How Does An Investor Make Money From An Equity Investment
Making Money Through Equity Investment
'Equity Investment' refers to the buying and holding of shares of public companies, such as those traded in Bombay Stock Exchange. By the action of buying 'shares', the investor becomes a part owner of the company. This brings a lot of benefits; and they are, voting rights to appoint the management, a share in profits and probable preference on new shares of the same company.
Equity is one of the few ways of making a big sum of money. Preferably for investors with relatively high risk appetite, equity is designed for individuals or firms who wants to play the 'high risk, high return' game. This is because it comes with the risk of losing the entire capital.
Investing in stocks has to be a very informed and researched decision. The price of the stock is directly linked to the performance of the company. Hence, it is important to choose the promising companies that will be consistently profitable, giving you growth through the years.
Fig 1: SENSEX through the years
The above graph indicates the yearly growth of SENSEX from 1981 to 2016. We can see that the index has been gradually giving great returns to the investors.
As stated before; upon purchasing a stock, an investor becomes a proportional owner of the company based on how many shares of stock have been purchased. There are 5 different ways for the investors to make money from an equity investment:
Dividend:
As an owner, the investor is entitled to a share in the profits of the company. If the company chooses to distribute these profits through dividend, the investor earns a specific amount for every share he owns.
Capital Gains:
An increase in the market price of the stock, benefits the investor since he/she can make profits from the sale of the holdings. Over the course of years, an investor may make more than 50 times of what he has invested.
Buy Back:
The company may declare to buy shares from it's shareholders at a price higher than the market rate. Although not every investor wishes to sell shares, one can make an extra profit through the buyback window.
Rights Issue:
On the issue of new shares, the company may give a discount to its existing shareholders. The investor can make profits by purchasing shares at a discounted price and selling them at a higher market price.
Bonus Issue:
If a company is performing exceptionally well, it might give free shares to its shareholders. These additional shares soon starts trading at market prices, giving an excellent opportunity to the investor to make profits.
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Long Call Butterfly Options Strategy
A Long Call Butterfly is implemented when the investor is expecting very little or no movement in the underlying assets. The motive behind initiating this strategy is to rightly predict the stock price till expiration and gain from time value with limited risk.
When to initiate a Long Call Butterfly?
A Long Call Butterfly spread should be initiated when you expect the underlying assets to trade in a narrow range as this strategy benefits from time decay factor. However, unlike Short Strangle or Short Straddle, the potential risk in a Long Call Butterfly is limited. Also, when the implied volatility of the underlying assets increases unexpectedly and you expect volatility to come down, then you can apply Long Call Butterfly strategy.
How to construct a Long Call Butterfly?
A Long Call Butterfly can be created by buying 1 ITM call, buying 1 OTM call and selling 2 ATM calls of the same underlying security with the same expiry. Strike price can be customized as per the convenience of the trader; however, the upper and lower strike must be equidistant from the middle strike.
| Strategy | Buy 1 ITM Call, Sell 2 ATM Call and Buy 1 OTM Call |
|---|---|
| Market Outlook | Neutral on market direction & Bearish on volatility |
| Upper Breakeven | Higher Strike price of buy call - Net Premium Paid |
| Lower Breakeven | Lower Strike price of buy call + Net Premium Paid |
| Risk | Limited to Net Premium Paid |
| Reward | Limited (Maximum profit is achieved when market expires at middle strike) |
| Margin required | Yes |
Let's try to understand with an example:
| Nifty Current spot price (Rs) | 8800 |
| Buy 1 ITM call of strike price (Rs) | 8700 |
| Premium paid (Rs) | 210 |
| Sell 2 ATM call of strike price (Rs) | 8800 |
| Premium received (Rs) | 300 (150*2) |
| Buy 1 OTM call of strike price (Rs) | 8900 |
| Premium paid (Rs) | 105 |
| Upper breakeven | 8885 |
| Lower breakeven | 8715 |
| Lot Size | 75 |
| Net Premium Paid (Rs) | 15 |
Suppose Nifty is trading at 8800. An investor Mr A thinks that Nifty will not rise or fall much by expiration, so he enters a Long Call Butterfly by buying a March 8700 call strike price at Rs 210 and March 8900 call for Rs 105 and simultaneously sold 2 ATM call strike price of 8800 @150 each. The net premium paid to initiate this trade is Rs 15, which is also the maximum possible loss. This strategy is initiated with a neutral view on Nifty hence it will give the maximum profit only when there is no movement in the underlying security. Maximum profit from the above example would be Rs 6375 (85*75). The maximum profit would only occur when underlying assets expires at middle strike. Maximum loss will also be limited if it breaks the upper and lower break-even points i.e. Rs 1125 (15*75). Another way by which this strategy can give profit is when there is a decrease in implied volatility.
