While there is no disputing that options offer many investment benefits, option trading involves risk and is not for everyone. For the same reason that one's returns can be large, so too can the losses - leverage. Also, while the potential for financial success does exist in option trading, the means of realizing such opportunities are often difficult to create and to identify. With dozens of variables, several pricing models, and hundreds of different strategies to choose from, it is no wonder that options and option pricing have been a mystery to the majority of the trading public.

Most often, a great deal of information must be processed before an informed trading decision can be reached. Computers and sophisticated trading models are often relied upon to select trading candidates. However, as humans, we like things to be as simple as possible. This often creates a conflict when deciding what, when, and how to trade a particular investment. It is much easier to buy or sell an asset outright than to contend with the many extraneous factors of these derivative markets. If an investor thinks an asset's value will appreciate, he or she can simply buy the security; if an investor thinks an asset's value will depreciate, he or she can simply sell the security. In these scenarios, the only thing an investor must worry about is the value of the investment relative to the value of the prevailing market. If only options were that easy!

Collar Strategy is applicable when you want to purchase the stock of a particular company. The stock as per your assessment is not likely to move up at a rapid pace and you want to limit your downside. The potential risk or reward in a collar is limited.

A collar strategy involves three distinct transactions, namely the purchase of the asset in the spot market. purchase of an out-of-the-money put option and sale of an out-of-the-money call option, in a manner that the cash in-flow and cash-outflow in the sale and purchase transactions are near equal. In this way the buyer is able to buy the stock at a cost equal to that of buying in the spot market.

An example would make the operation clearer. Assume that the stock of XYZ is selling at Rs 100. The investor purchases 10 shares of XYZ, which means a net outflow of Rs 1,000 (for the purchase in spot market). At the same time the investor also purchases 1 put option (10 shares) with strike price at Rs 95. The investor also sells 1 call option (10 shares) with a strike of Rs 110. Since the premium paid for the put option is the same as the premium received for the call option, the net cost for the investor is Rs 1,000 only. Assume that the stock price moves down to Rs 90. In that case three events happen. Firstly the call option is worthless. The investor will exercise his put option and thereby receives a cash inflow of Rs 50. The spot position incurs a loss of Rs 100. Therefore, the maximum loss that an investor will suffer is Rs 50. The same condition holds true for any combination of the spot price. If the asset price falls below the put strike, then the maximum loss that the investor can suffer is the difference between the put strike and initial spot price.

Similarly assume that the price of the asset rises to Rs 120. Then the put option is worthless. The investor will have to provides the shares at Rs 110. This means that he will lose Rs 100 (10*10) in the process. However the spot position will gain by around Rs 200. Therefore the net gain will always be Rs 100, that is the difference between the call strike and the original asset price. Hence we can see that while the risks are minimised, the rewards are also is not large.

The (long) straddle strategy can be used to restrict risk to the minimum, yet with unlimited potential for gain (reward). This is applicable when you want to purchase stock, but unable to predict in which direction the price will fluctuate.

A (long) straddle involves the purchase of a call and put option with the same exercise and terms and conditions. The (short) straddle involves selling of a put and a call option with the same exercise and terms and conditions. The more volatile the stock, the better the payoffs from a (long) straddle and vice versa. Investors have to be careful when using this strategy because options tend to lose value quickly. In the case of a straddle, the erosion is twice that of holding a call or a put option. In addition to this the transaction costs would also be higher as the investor has to buy twice the number of options. An example would make the strategy more clear. First let us look at an example of the (long) straddle strategy. Assume that the stock of XYZ is selling at Rs 100. The investors purchases one call option at a strike price of Rs 105 and one put option with the same strike price. All other terms and conditions are similar for both options. Further assume that the investor pays a total premium (inclusive of call and put) of Rs 10. Therefore the cost for the investor is Rs 10. This effectively means that if the stock price moves beyond Rs 110, the call option will make money and if it falls below Rs 95, the put option will make money. In the event of the stock price remaining range-bound between Rs 95 and Rs 110, the maximum loss suffered by the investor is Rs 10.

The (short) straddle is an extremely risky strategy. For instance, as in our above example, the investor will write a call and a put option with a strike price of Rs 105. He receives a total premium of Rs 10 for his troubles. Therefore his maximum profit from the transaction is Rs 10 only. However of the stock fluctuates beyond the range stated above, the loss for the investor is unlimited.

The investor can consider using a long strangle strategy, when he desires to purchase a stock, which is volatile, but the direction of movement is not known.

Similar to a straddle, a strangle strategy involves two separate transactions. The long strangle strategy involves a purchase of an out-of-the-money call and an out-of-the-money put option with different exercise prices, but all other terms remaining constant. The basic difference between a straddle and a strangle is that in the case of the strangle, the exercise prices are different. The more volatile the stock, the better the payoffs from a (long) strangle strategy and vice versa. As in the case of a strangle, the erosion is twice that of holding a call or a put option. This apart the transaction costs would also be higher as the investor has to buy twice the number of options. An example would make the strategy more clear.

