OPTIONS

An option is a contract that gives the buyer the right, but not the obligation, to buy or sell
an underlying asset at a specific price on or before a certain date. An option, just like a
stock or bond, is a security. It is also a binding contract with strictly defined terms and
properties.
The idea behind an option is present in many everyday situations. Say, for example,
that you discover a house that you'd love to purchase. Unfortunately, you won't have the
cash to buy it for another three months. You talk to the owner and negotiate a deal that
gives you an option to buy the house in three months for a price of $200,000. The
owner agrees, but for this option, you pay a price of $3,000.
Now, consider two theoretical situations that might arise:
1. It's discovered that the house is actually the true birthplace of Elvis! As a result,
the market value of the house skyrockets to $1 million. Because the owner sold
you the option, he is obligated to sell you the house for $200,000. In the end, you
stand to make a profit of $797,000 ($1 million - $200,000 - $3,000).
2. While touring the house, you discover not only that the walls are chock-full of
asbestos, but also that the ghost of Henry VII haunts the master bedroom;
furthermore, a family of super-intelligent rats have built a fortress in the
basement. Though you originally thought you had found the house of your
dreams, you now consider it worthless. On the upside, because you bought an
option, you are under no obligation to go through with the sale. Of course, you
still lose the $3,000 price of the option.
This example demonstrates two very important points. First, when you buy an option,
you have a right but not an obligation to do something. You can always let the expiration
date go by, at which point the option becomes worthless. If this happens, you lose 100%
of your investment, which is the money you used to pay for the option. Second, an
option is merely a contract that deals with an underlying asset. For this reason, options
are called derivatives, which means an option derives its value from something else. In
our example, the house is the underlying asset. Most of the time, the underlying asset is
a stock or an index.

Calls and Puts

The two types of options are calls and puts:
1. A call gives the holder the right to buy an asset at a certain price within a specific
period of time. Calls are similar to having a long position on a stock. Buyers of
calls hope that the stock will increase substantially before the option expires.
2. A put gives the holder the right to sell an asset at a certain price within a specific
period of time. Puts are very similar to having a short position on a stock. Buyers
of puts hope that the price of the stock will fall before the option expires
Terminologies used in Options
Premium- The purchase price of the option is called the premium . It represents the
compensation the purchaser of the call must pay for the right to exercise the option only
when exercise is desirable.
Buyer of an option: The buyer of an option is the one who by paying the option
premium buys the right but not the obligation to exercise his option on the seller/writer.
Writer / seller of an option: The writer / seller of a call/put option is the one who
receives the option premium and is thereby obliged to sell/buy the asset if the buyer
exercises on him.
Strike Price The pre-agreed price per share at which stock may be bought or sold
under the terms of an option contract. Some people refer to the strike price as the
exercise price

Intrinsic Value The amount an option is in-the-money. Obviously, only in-the-money

options have intrinsic value.

Time Value The part of an option price that is based on its time to expiration. If you
subtract the amount of intrinsic value from an option price, youre left with the time
value. If an option has no intrinsic value (i.e., its out-of-the-money) its entire worth is
based on time value.
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Exercise This occurs when the owner of an option invokes the right embedded in the
option contract. In laymans terms, it means the option owner buys or sells the
underlying stock at the strike price, and requires the option seller to take the other side
of the trade.

Moneyness of an Options
In the money
An option is described as in the money when its exercise would produce a positive cash
flow. Therefore, a call option is in the money when the asset price is greater than the
exercise price, and a put option is in the money when the asset price is less than the
exercise price.
Out of money
A call is out of the money when the asset price is less than the exercise price; no one
would exercise the right to purchase for the strike price an asset worth less than that
amount. A put option is out of the money when the exercise price is less than the asset
price.
At the money
Options are at the money when the exercise price and asset price are equal.
An option is at-the-money when the stock price is equal to the strike price. (Since the
two values are rarely exactly equal, when purchasing options the strike price closest to
the stock price is typically called the ATM strike.)

American and European Options

An American option allows its holder to exercise the right to purchase (if a call) or sell
(if a put) the underlying asset on or before the expiration date. European options allow
for exercise of the option only on the expiration date. American options, because they
allow more leeway than their European counterparts, generally will be more valuable.
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Virtually all traded options in the United States are American style. Foreign currency
options and stock index options are notable exceptions to this rule, however.

