MU-IDOL- MMS SEM.

3 – DRIVATIVES & RISK MGMT

CHAPTER 1
INTRODUCTION TO DERIVATIVES

Introduction
The past decade has witnessed the multiple growths in the volume of international trade and
business due to the wave of globalization and liberalization all over the world. As a result, the
demand for the international money and financial instruments increased significantly at the global
level. In this respect, changes in the interest rates, exchange rates and stock market prices at the
different financial markets have increased the financial risks to the corporate world. Adverse
changes have even threatened the very survival of the business world. It is, therefore, to manage
such risks; the new financial instruments have been developed in the financial markets, which are
also popularly known as financial derivatives.

The basic purpose of these instruments is to provide commitments to prices for future dates for
giving protection against adverse movements in future prices, in order to reduce the extent of
financial risks. Not only this, they also provide opportunities to earn profit for those persons who
are ready to go for higher risks. In other words, these instruments, indeed, facilitate to transfer the
risk from those who wish to avoid it to those who are willing to accept the same.

Today, the financial derivatives have become increasingly popular and most commonly used in the
world of finance. This has grown with so phenomenal speed all over the world that now it is called
as the derivatives revolution. In an estimate, the present annual trading volume of derivative
markets has crossed US $ 30,000 billion, representing more than 100 times gross domestic product
of India.

Financial derivatives like futures, forwards options and swaps are important tools to manage
assets, portfolios and financial risks. Thus, it is essential to know the terminology and conceptual
framework of all these financial derivatives in order to analyze and manage the financial risks. The
prices of these financial derivatives contracts depend upon the spot prices of the underlying assets,
costs of carrying assets into the future and relationship with spot prices. For example, forward and
futures contracts are similar in nature, but their prices in future may differ. Therefore, before using
any financial derivative instruments for hedging, speculating, or arbitraging purpose, the trader or
investor must carefully examine all the important aspects relating to them.

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Definitions Of Derivatives
The term “Derivative” indicates that it has no independent value, i.e., its value is entirely derived
from the value of the underlying asset. The underlying asset can be securities, commodities, bullion
currency, livestock or anything else. In other words, derivative means forward, futures, option or
other hybrid contract of predetermined fixed duration, linked for the purpose of contract fulfilment
to the value of a specified real or financial asset or to an index of securities. The Securities Contracts
(Regulation) Act 1956 defines “derivative” as under:
“Derivative” includes:
• Security derived from a debt instrument, share, loan whether secured or unsecured, risk
instrument or contract for differences or any other form of security.
• A contract which derives its value from the prices, or index of prices of underlying securities.

The above definition conveys that: The derivatives are financial products. Derivative is derived
from another financial instrument/contract called the underlying. In the case of Nifty futures, Nifty
index is the underlying. A derivative derives its value from the underlying assets. Accounting
Standard SFAS 133 defines a derivative as, ‘a derivative instrument financial derivative or other
contract with all three of the following characteristics: It has
(1) one or more underlying, and
(2) one or more notional amount or payments provisions or both. Those terms determine the
amount of the settlement or settlements.

It requires no initial net investment or an initial net investment that is smaller than would be
required for other types of contract that would be expected to have a similar response to changes
in market factors.

Its terms require or permit net settlement. It can be readily settled net by means outside the
contract or it provides for delivery of an asset that puts the recipients in a position not substantially
different from net settlement.

The term “financial derivative” relates with a variety of financial instruments which include stocks,
bonds, treasury bills, interest rate, foreign currencies and other hybrid securities. Financial
derivatives include futures, forwards, options, swaps, etc. Futures contracts are the most important
form of derivatives, which are in existence long before the term ‘derivative’ was coined. Financial
derivatives can also be derived from a combination of cash market instruments or other financial
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derivative instruments. In fact, most of the financial derivatives are not revolutionary new
instruments rather they are merely combinations of older generation derivatives and/or standard
cash market instruments.

In the 1980s, the financial derivatives were also known as off-balance sheet instruments because
no asset or liability underlying the contract was put on the balance sheet as such. Since the value of
such derivatives depend upon the movement of market prices of the underlying assets, hence, they
were treated as contingent asset or liabilities and such transactions and positions in derivatives
were not recorded on the balance sheet. However, it is a matter of considerable debate whether off-
balance sheet instruments should be included in the definition of derivatives. Which item or
product given in the balance sheet should be considered for derivative is a debatable issue.

Features of a Financial Derivatives

As observed earlier, a financial derivative is a financial instrument whose value is derived from the
value of an underlying asset; hence, the name ‘derivative’ came into existence. There are a variety
of such instruments which are extensively traded in the financial markets all over the world, such
as forward contracts, futures contracts, call and put options, swaps, etc. A more detailed discussion
of the properties of these contracts will be given later part of this lesson. Since each financial
derivative has its own unique features, in this section, we will discuss some of the general features
of simple financial derivative instrument. The basic features of the derivative instrument can be
drawn from the general definition of a derivative irrespective of its type. Derivatives or derivative
securities are future contracts which are written between two parties (counter parties) and whose
value are derived from the value of underlying widely held and easily marketable assets such as
agricultural and other physical (tangible) commodities, or short term and long term financial
instruments, or intangible things like weather, commodities price index (inflation rate), equity price
index, bond price index, stock market index, etc. Usually, the counter parties to such contracts are
those other than the original issuer (holder) of the underlying asset. From this definition, the basic
features of a derivative may be stated as follows:

1. A derivative instrument relates to the future contract between two parties. It means there
must be a contract-binding on the underlying parties and the same to be fulfilled in future.
The future period may be short or long depending upon the nature of contract, for example,
short term interest rate futures and long term interest rate futures contract.

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2. Normally, the derivative instruments have the value which derived from the values of other
underlying assets, such as agricultural commodities, metals, financial assets, intangible assets,
etc. Value of derivatives depends upon the value of underlying instrument and which changes
as per the changes in the underlying assets, and sometimes, it may be nil or zero. Hence, they
are closely related.

3. In general, the counter parties have specified obligation under the derivative contract.
Obviously, the nature of the obligation would be different as per the type of the instrument of
a derivative. For example, the obligation of the counter parties, under the different
derivatives, such as forward contract, future contract, option contract and swap contract
would be different.

4. The derivatives contracts can be undertaken directly between the two parties or through the
particular exchange like financial futures contracts. The exchange- traded derivatives are
quite liquid and have low transaction costs in comparison to tailor-made contracts. Example
of exchange traded derivatives are Dow Jones, S&P 500, Nikki 225, NIFTY option, S&P Junior
that are traded on New York Stock Exchange, Tokyo Stock Exchange, National Stock Exchange,
Bombay Stock Exchange and so on.

5. In general, the financial derivatives are carried off-balance sheet. The size of the derivative
contract depends upon its notional amount. The notional amount is the amount used to
calculate the pay off. For instance, in the option contract, the potential loss and potential
payoff, both may be different from the value of underlying shares, because the payoff of
derivative products differs from the payoff that their notional amount might suggest.

6. Usually, in derivatives trading, the taking or making of delivery of underlying assets is not
involved; rather underlying transactions are mostly settled by taking offsetting positions in
the derivatives themselves. There is, therefore, no effective limit on the quantity of claims,
which can be traded in respect of underlying assets.

7. Derivatives are also known as deferred delivery or deferred payment instrument. It means
that it is easier to take short or long position in derivatives in comparison to other assets or
securities. Further, it is possible to combine them to match specific, i.e., they are more easily
amenable to financial engineering.

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8. Derivatives are mostly secondary market instruments and have little usefulness in mobilizing
fresh capital by the corporate world; however, warrants and convertibles are exception in this
respect.

9. Although in the market, the standardized, general and exchange-traded derivatives are being
increasingly evolved, however, still there are so many privately negotiated customized, over-
the-counter (OTC) traded derivatives are in existence. They expose the trading parties to
operational risk, counter-party risk and legal risk. Further, there may also be uncertainty
about the regulatory status of such derivatives.

10. Finally, the derivative instruments, sometimes, because of their off-balance sheet nature, can
be used to clear up the balance sheet. For example, a fund manager who is restricted from
taking particular currency can buy a structured note whose coupon is tied to the performance
of a particular currency pair.

PRODUCTS OF DERIVATIVES
In this section, we discuss a range of derivatives products that derive their values from the
performance of five underlying asset classes: equity, fixed-income instrument, commodity, foreign
currency and credit event. However, given the speed of financial innovation over the past two
decades, the variety of derivatives products have grown substantially. Thus, a few key examples
will be discussed below:

Equity Derivatives :
Equity futures and options on broad equity indices are perhaps the most commonly cited equity
derivatives securities. Way back in 1982, trading of futures based on S&P’s composite index of 500
stocks began on the Chicago Mercantile Exchange (CME). Options on the S&P 500 futures began
trading on the CME in the following year. Today, investors can buy futures based on benchmark
stock indices in most international financial centres. Index futures contract enable an investor to
buy a stock index at a specified date for a certain price. It can be an extremely useful hedging tool.

For example : An investor with a stock portfolio that broadly matches the composition of the Hang
Seng index (HSI), he will suffer losses should the HSI record a fall in market value in the near future.
Since he means to hold the portfolio as a long term strategy, he is unwilling to liquidate the portfolio.
Under such circumstances, he can protect his portfolio by selling HSI futures contracts so as to profit

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from any fall in price. Of course, if his expectations turned out to be wrong and the HSI rose instead,
the loss on the hedge would have been compensated by the profit made on the portfolio. Some
investors prefer to purchase options on futures (or “futures options”) instead of straight futures
contracts. The option strike price is the specified futures price at which the future is traded if the
option is exercised. For some market participants, the pricing of an option reveal valuable
information about the likely future volatility of the returns of the underlying asset.

One commonly cited example is the Chicago Board Options Exchange Market Volatility Index (VIX
index), which is calculated based on a range of options on the S&P 500 index. When investors are
concerned about a potential drop in the US stock market, they buy the VIX index as an insurance
against losses in the value of their portfolio. The more investors demand, the higher the price of the
VIX. As such, the VIX can be viewed as an “investor fear gauge”.

Other commonly traded equity derivatives are equity swaps. Under an equity swap contract, an
investor pays the total return on a stock to his counterparty and receives in return a floating rate of
interest. With this equity swap, the investor can hedge his equity position without giving up
ownership of his share. At the same time, the party receiving equity return enjoys exposure without
actually taking ownerships of shares.

Interest Rate Derivatives

One of the most popular interest rate derivatives is interest rate swap. In one form, it involves a
bank agreeing to make payments to a counterparty based on a floating rate in exchange for
receiving fixed interest rate payments. It provides an extremely useful tool for banks to manage
interest rate risk. Given that banks’ floating rate loans are usually tied closely to the market interest
rates while their interest payments to depositors are adjusted less frequently, a decline in market
interest rates would reduce their interest income but not their interest payments on deposits. By
entering an interest rate swap contract and receiving fixed rate receipts from counterparty, banks
would be less exposed to the interest rate risk. Meanwhile, interest rate futures contract allows a
buyer to lock in a future investment rate.

Commodity Derivatives
The earliest derivatives markets have been associated with commodities, driven by the
problems about storage, delivery and seasonal patterns. But modern day commodity
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derivatives markets only began to develop rapidly in the 1970s. During that time, the
break-up of the market dominance of a few large commodity producers allowed price
movements to better reflect the market supply and demand conditions. The resulting
price volatility in the spot markets gave rise to demand of commodity traders for
derivatives trading to hedge the associated price risks.

Foreign Exchange Derivatives

The increasing financial and trade integration across countries have led to a strong rise in demand
for protection against exchange rate movements over the past few decades. A very popular hedging
tool is forward exchange contract. It is a binding obligation to buy or sell a certain amount of foreign
currency at a pre-agreed rate of exchange on a certain future date. Consider a Korean shipbuilder
who expects to receive a $1 million payment from a US cruise company for a boat in 12 months.
Suppose the spot exchange rate is 1,200 won per dollar today. Should the won appreciate by 10 per
cent against the dollar over the next year, the Korean shipbuilder will receive only 1,090 millions
of won (some 109 millions of won less than he would have received today). But if the shipbuilder
can hedge against the exchange risk by locking in buying dollars forwards at the rate of say 1,100
won per dollar. For thinly trade currencies or currencies of those countries with restrictions on
capital account transactions, the profit or loss resulting from the forwards transaction can be
settled in an international currency. This is the so-called non-deliverable forwards contract, and
very often they are traded offshore. Another type of foreign exchange derivatives are cross-
currency swaps. This involves two parties exchanging payments of principal (based on the spot rate
at inception) and interest in different currencies. According to many market participants, having a
liquid cross-currency swap market is an important for local currency bond market developments.

This is because such instruments allow foreign borrowers in local bond markets to swap back their
proceeds to their own currencies while hedging against the interest rate risk.

Credit Derivatives
A credit derivative is a contract in which a party (the credit protection seller) promises a payment
to another (the credit protection buyer) contingent upon the occurrence of a credit event with
respect to a particular entity (the reference entity). A credit event in general refers to an incident
that affects the cash flows of a financial instrument (the reference obligation). There is no precise

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definition, but in practice, it could be filing for bankruptcy, failing to pay, debt repudiation or
moratorium.

The fastest growing type of credit derivatives over the past decade is credit default swap (CDS). In
essence, it is an insurance policy that protects the buyer against the loss of principal on a bond in
case of a default by the issuer. The buyer of CDS pays a periodic premium to the seller over the life
of the contract. The premium reflects the buyer’s assessment of the probability of default and the
expected loss given default. In its simplest form, the CDS is written with respect to one single
reference entity, the so called single-name CDS. Some data providers compile indices of a basket of
single-name CDSs of similar ratings (e.g., the S&P US Investment Grade CDS Index consists of 100
equally weighted investment grade US corporate credits). These index trenches give investors the
opportunity to take on exposures to specific segments of the CDS index default loss distribution.

Participants and Functions

Banks, financial institutions, corporate, brokers and individuals are the participants of the
derivative market in India. It is observed that financial derivatives are those assets whose values
are determined by the value of some other assets, called as the underlying. Presently, there are
bewilderingly complex varieties of derivatives already in existence, and the markets are innovating
newer and newer ones continuously. Now let us discuss the various participants and economic
functions of derivative market in the following sub-sections:

Participants in a Derivative Market : The derivatives market is similar to any other financial
market and has following three broad categories of participants:
• Hedgers: These are investors with a present or anticipated exposure to the underlying asset
which is subject to price risks. Hedgers use the derivatives markets primarily for price risk
management of assets and portfolios. Example: An importer has to pay US $ to buy goods
and rupee is expected to fall to Rs. 50/$ from Rs. 48/$, then the importer can minimize his
losses by buying a currency future at Rs. 49/$.
• Speculators: These are individuals who take a view on the future direction of the markets.
They take a view whether prices would rise or fall in future and accordingly buy or sell
futures and options to try and make a profit from the future price movements of the
underlying asset. Example: If you will the stock price of Reliance is expected to go up to Rs.
400 in 1 month, one can buy a 1 month future of Reliance at Rs. 350 and make profits.

