Options Trading Strategy Guide: ForewordIn Global Financial
Markets, for many years, options have been a means of conveying
rights from one party to another at a specified price on or before
a specific date. Options to buy and sell are commonly executed in
real estate and equipment transactions, just as they have been for
years in the securities markets. There are two types of option
agreements: CALLS and PUTS.
A CALL OPTION is a contract that conveys to the owner the right,
but not the obligation, to purchase a prescribed number of shares
or futures contracts of an underlying security at a specified price
before or on a specific expiration date.
A PUT OPTION is a contract that conveys to the owner the right,
but not obligation, to sell a prescribed number of shares or
futures contracts of an underlying security at a specified price
before or on a specific expiration date.
Consequently, if the market in a security were expected to
advance, a trader would purchase a call and, conversely, if the
market in a security were expected to decline, a trader would
purchase a put. With the advent of listed options, the
inconvenience and difficulties originally associated with
transacting options have been greatly diminished. The purpose of
this book is to provide an introduction to some of the basic equity
option strategies available to option and/or stock investors.
Exchange-traded options have many benefits including flexibility,
leverage, limited risk for buyers employing these strategies, and
contract performance guaranteed by Stock Exchanges. Options allow
you to participate in price movements without committing the large
amount of funds needed to buy stock outright. Options can also be
used to hedge a stock position, to acquire or sell stock at a
purchase price more favorable than the current market price, or, in
the case of writing (selling) options, to earn premium income.
Options give you options. You're not just limited to buying,
selling or staying out of the market. With options, you can tailor
your position to your own financial situation, stock market outlook
and risk tolerance. Whether you are a conservative or
growth-oriented investor, or even a short-term, aggressive trader,
your broker can help you select an appropriate options strategy.
The strategies presented in this book do not cover all, or even a
significant number, of the possible strategies utilizing options.
These are the most basic strategies, however, and will serve well
as building blocks for more complex strategies. Despite their many
benefits, options are not suitable for all investors. Individuals
should not enter into option transactions until they have read and
understood the risk disclosure section coming later in this
document which outlines the purposes and risks thereof. Further, if
you have only limited or no experience with options, or have only a
limited understanding of the terms of option contracts and basic
option pricing theory, you should examine closely another industry
document.
An investor who desires to utilize options should have
well-defined investment objectives suited to his particular
financial situation and a plan for achieving these objectives.
Options are currently traded on the following Indian exchanges:
Bombay Stock Exchange (BSE) and National Stock Exchange (NSE). Like
trading in stocks, options trading are regulated by the SEBI. These
exchanges seek to provide competitive, liquid, and orderly markets
for the Purchase and sale of standardized options. It must be noted
that, despite the efforts of each exchange to provide liquid
markets, under certain conditions it may be difficult or impossible
to liquidate an option position. Please refer to the disclosure
document for further discussion on this matter. All strategy
examples described in this book assume the use of regular, listed,
American-style equity options, and do not take into consideration
margin requirements, transaction and commission costs, or taxes in
their profit and loss calculations. You should be aware that in
addition to SEBI margin requirements, each brokerage firm may have
its own margin rules that can be more detailed, specific or
restrictive. In addition, each brokerage firm may have its own
guidelines with respect to commissions and transaction costs. It is
up to you to become fully informed on the specific procedures,
rules and/or fee and commission schedules of your specific
brokerage firm(s). The successful use of options requires a
willingness to learn what they are, how they work, and what risks
are associated with particular options strategies. Individuals
seeking expanded investment opportunities in today's markets will
find options trading challenging, often fast moving, and
potentially rewarding. BRIEF OPTIONS HISTORY Ancient Origins
Although it isn't known exactly when the first option contract
traded, it is known that the Romans and Phoenicians used similar
contracts in shipping. There is also evidence that Thales, a
mathematician and philosopher in ancient Greece used options to
secure a low price for olive presses in advance of the harvest.
Thales had reason to believe the olive harvest would be
particularly strong. During the off-season when demand for olive
presses was almost nonexistent, he acquired rights-at a very low
cost-to use the presses the following spring. Later, when the olive
harvest was in full-swing, Thales exercised his option and
proceeded to rent the equipment to others at a much higher price.
In Holland, trading in tulip options blossomed during the early
1600s. At first, tulip dealers used call options to make sure they
could secure a reasonable price to meet the demand. At the same
time, tulip growers used put options to ensure an adequate selling
price. However, it wasn't long before speculators joined the mix
and traded the options for profit. Unfortunately, when the market
crashed, many speculators failed to honor their agreements. The
consequences for the economy were devastating. Not surprisingly,
the situation in this unregulated market seriously tainted the view
most people had of options. After a similar episode in London one
hundred years later, options were even declared illegal.
Early Options in the US In the US, options appeared on the scene
around the same time as stocks. In the early 19thCentury, call and
put contracts-known as "privileges"-were not traded on an exchange.
Because the terms differed for each contract, there wasn't much in
the way of a secondary market. Instead, it was up to the buyers and
sellers to find each other. This was typically accomplished when
firms offered specific calls and puts in newspaper ads. Not unlike
what happened in Holland and England, options came under heavy
scrutiny after the Great Depression. Although the Investment Act of
1934 legitimized options, it also put trading under the watchful
eye of the newly formed Securities and Exchange Commission (SEC).
For the next several decades, growth in option trading remained
slow. By 1968, annual volume still didn't exceed 300,000 contracts.
For the most part, early over-the-counter options failed to attract
a following because they were cumbersome and illiquid. In the
absence of an exchange, all trades were done by phone. To make
matters worse, investors had no way of knowing what the real market
for a given contract was. Instead, the put-call dealer functioned
only to match the buyer and seller. Operating without a fixed
commission, the dealer simply kept the spread between the price
paid and the price sold. There was no limit to the size of this
spread. Worse yet, all option contracts had to be exercised in
person. If the holder of the option somehow missed the 3:15 pm
deadline, the option would expire worthless regardless of its
intrinsic value. Chicago Board of Trade In the late 1960s, as
exchange volume for commodities began to shrink, the Chicago Board
of Trade (CBOT) explored opportunities for diversification into the
option market. Joseph W. Sullivan, Vice President of Planning for
the CBOT, studied the over-the-counter option market and concluded
that two key ingredients for success were missing. First, Sullivan
believed that existing options had too many variables. To correct
this, he proposed standardizing the strike price, expiration, size,
and other relevant contract terms. Second, Sullivan recommended the
creation of an intermediary to issue contracts and guarantee
settlement and performance. This intermediary is now known as the
Options Clearing Corporation. To replace the put-call dealers, who
served only as intermediaries, the CBOT created a system in which
market makers were required to provide two-sided markets. At the
same time, the presence of multiple market makers made for a
competitive atmosphere in which buyers and sellers alike could be
assured of getting the best possible price. Chicago Board Options
Exchange (CBOE) After four years of study and planning, the Chicago
Board of Trade established the Chicago Board Options Exchange
(CBOE) and began trading listed call options on 16 stocks on April
26, 1973. The CBOE's first home was actually a smoker's lounge at
the Chicago Board of Trade. After achieving first-day volume of 911
contracts, the average daily volume skyrocketed to over 20,000 the
following year. Along the way, the new exchange achieved several
important milestones.
As the number of underlying stocks with listed options doubled
to 32, exchange membership doubled from 284 to 567. About the same
time, new laws opened the door for banks and insurance companies to
include options in their portfolios. For these reasons, option
volume continued to grow. By the end of 1974, average daily volume
exceeded 200,000 contracts. The newfound interest in options also
caught the attention of the nation's newspapers, which voluntarily
began carrying listed option prices. That's quite an accomplishment
considering that the CBOE initially had to purchase news space in
The Wall Street Journal in order to publish quotes. The Emergence
of Put Trading After repeated delays by the SEC, put trading
finally began in 1977. Determined to monitor the situation closely,
the SEC only permitted puts to be traded on five stocks. Despite
the rapid acceptance of puts and the rising interest in options,
the SEC imposed a moratorium halting the listing of additional
options. Nevertheless, annual volume at the CBOE reached 35.4
million in 1979. Today, more than ever, option volume and open
interest continues to climb. In 1999 alone, option volume at the
CBOE doubled. By the end of 1999, the number of open contracts
reached almost 60 million. Today, options on all sorts of financial
instruments are also traded at the Chicago Mercantile Exchange, the
CBOT, and other exchanges. Employee Stock Options With the rapid
growth in Internet companies over the past few years and the
enormous wealth created by employee stock options, more and more
people are developing an interest in the concept of owning and
trading options. Although there are fundamental differences between
the options granted to an employee by a company and the options
traded on the floor of an exchange, there are important
similarities. When a company grants stock options to an employee,
it gives that person the right to buy a certain number of shares at
a price often well below market value. Although the options granted
by a company eventually expire, they are usually good for extended
periods (e.g., 10 years). Generally speaking, options issued by a
company are not transferable. Therefore, they cannot be sold or
traded to a third party. However, if the company is publicly
traded, the employee can exercise the options and convert it to
stock. This stock can then be sold on the open market. For example,
the person might have options to buy 1,000 shares at an exercise
(strike) price of 120 per share when the stock (in the case of a
public company) is actually trading at 250. In this case, the
person pays Rs.120,000 for stock that is worth Rs.250,000 on the
open market. Not a bad deal at all.
