Options

Monieness and OptionsMonieness and Options

RelationshipRelationship CallsCalls PutsPuts

A > SA > S in-the-moneyin-the-money out-of-the-out-of-the-moneymoney

A = SA = S at-the-moneyat-the-moneyat-the-moneyat-the-money

A < SA < S out-of-the-out-of-the- in-the-moneyin-the-money

moneymoney

‘‘A’ denotes the current price of the underlying A’ denotes the current price of the underlying assetasset

‘‘S’ denotes the strike price of the optionS’ denotes the strike price of the option

Value of an OptionValue of an Option

The two components are,The two components are,Intrinsic Value:Intrinsic Value: of call = Max [A-S, 0]of call = Max [A-S, 0]

of put = Max [S-A, 0]of put = Max [S-A, 0]Time value:Time value: It is the value in excess It is the value in excess

of the intrinsic value and indicates of the intrinsic value and indicates option’s potential to become more option’s potential to become more valuable before it expires. It decays valuable before it expires. It decays with passage of time.with passage of time.

How is Value of Options How is Value of Options Affected*?Affected*?

FactorFactor Call Call ValueValue

Put Put ValueValue

Increase in asset valueIncrease in asset value IncreaseIncrease Decrease Decrease

Increase in strike priceIncrease in strike price DecreasDecreasee

IncreaseIncrease

Increase in variance of Increase in variance of underlying assetunderlying asset

IncreaseIncrease IncreaseIncrease

Increase in time to Increase in time to expirationexpiration

Increase Increase IncreaseIncrease

Increase in interest rateIncrease in interest rate Increase Increase Decrease Decrease

Increase in dividend paidIncrease in dividend paid DecreasDecrease e

IncreaseIncrease*American Options

Call OptionCall Option

Pay-off Diagram:Pay-off Diagram:Net payoff Net payoff

on callon call

Strike Strike

PricePrice

Price of Price of underlying underlying assetasset

Put OptionPut Option

Pay-off Diagram:Pay-off Diagram:Net payoff Net payoff

on puton put

Strike Strike

PricePrice

Price of underlying Price of underlying assetasset

Options other than Calls and Options other than Calls and PutsPuts

Convertible in bonds: purchaser buys Convertible in bonds: purchaser buys a straight bond and a call optiona straight bond and a call option

Callable bonds: purchaser buys a Callable bonds: purchaser buys a straight bond and sells a call option straight bond and sells a call option to issuerto issuer

An equity share can be viewed as a An equity share can be viewed as a call option on the assets of a call option on the assets of a company.company.

Buying and Selling Stock:Buying and Selling Stock:Long PositionLong Position

400

EMP (T)

Profit

(-) 400Loss

0

Buying and Selling Stock:Buying and Selling Stock:Short PositionShort Position

MP (T)

Profit240

Loss

0240

E

Elementary Investment Elementary Investment StrategiesStrategies

Long CallLong CallShort CallShort CallLong PutLong PutShort PutShort Put

Long CallLong Call

MP (T)

Profit

Loss

0400

440

E

(-) 40

This refers to the purchase of a call

These are cash flows when a bullishInvestor buys a 3-month call on the Stock with an exercise price of Rs.400Per share by paying a premium of Rs.40

Short CallShort Call

MP (T)

Profit

Loss

0

400

440

E

(+) 40

This involves writing a call without owning the underlying asset

These cash flows relate to writing a 3-month call on a stock at an exercise price of Rs.400 per share by receiving a premium of Rs.40.

Long PutLong Put

MP (T)

Profit

Loss

0240

216

E

(-) 24

(+) 216

This involves buying a put – the right to sell the Underlying asset at a specified price

These cash flows relate to a bearish investorBuying 3-month put with a exercise price of Rs.240 per share by paying a premium of Rs.24

Short PutShort Put

MP (T)

Profit

Loss

0240216

E

(-) 216

This involves writing a put

These cash flows relate to a bullish investor Writing a put at an exercise price of Rs.240Per share receiving a premium of Rs.24.

Complex Investment Complex Investment StrategiesStrategies

Covered Call WritingCovered Call WritingProtective PutProtective PutStraddlesStraddlesStranglesStranglesSpreadsSpreads

Covered Call WritingCovered Call Writing

It involves buying the stock and writing call It involves buying the stock and writing call on that.on that.Profit

MP (T)

(+)48

(-)302

302 350

E

These are cash flows when we buy 100 shares @310 and write a May 350 call for Rs.8 so that initial Investment is Rs.302

Covered Call Writing: Covered Call Writing: CFCF00 = (Rs.302) = (Rs.302)

MP (T)MP (T) At Time TAt Time T NCFNCF

Sell StockSell Stock Buy CallBuy Call CF(T)CF(T)

270270 270 270 0 0 270270 -32 -32

290290 290 290 0 0 290290 -12-12

310310 310 310 0 0 310310 8 8

330330 330 330 0 0 330330 28 28

350350 350 350 0 0 350350 48 48

370370 370 370 -20-20 350350 48 48

Covered Call:Covered Call:Why better than stock or only short calls?Why better than stock or only short calls?

