Options Trading

Level I
 Options Basics

 Options are the contracts that give the buyers the right, but not the
obligation, to buy or sell a specified underlying at a set price on or
before a specified date.
Type of
Options

Call Put

Bullish Bearish
 Options Basics ... Contd.
 A Call Option is a contract that gives the owner of the call option the right, but not
obligation to buy the underlying asset by a specified date and at a specified price.
Upon exercise of that right, the option seller is obliged to sell the underlying
product under specified conditions to the option buyer.
- Example: You are Bullish on the market, then you can Buy Nifty Index Call
Option. But again you will have to analyze which Strike to buy.
- Call option is exercised at expiry if the underlying (stock/index) price rises
above the strike price and not if it is below.
 A Put Option is a contract that gives the owner of the put option the right, but not
obligation to sell the underlying asset by a specified date and at a specified price.
Upon exercise of that right, the option seller has the obligation to sell the
underlying product to the option buyer under the specified conditions.

- Example: You are Bearish on the market, then you can Buy Nifty Index Put
Option. But again you will have to analyze which Strike to buy.
- Put option is exercised at expiry if the underlying (stock) price falls below
the strike price and not if it rises above the strike price.
 Types of Options
 American style options:
– The buyer of the option can choose to exercise his option at any
given period of time between the purchase date and the expiry
date

 European style options:

– The buyer of the option can choose to exercise his option only on
the expiry date
– NSE Options are European Style

The premium paid to buy an American style option is normally equal

to or greater than the European style option for the same underlying.
 Options Basics ... Example
1 Buy Nifty 8900 Strike Call Sep 29 @ 97.15 (Bullish View)

2 Pay Premium of Rs.7286.25 (97.15 X 75 (lot size))

Case 1: Nifty trades higher, say at 9000 and view is correct,

3 then Option Premium value changes based on Options greeks
(more later) & results in PROFIT.

Nifty 8900 Call Option value increases from 97.15 to 137.15.

4 Profit = 40 X 75 = Rs.3,000

Case 2: Nifty trades lower, say at 8800 and view is wrong, then
5 Option Premium value changes based on Options greeks (more
later) & results in LOSS.
Nifty 8900 Call Option value decreases from 97.15 to 67.15.
4
Loss = 30 X 75 = Rs.2,250
Options Basics ... Contd.
 Option Moneyness
Call Option

Put Option
 Options Greeks - Delta

The option's delta is the "rate of change" of the price of the option with respect to
its underlying security'sprice. The delta of an option ranges in value from 0 to 1
for calls (0 to -1 for puts) & reflects the increase or decrease in price of the option in
response to a 1 point movement of the underlying asset price.
Far out-of-the-money options have delta values close to 0 while deep in-the-
money options have deltas that are close to 1.

 Passage of time and its effects on the delta

As the time remaining to expiration grows shorter, the time value of the option
evaporates and correspondingly, the delta of in-the-money options increases while the
delta of out-of-the-money options decreases.

Example: If Delta is 0.6, it means for 1 point positive move in the underlying value,
the Call Option will move by 0.6 points.
 Options Greeks - Gamma

The option's gamma is a measure of the rate of change of its delta. The gamma of an
option is expressed as a % and reflects change in the delta in response to a 1 point
movement of the underlying stock price.

Like delta, gamma is constantly changing, even with tiny movements of the underlying
stock price. It generally is at its peak value when the stock price is near the strike
price of the option and decreases as the option goes deeper into or out of the money.
Options that are very deeply into or out of the money have gamma values close to 0.

