Option Basics Trading Guide

Version 1.0

By
Santosh Kumar Pasi
[email protected]

www.pasitechnologies.com

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Contents
Welcome ............................................................................................................................................ 3
1. Option...................................................................................................................................... 4
2. Why should we trade Option? .................................................................................. 4
3. Options Terminologies .................................................................................................. 5
4. LONG position characteristics ................................................................................ 11
5. SHORT position characteristics ............................................................................. 12
6. Basic Options positions .............................................................................................. 13
7. Option Premium Pricing ............................................................................................. 14
8. Option Writer Advantages and Disadvantages ............................................ 15
9. Volatility .............................................................................................................................. 16
A. Historical Volatility .................................................................................................... 16
B. Implied Volatility ........................................................................................................ 16
C. Historical Volatility Vs Implied Volatility ..................................................... 17
10. Implied Volatility expected behavior ................................................................. 17
11. Option Greeks................................................................................................................... 18
12. Understanding Chart (Candlestick)..................................................................... 21
13. Price patterns ................................................................................................................... 22
14. Trend...................................................................................................................................... 23
A. Identifying Trend ....................................................................................................... 23
15. Tools: OpStrater .............................................................................................................. 24
16. OpStrater: Strategy Decision Maker (VIX) ..................................................... 24
17. OpStrater: Strategy Decision Maker (HV-IV) ................................................ 25
18. Tools: OptionsOracle India Plugin ....................................................................... 26
19. Configuring OptionsOracle ....................................................................................... 26
20. Using OptionsOracle ..................................................................................................... 32
21. Understanding Strategy Summary ...................................................................... 34
22. Exercise ................................................................................................................................ 36
23. Additional resources .................................................................................................... 37
24. Modules ................................................................................................................................ 38

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 Welcome

Thank you for purchasing Options Strategy Premium Tool.

Following are components of Options Strategy Premium Tools:

1. OpStrater
2. OptionsOracle India Plugin (supporting USDINR)
3. Options Basics Guide (installer copies this file on
desktop)
4. One hour session on effectively using both above tools.
5. One year technical support

This tool is for personal and standard use for authorized

user only and not to be shared with others or public. If it
is shared or attempted to reverse engineer tool, we will
remove access without prior notice. Fee paid will not be
returned on violation of terms and conditions.

This guide explains the basic concept of Option trading, Option

terminologies, Option Greeks in a very simple language with
examples. This is first module of the Options Trading Workshop.

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1. Option
An option is a contract between two parties giving the taker (buyer) the
right, but not the obligation, to buy or sell a security at a predetermined
price on or before a predetermined date. To acquire this right the taker
pays a premium to the writer (seller) of the contract.

2. Why should we trade Option?

There are different instruments available in the market namely
• Equities (Shares)
• Derivative Products:
o Futures
o Options

Equities
We generally trade if our biased is bullish. It requires huge money to make
decent profit.

Futures
We trade if our biased is either bullish or bearing. Compare of equities, it
requires lesser capital to make equivalent profit.

Options
We can trade if our biased is either bullish or bearish or neutral
(sideways). Compare of futures, it requires lesser capital to make
equivalent profit. It is leveraged product.

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3. Options Terminologies

Derivatives
Derivatives, such as futures or options, are financial contracts which derive
their value from a spot price, which is called the “underlying”.

Option
An option is an agreement, or a contract, between 2 people (The buyer and
the seller).

Premium
The price paid for the option is the premium.

Option Types
There are two types of Options available:
Call Option
Put Option

Call Option
This type of contract gives the holder (buyer) the right to buy (“call away”)
the underlying stock from the seller (writer) at a specific price (strike), but
only for a specified amount of time (expiry).

Example:
NIFTY 28Jan16 CE 7200

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Put Option
This type of contract gives the holder (buyer) the right to sell (“put”) the
underlying stock to the seller (writer) at a specific price (strike), but only
for a specified amount of time (expiry)

Example:
NIFTY 28Jan16 PE 7000

Underlying Asset/Security/Stock
Options are derivate products of underlying asset/security.

Examples:
If we are considering NIFTY Option, its underlying asset is NIFTY 50 Index.
If we are considering BANKNIFTY Option, its underlying asset is BAKNIFTY
Index.
If we are considering TCS Option, its underlying asset is TCS Equity.

Strike Price
The strike price is defined as the price at which the holder of an options can
buy (in the case of a call option) or sell (in the case of a put option) the
underlying security when the option is exercised. Hence, strike price is also
known as exercise price.
Note in India, we follow European type option, so instead of exercise, it is
settled in cash by exchange.

