Low risk options

GUEST COLUMN

Call 70 Buy

       4100

Put25Buy  What is a Gut? A Gut is also created by either buying or selling, a call and a put option. When we create this position by buying options, we create the Long Gut and by selling options, we create the Short Gut.  The Put option has a higher strike price than the Call option. Table 2 and Chart 2 explain the pay off of a Nifty Long Gut. The total premium outlay is Rs 147.85 + Rs 53.6 = Rs 201.45. The breakeven points are 3937 and 4312. 
 

TABLE 2 LONG GUT
Strike Price	Option type	Price	Buy/Sell
4100	Call	147.85	Buy
4200	Put	53.6	Buy

 The biggest difference between the two strategies is that, in a Strangle, the premium outlay is lesser than that in a Gut. In a Long Strangle, a person buys two out-of-money options whereas in a Gut both the options are in-the-money.  Secondly, the maximum loss in case of a Long Strangle is limited to the total premium paid: Rs 95 in our example. But in the case of a Long Gut, the maximum loss is the total premium paid less the difference between the two strike prices.  In our example, the premium paid is Rs 201.45 and the difference between the strike prices is 100 which ensures that the maximum loss cannot exceed Rs 101.45.  THE STRATEGY
On doing a comparative analysis of the examples above we see that the Strangles can be created with an outlay of Rs 95 with a no-profit range of 4004-4295.  Similarly, the Gut can be created with an outlay of Rs 201.45 with a no-profit range of 3937 - 4312. The no-profit range for both the strategies is almost the same but the premium outlay is not. 
 

TABLE 3        LONG STRANGLE- SHORT GUT           TABLE 5
Strike  Price	Option  type	Price	Buy/Sell
4100	Call	147.85	Sell	Short Gut
4200	Put	53.6	Sell
4200	Call	70	Buy	Long Strangle
4100	Put	25	Buy
3900	Call	331	Sell	Short Gut
4250	Put	77.5	Sell
4200	Call	78.2	Buy	Long Strangle
4100	Put	25.85	Buy

 Thus, we would try to construct a more complex strategy by opening a trading position that is a combination of both these strategies. The idea is to sell the Gut and go long on the Strangle. Table 3, Table 4 and Chart 3 detail the pay off of this new structure.  We have created a strategy that gives a risk-free gain of Rs 6.45 for the given combination of a Gut and a Strangle. This is a classic arbitrage situation where we have been able to exploit the inefficiencies in the market to the advantage of the trader. 
 

TABLE 4  PAY OFF OF DIFFERENT OPTIONS AT A GIVEN SETTLEMENT PRICE
Close Price	Sell Call  4100	Sell Put  4200	Gut  Pay off	Buy Call  4200	Buy Put 4100	Strangle  Pay Off	Gain
3735	147.85	-411.4	-263.55	-70	340	270	6.45
3768.2	147.85	-378.2	-230.35	-70	306.8	236.8	6.45
3801.4	147.85	-345	-197.15	-70	273.6	203.6	6.45
3834.6	147.85	-311.8	-163.95	-70	240.4	170.4	6.45
3867.8	147.85	-278.6	-130.75	-70	207.2	137.2	6.45
3901	147.85	-245.4	-97.55	-70	174	104	6.45
3934.2	147.85	-212.2	-64.35	-70	140.8	70.8	6.45
3967.4	147.85	-179	-31.15	-70	107.6	37.6	6.45
4000.6	147.85	-145.8	2.05	-70	74.4	4.4	6.45
4033.8	147.85	-112.6	35.25	-70	41.2	-28.8	6.45
4067	147.85	-79.4	68.45	-70	8	-62	6.45
4100.2	147.65	-46.2	101.45	-70	-25	-95	6.45
4133.4	114.45	-13	101.45	-70	-25	-95	6.45
4166.6	81.25	20.2	101.45	-70	-25	-95	6.45
4199.8	48.05	53.4	101.45	-70	-25	-95	6.45
4233	14.85	53.6	68.45	-37	-25	-62	6.45
4266.2	-18.35	53.6	35.25	-3.8	-25	-28.8	6.45
4299.4	-51.55	53.6	2.05	29.4	-25	4.4	6.45
4332.6	-84.75	53.6	-31.15	62.6	-25	37.6	6.45
4365.8	-117.95	53.6	-64.35	95.8	-25	70.8	6.45
4399	-151.15	53.6	-97.55	129	-25	104	6.45
4432.2	-184.35	53.6	-130.75	162.2	-25	137.2	6.45

 Another combination of a Long Strangle and a Short Gut that would give a low risk return is mentioned below in Table 5 and Chart 4. The maximum loss here is Rs 45.55 and maximum gain is Rs 154.45, resulting in a risk-reward ratio of 1: 3.  Conclusion
The markets do not price the instruments fairly and there is always a possibility of arbitrage. A combination of Strangles and Guts can be used to exploit these opportunities. Depending on the inefficiencies prevailing in the market, a trader can earn risk-less returns.  In our analysis, we have ignored the brokerage, fees, the cost of capital and any other trading costs. These costs can change the pay-off profiles to the extent that the positions might not result in a positive pay-off.  However, this approach can be very useful for the in-house trading desk of Financial Institutions and Banks.  Note: All derivative prices are used for the NIFTY as on 18th May 2007 and can be downloaded from www.nseindia.com