PM using OPTIONS

Option
• Contract
• Seller of the contract
• Buyer’s right to purchase granted by seller
• Designated instrument /asset
• Agreed price
• Option buyer has no obligation to buy/sell
• Seller has the obligation if buyer exercises
 Terms
• Call Option
• Put Option
• Exercise Date
• Strike Price
• Expiration Period
• Option Premium/ Price
• Expiration Cycle
 Expiration Cycle
• Cycle-1 January, February,- April, July
• Cycle-2 February, March, April, July
• Cycle-3 March, April, - July, October
Expiry within 9 months
• At-the-Money
• In-the-Money
• Out-of-the-Money
Put Options Call Options
• Spot price>Exercise • Spot price<exercise
• Spot price<Exercise • Spot price> exercise
• Spot price=Exercise • Spot price= exercise
 Intrinsic Value
• Call option; max.(0, S- X)
• Put option; max. (0, X – S)
• X =strike price of the option
• S =spot price of the underlying asset
Factors Influencing Option Price
• Spot price/ current price of underlying asset
• Exercise /strike price of the option
• Time-to-maturity or time-to-expiration
• Volatility of the underlying asset or
volatility in the price of the underlying asset
• The risk-free rate of interest
• Dividend expected during the life of the
option from dividend paying stock
• 3 month call on the stock with an exercise
price of Rs.400, Premium Rs.40 per share
 Long Position/ Call

Profit

400
MP(T)
440
- 40

Loss
• If stock price is Rs.400 or less
• Option expires worthless
• Maximum loss is Rs.40
• At Rs.440 the option buyer breaks even
 Short Call
• Writing a call without owning the
underlying asset
• Call writer makes a profit if the option is
not exercised (Price Rs.400 and less)
• Call writer breaks even at Rs.440
 Profit

+40
440
MP(T)
400 E

Loss
 Long Put
• Buying a Put
• Anticipates decline in stock price
• Buys a 3-month Put, Exercise price Rs.240
• Premium Rs.24
+216

216 240
MP(T)
-24

Loss
 Short Put
• Strategy of writing a put
Profit

E
MP(T)
216 240

-216
Loss
 Trading Strategies
• Covered call writing
• Protective put
• Straddles and strangles
• Strips and straps
• Spreads
 Covered Call Writing
• Option is covered by the writer by
depositing the shares of the company on
which the option is written with the
brokerage firm in an ESCROW account.
• No margin is required to be deposited.
• Buying the underlying asset and writing a
call on the asset
• 100 shares of Arvind @Rs.310 per share,
writes June 350 call, premium Rs.8 per
share.
• Initial cash flow:Rs.310-Rs.8 =Rs.302
• MP(T) Rs.270, 290, 310, 330, 350, 370
• Net cash flow (-)32, (-) 12, 8, 28,48, 48
Profit

+48
E MP(T)
302 350

-302

Loss
• The investor breaks even at Rs.302 per share,
• Maximum loss bounded to Rs.302
• When expiration date price exceeds Rs.350 call
closes in-the-money
• One rupee increase in price of stock the investor
makes a profit of one rupee but loses that in
favour of the call holder
• Profit stabilises at Rs.48 for MP(T)=Rs.350
• Buy 100 shares @Rs.310 per share
• Write a June 350 call at a Premium of Rs.8
• PROTECTIVE PUT
• Buy 100 shares @ Rs.310 per share
• Buy March 270 put at a premium of Rs.2
 Protective Put
• Buying the underlying asset and buying a
put on that asset
• Put expires worthless for prices at /above
Rs.270
• Investor breaks even at Rs.312
• Prices below Rs.270 put closes in the money
• Net loss remains steady at Rs.42
• MP(T) = 240,260,280,300,320,340
 PROTECTIVE PUT
Profi
t

E
270 312 MP (T)

(-)
42

Loss
 Option Combinations
• Straddle:
A call and a put option with the same exercise
price and the same expiration date.
A straddle buyer:
buys a March 310 call option @ Rs.21
buys a March 310 put option @ Rs.42
Initial investment Rs.63 per share
MP(T) Sell call Sell put CF(T) Net CF

220 0 90 90 27
240 0 70 70 7
260 0 50 50 -13
280 0 30 30 -33
300 0 10 10 -53
310 0 0 0 -63
320 10 0 10 -53
340 30 0 30 -33
360 50 9 50 -13
380 70 9 70 7
400 90 0 90 27
 PAYOFF OF A STRADDLE

Payof
f
X Spot Price
Call option Put option payoff
payoff
 LONG STRADDLE
STRATEGY
Profit
247