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• Arbitragers: These are the third important participants in the derivatives market. They take
positions in financial markets to earn risk less profits. The arbitragers take short and long
positions in the same or different contracts at the same time to create a position which can
generate a risk less profit.

Economic Function of the Derivative Market : The derivatives market performs a number of
economic functions. In this section, we discuss some of them.
• Detection of Prices: Prices in an organized derivatives market reflect the perception of the
market participants about the future and lead the prices of underlying to the perceived
future level. The prices of derivatives converge with the prices of the underlying at the
expiration of the derivative contract. Thus derivatives help in discovery of future as well as
current prices.
• Transfer of Risk: The derivatives market helps to transfer risks from those who have them
but do not like them to those who have an appetite for them.
• Liquidity and Volume Trading: Third, derivatives due to their inherent nature are linked to
the underlying cash markets. With the introduction of derivatives, the underlying market
witnesses higher trading volumes. This is because of participation by more players who
would not otherwise participate for lack of an arrangement to transfer risk.
• Encourages participating more people: An important incidental benefit that flows from
derivatives trading is that it acts as a catalyst for new entrepreneurial activity. The
derivatives have a history of attracting many bright, creative, well-educated people with an
entrepreneurial attitude. They often energize others to create new businesses, new products
and new employment opportunities, the benefit of which are immense. In a nut shell,
derivatives markets help increase savings and investment in the long run. Transfer of risk
enables market participants to expand their volume of activity.

Types of Derivatives
It is observed that financial derivatives are those assets whose values are determined by the value
of some other assets, called as the underlying. Presently, there are bewilderingly complex varieties
of derivatives already in existence, and the markets are innovating newer and newer ones
continuously. For example, various types of financial derivatives based on their different properties
like, plain, simple or straightforward, composite, joint or hybrid, synthetic, leveraged, mildly
leveraged, customized or OTC traded, standardized or organized exchange traded, etc., are available
in the market.
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Figure 1.1 Forwards

Futures

Basic
Options

Warrants &
Financial Convertibles

Derivatives
Swaps
Commodities
Complex
Exoctic

Due to complexity in nature, it is very difficult to classify the financial derivatives, so in the present
context, the basic financial derivatives which are popular in the market have been described in
brief. The details of their operations, mechanism and trading, will be discussed in the forthcoming
respective units. In simple form, the derivatives can be classified into different categories which are
shown in the Figure 1.1.

One form of classification of derivative instruments is between commodity derivatives and financial
derivatives. The basic difference between these is the nature of the underlying instrument or asset.
In a commodity derivatives, the underlying instrument is a commodity which may be wheat, cotton,
pepper, sugar, jute, turmeric, corn, soybeans, crude oil, natural gas, gold, silver, copper and so on.
In a financial derivative, the underlying instrument may be treasury bills, stocks, bonds, foreign
exchange, stock index, gilt-edged securities, cost of living index, etc. It is to be noted that financial
derivative is fairly standard and there are no quality issues whereas in commodity derivative, the
quality may be the underlying matters. However, the distinction between these two from structure
and functioning point of view, both are almost similar in nature.

Another way of classifying the financial derivatives is into basic and complex derivatives. In this,
forward contracts, futures contracts and option contracts have been included in the basic
derivatives whereas swaps and other complex derivatives are taken into complex category because

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they are built up from either forwards/futures or options contracts, or both. In fact, such derivatives
are effectively derivatives of derivatives.

Popular Derivative Instruments : The most popularly used derivatives contracts are Forwards,
Futures, Options and Swaps, which we shall discuss in detail later. Here we take a brief look at
various derivatives contracts that have come to be used.
• Forwards: A forward contract is a customized contract between two entities, where
settlement takes place on a specific date in the future at today’s pre-agreed price. The rupee-
dollar exchange rates is a big forward contract market in India with banks, financial
institutions, corporate and exporters being the market participants.

• Futures: A futures contract is an agreement between two parties to buy or sell an asset at a
certain time in the future at a certain price. Futures contracts are special types of forward
contracts in the sense that the former are standardized exchange-traded contracts. Unlike
forward contracts, the counterparty to a futures contract is the clearing corporation on the
appropriate exchange. Futures often are settled in cash or cash equivalents, rather than
requiring physical delivery of the underlying asset. Parties to a Futures contract may buy or
write options on futures.

• Options: An option represents the right (but not the obligation) to buy or sell a security or
other asset during a given time for a specified price (the “strike price”). Options are of two
types - calls and puts. Calls give the buyer the right but not the obligation to buy a given
quantity of the underlying asset, at a given price on or before a given future date. Puts give
the buyer the right, but not the obligation to sell a given quantity of the underlying asset at
a given price on or before a given date.

• Swaps: Swaps are private agreements between two parties to exchange cash flows in the
future according to a prearranged formula. They can be regarded as portfolios of forward
contracts. Swaps generally are traded OTC through swap dealers, which generally consist of
large financial institution, or other large brokerage houses. There is a recent trend for swap
dealers to mark to market the swap to reduce the risk of counterparty default. The two
commonly used swaps are:
▪ Interest rate swaps: These entail swapping only the interest related cash flows
between the parties in the same currency.
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▪ Currency swaps: These entail swapping both principal and interest between the
parties, with the cash flows in one direction being in a different currency than
those in the opposite direction. Swaps may involve cross-currency payments
(U.S. Dollars vs. Mexican Pesos) and cross market payments, e.g., U.S. short-term
rates vs. U.K. short-term rates.

Other Types of Financial Derivatives

▪ Warrants: Options generally have lives of up to one year, the majority of options traded on
options exchanges having a maximum maturity of nine months. Longer-dated options are
called warrants and are generally traded over-the-counter.

▪ LEAPS: The acronym LEAPS means Long-term Equity Anticipation Securities. These are
options having a maturity of up to three years.

▪ Baskets: Basket options are options on portfolios of underlying assets. The underlying asset
is usually a moving average of a basket of assets. Equity index options are a form of basket
options.

Exchange-Traded Vs. OTC Derivatives Markets

Derivatives that trade on an exchange are called exchange traded derivatives, whereas privately
negotiated derivative contracts are called OTC contracts. The OTC derivatives markets have
witnessed rather sharp growth over the last few years, which have accompanied the modernization
of commercial and investment banking and globalization of financial activities. The recent
developments in information technology have contributed to a great extent to these developments.
While both exchange-traded and OTC derivative contracts offer many benefits, the former have
rigid structures compared to the latter. It has been widely discussed that the highly leveraged
institutions and their OTC derivative positions were the main cause of turbulence in financial
markets in 1998. These episodes of turbulence revealed the risks posed to market stability
originating in features of OTC derivative instruments and markets.

The first exchange-traded financial derivatives emerged in 1970’s due to the collapse of fixed
exchange rate system and adoption of floating exchange rate systems. As the system broke down
currency volatility became a crucial problem for most countries. To help participants in foreign

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exchange markets hedge their risks under the new floating exchange rate system, foreign currency
futures were introduced in 1972 at the Chicago Mercantile Exchange. In 1973, the Chicago Board of
Trade (CBOT) created the Chicago Board Options Exchange (CBOE) to facilitate the trade of options
on selected stocks. The first stock index futures contract was traded at Kansas City Board of Trade.
Currently the most popular stock index futures contract in the world is based on S&P 500 index,
traded on Chicago Mercantile Exchange. During the mid-eighties, financial futures became the most
active derivative instruments generating volumes many times more than the commodity futures.
Index futures, futures on T-bills and Euro-Dollar futures are the three most popular futures
contracts traded today. Other popular international exchanges that trade derivatives are LIFFE in
England, DTB in Germany, SGX in Singapore, TIFFE in Japan, MATIF in France, Eurex etc.

REVIEW QUESTIONS
1. Explain the term ‘derivatives’, using suitable examples.
2. What are the underlying assets for a derivative instrument?
3. What are the products of derivatives?
4. Discuss the participants of derivatives in the trading context.
5. Explain the different types of derivatives along with their features, in brief.
6. ‘Derivatives are effective risk management tools’. Comment on the statement.
7. ‘Future contracts are obligations, whereas options are rights’. Do you agree?
8. Bring out the similarities and dissimilarities between Forwards, Futures, Options and Swaps.
9. Can you think of a cash market in which options or futures could be useful but does not yet exist?
Explain.
10. Highlight the various functions of derivatives.
11. What is Exchange-traded and over the contract derivatives?
12. Briefly, explain the Exchange-traded vs. OTC derivatives markets.

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CHAPTER 2
FORWARDS & FUTURES

INTRODUCTION TO FORWARD CONTRACTS

In the previous unit, we studied about the derivatives market in India i.e. derivatives market at NSE,
BSE, NIFTY and SENSEX. We also discussed about the important eligibility/regulatory conditions
specified by SEBI, comparison between NSE and BSE, Index derivatives and Exchange Traded Funds
in the last unit. This unit will helps you to understand the concept of forward contracts and the
terminologies used in it. We will also learn the various features, classification, benefits and
limitations of forward contracts in the various sections and sub section of this unit. To make the
learning easier, we will take the help of globally recognised best practices.

A Forward Contract is a contract made today for delivery of an asset at a pre-specified time in the
future at a price agreed upon today. The buyer of a forward contract agrees to take delivery of an
underlying asset at a future time (T), at a price agreed upon today. No money changes hands until
time T. The seller agrees to deliver the underlying asset at a future time T, at a price agreed upon
today. Again, no money changes hands until time T. A forward contract, therefore, simply amounts
to setting a price today for a trade that will occur in the future. In other words, a forward contract
is a contract between two parties who agree to buy/sell a specified quantity of a financial
instrument/commodity at a certain price at a certain date in future.

FORWARD CONTRACTS
A forward contract is a simple customised contract between two parties to buy or sell an asset at a
certain time in the future for a certain price. Unlike future contracts, they are not traded on an
exchange, rather traded in the over-the-counter market, usually between two financial institutions
or between a financial institution and one of its clients.

Example: An Indian company buys Automobile parts from USA with payment of one million dollar
due in 90 days. The importer, thus, is short of dollar that is; it owes dollars for future delivery.
Suppose present price of dollar is ` 48. Over the next 90 days, however, dollar might rise against `
48. The importer can hedge this exchange risk by negotiating a 90 days forward contract with a
bank at a price ` 50. According to forward contract in 90 days the bank will give importer one million
dollar and importer will give the bank 50 million rupees hedging a future payment with forward
contract. On the due date importer will make a payment of ` 50 million to bank and the bank will
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pay one million dollar to importer, whatever rate of the dollar is after 90 days. So this is a typical
example of forward contract on currency.

A forward contract is an agreement between two parties to buy or sell underlying assets at a pre-
determined future date at a price agreed when the contract is entered into. Forward contracts are
not standardised products. They are over-the-counter (not traded in recognised stock exchanges)
derivatives that are tailored to meet specific user needs. The underlying assets of this contract
include:

1. Traditional agricultural or physical commodities

2. Currencies (foreign exchange forwards)
3. Interest rates (forward rate agreements or FRAs)

Example: Suppose you decide to subscribe to cable TV. As the buyer, you enter into an agreement
with the cable company to receive a specific number of cable channels at a certain price every
month for the next year. This contract made with the cable company is similar to a futures contract,
in that you have agreed to receive a product at a future date, with the price and terms for delivery
already set. You have secured your price for now and the next year-even if the price of cable rises
during that time. By entering into this agreement with the cable company, you have reduced your
risk of higher prices.

At the time the forward contract is written, a specified price is fixed at which the asset is purchased
or sold. This delivery price is referred to as the delivery price. This delivery price is set such that
the either a long (buyer) or a short (seller) position. This is done by convention so that no cash is
exchanged between the parties entering into the contracts. In this way, the delivery price yields a
‘fair’ price for the future delivery of the underlying asset. One of the parties to a forward contract
agrees to buy the underlying asset is aid to have a ‘long’ position. On the other hand, the party that
agrees to sell the same underlying asset is said to have a ‘short’ position.

Definitions
A forward contract is an agreement between two parties to buyer sells, as the case may be, a
commodity (or financial instrument or currency) at a predetermined future date at a price agreed
when the contract is entered into. The key elements are:
1. The date on which the commodity will be bought/sold is determined in advance.
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2. The price to be paid/received at that future date is determined at present.

Legal Definitions Of Forward Contracts

Under the Forward Contracts (Regulation) Act, 1952 forward contracts are classified into:
▪ Hedge contracts: These are freely transferable and do not specify any particular lot,
consignment or variety for delivery. Delivery in such contracts (which may be of any of the
approved deliverable varieties) is unnecessary except in a residual or optional sense, Hedge
contracts are subject to the regulatory provisions of the forward Contracts (Regulation) Act.

▪ Transferable Specific Delivery (TSD) contracts: These are contracts, which, though freely
transferable from one party to another, are concerned with a specific and predetermined
consignment or variety of the commodity. Delivery, of the agreed variety, is mandatory. Such
contracts are normally subject to the regulatory provisions of the Act but may be exempted
from regulation (in specified cases) by the Central Government.

▪ Non-transferable Specific Delivery (NTSD) contracts: These are concerned with a specific
variety or consignment and are not transferable at all. Contract terms are highly specific.
Delivery is mandatory. NTSD contract are normally exempt from the regulatory provisions of
the Act, but may be brought under regulation by the Central Government, wherever felt
necessary (in practice, NTSD contracts in most items have been brought under regulation).

As will be obvious, the legal definition of hedge contracts corresponds to the analytical definition of
futures contracts, while the latter two categories are not ‘futures’ contracts or hedge contracts does
not specify precisely which variety or consignment will actually be delivered because the limits are
set by the rules of the exchange on which types can or cannot be delivered. Where a variety superior
or inferior to the basis variety is tendered for delivery, prices are adjusted by means of premia or
discounts, as they may be, these are commonly known as tendering differences.

Other Forward Contracts

Forward Rate Agreements (FRA)
Forward contracts are commonly arranged on domestic interest-rate bearing instruments as well
as on foreign currencies. A forward rate agreement is a contract between the two parties, (usually
one being the banker and other a banker’s customer or independent party), in which one party (the
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banker) has given the other party (customer) a guaranteed future rate of interest to cover a
specified sum of money over a specified period of time in the future. For example, two parties agree
that a 6 percent per annum rate of interest will apply to one year deposit in six months time. If the
actual rate of interest proves to be different from 6 percent then one company will pay and other
receives the difference between the two sets of interest cash flows.