OPTIONS PAYOFFS
The optionality characteristic of options results in a non-linear payoff for options. In
simple words, it means that the losses for the buyer of an option are limited, however
the profits are potentially unlimited. For a writer (seller), the payoff is exactly the
opposite. His profits are limited to the option premium, however his losses are
potentially unlimited. These nonlinear payoffs are fascinating as they lend themselves to
be used to generate various payoffs by using combinations of options and the
underlying.
Payoff profile of buyer of asset: Long asset
In this basic position, an investor buys the underlying asset, ABC Ltd. shares for
instance, for Rs. 2220, and sells it at a future date at an unknown price, St. Once it
is purchased, the investor is said to be "long" the asset.

Payoff profile for seller of asset: Short asset

In this basic position, an investor shorts the underlying asset, ABC Ltd. shares for
instance, for Rs. 2220, and buys it back at a future date at an unknown price, St.
Once it is sold, the investor is said to be "short" the asset.

Payoff profile for buyer of call options: Long call

A call option gives the buyer the right to buy the underlying asset at the strike price
specified in the option. The profit/loss that the buyer makes on the option depends
on the spot price of the underlying. If upon expiration, the spot price exceeds the
strike price, he makes a profit. Higher the spot price, more is the profit he makes. If
the spot price of the underlying is less than the strike price, he lets his option expire
un-exercised. His loss in this case is the premium he paid for buying the option.

Payoff profile for writer (seller) of call options: Short call

A call option gives the buyer the right to buy the underlying asset at the strike price
specified in the option. For selling the option, the writer of the option charges a
premium. The profit/loss that the buyer makes on the option depends on the spot
price of the underlying. Whatever is the buyer's profit is the seller's loss. If upon
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expiration, the spot price exceeds the strike price, the buyer will exercise the option
on the writer. Hence as the spot price increases the writer of the option starts
making losses. Higher the spot price, more is the loss he makes. If upon expiration
the spot price of the underlying is less than the strike price, the buyer lets his option
expire un-exercised and the writer gets to keep the premium.

Payoff profile for buyer of put options: Long put

A put option gives the buyer the right to sell the underlying asset at the strike price
specified in the option. The profit/loss that the buyer makes on the option depends
on the spot price of the underlying. If upon expiration, the spot price is below the
strike price, he makes a profit. Lower the spot price, more is the profit he makes. If
the spot price of the underlying is higher than the strike price, he lets his option
expire un-exercised. His loss in this case is the premium he paid for buying the
option.

Payoff profile for writer (seller) of put options: Short put

A put option gives the buyer the right to sell the underlying asset at the strike price
specified in the option. For selling the option, the writer of the option charges a
premium. The profit/loss that the buyer makes on the option depends on the spot
price of the underlying. Whatever is the buyer's profit is the seller's loss. If upon
expiration, the spot price happens to be below the strike price, the buyer will
exercise the option on the writer. If upon expiration the spot price of the underlying
is more than the strike price, the buyer lets his option un-exercised and the writer
gets to keep the premium.

