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*Options are contracts that give the buyers the right but

not the obligation to buy or sell a specified quantity of certain underlying asset at a specified price on or before a specified date

*The seller is under obligation to perform the contract (i.e.


buy or sell the underlying as per the wish of the buyer of the option)

*The underlying asset can be share, index, interest rate,


bond, commodities, etc.

DERIVATIVES

OPTIONS

CALL
RIGHT BUT NOT OBLIGATION TO BUY

PUT
RIGHT BUT NOT THE OBLIGATION TO SELL

*AMERICAN OPTIONS:
It can be exercised any time up to expiration Premium charged are high These are flexible in nature Options traded on NSE for securities are American style of options *EUROPEAN OPTIONS: It can be exercised only at the time of expiration Premium charged are low Easier to analyze Example: S&P CNX IT options at NSE

CALL OPTION BUYER

CALL OPTION WRITER

*PAYS PREMIUM
*RIGHT TO EXERCISE &
BUY

* RECEIVES PREMIUM * OBLIGATION TO SELL IF


BUYER EXERCISES RIGHT

*PROFIT
PRICES

FROM RISING

* PROFIT FROM FALLING


PRICES OR REMAINING NEUTRAL

*UNLIMITED GAINS,
LIMITED LOSSES

* LIMITED GAIN, UNLIMITED


LOSSES

*MEANING: BUYING A CALL-RIGHT TO BUY *PREMIUM PAID, THUS STARTS WITH LOSS *PROFIT FROM RISING PRICES

*LIMITED LOSS, UNLIMITED PROFIT


*TO BREAK-EVEN,
RECOVER STRIKE PRICE(K)+PREMIUM

*SPOT>STRIKE, PROFIT FOR LONG CALL

PROFIT

+20
0 -20 LOSS STRIKE PRICE PROFIT SPOT PRICE

LOSS
BREAK-EVEN

*MEANING: TAKING OBLIGATION TO SELL A CALL


*SELLING A CALL WITHOUT OWNING AN ASSET *RECEIVES PREMIUM, THUS STARTS WITH PROFIT *PROFIT FROM FALLING PRICES *UNLIMITED LOSS, LIMITED PROFIT

*TO EARN PROFIT, STRIKE PRICE< SPOT

PROFIT
+20

STRIKE PRICE
0 LOSS -20 LOSS

PROFIT SPOT PRICE

BREAK-EVEN

*MEANING: BUYING THE RIGHT TO SELL SHARE *PAYS PREMIUM, THUS STARTS WITH LOSS *PROFIT FROM FALLING PRICES *LIMITED LOSS, UNLIMITED PROFIT *TO EARN PROFIT, SPOT PRICE < STRIKE PRICE

PROFIT +20 PROFIT 0 SPOT PRICE -20 LOSS LOSS

STRIKE PRICE

BREAK-EVEN

*MEANING: TAKES THE OBLIGATION TO BUY


WHAT LONG PUT HOLDER SELLS

*RECEIVES PREMIUM, THUS STARTS WITH PROFIT

*LIMITED PROFIT, UNLIMITED LOSS


*LOSS FROM FALLING PRICES *TO EARN PROFIT, SPOT PRICE > STRIKE PRICE

PROFIT +20

PROFIT
0 LOSS STRIKE PRICE

SPOT PRICE

-20
LOSS

BREAK-EVEN

* STRIKE PRICE: The price specified in the options contract


is known as the strike price or the exercise price

The price at which the buyer of an option can buy the


stock (in the case of a call option) or sell the stock (in the case of a put option) on or before the expiry date of option contracts is called strike price

* EXPIRATION DATE: The date specified in the options


contract is known as the expiration date, the exercise date, the strike date or the maturity.

It is also called the final settlement date

* 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 Comprises of Intrinsic Value and Time Value * INTRINSIC VALUE OF AN OPTION: STRIKE PRICE-SPOT PRICE The intrinsic value of an option is defined as the amount by which an
option is in-the-money or the immediate exercise value of the option when the underlying position is marked-to-market

For CA: Intrinsic Value= MAX(spot-strike, 0) For PA: Intrinsic Value= MAX(strike-spot, 0) * TIME VALUE OF AN OPTION: PREMIUM-INTRINSIC VALUE Both calls and puts have time value. An option that is OTM or ATM has only time value.
maximum time value exists when the option is ATM.