In forward rate agreement, no actual lending or borrowing is affected. Only it fixes the rate of
interest for a futures transaction. At the time of maturity, when the customer actually needs funds,
then he has to borrow the funds at the prevailing rate of interest from the market. If the market rate
of interest is higher than the FRA interest then the banker will have to pay to the other party
(customer) the difference in the interest rate. However, if market interest is lesser than the FRA
rate then the customer will have to pay the difference to the banker. This transaction is known as
purchase of FRA from the bank.

Sometimes, a customer (depositor) may also make a FRA contract with the bank for his deposits for
seeking a guaranteed rate of interest on his deposits. If the market rate on his deposit turns out to
be lower than that guaranteed interest rate in the FRA, the bank will compensate him for the
difference, i.e., FRA rate minus market interest. Similarly, if the FRA is lower than the deposit rate
then the customer will pay difference to the banker. This transaction is known as sale of a FRA to
the bank. In this way, purchase of FRA protects the customer against a rise in interest in case of
borrowing from the bank. Similarly, sale of FRA will protect the customer from deposits point of
view. The bank charges different rates of interest for borrowing and lending, and the spread
between these two constitutes bank’s profit margin. As a result, no other fee is chargeable for FRA
contracts.

Example 1
Suppose three month forward rupee is at ` 45 per US dollar. A quotation is given in terms of range.
The forward rupee would be quoted at “` 48 to ` 50”. If the spot rate rises above the maximum, i.e.,
` 50 then the maximum level is used. If the spot rate falls below the minimum rate, i.e., ` 48 then the
minimum level will be used.

Example 2
Assume two companies might agree that 8 percent per annum rate of interest will apply to a one-
year deposit in fix month’s time. If the actual rate proves to be different from 8 percent per annum,
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one company pays and the other receives the present value of the difference between two sets of
interest (cash flows). This is known as a forward-rate agreement (FRA).

Range Forwards
These instruments are very much popular in foreign exchange markets. Under this instrument,
instead of quoting a single forward rate, a quotation is given in terms of a range, i.e., a range may be
quoted for Indian rupee against US dollar at ` 47 to ` 49. It means there is no single forward rate
rather a series of rate ranging from ` 47 1049 has been quoted. This is also known as flexible
forward contracts. At the maturity, if the spot exchange rate is between these two levels, then the
actual spot rate is used. On the other hand, if the spot rate rises above the maximum of the range,
i.e., ` 49 in the present case then the maximum level is used. Further, if the spot rate falls below the
minimum level, i.e., ` 47, then the minimum rate will be used. As such we see that these forward
range contracts differ from normal forward contracts in two respects, namely, (a) they give the
customer a range within which he can earn or use from the exchange rate fluctuations, and (b)
further they provide protection to the party from the extreme variation in exchange rates.

Forward Trading Mechanism

Forward contracts are very much popular in foreign exchange markets to hedge the foreign
currency risks. Most of the large and international banks have a separate ‘Forward Desk’ within
their foreign exchange trading room which is devoted to the trading of forward contracts. Let us
take an example to explain the forward contract.

Suppose on April 10, 2002, the treasurer of an UK Multinational firm (MNC) knows that the
corporation will receive one million US dollar after three months, i.e., July 10, 2002 and wants to
hedge against the exchange rate movements.

In this situation, the treasurer of the MNC will contact a bank and find out that the exchange rate
for a three-month forward contract on dollar against pound sterling, i.e.,
£I$ = 0.6250 and agrees to sell one million dollar. It means that the corporation has short forward
contracts on US dollar. The MNC has agreed to sell one million dollar on July 10, 2002 to the bank
at the future dollar rate at 0.6250. On the other hand, the bank has a long forward contract on dollar.
Both sides have made a binding contract/commitment.

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Before discussing the forward trading mechanism, let us see some important terminology
frequently used in the forward trading.

Long Position : The party who agrees to buy in the future is said to hold long position. For example,
in the earlier case, the bank has taken a long position agreeing to buy 3-month dollar in futures.

Short Position : The party who agrees to sell in the future holds a short position in the contract. In
the previous example, UK MNC has taken a short position by selling the dollar to the bank for a 3-
month future.

The Underlying Asset : It means any asset in the form of commodity, security or currency that will
be bought and sold when the contract expires, e.g., in the earlier example US dollar is-the underlying
asset which is sold and purchased in future.

Spot-Price : This refers to the purchase of the underlying asset for immediate delivery. In other
words, it is the quoted price for buying and selling of an asset at the spot or immediate delivery.

Future Spot Price : The spot price of the underlying asset when the contract expires is called the
future spot price, since it is market price that will prevail at some futures date.

Delivery Price : The specified price in a forward contract will be referred to as the delivery price.
This is decided or chosen at the time of entering into forward contract so that the value of the
contract to both parties is zero. It means that it costs nothing to take a long or a short position. In
other words, at the day on writing of a forward contract, the price which is determined to be paid
or received at the maturity or delivery period of the forward contract is called delivery price. On
the first day of the forward contract, the forward price may be same as to delivery price. This is
determined by considering each aspect of forward trading including demand and supply position
of the underlying asset. However, a further detail regarding this will be presented in forthcoming
chapter.

The Forward Price

It refers to the agreed upon price at which both the counter parties will transact when the contract
expires. In other words, the forward price for a particular forward contract at a particular time is
the delivery price that would apply if the contract were entered into at that time. In the example
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discussed earlier, on April 10, 2002, 0.6250 is the forward price for a forward contract that involves
the delivery of US dollar on July 10, 2002.

The Determination of Forward Prices

Forward contracts are generally easier to analyze than futures contracts because in forward
contracts there is no daily settlement and only a single payment is made at maturity. Though both
futures prices and forward prices are closely related, this will be described in the latter part of this
chapter.

It is essential to know about certain terms before going to determine the forward prices such as
distinction between investment assets and consumption assets, compounding, short selling, repo
rate and so on because these will be frequently used in such computation. We are not discussing
these here in detail but the traders must be aware about them thoroughly. A brief view of these
terms is explained here as under:

An investment asset is an asset that is held for investment purposes, such as stocks, shares, bonds,
treasury, securities, etc. Consumption assets are those assets which are held primarily for
consumption, and not usually for investment purposes. There are commodities like copper, oil, food
grains and live hogs.

Compounding is a quantitative tool which is used to know the lump-sum value of the proceeds
received in a particular period. Consider an amount A invested for n years at an interest rate of R
per annum. If the rate is compounded once per annum, the terminal value of that investment will
be
Terminal value =A (1 +R)n
and if it is compounded m times per annum then the terminal value will be Terminal value =A (1
+R/m)mn
where A is amount for investment, R is rate of return, n is period for return and m is period of
compounding.
Suppose A = ` 100, R = 10% per annum, n = 1 (one year), and if we compound once per annum (m
= 1) then as per this formula, terminal value will be
100(1 + 10)1 = 100(1.10) = ` 110,
if m=2 then
100(1 + 0.05)2x1 = 100 x 1.05 x 1.05= ` 110.25
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and so on.

Short selling refers to selling securities which are not owned by the investor at the time of sale. It
is also called ‘shorting’, with the intention of buying later. Short selling may not be possible for all
investment assets. It yields a profit to the investor when the price of the asset goes down and loss
when it goes up.
For example, an investor might contract his broker to short 500 State Bank of India shares then the
broker will borrow the shares from another client and sell them in the open market. So the investor
can maintain the short position provided there are shares available for the broker to borrow.
However, if the contract is open, the broker has no shares to borrow, then the investor has to close
his position immediate, this is known as short- squeezed.

The repo rate refers to the risk free rate of interest for many arbitrageurs operating in future
markets. Further, the ‘repo’ or repurchase agreement refers to that agreement where the owner of
the securities agrees to sell them to a financial institution, and buy the same back later (after a
particular period). The repurchase price is slightly higher than the price at which they are sold. This
difference is usually called interest earned on the loan. Repo rate is usually slightly higher than the
Treasury bill rate.

Assumptions and Notations

Certain assumptions considered here for determination of forward or futures prices are:
➢ There are no transaction costs.
➢ Same tax rate for all the trading profits.
➢ Borrowing and lending of money at the risk free interest rate.
➢ Traders are ready to take advantage of arbitrage opportunities as and when arise. These
assumptions are equally available for all the market participants; large or small.

Further, some Notations which have been used here are:

T = Time remained upto delivery date in the contract
S = Price of the underlying asset at present, also called as spot or cash or current K = Delivery price
in the contract at time T
F = Forward or future price today
f = Value of a long forward contract today
r = Risk free rate of interest per annum today
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t = Current or today or present period of entering the contract

Now, we will discuss the mechanism of determination of forward prices of different types of assets.
The Forward Price for Investment Asset (Securities)
Here we will consider three situations in case of investment assets:
1. Investment assets providing no income
2. Investment assets providing a known income
3. Investment assets providing a known dividend income
Forward Price for An Asset that Provides no Income
This is the easiest forward contract to value because such assets do not give any income to the
holder. These are usually non dividend paying equity shares and discount bonds. Let us consider
the relationship between the forward price and spot price with an example.

Example
Consider a long forward contract to purchase a share (Non-dividend paying) in three- months.
Assume that the current stock price is ` 100 and the three-month risk free rate of interest is 6% per
annum. Further assume that the three months forward price is ` 105.

Arbitrageur can adopt the following strategy

Borrow ` 100 @ 6% for three months, buy one share at ` 100 and short a forward contract for ` 105.
At the end of three months, the arbitrageur delivers the share for ` 105, the sum of money required
to pay off the loan is 100e 0.06 x0.2 = ` 101.50, and in this way, he will book a profit of ` 3.50, (`
105—` 101.50). Further suppose that the three-month forward price is ` 99. Now, an arbitrageur
can one share, invest the proceeds of the short sale at 6 percent per annum for three months, and a
long position in a three-month forward contract. The proceeds of short sales will grow to
100e0.006x0.25= ` 101.50, at the end of three months, the arbitrageur will pay ` 99 and takes the
delivery of the share under forward contract, and uses it to close its short sale position. His net gain
is ` 101.50— ` 99 = ` 2.5.

Generalization: We call from the previous example using the notations mentioned earlier for
investment asset providing no income:

F = SerT

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where F is forward price of the stock, S is spot price of the stock, T is maturity period (remained), r
is risk- free interest rate.
If F> SerT then the arbitrageur can buy the asset and will go for short forward contract on the asset.
If F < SerT then he can short the asset and go for long forward contract on it.

Forward Prices for Security that Provides a Known Cash Income

We will consider forward contracts on such assets which provides a known cash income, for
example, coupon bearing bonds, treasury securities, known dividend, etc. Let us explain with an
example:

Example
Consider a long forward contract to purchase a coupon bond whose current price is ` 900 maturing
5 years. We assume that the forward contract matures in one year, so that the forward contract is
a contract to purchase a four-year bond in one year. Further assume that the coupon payment of `
40 are expected after six months and 12 months, and six-month and one-year risk free interest rate
are 9 percent and 10 percent respectively.

In first situation, we assume that the forward price is high at ` 930. In this case, can arbitrageur can
borrow ` 900 to buy the bond and short a forward contract. Then the first coupon payment has a
present value of 40e-09 x 0.5 = ` 38.24. So the balance amount ` 861.76 (900-38.24) is borrowed @
10% for year. The amount owing at the end of the year is 86l.76e01 x = ` 952.39. The second coupon
provides ` 40 toward this amount, and ` 930 is received for the bond under the terms of the forward
contract. The arbitrageur will earn
= (` 40 + ` 930) — ` 952.39 = ` 17.61

Similarly, in the second situation, we may assume the low forward price at ` 905, then in that case
the arbitrageur can short the bond and outer into long forward contract. Likewise above, the
arbitrageur will earn:
` 952.39— (` 40 + 905) = ` 7.39

Generalization: From the above example, it can be generalized that such assets which provide
known income (i.e. I) during the life of a forward contract, then forward price would be as follows:
F = (S – I)erT
In the earlier example, S = ` 900, I = 40, r = 0.09 and 0.1 and T= 1. I is calculated as:
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I = 40e-0.09+40e-0.10x1 = ` 74.433
Then F = (900— 74.333)0.10x1 = ` 912.39

This can be an agreement with our calculation, and it applies to any investment asset that provides
a known cash income. So we can generalized from the above: If F > (S - I)erT, the investor can earn
the profit by buying the asset and shorting a forward contract on the asset. If F < (S - I)erT, an
arbitrageur can earn the profit by shorting the asset and taking a long position in a forward contract.
Further, if there is no short sale, the arbitrageur who owns the asset will find it profitable to sell the
asset and go long forward contract.

Forward Price where the Income is a Known Dividend Yield

A known dividend yield means that when income expressed as a percentage of the asset life is
known. Let us assume that the dividend yield is paid continuously as a constant annual rate at q
then the forward price for a asset would be F = Se(r-q)T

Example
Let us consider a six-month forward contract on a security where 4 percent per annum continuous
dividend is expected. The risk free rate of interest is 10 percent per annum. The asset’s current
price is ` 25. Then we can calculate the forward price as:
F = Se(r-q)T
F = 25e(0.10-0.04)x0.5 = ` 25.76

If F> Se(r-q)T then an investor can buy the asset and enter into a short forward contract to lock in
a riskless profit. If F< Se(r-q)T then an investor can enter into a long forward contract and short the
stock to earn riskless profit. Further, if dividend yield varies during the life of a forward contract
the q should be set equal to the average dividend yield during the life of the contract.

Valuing Forward Contracts

On the basis of generalization in different situations, we can find out the value of a forward contract.
As we know that the value of a forward contract at the time it is first written (entered) into is zero.
However, at later stage, it may prove to have a positive or negative value. In general, the value of a
forward contract can be determined as follows:

f = (F – K)e-rT
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where f is value of a forward contract, F is forward price (current) of the asset, K is delivery price
of the asset in the contract, T is time to maturity of contract and r is risk free rate of interest.

Let us examine the equation

We compare a long forward contract that has a delivery price of F with an otherwise identical long
forward contract with a delivery price of K. As we know that the forward price is changing with the
passage time, and that is why later on, F and K may not be equal which were otherwise equal at the
time of entrance of the contract. The difference between the two is only in the amount that will be
paid for the security at time T. Under the first contract, this amount is F, and under the second
contract, it is K. A cash outflow difference of F- K at time T translates to a difference of (F - K)e-rT
today. Therefore, the contract with a delivery price F is less valuable than the contract with a
delivery price K by an amount (F - K)e-rT. The value of contract that has a delivery price of F is by
definition, zero.
Similarly, the value of a short forward contract with the delivery price K is f= (F - K)e-rT

Example
Consider a six-month long forward contract of a non-income-paying security. The risk free rate of
interest is 6 percent per annum. The stock price is ` 30 and the delivery price is ` 28. Compute the
value of forward contract.
Forward price F = 30e0.06x05 = ` 30.90
Value of forward contract f= (F - K)e-rT
= (30.90 - 28)e-0.06x0.5
= ` 2.90-0.09 = 2.8* (app.)