Exchange Traded Options Although there are a variety of
different types of options (e.g., stock options, index options),
this section will focus exclusively on stock options. Once you
understand the basic principles, they can easily be applied to the
other financial instruments. Exchange-traded stock options, also
known as equity options, differ from those granted to employees by
their company in a number of important ways. First, they typically
have shorter-term expirations. Options granted by companies are
often good for several years. During that period, they can be
exercised (converted to stock) at any point. However, employee
stock options cannot usually be sold or transferred. In contrast,
exchange traded options (with the exception of LEAPS) are generally
valid for only a few months and can be bought or sold at any time
prior to expiration. To many people, it seems odd that
exchange-traded options are not issued by the companies themselves.
Instead, they are issued by the Exchange Options Clearing (EOC). By
centralizing and standardizing options trading, the EOC has created
a more liquid market. Unless otherwise specified, each option
contract controls 100 shares of stock. In simplest terms, an option
holder has the right, but not the obligation, to buy or sell a
particular stock at a set price (strike) on or before the day of
expiration (assignment). For example, someone holding a Nifty June
1120 Call would have the right to buy 200 units of Nifty for 1120
per unit. Likewise, a Nifty June 1120 Put gives the holder the
right to sell 200 units of Nifty for 1120 per unit.
Options Trading Strategy Guide: Introduction to Basics
WHAT IS AN OPTION? We all know many opportunities exist in
trading today. Everywhere you turn, someone is waiting to inform
you of the tremendous profits to be realized in the stock and
futures markets. However, many people are unaware of the derivative
trading possibilities that are available within and across several
different markets. Option trading is just one of the many ways to
participate in these secondary markets. And contrary to popular
belief, this potential trading arena is not limited strictly to the
practice of selling or writing options. Options are an important
element of investing in markets, serving a function of managing
risk and generating income. Unlike most other types of investments
today, options provide a unique set of benefits. Not only does
option trading provide a cheap and effective means of hedging one's
portfolio against adverse and unexpected price fluctuations, but it
also offers a tremendous speculative dimension to trading.
One of the primary advantages of option trading is that option
contracts enable a trade to be leveraged, allowing the trader to
control the full value of an asset for a fraction of the actual
cost. And since an option's price mirrors that of the underlying
asset at the very least, any favorable return in the asset will be
met with a greater percentage return in the option provides limited
risk and unlimited reward. With options, the buyer can only lose
what was paid for the option contract, which is a fraction of what
the actual cost of the asset would be. However, the profit
potential is unlimited because the option holder possesses a
contract that performs in sync with the asset itself. If the
outlook is positive for the security, so too will the outlook be
for that asset's underlying options. Options also provide their
owners with numerous trading alternatives. Options can be
customized and combined with other options and even other
investments to take advantage of any possible price dislocation
within the market. They enable the trader or investor to acquire a
position that is appropriate for any type of market outlook that he
or she may have, be it bullish, bearish, choppy, or silent. While
there is no disputing that options offer many investment benefits,
option trading involves risk and is not for everyone. For the same
reason that one's returns can be large, so too can the losses -
leverage. Also, while the potential for financial success does
exist in option trading, the means of realizing such opportunities
are often difficult to create and to identify. With dozens of
variables, several pricing models, and hundreds of different
strategies to choose from, it is no wonder that options and option
pricing have been a mystery to the majority of the trading public.
Most often, a great deal of information must be processed before an
informed trading decision can be reached. Computers and
sophisticated trading models are often relied upon to select
trading candidates. However, as humans, we like things to be as
simple as possible. This often creates a conflict when deciding
what, when, and how to trade a particular investment. It is much
easier to buy or sell an asset outright than to contend with the
many extraneous factors of these derivative markets.* If an
investor thinks an asset's value will appreciate, he or she can
simply buy the security; if an investor thinks an asset's value
will depreciate, he or she can simply sell the security. In these
scenarios, the only thing an investor must worry about is the value
of the investment relative to the value of the prevailing market.
If only options were that easy! * A derivative security is any
security, in whole or in part, the value of which is based upon the
performance of another (underlying) instrument, such as an option,
a warrant, or any hybrid securities. Typically, option trading is
more cumbersome and complicated than stock trading because traders
must consider many variables aside from the direction they believe
the market will move. The effects of the passage of time, variables
such as delta, and the underlying market volatility on the price of
the option are just some of the many items that traders need to
gauge in order to make informed decisions. If one is not prudent in
one's investment decisions, one could potentially lose a lot of
money trading options. Those who disregard careful consideration
and sound money management techniques often find out the hard way
that these factors can quickly and easily erode the value of their
option portfolios.
Because of these risks and benefits, options offer tremendous
profit potential above and beyond trading in any other instrument,
including the underlying security itself. This is the juncture at
which option theoreticians enter the picture. Once the benefits
have been defined, it is now a matter of determining how to best
attain them. Up to now, the vast majority of option techniques have
been elaborate mathematical models designed to help identify when
option-writing or -selling opportunities exist. However, we hope to
break new ground by introducing simple market-timing techniques
that will enable traders to buy options with greater confidence and
with greater success. TYPE OF OPTIONS Call Options A call option
gives the holder (buyer/ one who is long call), the right to buy
specified quantity of the underlying asset at the strike price on
or before expiration date. The seller (one who is short call)
however, has the obligation to sell the underlying asset if the
buyer of the call option decides to exercise his option to buy.
Example: An investor buys One European call option on Infosys at
the strike price of Rs. 3500 at a premium of Rs. 100. If the market
price of Infosys on the day of expiry is more than Rs. 3500, the
option will be exercised. The investor will earn profits once the
share price crosses Rs. 3600 (Strike Price + Premium i.e.
3500+100). Suppose stock price is Rs. 3800, the option will be
exercised and the investor will buy 1 share of Infosys from the
seller of the option at Rs 3500 and sell it in the market at Rs
3800 making a profit of Rs. 200 {(Spot price - Strike price) -
Premium}. In another scenario, if at the time of expiry stock price
falls below Rs. 3500 say suppose it touches Rs. 3000, the buyer of
the call option will choose not to exercise his option. In this
case the investor loses the premium (Rs 100), paid which should be
the profit earned by the seller of the call option. Put Options A
Put option gives the holder (buyer/ one who is long Put), the right
to sell specified quantity of the underlying asset at the strike
price on or before an expiry date. The seller of the put option
(one who is short Put) however, has the obligation to buy the
underlying asset at the strike price if the buyer decides to
exercise his option to sell. Example: An investor buys one European
Put option on Reliance at the strike price of Rs. 300/- , at a
premium of Rs. 25/-. If the market price of Reliance, on the day of
expiry is less than
Rs. 300, the option can be exercised as it is 'in the money'.
The investor's Break-even point is Rs. 275/ (Strike Price - premium
paid) i.e., investor will earn profits if the market falls below
275. Suppose stock price is Rs. 260, the buyer of the Put option
immediately buys Reliance share in the market @ Rs. 260/- &
exercises his option selling the Reliance share at Rs 300 to the
option writer thus making a net profit of Rs. 15 {(Strike price -
Spot Price) - Premium paid}. In another scenario, if at the time of
expiry, market price of Reliance is Rs 320/ -, the buyer of the Put
option will choose not to exercise his option to sell as he can
sell in the market at a higher rate. In this case the investor
loses the premium paid (i.e. Rs 25/-), which shall be the profit
earned by the seller of the Put option. (Please see table) The
Options GameOption holder Option writer buyer seller or or option
option Call Option Buys the right to buy the underlying asset at
the specified price Has the obligation to sell the underlying asset
(to the option holder) at the specified price Put Option Buys the
right to sell the underlying asset at the specified price Has the
obligation to buy the underlying asset (from the option holder) at
the specified price
Options are different from Futures There are significant
differences in Futures and Options. Futures are
agreements/contracts to buy or sell specified quantity of the
underlying assets at a price agreed upon by the buyer and seller,
on or before a specified time. Both the buyer and seller are
obligated to buy/sell the underlying asset. Futures Contracts have
symmetric risk profile for both buyers as well as sellers, whereas
options have asymmetric risk profile. In options the buyer enjoys
the right and not the obligation, to buy or sell the underlying
asset. In case of Options, for a buyer (or holder of the option),
the downside is limited to the premium (option price) he has paid
while the profits may be unlimited. For a seller or writer of an
option, however, the downside is unlimited while profits are
limited to the premium he has received from the buyer. The futures
contracts prices are affected mainly by the prices of the
underlying asset. Prices of options are however, affected by prices
of the underlying asset, time remaining for expiry of the contract
and volatility of the underlying asset. It costs nothing to enter
into a futures contract whereas there is a cost of entering into an
options contract, termed as Premium.