Reduces the risk of uncovered call writing.Reduces the risk of uncovered call writing. Downside risk is reduced by the premium amount.Downside risk is reduced by the premium amount. Loss of upward gains can be minimized by rolling up Loss of upward gains can be minimized by rolling up

the exercise price.the exercise price. When call ends up out-of-the-money, profits increase When call ends up out-of-the-money, profits increase

by every dollar by which the stock price exceeds the by every dollar by which the stock price exceeds the original price.original price.

Has a lower B.E.P. compared to only stock.Has a lower B.E.P. compared to only stock. Writing a covered call at lower exercise price is Writing a covered call at lower exercise price is

conservative, it reduces the loss but also the upward conservative, it reduces the loss but also the upward gains.gains.

Writing at higher exercise price is risky. Downside loss Writing at higher exercise price is risky. Downside loss is higher (less protective) and also gains are higher.is higher (less protective) and also gains are higher.

A short holding period reduces the stock movement A short holding period reduces the stock movement possibility and is the best.possibility and is the best.

Protective PutProtective Put

It involves buying the stock and buying put on It involves buying the stock and buying put on that.that.Profit

Loss

(-)42

MP (T)270 312

E

These are cash flows when buy 100 shares @ Rs.310 and buy aJun 270 put for Rs.2 so that initial Investment is Rs.312

Protective PutProtective Put

Guards against fall and also participate in gains. Put Guards against fall and also participate in gains. Put ensures min. selling price for stock.ensures min. selling price for stock.

Gain on upside movement is restricted by the Gain on upside movement is restricted by the premium.premium.

Smaller downside risk and smaller upward gains and Smaller downside risk and smaller upward gains and higher BEP.higher BEP.

Higher strike price costs maximum but also provides Higher strike price costs maximum but also provides maximum protection. Reduces the profits maximum.maximum protection. Reduces the profits maximum.

Lower strike price costs less, less protective and Lower strike price costs less, less protective and reduces profits less.reduces profits less.

Long holding period has chances of recovery of time Long holding period has chances of recovery of time value due to more chances of price movements.value due to more chances of price movements.

Synthetic Put and CallSynthetic Put and Call

A A synthetic putsynthetic put involves long calls involves long calls and short sale of an equal number of and short sale of an equal number of shares of stock.shares of stock.

Synthetic callSynthetic call involves buying stock involves buying stock and an equal number of puts and is and an equal number of puts and is nothing but protective put.nothing but protective put.

Long StraddleLong StraddleInvolves buying a put and a call, each with same Involves buying a put and a call, each with same

exercise price exercise price

and same time to expiration.and same time to expiration.Profit247

Loss

(-)63

MP (T)247 373

E1

Buying a Jun 310 call for Rs.21 And Jun 310 put for Rs.42 per Share. Initial investment Rs63.

310

E2

Short StraddleShort StraddleInvolves selling a put and a call, each with same Involves selling a put and a call, each with same

exercise price exercise price

and same time to expiration.and same time to expiration.Profit

Loss(-)247

(63)

MP (T)247 310

E2

373

E1

Straddle VariantsStraddle Variants

Straps:Straps:

A bullish variation of straddle, involves two A bullish variation of straddle, involves two calls and one put. Investors are more calls and one put. Investors are more bullish than bearish and therefore increase bullish than bearish and therefore increase calls.calls.

Strips:Strips:

It is a slightly bearish variation of straddle, It is a slightly bearish variation of straddle, has long position in two puts and one call has long position in two puts and one call and involves one’s bet that the market will and involves one’s bet that the market will go down.go down.

Long StrangleLong Strangle

Involves buying a call and a put on the same Involves buying a call and a put on the same underlying assetunderlying asset

for same expiration period at for same expiration period at different exercise pricesdifferent exercise pricesProfit247

-23

Loss

E1 E2333247

270 310

Buy Jun 310 call for Rs.21 and Jun 270Put for Rs. 2. Initial investment Rs.23. Usually one in-the-money and another Out-of-the-money. Initial investment Can be less than straddle

MP (T)

SpreadsSpreads

Involve buying of one option and selling of Involve buying of one option and selling of another.another.