Alternatively, using the other equation:

f = 30 - 28-0.06x0.5
f= 30 - 27.16 = 2.84 (app.)

*The above difference is due to annual compounding.

Using the earlier equation of value of forward contract, we can show the value of long forward
contract in all the three situations, which are as under:
(a) Asset with no income: f= S - Ke-rT
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(b) Asset with known income (l):f= S - I - Ke-rT

(c) Asset with known dividend yield at the rate q: f= Se-qT - Ke-rT

Note that in each case the forward price F is the value of K which makes f equal to zero.

Forward Prices Versus Futures Prices

Whether the forward prices are equal to futures prices, this is very important and debatable issue.
It is argued that if risk free interest rate is constant and the same for all maturities, in such market
situations, lie forward price will be same as the futures price for the contract. However, in actual
practice, the interest rates do not remain constant and usually vary unpredictably, then forward
prices and futures prices no longer remain the same. We can get sense of the nature of the
relationship by considering the situation where the price of the underlying asset is strongly
positively correlated with interest rates.

Since in futures contracts, there is daily settlement, so if current price(s) increases, an investor who
holds a long future position, makes an immediate profit, which will be reinvested at a higher than
average rate of interest. Similarly when current price(s) decreases, the investor will incur
immediate loss, and this loss will be financed at a lower than average rate of interest. However, this
position does not arise in the forward contract because there is no daily settlement and interest
rate movements will not have any affect till maturity. It is further argued that when spot (current)
prices are strongly positively correlated with the interest rates, futures prices will tend to higher
than the forward prices, similarly, if spot prices are strongly negatively correlated with the interest
rates then forward prices will tend to higher than the futures prices. It is further observed that
though there may be theoretical difference between forward prices and futures prices due to
various factors like taxes, transaction costs, treatment of margin and default risk, but this difference
is very small which may be ignored. Thus, in our further discussion in various chapters, both
forward contracts and futures contracts are assumed to be the same and the symbol F will be used
to represent both futures price and forward price same at time zero.

Features Of A Forward Contract

The salient features of forward contracts are:
▪ Forward contracts are bilateral contracts, and hence, they are exposed to counter party risk.
There is risk of non-performance of obligation either of the parties, so these are riskier than to
futures contracts.
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▪ Each contract is custom designed, and hence, is unique in terms of contract size, expiration date,
the asset type, quality, etc.
▪ In forward contract, one of the parties takes a long position by agreeing to buy the asset at a
certain specified future date. The other party assumes a short position by agreeing to sell the
same asset at the same date for the same specified price. A party with no obligation offsetting
the forward contract is said to have an open position.
▪ The specified price in a forward contract is referred to as the delivery price. The forward price
for a particular forward contract at a particular time is the delivery price that would apply if
the contract were entered into at that time. It is important to differentiate between the forward
price and the delivery price. Both are equal at the time the contract is entered into.
▪ In the forward contract, derivative assets can often be contracted from the combination of
underlying assets, such assets are generally known as synthetic assets in the forward market.
▪ In the forward market, the contract has to be settled by delivery of the asset on expiration date.
In case the party wishes to reverse the contract, it has to compulsory go to the same counter
party, which may dominate and command the price it wants as being in a monopoly situation.
▪ In the forward contract, covered parity or cost-of-carry relations are relation between the
prices of forward and underlying assets. Such relations further assist in determining the
arbitrage-based forward asset prices.
▪ Forward contracts are very popular in foreign exchange market as well as interest rate bearing
instruments. Most of the large and international banks quoted the forward rate through their
‘forward desk’ lying within their foreign exchange trading room. Forward foreign exchange
quotes by these banks are displayed with the spot rates.
▪ As per the Indian Forward Contract Act 1952, different kinds of forward contracts can be done
like hedge contracts, transferable specific delivery (TSD) contracts and non-transferable
specify delivery (NTSD) contracts. Hedge contracts are freely transferable and do not specific,
any particular lot, consignment or variety for delivery. Transferable specific delivery contracts
are though freely transferable from one party to another, but are concerned with a specific and
predetermined consignment. Delivery is mandatory. Non-transferable specific delivery
contracts, as the name indicates, are not transferable at all, and as such, they are highly specific.

REVIEW QUESTIONS
1. What do you mean by a Forward Contract? Explain using a suitable example.
2. Define the concept forward contract and explain its features.

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3. “Forward contracts act as fore-runners of futures market”. Critically evaluate the statement in
the light of growth of forward market worldwide.
4. Write a detailed note on classification of forward contracts with examples.
5. Briefly discuss the trading mechanism of the forward market.
6. What are important terms used in trading forward contract? Explain.
7. List the major features of forward contracts.
8. Explain the main benefits and limitation of forward contracts.
9. Explain the statement: “Forwards are zero-sum games”.
10. Explain the various uses of forward contract with suitable examples.

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CHAPTER 3
MECHANICS AND PROPERTIES OF OPTIONS

Introduction
An option is a unique instrument that confers a right without an obligation to buy or sell another
asset, called the underlying asset. Like forwards and futures it is a derivative instrument because
the value of the right so conferred would depend on the price of the underlying asset. As such
options derive their values inter alia from the price of the underlying asset. For easier
comprehension of the concept of an option, an example from the stocks as underlying asset is most
apt.

Consider an option on the share of a firm, say ITC Ltd. It would confer a right to the holder to either
buy or sell a share of ITC. Naturally, this right would be available at a price, which in turn is derived
from the price of the share of ITC? Hence, an option on ITC would be priced according to the price
of ITC shares prevailing in the market. Of course this right can be made available at a specific
predetermined price and remains valid for a certain period of time rather than extending
indefinitely in time.

The unique feature of an option is that while it confers the right to buy or sell the underlying asset,
the holder is not obligated to perform. The holder of the option can force the counterparty to honors
the commitment made. Obligations of the holder would arise only when he decides to exercise the
right. Therefore, an option may be defined as a contract that gives the owner the right but no
obligation to buy or sell at a predetermined price within a given time frame. It is the absence of
obligation to perform for one of the parties that makes the option contract a substantially different
derivative product from forwards and futures, where there is equal and binding obligation on both
the parties to the contract. This unique feature of an option makes several applications possible that
may not be feasible with other derivative products.

Terminology of Options
Before we discuss how an option contract works it would be useful to familiarize with the basic
terms that are often used in describing and using options. These basic terms are described below.

▪ Call Option: A right to BUY the underlying asset at predetermined price within specified
interval of time is called a CALL option.
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▪ Put Option: A right to SELL the underlying asset at predetermined price within a specified
interval of time is called a PUT option.

▪ Buyer or Holder: The person who obtains the right to buy or sell but has no obligation to
perform is called the owner/holder of the option. One who buys an option has to pay a
premium to obtain the right.

▪ Writer or Seller: One who confers the right and undertakes the obligation to the holder is
called seller/writer of an option.

▪ Premium: While conferring a right to the holder, who is under no obligation to perform, the
writer is entitled to charge a fee upfront. This upfront amount is called the premium. This is
paid by the holder to the writer and is also called the price of the option.

▪ Strike Price: The predetermined price at the time of buying/writing of an option at which it
can be exercised is called the strike price. It is the price at which the holder of an option buys/
sells the asset.

▪ Strike Date/Maturity Date: The right to exercise the option is valid for a limited period of
time. The latest time when the option can be exercised is called the time to maturity. It is also
referred to as expiry/maturity date.

These terms would become clearer when the two basic options, call and put are described in detail.

Call Option
Assume that share of ITC is currently trading at ` 180. An investor, John, believes that share is going
to rise at least to ` 220 in the immediate future of the next three months. John does not have
adequate funds to buy the shares now but is expecting to receive substantial money in the next
three months. He cannot afford to miss an opportunity to own this share. Waiting for three months
implies not only a greater outlay at a later point of time, but also means foregoing of substantial
potential gains. Another investor, Mohammad, holds contrary views and believes that optimism of
John is exaggerated. He is willing to sell the share.

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What can John do under these circumstances where he cannot buy the shares on an outright basis
now? He possibly could borrow to acquire the stock of ITC. This is fraught with risk of falling prices.
Amongst the many alternatives that may be available to John is included an instrument called call
option. He can instead buy a call option from Mohammad (assuming he is willing to confer the same)
stating that John has a right to buy a share of ITC from Mohammad at a price of, say, ` 190 at any
time during the next three months. This would be a call option (the option to buy). John is the holder
of the option, while Mohammad is the writer/seller of the option. In case John decides to buy the
share (exercise the option) he would pay ` 190, the strike/ exercise price. The period up to which
John can exercise this option is three months. Note that John has the option, which he may not
exercise, but Mohammad has no such choice and he stands committed to deliver the share and
receive ` 190 from John, irrespective of the price of ITC share at that time. Naturally, Mohammad
would not provide such a right for free as he is obligated to perform at the option of another.
Therefore, Mohammad would charge some fee, called option premium, to grant this right to John.
This premium is determined inter alia by the price of the underlying asset, the ITC share. We shall
discuss later how this premium is decided.

We now discuss the circumstances when John would exercise his option. He would use this right
only when the actual price of the ITC share has gone beyond ` 190 (the exercise price). Imagine it
has moved to ` 200. By exercising the option he stands to gain immediately ` 10, as he gets one share
from Mohammad by paying ` 190 and sells immediately in the market at ` 200. Logically, John would
not exercise the option if the price remained below ` 190. In any case he loses the premium paid. If
the price remains below ` 190, Mohammad would not be asked to deliver and the upfront premium
he received would be his profit.

We may generalize the outcome of a call option in the following manner.

As long as the price of the underlying asset, S, remains below the strike price, X the buyer of the call
option will not exercise it; and the loss of the buyer would be limited to the premium paid on the
call option c and if the price is more than exercise price the holder exercises the option and
generates profit equal to the difference of the two prices. Alternatively,

When S <X Buyer lets the call expire Loss = premium c

S=X Buyer is indifferent Loss = premium c

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S>X Buyer exercises the call option Gain = S- X— c

Mathematically, the value of the call is given by Equation (2.1) Value of the call option = Max (0, S—
X) - c (2.1)

A graphical depiction of the payoff of the holder and the writer of the call option is easier to
comprehend and is presented in Figure

Put Option
Put option is similar to call option except the fact that it is an option to sell. Again we take a small
example from stock markets to clarify how put option works.
Again assume that share of ITC is currently trading at ` 180. An investor, John, in possession of the
share (it is not necessary to have the share to enter into an options contract) believes that the share
is likely to fall to ` 150 in the immediate future of the next three months. John is not sure of the fall
but would like to exit from his investment at ` 175.

He is seeking protection against the heavy fall in the price. Another investor, Mohammad, holding
contrary views believes that the pessimism of John is exaggerated. He is willing to buy the share at
` 175 since he feels that is the lowest it can go.

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John believes ITC is a good long-term buy but is unsure when the scrip would show its potential. He
does not want to exit unnecessarily. Under these circumstances John can buy a put option (the right
to se4 to Mohammad stating that he has a right to sell a share of ITC to at a price of ` 175 at any time
during the next three months. In case John decides to sell the share (exercise the option) he would
receive ` 175, the strike/exercise price in the next three months. John has the option, which he may
or may not exercise, but Mohammad has no such choice and he stands committed to pay the agreed
price and claim the share. Like in the call option, Mohammad would not grant such a right for free
and charge some fee, called option premium. This premium is determined inter alia by the price of
the underlying asset, the ITC share.

John would exercise his option only when it is profitable to do so. The option would become
profitable when the actual price of the ITC share falls below ` 175 (the exercise price). Imagine that
it has moved to ` 160. By exercising the option John stands to gain immediately ` 15 by placing the
share to Mohammad and realize ` 175 from him and using the proceeds to acquire a share of ITC
from the market at ` 160. This keeps his earlier position intact and yet gives ` 15 as profit. Logically,
John would not exercise the option if the price remains above ` 175. However, under all
circumstances he loses the premium paid.

We may generalize the outcome of a put option in the following manner.

As long as the price of the security remains below the strike price the buyer of the option will
exercise it because he stands to gain; otherwise his loss would be limited to the premium paid on
the put option p.

When S< X Buyer exercises the option Gain= X— S—p

When S= X Buyer is indifferent Loss = premium, p
When S> X Buyer lets the contract expire Loss = premium, p
Mathematically, the value of the put is given by Equation 2.2.
Value of the put option = Max (0, X— S) – p (2.2)

The graphical view of the payoff for put option, holder and writer is shown in Figure
(a) and (b).

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The payoff diagrams for call and put options as depicted in Figures and respectively, reveal that the
payoff of options is not linear. While it may be unbounded at one end the other end is limited to
loss/gain equal to the premium of option. This non-symmetrical non- linear payoff results from
feature of ‘right but no obligation’ and makes options different from other derivative products.

Types of Options
Options have several features, certainly more than forwards and futures making several
differentiations possible in the basis products of calls and puts. Based on several considerations the
options can be categorized in a number of ways, such as:
➢ Based on nature of exercise of options
➢ Based on how are they generated, traded, and settled
➢ Based on the underlying asset on which options are created

Nature of Exercise: American Versus European

Based on the timing of exercise the options can be either American or European. American options
can be exercised at any point of time before the expiry date of the option, while European options
are exercisable only upon maturity.

Nature of Markets: OTC Versus Exchange Traded

Options can also be categorized as OTC or exchange traded depending upon where and how they
are created, traded, and settled. Options may be like it forward contracts, which are specific and
negotiated by two contracting parties mutually with direct negotiations, known as OTC, or they can
be like futures which may be bought and sold on the specific exchanges where the two contracting
parties may not be known to each other but instead

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enter into a contract on the floor/screen of an exchange. In the exchange-traded options the
contracts need to be standardized, while an OTC product is tailor-made to the requirements of the
parties concerned.

The standardization of option contract would be in at the discretion of the exchange and is done in
terms of Quantity of Underlying Asset Only specific quantity of the underlying asset could be
traded on the exchange and need to be predetermined.

Strike Prices
Only specific strike prices can be handled in a standardized product traded on the exchanges. OTC
products can have any strike price as agreed by the two contracting parties.

Expiration Dates
Like strike price the expiration dates too must be known before trading can take place in options at
the exchanges.

Nature of Exercise of Option Whether the options are American or European in nature too must be
known to traders in options.

Ways of Settlement
Options can be settled either by delivery of underlying asset or by cash settlement, which is closing
out by exchanging the differential of price at initiation and closing out. Cash settlement at the expiry
is done by exchanging difference between the exercise price and price of the underlying asset. It
can also be settled by the cancellation of the contract by entering into an equal and opposite
contract to the original one.