For the ease of understanding, we did not take in to account commission charges. Following is the payoff chart and payoff schedule assuming different scenarios of expiry.
The Payoff chart:
The Payoff Schedule:
| On Expiry NIFTY closes at | Net Payoff from 1 ITM Call Bought (Rs) | Net Payoff from 2 ATM Calls Sold (Rs) | Net Payoff from 1 OTM Call Bought (Rs) | Net Payoff (Rs) |
|---|---|---|---|---|
| 8200 | -210 | 300 | -105 | -15 |
| 8300 | -210 | 300 | -105 | -15 |
| 8400 | -210 | 300 | -105 | -15 |
| 8500 | -210 | 300 | -105 | -15 |
| 8600 | -210 | 300 | -105 | -15 |
| 8700 | -210 | 300 | -105 | -15 |
| 8715 | -195 | 300 | -105 | 0 |
| 8800 | -110 | 300 | -105 | 85 |
| 8885 | -25 | 130 | -105 | 0 |
| 8900 | -10 | 100 | -105 | -15 |
| 9000 | 90 | -100 | -5 | -15 |
| 9100 | 190 | -300 | 95 | -15 |
| 9200 | 290 | -500 | 195 | -15 |
| 9300 | 390 | -700 | 295 | -15 |
| 9400 | 490 | -900 | 395 | -15 |
Impact of Options Greeks before expiry::
Delta: The net delta of a Long Call Butterfly spread remains close to zero.
Vega: Long Call Butterfly has a negative Vega. Therefore, one should buy Long Call Butterfly spread when the volatility is high and expect to decline.
Theta: It measures how much time erosion will affect the net premium of the position. A Long Call Butterfly will benefit from theta if it expires at middle strike.
Gamma: This strategy will have a long gamma position.
How to manage Risk?
A Long Call Butterfly is exposed to limited risk, so carrying overnight position is advisable but one can keep stop loss to further limit losses.
Analysis of Long Call Butterfly strategy:
A Long Call Butterfly spread is best to use when you are confident that an underlying security will not move significantly and will stay in a range. Downside risk is limited to net debit paid, and upside reward is also limited but higher than the risk involved.
Next Article
How to make Profit in a Neutral Market: Short Straddle Option Strategy
A Short Straddle strategy is a race between time decay and volatility. Every day that passes without movement in the underlying assets will benefit this strategy from time erosion. Volatility is a vital factor and it can adversely affect a trader's profits in case it goes up.
When to initiate a Short Straddle Options Trading Strategy?
A short options trading straddle strategy can be used when you are very confident that the security won't move in either direction because the potential loss can be substantial if that happens. This strategy can also be used by advanced traders when the implied volatility goes abnormally high for no obvious reason and the call and put premiums may be overvalued. After selling straddle, the idea is to wait for implied volatility to drop and close the position at a profit. Inversely, this strategy can lead to losses in case the implied volatility rises even if the stock price remains at same level.
How to Construct a Short Straddle Options Trading Strategy?
A short straddle is implemented by selling at-the-money call and put option of the same underlying security with the same expiry.
| Strategy | Sell ATM Call and Sell ATM Put |
|---|---|
| Market Outlook | Neutral or very little volatility |
| Motivation | Earn income from selling option premium |
| Upper Breakeven | Strike price of short call + Net Premium received |
| Lower Breakeven | Strike price of short call + Net Premium received |
| Risk | Unlimited |
| Reward | Limited to Net Premium received (when underlying assets expires exactly at the strikes price sold) |
| Margin required | Yes |
Let's try to understand with an example:
| Nifty Current spot price | Rs. 8800 |
| Sell ATM Call & Put(Strike Price) | Rs 8800 |
| Premium received (per share) Call | Rs 80 |
| Put | Rs 90 |
| Upper breakeven | Rs 8970 |
| Lower breakeven | Rs 8630 |
| Lot Size(in units) | 75 |
Suppose, Nifty is trading at 8800. An investor, Mr. A is expecting no significant movement in the market, so he enters a Short Straddle by selling a FEB 8800 call strike at Rs 80 and FEB 8800 put for Rs 90. The net upfront premium received to initiate this trade is Rs 170, which is also the maximum possible reward. Since this strategy is initiated with a view of no movement in the underlying security, the loss can be substantial when there is significant movement in the underlying security. The maximum profit will be limited to the upfront premium received, which is around Rs 12750 (170*75) in the example cited above. Another way by which this strategy can be profitable is when the implied volatility falls.