Offer potential for small profit and limit the Offer potential for small profit and limit the risk.risk.

VerticalVertical Spreads also called Spreads also called StrikeStrike or or MoneyMoney spreads. Could be written as say, spreads. Could be written as say, July 120/125 Spread.July 120/125 Spread.

Horizontal Horizontal Spreads also called as Spreads also called as TimeTime or or CalendarCalendar Spreads. Could be written as Spreads. Could be written as June/July 120 Spread.June/July 120 Spread.

SpreadsSpreads

For Vertical Spreads:For Vertical Spreads:A July 120/125 call spread is a net long A July 120/125 call spread is a net long

position and is called Buying the position and is called Buying the Spread, sometimes referred to as Spread, sometimes referred to as Debit Spread.Debit Spread.

A July 120/125 put spread is a net A July 120/125 put spread is a net short position and is called Selling the short position and is called Selling the Spread, sometimes referred to as Spread, sometimes referred to as Credit Spread.Credit Spread.

SpreadsSpreads

For Horizontal Spreads:For Horizontal Spreads:A June/July 120 call spread is a net A June/July 120 call spread is a net

short position and is called Selling the short position and is called Selling the Spread, sometimes referred to as Spread, sometimes referred to as Credit Spread.Credit Spread.

A July/June 120 call spread is a net A July/June 120 call spread is a net long position and is called Buying the long position and is called Buying the Spread, sometimes referred to as Spread, sometimes referred to as Debit Spread.Debit Spread.

Vertical Spread Vertical Spread (Across Strike Prices)(Across Strike Prices)

Involves buying an option and selling another option of the Involves buying an option and selling another option of the

same type and time to expiration but with different exercise same type and time to expiration but with different exercise price price

MP (T)

Profit

Loss

E

+ 30

- 50

270 320 350

Bullish vertical spread using calls wherein weBuy Mar 270 calls for Rs.58 and sell Mar 350 Calls for Rs.8 i.e. buy lower strike price and Sell higher strike price calls.

Vertical SpreadVertical SpreadInvolves buying an option and selling another option of the Involves buying an option and selling another option of the

same type and time to expiration but with different exercise same type and time to expiration but with different exercise price price

MP (T)

Profit

Loss

E

+ 68

- 12

282270 350

Bullish vertical spread using puts whereinWe buy Mar270 put for Rs.2 and sell Mar 350 put for Rs.70.

Vertical SpreadVertical Spread..

MP (T)E

Profit

Loss

+59

-21

270 329 350

Bearish vertical spread wherein Sell Jun 270 call for Rs.71 and buy Jun 350 call for Rs.12.

Vertical SpreadVertical Spread..

MP (T)E

Profit

Loss

+12

-68

270 282 350

Bearish vertical spread using Puts wherein Buy Mar 350 put for Rs.70 and sell Mar 270 put for Rs.2

Horizontal SpreadsHorizontal Spreads (Across Expiration (Across Expiration

Months)Months)

Involve buying an option and selling Involve buying an option and selling another of same type with same exercise another of same type with same exercise price but with different expiration time.price but with different expiration time.

In a horizontal bull spread, we buy back In a horizontal bull spread, we buy back month and sell the front month. In a month and sell the front month. In a horizontal bear spread, we buy front month horizontal bear spread, we buy front month and sell back month.and sell back month.

Horizontal bull spread has similar pay-off as Horizontal bull spread has similar pay-off as that of a short straddle and horizontal bear that of a short straddle and horizontal bear spread has similar payoff as that of a long spread has similar payoff as that of a long straddle.straddle.

Diagonal Spreads Diagonal Spreads

They are vertical and horizontal They are vertical and horizontal at the same time i.e. the are at the same time i.e. the are across both strike price and across both strike price and expiration month.expiration month.

Butterfly SpreadButterfly Spread

Involves four options, all calls or all Involves four options, all calls or all puts.puts.

All have same expiration month and All have same expiration month and same underlying asset.same underlying asset.

One option has high strike price, one One option has high strike price, one has low strike price and two have has low strike price and two have same strike price which is between same strike price which is between those of high strike and low strike.those of high strike and low strike.

Two middle strike price are sold and Two middle strike price are sold and the two end options are purchased.the two end options are purchased.

Reverse Butterfly or Sandwich Reverse Butterfly or Sandwich SpreadsSpreads

This is strategy reverse of the This is strategy reverse of the butterfly spread.butterfly spread.

The two middle strike price The two middle strike price options are purchase and the options are purchase and the two end strike price options are two end strike price options are sold.sold.