Nature of Underlying Assets

Like forwards and futures, options too can have any asset as underlying. Options on stocks, indices,
commodities, currencies, and interest rates are available either OTC or on exchanges. Though not
available in India as of now, options on commodities are traded internationally on agricultural
products, live stock, food products, energy, and metals.

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Options are also available on various currencies, such as US dollar, euro, yen, pound, etc. in major
exchanges in the USA and Europe as also other parts of the world. Options on currencies are mostly
OTC.

Besides, options are also traded on the exchanges on futures contracts rates. Options on futures
have futures contract as underlying asset, which give the buyer a right to buy (call) or sell (put) the
specified futures contract within or at specified time. Naturally, the expiry of the futures contract
must extend beyond that of option contract.

Similarly, options can also be traded on interest rates, either on cash assets such as treasury bonds
and notes, or on interest rate futures contracts. These options serve the same purposes as do the
options on stocks and indices.

Options on stocks and stock indices are most common. Several exchanges across the world offer
options on indices and stock. National Stock Exchange (NSE) in India offers options on several
indices such as Nifty, a broad-based index of 50 stocks from banking, information technology,
infrastructure, etc.

Presently these options cover limited exercise prices and cover periods up to three months.
However, internationally options for longer periods of up to two to three years are also available.
NSE attempts to provide minimum j five strike prices—two ITM, one ATM, and two OTM at any
point of time).

Naked (Uncovered) and Covered Option

Naked or uncovered options are those which do not have offsetting positions, and therefore, are
more risky. On the other hand, where the writer has corresponding offsetting position in the asset
underlying (he option is called covered option. Writing a simple uncovered (or naked) call option
indicates toward exposure of the option writer to unlimited potential losses. The basic aim is to
earn the premium. In period of stable or declining prices, call option writing may result in attractive
profits by capturing the time value of an option. The strategy of writing uncovered calls reflects an
investor’s expectations and tolerance for risk.

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A covered option position involves the purchase or sale of an option in combination with an
offsetting (or opposite) position in the asset which underlies the option. As observed earlier, the
writer of the call option incurs losses when stock prices rise, and put writers incur losses when
prices fall. In such situation, the writer can cover the short put with a short position and short call
with a long position in the underlying asset. This can be stated as:
Covered call sale = Short call + Long futures
Covered put sale = Short put + Short futures

The Underlying Assets in Exchange-Traded Options

Various assets, which are actively traded on the recognized exchanges, are stocks, stock indices,
foreign currencies and futures contracts. These have been explained in brief here as under:

Stock Options
Options on individual shares of common stock have been traded for many years. Trading on
standardized call options on equity shares started in 1973 on CBOE whereas on put options began
in 1977. Stock options on a number of over-the-counter stocks are also available. While strike prices
are not because of cash dividends paid to common stock holders, the strike price is adjusted for
stock splits, stock dividends, reorganization, recapitalizations, etc. which affect the value of the
underlying stock.

Stock options are most popular assets, which are traded on various exchanges all over the world.
For example, more than 500 stocks are traded in United States. One contract gives the holder the
right to buy or sell 100 shares at the specified strike price. In India, the National Stock Exchange
and Bombay Stock Exchange have started option trading in certain stocks from the year 2001.

Foreign Currency Options

Foreign currency is another important asset, which is traded on various exchanges. One among
these is the Philadelphia Stock Exchange. It offers both European as well as American option
contracts. Major currencies which are traded in the option markets are US dollar, Australian dollar,
British pound, Canadian dollar, German mark, French franc, Japanese yen, Swiss franc, etc. The size
of the contract differs currency to currency. This has been explained in more detail in the chapter
on currency option.

Index Options
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Many different index options are currently traded on different exchanges in different countries. For
example, the S&P 100 index at CBOE and Major Market Index at AMEX are traded in the US options
markets. Similarly, in India, such index options have been started on National Stock Exchange and
Bombay Stock Exchange. Like stock option, index option’s strike price is the index value at which
the buyer of the option can buy or sell the underlying stock index. The strike index is converted into
dollar (rupee) value by multiplying the strike index by the multiple for the contract. If the buyer of
the stock index option intends to exercise the option then the stock must be delivered. It would be
complicated to settle a stock index option by delivering all the stocks that make up that particular
index. Hence, instead, stock index options are cash settlement contracts. In other words, if the
option is exercised, the exchange assigned option writer pays cash to the option buyer, and there
will be no delivery of any share.

The money value of the stock index underlying an index option is equal to the current cash index
value multiplied by the contracts multiple. This is calculated as:

Rupee value of the underlying index = Cash index value x Contract multiples

For example, the contract multiple for the S&P 100 is $100. So, assume, the cash index value for the
S&P 100 is 750 then the dollar value of the S&P 100 contracts is 750x 100 = $75,000.

Futures Options
In a futures option (or options on futures), the underlying asset is a futures contract. An option
contract on futures contract gives the buyer the rights to buy from or sell to the writer a specified
future contract at a designated price at a time during the life of the options. If the futures option is
a call option, the buyer has the right to acquire a long futures position. Similarly, a put option on a
futures contract grants the buyer the right to sell one particular future contracts to the writer at the
exercise price. It is observed that the futures contract normally matures shortly after the expiration
of the option. Futures options are now available for most of the assets on which futures contracts
are on the Euro dollar at CME and the Treasury bond at the CBOT.

Interest Rate Options

They are another important options contract, which are popular in the international financial
markets. Interest rate options can be written on cash instruments or futures. There are various debt
instruments, which are used as underlying instruments for interest rate options on different
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exchanges. These contracts are referred to as options on physicals. Recently, these interest rate
options have also gained popularity on the over-the-counter markets like on treasury bonds, agency
debentures and mortgagebacked-securities. There are governments, large banking firms and
mortgage-backed-securities dealers who make a market in such options on specific securities.

Leaps Options
These options contracts are created for a longer period. The longest time before expiration for a
standard exchange traded option is six-months. However, Long Term Equity Anticipated Securities
(LEAPS) are option contracts designed to offer with longer period maturities even up to 39 months.
These LEAPS options are available on individual stocks and some indexes. Usually, they are
designed for a particular purpose.

Flex Options
It is a specific type of option contract where some terms of the option have been customized. The
basic objective of customization of some terms is to meet the wide range of portfolio strategy needs
of the institutional investors that cannot be satisfied through the standard exchange-traded
options. FLEX options can be created for individual stocks, stock indexes, treasury securities, etc.
They are traded on an option exchange and cleared and guaranteed by the clearing house of that
exchange. The value of FLEX option depends upon the ability to customize the terms on four
dimensions, such as underlying asset, strike price, expiration date and settlement style (i.e.,
American vs European). Moreover, the exchange also provides a secondary market to offset or alter
positions and an independent daily marking of prices.

Exotic Options
The option contracts through the OTC market can be customized in any manner desired by an
institutional investor. For example, if a dealer can reasonably hedge the risk associated with
opposite side of the option sought, it will design an option as desired by the customer. OTC options
are not limited to only European or American type of options, rather a particular option can be
created with different exercise dates as well as the expiration date of the option. Such options are
also referred to as limited exercise options, Bermuda options, Atlantic options, etc. Thus, more
complex options created as per the needs of the customers are called exotic options which ma’ be
with different expiration dates, exercise prices, underlying assets, expiration date and so on.

Fundamental Determinants of Option’s Price

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An option’s price is affected by a variety factor in the financial markets but let us try to identify the
important factors. To this end, let us start with what we know about an option’s price - it is made
up of intrinsic value and time value 4Chapter 8) Intrinsic value is the difference between its exercise
price and the current price of the underlying asset, or symbolically
IW = St - X

Where St is the spot price of the asset and X is the exercise price of the asset. Therefore, one can see
that the higher the spot price of the asset relative to the exercise price, the higher (lower) will be a
call (put) option’s value because the strike price X remains unchanged and as spot price moves up,
the intrinsic value goes up and hence the option’s value will also go up. Consider the intrinsic value
of a call option with an exercise price of 100 As the spot price rises over 100, the intrinsic value
increases, thereby also increasing the option price. This can be noted from Table
SPOT PRICE AND INTRINSIC VALUE OF CALL OPTION
SPOT PRICE INTRINSIC VALUE
90 0
95 0
100 0
105 5
110 10
115 15
120 20
125 25
So the first factor identified by us is the spot price of the underlying asset and as it increases, the
call option’s price will also increase. In contrast to the call option, a put option will lose its value as
the spot price increases. This makes sense since as the spot price rises, the incentive for exercising
the put option will come down and the holder will chose to allow the put lapse.

The next part of the intrinsic value is defined by exercise price X. Now for a call option, the lower
the strike price, the more beneficial it is for the buyer and vice versa for a put option. As options are
struck at higher (lower) exercise prices, they will become lesser (more) useful for the buyer to profit
from the call (put) option. Consider two October call options on Infosys - one with a strike price of
` 1620 and the other with a strike price of ` 1740. If these two options are available, any buyer would
like to pay the minimum possible amount and consequently chooses the 1620 call over the 1740
call.

Therefore, the price of the call with a lower exercise price will be more than the call with a higher
exercise price. A similar logic (but in opposite direction) applies in the case of put option, i.e.,
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options at higher strikes will be preferred by put buyers since they can sell the underlying stock at
higher prices. The same can be observed from the real world prices of options that are given in
Table on the Infosys stock when the spot is trading at ` 1820.30.

Call Option Prices of on Infosys

(26 Oct. 2004)
Exercise price Option price
1620 203.50
1650 170
1680 142
1710 110.95
1740 80.65

The second part of an option’s price is the time value - given as the difference between option price
and the intrinsic value. The time value is the amount that the buyers are willing to pay for the
possibility that the option may become profitable to exercise sometime before expiration. In other
words, option buyers believe that the price may be unattractive today but price fluctuations in the
future may make the option profitable. Therefore, longer the time to expiry, the greater is the
probability that at expiry the asset price will be significantly different from the exercise price and
hence higher will be the option’s price, which is exactly reflected in the real world prices depicted
in Table

Time to Expiry and Option Prices

Option details Option price
Infosys October I 770 call 53.70
Infosys November 1770 call 82.20
RIL October 580 call 0.50
RIL November 580 call 6.05

The greater the expected movement in the price (higher the volatility) of the underlying asset, the
greater the chance of the asset rising largely over (for a call) or below (for a put) the exercise price
at expiry which leads to profitable exercise and hence the more valuable the option for its holder.
This movement in the asset prices is termed as volatility. One may wonder higher volatility may
also work against the holder, i.e., higher volatility may lead to a steeper fall (rise) in the underlying

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asset price but an option buyer need not worry about this and it will not hurt him since he will not
exercise the option to buy (sell) the underlying asset.

To understand the role of volatility, consider the following example.

Assume that a stock is currently traded at ` 100 and a call option on this stock with a strike price of
` 100. The payoff of this option is dependent on the price of the stock at expiry. Consider that the
stock can assume the prices as given in Table but the probability of the stock assuming that value
is dependent on its volatility.

Current Price Likely Price Call Payoff Probability of Probability of

low volatility high volatility
80 0 0.10 0.30
90 0 0.20 0.10
100 100 0 0.40 0.20
110 10 0.20 0.10
120 20 0.10 0.30

Price of the call if volatility is low will be equal to:

0 x 0.10 + 0 x 0.20 + 0 x 0.40 + 10 x 0.20 + 20 x 0.10 = ` 4

Price of the call if volatility is high will he equal to:

0 x 0.30 + 0 x 0.10 -F 0 x 0.20 + 10 x 0.10 + 20 x 0.30 = ` 7

So it is clear from the above example that higher the volatility, higher will be the option’s price.
Interest rates will also affect the option prices but the role of interest rates in option pricing is quite
complex. Intuitively we can say that when an investor buys a call option
instead of the stock itself, he can save capital that can be invested in a risk-free asset. Consequently,
the higher the rate of interest, the higher will he the value of a call option. We can summarize the
effect of each factor on the option’s value as given in Table.

Factor Call option’s value Put option’s value

Increase in underlying asset’s value Increase Decreases
Increase in strike price Decrease Increases
Increases in variance of underlying asset Increases Increases

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Increase in time to expiration Increases Increases

Increases in interest rates Increases Decreases
Increase in dividends paid Decreases Increases

Option Pricing Method

After the seminal paper of Black and Scholes in 1973, several other methods of option pricing were
proposed in the literature. Although these methods differ in nuances, they are almost similar in
approach and these approaches can be classified under the following heads:
1. Game theory approach: A portfolio comprising an option and the stock is constructed in such
a way that the final value of the portfolio is independent of the stock’s price, which is the only
cause for uncertainty. When this uncertainty is removed using risk- neutral valuation and
arbitrage arguments, the options price can be determined.
2. Replicating portfolio: In this method, a portfolio is constructed and this consists of the stock
and buying/selling a risk-free zero-coupon bond. The portfolio will be constructed such that
it mirrors the option payoffs for every state. Invoking the arbitrage arguments, the option
price is determined as equivalent to the value of the replicating portfolio.

We will illustrate the second method with the help of Example 2.1:

Example 2.1
Consider a stock which is currently trading at ` 100 and in exactly one year, the stock price will be
either ` 80 or ` 120. We do not have any a priori probabilities. If the interest rate is 5%, what is the
price of a call option on t-is stock with a strike price of ` 110 and expiry in one year’s time?
Solution
We will construct a replicating portfolio that mimics the option’s expiry payoff. This portfolio
comprises a position in the underlying stock and a risk-free debt security. Now the question is: what
combination of stock and debt security generates the same returns as a call option?
We know that at expiry the call will be worth ` 10 (120 - 110) if the stock goes up and zero if the
stock moves down.
Let us assume that we need to buy A number of shares and a zero-coupon bond of a current value
of B. The initial value of this portfolio will be:

Π0 = ∆. 100 + B (9.1)

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The final value of the portfolio after one period will be: Π1 = ∆. 120 + B x e0.05x1
If the stock goes up and

Π1 = ∆. 90 + B x e0.05x1

If the stock price goes down

Since the portfolio is mimicking the payoff of the call option, we can write the above equation as:

∆. 120 + B x e0.05x1 = 10
∆. 90 + B x e0.05x1 = 0

And

If we substitute the value of B x e0.05x1 as -∆. 90 from equation (9.3) in equation (9.2), we obtain
∆. 120 - ∆. 90 = 10 or ∆ = 1/3 and B = -28.54 (the negative sign shows that the bond has to sold
short).
Π0 = 1/3. ∆. 100 – 28.54 = 4.79
Which is nothing but the option’s price?

The same approach that we used in this example lies at the heart of the Binomial Option Pricing
Model (BOPM), a rigorous and a powerful tool for pricing a wide variety of options. John Cox,
Stephen Ross and Mark Rubinstein introduced this model in an influential paper published in the.
Journal of Financial Economics.

