What are Options

Options are one of the most popular derivatives. There are highly leveraged instruments.
They can be used for hedging, speculation and arbitrage. Options derive their value from the underlying stocks, index, forex or other forms of assets.
An option is in simple terms a contract entered into two parties i.e.
a) buyer and
b) seller
In options, buyer is also called as holder and seller is called as writer.
The buyer/holder of options contract is granted a privilege to buy or sell a security at a specific price for a specific period.
The seller/writer of options contract assumes obligation to buy or sell a security at a specific price for a specific period. In futures, buyers and sellers both have the rights as well
obligations to buy or sell the security.

In options, buyer of options has rights but no obligations to honour his contract and seller has only obligations and no rights to honour his commitment. This is the main difference between futures and options. In options, buyer has a right to buy or sell a security and he has got an option to exercise his right or leave it. Hence the name “option”. As the price of the security keeps on fluctuating during the
life of an option, there is a risk for the seller. Hence the
buyer pays the seller a fee for granting this privilege. This is
called premium.

What is Moneyness

Depending on the relationship between the strike price and current spot price, there are three types of options available.

  • In - The - Money Option = Strike <>

When strike price is less than the spot price of the underlying, then call option is said to be in the money option.
Difference between the spot price and the strike price creates intrinsic value.
When exercising of call option at the strike price (without premium) creates an intrinsic value, the option is said to be In The Money.
For Instance. Call options, if spot price is 3000, then strike prices of 2950 and 2900 are provide In The Money Options, where intrinsic value is Rs 50 & Rs.1000 respectively.

  • At - The - Money Option = Strike = Spot

When the strike price is equal to or near to the spot price, then there is no intrinsic value.
Exercising at this price creates neither profit nor loss. This option is said to be At The Money Option.
At spot price of Rs 3000 and the strike price also at Rs.3000, the option is said to be At The Money option.

  • Out - Of - The Money Option = Strike > Spot
When the strike price is more than the spot price, then there is no intrinsic value and exercising of call option at the strike price, would result in a loss. Hence the option is said to be Out Of The Money Options.
For call option, if spot price is 3000, then strike price of 3050 and 3100 provide the Out Of The Money Options. Now for the same strike prices, positions would be reversed for put options.
The positions, which are In The Money for call options, shall be Out Of The Money for Put ptions and vice versa.

What is a Premium

Premium is the fee paid by the option buyer to option seller for granting him privileged of the right of exercising an option. Option premium is always positive. When things go bad, premium hover around zero. When things go well, premium can be very large. Premium can never be negative.

Premium = Intrinsic Value (I) + Time Value (T)

Intrinsic value
= The difference between Strike Price and Spot Price. Only, In The Money Options have Intrinsic value. At The Money and Out Of The Money Options intrinsic value is
zero. It is never negative.

Time Value :

This is also known as extrinsic value. The is quantification of the probability of the change in the
underlying price during the remaining life of the Option. This value is function of two factors.

  • Time left for expiry.
  • Volatility of the underlying.

What is European & Americian Option

Assignment of Option: When a buyer selects to exercise his option, then who should be
asked to honor the contract?
In European options,
All options are exercised on last day of option. Hence Buyers and Sellers are matched and there is no question of assignment.
In American options,
Here Buyers can exercise option anytime during life of option. Now who from the Sellers, should be asked to honor the contract. Some Exchanges follow random assignment while some Exchanges follow First In First out Principle (FIFO).

SETTLEMENTS OF OPTIONS:
1. Some contracts are delivery based option contracts, which result in delivery after exercising of contract.
2. Some contracts are non- delivery based. These are cash settled i.e. that settlement takes place only in cash, by squaring up your position with spot price at the expiry.

Risks and Returns in Options

Risks and returns in options are asymmetric, unlike in futures.
Option Buyer : He has limited risk, only to the extent of the option premium, whereas the profits can be limited.
Option Seller : He has limited profit, only to the extent of the option premium, whereas his risk can be unlimited.

Fixing Of Strike prices

In Options, stock Exchanges fix the strike price. At any given time there are 4-5 strike prices for any option.
Some of them In The Money, some of them Out Of The Money and one In The Money Option.
For instance if spot price is 3000, then strike prices are 2900, 2950, 3000, 3050, 3100.
Here two options are in the money, two out of the money and one near the money. Now if the spot price suddenly rises to 3125, then Stock Exchange introduces a strike price of 3150, so that at least one out of the money contract is available for call buyer.