E E
247 310 373 MP(
T)
(-)
63

Loss
 SHORT STRADDLE STRATEGY

Profit

63

E E
247 MP(
310 37 T)
3
(-)
247
Loss
• The writer of the straddle will have a profit
diagram as shown
• Why he should write?
• Anticipates no major fluctuation in the price
of the underlying asset.
 Strangle
• A Call and a Put with the same expiration
date and different strike prices
• Buy a March 310 call @ premium Rs.21
• Buy a March 270 put @ Rs.2 premium
• Initial investment Rs.23
MP(T) Sell Call Sell Put CF(T) Net CF

220 0 50 50 27
240 0 30 30 7
260 0 10 10 -13
270 0 0 0 -23
300 0 0 0 -23
310 0 0 0 -23
320 10 0 10 -13
340 30 0 30 7
360 50 0 50 27
 PAYOFF OF STRANGLE

Payoff X2 X1
Spot
Price
• Buy a call and a put strike
price Rs.35 and Rs.30,
cost 3 and 5, Initial outflow –Rs.8
Exercise call if stock price goes above Rs.38
Exercise put if it goes below Rs.25
Below Rs.22 or above Rs.43
 LONG STRANGLE
STRATEGY
Profit
247

E E MP (T)
247 270 310 333
(-) 23

Los
s
 STRIPS
• Buy one call and 2 puts with the same exercise
price and expiration date
• Big stock price move but more likely to fall
than rise
• Buy one March 310 call @premium Rs.21
• Buy 2 March 310 put @ premium for 2 put
Rs.84
• Initial investment Rs.105
MP(T) Sell Call Sell Puts CF(T) Net CF

220 0 180 180 75

240 0 140 140 35
260 0 100 100 -5
270 0 80 80 -25
300 0 20 20 -85
310 0 0 0 -105
320 10 0 10 -95
340 30 0 30 -75
360 50 0 50 -55
400 90 0 90 -15
 STRIP

Profit

257.5 310 415

MP
(T)

(-) 105

Los
s
 STRAPS
• Buy two calls and one put with the same strike
price and expiration date
• Buyer expects bullish/ bearish but price rise
more likely
• Buy 2 March 310 Calls @ premium of Rs.42
for 2
• Buy one March 310 Put @ premium Rs.42
• Initial investment Rs.84
MP(T) SellCalls Sell Put CF(T) Net CF
220 0 90 90 6
240 0 70 70 -14
260 0 50 50 -34
270 0 40 40 -44
300 0 10 10 -74
310 0 0 0 -84
320 20 0 20 -64
340 60 0 60 -24
360 100 0 100 16
400 180 0 180 96
 STRAP

Profi P
t

0 226 310 312

MP
(T)

(-) 84
(-) 84
Loss
 Other Spread strategies
• Vertical spreads
– Buying an option and selling another of same type and
time of expiration different exercise prices
• Horizontal spreads
– Same type and same exercise price but different time
of expiration
• Diagonal spreads
– Same type but with different exercise price and
different time to expiration
 Vertical Spread
• Buy March 270 call Rs.58
• Sell March 350 call Rs.8
 Initial investment Rs.50(outflow)
MP(T) Buy Sell CF(T) Net
March March
270 350 call
240 0 0 0 -50
260 0 0 0 -50
270 0 0 0 -50
280 10 0 10 -40
300 30 0 30 -20
320 50 0 50 0
340 70 0 70 20
350 80 0 80 30
 Horizontal Spread
• Buy March 310Call @Rs.21
• Sell June 310Call @Rs.30
 Diagonal Spread
• Buy March 270 Put @Rs.2
• Sell June 310 Put @Rs.50
 VERTICAL BEAR SPREAD
USING CALLS
Payoff

Spot Rate
• Investor buys one June call option at a
premium of Rs.58 per share and strike price
of Rs.270. Sells one June call on the same
share at premium of Rs.8 and a strike price
of Rs.350. Draw pay-off table for MP
Rs.240 to Rs.360 at intervals of 10/20.
 BULLISH VERTICAL SPREAD
STRATEGY USING CALLS
Prof
it
(+) 30

E MP (T)
270 320 350
(-)
50

Loss
• For investor moderately bullish on the
underlying asset
• Maximum profit is made at the strike price
at which the call is sold
• What about the investors who are very
bullish?
 Bullish vertical spread using Puts

Buy March 270 put Rs.2

Sell March 350 put Rs.70
• Initial cash flow Rs.68 ( inflow )
 BULLISH VERTICAL SPREAD
STRATEGY USING PUTS

Profi
t(+)
68

E
27 282 MP (T)
0 350

(-) 12
Los
s
Bearish Vertical Spread Using Calls

• Sell October 270 calls Rs.71

• Buy October 350 call Rs.12
• Initial Cash Flow Rs.59
 BEARISH VERTICAL SPREAD
STRATEGY USING CALLS
Profi
t 59
(+)

