying falls to the level of the lower
strike or below

Reward: Limited to the net premium credit. Maximum profit occurs where underlying rises
to the level of the higher strike or above.

Breakeven: Strike Price of Short Put - Net Premium Received

STRATEGY 17 : 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
is 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 Calls will expire worthless and
the investor can retain the net credit. If the stock / index rises then the breakeven is the
lower strike plus the net credit.

When to use: When the investor is mildly bearish on market.

Risk: Limited to the difference between the two strikes minus the net premium.

Reward: Limited to the net premium received for the position i.e., premium received for
the short call minus the premium paid for the long call.

Break Even Point: Lower Strike + Net credit

STRATEGY 18 : 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 stoc k price / index falls. The
bought Puts will have the effect of capping the investor’s downside.

When to use: When you are moderately bearish on market direction

Risk: Limited to the net amount paid for the spread. i.e. the premium paid for long position
less premium received for short position.

Reward: Limited to the difference between the two strike prices minus the net premium
paid for the position.

Break Even Point: Strike Price of Long Put – Net Premium Paid

STRATEGY 19: 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.

When to use: When the investor is neutral on market direction and bearish on
volatility.

Risk Net debit paid.

Reward Difference between adjacent strikes minus net debit

Break Even Point:

 Upper Breakeven Point = Strike Price of Higher Strike Long Call – Net Premium Paid
 Lower Breakeven Point = Strike Price of Lower Strike Long Call + Net Premium Paid

STRATEGY 20 : 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.
When to use: You are neutral on market direction and bullish on volatility. Neutral
means that you expect the market to move in either direction - i.e. bullish and bearish.

Risk Limited to the net difference between the adjacent strikes less the premium received
for the position.
Reward Limited to the net premium received for the option spread.

Break Even Point:

Upper Breakeven Point = Strike Price of Highest Strike Short Call - Net Premium Received
Lower Breakeven Point = Strike Price of Lowest Strike Short Call + Net Premium Received

CALL OPTION (LOWER STRIKE), SELL 1 ITM CALL

OPTION (LOWER MIDDLE), SELL 1 OTM CALL
OPTION (HIGHER MIDDLE), 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 pay off profile is wider
than that of the Long Butterfly (see pay-off diagram).
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.

When to Use: When an investor believes that the underlying market will trade in a range
with low volatility until the options expire.

Risk Limited to the minimum of the difference between the lower strike call spread less the
higher call spread less the total premium paid for the condor.

Reward Limited. The maximum profit of a long condor will be realized when the stock is
trading between the two middle strike prices.

Break Even Point:

Upper Breakeven Point = Highest Strike – Net Debit
Lower Breakeven Point = Lowest Strike + Net Debit
STRATEGY 22 : 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 finishes on
either side of the upper or lower strike prices at expiration.

When to Use: When an investor believes that the underlying market will break out of a
trading range but is not sure in which direction.

Risk Limited. The maximum loss of a short condor occurs at the center of the option
spread.

Reward Limited. The maximum profit of a short condor occurs when the underlying stock /
index is trading past the upper or lower strike prices.

Break Even Point:

Upper Break even Point = Highest Strike – Net Credit
Lower Break Even Point = Lowest Strike + Net Credit