BASIC OPTION TERMINOLOGY Underlying - The specific security /
asset on which an options contract is based. Option Premium - This
is the price paid by the buyer to the seller to acquire the right
to buy or sell. Strike Price or Exercise Price - The strike or
exercise price of an option is the specified/ predetermined price
of the underlying asset at which the same can be bought or sold if
the option buyer exercises his right to buy/ sell on or before the
expiration day. Expiration date - The date on which the option
expires is known as Expiration Date. On Expiration date, either the
option is exercised or it expires worthless. Exercise Date - is the
date on which the option is actually exercised. In case of European
Options the exercise date is same as the expiration date while in
case of American Options, the options contract may be exercised any
day between the purchase of the contract and its expiration date
(see European/ American Option) Assignment - When the holder of an
option exercises his right to buy/ sell, a randomly selected option
seller is assigned the obligation to honor the underlying contract,
and this process is termed as Assignment. Open Interest - The total
number of options contracts outstanding in the market at any given
point of time. Option Holder - is the one who buys an option which
can be a call or a put option. He enjoys the right to buy or sell
the underlying asset at a specified price on or before specified
time. His upside potential is unlimited while losses are limited to
the Premium paid by him to the option writer. Option seller/ writer
- is the one who is obligated to buy (in case of Put option) or to
sell (in case of call option), the underlying asset in case the
buyer of the option decides to exercise his option. His profits are
limited to the premium received from the buyer while his downside
is unlimited. Option Class - All listed options of a particular
type (i.e., call or put) on a particular underlying instrument,
e.g., all Sensex Call Options (or) all Sensex Put Options Option
Series - An option series consists of all the options of a given
class with the same expiration date and strike price. E.g.
BSXCMAY3600 is an options series which includes all Sensex Call
options that are traded with Strike Price of 3600 & Expiry in
May. (BSX Stands for BSE Sensex (underlying index), C is for Call
Option, May is expiry date and strike Price is 3600)
HOW TO START TRADING OPTIONS? Before we devote our attention to
more sophisticated option applications, it is important that we
introduce a basic option foundation. While this introduction to
options will be descriptive in its scope, its coverage will by no
means be exhaustive. The sheer magnitude of option terminology and
strategy could comprise an entire book on its own, and that is not
our primary focus. For us to give our interpretation of existing
material is much like making an entire career out of singing covers
of popular songs of the past. Therefore, we will only be addressing
the items necessary to understanding option basics and the
techniques we will be presenting throughout the book. This simple
introduction is tailored to those who are unfamiliar with options.
Whether they apply to stocks, indices, or futures, all options work
in the same manner. Simply stated, an option is a financial
instrument that allows the owner the right, but not the obligation,
to acquire or to sell a predetermined number of shares of stock or
futures contracts in a particular asset at a fixed price on or
before a specified date. With each option contract, the holder can
make any of three possible choices: exercise the option and obtain
a position in the underlying asset; trade option, closing out the
trader's position in the contract by performing an offsetting
trade; or let the option expire if the contract lacks value at
expiration, losing only what was paid for the option. We will
discuss the benefits and implications of each action later in this
chapter. Option contracts are identified using quantity, asset
expiration date, strike price, type, and premium. With the
exception of the option's premium, each of these items is
standardized upon issuance of a listed option contract. In other
words, once an option contract is created, its rights are static;
the price that one would pay for those rights is not; it is dynamic
and determined by market forces. Seeing as there are many items
which make up the definition of an option contract, it is important
that each be addressed before moving on. The first aspects of an
option contract is the option's quantity. The number of shares or
contracts that can be obtained upon exercising an exchange-listed
option contract is standardized. Each stock option contract allows
the holder of that option to control 100 shares of the underlying
security while each futures option contract can be exercised to
obtain one contract in the underlying futures contract.* *Futures
are leveraged assets typically representing a large, standardized
quantity of an underlying security which expire at some
predetermined date in the future. Each futures option contract
allows the holder to control the total number of units that
comprise the futures contract until the option is liquidated, but
no later than its expiration date. Another item that identifies the
option contract is the asset itself. The asset refers to the type
of investment that can be obtained by the option holder. This asset
could be a futures contract, shares of stock in a company, or a
cash settlement in the case of an index contract. The type of
option is critical in determining the trader's market outlook.
Unlike trading stocks or futures themselves, option trading is not
simply being long a particular market or short a particular market.
Rather, there are two types of options, call options and put
options, and two sides to each type, long or short, allowing the
trader to take any of four possible positions. One
can buy a call, sell a call, buy a put, sell a put, or any
combination thereof. It is important to understand that trading
call options is completely separate from trading put options. For
every call buyer there is a call seller; while for every put buyer
there is a put seller. Also keep in mind that option buyers have
rights, while option sellers have obligations. For this reason,
option buyers have a defined level of risk and option sellers have
unlimited risk. A call option is a standardized contract that gives
the buyer the right, but not the obligation, to purchase a specific
number of shares or contracts of an underlying security at the
option's strike prices, or exercise price, sometime before the
expiration date of the contract. Buying a call contract is similar
to taking a long position in the underlying asset, and one would
purchase a call option if one believed that the market value of the
asset was going appreciate before the date the option expires. The
most trader can lose by purchasing a call option is simply the
price that he or she pays for the option; the most the trader can
make is unlimited. On the other side of the transaction, the
seller, or writer, of a call options has the obligation, not the
right, to sell a specific number of shares or contracts of an asset
to the option buyer at the strike price, if the option is exercised
prior to its expiration date. Selling a call contract acts as a
proxy for a short position in the underlying asset, and one would
sell a call option if one expected that the market value of the
asset would either decline or move sideways. (See Payoff Diagram)
The most an option seller can make on the trade is the price he or
she initially receives for the option contract; the most the trader
can lose is unlimited. In order to offset a long position in a call
option contract, one must sell a call option of the same quantity,
type, expiration date, and strike price. Similarly, in order to
offset a short position in a call option contract, one must buy a
call option of the same quantity, type, expiration date, and strike
price. Long With respect to this booklet's usage of the word, long
describes a position (in stock and/or options) in which you have
purchased and own that security in your brokerage account. For
example, if you have purchased the right to buy 100 shares of a
stock, and are holding that right in your account, you are long a
call contract. If you have purchased the right to sell 100 shares
of a stock, and are holding that right in your account, you are
long a put contract. If you have purchased 1,000 shares of stock
and are holding that stock in your brokerage account, or elsewhere,
you are long 1,000 shares of stock. When you are long an equity
option contract: You have the right to exercise that option at any
time prior to its expiration. Your potential loss is limited to the
amount you paid for the option contract.
PAYOFF DIAGRAM: Profit diagrams for a Long Call and a Long Put
LONG CALL OUTLOOK = S = STRIKE BEP = BREAK-EVEN-POINT DR = DEBIT =
INITIAL OPTION COST MAXIMUM GAIN = UNLIMITED BULLISH PRICE S+DR
MAXIMUM LOSS
= =
Stock BEARISH PRICE = S-DR = MAXIMUM LOSS
STRIKE BREAK-EVEN-POINT INITIAL OPTION COST
MAXIMUM
GAIN = UNLIMITED Stock
Price
Short
With respect to this booklet's usage of the word, short
describes a position in options in which you have written a
contract (sold one that you did not own). In return, you now have
the obligations inherent in the terms of that option contract. If
the owner exercises the option, you have an obligation to meet. If
you have sold the right to buy 100 shares of a stock to someone
else, you are short a call contract. If you have sold the right to
sell 100 shares of a stock to someone else, you are short a put
contract. When you write an option contract you are, in a sense,
creating it. The writer of an option collects and keeps the premium
received from its initial sale. When you are short (i.e., the
writer of ) an equity option contract:
You can be assigned an exercise notice at any time during the
life of the option contract. All option writers should be aware
that assignment prior to expiration is a distinct possibility. Your
potential loss on a short call is theoretically unlimited. For a
put, the risk of loss is limited by the fact that the stock cannot
fall below zero in price. Although technically limited, this
potential loss could still be quite large if the underlying stock
declines significantly in price.