Examples of Strike Price:

For NIFTY are: ..., 7000, 7050, 7100, 7150, 7200, 7250, 7200, …

Avoid illiquid strikes (current any strike with 50s ... like 7150, 7250, 7350)

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Expiration date
It is the last day on which the contracts expire. Futures and Options
contracts expire on the last Thursday of the expiry month. If the last
Thursday is a trading holiday, the contracts expire on the previous trading
day.

Examples:
Jan 28, 2016; Feb 25, 2016; Mar 31, 2016, April 28, 2016

Contract Size (Lot)

One option contract represents specific number of the underlying assets.

Examples:
One contract of NIFTY Options has 75 Nifty Index.
One contact of TCS Option has 200 TCS shares.

Contract size may change, please verify before placing order.

ITM (In-the-money)
An in-the-money option is an option that would lead to positive cash fl ow
to the holder if it were exercised immediately. A Call option is said to be in-
the-money when the current price stands at a level higher than the strike
price. If the Spot price is much higher than the strike price, a Call is said to
be deep in-the-money option. In the case of a Put, the put is in-the-money
if the Spot price is below the strike price.

Examples:
IF NIFTY is at 7510
CALL:
Any CALL strike lower than current price (7510) is considered as ITM i.e.
7400 CE, 7300 CE, 7200 CE, and lower.

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PUT:
Any Put strike higher than current price (7510) is considered as ITM i.e.
7600 PE, 7700 PE, 7800 PE or higher.

ATM (At-the-money)
An at-the-money option is an option that would lead to zero cash flow if it
were exercised immediately. An option on the index is said to be “at-the-
money” when the current price equals the strike price.

Examples:
IF NIFTY is at 7510
CALL:
Any CALL strike equal to or very close to current price (7510) is considered
as ATM i.e. 7500 CE.
PUT:
Any Put strike equal to or very close to current price (7510) is considered
as ATM i.e. 7500 PE.

OTM (Out-of-the-money)
An out-of- the-money Option is an option that would lead to negative cash
flow if it were exercised immediately. A Call option is out-of-the-money
when the current price stands at a level which is less than the strike price.
If the current price is much lower than the strike price the call is said to be
deep out-of-the money. In case of a Put, the Put is said to be out-of-money
if current price is above the strike price.

Examples:
IF NIFTY is at 7510
CALL:
Any CALL strike higher than current price (7510) is considered as OTM i.e.
7600 CE, 7700 CE, 7800 CE, and higher.

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PUT:
Any Put strike lower than current price (7510) is considered as OTM i.e.
7400 PE, 7300 PE, 7200 PE or lower.

Moneyness of an Option
CALL Option Moneyness PUT Option
Strike Price < Spot Price In-The-Money Strike Price > Spot Price
Strike Price = Spot Price At-The-Money Strike Price = Spot Price
Strike Price > Spot Price Out-of-The-Money Strike Price < Spot Price

http://www.nseindia.com/live_market/dynaContent/live_watch/
option_chain/optionKeys.jsp?symbolCode=-
10006&symbol=NIFTY&symbol=NIFTY
or
www.nseindia.com -> Live Market -> Option Chain -> Equity
Derivatives

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4. LONG position characteristics

Long Option Positions

Pays Premiums
RIGHT to exercise
Risk : Limited (limited to premium paid)
Reward : Unlimited

Here is Long CALL option P/L graphs:

As we can see in above chart, loss is limited and profit is unlimited.

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5. SHORT position characteristics

Short Option Position

Receives Premiums
OBLIGATIONS to settle
Risk : Unlimited
Reward : Limited (limited to premium received)

Here is Long CALL option P/L graphs:

As we can see in above chart, profit is limited and loss is unlimited.

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6. Basic Options positions
We can go LONG or SHORT Options (CALL or PUT), here are four basic
Option positions.

CALL PUT
Long (Buyer) Right to Buy Right to Sell
Short (Seller) Obligation to Sell Obligation to Buy

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7. Option Premium Pricing
Option Premium has two components
• Intrinsic value
• Extrinsic value (time value)

Option Premium

Time Value
Intrinsic Value
(Extrinsic Value)

Stock Price Time Rate of

Strike Rate Volatility
(SPOT) Remaining Interest

When we are long option, time value is against us.

When we are short option, time value is favorable.

