Project:

Options (call & put)

Shital

Sunita

Jinsha

Shifa

Submitted to department of Banking & Insurance.

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 ones 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 options 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.
2

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 assets 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 ones 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
3

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 assets value will appreciate, he or she can simply buy the security; if an investor thinks an assets 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 ones investment decisions, one could potentially lose a lot of money trading options. Those who disregard careful consideration and sound money
4

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
5

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 investors 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
7

(i.e. Rs 25/-), which shall be the profit earned by the seller of the Put option. (Please see table) 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.

Call Option Option buyer or option holder 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

Option seller or option writer

Rules for Buying Calls and Puts

Rule No. 1: Buy calls when the overall market is down; buy puts when the overall market is up. By and large, when the stock market rallies, most stocks rally, and when the stock market declines, most stocks perform likewise. The extent of this movement can easily be measured by observing stock indices. We recommend using the advance/decline index as a proxy for the overall market. However, if this is unavailable, one could also use the net price change of a comprehensive market average, such as the BSE SENSEX and NSE NIFTY. For the overall market to rally, the majority of individual stocks must rally, too. Sure there are days in which the market is rallying even though the number of advancing issues is less than the declining issues but this cannot last long if the stock market is to mount a sustainable advance. Similarly, on the downside, the market cannot undergo an extended decline unless the numbers of declining stocks outnumber the advancing stocks. When the overall market trades lower, call option premiums typically decrease. Therefore, by requiring the market index to be down for the day at the time a call is purchased, the prospects for a decline in a calls premium are enhanced. Similarly, when the overall market trades higher, put option premiums typically decrease. Therefore, by requiring the advance/decline market index to be up for the day at the time a put is purchased, the prospects for a decline in a puts premium are enhanced similarly. Since most stocks rise and fall with the general market with the possible exception of gold stocks this provides
10

a measure of much-needed discipline and helps prevent emotional, uncontrolled option buying. Rule No. 2: Buy calls when the industry group is down; buy puts when the industry group is up. Just as most stocks move in phase with the market, most industry group components move in sync with their counterparts within their specific industry as well. Therefore, when one stock within an industry group is down, chances are the others are down as well. Its the exception when one component of an industry advances while all the other members decline, or vice versa, especially over an extended period of time. For example, situations can arise where a buyout occurs and the accumulation of one companys stock causes it to outperform the others within the industry group. However, announcements such as these typically cause the other stocks within the same industry group to participate in the movement since the markets perception is that all companies within the group are likely acquisition candidates and their stocks are in play, so to speak.

Rule No. 3: Buy calls when the underlying security is down; buy puts when the underlying security is up. In order to time the purchase of calls, we look for the price of the underlying security to be down relative to the previous
11

trading days close. If the stocks current market price is less than the previous days close, most traders extrapolate that the downtrend will continue. It is also possible to relate the stocks current price with its opening price level to make this rule more stringent. Either relationship, that is, current price versus yesterdays close or current price versus the current days open, can be applied or a combination of the two can be used to insure that the composite outlook for the market is perceived bearish by most traders. In order to time the purchase of puts, we look for the price of the underlying security to be up relative to the previous trading days close. If the stocks current market price is greater than the previous days close, most traders extrapolate that the up trend will continue. It is also possible to relate the stocks current price with its opening price level to make this rule more stringent. Either relationship, that is, current price versus yesterdays close or current price versus the current days open, can be applied or a combination of the two can be used to insure that the composite outlook for the market is perceived bullish by most traders.

Rule No. 4: Buy calls when the option is down; buy puts when the option is down. Just as the previous series of rules required that specific relationships be fulfilled, so too must this
12

prerequisite be met. In fact, of all rules listed, this requirement is singularly the most important. The options price, be it a call or a put, must be less than the previous days close. As an additional requirement, it may also be less than the current days opening price level as well. Obviously, if an options price is inevitably going to rally, it is smarter to buy as low as possible. Further, if the call or the put unexpectedly continues to decline to zero, then the loss incurred is nevertheless less than if one had chased the price upside and purchased the option when it was trading above the previous days close. The combination of the preceding rules serves to remove a degree of emotionalism from operating in the options markets and instills a level of discipline in the trading process. We cant tell you how long it took to acquire and apply these important rules to our trading regimen. Obviously, the risk always exists that despite the fact that all the previously described rules may be met, option prices may continue to decline, and as a result purchasing the call options or the put options will translate into a losing proposition. Thats a concern that can only be diminished by introducing a series of sentiment measures or various market-timing indicators to confirm option buying at a particular point in time. The integration of these together with market sentiment information comparing put and call volume and the information regarding various indicators presented in the other chapters within this book enhance the timing and selection results
13

further by concentrating upon ideal candidates which are low-risk opportunities based upon all four requirements.