PAYOFF DIAGRAM Profit diagrams for a Short Call and a Short Put
SHORT CALL OUTLOOK = BEARISH S = STRIKE PRICE BEP =
BREAK-EVEN-POINT = S+CR CR = CREDIT = INITIAL OPTION PAYMENT
RECEIVED = MAXIMUM GAIN
MAXIMUM
= Stock
SHORT OUTLOOK = BULLISH S = STRIKE PRICE BEP = BREAK-EVEN-POINT
= S-CR CR = CREDIT = INITIAL OPTION PAYMENT RECEIVED = MAXIMUM
GAIN
MAXIMUM
LOSS
=
UNLIMITED
Stock
A put option is a standardized contract that gives the buyer the
right, but not the obligation, to sell a predetermined number of
shares or contracts of an underlying security at the option's
strike price, or exercise price, sometime before the expiration
date of the contract. A put contract is similar to taking a short
position in the underlying asset, and one could purchase a put
option contract if one believed that the market price of the asset
was going to decline at some point before the date the option
expires. The most a trader can lose by purchasing a put option is
simply the price that he or she pays for the option; the most the
trader can make is unlimited (in reality, it is the full value of
the underlying asset which is realized if its price declines to
zero). Conversely, the seller, or writer, of a put option has the
obligation, not the right, to buy a specific number of shares or
contracts of an asset to the option buyer at the strike price,
assuming the option is exercised prior to its expiration date.
Selling a put contract acts as a substitute for a long position in
the underlying asset, and a trader would sell a put contract if he
or she expected the market value of the asset to either increase or
move sideways. Again, the most an option seller can make on the
trade is the price he or she initially receives for the option
contract; the most the seller can lose is unlimited (in reality,
the most one can lose is the full value of the underlying asset
which is realized if its price declines to zero). (See Payoff
Diagram) In order to offset a long position in a put option
contract, one must sell a put option of the same quantity, type,
expiration date, and strike price. Similarly, in order to offset a
short position in a put option contract, one must buy a put option
of the same quantity, type, expiration date, and strike price. Open
An opening transaction is one that adds to, or creates a new
trading position. It can be either a purchase or a sale. With
respect to an option transaction, consider both:
Opening purchase - a transaction in which the purchaser's
intention is to create or increase a long position in a given
series of options. Opening sale - a transaction in which the
seller's intention is to create or increase a short position in a
given series of options.
Close A closing transaction is one that reduces or eliminates an
existing position by an appropriate offsetting purchase or sale.
With respect to an option transaction:
Closing purchase - a transaction in which the purchaser's
intention is to reduce or eliminate a short position in a given
series of options. This transaction is frequently referred to as
"covering" a short position.
Closing sale - a transaction in which the seller's intention is
to reduce or eliminate a long position in a given series of
options.
Note: An investor does not close out a long call position by
purchasing a put, or vice versa. A closing transaction for an
option involves the purchase or sale of an option con-tract with
the same terms, and on any exchange where the option may be traded.
An investor intending to close out an option position must do so by
the end of trading hours on the option's last trading day. Just
remember, call buyers want the market price of the underlying
security to go higher so the option will gain in value and they can
make money; and call writer want the market to go sideways or lower
so the option will expire worthless and they can make money. Put
buyers want the market price of the underlying security to go lower
so the option can gain in value and they can make money; and put
sellers want the market price to go higher or sideways so the
option will expire worthless and they can make money. Also
remember, option buyers can choose whether they wish to exercise
their options; option sellers cannot. The strike price or exercise
price is simply the price at which the underlying security can be
obtained or sold if one were to exercise the option. For a call
option, the strike price is the price at which the holder can buy
the security from the option writer upon exercising the option. For
a put option, the strike price is the price at which the holder can
sell the security to the option writer upon exercising the option.
These option strike prices are standardized, with the strike
increments determined by the asset's price. Newly created contracts
can only be issued with strike prices that straddle the current
market price of the security; however, at any one time, several
different previously existing strike prices trade on the open
option market. Which of the standardized strike prices the trader
chooses depends upon his or her investment needs and capital
outlay. Obviously, depending upon the prevailing underlying market
price, the rights to some option strike prices will cost more than
others. Strike prices for futures options contracts are different
than those for stock options. Much like options on stock, the
trader can choose from any of the standardized futures option
strike prices that are issued. However, the strike prices that are
set for the futures options are more contractspecific, contingent
upon the market price of the underlying contract, how the future is
priced, and how it trades. For obvious reasons, the issued strike
prices for Treasury bond options will be different than those for
soybean options. Because strikes vary depending on the commodity,
it is important that traders familiarize themselves with the option
contract and the underlying security before they initiate an option
position. The expiration date refers to the length of time through
which the option contract and its rights are active. At any time up
to and including the expiration date, the holder of an option is
entitled to the contract's benefits, which include exercising the
option (taking a position in the underlying asset), trading the
option (closing one's position in the contract by trading it away
to another individual), or letting it expire worthless (if the
contract lacks value at expiration). While the trader can choose
from any of the listed option expiration months he or she wishes to
purchase (or sell), the trader cannot choose the specific date the
option will expire. This date is standardized and is determined
when the option is listed on the exchange on which it is traded.
For most options on equity securities, the final trading day occurs
on the third Friday of each
month. The actual expiration occurs the following day, the
Saturday following the third Friday of the month. The expiration
date for futures options is more complicated than that for stock
options and depends upon the contract that is being traded. Some
futures option contracts expire the Saturday before the third
Wednesday of the expiration month while others expire the month
before the expiration month. Since an option's expiration date
depends upon the type of asset that is traded, it is important for
a trader to know the specific date the contract will expire before
investing in the option. The majority of listed options are issued
with expiration dates approximately nine months into the future. In
addition to these standard options, there are also options that
possess a longer life than the nine-month maximum for regular stock
options. These are called long-term equity anticipation options, or
LEAPS. LEAPS are issued each January with an expiration up to 36
months into the future. LEAPS allow traders to position themselves
for market movement that is expected over a longer period of time:
weeks, months, even years. They are more expensive than standard
options because the added life increases the likelihood that the
option will have value at some point prior to expiration. However,
LEAPS can be traded only on stocks, indices, and interest rate
classes and not every security offers them and currently are
available in United States and not in India. American Style of
options An American style option is the one which can be exercised
by the buyer on or before the expiration date, i.e. anytime between
the day of purchase of the option and the day of its expiry.
European Style of options The European kind of option is the one
which can be exercised by the buyer on the expiration day only
& not anytime before that. Leverage and Risk Options can
provide leverage. This means an option buyer can pay a relatively
small premium for market exposure in relation to the contract value
(usually 100 shares of underlying stock). An investor can see large
percentage gains from comparatively small, favorable percentage
moves in the underlying index. Leverage also has downside
implications. If the underlying stock price does not rise or fall
as anticipated during the lifetime of the option, leverage can
magnify the investment's percentage loss. Options offer their
owners a predetermined, set risk. However, if the owner's options
expire with no value, this loss can be the entire amount of the
premium paid for the option. An uncovered option writer, on the
other hand, may face unlimited risk. In-the-money, At-the-money,
Out-of-the-money An option is said to be 'at-the-money', when the
option's strike price is equal to the underlying asset price. This
is true for both puts and calls.
A call option is said to be in-the-money when the strike price
of the option is less than the underlying asset price. For example,
a Sensex call option with strike of 3900 is 'in-the-money', when
the spot Sensex is at 4100 as the call option has value. The call
holder has the right to buy a Sensex at 3900, no matter how much
the spot market price has risen. And with the current price at
4100, a profit can be made by selling Sensex at this higher price.