Intrinsic Value
The difference between the underlying's price and the strike price.
Intrinsic value can’t be negative (In case of OTM, Intrinsic value is
considered as zero)

Intrinsic Value (Call) = Underlying Price – Strike Price

Intrinsic Value (Put) = Strike Price – Underlying Price

Example:
Let’s assume NIFTY is at 7710 and below is Option chain table

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Intrinsic Value, Intrinsic Value Premium
Premium Calculation
Intrinsic Value (Call) = CE 7500: 231.05 (LTP)-210
Underlying Price – 7710-7500=210 =21.05
Strike Price
Intrinsic Value (Put) = PE 7500: 6.90 (LTP)-0.00
Strike Price – 7500-7710=-210 = 6.90
Underlying Price (taken as 0)

Now calculate:
Nifty at 7710 CE 7750:
Nifty at 7710 PE 7750:

8. Option Writer Advantages and Disadvantages

Options writing should be done if Option premium are higher.

Option Writing (Advantages)

Max gain = premium received (Receives premium for the obligation)
Time decay favors
Should be done only in case if IV or VIX is high.

As we are shorting Options, we need additional margin instead of just

premium value.

Option Writing (Disadvantages)

Max risk = unlimited (if without strategies/insurance)
Margin required
Should not be done if IV or VIX is low.

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9. Volatility
Volatility values needs to be analyzed before deciding if we will be seller or
buyer.
There are two types of volatility:
• Historical volatility
• Implied volatility

A. Historical Volatility

Historical Volatility
A measure of the price fluctuation of an asset averaged out over a
period of time.
Historical volatility is the measure of a stock’s price movement
based on historical prices.
It measures how active a stock price typically is over a certain
period of time.
Historical volatility is measured by taking the daily (close-to-close)
percentage price changes in a stock and calculating the average
over a given time period.

B. Implied Volatility

Implied Volatility
Implied volatility is the current volatility of a stock, as estimated
by its option price.
An option’s value consists of several components —
• The strike price
• Expiration date
• The current stock price
• Dividends paid by the stock (if any)
• The implied volatility of the stock
• Interest rates

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 C. Historical Volatility Vs Implied Volatility

Historical Volatility (HV) Implied Volatility (IV)

Looks back in time to show Trader’s view of expected future
where volatility has been in volatility based on current
the past. option prices.

Shows expected trading Indicator of the current

range of market. sentiment of the market.

10. Implied Volatility expected behavior

If Implied Volatility is high, it is expected to come to its normal/neutral
level.
If Implied Volatility is low, it is expected to come to its normal/neutral level.

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11. Option Greeks
Following are major Options Greeks to be considered before deciding
Options trade/strategy.
Option Greek:
• Delta
• Theta
• Vega
• Gamma
• Rho

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Option Greeks
Delta It is the amount that an option changes with respect to a
small change in the underlying.
So it rate of change in Option premium when underlying
prices changes by Rs. 1.
Its value is between 0 and 1.
Theta It is the amount that the option decays in one (1) day.
A writer receives income from time decay and therefore has
‘positive theta.’
A buyer incurs an expense from time decay and therefore
has ‘negative theta.’
Theta value increases we come close to expiry.
Vega It is the amount that an option changes if the ‘implied
volatility’ changes by one percentage (1%) point
Gamma Quantifies the rate of change of the delta with respect to a
change in the underlying

If Greek View (GRK button) is enabled in OptionsOracle, it does shows

Delta, Vega and Theta.

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Difference Between Theta and Time Value
Theta Time Value
Theta increases as we move Time value reduces as we move close to
close to expiry expiry
Rate of change $ value

Difference Between Volatility and Vega Exposure

If Volatility Vega (Vega Exposure) is
Very High Very Negative
High Negative
Neutral Neutral
Low Positive
Very Low Very Positive

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12. Understanding Chart (Candlestick)
Candlestick chart is most widely used to analysis trend. It is better than
line or area chart. Other charts normally based on closing price, whereas
candlestick shows all four components (Open, High, Low and Close –
OHLC).

Here is candlestick.

Green candlestick means price closed in positive.

Red candlestick means price closed in negative.

Try NIFTY candlestick chart on following URL:

www.investing.com/indices/s-p-cnx-nifty-advanced-chart

What is High-Low known as?

If we take average of High-Low for last 14 days, what is it referred

as?

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13. Price patterns
Price patterns on chart are made of four basic patterns.

Price Patterns

Reversal pattern:

Continuation Pattern:

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14. Trend
Trend shows us what direction to trade. Trend is assumed to continue until
it breaks.