Usually, the

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

* CALL OPTION:
In-the-money = strike price less than stock price. At-the-money = strike price same as stock price. Out-of-the-money = strike price greater than stock price

* PUT OPTION:
In-the-money = strike price greater than stock price At-the-money = strike price same as stock price Out-of-the-money = strike price less than stock price

* IN-THE-MONEY OPTION: An in-the-money (ITM) option is an

option that would lead to a positive cash flow to the holder if it were exercised immediately option that would lead to zero cash flow if it were exercised immediately. An option on the index is at-the-money when the current index equals the strike price (i.e. spot price = strike price)

* AT-THE-MONEY OPTION: An at-the-money (ATM) option is an

* OUT-OF-THE-MONEY OPTION: An out-of-the-money (OTM)

option is an option that would lead to a negative cash flow if it were exercised immediately

* Greeks help us to measure the risk associated with


derivative positions

* Greeks also come in handy when we do local valuation of


instruments.

* This is useful when we calculate value at risk * DELTA * GAMMA * THETA * VEGA * RHO

POSITION

DELTA

GAMMA

VEGA

THETA

RHO

LONG CALL

POSITIVE

POSITIVE

POSITIVE

NEGATIVE POSITIVE

POSITIVE NEGATIVE

SHORT CALL NEGATIVE

NEGATIVE NEGATIVE POSITIVE POSITIVE

LONG PUT

NEGATIVE POSITIVE

NEGATIVE NEGATIVE POSITIVE POSITIVE

SHORT PUT

NEGATIVE NEGATIVE

* Option Pricing Model assists the trader in keeping the

prices of calls and puts in proper numerical relationship to each other and helps the trader make BIDS & OFFER quickly

PRICING OF OPTIONS

Black-Scholes Option Pricing Model (BSOPM)

Binomial Option Pricing Model (BOPM)

*The Black Scholes Model is one of the most important


concepts in modern financial theory

*The BlackScholes model is a mathematical description

of financial markets and derivative investment instruments. The model develops partial differential equations whose solution, the BlackScholes formula, is widely used in the pricing of European-style options pricing

*The BlackScholes model is a tool for equity options

*Black Scholes Model which assumes that percentage


change in the prices of underlying follows normal distribution

Base price of the options contracts, on introduction of new contracts, would be the theoretical value of the options contract arrived at based on Black- Scholes model of calculation of options premiums. C = price of a call option P = price of a put option S = price of the underlying asset X = Strike price of the option r = rate of interest t = time to expiration = volatility of the underlying N represents a standard normal distribution with mean = 0 and standard deviation = 1 It represents the natural logarithm of a number. Natural logarithms are based on the constant e (2.71828182845904). Rate of interest may be the relevant MIBOR rate or such other rate as may be specified

*The options price for a CALL, computed as per


the following Black Scholes formula: C = S * N (d1) - X * e- rt * N (d2) and the price for a PUT is :

P = X * e- rt * N (-d2) - S * N (-d1) where : d1 = [ln (S / X) + (r + 2 / 2) * t] / * sqrt(t) d2 = [ln (S / X) + (r - 2 / 2) * t] / * sqrt(t) = d1 - * sqrt(t)

* BOPM was invented to explain the Black Scholes Model. * The Binomial Model is named so, as it returns two possibilities at
any given time

* Due to its simple and iterative structure, the model presents

certain unique advantages. For example, since it provides a stream of valuations for a derivative for each node in a span of time, it is useful for valuing derivatives such as American options which allow the owner to exercise the option at any point in time until expiration (unlike European options which are exercisable only at expiration). when compared to counterparts such as the Black-Scholes model, and is therefore relatively easy to build and implement with a computer spreadsheet

* The model is also somewhat simple mathematically

* A stock is currently priced at $40 per share. * In 1 month, the stock price may
* go up by 25%, or * go down by 12.5%.