On the other hand, a call option is out-of-the-money when the
strike price is greater than the underlying asset price. Using the
earlier example of Sensex call option, if the Sensex falls to 3700,
the call option no longer has positive exercise value. The call
holder will not exercise the option to buy Sensex at 3900 when the
current price is at 3700. (Please see table) Striking the price
Call OptionIn-the-money
Put Option
Strike Price less than Strike Price greater Spot Price of than
Spot Price of underlying asset underlying asset At-the-money Strike
Price equal to Strike Price equal to Spot Price of Spot Price of
underlying asset underlying asset Out-of-the-money Strike Price
greater Strike Price less than than Spot Price of Spot Price of
underlying asset underlying asset
A put option is in-the-money when the strike price of the option
is greater than the spot price of the underlying asset. For
example, a Sensex put at strike of 4400 is in-the-money when the
Sensex is at 4100. When this is the case, the put option has value
because the put holder can sell the Sensex at 4400, an amount
greater than the current Sensex of 4100. Likewise, a put option is
out-of-the-money when the strike price is less than the spot price
of underlying asset. In the above example, the buyer of Sensex put
option won't exercise the option when the spot is at 4800. The put
no longer has positive exercise value. Options are said to be deep
in-the-money (or deep out-of-the-money) if the exercise price is at
significant variance with the underlying asset price. The amount by
which an option, call or put, is in-the-money at any given moment
is called its intrinsic value. Thus, by definition, an at-the-money
or out-of-the-money option has no intrinsic value; the time value
is the total option premium. This does not mean, however, these
options can be obtained at no cost. Any amount by which an option's
total premium exceeds intrinsic value is called the time value
portion of the premium.
It is the time value portion of an option's premium that is
affected by fluctuations in volatility, interest rates, dividend
amounts and the passage of time. There are other factors that give
options value, therefore affecting the premium at which they are
traded. Together, all of these factors determine time value. Option
Premium = Intrinsic Value + Time Value FACTORS THAT AFFECT THE
VALUE OF AN OPTION PREMIUM There are two types of factors that
affect the value of the option premium: Quantifiable Factors:
Underlying stock price, The strike price of the option, The
volatility of the underlying stock, The time to expiration and; The
risk free interest rate.
Non-Quantifiable Factors:
Market participants' varying estimates of the underlying asset's
future volatility Individuals' varying estimates of future
performance of the underlying asset, based on fundamental or
technical analysis The effect of supply & demand- both in the
options marketplace and in the market for the underlying asset The
"depth" of the market for that option - the number of transactions
and the contract's trading volume on any given day.
Different pricing models for options The theoretical option
pricing models are used by option traders for calculating the fair
value of an option on the basis of the earlier mentioned
influencing factors. An option pricing model assists the trader in
keeping the prices of calls & puts in proper numerical
relationship to each other & helping the trader make bids &
offer quickly. The two most popular option pricing models are:
Black Scholes Model which assumes that percentage change in the
price of underlying follows a normal distribution. Binomial Model
which assumes that percentage change in price of the underlying
follows a binomial distribution.
Options Premium is not fixed by the Exchange. The fair value/
theoretical price of an option can be known with the help of
pricing models and then depending on market conditions the price is
determined by competitive bids and offers in the trading
environment.
An option's premium / price is the sum of Intrinsic value and
time value (explained above). If the price of the underlying stock
is held constant, the intrinsic value portion of an option premium
will remain constant as well. Therefore, any change in the price of
the option will be entirely due to a change in the option's time
value. The time value component of the option premium can change in
response to a change in the volatility of the underlying, the time
to expiry, interest rate fluctuations, dividend payments and to the
immediate effect of supply and demand for both the underlying and
its option. Covered and Naked Calls A call option position that is
covered by an opposite position in the underlying instrument (for
example shares, commodities etc), is called a covered call. Writing
covered calls involves writing call options when the shares that
might have to be delivered (if option holder exercises his right to
buy), are already owned. For example, a writer writes a call on
Reliance and at the same time holds shares of Reliance so that if
the call is exercised by the buyer, he can deliver the stock.
Covered calls are far less risky than naked calls (where there is
no opposite position in the underlying), since the worst that can
happen is that the investor is required to sell shares already
owned at below their market value. When a physical delivery
uncovered/ naked call is assigned an exercise, the writer will have
to purchase the underlying asset to meet his call obligation and
his loss will be the excess of the purchase price over the exercise
price of the call reduced by the premium received for writing the
call. Intrinsic Value of an option 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 a call option: Intrinsic Value = Spot
Price - Strike Price For a put option: Intrinsic Value = Strike
Price - Spot Price The intrinsic value of an option must be a
positive number or 0. It cannot be negative. For a call option, the
strike price must be less than the price of the underlying asset
for the call to have an intrinsic value greater than 0. For a put
option, the strike price must be greater than the underlying asset
price for it to have intrinsic value. Time Decay Generally, the
longer the time remaining until an option's expiration, the higher
its premium will be. This is because the longer an option's
lifetime, greater is the possibility that the underlying
share price might move so as to make the option in-the-money.
All other factors affecting an option's price remaining the same,
the time value portion of an option's premium will decrease (or
decay) with the passage of time. Note: This time decay increases
rapidly in the last several weeks of an option's life. When an
option expires in-the-money, it is generally worth only its
intrinsic value. Expiration Day The expiration date is the last day
an option exists. For list-ed stock options, this is the Saturday
following the third Friday of the expiration month. Please note
that this is the deadline by which brokerage firms must submit
exercise notices to Stock Exchange Clearing; however, the exchanges
and brokerage firms have rules and procedures regarding deadlines
for an option holder to notify his brokerage firm of his intention
to exercise. This deadline, or expiration cutoff time, is generally
on the third Friday of the month, before expiration Saturday, at
some time after the close of the market. Please contact your
brokerage firm for specific deadlines. The last day expiring equity
options generally trade is also on the third Friday of the month,
before expiration Saturday. If that Friday is an exchange holiday,
the last trading day will be one day earlier, Thursday. Exercise If
the holder of an American-style option decides to exercise his
right to buy (in the case of a call) or to sell (in the case of a
put) the underlying shares of stock, the holder must direct his
brokerage firm to submit an exercise notice to Stock Exchange
Clearing. In order to ensure that an option is exercised on a
particular day other than expiration, the holder must notify his
brokerage firm before its exercise cut-off time for accepting
exercise instructions on that day. Note: Various firms may have
their own cut-off times for accepting exercise instructions from
customers. These cut-off times may be specific for different
classes of options and different from Stock Exchange Clearing's
requirements. Cut-off times for exercise at expiration and for
exercise at an earlier date may differ as well. Once Stock Exchange
Clearing has been notified that an option holder wishes to exercise
an option, it will assign the exercise notice to a Clearing Member
- for an investor, this is generally his brokerage firm - with a
customer who has written (and not covered) an option contract with
the same terms. Stock Exchange Clearing will choose the firm to
notify at random from the total pool of such firms. When an
exercise is assigned to a firm, the firm must then assign one of
its customers who has written (and not covered) that particular
option. Assignment to a customer will be made either randomly or on
a "first-in first-out" basis, depending on the method used by that
firm. You can find out from your brokerage firm which method it
uses for assignments. Assignment The holder of a long
American-style option contract can exercise the option at any time
until the option expires. It follows that an option writer may be
assigned an exercise notice on a short
option position at any time until that option expires. If an
option writer is short an option that expires in-the-money,
assignment on that contract should be expected, call or put. In
fact, some option writers are assigned on such short contracts when
they expire exactly at-the-money. This occurrence is generally not
predictable. To avoid assignment on a written option contract on a
given day, the position must be closed out before that day's market
close. Once assignment has been received, an investor has
absolutely no alternative but to fulfill his obligations from the
assignment per the terms of the contract. An option writer cannot
designate a day when assignments are preferable. There is generally
no exercise or assignment activity on options that expire
out-of-the-money. Owners generally let them expire with no value.
What's the Net? When an investor exercises a call option, the net
price paid for the underlying stock on a per share basis will be
the sum of the call's strike price plus the premium paid for the
call. Likewise, when an investor who has written a call contract is
assigned an exercise notice on that call, the net price received on
a per share basis will be the sum of the call's strike price plus
the premium received from the call's initial sale. When an investor
exercises a put option, the net price received for the underlying
stock on per share basis will be the sum of the put's strike price
less the premium paid for the put. Likewise, when an investor who
has written a put contract is assigned an exercise notice on that
put, the net price paid for the underlying stock on per share basis
will be the sum of the put's strike price less the premium received
from the put's initial sale. Early Exercise / Assignment For call
contracts, owners might exercise early so that they can take
possession of the underlying stock in order to receive a dividend.
Check with your brokerage firm and/or tax advisor on the
advisability of such an early call exercise. It is therefore
extremely important to realize that assignment of exercise notices
can occur early - days or weeks in advance of expiration day. As
expiration nears, with a call considerably in-the-money and a
sizeable dividend payment approaching, this can be expected. Call
writers should be aware of dividend dates, and the possibility of
an early assignment. When puts become deep in-the-money, most
professional option traders will exercise them before expiration.