Binomial Option Pricing Model

The binomial model of stock price movements is a discrete time model, i.e., time is divided into
discrete bits and only at these time points are stock prices modeled. The binomial approach
assumes that the security price obeys a binomial generating process, i.e., at every point of time there
are exactly two possible states - stock can move up or down. A priori it is not known which of the
two states will occur but the amount by which it can go up or down is assumed as known. Figure
shows a binomial tree.

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Two – period binomial tree.

Let us understand the binomial tree’s terminology. The tree depicted in Figure is a two- period
binomial tree and the stock price changes two times. Each point where two lines meet is termed as
a node, which represents a possible future price of the stock. The tree is called as binomial because
the spot price at every node can either move up or down. If we denote the stock price at the
beginning as S0 and Su as the stock price in an up state and Sd as the stock price in a down state,
then we can define the up factor as Su/S0 and down factor as Sd/S0. The probability that the stock
price will move from one node to another is called as transition probability. The binomial trees as
given by Cox, Ross and Rubinstein, CRR here after have some important characteristics, which are
given below:

1. Length of the time interval remains constant throughout the tree, i.e., if the interval between
the nodes is in months, it will be months everywhere and if it is in terms of years, it will years
everywhere.
2. Volatility remains constant throughout the tree.
3. Transition probability remains the same in the entire tree.
4. The trees are recombining, i.e., an up move followed by a down move will take the stock to the
same value as a down move followed by an up move.

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A Recombining Tree

Single Period Binomial Model

Assume that a stock price follows a binomial model and we are interested in finding the price of a
European option that expires at the end of one period.
As explained earlier in the numerical example, formulate a hedge portfolio that exactly imitates the
payoff of the call option in all the states. This hedge portfolio at to comprises ∆ number of shares
and a risk-less zero-coupon bond maturing to the par value B by the time t1. Therefore, at time t0

Value of Portfolio ∆. S0 + e-rT. B (2.4)

Since this is a replicating portfolio, the value of the portfolio will be equal to C1, the option’s value
in case it moves up and Cd in case stock price moves down.

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Multi-Period Binomial Model

Earlier we considered that the time between now and the maturity day of the option is one period
but the binomial model can be used to price an option wherein the life of the
option may be divided into any number of periods or steps. The procedure of pricing the option
remains the same:

Finding the value of the option at the terminal nodes.

➢ Setting the price of the option at the nodes preceding the terminal nodes using the
one- period pricing formula, i.e.,
➢ C0 = e-rT {pCu + (1 – p) Cd}
➢ Repeat the process till we reach the initial node. This process of moving from the
terminal node to the initial node and pricing the option is known as bachvard
induction.

(a) European Put Option

The binomial model can also be used to price a put option in a similar way. The following example
shows pricing of a European style put option for the data given in Example 2.3.

Stage 1: As in the earlier case, first find the option’s value at expiry. Fig (a) depicts the initial
option price tree.

(b) Three period binomial tree for a put option

Stage II: Following the recursive process, find the value of the put option at t = 2Figure
(b) shows the same.
Pud = e-0.05x1/3 [0.5219 x 0 + 0.478 x 18.44] = 8.6686
and Pdd = e-0.05x1/3 [0.5219 x 18.44 + 0.478 x 40.14] = 28.3345

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Three period binomial for a put option

Stage III: Repeating the computations once again at t = 1, the tree looks like Figure (c).
Pu = e-0.05x1/3 [0.5219 x 0 + 0.478 x 8.6686] = 4.0751
and Pd = e-0.05x1/3 [0.5219 x 8.6686 + 0.478 x 28.3345] = 17.7694

(c) Three period binomial tree for a put option

Stage IV: Now we have reached the final stage from where initial price of the optioncan
be found as:
Po = e-0.05x1/3 [0.5219 x 4.0751 + 0.478 x 17.7694] = 10.4450

The final option price tree is depicted in Figure (d).

(a) Three period binomial tree for a put option

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Black—Scholes Option Pricing Model (BSOPM)

Chronologically speaking, BSOPM was introduced much earlier than binomial option pricing, but
for ease of understanding we first considered the binomial model. Infact, Black—Scholes provided
the first ever closed form of solution for pricing the European calls in 1973 and published the path-
breaking paper titled “The pricing of options and corporate liabilities” in Journal of Political
Economy. Prof. Scholes and Prof. Merton were awarded the Nobel Prize for their contributions in
option pricing.

The data inputs to this model are current stock price, exercise price, expected volatility, interest
rate and time to expiry. The pricing intuition remains the same - construct a replicating hedge
portfolio comprising a long position in stock and a short position in a zero-coupon bond.

The hedge portfolio will be constituted in such a way that at any given point of time its value will
always be equal to the option’s price at that time. If the option’s price differs from the hedge
portfolio’s value, then arbitrageurs’ actions will bring back the equilibrium relationship. The
proportion of stocks and bonds will be determined by the Black—Scholes formula.

As the formula depends on constantly changing factors like volatility, current market price of the
stock, etc., the portfolio mix has to be constantly adjusted so that it will reflect the current outputs
of Black—Scholes. Hence this portfolio is called as dynamic portfolio and the act of maintaining the
portfolio in balance is called as hedge rebalancing.

B-S Model Assumptions and Limitations

Just as with most other models in finance, BSOPM is also based on some assumptions, which are as
follows:

(a) Frictionless markets. More precisely it means there are no transaction costs, short-
selling is permitted, existence of similar borrowing and lending rates and infinitely
divisible assets. This is not a severely restrictive assumption since the intention is to
separate the effect of market forces on option prices.
(b) The asset pays zero dividends. This is also not an implausible assumption atleast in
the short run. But subsequent models in the literature proposed some adjustments to
the basic BSOPM to incorporate dividend/intermediate income.

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(c) The option is European style.

(d) Asset prices follow a geometric Brownian motion. In other words, asset returns are
normal and stationary. Many critics called this assumption as the biggest hole in the B-
S formula, including its inventor Prof. Fisher Black in an influential article in the. Journal
of Applied Corporate Finance in 1989.

But this way of making simplifying assumptions to describe the complex real world more well-
mannered is followed in many disciplines of Sciences and also in economics and finance from ages,
and in that spirit this model is not an exception. More importantly, despite these seemingly deficient
assumptions, the model does a reasonable job in pricing a variety of derivative instruments. But the
real utility of BSOPM is that it provides us a mechanism to hedge an option and the cost of hedging
gives us insights into the likely price of the option. In the B-S model, all the data inputs are directly
observable except volatility. In the next section, we will see some important ways of estimating
volatility.

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CHAPTER 4
OPTION TRADING STRATEGIES

Options Trading Strategies

➢ Building Blocks of Derivatives
➢ Options Trading Strategies
➢ Directional Strategies
➢ Volatility Strategies
➢ Horizontal Spreads
➢ Other Trading Strategies

Building Blocks of Derivatives

Now that we are armed with the knowledge of option greeks, we are well equipped to appreciate
and understand the various option trading strategies, their motives and the possible
consequences. We will start with the basic and simple strategies, also known as the building
blocks of derivatives.
The following are the basic elementary strategies:
➢ Long call
➢ Long put
➢ Short call
➢ Short put

To these we can also add long stock and short stock; we will have six basic strategies termed as
the building blocks. Let us see each of them in detail. In this section we will discuss these
strategies and other advanced strategies. Throughout our discussion on option strategies, we will
make use of greeks and profit/loss diagrams as they are our eyes and ears to discern all options-
based strategies.

Long Stock
When an investor expects that a particular stock will rise, until the advent of derivatives investors
will buy that stock as they have only that choice to profit from their bullish expectations. In this
case, the investor theoretically has unlimited profit; potential and losses are limited to the price

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he paid while acquiring the stock. Hence, if the stock price rises over what he paid for, he will be
gaining and vice versa. The payoff for a stock is shown in Figure

Profit/Loss diagram

Short Stock
This strategy will be resorted to when one is having bearish expectations or when one expects the
stock price to come down. Though this is currently not permitted in India for everyone, the
mechanics of short selling involve the following:

(a) Borrowing the stock for a specified period from someone who holds it; for instance, a
broker.
(b) Selling the borrowed stock now at the current market price.
(c) At the end of investment horizon, the stock will be bought from the market and will be
returned to the broker/stock lender.

This is a bearish strategy involving limited profits but unlimited losses because at maximum the
stock price may decline to zero and this extreme case represents the maximum profit potential.
On the other hand, if price moves against the seller then he has to put up with unlimited losses as
prices are unbounded on the upside (i.e., they can go up to infinity theoretically).

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Short stock profit/ (loss) diagram

Long Call
Buying call options is the simplest and a popular form of entering into the derivatives market. By
definition, call option buyer has the right to buy the stock at the strike price until the expiration
date. An investor will buy a call option with the expectation of a price rise. The advantages of a call
option over buying a stock are two fold:
(a) Leverage, and
(b) Limiting the downside risk.
Consider a call option on a stock with the following data:
▪ Strike price = ` 100
▪ Current market price = ` 100
▪ Time to expiry = 90 days
▪ Volatility = 25%
▪ Interest rate = 5%
The payoff diagram for this option is shown in Figure.
Now, in order to buy 100 shares, the investor has to invest ` 10,000 and if the stock gains ` 5 over
the next day, his gain will be ` 500 (100 shares x 5 per share) and return on investment = 5% over
a day {(500/10000) x 100}.
But if the investor bought 100 options, he will pay ` 555.50 as option premium and the gain for the
same ` 5 over next day will take the price of the option to ` 8.723 or ` 3.168 gain for each option, in
which case the profits will be 3.168 x 100 316.80, translating into a return of 57% over the day.
Therefore, call options entail investors to realize large percentage of gains for a modest advance in
the underlying price. But leverage is a double-edged sword and a ` 5 decline over the next day will
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cause the option price to fall to ` 3.11 and the percentage losses would be around 45%. Therefore,
the price of a larger reward is a larger risk. But the call buyer’s losses are limited to the premium
paid while the stock buyer’s risk is the entire investment of ` 10,000. Hence the call option can be
viewed as a sort of insurance in case the stock falls instead of going up. Thus, a call option provides
the following benefits to the buyer:

Translate a bullish view on the market into actual position and retain the ability to buy the
underlying stock in the future.
➢ Insure a major part of the capital due to losses arising from declines in the market prices
of the underlying stock.

Long call profit/(loss) diagram

To know more about the risks and rewards associated with a long call option, let us make use of the
Greeks and the profit/loss diagram. Table presents the greeks for the above mentioned data:

Option Fair Value Delta Gamma I-Day Theta Vega Rho

5.52 0.565 0.0319 -0.034 0.196 0.1240

For ATM and ITM options, at expiry gains/losses of every rupee in the underlying stock will be
reflected as gains/losses in the option prices. At expiry, the position wills break-even at the strike
price plus option’s premium. A delta of 0.565 indicates that one call option is equivalent to holding
56.5% of the underlying asset.

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The option has a gamma of 0.03 19 and a Vega of 0.196 while theta is —0.034. The Greeks give
insights into the underlying risks as well as motives of holding options that are not otherwise
obvious. Positive gamma indicates that deltas become more positive when underlying stock price
increases and will be beneficial to the option buyer. In other words, if the actual volatility increases
the buyer will be benefitted.
Similarly, a positive Vega implies that the option holder will benefit from any increases in implied
volatility. In fact the option price will increase by ` 0.196 for a 1% increase in implied volatility.
Hence we can understand that option buyer is having a bullish view on underling’s volatility along
with a bullish view on the underling’s direction. But the option buyer is exposed to theta risk - the
option loses its value by ` 0.034 everyday, even when all other things remain the same. This may
not seem as an innocuous number but remember that this is well before 90 days to expiry and that
theta increases rapidly as expiry date comes near.
Therefore, an option buyer has to note that:
➢ An increase in underling’s price and increase in actual and/or implied volatility will be
beneficial.
➢ The elapsing time will fritter away the premium, and this hurts the buyer more when
there is no increase in volatility or the underling’s price.

Short Call
When an investor sells a call option, he definitely expects that the stock price will not rise. Though
the outlook of the investor is not very positive, he is not utterly bearish since in order to profit the
market need not decline; even if it stands still, he will gain the premium. So, a call seller’s view on
the market is generally neutral to bearish. Similar to the view on underling’s direction, a short
trader in options expects that the underlying’s volatility will also decline. Let us see the Greeks in
Table to decipher more clearly the consequences of this strategy.

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Short call profit/(loss) diagram

Option Greeks for the short call option

Option Fair Value Delta Gamma I-Day Theta Vega Rho
5.52 -0.565 -0.0319 0.034 -0.196 -0.1240

The profit/loss diagram in Figure shows that the call seller is having a limited profit and the losses
are unlimited. Hence this is a high-risk strategy because utmost what he can gain is the option
premium while he can lose an unlimited amount. The greeks show that the short call has a negative
delta, suggesting that any rise in underlying’s price will hurt the option seller because the option
price increases with an increase in underlying’s price. The short call is also exposed to the twin
risks, gamma and vega risk, i.e., if underlying volatility and/or implied volatility increases, the
position will lose money. On the positive side, the call seller will benefit from time decay, as theta is
positive. So the call seller will be waiting for the option to reach the phase when theta rapidly
increases without the underlying stock rallying.

We can summarize that a call seller expects the market to be neutral or bearish and will benefit
from:
➢ A decline in underling’s price,
➢ A decline in actual or implied volatility, and
➢ Theta or the passing by of time.
Long Put

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By buying a put option, an investor is expressing a bearish view on the direction of the underling’s
price. Put options are extremely useful tools in markets where short selling is not permitted legally.
Though futures can also serve as an alternative means of short selling, they offer no protection if
the investor’s reading of the market pulse is wrong. A put option holder, if he is also long in the
underlying stock, is ensured that a large part of the current market value is not lost. Since options
are instruments that expose the holders not only to the underlying asset price’s direction but also
to the volatility, so a put option holder is expressing a neutral to bullish view on the implied
volatility. Therefore, a put option holder expects the market price of the underlying to decline and
anticipates that volatility would increase (or at least will remain same).

Let us understand the put option with the help of greeks and the profit/loss diagram given in Table
and Figure respectively

Long put profit/ (loss) diagram

Option Greeks for the long put option

Option Fair Value Delta Gamma I-Day Theta Vega Rho

4.44 -0.45 0.033 -0.022 0.196 -0.091

A put holder is having significant profit potential and the losses are limited to the amount paid as
the option premium. At expiry, the break-even point occurs at a price equal to the strike price minus
option premium and before expiry the BEP is even higher. It can be noticed that delta of the option
is negative at 0.45. Therefore, if the market price rises by
` 1.00, the option will start losing ` 0.45. Our premise on volatility exposure of put holders comes
out of the fact that gamma and Vega for long puts are positive. Therefore, they will be benefited if
there is all in implied volatility and/or the underlying stock experiences extreme price swings. But
as in long calls, all Greek that is working against the put holder is theta. Since it is negative, it is
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indicative of the erosion of the time value of the option. In summary we can say that a long put will
benefit:
➢ When the underling’s price declines and/or.
➢ From an increase in actual and/or implied volatility.
But a put option holder has to be wary of time decay.

