Search  Options Basics

Options: Is it just Another Derivative Options on stocks were first traded on an organised stock exchange in 1973. Since then there has been extensive work on these instruments and manifold growth in the field has taken the world markets by storm. This financial innovation is present in cases of stocks, stock indices, foreign currencies, debt instruments, commodities, and futures contracts. Terminology Call Options Put Options Market players Options undertakings Options Classifications OPTIONS PRICING TRADING STRATEGIES SPREADS Terminology Options are of two basic types: The Call and the Put Option A call option gives the holder the right to buy an underlying asset by a certain date for a certain price. The seller is under an obligation to fulfill the contract and is paid a price of this which is called "the call option premium or call option price". A put option, on the other hand gives the holder the right to sell an underlying asset by a certain date for a certain price. The buyer is under an obligation to fulfill the contract and is paid a price for this, which is called "the put option premium or put option price". The price at which the underlying asset would be bought in the future at a particular date is the "Strike Price" or the "Exercise Price". The date on the options contract is called the "Exercise date", "Expiration Date" or the "Date of Maturity". There are two kind of options based on the date. The first is the European Option which can be exercised only on the maturity date. The second is the American Option which can be exercised before or on the maturity date. In most exchanges the options trading starts with European Options as they are easy to execute and keep track of. This is the case in the BSE and the NSE Cash settled options are those where, on exercise the buyer is paid the difference between stock price and exercise price (call) or between exercise price and stock price (put). Delivery settled options are those where the buyer takes delivery of undertaking (calls) or offers delivery of the undertaking (puts). Top Call Options The following example would clarify the basics on Call Options. Illustration 1: An investor buys one European Call option on one share of Reliance Petroleum at a premium of Rs. 2 per share on 31 July . The strike price is Rs.60 and the contract matures on 30 September . The payoffs for the investor on the basis of fluctuating spot prices at any time are shown by the payoff table (Table 1). It may be clear form the graph that even in the worst case scenario, the investor would only lose a maximum of Rs.2 per share which he/she had paid for the premium. The upside to it has an unlimited profits opportunity. On the other hand the seller of the call option has a payoff chart completely reverse of the call options buyer. The maximum loss that he can have is unlimited though a profit of Rs.2 per share would be made on the premium payment by the buyer.

Payoff from Call Buying/Long (Rs.) S Xt c Payoff Net Profit 57 60 2 0 -2 58 60 2 0 -2 59 60 2 0 -2 60 60 2 0 -2 61 60 2 1 -1 62 60 2 2 0 63 60 2 3 1 64 60 2 4 2 65 60 2 5 3 66 60 2 6 4

A European call option gives the following payoff to the investor: max (S - Xt, 0). The seller gets a payoff of: -max (S - Xt,0) or min (Xt - S, 0). Notes: S - Stock Price Xt - Exercise Price at time 't' C - European Call Option Premium Payoff - Max (S - Xt, O )

Graph

Net Profit - Payoff minus 'c'

Exercising the Call Option and what are its implications for the Buyer and the Seller? The Call option gives the buyer a right to buy the requisite shares on a specific date at a specific price. This puts the seller under the obligation to sell the shares on that specific date and specific price. The Call Buyer exercises his option only when he/ she feels it is profitable. This Process is called "Exercising the Option". This leads us to the fact that if the spot price is lower than the strike price then it might be profitable for the investor to buy the share in the open market and forgo the premium paid. The implications for a buyer are that it is his/her decision whether to exercise the option or not. In case the investor expects prices to rise far above the strike price in the future then he/she would surely be interested in buying call options. On the other hand, if the seller feels that his shares are not giving the desired returns and they are not going to perform any better in the future, a premium can be charged and returns from selling the call option can be used to make up for the desired returns. At the end of the options contract there is an exchange of the underlying asset. In the real world, most of the deals are closed with another counter or reverse deal. There is no requirement to exchange the underlying assets then as the investor gets out of the contract just before its expiry. Top Put Options The European Put Option is the reverse of the call option deal. Here, there is a contract to sell a particular number of underlying assets on a particular date at a specific price. An example would help understand the situation a little better: Illustration 2: An investor buys one European Put Option on one share of Reliance Petroleum at a premium of Rs. 2 per share on 31 July. The strike price is Rs.60 and the contract matures on 30 September. The payoff table shows the fluctuations of net profit with a change in the spot price.