Therefore, investors with short positions in deep in-the-money puts
should be prepared for the possibility of early assignment on these
contracts. Volatility Volatility is the tendency of the underlying
security's market price to fluctuate either up or down. It reflects
a price change's magnitude; it does not imply a bias toward price
movement in one direction or the other. Thus, it is a major factor
in determining an option's premium. The higher the volatility of
the underlying stock, the higher the premium because there is a
greater
possibility that the option will move in-the-money. Generally,
as the volatility of an under-lying stock increases, the premiums
of both calls and puts overlying that stock increase, and vice
versa. OPTION GREEKS-DELTA, GAMMA, VEGA, THETA, RHO The price of an
Option depends on certain factors like price and volatility of the
underlying, time to expiry etc. The Option Greeks are the tools
that measure the sensitivity of the option price to the
above-mentioned factors. They are often used by professional
traders for trading and managing the risk of large positions in
options and stocks. These Option Greeks are:
Delta: is the option Greek that measures the estimated change in
option premium/price for a change in the price of the underlying.
Gamma: measures the estimated change in the Delta of an option for
a change in the price of the underlying Vega: measures estimated
change in the option price for a change in the volatility of the
underlying. Theta: measures the estimated change in the option
price for a change in the time to option expiry. Rho: measures the
estimated change in the option price for a change in the risk free
interest rates.
How the greeks help in hedging? Spreading is a risk-management
strategy that employs options as the hedging instrument, rather
than stock. Like stock, options have directional risk (deltas).
Unlike stock, options carry gamma, vega, and theta risks as well.
Therefore, if a position involves any combination of gamma, vega,
and/or theta risk, this can be reduced or eliminated by adding one
or more options positions. Table 8-4 summarizes the possible hedges
and their gamma, vega and theta impact for each of the six building
blocks. Notice that owning option contracts be they puts or calls,
means that you are adding positive gamma, positive vega, and
negative theta. Being short either of these contracts means
acquiring negative gamma, negative vega, and positive theta. This
statement points out that as far as these Greeks are concerned, you
get a package deal. By owning options, your position responds
favorably to stock-price movement (the position gets longer as the
stock price increases and gets shorter as the stock price
decreases). The position responds positively to increases in
implied volatility (and negatively to decreases in implied
volatility) and will lose value over time. By being short options,
your position responds adversely to stock-price movement (the
position gets shorter as the stock price increases and gets longer
as the stock price decreases). The position also responds
negatively to increases in implied volatility (and positively to
decreases in implied volatility) and will gain value over time as
the time premium of the short option decays. POSSIBLE HEDGING
STRATEGIES WITH THE GREEKS
Building Block
Hedge Delta Long Stock Sell Call Negative Sell Stock Negative
Positive delta, no Buy Put Negative gamma, no vega, no theta Short
Stock Buy Call Positive Buy Stock Positive Negative delta, no Sell
Put Positive gamma, no vega, no theta Long Call Sell Call Negative
Buy Put Negative Positive delta, positive Sell Stock Negative
gamma, positive vega, negative theta Short Call Buy Call Positive
Sell Put Positive Negative delta, Buy Stock Positive negative
gamma, negative vega, positive theta Long Put Sell put Positive Buy
Call Positive Negative delta, positive Buy Stock Positive gamma,
positive vega, negative theta Short Put Buy put Negative Sell Call
Negative Positive delta, negative Sell Stock Negative gamma,
negative vega, positive theta
Hedge
Hedge Hedge Gamma Vega Negative Negative None None Positive
Positive
Hedge Theta Positive None Negative
Positive Positive Negative None None None Negative Negative
Positive Negative Negative Positive Positive Positive Negative None
None None Positive Positive Negative Negative Negative Positive
None None None
Negative Negative Positive Positive Positive Negative None None
None Positive Positive Negative Negative Negative Positive None
None None
BENEFITS OF OPTIONS TRADING Besides offering flexibility to the
buyer in form of right to buy or sell, the major advantage of
options is their versatility. They can be as conservative or as
speculative as one's investment strategy dictates. Some of the
benefits of Options are as under:
High leverage as by investing small amount of capital (in form
of premium), one can take exposure in the underlying asset of much
greater value. Pre-known maximum risk for an option buyer Large
profit potential and limited risk for option buyer One can protect
his equity portfolio from a decline in the market by way of buying
a protective put wherein one buys puts against an existing stock
position.
This option position can supply the insurance needed to overcome
the uncertainty of the marketplace. Hence, by paying a relatively
small premium (compared to the market value of the stock), an
investor knows that no matter how far the stock drops, it can be
sold at the strike price of the Put anytime until the Put expires.
E.g. An investor holding 1 share of Infosys at a market price of Rs
3800/-thinks that the stock is over-valued and decides to buy a Put
option' at a strike price of Rs. 3800/- by paying a premium of Rs
200/If the market price of Infosys comes down to Rs 3000/-, he can
still sell it at Rs 3800/- by exercising his put option. Thus, by
paying premium of Rs 200,his position is insured in the underlying
stock. How can you use options for short-term trading? If you
anticipate a certain directional movement in the price of a stock,
the right to buy or sell that stock at a predetermined price, for a
specific duration of time can offer an attractive investment
opportunity. The decision as to what type of option to buy is
dependent on whether your outlook for the respective security is
positive (bullish) or negative (bearish). If your outlook is
positive, buying a call option creates the opportunity to share in
the upside potential of a stock without having to risk more than a
fraction of its market value (premium paid). Conversely, if you
anticipate downward movement, buying a put option will enable you
to protect against downside risk without limiting profit potential.
Purchasing options offer you the ability to position yourself
accordingly with your market expectations in a manner such that you
can both profit and protect with limited risk. Risks of an options
buyer The risk/ loss of an option buyer is limited to the premium
that he has paid. Risks for an Option writer The risk of an Options
Writer is unlimited where his gains are limited to the Premiums
earned. When a physical delivery uncovered call is exercised upon,
the writer will have to purchase the underlying asset and his loss
will be the excess of the purchase price over the exercise price of
the call reduced by the premium received for writing the call. The
writer of a put option bears a risk of loss if the value of the
underlying asset declines below the exercise price. The writer of a
put bears the risk of a decline in the price of the underlying
asset potentially to zero. Option writing is a specialized job
which is suitable only for the knowledgeable investor who
understands the risks, has the financial capacity and has
sufficient liquid assets to meet applicable margin requirements.
The risk of being an option writer may be reduced by the purchase
of other options on the same underlying asset thereby assuming a
spread position or by acquiring other types of hedging positions in
the options/ futures and other correlated markets. In
the Indian Derivatives market, SEBI has not created any
particular category of options writers. Any market participant can
write options. However, margin requirements are stringent for
options writers. STOCK INDEX OPTIONS The Stock Index Options are
options where the underlying asset is a Stock Index for e.g.
Options on NSE Nifty Index / Options on BSE Sensex etc. Index
Options were first introduced by Chicago Board of Options Exchange
in 1983 on its Index 'S&P 100'. As opposed to options on
Individual stocks, index options give an investor the right to buy
or sell the value of an index which represents group of stocks.
Uses of Index Options Index options enable investors to gain
exposure to a broad market, with one trading decision and
frequently with one transaction. To obtain the same level of
diversification using individual stocks or individual equity
options, numerous decisions and trades would be necessary. Since,
broad exposure can be gained with one trade, transaction cost is
also reduced by using Index Options. As a percentage of the
underlying value, premiums of index options are usually lower than
those of equity options as equity options are more volatile than
the Index. Index Options are effective enough to appeal to a broad
spectrum of users, from conservative investors to more aggressive
stock market traders. Individual investors might wish to capitalize
on market opinions (bullish, bearish or neutral) by acting on their
views of the broad market or one of its many sectors. The more
sophisticated market professionals might find the variety of index
option contracts excellent tools for enhancing market timing
decisions and adjusting asset mixes for asset allocation. To a
market professional, managing risks associated with large equity
positions may mean using index options to either reduce risk or
increase market exposure. Options on individual stocks Options
contracts where the underlying asset is an equity stock are termed
as Options on stocks. They are mostly American style options cash
settled or settled by physical delivery. Prices are normally quoted
in terms of the premium per share, although each contract is
invariably for a larger number of shares, e.g. 100. Benefits of
options in specific stocks to an investor
Options can offer an investor the flexibility one needs for
countless investment situations. An investor can create hedging
position or an entirely speculative one, through various strategies
that reflect his tolerance for risk. Investors of equity stock
options will enjoy more leverage than their counterparts who invest
in the underlying stock market itself in form of greater exposure
by paying a small amount as premium.