Short Put
The seller of a put option has an obligation to buy the underlying asset at the exercise price.
Therefore, the put seller expects that the underlying’s price will definitely not decline though he
may not be sure about the price rising, he should be certain that the stock will not go down. Put
writing can also be considered as a strategy of acquiring the underlying asset at or below the going
market price. For instance, when the market price of a stock is ` 264 and if a 250 strike put option
with 75 days to expiry is trading at ` 5.24, the buyer of the stock has to pay ` 250 to buy the stock
(assume r = 5% and volatility = 25%). If an investor expects that prices will not go beyond ` 250,
then by selling this put he can actually get the stock at a price less than ` 250 (because he will earn
a premium of ` 5.24, which will reduce the cost of purchase of the stock). However, the seller will
be hurt if the price falls significantly before the expiry.

short put profit/ (loss) diagram

Option Greeks for the short put option

Option Fair Value Delta Gamma I-Day Theta Vega Rho

5.42 -0.276 -0.011 0.056 -0.392 0.134

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As in the case of a short call, the put writer also assumes significant losses for a limited gain of the
option premium this can be noted from Figure. The short put has a negative delta from Table,
implying that the option writer will lose if the underlying stock price rises and will gain if the
underling’s price declines. In addition to a negative delta, a short put has a negative gamma and
Vega. Therefore, if the volatility increases, put writer will lose and if volatility decreases, put writer
will be benefited. So, ideally put writer desires a market price decline associated with a volatility
decline, in which case it is doubly beneficial. On the other hand, the position will gain from a positive
theta and this gain increases as time to expiry approaches.

In conclusion, we can say that a put seller will benefit from:

➢ Decline in the underling’s price.

➢ Decline in actual and/or implied volatility.
➢ Time decay.

These are known as the basic building blocks since they form the basis for constructing a variety of
esoteric spreads and combinations that will yield different payoffs depending on the view on
underlying market’s direction and volatility. Now let us start understanding some simple strategies
like combining calls and puts with the underlying stock.

Options Trading Stragegies

Options Trading in Combination with the Underlying Covered Call Writing

This is a conservative strategy and involves writing of a call option and simultaneously buying the
underlying stock. As the writer of a call option is obligated to deliver the underlying stock at the
exercise price, the writer of the naked call expects the stock price to end up below the exercise price
at expiry. But if the stock price ends up higher than the exercise price, the writer will suffer losses.
The covered call writer tries to hedge these losses by actually holding the underlying stock. A
covered call writer is more cautious than the stock buyer since a stock buyer has unliçnited gains
and losses whereas a covered call writer is more concerned with what he already has and this
strategy protects the investor from price declines upto an amount equal to the option premium he
has received. But of course in the bargain the writer of the call is actually exchanging his unlimited
profits to a constant profit if the stock rises. Covered writing provides the investor with additional

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income from his investment portfolio, which protects his securities, at least partially, from a decline
in market price and the premium received will lower the break-even point on the stock.

Assume that an investor holds 100 shares of a particular stock and the current market price of the
share is ` 100. He is concerned about the slight weakening trend in price of this stock and decides
to protect the moderate downfall by writing a call option at a strike price of ` 105 expiring in 90
days. He collects ` 7 as premium and in the deal he has protected his investment against mild
declines up to ` 93(100 - Premium).

To this extent these loses will be compensated by the option premium he has received. Now let us
chart the profit/loss diagram for the covered call the same is shown in Figure.

It may be noticed that as the stock price increases over ` 105, the call option will be exercised and
he has to deliver the share at ` 105. Therefore, his effective selling price will become ` 105 + 7 (being
the premium received) = ` 112. If the stock ends up at more than
` 112, he has to bear the opportunity loss as he cannot realize this higher price because he has
committed to sell the share at ` 105 by virtue of the sold call option.

If the stock price is below ` 105,, the call seller will retain the full amount of option premium since
the option will not be exercised and the returns will be higher vis-à-vis the exclusive stock position.
The break-even point is lower than the unheeded position—for the covered call it will be at ` 93 but
for the stock only position it will be ` 100. Infect at the break-even point of the stock only position,
the covered call will generate a return of 7.52% (unanalyzed). So it appears to be a better strategy
than the stock only position if the expected price is to remain more or less unchanged.

Covered call is a less risky strategy compared with either uncovered call writing or buying the stock
alone. In the naked call writing, the seller has to bear greater risks as losses are unlimited if the
stock price rises substantially and the returns are capped at the premium received whereas buying
the stock alone dives unlimited losses as well as gains but it entails larger initial investment.

Generally, the covered call writer sells OTM options in order to secure a part of the price
appreciation along with the premium. Looking at the profit/loss diagram of the covered call writer
reminds us of the profit/loss diagram for a short put.

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Covered call writing profit/(loss) diagram

Protective Put
We have seen that when an investor is long in the stock, he can protect his investment’s downside
risk against moderate price changes by writing a call option. The size of the protection will be
equivalent to the premium received. However, the investor has to give up all the upside potential
when stock price moves up significantly. Also, the losses are only pared down slightly when price
moves down substantially. So, instead of writing a call option if the investor buys a put option along
with a long position in the stock, his benefits are two-fold - if the stock price declines sharply below
the strike price, he will not suffer any losses because the put option will become in- the-money and
the portfolio will gain; but if the stock price moves up significantly, he will retain all the profits that
are associated with the long stock position and the portfolio gains will be equal to the stock gains
less the premium paid. Therefore, a protective put ensures that the unlimited gains associated with
stock price rally will accrue to the buyer and if the stock price moves down, the unlimited losses
associated with stock are nullified by the long put option and the twin benefits come at a cost equal
to the put option’s premium. The same inferences can be made from the profit/ loss diagram shown
in Figure.

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Protective put profit/(loss) diagram

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Suppose an investor holds 100 shares of Neptune Industries that have appreciated substantially in
value ever since he acquired them. Current market price of these shares is ` 325 per share and the
investor wants to continue to hold the shares for their long- term prospects. However he is
concerned about their decline if a far and wide forecasted market correction comes about. In order
to lock-in the gains, the investor buys 100 ATM put options at a price of ` 7.00 per option. This
assures him of a selling price of ` 320 per share if the stock price declines.

Now what happens if the stock price falls to, say, ` 290? The stocks will be worth only ` 29,000
instead of ` 32,500 - all of ` 3,500 in the stock’s value. But lie can exercise the put option and will
gain ` 3,000 {(320 - 290) x 100 options}. So the portfolio will be worth
` 31,300 (32,000 — 700 being the premium) and if the stock price rises to ` 350, then the put options
will be allowed to lapse and the investor will lose ` 700, which is the option premium paid, and the
stocks will be worth ` 35,000. The net portfolio value will be ` 34.300.

Effectively, a put option added to a long stock portfolio ensures a minimum value for the portfolio
or the strike price less option premium becomes the value of the portfolio. However, a protective
put may be of less utility if only a marginal decline in the underlying stock price is expected, i.e., if
the expected movement is less than the put’s premium, it may be better to absorb the losses rather
than hedge the stocks with put options.

From the above discussion of these basic strategies, it is clear that options traders can benefit or
can get hurt when the underlying market moves in a particular direction and/ or volatility itself
changes. So, depending on the expertise a trader has, he can benefit from either direction or
volatility or both by combining the basic building blocks. Accordingly derivatives offer all trading
strategies with varied risk-reward characteristics. These strategies can be broadly classified as (for
ease of exposition only) directional strategies, volatility strategies, and horizontal spreads.

Directional Strategies
Directional strategies are designed to speculate on the direction of the underlying market. So, they
are simply trades that reflect the views of traders on the direction of the underlying market like
‘bullish view’ (prices will rise) or ‘bearish view’ (prices will decline). Options can be combined in
such a way that investors will have exposures only to the market direction while remaining neutral
to the volatility. Therefore, directional strategies allow traders not to worry about volatility changes
and to make use of their expertise in predicting the market direction.
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It may appear that these are not very special strategies as one can always speculate about the
direction of the market with the help of the underlying assets directly or with the help of futures.
But it has to be noted that these two instruments allow traders to benefit only when their
predictions about the direction turn out to be right; but if their predictions or beliefs do not turn up
right, they will have to put up with unlimited losses. With options you get the best of both worlds -
have unlimited gains if you predict the market direction correctly otherwise content with the
limited losses. Also, as discussed in the earlier sections, options provide the investors with ample
leverage, which is another possibility that trading with the underlying assets alone would not be
providing.

Bull Vertical Spread

Among the directional strategies vertical spreads are quite common and these involve two options
with different strike prices on the same underlying for the same maturity. Vertical spreads are
characterized by limited risk and pofit potential. These spreads are termed as vertical spreads since
the spread consists of two options that appear one below the other (not necessarily immediately
below) in the options price quotations published in the business pess, are organized in an ascending
order of strike prices. A bull vertical spread involves buying a call option and simultaneously selling
a call option oil same stock with the same expiry but with a higher strike price. A bull spread can be
created with put options too and the principle remains the same - buy the lower strike option and
sell the higher strike option. So, in a bull spread:

Long call strike < Short call strike Long put strike < Short put strike

Bull call spread is somewhat similar to a covered call but instead of holding shares, the investor
owns an ITM call option. This strategy permits the trader to initiate the position even though he is
tentative of his bullish expectations. This is because in the worst case the call option he holds may
expire worthless. Of course bull vertical spread can be constructed so as to reflect his varying
bullish expectations, viz., if the investor is very bullish, he can select the strike prices which are
farther apart, and if he is cautious of his expectations, the strike prices will be closer to each other.
Also, the more ITM the long call, the more wary the trader is. Depending on the composition of the
spreads and with respect to the spot price, a spread is termed as ATM if it has one ITM and one OTM
option, whereas in an ITM vertical both options are currently ITM, and an OTM vertical is one where
both options are currently OTM.
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Consider the following data:

Stock price 100
Time to expiry 90 days
Volatility 25%
Interest rate 5%
Option price X=100 5.55
Option price X = 105 3.40

If an investor constructs a 100/105 bull spread, he pays ` 5.55 for the long call and receives ` 3.40
from the short call option, resulting in a net outflow of ` 2.15. Since there is a net outflow of money,
this type of spreads is sometimes termed as debit spreads. It is evident that the investor is reducing
the price of the option that was bought and aims to profit from his bullish views. Since the trader is
adding another option to the original position by selling another call at a higher strike, he is actually
limiting his gains and so also the risks. The maximum loss occurs when the purchased option
expires out-of-the-money and the loss is equal to the net premium paid. The profit is highest when
the sold option becomes in-the-money and the gains are equal to the difference between the two
strike prices less the premium paid. Hence the breakeven point is (this is also clear from the
profit/loss diagram

Lower exercise price + Net premium paid

Bull call spread profit/(loss) diagram

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For our example, let us see the cash flow consequences under different scenarios:

➢ When the stock price is below ` 100: In this situation, both options expire worthless and
the net loss would be the net premium paid and will equal to ` 2.15.
➢ When the stock price is between ` 100 and ` 105: At expiry, the investor exercises the `
100 call and sells the stock in the market at the going price. Since the breakeven point is
` 102.15, he will exercise the option as long as the stock is in the range of ` 100 and `
102.15.
➢ When the stock price is above ` 105: In this situation, both options are in-the-money and
the investor will exercise the ` 100 call and simultaneously the higher call sold by him
will also be exercised by the counterparty. The total gain will be ` S and net gain will be
` 2.85, considering ` 2.15 being the net premium paid to initiate the position. So as long
as the stock ends up higher than the sold call option, this represents the gains to the bull
spread holder.

Now let us see what insights the Greeks provide us. Table provides the greeks for the bull vertical
spread.
Option Greeks for the bull vertical spread
Price Delta Gamma Theta Vega
Long call option -5.55 0.565 0.031 -0.034 0.196
Short call option 3.40 -0.415 -0.031 0.033 -0.193
Net -2.15 0.15 0 -0.001 0.003

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The Greeks make our comprehension of the strategy much more thorough - the investor is exposed
only to the market direction with a positive delta of 0.15 and all other greeks are negligible with a
zero gamma and an insignificant vega, implying that the position is neither exposed to actual
volatility nor to implied volatility. The best part of this bullish strategy is that time decay is almost
zero.
Generally, with a long option position, the holder is subjected to massive time decays, but with a
bull spread, the position has a long bias towards the market without being wrecked by time decay.
In this case, the delta is just 0.15, meaning that the traders’ exposure is only 15% of the underlying
but if he desires more exposure to the underlying, this can be achieved by driving the delta to any
desired value. For example, if the trader intends to have a delta equivalent to that of the underlying
stock, i.e., 1.0, all he has to do is add more bull spreads. In this case he needs around 6 to 7 sprads
(1.0/0.15 = 6.67).

In a similar way, bull vertical spreads can be constructed using put options instead of call options.
This is done by selling the higher strike option and buying the lower strike put option. Since we are
writing an ITM put and buying an OTM put option, there will be a cash inflow. Hence these spreads
are also termed as credit spreads. The more ITM the two exercise prices, the more aggressive is the
spread. The profit/loss diagram for the bull put spread is depicted in Figure. The nature of the
strategy and the consequences are as discussed in the case of bull call spread.

Bull put spread profit/(loss) diagra

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Bear Vertical Spreads

When the outlook for the market direction is bearish, an investor can benefit by trading bear
vertical spreads using either call options or put options. In a bear vertical spread the strike prices
are chosen as follows:

Long call strike > Short call strike Long put strike > Short put strike

A bear spread is a versatile strategy when an investor expects the market to decline but is unsure
of the amount by which it will fall. An aggressive spread can be constructed by using more out-of-
the-money options. When an investor initiates a bear put spread as in the case of a bull call spread,
he pays the premium. So a bear put spread is also a debit spread. If the underlying security rises
subsequently, the loss will be limited to the net premium paid. For instance, an investor who is
having a bearish view on the market can profit from his forecast by using a bear spread, which
entails less investment than that involved in a long put option.
Assume that the investor expects the earlier stock to come down and he constructs a bear spread
with the following information:
➢ Buy a 105 put option at ` 7.33
➢ Sell a 100 put option at ` 4.44
➢ Net premium paid is ` 2.89

The short put does two things - reduce the cost of buying the 105 put option and limits the profits
at expiry. At expiry if the stock price falls below ` 100, then both the puts will be exercised (long put
will be exercised by the investor the 105 and the buyer of 100 put will also exercise it) and this will
result in ` 5 as inflow to the spread holder. However, since he paid a premium of ` 2.89, his net gain
will be ` 2.11 (5 - 2.89). On the other hand, if the stock ends up between ` 100 and ` 105, the investor
will exercise the 105 long put and the 100 short put will be allowed to lapse. Since the breakeven
point is ` 102.11, to limit the losses the investor will exercise the option as long as the stock is
between ` 102.11 to ` 105. The last possibility is when the stock price is over ` 105 and in this case
both options will be worthless and this represents the worst case for the bear spread buyer and he
has to bear a maximum loss of ` 2.89 being the initial premium paid by him. So, the bear put spread
has a limited upside and a limited downside risk which can be observed from the profit/loss
diagrams given in Figure

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Price Delta Gamma Theta Vega

Long call option -7.33 -0.612 0.033 -0.02 0.193
Short call option 4.44 0.45 -0.033 0.022 -0.196
Net -2.89 -0.162 0 0.002 -0.003
Option Greeks for the bull vertical spread

Bear put spread profit/(loss) diagram

The option Greeks for the, bear put spread are presented in Table.
The net delta of the spread is around —0.16, implying that the position will benefit if the market
price of the stock falls. Gamma and Vega are almost zero. Hence the position is neutral to volatility
and is exposed only to the market direction. Importantly, theta for the spread is negligible (though
for this spread it is infect insignificantly positive). This is a major benefit over simply buying a put
option, which is also a bearish strategy that is subjected to serious time decay losses.