For the ease of understanding, we did not take into account commission charges. Following is the payoff chart and payoff schedule assuming different scenarios of expiry.
The Payoff Chart:
The Payoff Schedule:
| On Expiry NIFTY closes at | Net Payoff from Call Sell (Rs) | Net Payoff from Put Sell (Rs) | Net Payoff (Rs) |
|---|---|---|---|
| 8300 | 80 | -410 | -330 |
| 8400 | 80 | -310 | -230 |
| 8500 | 80 | -210 | -130 |
| 8600 | 80 | -110 | -30 |
| 8630 | 80 | -80 | -0 |
| 8700 | 80 | 10 | 70 |
| 8800 | 80 | 90 | 170 |
| 8900 | -20 | 90 | 70 |
| 8970 | -90 | 90 | 0 |
| 9000 | -120 | 90 | -30 |
| 9100 | -220 | 90 | -130 |
| 9200 | -320 | 90 | -230 |
| 9300 | -420 | 90 | -330 |
Impact of Options Greeks:
Delta: Since we are initiating ATM options position, the Delta of call and put would be around 0.50.
-
8800 CE Delta @ 0.5, since we are short, the delta would be -0.5.
-
8800 PE Delta @-0.5, since we are short, the delta would be +0.5.
-
Combined delta would be -0.5+0.5=0.
Delta neutral in case of Short Straddle suggests profit is capped. If the underlying assets move significantly, the losses would be substantial.
Gamma: Gamma of the overall position would be Negative.
Vega: Short Straddle Strategy has a negative Vega. Therefore, one should initiate Short Straddle only when the volatility is high and expects to fall.
Theta: Time decay is the sole beneficiary for the Short Straddle trader given that other things remain constant. It is most effective when the underlying price expires around ATM strike price.
How to manage risk?
Since this strategy is exposed to unlimited risk, it is advisable not to carry overnight positions. Also, one should always strictly adhere to Stop Loss in order to restrict losses.
Analysis of Short Straddle Option Trading Strategy:
A Short Straddle Option Trading Strategy is the combination of short call and short put and it mainly profits from Theta i.e. time decay factor if the price of the security remains relatively stable. This strategy is not recommended for amateur/beginner traders, because the potential losses can be substantial and it requires advanced knowledge of trading.
Next Article
Bearish Options Trading strategies for Falling Markets
Bearish Option Trading strategy is best used when an options trader expects the underlying assets to fall. It is very important to determine how much the underlying price will move lower and the timeframe in which the rally will occur in order to select the best option strategy. The simplest way to make profit from falling prices using options is to buy put. However, buying put is not necessarily the best way to make money in moderately or mildly bearish markets. Following are the most popular strategies that can be used in different scenarios.
Extremely Bearish - Long Put
Moderately Bearish - Bear Put Spread
Long Put Options Trading
When should you initiate a Long Put Options Trade?
A Long Put strategy is best used when you expect the underlying asset to fall significantly in a relatively short period of time. It would still benefit if you expect the underlying asset to fall gradually. However, one should be aware of the time decay factor, because the time value of put will reduce over a period of time as you reach near expiry.
Why should you use Long Put?
This is a good strategy to use because the downside risk is limited only up to the premium/cost of the put you pay, no matter how much the underlying asset rises. It also gives you the flexibility to select the risk to reward ratio by choosing the strike price of the options contract you buy. In addition, Long Put can also be used as a hedging strategy if you want to protect an asset owned by you from a possible reduction in price.
| Strategy | Buy/Long Put Option |
|---|---|
| Market Outlook | Extremely Bearish |
| Breakeven at expiry | Strike price - Premium paid |
| Risk | Limited to premium paid |
| Reward | Unlimited |
| Margin required | No |
Let's try to understand with an example:
| Current Nifty Price | Rs 8200 |
| Strike price | Rs 8200 |
| Premium Paid (per share) | Rs 60 |
| BEP (Strike Price - Premium paid) | Rs 8140 |
| Lot size (in units) | 75 |
Suppose Nifty is trading at Rs 8200. A put option contract with a strike price of Rs 8200 is trading at Rs 60. If you expect that the price of Nifty will fall significantly in the coming weeks, and you paid Rs 4,500 (75*60) to purchase a single put option covering 75 shares.
As per expectation, if Nifty falls to Rs 8100 on options expiration date, then you can sell immediately in the open market for Rs 100 per share. As each option contract covers 75 shares, the total amount you will receive is Rs 7,500 (100*75). Since, you had paid Rs 4,500 (60*75) to purchase the put option, your net profit for the entire trade is therefore Rs 3,000. For the ease of understanding, we did not take into account commission 
How to manage risk?
