It is possible to create zero-risk strategies in F&O

Stock Market | Published on 24th May 2018 | 6643

The very term zero-risk F&O strategy might look quite incongruous to you. After all, you always thought that futures and options were high risk products. So, how can there ever be a zero-risk F&O strategy. That is what F&O is all about where you can actually define the maximum loss and create zero risk positions with minimal loss. Let us look at two such strategies

How to create a collar strategy with zero risk?

A collar is basically the combination of a futures/cash market position plus buying a lower put plus selling a higher call option. The strategy is designed in such a way that the premium received on the call option will compensate for the cost of the put option. Of course, selling a higher call will restrict your profits on the upside but it will also ensure that your maximum loss on the strategy will be zero or positive even in the worst case scenario. Let us look at a practical example of how such a collar strategy works.

Case 1: Investor X buys 1 lot of Reliance May 2018 futures at a price of Rs.968. However, since he believes that there could be downside risk on the stock, he also buys a 960 May 2018 put option at Rs.8. To reduce the cost of the put option, the investor also sells a 980 May 2018 call option at a price of Rs.16. Let us look at what happens at different price scenarios…

RIL Price Scenario

P/L on Futures

P/L on Put Option

P/L on Call Option

Total Profit/Loss

910

-58

+42

+16

00

920

-48

+32

+16

00

930

-38

+22

+16

00

940

-28

+12

+16

00

950

-18

+02

+16

00

960

-08

-08

+16

00

970

+02

-08

+16

+10

980

+12

-08

+16

+20

990

+22

-08

+06

+20

1000

+32

-08

-04

+20

1010

+42

-08

-14

+20

1020

+52

-08

-24

+20

The above table is self-explicit on why this is a zero risk strategy. Any level below Rs.960 means that the total cost of Rs.16 on put (8+8) is fully compensated for by the premium of Rs.16 received on the call option. As we go higher, the maximum profit of Rs.20 is achieved at the RIL price of Rs.980. Remember that Rs.980 is the price at which the call is sold. So any profit on futures above the level of Rs.980 is fully adjusted by the loss on the call option. So the maximum profit in this strategy under any condition can only be Rs.20 (980-960).

There are two things you must understand in the collar strategy. Firstly, this strategy works best when the stock is in bullish mode. That means the calls will be slightly overpriced while the puts will be slightly underpriced. This will give you an opportunity to create the Collar at zero loss or at a small worst-case profit. On the upside, your maximum profit is capped at Rs.20. That is a trade-off you have to pay for creating a virtually zero-loss strategy.

Four-Legged Iron Condor Strategy with assured profit

In the Iron Condor strategy, there are four legs to the transaction. What you basically do is to combine a long strangle with a short strangle. A strangle is when you buy a call of a higher strike price and buy a put option of a lower strike price. Normally you buy a strangle you expect the market to be volatile. On the other hand when you sell strangles, you expect the market to be range-bound. When you combine a long strangle and a short strangle, you get an Iron Condor. This is how the Condor will look like. Assume that the Nifty Spot is at 10,550.

Buy Nifty 10,400 Put

Sell Nifty 10,500 Put

Sell Nifty 10,600 call

Buy Nifty 10,700 Call

10

90

90

20

Case 2: In the above table, the two yellow shaded portions represent a long strangle while the two blue shaded portions represent a short strangle. Let us see how the Iron Condor will play out under different price conditions

Price

Buy 10400 Put

Sell 10500 Put

Sell 10600 Call

Buy 10700 Call

Profit/Loss

10,200

+190

-210

+90

-20

+50

10,300

+90

-110

+90

-20

+50

10,400

-10

-10

+90

-20

+50

10,500

-10

+90

+90

-20

+150

10,600

-10

+90

+90

-20

+150

10,700

-10

+90

-10

-20

+50

10,800

-10

+90

-110

+80

+50

10,900

-10

+90

-210

+180

+50

11,000

-10

+90

-310

+280

+50

In the above case, the Iron Condor has a positive net pay-off. The maximum profit on the Iron Condor is generated between the range of 10,500 and 10,600 where the short strangle leg has been sold by the investor. But irrespective of the price movement, the Iron Condor strategy is still generating a minimum profit of Rs.50. You will also notice that the maximum profit in the strategy of Rs.150 is the actual net premium received by the investor.

There are two very important things to remember here. Firstly, you do not need to wait for the expiry of the contracts. If the Nifty remains in the range of 10,500 to 10,600 the net payoff of the Iron Condor will come down and at that level you can reverse your position and book the profits. Secondly, this is a 4-leg strategy and including closure it will entail 8 legs. You need to factor in the brokerage and other statutory charges into your calculations when you actually create these zero risk strategies.