Payoff from Put Buying/Long (Rs.) S Xt p Payoff Net Profit 55 60 2 5 3 56 60 2 4 2 57 60 2 3 1 58 60 2 2 0 59 60 2 1 -1 60 60 2 0 -2 61 60 2 0 -2 62 60 2 0 -2 63 60 2 0 -2 64 60 2 0 -2

The payoff for the put buyer is :max (Xt - S, 0) The payoff for a put writer is : -max(Xt - S, 0) or min(S - Xt, 0)

Graph

These are the two basic options that form the whole gamut of transactions in the options trading. These in combination with other derivatives creat a whole world of instruments to choose form depending on the kind of requirement and the kind of market expectations. Exotic Options are often mistaken to be another kind of option. They are nothing but non-standard derivatives and are not a third type of option. Top Market players Hedgers: The objective of these kind of traders is to reduce the risk. They are not in the derivatives market to make profits. They are in it to safeguard their existing positions. Apart from equity markets, hedging is common in the foreign exchange markets where fluctuations in the exchange rate have to be taken care of in the foreign currency transactions or could be in the commodities market where spiraling oil prices have to be tamed using the security in derivative instruments. Speculators: They are traders with a view and objective of making profits. They are willing to take risks and they bet upon whether the markets would go up or come down. Arbitrageurs: Riskless Profit Making is the prime goal of Arbitrageurs. Buying in one market and selling in another, buying two products in the same market are common. They could be making money even without putting there own money in and such opportunities often come up in the market but last for very short timeframes. This is because as soon as the situation arises arbitrageurs take advantage and demand-supply forces drive the markets back to normal. Top Options undertakings a Stocks a Foreign Currencies a Stock Indices a Commodities a Others - Futures Options, are options on the futures contracts or underlying assets are futures contracts. The futures contract generally matures shortly after the options expiration Top Options Classifications Options are often classified as In the money - These result in a positive cash flow towards the investor At the money - These result in a zero-cash flow to the investor Out of money - These result in a negative cash flow for the investor Example: Calls Reliance 350 Stock Series Naked Options: These are options which are not combined with an offsetting contract to cover the existing positions. Covered Options: These are option contracts in which the shares are already owned by an investor (in case of covered call options) and in case the option is exercised then the offsetting of the deal can be done by selling these shares held. Top OPTIONS PRICING Prices of options are commonly depend upon six factors. Unlike futures which derives there prices primarily from prices of the undertaking. Option's prices are far more complex. The table below helps understand the affect of each of these factors and gives a broad picture of option pricing keeping all other factors constant. The table presents the case of European as well as American Options. EFFECT OF INCREASE IN THE RELEVANT PARAMETRE ON OPTION PRICES

EUROPEAN OPTIONS Buying AMERICAN OPTIONS Buying PARAMETERS CALL PUT CALL PUT Spot Price (S) Strike Price (Xt) Time to Expiration (T) ? ? Volatility () Risk Free Interest Rates (r) Dividends (D)

Favourable   Unfavourable

SPOT PRICES: In case of a call option the payoff for the buyer is max(S - Xt, 0) therefore, more the Spot Price more is the payoff and it is favourable for the buyer. It is the other way round for the seller, more the Spot Price higher are the chances of his going into a loss. In case of a put Option, the payoff for the buyer is max(Xt - S, 0) therefore, more the Spot Price more are the chances of going into a loss. It is the reverse for Put Writing. STRIKE PRICE: In case of a call option the payoff for the buyer is shown above. As per this relationship a higher strike price would reduce the profits for the holder of the call option. TIME TO EXPIRATION: More the time to Expiration more favourable is the option. This can only exist in case of American option as in case of European Options the Options Contract matures only on the Date of Maturity. VOLATILITY: More the volatility, higher is the probability of the option generating higher returns to the buyer. The downside in both the cases of call and put is fixed but the gains can be unlimited. If the price falls heavily in case of a call buyer then the maximum that he loses is the premium paid and nothing more than that. More so he/ she can buy the same shares form the spot market at a lower price. Similar is the case of the put option buyer. The table show all effects on the buyer side of the contract. RISK FREE RATE OF INTEREST: In reality the r and the stock market is inversely related. But theoretically speaking, when all other variables are fixed and interest rate increases this leads to a double effect: Increase in expected growth rate of stock prices Discounting factor increases making the price fall In case of the put option both these factors increase and lead to a decline in the put value. A higher expected growth leads to a higher price taking the buyer to the position of loss in the payoff chart. The discounting factor increases and the future value becomes lesser. In case of a call option these effects work in the opposite direction. The first effect is positive as at a higher value in the future the call option would be exercised and would give a profit. The second affect is negative as is that of discounting. The first effect is far more dominant than the second one, and the overall effect is favourable on the call option. DIVIDENDS: When dividends are announced then the stock prices on ex-dividend are reduced. This is favourable for the put option and unfavourable for the call option.