OPTION STRATEGIES
In finance an option strategy is the purchase and/or sale of one or various option
positions and possibly an underlying position. Options strategies can favor movements
in the underlying that are bullish, bearish or neutral. In the case of neutral strategies,
they can be further classified into those that are bullish on volatility and those that are
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bearish on volatility. The option positions used can be long and/or short positions in calls
and/or puts at various strikes.
Bullish strategies
Bullish options strategies are employed when the options trader expects the underlying
stock price to move upwards. It is necessary to assess how high the stock price can go
and the timeframe in which the rally will occur in order to select the optimum trading
strategy. The most bullish of options trading strategies is the simple call buying strategy
used by most novice options traders. Stocks seldom go up by leaps and bounds.
Moderately bullish options traders usually set a target price for the bull run and utilize
bull spreads to reduce cost. (It does not reduce risk because the options can still expire
worthless.) While maximum profit is capped for these strategies, they usually cost less
to employ for a given nominal amount of exposure. The bull call spread and the bull
put spread are common examples of moderately bullish strategies. Mildly bullish trading
strategies are options strategies that make money as long as the underlying stock price
does not go down by the option's expiration date. These strategies may provide a small
downside protection as well. Writing out-of-the-money covered calls is a good example
of such a strategy.
Bearish strategies
Bearish options strategies are the mirror image of bullish strategies. They are employed
when the options trader expects the underlying stock price to move downwards. It is
necessary to assess how low the stock price can go and the time frame in which the
decline will happen inorder to select the optimum trading strategy. The most bearish of
options trading strategies is the simple put buying strategy utilized bymost novice
options traders. Stock prices only occasionally make steep downward moves.
Moderately bearish options traders usually set a target price for the expected decline
and utilize bear spreads to reduce cost. While maximum profit is capped for these
strategies, they usually cost less to employ. The bear call spread and the bear put
spread are common examples of moderately bearish strategies. Mildly bearish trading
strategies are options strategies that make money as long as the underlying stock price
does not go up by the options expiration date. These strategies may provide a small
upside protection as well. In general, bearish strategies yield less profit with less risk of
loss.
Neutral or non-directional strategies
Neutral strategies in options trading are employed when the options trader does not
know whether the underlying stock price will rise or fall. Also known as non-directional
strategies, they are so named because the potential to profit does not depend on
whether the underlying stock price will go upwards or downwards. Rather, the correct
neutral strategy to employ depends on the expected volatility of the underlying stock
price.

Bullish on volatility
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Neutral trading strategies that are bullish on volatility profit when the underlying stock
price experiences big moves upwards or downwards. They include the long straddle,
long strangle, short condor and short butterfly.
Bearish on volatility
Neutral trading strategies that are bearish on volatility profit when the underlying stock
price experiences little or no movement. Such strategies include the short straddle,
short strangle, ratio spreads, long condor and long butterfly.

The spread strategy in Options Derivative

In options trading, an option spread is created by the simultaneous purchase and sale
of options of the same class on the same underlying security but with different strike
prices and/or expiration dates.
Any spread that is constructed using calls can be refered to as a call spread.
Similarly, put spreads are spreads created using put options.
Option buyers can consider using spreads to reduce the net cost of entering a trade.
Naked option sellers can use spreads instead to lower margin requirements so as to
free up buying power while simultaneously putting a cap on the maximum loss potential.
Vertical, Horizontal & Diagonal Spreads
The three basic classes of spreads are the vertical spread, the horizontal spread and
the diagonal spread. They are categorized by the relationships between the strike price
and expiration dates of the options involved.
Vertical spreads are constructed using options of the same class, same underlying
security, same expiration month, but at different strike prices.
Horizontal or calendar spreads are constructed using options of the same underlying
security, same strike prices but with different expiration dates.
Diagonal spreads are created using options of the same underlying security but
different strike prices and expiration dates.
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Bull & Bear Spreads

If an option spread is designed to profit from a rise in the price of the underlying
security, it is a bull spread. Conversely, a bear spread is a spread where favorable
outcome is attained when the price of the underlying security goes down.
Credit & Debit Spreads
Option spreads can be entered on a net credit or a net debit. If the premiums of the
options sold is higher than the premiums of the options purchased, then a net credit is
received when entering the spread. If the opposite is true, then a debit is taken. Spreads
that are entered on a debit are known as debit spreadswhile those entered on a credit
are known as credit spreads.

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BULL CALL SPREAD STRATEGY (BUY CALLOPTION, SELL CALL OPTION)

A bull call spread is constructed by buying an in-the-money (ITM) call option, and selling
another out-of-the-money (OTM) call option. Often the call with the lower strike price
will bein-the-money while the Call with the higher strike price is out-of-the-money. Both
calls must have the same underlying security and expiration month. This strategy
is exercised when investor is moderately bullish to bullish, because the investor
will make a profit only when the stock price / index rise.
When to Use:
Investor is moderately bullish.
Risk:
Limited to any initial premium paid in establishing the position. Maximum loss occur
where the underlying falls to the level of the lower strike or below.
Reward:
Limited to the difference between the two strikes minus net premium cost. Maximum
profit occurs where the underlying rises to the level of the higher strike or above
Break-Even-Point (BEP):
Strike Price of Purchased call+ Net Debit Paid
Example:
Mr. XYZ buys a Nifty Call with a Strike price Rs. 4100 at a premium of Rs. 170.45 and
he sells a Nifty Call option with a strike price Rs. 4400 at a premium of Rs. 35.40. The
net debit here is Rs. 135.05 which is also his maximum loss. The breakeven point for
this strategy is Rs 4235.05 and for this case risk and return are limited