*Stock price dynamics:


t = now t = now + 1 month

$40x(1+.25) = $50

UP STATE DOWN STATE

$40

$40x(1-.125) = $35

* A call option on this stock has a strike price of


$45
t=0 t=1 Stock Price=$50; Stock Price=$40; Call Value=$5

Call Value=$c

Stock Price=$35;
Call Value=$0

* A ratio of the trading volume of put options to call options * The put-call ratio has long been viewed as an indicator of
investor sentiment in the markets

* The put-call ratio is a popular tool specifically designed to help


individual investors gauge the overall sentiment (mood) of the market put options by the number of open interest call options

* The ratio is calculated by dividing the number of open interest


* As this ratio increases, it can be interpreted to mean that
investors are putting their money into put options rather than call options either starting to speculate that the market will move lower, or starting to hedge their portfolios in case of a sell-off

* An increase in traded put options signals that investors are

*Options are instruments that can be used to hedge as


well as to speculate

*Different options can be combined to create different


synthetic instruments, which will match the risk and return profile of the option user

*Covered option strategies: Covered call and put *Synthetic options: Synthetic call and put *Straddles: long and short *Strangles: long and short *Butterfly spread: long and short

* The covered call is a strategy in which an investor Sells a Call


option on a stock he owns.

* The Call would not get exercised unless the stock price increases
above the strike price. Till then the investor in the stock (Call seller) can retain the Premium with him. This becomes his income from the stock. who is Neutral to moderately Bullish about the stock.

* WHEN TO USE: This strategy is usually adopted by a stock owner * RISK: If the stock price falls to zero, the investor loses the entire
value of the stock but retains the premium, since the call will not be exercised against him.

* So MAXIMUM RISK= STOCK PRICE PAID-CALL PREMIUM * REWARD: Limited to (CALL STRIKE PRICE-STOCK PRICE PAID) +
PREMIUM RECEIVED

* BREAKEVEN: STOCK PRICE PAID-PREMIUM RECEIVED

LONG ASSET
PROFIT

+20
0 -20 LOSS

COVERED CALL
STRIKE PRICE
SPOT PRICE

SHORT CALL

* This strategy is opposite to a Covered Call. A Covered Call is a

neutral to bullish strategy, whereas a Covered Put is a neutral to Bearish strategy to remain range bound or move down

* This strategy is done when the price of a stock / index is going * Covered Put writing involves a short in a stock / index along
with a short Put on the options on the stock/ index
are moderately bearish

* WHEN TO USE: If the investor is of the view that the markets * RISK: Unlimited if the price of the stock rises substantially * REWARD: Maximum is (SALE PRICE OF THE STOCK STRIKE
PRICE) + PUT PREMIUM

* BREAKEVEN: SALE PRICE OF STOCK + PUT PREMIUM

PROFIT SHORT PUT +20 0

K
COVERED PUT

-20
LOSS

SHORT ASSET

* In this strategy, we purchase a stock since we feel bullish about

it. But what if the price of the stock went down. You wish you had some insurance against the price fall. So buy a Put on the stock. This gives you the right to sell the stock at a certain price which is the strike price. The strike price can be the price at which you bought the stock or slightly below

* SYNTHETIC CALL: LONG PUT + LONG ON UNDERLYING ASSET * WHEN TO USE: When ownership is desired of stock yet investor is
concerned about near-term downside risk. The outlook is conservatively bullish

* RISK: Losses limited to Stock price + Put Premium Put Strike


price

* REWARD: Profit potential is unlimited * BREAK-EVEN POINT: Put Strike Price + Put Premium + Stock Price
Put Strike Price

LONG ASSET PROFIT PROTECTIVE PUT +20 0 -20 LOSS

K
LONG PUT

* This is a strategy wherein an investor has gone short on a stock

and buys a call to hedge * This is an opposite of Synthetic Call. The net effect of this is that the investor creates a pay-off like a Long Put, but instead of having a net debit (paying premium) for a Long Put, he creates a net credit (receives money on shorting the stock) * This strategy hedges the upside in the stock position while retaining downside profit potential * SYNTHETIC CALL: LONG CALL + SHORT ON UNDERLYING ASSET * When to Use: If the investor is of the view that the markets will go down (bearish) but wants to protect against any unexpected rise in the price of the stock * Risk: Limited. Maximum Risk is Call Strike Price Stock Price + Premium * Reward: Maximum is Stock Price Call Premium * Breakeven: Stock Price Call Premium