Example

Suppose SAIL, is currently trading at 47, there is a NOV 50 Call option selling for 2 and
let's assume it has a Delta of 0.4 and a Gamma of 0.1 or 10 percent. If the stock price
moves up by 1 to 48, then the Delta will be adjusted upwards by 10 percent from 0.4
to 0.5. However, if the stock trades downwards by 1 to 46, then the delta will decrease
by 10 percent to 0.3.
 Options Greeks - Theta
The option's theta is a measurement of the option's time decay. The theta measures
the rate at which options lose their value, specifically the time value, as the expiration
date draws nearer. Generally expressed as a (-) number, the theta of an option reflects
the amount by which the option's value will decrease every day.
Example: A call option with current price of 2 & a theta of -0.05 will experience a drop
in price of 0.05 per day. So in two days' time, the price of the option should fall to 1.90.
Passage of time and its effects on the theta
Longer term options have theta of almost 0 as they do not lose value on a daily basis.
Theta is higher for shorter term options, especially at-the-money options. This is pretty
obvious as such options have the highest time value and thus have more premium to
lose each day. Conversely, theta goes up dramatically as options near expiration as
time decay is at its greatest during that period.
Changes in volatility and its effects on the theta
In general, options of high volatility stocks have higher theta than low volatility stocks.
This is because the time value premium on these options are higher and so they have
more to lose per day.
 Intrinsic Value & Time value
 Intrinsic value is the difference between Strike Price and CMP.
Intrinsic value is always found in ITM options. OTM options have zero
Intrinsic Value
 Option Value = Intrinsic Value + Time Value
 Time value premium decreases at an accelerated rate as the option
approaches maturity.
Date Contracts Future
1-Sep-16 Sep '16 8400
8100 CE 8200 CE 8300 CE 8400 CE 8500 CE 8600 CE 8700 CE
Premium 340 260 185 120 80 50 20
Intrinsic Value 300 200 100 0 0 0 0
Time Value 40 60 85 120 80 50 20
8100 PE 8200 PE 8300 PE 8400 PE 8500 PE 8600 PE 8700 PE
Premium 40 60 85 120 180 250 320
Intrinsic Value 0 0 0 0 100 200 300
Time Value 40 60 85 120 80 50 20
 Intrinsic vs Time Value

Out of the
Option Type In the Money At the Money
Money

Time value is
Time Value Time value
at the
decreases as decreases as
maximum
the option option gets
when an
Put / Call gets deeper in cheaper out of
option is at the
the money, so the money, so
money,
intrinsic value intrinsic value
intrinsic value
increases. becomes zero.
is zero.
Options Pay-Off
 Lets do the Math
 Harish invested in Nifty Futures when market is at 8400 Levels
 Manish invested in Options and Bought a call option as he is Bullish @ 100
(Option Premium) for 8400 Strike

If market falls by 100 points than

Harish Loses: 75*100 = Rs. 7500 by trading in Nifty Futures (Is Riskier)

Manish Loses: 75*65 = Rs. 4875* by trading in Nifty Options

*Assuming Delta of 0.65

(For every 1 point movement in Futures, the equivalent movement in Options)
 Lets do the Math
Market Rises by 100 points

Futures Trading
Harish gains: 75*100 = Rs.7,500 on Invested Margin of Rs.50,000
i.e. 15% return on an investment of Rs.50,000

Options Trading
Manish Gains: 75*65 = Rs.4,875
i.e. 65%* return on investment of Rs.7,500 (Option Premium)

*Assuming Delta of 0.65

Buying Options minimizes Risk while at the same time, maximizing Returns.
Its all a game of timing the market.
 Volume / Open Interest Analysis

Price Volume Open Interest Market

Rising Rising Rising Strong
Weak /
Rising Falling Falling
Trend Reversal
Falling Rising Rising Weak
Strong /
Falling Falling Falling
Trend Reversal
 Basic Options Strategies

 Buying Options to protect Futures (Synthetics)

Buying options to protect Futures involves buying a Put with a long

Futures or buying a Call with short Futures. It is very helpful during
volatile times and can help protect your downside.

When you are holding position in Futures, and the market has rallied
or corrected sharply in your favour, you can use Puts and Calls, to
further tighten your exit points.
 Basic Options Strategies Contd...

 Covered Option Writing

This basically invoves selling Call Options and buying Futures, OR

selling Put Options and shorting Futures. This strategy can allow you to
take advantage of the high Options Premium but it is less risky in a
volatile market.

