Options Contracts & Trading

Strategies
Module 3
 Characteristics of Options-Options
Terminologies
 Index options:These options have the index as the underlying.
In India, they have a European style settlement. Eg. Nifty options,
Bank Nifty options etc.
 Stock options: Stock options are options on individual stocks. A
stock option contract gives the holder the right to buy or sell the
underlying shares at the specified price.
 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.
 Characteristics of Options-Options
Terminologies
 Call option: A call option gives the holder the right but not the
obligation to buy an asset by a certain date for a certain price.
 Put option: A put option gives the holder the right but not the
obligation to sell an asset by a certain date for a certain price.
 Option price/premium: Option price is the price which the
option buyer pays to the option seller. It is also referred to as the
option premium.
 Expiration date:The date specified in the options contract is
known as the expiration date, the exercise date, the strike date or
the maturity.
 Strike price:The price specified in the options contract is
known as the strike price or the exercise price.
Characteristics of Options-Options
Terminologies
 American options: American options are options that can
be exercised at any time upto the expiration date.
 European options: European options are options that can
be exercised only on the expiration date itself.
 Characteristics of Options- In-the-
money option
 In-the-money option: An In-The call option means the option holder has the
opportunity to buy the security below its current market price.
 An in-the-money (ITM) option is an option that would lead to a positive
cashflow to the holder if it were exercised immediately.
 A call option is said to be In the Money if the Spot Price of the underlying
Asset is higher than Call Options Strike Price(i.e. spot price(So) > strike
price(E))
 If the index is much higher than the strike price, the call is said to be deep ITM.
 For Example: Nifty CE 10400, Spot Nifty 10500- In-the-money option. So> E
 A Put option is said to be In the Money if the Spot Price of the underlying
Asset is Lower than Put Options Strike Price(i.e. spot price(So) < strike
price(E))
 For Example: Nifty PE 10400, Spot Nifty 10300- In-the-money option So <E
 Characteristics of Options- At-the-
money option
 An at-the-money (ATM) option is an option that would lead to
zero cashflow if it were exercised immediately.
 An Option is said to be At the Money if the Spot Price of the
underlying Asset is equal to Options Strike Price(i.e. spot
price(So) = strike price(E))
 For Example: Nifty CE 10500, Spot Nifty 10500- At-the-
money option.
 For Example: Nifty PE 10400, Spot Nifty 10400- At-the-money
option.
 Characteristics of Options- Out Of-the-
money option
 An out-of-the-money (OTM) option is an option that would lead to a
negative cashflow if it were exercised immediately.
 A call option is said to be Out of the Money if the Spot Price of the
underlying Asset is lesser than Call Options Strike Price(i.e. spot
price(So) < strike price(E))
 For Example: Nifty CE 10500, Spot Nifty 10400- Out of-the-money
option. So< E
 If the index is much lower than the strike price, the call is said to be deep
OTM.
 A Put option is said to be Out of the Money if the Spot Price of the
underlying Asset is Higher than Put Options Strike Price(i.e. spot
price(So) > strike price(E))
 For Example: Nifty PE 10400, Spot Nifty 10500- Out of-the-money
option. So> E
Condition Call Option Put Option

So>E In-the-Money Out of-the-Money

So<E Out of-the-Money In-the-Money

At-the-Money
So=E At-the-Money
Components of Option Premium
 Intrinsic value of an option
 Time value of an option
Intrinsic Value-Call Option
 Option will have Intrinsic Value only if it is In-The-Money
 If the option is Out-Of-The Money, its intrinsic value is zero.
 Intrinsic Value can never be zero for In the Money Call Options
 The intrinsic value of a call is Max[0, (So — E)] which means the
intrinsic value of a call is the greater of 0 or (So — E).

 For Example- Nifty CE 10400, Spot Nifty 10500,Intrinsic Value

Max(0,10500-10400) or Max(0,100) which is 100
 Nifty CE 10400, Spot Nifty 10300,Intrinsic Value Max(0,10300-
10400) or Max(0,-100) which is 0
 Intrinsic Value-Put Option
 The intrinsic value of a put is Max[0,E — So],i.e. the greater of 0 or (E — So).
 If the Put is OTM, its intrinsic value is zero.