What is basic pricing of options

Pricing of options means pricing of premiums. How premiums are fixed? What are the factors that go into building up of premium?
Option premium is also known as Option price or option value. It should be clear that, once we have a strike price, it is constant, we trade in the market is option premium. Like any
price, option premium is also governed by forces of demand and supply.
What are basis determinants of option pricing ?

  • Spot price of underlying
  • Strike Price
  • Volatility of the underlying
  • Time left for expiration
  • Interest rates

Option Derivatives for Greeks

OPTION DERIVATIVES FOR GREEKS
Option premiums keep on moving. The measures of
sensitivity of the option premiums are called Option
Derivatives or Option Greeks.
They are :
• Delta
• Gamma
• Vega
• Theta

Options Trading : Buy Calls / Sell Calls / Buy Puts / Sell Puts

OPTIONS TRADING
There can be four basic types of transaction in options.

  • Buy Calls
  • Sell Calls
  • Buy Puts
  • Sell Puts

1)Buy Calls
Outlook – Bullish
Risk –only to the extent of the premium
Rewards are unlimited.

2) Sell Calls
Outlook – neutral to Bearish
Risk –unlimited
Reward –only to the extent of the premium

3) Buy Puts
Outlook – Bearish
Risk – only to the extent of the premium
Reward – substantial (lower price 0 cap)

4) Sell Puts
Outlook – neutral to Bullish
Risk – substantial
Reward –only to the extent of the premium)

Relation Between Calls & Puts

What are Option Spreads

Option spreads is one such strategy. It means, taking position in two or more options of the
same type (call or put) on the same underlying.
Types of Spreads:
• Vertical Spreads
• Horizontal Spreads or Time Spreads
• Diagonal Spreads
A) Vertical Spreads
It is an option spread, where you may buy a call with another strike price with same expiration period. Here you are using Different strike prices with same expirations.
Bullish Vertical Spreads :
Here you buy lower strike price options and sell higher strike price options.
Bullish vertical Spreads using calls.
Buy lower strike price calls and sell higher strike price calls. We are buying lower strike price calls, which are costlier, i.e. premiums are higher and we are selling higher strike price
calls, where premium are lower.
Hence in this spread there would be net outflows of premium or net debit. This is a net debit strategy. Net debit and credit is the terms used in options, just to define that the net premium in a spread is payable or receivable.


Bullish Vertical Spread using puts:


  • Buy lower strike puts
  • Sell higher strike puts.

As lower strike price put premium is lower than higher strike price put, you will receive net premium and hence this is a net credit strategy.


Bearish Vertical Spreads :

Here you buy high strike options and sell low strike options.

B) Horizontal or Time spreads
Horizontal or time spread is established by taking two opposite positions in two call (or put) options, at the same strike price but with different expiry months.
In this strategy, outlook is stable. Trader expects to gain from the declining time value of options. The concept of time value of options declining at an accelerated pace with approaching expiry, works for the tracker.


C) Diagonal Spreads

Here two legs of the spread, have different strike prices and also different expiry months. This combines features of both vertical and horizontal spreads.

This spread may be used to create a bullish spread or a bearish spread.

Bullish diagonal spread using calls:

  • Buy call with low strike and long term expiry.
  • Sell call with higher strike and short term expiry.

Without different expiry periods, this is exactly a vertical bullish spread. Different expiry periods add a dimension of horizontal spread.

Types Of Options Spreads

  • Straddles
  • Strangles
  • Ratio Call writing
  • Butterfly Spreads
  • Strip Strategy

What is Straddle

Anticipate Volatility
When you are uncertain about the market, but expect a lot of volatility, then buying straddle is one of the strategies.

Typical example of this type of situation is around budget time, where a lot of volatility is certain, but the direction of the market is uncertain.

Straddle involves buying or selling combination of one call and one put at the same strike price and the same expiry. This is normally done at At-the-money or near – the – money strike prices.

Long straddle :
Here buy one Call (At-the-money ) and buy one Put (At-the-money )

Short Straddle: Anticipate Stability
Here one call and one put are sold at the strike price, which is at-the-money for the same expiryWhat is Strangle

Strangle is a modified version of straddle. Here buying or selling of a call and a put is done at
different strike prices, but with the same expiry. Position is generally taken at Out-of-the money strikes for both call and put. Here also the outlook is uncertain but volatile.
Long Strangle:
Buy One Out-of-the money Call & Buy One Out-of-the money Put.
Strangle is the extension of straddle position, which is taken in a more aggressive way. It is aggressive because both the options are out-of-the- money. Thus this strangle comes cheap, as premiums are low. However, no profit zone in this strategy is a little wider.

