Chapter 5 Options

Options

An Option is a contract that gives the right, but not the obligation, to buy or sell the underlying asset on or before a stated date, at a stated price. The party taking a long position, i.e. buying the option is called buyer/holder of the Option and the party taking a Short position, i.e. selling the Option is called the seller/writer of the Option; the contract value and lots size are similar to Futures.

Types of Options

There are two types of Options:

• Call Option

• Put Option

Options, which give you a right to buy the underlying asset, are called Call Options. On the other hand, the Options that give you a right to sell the underlying asset are called Put Options.

Key features

Index Option

These Options have Index as the underlying asset. For example, options on Nifty, Sensex, Bank Nifty etc.

Stock Option

These Options have individual stocks as the underlying asset. Examples include Options on ONGC, NTPC, etc.

Buyer of an Option

The buyer of an Option has a right but not the obligation in the contract. For owning this right, you pay a price to the seller of this right, called ‘option premium’.

Writer of an Option

The writer of an Option receives the Option premium and is thereby obliged to sell the asset if the buyer of Option exercises his right.

Option Price/Premium

It is the price which you, as an Option buyer, pay to the Option seller.

Lot Size

Lot size is the number of units of underlying asset in a contract.

Expiration Day

This is the day on which a derivative contract ceases to exist. It is the last trading date of the contract. The expiration day of Nifty contracts is Aug 31, 2017 in the following example.

Spot Price

It is the price at which the underlying asset trades in the spot market. Underlying stock value of Nifty option was 9912 as on Aug 28, 2017.

Strike Price or Exercise Price

Strike price is the price per share for which the underlying security may be purchased or sold by the Option holder. For e.g. when underlying value of NIFTY is 9912, then prices of 9900 Call and 9900 Put is:

Open Interest

As discussed in futures section, Open Interest is the total number of Option contracts outstanding for an underlying asset.

Option Premium

Intrinsic Value

Option premium, consists of two components - intrinsic value and time value.

For an Option, intrinsic value refers to the amount by which an Option is in the money, i.e. the amount an Option buyer will realize, before adjusting for premium paid, if he exercises the Option instantly.

Therefore, only in-the-money Options have intrinsic value whereas at-the-money and out-of-the-money Options have zero intrinsic value. The intrinsic value of an Option can never be negative. Thus, for call Option, which is in-the-money, intrinsic value is the excess of spot price (S) over the exercise price (X).

Intrinsic value of a Call Option can be calculated as S-X, with a possible minimum value of zero because no one would like to exercise his right under no advantage condition. Similarly, for Put Option which is in-the-money, intrinsic value is the excess of exercise price (X) over the spot price (S). Thus, intrinsic value of Put Option can be calculated as X-S, with minimum possible value of zero.

Time Value

It is the difference between premium and intrinsic value, if any, of an Option. ATM and OTM Options will have only time value because the intrinsic value of such Options is zero.

Option Greeks

Delta

Delta measures the change in Option price for a unit change in the price of underlying. So if my delta is 0.46, it shows that for each unit increase/decrease in underlying, Option price will increase/decrease by 0.46.

Important points for Delta:

• Delta of Call Option is always positive and Delta of Put Option is always negative.

• When you buy Call Option, Delta is positive and when you sell Call Option, Delta is negative.

• When you buy Put Option, Delta is negative and when you sell Put Option, Delta is positive.

• Call Delta ranges from 0 to 1 and Put Delta ranges from 0 to -1

• Total of absolute value of call Delta and put Delta always comes to 1

Gamma

Gamma measures the change in Delta with respect to per unit change in underlying. If Gamma value is 0.0008, it shows that the next move in Delta will be 0.0008 if underlying changes by 1. So Gamma shows what will be the next change in Delta with respect of change in underlying.

Important points for Gamma:

• Gamma of Option is always positive.

• Gamma of Call and Put Option is same.

• Gamma is highest at ATM & decreases as Underlying moves away.

• Call Delta ranges from 0 to 1 and Put Delta ranges from 0 to -1

• Gamma of Future is 0.

Vega

Vega measures the change in Options price per unit change in volatility. A Vega value of 6.87 shows that for every unit increase in volatility, Option price will increase by 6.87. Thus, Vega shows effect of volatility on Option price.

Theta

Theta measures the change in Option price per day change in time to expiry. If Theta is -3.87, it signifies that for each day passing towards expiry, the Options price will decrease by 3.87.

Rho

Rho measures the change in Option price per unit change in interest rate. A Rho value of 2 shows that for every unit increase in interest rate, Option price will change by 2. Rho is inversely related to puts and directly related to calls.