Trend can be one of following three:

• Uptrend : Bullish
• Downtrend : Bearish
• Sideways : Non-directional

A. Identifying Trend
There are different methodologies to identify/confirm trend. We can
use one or combination of following:

• Moving Average (E20 (Exponential 20 days), E50, E100) and

retracement or trend line.
• Moving Average crossover (E10 and E20, E50 and E100)
• Higher High, Higher low, Lower Low, Lower High
• Breaking two or higher Support or resistance level

Try practice trend on NIFTY candlestick chart on following URL:

www.investing.com/indices/s-p-cnx-nifty-advanced-chart

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15. Tools: OpStrater
OpStrater consists of following major components:

• Strategy Decision Maker VIX

• Strategy Decision Maker HV-IV
• Strategy Trader Manager
• Options Morphing
• Open Trades

16. OpStrater: Strategy Decision Maker (VIX)

Strategy Decision Maker (VIX) analysis INDIAVIX and recommends
strategies based on current volatility level.

Click on button “Update” to see recommendations.

Once it is updated, shows recommended strategies in second half of the

screen.

Steps:
1. Click on “Update” button.
2. Check “Last Updated” value
3. Check “VIX (Current)” value
4. Check “52 Week High” value
5. Check “52 Week Low” value
6. What is “Volatility Level”?
7. What is recommended Neutral Strategy?

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8. What is recommended Bullish Strategy?
9. What is recommended Bearish Strategy?

17. OpStrater: Strategy Decision Maker (HV-IV)

Strategy Decision Maker (HV-IV) analysis Implied volatility verses
Historical volatility and recommends strategies.

Steps:
1. Select Scrip NIFTY using HV-IV method.
2. Click on URL link to open Option Chain table
3. Add ATM IV values
4. Click on “Download”
5. What is Last Update date?
6. What is current ATR?
7. What is “Volatility Level”?
8. What is recommended Neutral Strategy?
9. What is recommended Bullish Strategy?
10. What is recommended Bearish Strategy?

Remaining tool (Strategy Trade Manager, Options Morphing and Open

Trades) will be covered during workshop. These are not supported for
premium users.

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18. Tools: OptionsOracle India Plugin
OptionsOracle is strategy analysis tools that allows testing of different
options strategies using real-time options and stock-market information.
The tool provides an easy interface to build a stock/options position and
then test it using graphs and analytical tools. Its payoff chart helps to
analyze strategy status at different price, date and volatility.

19. Configuring OptionsOracle

Click on button “Config” to configure OptionsOracle.

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 1. Under “General” tab, make following settings as shown below:

Click on Online Servers& Stock Exchange Selection drop down menu and
select servers. If you are trading Indian market, select “Plugin Server India
(NSE) …”.

Also recommended to use “Use Last Price” for Options Positions.

If you are behind proxy, then proxy settings needs to be mentioned in

section “Proxy / Communication”. Your system administration or network
administration will be able to guide on this. This is only required if you are
behind proxy server and don’t have direction Internet connection.

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 2. Under “Commissions” tab, make following settings as shown below:

Make sure all Commissions and even Federal rates are mentioned as
zero, unless you know significance and impact of same.

If you are very sensitive to commissions, then make sure to write correct
value including Unit/Contract.

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 3. Under “Margin” tab, you ca set margin requirements based on your
broker. Generally we recommend not to change default settings

If you wish to have exact margin setup, please see blog post on

http://www.pasitechnologies.com/2016/06/optionsoracle-
margin-settngs-for-nifty.html

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 4. Under “Volatility & Math” tab, make changes as shown below:

Some time, we use “Download Historical Volatility if Available

(increase download time), but generally we recommend to disable it
as it increases download time.

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 5. Under “Summary” tab, following is recommendation settings.

This is important settings and we highly recommend to use as shown

above, in same order. If you are participating in workshop, will let you
know importance of this in workshop under module 2 section.

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20. Using OptionsOracle
Please follow following steps:

1. Start OptionsOracle India Plugin

2. Use “NIFTY” scrip in Symbol, and click Update
3. Click on Template and select Neutral Strategies (Neutral: Call
Calendar Spread)

Try selecting different strategies and see what happens in Strategy Position
tables.

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 4. Click on Graph and try to find out different parameters in Graph.

Try changing mouse pointer over chart and see what it shows at
status bar of graph chart.

Try changing parameters at top and see how it impact.

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21. Understanding Strategy Summary
Let us understand “Strategy Summary” as shown in OptionsOracle main
screen with example.

Maximum Profit Potential

Maximum profit that can happen in this strategy is 165.04 points. If our
scrip (NIFTY) closes at 9300 on expiry, we will have maximum profit of
165.04.

