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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 ‡ Spot price>Exercise ‡ Spot price<Exercise ‡ Spot price=Exercise

Call Options ‡ 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

400 440 - 40 Loss

MP(T)

‡ ‡ ‡ ‡

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 +40 400

440 E

MP(T)

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 -24

240

MP(T)

Loss

Short Put
‡ Strategy of writing a put
Profit

E 216 -216 Loss

240

MP(T)

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 302 -302 Loss MP(T) 350

‡ 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

270 (-) 42 Loss

E MP (T) 312

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) 220 240 260 280 300 310 320 340 360 380 400

Sell call 0 0 0 0 0 0 10 30 50 70 90

Sell put 90 70 50 30 10 0 0 0 9 9 0

CF(T) 90 70 50 30 10 0 10 30 50 70 90

Net CF 27 7 -13 -33 -53 -63 -53 -33 -13 7 27

PAYOFF OF A STRADDLE

Payof f X Call option payoff

Spot Price Put option payoff

LONG STRADDLE STRATEGY
Profit 247

E 247 (-) 63 Loss 310

E 373

MP( T)

SHORT STRADDLE STRATEGY
Profit 63 E 247 (-) 247 Loss E 310 37 3 MP( T)

‡ 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) 220 240 260 270 300 310 320 340 360

Sell Call Sell Put 0 0 0 0 0 0 10 30 50 50 30 10 0 0 0 0 0 0

CF(T) 50 30 10 0 0 0 10 30 50

Net CF 27 7 -13 -23 -23 -23 -13 7 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 247 (-) 23

270

E 310 333

MP (T)

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) 220 240 260 270 300 310 320 340 360 400

Sell Call 0 0 0 0 0 0 10 30 50 90

Sell Puts CF(T) 180 140 100 80 20 0 0 0 0 0 180 140 100 80 20 0 10 30 50 90

Net CF 75 35 -5 -25 -85 -105 -95 -75 -55 -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) 220 240 260 270 300 310 320 340 360 400

SellCalls Sell Put 0 0 0 0 0 0 20 60 100 180 90 70 50 40 10 0 0 0 0 0

CF(T) 90 70 50 40 10 0 20 60 100 180

Net CF 6 -14 -34 -44 -74 -84 -64 -24 16 96

STRAP
Profi P t 312

0

226

310

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 ‡ Sell March 350 call Rs.58 Rs.8

Initial investment Rs.50(outflow)
MP(T) Buy March 270 0 0 0 10 30 50 70 80 Sell March 350 call 0 0 0 0 0 0 0 0 CF(T) Net

240 260 270 280 300 320 340 350

0 0 0 10 30 50 70 80

-50 -50 -50 -40 -20 0 20 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 270 (-) 50 Loss 320 350 MP (T)

‡ 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 Sell March 350 put Rs.2 Rs.70

‡ Initial cash flow Rs.68 ( inflow )

BULLISH VERTICAL SPREAD STRATEGY USING PUTS
Profi t(+) 68 27 0 (-) 12 Los s E 282 350 MP (T)

Bearish Vertical Spread Using Calls
‡ Sell October 270 calls ‡ Buy October 350 call Rs.71 Rs.12

‡ Initial Cash Flow

Rs.59

BEARISH VERTICAL SPREAD STRATEGY USING CALLS
Profi t (+) 59

(+)1 2

E 270

282 350

MP(T )

(-) 68 Loss

Bearish Vertical Spread Using Puts
Buy March 350 put Sell March 270 put
Profit 12 270 350 MP(T)

Rs.70 Rs.2

-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 0 X 1 X2 X3 Short Butterfly Spread 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 X1

X3 X4

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

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