Top

TRADING STRATEGIES

Single Option and Stock

These strategies involve using an option along with a position in a stock.

Strategy 1:

A Covered Call: A long position in stock and short position in a call option.

Illustration : An investor enters into writing a call option on one share of Rel. Petrol. At a strike price of Rs.60 and a premium of Rs.6 per share. The maturity date is two months form now and along with this option he/she buys a share of Rel.Petrol. in the spot market at Rs. 58 per share.

By this the investor covers the position that he got in on the call option contract and if the investor has to fulfill his/her obligation on the call option then can fulfill it using the Rel.Petrol. share on which he/she entered into a long contract. The payoff table below shows the Net Profit the investor would make on such a deal.

Strategy 2:

Reverse of Covered Call: This strategy is the reverse of writing a covered call. It is applied by taking a long position or buying a call option and selling the stocks.

Illustration :

An investor enters into buying a call option on one share of Rel. Petrol. At a strike price of Rs.60 and a premium of Rs.6 per share. The maturity date is two months from now and along with this option he/she sells a share of Rel.Petrol. in the spot market at Rs. 58 per share.

The payoff chart describes the payoff of buying the call option at the various spot rates and the profit from selling the share at Rs.58 per share at various spot prices. The net profit is shown by the thick line.

Strategy 3:

Protective Put Strategy:

This strategy involves a long position in a stock and long position in a put. It is a protective strategy reducing the downside heavily and much lower than the premium paid to buy the put option. The upside is unlimited and arises after the price rises high above the strike price.

Illustration 5:

An investor enters into buying a put option on one share of Rel. Petrol. At a strike price of Rs.60 and a premium of Rs.6 per share. The maturity date is two months from now and alongwith this option he/she buys a share of Rel.Petrol. in the spot market at Rs. 58 per share.

This strategy is just the reverse of the above and looks at the case of taking short positions on the tock as well as on the put option.

Illustration 6:

An investor enters into selling a put option on one share of Rel. Petrol. At a strike price of Rs.60 and a premium of Rs.6 per share. The maturity date is two months from now and alongwith this option he/she sells a share of Rel.Petrol. in the spot market at Rs. 58 per share.

All the four cases describe a single option with a position in a stock. Some of these cases look similar to each other and these can be explained by Put-Call Parity.

Put Call Parity

P + S = c + Xe^-r(T-t) + D ---------------------- (1)

Or

S - c = Xe^-r(T-t) + D - p ---------------------- (2)

The second equation shows that a long position in a stock and a short position in a call is equivalent to the short put position and cash equivalent to Xe^-r(T-t) + D.

The first equation shows a long position in a stock combined with long put position is equivalent to a long call position plus cash equivalent to Xe^-r(T-t) + D.

The above involved positions in a single option and squaring them off in the spot market. The spreads are a little different. They involve using two or more options of the same type in the transaction.

The investor expects prices to increase in the future. This makes him purchase a call option at X1 and sell a call option on the same stock at X2, where X1<X2.

Using an illustration it would be clear how this is put to use.

Illustration

An investor purchases a call option on the BSE Sensex at premium of Rs.450 for a strike price at 4300. The investor squares this off with a sell call option at Rs. 400 for a strike price at 4500. The contracts mature on the same date. The payoff chart below describes the net profit that one earns on the buy call option, sell call option and both contracts together.

The premium on call with X1 would be more than the premium on call with X2. This is because as the strike price rises the call option becomes unfavourable for the buyer. The payoffs could be generalised as follows.

The features of the Bull Spread:

• This requires an initial investment.
• This reduces both the upside as well as the downside potential.

The spread could be in the money, on the money and out of money.

Another side of the Bull Spread is that on the Put Side. Buy at a low strike price and sell the same stock put at a higher strike price.

This contract would involve an initial cash inflows unlike the Bull Spread based on the Call Options. The premium on the low strike put option would be lower than the premium on the higher strike put option as more the strike price more is favourability to buy the put option on the part of the buyer.

Illustration

An investor purchases a put option on the BSE Sensex at premium of Rs.50 for a strike price at 4300. The investor squares this off with a sell put option at Rs. 100 for a strike price at 4500. The contracts mature on the same date. The payoff chart below describes the net profit that one earns on the buy put option, sell put option and both contracts together.

Top