Strategies and applications
In this chapter: Hedging, speculation, arbitrage · The four basic option strategies and their P&L diagrams
Three motives drive derivatives use. Hedging — protect an existing position from adverse moves (e.g., buy a put against equity holdings). Speculation — bet on direction with leverage (e.g., buy a call to bet on rise). Arbitrage — exploit pricing differences between linked instruments (e.g., cash-and-carry between spot and futures). The four basic options strategies: long call, long put, short call, short put.
Long call: pay premium, profit if underlying rises above (strike + premium); loss capped at premium. Long put: profit if underlying falls below (strike − premium). Short call (writer): collect premium, profit if underlying stays at or below strike at expiry; loss potentially unlimited. Short put: collect premium, profit if underlying stays at or above strike; loss capped at strike (when underlying goes to zero). Multi-leg strategies (spreads, straddles, condors) are combinations of these four primitives. Bull call spread = long lower-strike call + short higher-strike call; defined risk and reward.
Most retail Indian traders lose money on options because they buy out-of-money options on weekly expiries. The expected value of these positions is negative due to time decay. SEBI has acknowledged this through periodic studies (89% of derivative-trading retail accounts show losses, etc.). Distributors and dealers should know and disclose this — recommending derivative speculation to retail clients is a compliance landmine. Hedging applications, on the other hand, are entirely legitimate and widely under-used.