In the Money (ITM) option

A Call Option is said to be ITM when spot price is higher than strike price. A Put Option is said to be ITM when spot price is lower than strike price.

For example, last traded price of different ITM Calls and Puts, when underlying Nifty is trading at 9912, are as follows:

At the Money (ATM) Option

At-The-Money is a situation where an Option’s strike price is same as the price of the underlying security. Both the Call and Put Options are simultaneously At-The-Money. At-The-Money Options have no intrinsic value, but it may still have time value.

Out of the Money (OTM) Option

Call Option is said to be OTM, when spot price is lower than strike price. And a Put Option is said to be OTM when spot price is higher than strike price.

For example, last traded price of different OTM Calls and Puts, when underlying Nifty is trading at 9912, are as follows:

Difference between ITM, ATM and OTM

Exercise of Options

In case of American option, buyers can exercise their Option any time before the maturity of contract. All these Options are exercised with respect to the settlement value/closing price of the stock on the day of exercise of Option.

Payoff Diagram

Long Call Payoff

On Aug 28, 2017, Nifty was trading at 9912. Assume that you buy a Call Option with strike price of 9900 at a premium of Rs. 52 with expiry date Aug 31, 2017.

Scenario Analysis at various expiry levels:

Long Put Payoff

On Aug 28, 2017, Nifty is at 9912. Assume that you buy a Put Option with strike price of 9900 at a premium of Rs.34 with expiry date Aug 31, 2017.

Scenario Analysis at various expiry levels:

Opening a Position

An opening transaction is one that adds or creates a new trading position. It can be either a purchase or a sale. With respect to an Option transaction, we will consider both:

• Opening purchase – This is done with the purchasing intention of creating or increasing a long position in a given series of Options.

• Opening sale – This is done with the selling intention of creating or increasing a Short position in a given series of Options.

Closing a Position

A Closing transaction is one that reduces or eliminates an existing position by an appropriate offsetting purchase or sale. This is also known as “squaring off” your position. With respect to an Option transaction:

• Closing purchase – This is done with the purchasing intention of reducing or eliminating a short position in a given series of Options. This transaction is frequently referred to as “covering” a short position.

• Closing sale – This is done with the selling intention of reducing or eliminating a long position in a given series of Options.

You cannot close out a long call position by purchasing a Put or any other similar transaction. A closing transaction for an Option involves the sale of an Option contract with the same terms.

Leverage

You, as an Option buyer, pay a relatively small premium for market exposure in relation to the contract value. This is known as Leverage. You can see large percentage gains from comparatively small, favorable percentage moves in the underlying equity. Leverage also has downside implications. If the underlying price does not rise/falls during the lifetime of the Option, Leverage can magnify your percentage loss.

A Long Option position has limited risk (premium paid) and unlimited profit potential. A Short Option position has unlimited downside risk, but limited upside potential (to the extent of premium received).

Option Trading Strategies

Option Strategies

Options trading, in particular, has many advantages and there are plenty of reasons why this form of trading is worthy of consideration for anyone looking to trade in the market ,even if it is slightly more complex subject to learn than direct equity trading.

We will look at some of the benefits of for trading in the options market and why it is can be such a good idea.

Leverage

One of the primary reasons for trading in the options markets is the benefit of leverage that a trader receives. It is possible to make significant profits without necessarily having large sums of cash. In simple terms we can make use of leverage to get more trading power from the capital we have.

Risk & Reward

Options trading can offer a much better risk versus reward ratio if the right trading strategies are employed. Through the wide range of option strategies we place different orders and limit our risk, which may not be possible by simply buying and selling stocks. As we learn about the various options strategies in the following section we will understand the power of the tool when it comes to handling risk.

Flexibility & Versatility

One of the most appealing elements of options is the flexibility that they offer. When we trade in the cash market there are limitations involved, we can either buy the stock or sell its. But in the options market there are trading strategies based on the prevailing situation and trend in the market.

• Bullish Option Strategies
• Bearish Option Strategies
• Neutral Option Strategies
• Volatility Option Strategies

Key Takeaways

• There are two types of Options - Call Option and Put Option.

• Call Option is bought when view is bullish.

• Put Option is bought when view is bearish.

• Buyer of Option pays the Option premium.

• Writer of the Option receives the Option premium.

• Only ITM Options have intrinsic value.

• Time value is the difference between premium and intrinsic value.

• Delta measures the change in Option price for a unit change in the price of underlying.

• Gamma measures the change in Delta with respect to per unit change in underlying.

• Vega measures the change in Options price per unit change in volatility.

• Theta measures the change in Option price per day change in time to expiry.

• Rho measures the change in Option price per unit change in interest rate.

• All option strategies use basic Call and Put Options.