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BULL PUT SPREAD STRATEGY (SELL PUT OPTION,BUY PUT OPTION)

A bull put spread can be profitable when the stock / index are either range bound or
rising. The concept is to protect the downside of a Put sold by buying a lower strike Put,
which acts as an insurance for the Put sold. The lower strike Put purchased is further
OTM than the higher strike Put sold ensuring that the investor receives a net credit,
because the Put purchased (further OTM) is cheaper than the Put sold. This strategy is
equivalent to the Bull Call Spread but is done to earn a net credit (premium) and
collect an income.
When to Use:
When the investor is moderately bullish.
Risk:
Limited. Maximum loss occurs where the underlying falls to the level of the lower strike
or below
Reward:
Limited to the net premium credit. Maximum profit occurs where underlying rises to the
level of the higher strike or above.
Breakeven:
Strike Price of Short Put - Net Premium Received
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Example:
Mr. XYZ sells a Nifty Put option with a strike price of Rs. 4000 at a premium of Rs.
21.45and buys a further OTM Nifty Put option with a strike price Rs.3800 at a premium
of Rs.3.00 when the current Nifty is at 4191.10, with both options expiring on 31st July.
Here the breakeven point is Rs 3981.55 and both risk and return are limited.

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BEAR CALL SPREAD STRATEGY (SELL ITM CALL,BUY OTM CALL)

The Bear Call Spread strategy can be adopted when the investor feels that the stock /
index is either range bound or falling. The concept is to protect the downside of a Call
Sold by buying a Call of a higher strike price to insure the Call sold. In this strategy the
investor receives a net credit because the Call he buys is of a higher strike price than
the Call sold. The strategy requires the investor to buy out-of-the-money (OTM) call
options while simultaneously selling in-the-money (ITM) call options on the same
underlying stock index. This strategy can also be done with both OTM calls with the Call
purchased being higher OTM strike than the Call sold. If the stock / index falls both
Calls will expire worthless and the investor can retain the net credit.
When to use: When the investor is Mildly bearish on market.
Risk: Limited to the difference between the two strikes minus the net premium.
Reward: Limited to the net premium received for the position i.e., premium received
for theshort call minus the premium paid for the long call.
Break Even Point: Lower Strike + Net credit
Example:
Mr. XYZ is bearish on Nifty. He sells an ITM call option with strike price of Rs. 2600 at a
premium of Rs. 154 and buys an OTM call option with strike price Rs. 2800 at a
premium of Rs. 49.In this strategy the breakeven point is Rs 2705, here the risk is
Limited to the difference between the two strikes minus the net premium and return is
Limited to the net premium received for the position i.e., premium received for the short
call minus the premium paid for the long call.

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BEAR PUT SPREAD STRATEGY (BUY PUT, SELLPUT)

This strategy requires the investor to buy an in-the-money (higher) put option and sell
an out-of-the-money (lower) put option on the same stock with the same expiration date.
This strategy creates a net debit for the investor. The net effect of the strategy is to bring
down the cost and raise the breakeven on buying a Put (Long Put). The strategy needs
a Bearish outlook since the investor will make money only when the stock price / index
falls.
When to use: When you are moderately bearish on market direction
Risk: Limited to the net amount paid for the spread. i.e. the premium paid for long
position less premium received for short position.
Reward: Limited to the difference between the two strike prices minus the net premium
paid for the position.
Break Even Point: Strike Price of Long Put Net Premium Paid
Example:
Nifty is presently at 2694. Mr. XYZ expects Nifty to fall. He buys one Nifty ITM Put with a
strike price Rs. 2800 at a premium of Rs. 132 and sells one Nifty OTM Put with strike
price Rs. 2600 at a premium Rs. 52.In this example the breakeven point is Rs 2720, risk
is Limited to the premium paid for long position less premium received for short position.

