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

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

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

*PAYS PREMIUM

*RIGHT TO EXERCISE &

BUY

BUYER EXERCISES RIGHT

*PROFIT

PRICES

FROM RISING

PRICES OR REMAINING NEUTRAL

*UNLIMITED GAINS,

LIMITED LOSSES

LOSSES

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

*TO BREAK-EVEN,

RECOVER STRIKE PRICE(K)+PREMIUM

PROFIT

+20

0 -20 LOSS STRIKE PRICE PROFIT SPOT PRICE

LOSS

BREAK-EVEN

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

PROFIT

+20

STRIKE PRICE

0 LOSS -20 LOSS

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

STRIKE PRICE

BREAK-EVEN

WHAT LONG PUT HOLDER SELLS

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

PROFIT +20

PROFIT

0 LOSS STRIKE PRICE

SPOT PRICE

-20

LOSS

BREAK-EVEN

is known as the strike price or the exercise price

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

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

* 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.

* 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

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)

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

derivative positions

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

LONG PUT

NEGATIVE POSITIVE

SHORT PUT

NEGATIVE NEGATIVE

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

PRICING OF OPTIONS

concepts in modern financial theory

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

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

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

any given time

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

* 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%.

t = now t = now + 1 month

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

$40

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

$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

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

* 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

well as to speculate

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

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

LONG ASSET

PROFIT

+20

0 -20 LOSS

COVERED CALL

STRIKE PRICE

SPOT PRICE

SHORT CALL

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

K

COVERED PUT

-20

LOSS

SHORT ASSET

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

price

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

Put Strike Price

K

LONG PUT

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

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

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

+ Net Premium Paid Paid

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

SHORT STRADDLE

SHORT CALL

SHORT PUT

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

SHORT CALL

LONG CALL

100

150

LOSS

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

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

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

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