A Long Put is a limited risk and unlimited reward strategy. So carrying overnight position is advisable but one can keep stop loss to restrict losses due to opposite movement in the underlying assets and also time value of money can play spoil sports if underlying assets doesn't move at all.
Conclusion:
A Long Put is a good strategy to use when you expect the security to fall significantly and quickly. It also limits the downside risk to the premium paid, whereas the potential return is unlimited if Nifty moves lower significantly. It is perfectly suitable for traders who don't have a huge capital to invest but could potentially make much bigger returns than investing the same amount directly in the underlying security.
Next Article
Difference Between In-The-Money (ITM), At-The-Money (ATM) And Out-The-Money (OTM) Call & Put Options?
An option premium consists of components, namely Intrinsic value and the Time value.
Option premium = Intrinsic value + Time value
| ITM | ATM | OTM | |
|---|---|---|---|
| INTRINSIC VALUE | YES | NO | NO |
| TIME VALUE | YES | YES | YES |
Intrinsic value: The Intrinsic value is the amount by which the strike price of an option is In-the-money. The Intrinsic value for call option will be the underlying stock's price minus its call strike price, whereas for the put option, it is the put strike price minus the underlying stock price. ATM and OTM options don't have any Intrinsic value.
Time Value: The Time value is also referred to as the Extrinsic value. It is the excess amount over and above an option's intrinsic value. Time value decreases to zero over time as the option moves closer to expiration. This circumstance is called as Time decay. Options premium depends on time to expiration. Options that would expire after a longer duration of time would be more expensive as compared to those expiring in the current month as the former would have more time value left, increasing the probability of trade going in your favour.
In-The-Money Call Option
An In-the-money call option is described as a call option whose strike price is less than the spot price of the underlying assets.
In the following example of Nifty, the In-the-money call option would be any strike price below Rs.8300 (spot price) of the stock (i.e. Strike price< Spot price).So, NIFTY FEB 8200 CALL would be the example of In-the-money call. An In-the-money option always has some Intrinsic value and Time value.
At-The-Money Call Option
An At-the-money call option is described as a call option whose strike price is approximately equal to spot price of the underlying assets (i.e. Strike price=Spot price). Hence, NIFTY FEB 8300 CALL would be an example of At-the-money call option, where the spot price is Rs 8300. An At-the-money call option doesn't have any Intrinsic value and it consists of only time value.
Out-The-Money Call Option
An Out-the-money call option is described as a call option whose strike price is higher than the spot price of the underlying assets(i.e. Strike price> Spot price).Thus, an Out-the-money call option's entire premium consists of Time value/Extrinsic value and it doesn't have any Intrinsic value. So, NIFTY FEB 8400 CALL would be an example of Out-the-money call option, where the spot price is Rs 8300.
| NIFTY (CALL OPTION) | Expiry: 23FEB2017 | SPOT PRICE: 8300 | ||
|---|---|---|---|---|
| STRIKE PRICE | STATUS | OPTION PRICE | INTRINSIC VALUE | TIME VALUE |
| 8000 | ITM | 330 | 300 | 30 |
| 8100 | ITM | 240 | 200 | 40 |
| 8200 | ITM | 160 | 100 | 60 |
| 8300 | ATM | 80 | 0 | 80 |
| 8400 | OTM | 60 | 0 | 60 |
| 8500 | OTM | 40 | 0 | 40 |
| 8600 | OTM | 30 | 0 | 30 |
In-the-money put option
An In-the-money put option is described as a put option whose strike price is higher than the current price of the underlying. An In-the-money option always has some Intrinsic value and Time value.
So, the In-the-money put option would be any strike price above Rs8300 (spot price) of the stock. And NIFTY FEB 8400 PUT would be the example of In-the-money put.
At-the-money put option
An At-the-money put option is described as a put option whose strike price is approximately equal to the spot price of the underlying assets. From the following example, NIFTY FEB 8300 PUT would be an example of At-the-money put option, where the spot price is Rs. 8300. An At-the-money put option doesn't have any Intrinsic value, it consists of only time value.
Out-the-money put option
An Out-the-money put option is described as a put option whose strike price is lower than the spot price of the underlying. Thus, an Out-the-money put option's entire premium consists of Time value / Extrinsic value and it doesn't have any Intrinsic value. So, NIFTY FEB 8200 PUT would be an example of Out-the-money put option.
| NIFTY ((PUT OPTION) | Expiry: 23FEB2017 | SPOT PRICE: 8300 | ||
|---|---|---|---|---|
| STRIKE PRICE | STATUS | OPTION PRICE | INTRINSIC VALUE | TIME VALUE |
| 8000 | OTM | 30 | 0 | 30 |
| 8100 | OTM | 40 | 0 | 40 |
| 8200 | OTM | 60 | 0 | 60 |
| 8300 | ATM | 80 | 0 | 80 |
| 8400 | OTM | 160 | 100 | 60 |
| 8500 | OTM | 240 | 200 | 40 |
| 8600 | OTM | 330 | 300 | 30 |
Next Article
What Is A Bear Put Spread Options Trading Strategy?