Investors can also use options in specific stocks to hedge their
holding positions in the underlying (i.e. long in the stock
itself), by buying a Protective Put. Thus they will insure their
portfolio of equity stocks by paying premium. ESOPs (Employees'
stock options) have become a popular compensation tool with more
and more companies offering the same to their employees. ESOPs are
subject to lock in periods, which could reduce capital gains in
falling markets - Derivatives can help arrest that loss along with
tax savings. An ESOPs holder can buy Put Option in the underlying
stock & exercise the same if the market falls below the strike
price & lock in his sale prices.
The equity options traded on exchange are not issued by the
companies underlying them. Companies do not have any say in
selection of underlying equity for options. Holder of the equity
options contracts do not have any of the rights that owners of
equity shares have - such as voting rights and the right to receive
bonus, dividend etc. To obtain these rights a Call option holder
must exercise his contract and take delivery of the underlying
equity shares. Leaps - Long Term Equity Anticipation Securities
(Currently not available in India) Long-term equity anticipation
securities (Leaps) are long-dated put and call options on common
stocks or ADRs. These long-term options provide the holder the
right to purchase, in case of a call, or sell, in case of a put, a
specified number of stock shares at a pre-determined price up to
the expiration date of the option, which can be three years in the
future. Exotic Options (Currently not available in India)
Derivatives with more complicated payoffs than the standard
European or American calls and puts are referred to as Exotic
Options. Some of the examples of exotic options are as under:
Barrier Options: where the payoff depends on whether the underlying
asset's price reaches a certain level during a certain period of
time. CAPS traded on CBOE (traded on the S&P 100 & S&P
500) are examples of Barrier Options where the payout is capped so
that it cannot exceed $30. A Call CAP is automatically exercised on
a day when the index closes more than $30 above the strike price. A
put CAP is automatically exercised on a day when the index closes
more than $30 below the cap level. Binary Options: are options with
discontinuous payoffs. A simple example would be an option which
pays off if price of an Infosys share ends up above the strike
price of say Rs. 4000 & pays off nothing if it ends up below
the strike. Over-The-Counter Options: are options are those dealt
directly between counter-parties and are completely flexible and
customized. There is some standardization for ease of trading in
the busiest markets, but the precise details of each transaction
are freely negotiable between buyer and seller.
Contract specifications of BSE Sensex Options BSE's first index
options is based on BSE 30 Sensex. The Sensex options would be
European style of options i.e. the options would be exercised only
on the day of expiry. They will be premium style i.e. the buyer of
the option will pay premium to the options writer in cash at the
time of entering into the contract. The underlying for the index
options is the BSE 30 Sensex, which is the benchmark index of
Indian Capital markets, comprising 30 scrips. Like stocks, options
and futures contracts are also traded on any exchange. In Bombay
Stock Exchange, stocks are traded on BSE On Line Trading (BOLT)
system and options and futures are traded on Derivatives Trading
and Settlement System (DTSS). The Premium and Options Settlement
Value (difference between Strike and Spot price at the time of
expiry), will be quoted in Sensex points The contract multiplier
for Sensex options is INR 50 which means that monetary value of the
Premium and Settlement value will be calculated by multiplying the
Sensex Points by 50. For e.g. if Premium quoted for a Sensex
options is 50 Sensex points, its monetary value would be Rs. 2500
(50*50). There will be at-least 5 strikes (2 In the Money, 1 Near
the money, 2 Out of the money), available at any point of time. The
expiration day for Sensex option is the last Thursday of Contract
month. If it is a holiday, the immediately preceding business day
will be the expiration day. There will be three contract month
series (Near, middle and far) available for trading at any point of
time. The settlement value will be the closing value of the Sensex
on the expiry day. The tick size for Sensex option is 0.1 Sensex
points (INR 5). This means the minimum price fluctuation in the
value of the option premium can be 0.1.In Rupee terms this
translates to minimum price fluctuation of Rs 5. (Tick Size *
Multiplier =0.1* 50). OPTIONS WITH OPTIONS As we briefly touched
upon earlier, an option contract holder is bestowed with three
choices exercise the option, let the option expire, or trade the
option. But how does a trader decide which of the three
alternatives to choose? A large portion of this decision is
contingent upon the value of the option contract (or lack thereof)
as well as the amount of time remaining before the option expires.
When an option lacks value, meaning it is out-of-the-money, the
trader can simply let the option expire worthless. When an option
has value, meaning it is in-the-money, the trader can choose
whether to trade the contract to another individual or exercise the
contract and obtain the underlying asset. The ultimate decision
that is made depends upon the individual investor, his or her
trading style, his or her trading needs, and the situation at hand.
Exercise the Option
As we just mentioned, one will only exercise a long option
contract when one stands to make money from that position,
otherwise one could simply let the option expire and lose the
premium.* When an option buyer exercises an option, he or she is
choosing to take a position in the underlying instrument.
Naturally, the position is determined by the option type and
whether it is a call or a put. In exercising a stock or futures
call option, the holder agrees to purchase standardized quantity of
the underlying asset from the option writer at the predetermined
strike price. Because of their contract, the writer is obligated to
sell the asset to the buyer at the strike price, regardless of the
price at which the market is currently trading. This transaction
gives the buyer a long position in the asset and gives the writer a
short position in the asset.# Option is a contract which has a
market value like any other tradable commodity. Once an option is
bought there are following alternatives that an option holder
has:
You can sell an option of the same series as the one you had
bought and close out /square off your position in that option at
any time on or before the expiration. You can exercise the option
on the expiration day in case of European Option or; on or before
the expiration day in case of an American option. In case the
option is 'Out of Money' at the time of expiry, it will expire
worthless.
#Please note that while options provide the right to acquire the
underlying instrument, the owner must still produce the necessary
funds for the asset itself. In exercising a stock or futures put
option, the option holder agrees to sell the standardized quantity
of the underlying asset to the option writer at the predetermined
strike price. Because of their contract, the writer must purchase
the asset from the option holder at the strike price, regardless of
the price at which the market is currently trading. This
transaction gives the buyer a short position in the asset and gives
the seller long position in the asset. Exercising an index option,
be it a call or a put, is handled differently because index options
are settled in cash as opposed to the physical asset. When a call
option buyer or put option buyer exercises an index option, the
holder is simply credited to the amount by which the option is
inthe-money, less any commission that applies. On the other hand,
the call option writer or the put option writer is debited the
amount by which the option is in-the-money, plus any commission
that applies. For obvious reasons, an index option holder would
choose to exercise his or her position only if it were profitable
to do so, meaning the contract were in-the-money. The majority of
index options today are European-style options, meaning that
exercise can only occur at the end of the contract's life. However,
the most widely traded index option, the NSE Nifty option which
covers the Nifty 30, is an American-style contract, meaning
exercise can occur at any point during the life of the option. On
the whole, most traders choose not to exercise an option prior to
expiration. Doing so only entitles the investor to the intrinsic
value of the option and sacrifices the added effect of time value.
Exercising one's option before the expiration date is not common
when it comes to futures. Unless the option is deep in-the-money,
where time value has a much lower impact, it generally makes more
sense to trade out of the position. Exercising before the
expiration date
does occur more frequently when it comes to equity call options.
Because option holders are not entitled to cash dividends, call
options are usually exercised right before a stock goes exdividend
so no contract value will be lost. Defining the profit In each of
these cases, exercise will only occur when it is profitable to do
so - when the option is in-the-money. However, any time an
individual exercises an option, that individual loses the full cost
of the premium. Because of this, any gains on the trade will be
offset by the losses on the cost of the option. One does not really
make a profit on the transaction until the premium is recovered.
Therefore, there is a break-even-point that occurs with options
that are exercised. With call options, the break-even-point occurs
when the underlying asset has increased in price to a point where
the intrinsic value is equal to the initial cost of the option - in
other words, the strike price of the option plus the call premium.
Any price above this break-even-point would produce a profit on the
transaction, if exercised, and any price below this
break-even-point would produce a loss on the transaction, if
exercised. With put options, the break-even-point occurs when the
underlying asset has decreased in price to a point where the
intrinsic value is equal to the initial cost of the option - in
other words, the strike price of the option minus the put premium.