 For Example- Nifty PE 10400, Spot Nifty 10300,Intrinsic

Value Max(0,10400-10300) or Max(0,100) which is 100
 Nifty PE 10400, Spot Nifty 10500,Intrinsic Value
Max(0,10400-10500) or Max(0,-100) which is 0
Intrinsic Value-Call Option & Put Option
Type of Option IntrinsicValue

Call Max[0, (So — E)]

Put Max[0,E — So],

 Time value of an option
 The time value of an option is the difference between its premium
and its intrinsic value.
 Options will always have time value irrespective whether the
Options in ITM,ATM or OTM
 Both calls and puts have time value.
 An option that is OTM or ATM has only time value but no Intrinsic
Value
 An ITM Option will have both Time Value & Intrinsic Value
 Usually, the maximum time value exists when the option is ATM.
 The longer the time to expiration, the greater is an option's time
value, all else equal.
 At expiration, an option should have no time value.
Time Value-Call Option & Put Option

Type of Option IntrinsicValue

Call Premium-Max[0, (So — E)]

Call

Put Premium-Max[0,E — So],

Put
 Example
Exercise
Option
Option Price/Strike Spot Price
Premium
Price
Rs
Call Option Rs 80 Rs 83.5
6.75(3.5+3.25)
Call Option Rs 85 Rs 83.5 Rs 2.50
Option Exercise Price Spot Price Intrinsic Value Option Prm Time value
/Strike Price

Call Option Max[0,So-E] Rs 6.75 Rs 6.75-IV

Max[0,83.5-80] =Rs 6.75-3.5
Rs 80 Rs 83.5
Max[0,3.5]=Rs 3.5 =Rs 3.25

Call Option Max[0,So-E] Rs 2.50 Rs 2.5-IV

Max[0,83.5-85] =Rs 6.75-0
Rs 85 Rs 83.5 Max[0,-1.5]=Rs 0 =Rs 2.5
OPTIONS PAYOFFS
 Options have a non-linear payoff.
 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.
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.

The figure shows the profits/losses from a long position on ABC Ltd.. The investor
bought ABC
Ltd. at Rs. 2220. If the share price goes up, he profits. If the share price falls he
loses.
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.