Benefits of Options Trading

14

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 ones 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 200/15

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.
16

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.

17

Participants in the Options Market There are four types of participants in options markets depending on the position they take: 1. Buyers of calls 2. Sellers of calls 3. Buyers of puts 4. Sellers of puts People who buy options are called holders and those who sell options are called writers; furthermore, buyers are said to have long positions, and sellers are said to have short positions. Here is the important distinction between buyers and sellers: -Call holders and put holders (buyers) are not obligated to buy or sell. They have the choice to exercise their rights if they choose. -Call writers and put writers (sellers), however, are obligated to buy or sell. This means that a seller may be required to make good on a promise to buy or sell. Don't worry if this seems confusing - it is. For this reason we are going to look at options from the point of view of the buyer. Selling options is more complicated and can be even riskier. At this point, it is sufficient to understand that there are two sides of an options contract.

18

Options Trading Strategies in India

Stock options provide strategies that ordinary stock transactions cannot offer. Stock options are financial contracts that trade in the public markets. They trade on many stocks and also on most exchange-traded funds (ETFs). For investors outside of India, an ETF option strategy allows you to profit from different scenarios in the Indian stock market. Since most investors don't have direct access to specific Indian stocks, an options trading strategy on an India ETF is a particularly convenient technique.

BULLISH STRATEGY If you're "bullish" and believe the overall Indian stock market will rise in the short term, you can
19

significantly profit by purchasing "call" options on an Indian ETF. The ETF with the ticker symbol "INP" is one of the largest ETFs that tracks the Indian stock market; buying "call" options on this ETF will provide significant returns if the market does indeed rise. A "call" stock option is one of the two main types of options. The value of a "call" contract rises at a fast pace when its underlying entity, the ETF, rises. However, since all options have expiration dates, it's risky to trade the option if it expires soon. Choose an option that expires at least two months down the road so that you have ample time to make sure the ETF does indeed move up.

BEARISH STRATEGY If you're "bearish" and think the Indian stock market will likely decline in value in the short term, purchase a "put" stock option on the ETF "INP." A put is the other main type of stock option, and is the complement to a "call." A "put" option rises in value when its underlying entity falls in price. If you successfully hold a "put" while the Indian stock market declines, you'll profit from this scenario. As with all option strategies, always be cognizant of the option expiration date. All options are worthless after their expiration date.
20

For this reason, you should minimize risks by purchasing a "put" with an expiration date of at least two months in the future. When you become more experienced with predicting short-term stock market activity, you may consider more risky positions with options that expire more quickly.

STRADDLES Options offer unique investment strategies beyond bullish or bearish market conditions. Unlike a stock purchase, you can make money by predicting a major price move in the Indian stock market without predicting the direction of the move. A "straddle" is an option strategy where you purchase an equal amount of both "calls" and "puts." Buying these on the "INP" ETF creates an option position that profits from a major movement in the Indian stock market either up or down. One of the two option types will significantly rise in price if the market moves, while the other will significantly decline. However, the gains of one option can overwhelm the losses of the other, leading to profit regardless of the market direction Option Selling or "Writing" Many traders opt to buy options in an effort to maximize gains and limit losses to the purchase price of the option. On the surface this seems ideal, except for one major flaw: time decay. The
21

Chicago Mercantile Exchange estimates that over 80% of all options expire worthless. Those who sell these options to the buyers are known as option writers or sellers. Their objective is to collect the premium paid by the option buyer. Option writing can also be used for hedging purposes and reducing risk.. In appropriate situations you should consider selling out-of-the-money options instead of buying them.

Thank you

22