A Bear Put Spread strategy involves two put options with different strike prices but the same expiration date. Bear Put Spread is also considered as a cheaper alternative to long put because it involves selling of the put option to offset some of the cost of buying puts.
When To Initiate A Bear Put Spread Options Trading?
A Bear Put Spread strategy is used when the option trader thinks that the underlying assets will fall moderately in the near term. This strategy is basically used to reduce the upfront costs of premium, so that less investment of premium is required and it can also reduce the affect of time decay. Even beginners can apply this strategy when they expect security to fall moderately in near the term.
How To Construct The Bear Put Spread?
Buy 1 ITM/ATM Put
Sell 1 OTM Put
Bear Put Spread is implemented by buying In-the-Money or At-the-Money put option and simultaneously selling Out-The-Money put option of the same underlying security with the same expiry.
| Strategy | Buy 1 ITM/ATM put and Sell 1 OTM put |
|---|---|
| Market Outlook | Moderately Bearish |
| Breakeven at expiry | Strike price of buy put - Net Premium Paid |
| Risk | Limited to Net premium paid |
| Reward | Limited |
| Margin required | Yes |
Let's try to understand Bear Put Spread Options Trading with an example:
| Nifty current market price | Rs. 8100 |
| Buy ATM Put (Strike Price) | Rs 8100 |
| Premium Paid (per share) | Rs 60 |
| Sell OTM Put (Strike Price) | Rs 7900 |
| Premium Received | Rs 20 |
| Net Premium Paid | Rs 40 |
| Break Even Point (BEP) | Rs 8060 |
| Lot Size (in units) | 75 |
Suppose Nifty is trading at Rs 8100. If you believe that price will fall to Rs 7900 on or before the expiry, then you can buy At-the-Money put option contract with a strike price of Rs 8100, which is trading at Rs 60 and simultaneously sell Out-the-Money put option contract with a strike price of Rs 7900, which is trading at Rs 20. In this case, the contract covers 75 shares. So, you paid Rs 60 per share to purchase single put and simultaneously received Rs 20 by selling Rs 7900 put option. So, the overall net premium paid by you would be Rs 40.
So, as expected, if Nifty falls to Rs 7900 on or before option expiration date, then you can square off your position in the open market for Rs 160 by exiting from both legs of the trade. As each option contract covers 75 shares, the total amount you will receive is Rs 15,000 (200*75). Since, you had paid Rs 3,000 (40*75) to purchase the put option, your net profit for the entire trade is, therefore Rs 12,000 (15000-3000). For the ease of understanding, we did not take in to account commission charges.
Following is the payoff schedule assuming different scenarios of expiry.
The Payoff Schedule:
| On Expiry NIFTY closes at | Net Payoff from Put Buy (Rs) | Net Payoff from Put Sold (Rs) | Net Payoff (Rs) |
|---|---|---|---|
| 7500 | 540 | -380 | 160 |
| 7600 | 440 | -280 | 160 |
| 7700 | 340 | -180 | 160 |
| 7800 | 240 | -80 | 160 |
| 7900 | 140 | 20 | 160 |
| 8000 | 40 | 20 | 60 |
| 8100 | -60 | 20 | -40 |
| 8200 | -60 | 20 | -40 |
| 8300 | -60 | 20 | -40 |
| 8400 | -60 | 20 | -40 |
| 8500 | -60 | 20 | -40 |
| 8600 | -60 | 20 | -40 |
| 8700 | -60 | 20 | -40 |
Bear Put Spread's Payoff Chart:
The overall Delta of the bear put position will be negative, which indicates premiums will go up if the markets go down. The Gamma of the overall position would be positive. It is a long Vega strategy, which means if implied volatility increases; it will have a positive impact on the return, because of the high Vega of At-the-Money options. Theta of the position would be negative.
Analysis of Bear Put Spread strategy:
A Bear Put Spread strategy is best to use when an investor is moderately bearish because he or she will make the maximum profit only when the stock price falls to the lower (sold) strike. Also, your losses are limited if price increases unexpectedly higher.
How Does An Investor Make Money From An Equity Investment
Source: https://www.5paisa.com/blog/making-money-through-equity-investment
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