Any price below this break-even-point would produce a profit on the
transaction, if exercised, and any price above this
break-even-point would produce a loss on the transaction, if
exercised. Because the trader must lose money in order to lock-in
profits, some people choose to forego the exercising of their
options and instead turn to the second option alternative. Trade
the Option The second choice the holder of an option can make is to
trade out of the option position before the option expires. Trading
one's option is exactly the same as trading any other asset. To
close out a position, one must perform the opposite side of the
trade in the same asset. To offset a long position, be it a call or
a put, the holder must sell an option of the same type, expiration
month, and strike price. To offset a short position, be it a call
or a put, holder must buy an option of the same type, expiration
month, and strike price. When one initiates a long option trade,
the premium that is paid for the option is the entry price and when
one liquidates a long option trade, the premium that is received
for the option is the exit price. Obviously, if the exit price is
greater than the entry price, the holder will profit on the trade.
When one initiates a short option trade, the premium that is
received for the option is the entry price and the premium that is
paid for the option is closing price. In this case, if the exit
price is less than the entry price, the writer will profit on the
trade. Trading versus exercising There is a common misconception
that the most profitable way to make money with options is by
exercising the contract when it is in-the-money, when in reality,
trading out of one's option
can be far more lucrative. There are three reasons why this is
so. The primary reason is that exercising an option can only
provide the investor with the intrinsic value of the trade, while
trading an option position can entitle the investor to the
intrinsic value as well as additional time value. How much more the
time value will provide is determined by the factors we mentioned
earlier, such as time to expiration, volatility, dividend rates,
and interest rates. A second reason is that trading one's position
does not force the option buyer to incur the full cost of the
premium, which is what occurs when one exercises an option. Since
the gains from trading an option are not used to cover the cost of
the premium, there is no break-even-point, there is simply the
entry price and the exit price. Finally, by trading out of one's
option(s), the trader saves on commission costs. This is
particularly helpful when a trader has a large option position.
With the tremendous growth that will occur in the option markets
over the years, it should come as no surprise that options provide
an excellent trading opportunity. As you have probably been able to
gather thus far, buying options responsibly can provide a greater
level of security to traders, allowing them to rest easy during the
day and sleep better at night. Options give traders more time to
think about their positions without worrying about how much they
could potentially lose. As one family friend puts it, buying
options enables the trader to leave the computer screen and hit
golf balls. If traders were to take positions in the actual
security, or sell options, they must closely monitor their
positions and only watch others hit golf balls on ESPN. Let the
Option Expire A final alternative available to the option holder is
to let the option expire. Simply put, the trader can do nothing
with the option and lose only what he or she paid in premium.
Naturally, an option buyer will only let the contract expire if it
lacks value at expiration, meaning it is out-ofthe-money. Once the
expiration occurs, the option buyer no longer controls the
underlying asset and loses all rights conveyed by the contract.
Doing nothing is a luxury that is afforded only to option traders.
This eliminates the necessity of offsetting a losing position,
thereby serving as an inherent stop loss on the trade. Trading any
other type of asset obligates the investor to eventually offset the
position, regardless of whether it is profitable to do so. In
comparison, by trading out of the option position the option holder
was able to realize a greater profit on the trade. This is usually
the case with options. However, the closer to expiration on the
option gets, the less a trader will be able to retrieve in premium
by trading out of his or her position. It is important that a
trader compare the two processes before making a decision as to
what to do with the option position.
Options Trading Strategy Guide: Option Trading StrategiesAs we
described earlier, four possible option selections exist for a
trader: (1) long a call, (2) long a put, (3) short a call, and (4)
short a put. These four can be used independently, together, or in
conjunction with other financial instruments to create a number of
option-trading strategies. These combinations enable a trader to
develop an option-trading model which meets the trader's specific
trading needs, expectations, and style, and enables him or her to
anticipate every
conceivable situation in the market. This trading structure can
be adapted to handle any type of market outlook, whether it be
bullish, bearish, choppy, or neutral. Options are unique trading
instruments. They can be used for a multitude of purposes,
providing tremendous versatility and utility. Among their multiple
applications are the following: to speculate on the movement of an
asset; to hedge an existing position in an asset; to hedge other
option positions; to generate income by writing options against
different quantities of options strategies that arise from these
applications and the fact that the scope of this book is limited,
we will devote coverage to a cursory explanation of two of the most
popular strategies which are designed to take advantage of market
movement: spreads and straddles. SPREADS Option spreads are hedged
positions that can be utilized to control a trade's risk, while at
the same time limiting gains. They accomplish this goal by
simultaneously taking positions on both sides of the market. A call
option spread is the simultaneous purchase and sale of call options
with different strike prices, different expiration dates, or with
both different strike prices and different expiration dates.
Likewise, a put option spread is the simultaneous purchase and sale
of a put option with different strike prices, different expiration
dates, or with both different strike prices and different
expiration dates. Spreads with different strike prices are referred
to as price spreads or vertical spreads because the strike prices
are stacked vertically on top of each other in financial listings.
Spreads with different expiration months are referred to as
calendar spreads, horizontal spreads, or time spreads because the
options expire at different times. A spread where both the strike
price and expiration month are different is referred to as a
diagonal spread. Option spreads can be used when one has an
inclination as to where the underlying market is heading, but is
somewhat uncertain. Because the position is hedged, a spread allows
the trader to participate in the market while effectively
containing risk, sometimes even more so than with single option
positions. Option spread can also be used when a trader has
particular price targets in mind - because spreads limit gains as
well as losses, spreads can be initiated that will enable the
trader to take advantage of these targets while at the same time
keeping risk at a minimum. Vertical / Price Spreads As is the case
with options, any of four possible vertical option spreads can be
selected depending on what a trader expects will happen in the
market: one can buy a call spread, one can sell a call spread, one
can buy a put spread, or one can sell a put spread. A long call
spread and short put spreads are considered bull spreads because
they are used when a trader's market outlook is positive, or
bullish. A short call spread and long put spreads are considered
bear spreads because they are used when a trader's outlook is
negative, or bearish. Horizontal / Time Spreads The four types of
spreads just mentioned were vertical spreads, or price spreads.
Another group of spreads is referred to as horizontal spreads, time
spreads, or calendar spreads. Whereas vertical spreads are used to
take advantage of price movements in the underlying security,
horizontal spreads are used to take advantage of time erosion and
the pricing discrepancies that arise from movements in the
underlying market. A horizontal spread involves
the simultaneous purchase and sale of an option contract of the
same asset, type, and strike price but with different expiration
dates. As we indicated earlier, the option's time value erodes
toward zero as time passes toward option expiration. The erosion
occurs more rapidly as the option's life decreases and the
expiration date comes into view. A calendar spread is intended to
take advantage of this decline in an option's premium. Typically, a
trader will sell an option with the closer expiration month and
purchase an option with the distant expiration month to take
advantage of the fact that the latter position will retain more of
its value. Since the near-month option has less time to expiration
than the back-month option, the premium the trader receives will be
less than the premium the trader must pay for the spread.
Therefore, this spread is considered a debit spread. Also, because
one option expires before the other, oftentimes one or both legs of
the calendar spread are offset by trading out of the position.
SELECTING AN OPTION TRADE Given the wide assortment of possible
option expirations and strike prices, which is the preferable
option contract selection for a trader? This answer is not black
and white and varies depending upon the goals of the trader. For
those option traders who believe that the trend of an underlying
security has been or soon will be established for some time to
come, they may wish to hold the option until it approaches
expiration and a significant profit is captured. These individuals
are referred to as position traders. Other traders are not
concerned with long-term projections in the underlying security and
are only interested in what will occur on a particular trading day.
These individuals are referred to as day traders. Position traders
and day traders have two very different approaches and attitudes
when selecting the appropriate option contract to trade. Most
position traders typically choose an expiration month and a strike
price matches their price target and the time frame in which they
believe that target will be reached. Day traders, on the other
hand, are not concerned with which expiration month or strike price
they should choose, all they are concerned with is being on the
right side of the market in the option that will bring them the
greatest return. When day trading options, various time and price
considerations are not as important as they would be to a long-term
option trader. Since option positions are held for such a short
period of time, the impact of time decay is negligible when day
trading and does not really work for or against the trader (unless
it is the day of option expiration or one or two trading days
before expiration, where time premium typically erodes more
rapidly). Although our opinion is by no means absolute, we suggest
that when one wishes to day trade options or intends to hold an
option position for no more than one to two trading days, that one
trade the nearby (closest expiration month) option contract which
is at- or slightly in-the-money, when the underlying security has,
or is just about to, exceed the exercise price. As we discussed
earlier, as the price of the underlying security trades through the
exercise price and proceeds to move in-the-money, the time value
initia