LONG CALL
PROFIT +20 0 -20 LOSS

K
PROTECTIVE CALL

SHORT ASSET

* A Straddle is a volatility strategy and is used when the stock


price / index is expected to show large movements

* LONG STRADDLE: * This strategy involves buying a call as well as put on the same
stock / index for the same maturity and strike price, to take advantage of a movement in either direction index will experience significant volatility in the near term

* WHEN TO USE: The investor thinks that the underlying stock /


* RISK: Limited to the initial premium paid * REWARD: Unlimited * BREAKEVEN: Upper Breakeven Point = Strike Price of Long Call
+ Net Premium Paid Paid

* Lower Breakeven Point = Strike Price of Long Put - Net Premium

PROFIT +20 0 -20

LONG PUT

LONG CALL

LOSS

LONG STRADDLE

* SHORT STRADDLE: * A Short Straddle is the opposite of Long Straddle * It is a strategy to be adopted when the investor feels the

market will not show much movement * He sells a Call and a Put on the same stock / index for the same maturity and strike price. It creates a net income for the investor. If the stock / index does not move much in either direction, the investor retains the Premium as neither the Call nor the Put will be exercised * WHEN TO USE: The investor thinks that the underlying stock / index will experience very little volatility in the near term * RISK: Unlimited * REWARD: Limited to the premium received * BREAKEVEN: * Upper Breakeven Point = Strike Price of Short Call + Net Premium Received * Lower Breakeven Point = Strike Price of Short Put - Net Premium Received

PROFIT +20 0 -20 LOSS

SHORT STRADDLE

SHORT CALL

SHORT PUT

* A Strangle is a slight modification to the Straddle to make it cheaper to

execute. This strategy involves the simultaneous buying of a slightly outof-the-money (OTM) put and a slightly out-of-the-money (OTM) call of the same underlying stock / index and expiration date. potentially be higher for a Strangle to make money, it would require greater movement on the upside or downside for the stock / index than it would for a Straddle experience very high levels of volatility in the near term.

* The initial cost of a Strangle is cheaper than a Straddle, the returns could

* WHEN TO USE: The investor thinks that the underlying stock / index will * RISK: Limited to the initial premium paid * REWARD: Unlimited * BREAKEVEN: * Upper Breakeven Point = Strike Price of Long Call + Net Premium Paid * Lower Breakeven Point = Strike Price of Long Put - Net Premium Paid

PROFIT +20 0 -20

SHORT CALL

LONG CALL

100

150

LOSS

* SHORT STRANGLE: * A Short Strangle is a slight modification to the Short Straddle. It


tries to improve the profitability of the trade for the Seller of the options by widening the breakeven points so that there is a much greater movement required in the underlying stock / index, for the Call and Put option to be worth exercising options investor thinks that the underlying stock will experience little volatility in the near term.

* WHEN TO USE: This options trading strategy is taken when the * RISK: Unlimited * REWARD: Limited to the premium received * BREAKEVEN: * Upper Breakeven Point = Strike Price of Short Call + Net
Premium Received Premium Received

* Lower Breakeven Point = Strike Price of Short Put Ne

PROFIT +20

0
100 -20 LOSS SHORT PUT SHORT CALL 150

LONG CALL BUTTERFLY: SELL 2 ATM CALL OPTIONS, BUY 1 ITM CALL OPTION AND BUY 1 OTM CALL OPTION * 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. * 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

PROFIT

LONG BUTTERFLY

OTM LONG CALL

+20 LOWER STRIKE PRICE


0 MIDDLE STRIKE PRICE -20 ITM LONG CALL LOSS 2 ATM SHORT CALL HIGHER STRIKE PRICE

* BUY 2 ATM CALL OPTIONS, SELL 1 ITM CALL OPTION AND SELL 1 OTM
CALL OPTION.

* A Short Call Butterfly is a strategy for volatile markets * It is the opposite of Long Call Butterfly, which is a range bound strategy * 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 premium received for the position

* RISK: Limited to the net difference between the adjacent strikes less the
* 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 Premium Received

* Lower Breakeven Point = Strike Price of Lowest Strike Short Call + Net

PROFIT +20 LOWER STRIKE PRICE 0 MIDDLE STRIKE PRICE -20 BUY 2 ATM LONG CALL

HIGHER STRIKE PRICE

SELL ITM SHORT CALL LOSS SHORT CALL BUTTERFLY

BUY OTM CALL OPTION