Evaluation of the Evaluation of the StrategiesStrategies

Transaction costs have not been Transaction costs have not been considered and should be kept in mind.considered and should be kept in mind.

Bid-ask spreads may affect payoffs.Bid-ask spreads may affect payoffs. They are not dividend protected.They are not dividend protected. Margin requirements are applicable to Margin requirements are applicable to

option writing.option writing. Possibility of early exercise may pose Possibility of early exercise may pose

new risks.new risks. Timing of cash flows can make a Timing of cash flows can make a

difference.difference.

Futures vs. Options: Futures vs. Options: PerformancePerformance

Option purchasers do not post margins Option purchasers do not post margins

since they have no obligationssince they have no obligations

An option clearing house serves the similar An option clearing house serves the similar

functions as those of clearing associations functions as those of clearing associations

in futures tradingin futures trading

Option writers have to post margins to Option writers have to post margins to

clearing housesclearing houses

Options are also OTC and dealers may Options are also OTC and dealers may

require margins or guarantees.require margins or guarantees.

Illustration 1Illustration 1

Consider the price of the stock at Consider the price of the stock at $165.125. Buy 100 shares of stock $165.125. Buy 100 shares of stock and write one August 170 call and write one August 170 call contract at a premium of $3.25. Hold contract at a premium of $3.25. Hold the position until expiration. the position until expiration. Determine the profits and graph the Determine the profits and graph the results. Identify the breakeven stock results. Identify the breakeven stock price at expiration, the maximum price at expiration, the maximum profits, and the maximum loss.profits, and the maximum loss.

Illustration 2Illustration 2

Consider the price of the stock at the Consider the price of the stock at the same level as in the previous same level as in the previous illustration i.e. $165.125. Now assume illustration i.e. $165.125. Now assume that you buy 100 shares of stock and that you buy 100 shares of stock and buy one August 165 put contract at a buy one August 165 put contract at a premium of $4.75. Hold the position till premium of $4.75. Hold the position till expiration. Determine the profits and expiration. Determine the profits and graph the results. Identify the graph the results. Identify the breakeven stock price at expiration, breakeven stock price at expiration, the maximum profits, and the the maximum profits, and the maximum loss.maximum loss.

Illustration 3Illustration 3

A call option with a strike price of A call option with a strike price of $50 costs $2. A put option with a $50 costs $2. A put option with a strike price of $45 costs $3. Explain strike price of $45 costs $3. Explain how a strangle can be created from how a strangle can be created from these two options. What is the these two options. What is the pattern of profits from the strangle?pattern of profits from the strangle?

Illustration 4Illustration 4

A call with a strike price of $50 A call with a strike price of $50 costs $6. A put with the same strike costs $6. A put with the same strike price and expiration date costs $4. price and expiration date costs $4. Construct a table that shows the Construct a table that shows the profits from a straddle. For what profits from a straddle. For what range of stock prices would the range of stock prices would the straddle lead to a loss?straddle lead to a loss?

Illustration 5Illustration 5

1.1. Discuss the main objectives of Discuss the main objectives of covered call and protective put vis-covered call and protective put vis-à-vis simple call and put strategies.à-vis simple call and put strategies.

2.2. What is synthetic puts and What is synthetic puts and synthetic calls?synthetic calls?

A Transaction on an Option A Transaction on an Option ExchangeExchange

..

Buyer Buyer’sBroker

OptionsExchange

3

Buyer’s Broker’sFloor Broker

OptionsClearingHouse

Buyer’s Broker’sClearing Firm

Buyer’s Broker’sClearing Firm

Seller’s Broker’sFloor Broker

Seller’sBroker

Seller

1a 1b Buyer and seller instruct their respective brokers to conduct an option transaction.2a 2b Buyer’s and seller’s brokers request their firm’s floor brokers execute the transaction.3 Both floor brokers meet in the pit on the floor of the options exchange and agree on a price.4 Information on the trade is reported to the clearinghouse.5a 5b Both floor brokers report the price obtained to the buyer’s and seller’s brokers.6a 6b Buyer’s and seller’s brokers report the price obtained to the buyer and seller.7a 7b Buyer deposits premium with buyer’s broker. Seller deposits margin with seller’s broker.8a 8b Buyer’s and seller’s brokers deposit premium and margin with their clearing firms.9a 9b Buyer’s and seller’s brokers’ clearing firms deposit premium and margin with clearinghouse.

1a

6a

7a

2a5a

48a 8b

9a 9b

2b5b

1b

6b

7b

Note: Either buyer or seller (or both) could be a floor trader, eliminating the broker and floor broker.