BY way of an example of a (long) strangle strategy, assume that the stock of XYZ is selling at Rs 100. The investor purchases one call option at a strike price of Rs 105 and one put option with a strike price of Rs 95. All other terms and conditions are the same for both options. Further assume that the investor pays a total premium of Rs 10 (5+5) for both options put together. This effectively means that the stock price has to either move beyond 110 or move below 90 for the investor to make money. If the price moves beyond Rs 110, then the call option will make money and if the price falls below Rs 90, the put option will make money. In the event of the stock price moving between Rs 90 and Rs 110, the options would be worthless and the maximum loss is set at Rs 10.

Example of a (short) strangle - This is again an extremely risky strategy. For instance, as in our above example, the investor will write a call and a put option with a strike price of Rs 105 and Rs 95 respectively. He receives a total premium of Rs 10 for the risk borne by him. His maximum profit is limited to Rs 10. However if there is a substantial movement of the stock in either direction, the writer's losses are unlimited. This is an extremely risky strategy and advised only for players with substantial financial backing and experience in trading options.

The advantage from using a strangle over a straddle is that the downside is better hedged than when using a straddle.

The Bull spread strategy is suitable to the bullish investor to purchase a stock with a definite upward trend in its movement. But still as an investor, you want to limit any possible unforeseen risks.

A bull spread also involves two distinct transactions. As a matter of fact it can be created by using both calls and puts. For instance using calls an investor can buy a call option with a particular strike price and sell another call option with a higher strike price. In the case of using puts, the reverse applies. A bull spread when created using calls requires an initial investment, unless the premiums received are equal. However, this is not likely to be the case as the premium declines as the strike price increases. This would imply that since the call option sold has a higher strike price, the premium received will be lower.

Example - Assume that the current stock price of ABC is Rs 100. You create a bull spread using call options. The two options used have strike prices of Rs 105 and Rs 115. Therefore, the investor would have bought the call option with a strike of Rs 105 by paying Rs 15 as premium and sold the call option with a strike of Rs 115 thereby receiving say Rs 10. Therefore, the net cost of creating the position is the difference between the premium paid and received which is Rs 5. If at maturity the investors view holds good and the stock has closed well above the higher strike price at Rs 125, the profit for the investor would be the difference between the two strike prices which would be equal to Rs 10. This so because the call option that the investor has bought will be exercised thereby he makes a profit of Rs 20 on each option. At the same time he has written an option at Rs 115. This means that at any price above Rs 115, the counterparty to his obligation would exercise the option. Therefore from this he incurs a loss of Rs 10 (Rs 125-115). Therefore the net gains for the investor is the difference between the two strike prices. Now if the stock price lies between the two strike prices, then the investors profit would be the difference between the stock price and the strike price of the option that he bought. For instance if the stock closed at Rs 110, the investors profit is Rs 5 (110-105). Why is this so? Since the call written at Rs 115 by the investor will not be exercised, there is not loss arising out of that. At the same time, the call option that he has bought will be exercised thereby providing him with a profit.

As an investor you choose to purchase a stock, which is volatile, and that you are able to foresee the direction in which the price will move. A butterfly spread is suitable in such a case to earn a profit and at the same time have a limited risk exposure. Buying a butterfly would yield a profit when volatility is expected to come down and selling a butterfly would result in a profit when volatility is expected to go up. A butterfly strategy requires three distinct transactions. For instance, in the case of a long butterfly, investors have to buy two options with different strike prices and sell two options on the strike price which is the middle of the ones that have been bought. Therefore, if the investor buys options with strike prices of 50 and 60 respectively, he has to sell options with a strike of 55. The reverse strategy is applicable for a short butterfly. A butterfly is by definition "contract-neutral". This means that the number of contracts bought should be equal to the number of contracts sold.

You thus create a long butterfly by buying two options with strike prices fixed at Rs 90 and Rs 110 respectively. At the same time you have to sell two options with the strike price of Rs 100. Assume for the moment that the premiums paid for the options purchased is worth Rs 15 and the premiums received on the sale of the options is Rs 10. Therefore, the net cost for the investor is the difference in premium which is equal to Rs 5.

At maturity, the maximum loss that can be suffered by the investor is the net difference in premium which is equal to Rs 5. For instance, the price of the asset closes at Rs 115. Then what happens? Both the options that the investor has bought will be in the money and it will give him a net gain of Rs 30 (25+5). However, remember that he has also written options at Rs 100. Therefore, his loss is equal to two times the loss of Rs 15 each per option. Therefore the net loss is Rs 30. This implies since the options cancel out each other, the maximum loss for the investor is always the premium paid.

The profits in a butterfly spread are maximum if the stock closes at the strike on which the investor has sold options. For instance consider what happens when the stock closes at Rs 100. The option he bought for Rs 90 will give him a net gain of Rs 10. The other option that he has bought at Rs 110 is worthless. What will happen to the options that have been written. These options also will not be exercised as the option buyer would not be able to cover even a fraction of the premium paid. Therefore, the contract that have been written will also not be exercised. This means that the maximum possible gain for the investor from this strategy would be Rs 10.