(+)1 E MP(T
2 270 282 350
)

(-) 68
Loss
 Bearish Vertical Spread Using Puts

Buy March 350 put Rs.70

Sell March 270 put Rs.2
Profit

12

270 350 MP(T)

-68
Loss
• Strategy can be profitably employed when
an investor believes that the stock price will
move only to the strike price
• Spread strategy can be used to limit the
maximum loss of a naked option writer
 Box Spread
• Combination of bull and bear spreads
• Buying calls with strike price X1
• Selling calls with strike price X2
• Buying puts with strike price X2
• Selling puts with strike price X1
• This always gives a payoff of X2 –X1
• An options strategy built on four trades at one
expiration date and three different strike prices.
For call options, one option each at the high
and low strike price are bought, and two
options at the middle strike price are sold.
• For put options, the trades are reversed. This is
a limited risk, limited return strategy that pays
off when the price of the underlying remains
around the middle strike price.
• This strategy is essentially a combination of a
bull and bear spread.
 Butterfly Spread
• 4 identical options with the same expiration
date but different exercise prices
• Buy one option at strike price X1
• Sell two options at strike price X2
• Buy one option at strike price X3
• X1<X2<X3
• Investor buys 2 march call options on
Reliance shares, premium Rs.25 and SP
Rs.200 and the other at premium 15 and SP
Rs.300. Also sells 2 march call options at a
premium of Rs.17 and SP Rs.250.Calculate
the pay off table for MPs 180 to 320 at
intervals of Rs.20
 BUTTERFLY SPREAD

Payof
f Short Butterfly
X Spread
0 X2 X3
1 Spot price

Long Butterfly
Spread
• DJX trading @ $75.28
• Buy1 DJX 72 Call @ $6.10 x 100
$610(wing)
• Sell2 DJX 75 Call @ $4.10 x 100
($820)(butterfly body)
• Buy1 DJX 78 Call @ $2.60 x 100 $260(wing)
• Net Debit from Trade($870 - $820)
• An expiration profit and loss graph for this strategy is displayed below.
•
• *The profit/loss above does not factor in commissions, interest, tax, or
margin considerations.
• This profit and loss graph allows us to easily see the break-even points,
maximum profit and loss potential at expiration in dollar terms. The
calculations are presented below.
• The two break-even points occur when the underlying equals 72.50 and
77.50. On the graph these two points turn out to be where the profit and
loss line crosses the x-axis.
• First Break-even Point=Lowest Strike (72) + Net Debit (.50) =
72.50Second Break-even Point=Highest Strike (78) - Net Debit (.50) =
77.50

• The maximum profit can only be reached if the DJX is equal to the middle
strike (75) on expiration. If the underlying equals 75 on expiration, the
profit will be $250 less the commissions paid.
• Maximum Profit=Middle Strike (75) - Lower Strike
(72) - Net Debit (.50) = 2.50 $2.50 x Number of
Shares per Contract (100) = $250 less commissions
The maximum loss, in this example, results if the DJX
is below the lower strike (72) or above the higher strike
(78) on expiration. If the underlying is less than 72 or
greater than 78 the loss will be $50 plus the
commissions paid.
• Maximum Loss=Net Debit (.50) $.50 x Number of
Shares per Contract (100) = $50 plus commissions
• Less risky compared to straddle
• Limited profit potential
 Ratio Spread
• Two or more related options are treaded in
specified proportions
• Buy two options and sell one option is a 2:1
ratio spread
 CONDOR
• An options strategy similar to a butterfly spread.
The only difference is that in a condor, the two
middle options have different strike prices within
the range established by the other two options.
• This strategy is often undertaken when an
increase in volatility is expected, since it allows
for positive payoffs over a relatively large range
of underlying prices.
 Condor Spread
• Four different strike prices
• 2 options are bought at extreme strike prices
• 2 options sold at intermediate strike prices
Condor Spread

X2 X3 X4

X1
 Evaluation of Option based
Investment Strategies
• Not accounted for:
• Transaction Costs: brokerage commissions for
each leg
• Bid-Ask Spread : buys option at high ask price
sells it at lower bid price
• Dividends: declared prior to expiration period
• Margin Requirements: applicable to writing of
options
• Early exercise: most of the equity options are
American type, higher risk can be apprehended
• Timing of cash flows : time value not considered
• Initial Margin: Option which is out of the money
– Method-I :
• 1 -Calculate the option premium for 100 shares
• 2 -Compute 0.20(market value per share) 100
• 3 -The amount by which the contract is out of the money
Margin = 1+2 –3
Method II:
100 x Option premium + 0.10(Stock MP)100
MARGIN IS THE HIGHER OF THE TWO
Thanks