Maximum Loss Risk

Maximum loss in this strategy is limited to 80 points. That would be around

5% loss based on investment in this strategy (including margin
consideration).

Upper Protection

We are protected (in profit) until NIFTY (our scrip) is below 9535 i.e. 2.34%
away from current price. If NIFTY crosses upper protection (9535) and goes
above, loss will start in strategy.

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Lower Protection

We are protected until NIFTY (our scrip) is above 9073 i.e. 2.63% away
from current price. If NIFTY crosses lower protection (9073) and goes
below, loss will start in our strategy.

Return if Unchanged

Currently NIFTY is at 9318 and if NIFTY closes on this price on expiry, our
profit will be 146.99 that is around 9.36% return on investment based on
margin consideration.

Current Return

As of now, our strategy is in 25 points profit i.e. 1.59% return on

investment.

Total Delta

Total delta for strategy is -0.01.

So if price goes against us by Rs 1, we will be impacted by Rs 0.01.

Total Vega

Total vega for strategy is 10.27 points.

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Total Theta

Total theta for strategy is 1.36.

So if we stay one more day in strategy, theta earning will be 1.36 points.

22. Exercise

Try answering following questions:

1. What is value of delta at ATMs?
2. Where is Vega highest?
3. What is positive Theta, who will be impacted?
4. What is negative Theta, who will be impacted?
5. What happens to Theta as we move nearer to expiry?
6. What happens to time value as we move nearer to expiry?
7. If market is bullish and option premium are cheap, what will you do?
8. If market is bullish and option premium are expensive, what will you
do?
9. If market is bearish and option premium are cheap, what will you do?
10. If market is bearish and option premium are expensive, what will you
do?
11. What is insurance for Short CALL position?
12. What is insurance for Short PUT position?
13. Do we need insurance for Long position?
14. What is insurance for Long CALL position?
15. What is insurance for Long PUT position?

Try following on OptionsOracle:

1. Scrip: NIFTY
2. Add current month ATM CALL
3. Add next month ATM CALL
4. Change current month ATM CALL to Short
5. Change Sell price lower by Rs. 1
6. Change Buy price higher by Rs. 2
7. What is P/L at expiry at current LTP?

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Try another exercise on OptionsOracle:
1. Scrip: BankNifty
2. SELL NEXT MONTH END ATM CALL (Strikes ending with 500 or 1000
only)
3. SELL NEXT MONTH END ATM PUT (Strikes ending with 500 or 1000
only)
4. Lower price for both SELL by Rs. 1
5. What is P/L at expiry at current LTP?
6. What is maximum profit in this strategy?
7. What is maximum Loss?
8. As I’m not comfortable with Unlimited Risk, so add protection such
that maximum loss is 145 points or lower.
9. What is maximum profit now?
10. Does profit increased or reduced compare to earlier?
11. If BankNifty LTP increases by 1%, what will be profit or loss at
expiry?
12. If BankNifty LTP increases by 1%, what will be maximum profit or
loss today?

23. Additional resources

Please watch following videos on YouTube:

https://www.youtube.com/watch?v=P9QZm-xAH6Q

https://www.youtube.com/watch?v=qz4IMeAeQLk&t=5s

Also, we recommend you to see following URL:

http://www.pasitechnologies.com/2015/08/how-to-use-
optionsoracle-nse-india.html

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24. Modules
All seven modules will be in “Options Trading Workshop” in details.

Modules:

1. Option Basics

2. Option Analysis and Trading Tools

Effectively using OptionsOracle
Effectively using OpStrater
• Strategy Decision Maker (VIX)
• Strategy Decision Maker (HV-IV)
• Strategy Trader Manager

3. Non-directional Strategies
Strategy guidelines
Mastering non-directional Option Strategies

4. Directional Strategies
Mastering bullish Option Strategies
Mastering bearish Option Strategies
Option Morphing

5. Adjusting Option Strategy Trades

Importance of adjustment
When to initiate adjustment
How to adjust Option strategies to protect current profit?
How to adjust Option strategies to minimize loss in case trade
is going against us?

6. Risk Management
Position sizing for strategies
Money management
Avoiding common mistakes

7. Practice
Identifying Option trades
Case studies

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 Thank you for reading Option Basics Trading Guide

You can read more updates on

http://www.pasitechnologies.com

https://www.facebook.com/OptionTrainingProgram

Safe and Happy Trading ☺

Santosh Kumar Pasi, Options Trader and Trainer

+91.98202.00550

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