Short Strangle :
Here one call and one put are sold at different strike prices, but with the same expiry. Positions are generally taken out-of-the- money strikes. Strangle seller assumes stability and that the price will remain in a particular zone.

What is Butterfly Spread

To establish a butterfly spread, you take the positions in four options and at three strikes. Outlook of the buyer is stable.

Long Butterfly spread:
Buy one call at lower strike , sell two calls at middle strike and buy one call at higher strike.
Actually it is a combination of a vertical bullish spread and a vertical bearish spread.
The positions can be established either with only calls or only puts.
Assume January RPL calls at :

  • Strike 90 @ 13
  • Strike 100 @ 7
  • Strike 110 @ 1
  1. Buy one call at 90, premium Rs.13
  2. Sell two calls at 100, premium Rs.7
  3. Buy one call at 110, premium Rs.4

Net premium = -13+14-4 =-3
Net debit = -3

Maximum loss in this spread can be Rs.3, premium paid, below
Rs. 90 and above Rs.110 spot expiry.
Maximum profit is Rs.7 at Rs. 100 expiry


Short Butterfly spread: Here outlook is volatile.

  1. Sell one call at lower strike.
  2. Buy two calls at middle strike
  3. Sell one call at higher strike.


If we take the same figures as in long butterfly spread then, the butterfly spread seller will make a profit of Rs.3,below Rs.90 and above Rs.110 spot expiry. He will incur a loss of Rs.7 at Rs. 100 spot expiry.

What is Strip & Strap Strategy

Strip Strategy:

It is an extension of Straddle. If straddle we assume volatility, but uncertain outlook, i.e. we do not know which side market will go. Here the trader still assumes same things; however he has a little downwards bias.
So instead of buying one call and one put, he buys one call and two puts.

Strap strategy :

Here also Straddle buyer assumes the same outlook, but has a little upward bias. So instead of buying one call and one put, he buys two calls and one put.

Strategy For Future Option Players

RPL ( Bse Cmp 74.50 ) - Lot size 1675
1) Buy (1 lot) Call option RPL of December Month Strike Price 75 @ 4.05 Rs
Premium Paid = 1675 * 4.05 = 6783.75 Rs
2) Sell ( 1 lot ) Call Option RPL of December Month Strike Price 85 @ 1.05
Premium Received = 1675 * 1.05 = 1758.75

Net Premium Paid = Maximum Loss in this strategy.
Net Premium = 6783.75-1758.75 = 5025
Maximum Profit from the strategy.
Call Option bought at 75+4.05 = 79.05
Call Option sold at 85 + 1.05 = 86.05
Maximum Profit = ( 86.05 -79.05 ) * lot size= 7 * 1675= 11725
Breakeven = 75+4.05-1.05 = 78.05

Note : RPL is looking good for short term delivery. Buy at cmp for target 80-83.50-86.75. In the above strategy maximum profit will be earned if RPL moves up till expiry. All the rates above are without brokerages, so net profit / loss will vary accordingly.
Risk Reduced = Sell ( 1 lot) option call of Strike Price 80@ 2.15 instead of Strike Price 85. But in this case the profits will also be reduced accordingly.

Covered Strategy for Future Option players

Cairns Ind ( Nse Fut 150.90 ) - Lot size 1250
1)Buy (1 lot) Fut Cairns of December Month @ 150.90 Rs
Approx. Margin Paid = 150.90 *1250 *15% = 28293.75 Rs
2)Sell ( 1 lot ) Call Option Cairns of December Month Strike Price 150 @ 8.95
Premium Received = 1250 * 8 = 11187.50 Rs

Net Margin Paid = 28293.75 - 11185.70 = 17106.25 Rs
Maximum Profit in this strategy = Net Premium received = 11187.50 Rs
Loss from the strategy = Fut Buy Rate - Call Premium = 150.90-141.95 = 141.95
* Imp : In this strategy no loss till Cairns falls below 141.95.

Breakeven = 141.95

Note : Cairns Ind is looking good for short term delivery. Buy at cmp for target 160-177-184 for short term. In the above strategy maximum profit will be earned if Cairns moves up till expiry. Also no loss till 141.95. All the rates above are without brokerages, so net profit / loss will vary accordingly.