The figure shows the profits/losses from a short position on ABC Ltd.. The investor
sold ABC Ltd. at Rs. 2220. If the share price falls, he profits. If the share price
rises, he loses.
Payoff profile for buyer of call options: Long call
 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 buyer of call
options: Long call
Payoff for the buyer of a three month call option with a strike of 2250
bought at a premium of 86.60.
 Payoff profile for writer (seller) of call options:
Short call
 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 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 for writer of call option
Payoff for the Seller(Writer) of a three month call option with a strike
of 2250 sold at a premium of 86.60.
Payoff profile for buyer of put options: Long put
 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.
 Higher the spot price, more is the profit he makes.
 If the spot price of the underlying is more 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 buyer of Put options:
Long Put
Payoff for the buyer of a three month Put option with a strike of 2250
bought at a premium of 61.70.
 Payoff profile for writer (seller) of Put options:
Short Put
 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 is below the strike price, the
buyer will exercise the option on the writer.
 Hence as the spot price reduces the writer of the option starts
making losses.
 Lower the spot price, more is the loss he(Writer/Seller) makes.
 If upon expiration the spot price of the underlying is more than
the strike price, the buyer lets his option expire un-exercised and
the writer gets to keep the premium.
Payoff for writer of Put option
Payoff for the Seller(Writer) of a three month Put option with a strike
of 2250 sold at a premium of 61.70.
STRATEGY 1 : LONG CALL
The Payoff schedule & Payoff chart (Long
Call)
STRATEGY 4 : SHORT CALL
The Payoff schedule & Payoff chart (Short Call)
STRATEGY 3 : SYNTHETIC LONG CALL-Buy
Stock, Buy PUT
The Payoff schedule & Payoff chart (SYNTHETIC
LONG CALL)
SYNTHETIC LONG CALL
STRATEGY 4 : LONG PUT
The Payoff schedule & Payoff chart (LONG PUT)
STRATEGY 5 : SHORT PUT
The Payoff schedule & Payoff chart (SHORT PUT)
STRATEGY 6 : LONG STRADDLE-Neutral
Strategy
The Payoff schedule & Payoff chart (LONG
STRADDLE)
Payoff Chart-LONG STRADDLE-Ex
STRATEGY 7 : SHORT STRADDLE-LESS
VOLATILITY
The Payoff schedule & Payoff chart (SHORT
STRADDLE)
Payoff Chart-SHORT STRADDLE-Ex
STRATEGY 8 : LONG STRANGLE
The Payoff schedule & Payoff chart (LONG
STRANGLE)
Payoff Chart- LONG STRANGLE-Ex
STRATEGY 9 : SHORT STRANGLE
The Payoff schedule & Payoff chart (SHORT
STRANGLE)
Payoff Chart- SHORT STRANGLE-Ex
STRATEGY 11 : BULL CALL SPREAD STGY
The Payoff schedule & Payoff chart (BULL CALL
SPREAD )
Payoff Chart- BULL CALL SPREAD -Ex
STRATEGY 12 : BULL PUT SPREAD STGY
The Payoff schedule & Payoff chart (BULL PUT
SPREAD )
Payoff Chart- BULL PUT SPREAD -Ex
STRATEGY 13 : BEAR CALL SPREAD STGY
The Payoff schedule & Payoff chart (BEAR CALL
SPREAD )
Payoff Chart- BEAR CALL SPREAD -Ex
STRATEGY 14 : BEAR PUT SPREAD STGY
The Payoff schedule & Payoff chart (BEAR PUT
SPREAD )
Payoff Chart- BEAR PUT SPREAD -Ex
STRATEGY 15 : COVERED CALL STGY
The Payoff schedule & Payoff chart (COVERED
CALL SPREAD )
Payoff Chart- COVERED CALL
STRATEGY 16 : COVERED PUT STGY
The Payoff schedule & Payoff chart (COVERED
PUT)
Payoff Chart- COVERED PUT
STRATEGY 17 :LONG CALL BUTTERFLY
The Payoff schedule & Payoff chart (LONG CALL
BUTTERFLY)
Payoff Chart- LONG CALL BUTTERFLY
STRATEGY 18 :SHORT CALL BUTTERFLY
The Payoff schedule & Payoff chart (SHORT CALL
BUTTERFLY)
Payoff Chart- SHORT CALL BUTTERFLY
STRATEGY 19 : COLLAR
The Payoff schedule & Payoff chart (COLLAR)
Payoff Chart- COLLAR
STRATEGY 20 : COVERED CALL
The Payoff schedule & Payoff chart (COVERED
CALL)
Payoff Chart- COVERED CALL
STRATEGY 21 : COVERED PUT
The Payoff schedule & Payoff chart (COVERED
PUT)
Payoff Chart- COVERED PUT
STRATEGY 22 : LONG COMBO
The Payoff schedule & Payoff chart (LONG COMBO)
Payoff Chart- LONG COMBO
STRATEGY 23 : PROTECTIVE CALL/
SYNTHETIC LONG PUT
The Payoff schedule & Payoff chart (PROTECTIVE
CALL/ SYNTHETIC LONG PUT)
Payoff Chart- PROTECTIVE CALL/
SYNTHETIC LONG PUT
STRATEGY 24 : LONG CALL CONDOR
The Payoff schedule & Payoff chart (LONG CALL
CONDOR)
Payoff Chart- LONG CALL CONDOR
STRATEGY 25 : SHORT CALL CONDOR
The Payoff schedule & Payoff chart (SHORT CALL
CONDOR)
Payoff Chart- SHORT CALL CONDOR
STRATEGY 26 : STRAP
 Strap Strategy is similar to Long Straddle, the only difference
is the quantity traded
 A trader will buy two Call Options and one Put Options.
 In this strategy, a trader is very bullish on the market and
volatility on upside
 but wants to hedge himself in case the stock doesn’t perform
as per his expectations.
 This strategy will make more profits compared to long
straddle since he has bought 2 calls.
Payoff Chart- STRAP
STRATEGY 27 : STRIP
 STRIP Strategy is the opposite of STRAP Strategy.
 When a trader is bearish on the market and bullish on
volatility
 He will implement this strategy by buying 2 ATM Put
Options & 1 ATM Call Option, of the same strike price,
expiry date & underlying asset.
 If the prices move downwards then this strategy will make
more profits compared to short straddle because of the
(double) quantity involved.
Payoff Chart- STRIP