The disadvantage of this strategy is that the most you can make is only
the premuim received.
Favourable View - Bull Call Spread Date Future
Date: 1st Sep 2016 1-Sep-16 8400
(a) Buy 8400 CE @ 120 & 8400 CE 8500 CE
(b) Sell 8500 CE @ 80 when Nifty 120 80
Futures was @ 8400
Net Outflow = 120 - 80 = 40 Date Future
2-Sep-16 8500
Profitable Trade
Date: 2nd Sep 2016
8400 CE 8500 CE
Nifty Futures @ 8500 180 115
(a) Sell 8400 CE @ 180 & Profit on 8400 Ce = +60
(b) Buy 8500 CE @ 115 Loss on 8500 Ce = -35
Net Cash Inflow = 180-115 = 65 Net Profit = +25

Net Profit = 65 - 40 = 25
Date Future
Break Even Point (BEP) 30-Sep-16 8500
On Expiry day, if the market closes 8400 CE 8500 CE
@ 8440, there would be Zero loss 100 0
BUT for any profit, it must close At Expiry
Above 8840. Loss on 8400 Ce = -20
Profit on 8500 Ce = +80
Net Profit = +60
 Date Future
1-Sep-16 8400
8400 CE 8500 CE
Unfavourable View - Bull Call Spread 120 80
Date: 1st Sep 2016 Date Future
(a) Buy 8400 CE @ 120 & 2-Sep-16 8300
(b) Sell 8500 CE @ 80 when Nifty 8400 CE 8500 CE
Futures was @ 8400 80 50
Net Outflow = 120 - 80 = 40
Loss on 8400 Ce = -40
Loss Making Trade
Profit on 8500 Ce = +30
Date: 2nd Sep 2016 Net Loss = -10
Nifty Futures @ 8300
(a) Sell 8400 CE @ 80 &
(b) Buy 8500 CE @ 50
Net Cash Inflow = -80+50 = -30
Net Profit = -40+30 = -10
 Straddles

 These are option spreads that involve both puts and calls.

 The Straddle involves buying or selling puts and calls at the same strike
price. During the life of a straddle, it is almost a certainty that one of both of
the options will be in-the-money at any point in time.

 Buying a straddle – example: You buy a Dec 105 call and 105 put, paying
premium of say 20. Here, you know the maximum risk per trade. The
disadvantage is that you have to overcome both the premiums to make
money.

 Selling a straddle – this is a strategy that places the odds in your favour but
raises the level of risk. If market moves within a range, seller makes profit, not
otherwise.
 Strangles

 These are option spreads that involve both puts and calls.

 The Strangle involves different strike prices, so it is less likely that both, or
even one of the strangle legs, will be in the-money at any point in time.

 Buying a strangle – here, the strangle player uses different strikes, usually at
the either side of the marker price. As a buyer, your risk is limited. Example –
Buying 108 call and 102 put.

 Selling a strangle – this is a strategy that is profitable quite often as most of

the time, out-of-money calls expire worthless if at least they do not totally
overcome the premiums paid.
 ButterFly Spreads

 It is a combination of both a bull spread and a bear spread. It

involves there strike prices, for example, buying a June 290 call,
selling 2 June 300 calls, and buying a June 310 call.

 The risks are limited, but the profit potential generally does not
justify the costs involved.

 Hence one needs to be very careful while getting into strategies,

only after understanding the payoff.
 Winning Options - Trading Rules

 Stay away from deep in-the-money options

Key advantage to buying options are the high leverage and limited risk.
If an option is deep in-the-money, it cut down on your leverage and
adds to your risk. Also, the biggest disadvantage of this option seller is
time decay and deep in-the-money options have less time decay.

 Stay away from deep out-of-money options.

Illusion is that deep out-of-money gives you a lot of leverage but in
reality, it just gives you a lot of hope, encourages over-commitment
and generally offers little profit opportunity.
 Winning Options - Trading Rules

 Trade slightly out-of-money, at-the-money or slightly in-the-money

options.
These options have a reasonable chance of proving profitable when
buying; you gain from the maximun possible time decay when selling,
and they are generally the most liquid.

 There is a time for all seasons

This means you need to have a feel for the market conditions prior to
implementating any option strategy. Illusion is that deep out-of-
money gives you a lot of leverage but in reality, it just gives you a lot of
hope, encourage over-commitment and generally offers little profit
opportunity.
 Precautions while using Options

 Always maintain strict Stop-Loss.

 Never average a losing position.

 As the option nears the expiry, the value of the option reduces due
to time decay.

 Losses are limited in buying of options in comparison to selling of

options.

 Always prefer to take view in option’s closer to market price (in the
money option is better than out of the money).
HAPPY INVESTING