Option buying attracts many market participants because it offers a way to benefit from price movements without large capital commitments. When used with the right approach, it helps in benefiting from trends and shifts in the market. But without a structure, results can be inconsistent. Choosing the correct setup and applying it at the right time is essential.
In this guide, we will explore key rules and some of the best option buying strategies.
Option Buying Strategies
Options are a form of derivative contracts that allow us to take a view on price direction without directly buying or selling the asset. Because of this flexibility, options are often used in different market conditions.
In option buying, call or put options are purchased with the aim to benefit from price movement or volatility in the underlying asset. One distinct feature of option buying is that the downside is capped at the premium paid for the contract.
Options trading strategies help in responding to shifts in market direction and volatility in a more structured manner.
Key principles before Option Buying
Before jumping into option buying strategies, it is important to understand a few core principles. They serve as guidelines that improve consistency and reduce unnecessary risk.
- Right Market Conditions
Option buying is most effective when a clear directional move in the market is expected. If the market remains sideways, the options value decline as the expiry date approaches. - Manage Position Size
Even though the risk is limited, taking too many options can still result in large losses. Keeping the position size under control helps in maintaining discipline and the protection of capital. - Understand Time Decay
As the expiry date approaches, options gradually lose value. This effect is called time decay. It is crucial to be aware of it as timing plays an important role in planning the trade. - Strike Price Selection
The strike price is an important aspect for option buying. At-the-money (ATM) or slight In-the-Money (ITM) options are more realistic and liquid, while out-of-the-money (OTM) options are cheaper but require stronger movement. - Volatility Analysis
Volatility influences option pricing significantly. Understanding the volatility levels helps in determining whether options are relatively expensive or reasonably priced before entering a trade.
Best Option Buying Strategies
Below are some commonly used option buying strategies that focus on different market conditions.
1. Volatility mispricing around events
Sometimes, market events can cause prices to fluctuate in a short time period. Announcements such as company earnings reports, changes by the central bank, or major economic data increase uncertainty in the market.
In such situations, option buyers may look for cases where the expected volatility is not fully reflected in the option price. If the price movement turns out to be stronger than expected, the option value increases due to price movement and volatility expansion.
Example: Imagine a stock is trading at ₹1,000 before its quarterly earnings announcement. The market is expecting a moderate move, and a one-week call option with a strike price of ₹1,020 is trading at ₹15.
An investor anticipates movement and buys the call option. After a week, the results are announced, and the stock jumps to ₹1,080. The option’s intrinsic value becomes ₹60 (₹1,080 – ₹1,020) and leads to a gain on the position.
2. Trend breakout call buying
This approach is built on the concept that when the price crosses major support or resistance levels, it may lead to stronger momentum. The breakout indicates increasing participation and higher conviction among market participants.
This approach is often used when a strong directional move is expected. In such cases, buying call options during bullish breakouts or put options during bearish breakdowns allows participation in the momentum without directly buying or selling the asset.
For example, suppose a share trading at ₹500 has failed to move beyond the resistance at ₹520 for several weeks. When the price finally breaks above ₹520, Rajan buys a call option with a ₹530 strike price at ₹8.
The breakout continued for the next few days, and the share price rose to ₹560, making the option’s intrinsic value ₹30 (₹560 – ₹530), increasing the option price and resulting in a profitable trade.
3. LEAPS for long-term conviction
Long-Term Equity Anticipation Securities (LEAPS) are long-dated option contracts with expiration periods ranging from 1 to 3 years. They allow participation in long-term trends while committing less capital compared to buying the underlying asset.
As they have longer expiry periods, they allow more room for the expected movement to play out. They are appropriate for situations where the anticipated price move may take months or even years to develop.
As an example, assume the stock of ABC Enterprises is currently at ₹1,200. Mohan conducted his fundamental research and came to the conclusion that the stock can reach ₹1,700 in the next two years.
Instead of buying shares of the company, he purchased a two-year LEAP call option with a strike price of ₹1,300 for ₹120. After 22 months, the stock has climbed to ₹1,700. The option’s intrinsic value becomes ₹400, delivering substantial returns.
4. Event-based trades with short-term options
Event-based trades are used when a specific announcement can trigger a quick price reaction. The goal is to position ahead of the announcement with a clear directional view.
This strategy uses short-term options as they are more sensitive to the immediate price movement. As the reaction occurred in a short time window, options with near-term expiries that align with the timing of the event are chosen.
Example: Nifty 50 is at 22,000 ahead of an announcement by the RBI. A one-day call option with a strike price of 22,200 is trading at ₹50. An investor expects a positive market reaction and buys the option.
After the announcement, Nifty rises to 22,500, increasing the option’s intrinsic value to ₹300. This sharp movement results in a significant increase in the option price.
5. Skewed diagonal or calendar (diagonal) strategies
Diagonal or calendar strategies involve combining options with varying strike rates and different expiration periods. The focus here is to take advantage of the difference in time decay between short-term and longer-term options.
These strategies are used when gradual price movement is expected. The longer-dated option provides exposure to the underlying trend, while the shorter-dated option may benefit from faster time decay.
For example, imagine XYZ Enterprises is trading at ₹800. Amit buys a three-month ₹820 call option for ₹40 and simultaneously sells a one-month ₹840 call option for ₹12. In the next month, the stock moves toward ₹830, and the short-term option loses its value.
The longer option still retains value and gives more space for favourable price movement. This difference can help improve the overall position outcome.
Conclusion
Option buying helps to benefit from the market movements while keeping the loss limited. They can be useful in situations where strong price moves are expected. Success in option trading does not rely on predicting the right direction alone. There are factors such as volatility, strike price, expiry date, and position sizing that should be considered before taking a trade.
By following key principles and applying structured strategies, option buying can become a useful part of a broader market approach.
FAQ’s
There is no single best strategy for option buying. The choice often depends on market conditions. Breakout-based buying, volatility trades around events, and LEAPS are among the commonly used approaches.
Option buying can be profitable when the market moves strongly in the expected direction in the chosen timeframe. However, timing and volatility play a crucial role in determining the outcome.
Option buying offers limited risk because the maximum loss is restricted to the premium paid. Option selling may provide a higher probability of smaller gains but can involve larger potential risk if markets move sharply.
Strike price selection depends on the expected price movement and time horizon. ATM and ITM options respond quickly to price changes, while OTM options require stronger movement.
The expiry should match the expected timeframe. Short-term options react quickly to market moves, while longer expiries provide more time for the trade to develop.
Beginners can start with a simple call or put buying with small position sizes because the maximum loss is limited to the premium paid.
A long straddle involves buying a call and a put at the same strike price, while a long strangle uses different strike prices. Both strategies attempt to benefit from large price movements regardless of direction.