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LONG CALL BUTTERFLY (SELL 2 ATM CALLOPTIONS, BUY 1 ITM CALL OPTION
AND BUY 1 OTM CALLOPTION).
A Long Call Butterfly is to be adopted when the investor is expecting very little
movement in the stock price / index. The investor is looking to gain from low volatility at
a low cost. The strategy offers a good risk / reward ratio, together with low cost. A long
butterfly is similar to a Short Straddle except your losses are limited. The strategy can
be done by selling 2 ATM Calls, buying 1 ITM Call, and buying 1 OTM Call options
(there should be equidistance between the strike prices). The result is positive incase
the stock / index remains range bound .The maximum reward in this strategy is however
restricted and takes place when the stock / index is at the middle strike at expiration.
The maximum losses are also limited.
When to use: When the investor is neutral on market direction and bearish on
volatility
Risk Net debit paid.
Reward Difference between adjacent strikes minus net debit
Break Even Point: Upper Breakeven Point = Strike Price of Higher Strike Long Call
Net Premium Paid Lower Breakeven Point = Strike Price of Lower Strike Long Call +
Net Premium Paid
Example
Nifty is at 3200. Mr. XYZ expects very little movement in Nifty. He sells 2 ATM Nifty Call
Options with a strike price of Rs. 3200 at a premium of Rs. 97.90 each, buys 1 ITM Nifty
Call Option with a strike price of Rs. 3100 at a premium of Rs. 141.55 and buys 1 OTM
Nifty Call Option with a strike price of Rs. 3300 at a premium of Rs. 64. The Net debit is
Rs. 9.75.In this case there are two breakeven point upper and lower , upper breakeven
point is Rs 3290.25 and lower breakeven point is Rs 3109.75, risk is net debit paid and
return is Difference between adjacent strikes minus net debit

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The payoff schedule and the payoff diagram

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SHORT CALL BUTTERFLY (BUY 2 ATM CALLOPTIONS, SELL 1 ITM CALL OPTION
AND SELL 1 OTM CALLOPTION)
A Short Call Butterfly is a strategy for volatile markets. It is the opposite of Long Call
Butterfly, which is a range bound strategy. The Short Call Butterfly can be constructed
by Selling one lower striking in-the-money Call, buying two at-the-money Calls and
selling another higher strike out-of-the-money Call, giving the investor a net credit.
There should be equal distance between each strike. The resulting position will be
profitable in case there is a big move in the stock / index. The maximum risk occurs if
the stock / index are at the middle strike at expiration. The maximum profit occurs if the
stock finishes on either side of the upper and lower strike prices at expiration. However,
this strategy offers very small returns when compared to straddles, strangles with only
slightly less risk.
When to use:
You are neutral on market direction and bullish on volatility .Neutral means that you
expect the market to move in either direction - i.e. bullish and bearish.
Risk
Limited to the net difference between the adjacent strikes (Rs. 100 in this example) less
the Premium received for the position.
Reward
Limited to the net premium received for the option spread
.
Break Even Point: Upper Breakeven Point = Strike Price of Highest Strike Short Call Net Premium Received Lower Breakeven Point = Strike Price of Lowest Strike Short
Call + Net Premium Received
Example:
Nifty is at 3200. Mr. XYZ expects large volatility in the Nifty irrespective of which
direction the movement is, upwards or downwards. Mr. XYZ buys 2 ATM Nifty Call
Options with a strike price of Rs. 3200 at a premium of Rs. 97.90 each, sells 1 ITM Nifty
Call Option with a strike price of Rs. 3100 at a premium of Rs. 141.55 and sells 1 OTM
Nifty Call Option with a strike price of Rs. 3300 at a premium of Rs. 64. The Net
Credit is Rs. 9.75.In this case again we have two breakeven one is upper and another is
lower, upper breakeven point is 3290.25 and lower breakeven point is Rs 3109.75, Risk
is Limited to the net difference between the adjacent strikes less the premium received
for the position and Reward is Limited to the net premium received for the option
spread.

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