To sum up, we can say that the vertical spreads (bull/bear) achieve the following:
➢ Provide a position that benefits if market rises/declines • Unaffected by volatility
changes
➢ Time decay losses are almost negligible

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Volatility Strategies
Option markets actually facilitate securitization of risk. Hence options are one of the most
important and accessible tools to construct strategies that benefit from the traders’ knowledge of
volatility changes without bothering about direction of the underlying price. Therefore, volatility
strategies benefit investors who have their expertise in forecasting volatility but may not be
proficient in forecasting the direction of the market. The following are the important volatility
trading strategies.

Straddles
This is the most popular strategy to trade volatility since this gives the buyer exposure only to
volatility with insignificant exposure to the underlying asset. Therefore, without bothering about
the market direction, one can take positions on changes in market expectations of price volatility
alone. A long straddle comprises buying a call option and a put option on the same stock with the
same strike price and expiry. Prima facie it may appear foolish to buy a call and a put on the same
underlying at the same strike and for the same expiry, but the real purpose is to stay neutral to the
market and get exposure only to volatility. Hence a long call and a long put will just achieve that -
remain unexposed to the underlying, but since the buyer has paid the premium and is long in two
options, he is long volatility (option buyers are in fact buyers of volatility). In other words, the
straddle buyer expects the volatility to rise from the current levels.
The profit and loss diagram for a long straddle is shown in Figure. In this case, the straddle was
constructed for the following data:

Stock price 60
Time to expiry 90 days
Volatility 25%
Interest rate 5%
Call option X = 60 2.81
Put option X = 60 3.15

It may be noticed that by buying a call option, and a put option, the investor is setting lower and
upper breakeven points for his position and the breakeven points corresponds to strike price ± total
premium paid.

The total premium paid by the straddle buyer is ` 5.96. Hence the lower BEP is 60

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- 5.96 = 54.04 and the upper BEP is 60 + 5.96 = 65.96. This implies that the trade will be

profitable if the price of the stock moves outside this range. So, the straddle buyer will be benefitted
even if the stock moves up or down but it should move significantly beyond the breakeven points.
He will be incurring losses if the stock remains range-bound and moves in the range depicted
between the lower and upper BEPs. The greeks for the long straddle are given in Table.
Option Greeks for the long straddle

Price Delta Gamma Theta Vega

Long call option -2.81 0.513 0.053 -0.02 0.117
Long put option -3.15 -0.505 0.057 -0.013 0.117
Net -5.96 0.008 0.110 -0.033 0.234

The delta of straddles can be insignificantly positive, negative or zero. Here the delta is slightly
positive at 0.008 but for all practical purposes this value is insignificant. In general, if the delta is
near 0.01, the position can be considered as delta neutral. Since long straddle involves buying
options, the gamma is almost doubled. Similar to delta, the gamma of the straddle depends on where
the stock price is compared to the strike price. The gamma of a straddle is highest when it is made
from ATM options because gamma for an option is highest when the stock price is equal to the strike
price. A positive gamma signifies that the straddle buyer wants the stock price to change
significantly. The higher the positive gamma, the more positive delta will become as the stock price
surges up, on the contrary more negative delta will be as the stock price falls. As the stock price
moves away from the strike price of the straddle, gamma starts to decrease. When the stock price
moves, the options become either ITM or OTM, and their gamma drops accordingly.

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Long straddle profit/(loss) diagram

Similarly, the Vega of the position is doubled and, positive stands at 0.234 i.e., if the volatility of the
underlying stock changes by 1%, the position will profit by ` 0.234. Assume that the implied
volatility increases to 45% after initiating the position. Then the position will gain in value by an
amount of 20% x 0.234 = ` 4.68 for each straddle. This is almost equal to the initial premium paid
by the straddle owner. So, straddle buyers look for such a kind of volatility changes.

So far so good, all the greeks are working for the straddle buyer except one - theta. The net theta is
negative at 0.033. This is not unusual because the straddle buyer is long in two options. So theta
will also double up and is slowly eating into the initial investment. Since the position loses due to
time decay and theta is highest for options that are near to expiration, few traders afford to
maintain/hold straddles for long periods or till expiration. By and large investors hold straddles for
a short time period and close out the position as soon as volatility changes. A straddle is an effective
strategy particularly before important economic events like budgets or any company-specific
events (like a judgment in a court case) that may have either a highly favourable/unfavourable
impact oil price of the underlying stock but the investor is unsure of the direction. Unfortunately if
nothing happens and if the volatility and the underlying stock price remain stable, the trader has to
unwind his position before being ruined by time decay.
With a short straddle, the seller expects just the opposite of the buyer - the volatility will come down
in future. A short straddle comprises simultaneous selling of a call option and a put option. If the
strike prices are close to the market price, then the net delta will be close to zero. Hence the writer’s

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exposure to the underlying market is negligible or neutral. The position will be most profitable
when the stock finishes at the strike price and both options expire worthless. The profit/loss
diagram for a short straddle is depicted in Figure along with the greeks in Table which are exactly
opposite in sign to that of a long straddle.

Short straddle profit / (loss) diagram

Option Greeks for the short straddle

Price Delta Gamma Theta Vega
Short call option 2.81 -0.513 -0.053 0.02 -0.117
Short put option 3.15 0.505 -0.057 0.013 -0.117
Net 5.96 -0.008 -0.110 0.033 -0.234

It is very much evident that writing straddles is very risky since the upside is limited only to the
amount of premium collected from the two options but the downside is unlimited and the risks are
substantial if a large price move occurs. The theoretical price of the spread is ` 5.96 that will be
received by the seller. The delta is slightly negative, which can be considered as neutral. Since two
options were sold, gamma is negative and this means that if extreme movements occur in the price
of the underlying, the position will experience grave losses in both the directions. Like the gamma,
the vega for the short straddle is also doubly negative. If the volatility rises from 25% to 26%, the
straddle’s price rises to ` 6.19 and this is the price the seller has to pay to close his position and in
the process he will incur a loss of ` 0.234 per straddle.

The theta for the options stands at 0.033 and is positive. Hence among all the greeks only theta
works for the straddle seller and he gains from time decay and this time decay will increase as time
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passes by. The heaviest decay is experienced by the straddle near expiration. Hence many traders
may be interested in writing straddles that are near to expiry. However, they will be wary of gamma
as it will be highest for options that are closer to maturity. Short straddles may be suitable strategies
particularly when the volatilities are near the historic high levels.

Strangles
Strangle is another combination to trade volatility and is very much similar to a straddle but the
virtue of a strangle is that it costs far less than a straddle. In a strangle, the two options have
different strike prices and are normally OTM options. Since the options are out-of-the-money, they
cost less while a straddle is constructed usually with ATM options that have the highest time value.
Therefore, a long strangle involves:
(i) An OTM long call option
(ii) An OTM long put option
(iii)
A strangle comprises a long position in a call as well as in a put option. The strike price of the put
option will be less than that of a call option’s strike price and they will have the same expiry date,
i.e., both of them are OTM and the farther they are from the current market price, the cheaper the
strangle will he.
Consider the following example wherein a strangle is established with the following information:

Stock price 60
Time to expiry 90 days
Volatility 25%
Interest rate 5%
Call option X = 65 1.42
Put option X = 55 0.87

The total premium paid in this case is ` 2.29 and this is the maximum loss that will be incurred by
the buyer in the worst case while the profits are unlimited beyond the breakeven points on either
side, i.e., whether the stock moves up or down which can be noted from Figure. This is one reason
why these spreads are termed as straddles and strangles as these positions profit on both sides.
Long straddles and strangles make money if the stock price moves up or down significantly. A
strangle buyer expects the volatility to go up and he will start gaining if the price of the underlying
stock goes beyond the upper BEP or falls below the lower breakeven point. Even if the underlying

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does not move and the volatility increases, then also he will be gaining. The maximum loss is
incurred when the price of the stock is in the range of strike price ± total premium paid.

Option Greeks for the long strangle

Price Delta Gamma Theta Vega
Long call option X = 65 -1.42 0.323 0.047 -0.017 0.106
Long put option X = 55 -0.87 -0.205 0.038 -0.01 0.082
Net -2.29 0.118 0.085 -0.027 0.188

To understand more about the strategy let us make use of the greeks given in

The net delta is positive at 0.118 and this exposes the buyer to the underlying market to the extent
of 11.8%. If the trader wants exposure only to the volatility, then he can chose the calls and puts in
such a way that delta can be made negligible.

Long strangle proft/(loss) diagram

The gamma for the position is positive since both options were purchased and is equal to 0.085.
This implies that extreme price movements will benefit the buyer in both directions. The vega for
the combination is 0.188. This implies that the strangle buyer will gain if implied volatility
increases. Lastly, theta for the strangle is negative at 0.027 and this is of concern for the buyer since
if nothing changes and the market is stable, the strangle buyer will be losing everyday due to time
decay.

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Hence many traders will take them off within a short period of time after initiating the position but
strangles can be held for a little longer than straddles as theta is less than that of straddles.

The seller of a strangle is betting that volatility will be low and it is a preferred way to sell volatility
since the position remains delta-neutral over a wide range of prices. In a short strangle, the investor
simultaneously sells OTM call and put options on the same underlying stock with the same expiry
date. The maximum gain is the total premium received which happens when the stock closes
between the strike prices. But beyond the breakeven points, losses are unlimited.
The short strangle benefits from two sources:
➢ Fall in volatility of the underlying and/or
➢ Time decay due to passage of time

The consequences will become much more clearer if we look at the greeks along with the profit/loss
diagram given in Table and in Figure respectively.

Option Greeks for the short strangle

Price Delta Gamma Theta Vega

Long call option X = 65 1.42 -0.323 -0.047 0.017 -0.106
Long put option X = 55 0.87 0.205 -0.038 0.01 -0.082
Net 2.29 -0.118 -0.085 0.027 -0.188

Short strangle profit/(loss) diagram

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As can be observed, a short strangle is a risky strategy as the losses are unlimited on either side but
the gains are at best equal to the premiums received from both the options sold. Though the delta
is positive, it can be forced to zero if desired. The gamma is negative and this indicates that as the
price volatility increases, the position will incur losses on either side. The strangle seller has a
negative vega position. Hence if implied volatility is muted, the seller will benefit. Finally, the seller
will be benefitting from a positive theta even if all other things remain unchanged.

Butterfly
The best way to sell volatility is to sell an option but when we sell an option, we inherently assume
a position in the underlying market also. Hence a pure volatility trader may wish to be neutral to
the market and would like to have a position that reflects his view on volatility alone. This is
possible with the help of strategies discussed above, viz., straddles and strangles. But these
strategies are very risky, particularly for selling volatility. It is very clear from the profit/ loss
diagrams that beyond the breakeven points, the losses are unlimited on both sides and for
comprehending this, one need not actually dip into the greeks. Using options skillfully we can
reduce these unlimited losses in short straddles and strangles too. For instance, if a trader is having
a bearish view on the volatility and he is assuming a short straddle to gain from his view and he is
also concerned about the losses, he can actually pare down these losses by buying two out of the
money options (a call and a put option) as some sort of protection on either side of the breakeven
points. But this comfort is achieved at the cost of sacrificing some of the potential profit.

A butterfly is an options strategy using multiple puts and/or calls speculating on future volatility
without having to guess in which direction the market will move. A long butterfly comprises three
types of either puts or calls having the same expiration date but different exercise prices (strikes).
For example, with the underlying asset trading at ` 100, a long butterfly strategy can be built by
buying puts (or calls) at ` 95 and ` 105, and selling (shorting) twice as many puts (or calls) at ` 100.
A long butterfly can also be created by selling a Put and a call that are ATM and buying a put at the
lowest strike and a call at the highest strike. Such a strategy is termed as iron butfeifly, probably
named after the popular rock group of the sixties (Tompkins (1994)).

A long butterfly generates profits that are far lesser than that of a short straddle. So, this is meant
for those investors who intend to profit from a forecast of a range-bound trading of the underlying

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stock and are not keen on assuming the risks involved in a short straddle. The maximum profit is
equal to the premium received and the real gains occur in the last few days to expiry from time
decay. The maximum losses occur in either direction when the stock ends at a price equal to the
(strike price of ATM options - net premium) or above the (strike price of ATM options + net
premium). Infact these two points are the breakeven points. To make sense of this discussion, let
us take the help of Greeks for the following data

Stock price 60 55 put 1.78

Time to expiry 90 days 60 call 4.51
Volatility 25% 60 put 3.84
Interest rate 5% 65 call 2.53

Option Greeks for the long butterfly

Price Delta Gamma Theta Vega

Long 55 put -1.78 -0.264 0.031 -0.017 0.096
Short 60 call 4.51 -0.565 -0.037 0.027 -0.117
Short 60 put 3.84 0.445 -0.038 0.02 -0.117
Long 65 call -2.53 0.389 0.036 -0.025 0.114
Net 4.04 0.005 -0.008 0.005 -0.024

Long butterfly profit/(loss) diagram

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Long butterfly is an interesting strategy in that it is generally a short yolatility strategy though this
is a long position. The strategy diagram in Figure shows very clearly that losses are limited on both
side and so are the profits. From the greeks in Table it can be noted that the delta of the position is
positive but very insignificant in magnitude. Hence for a small change in the underlying, the position
is unaffected. Just as with the premium, the delta of a long butterfly is also interesting - delta is
positive when the stock price is below the middle strike of the butterfly, neutral when the stock
price is at the middle strike and negative when it is above the middle strike. Hence in this example
the delta is almost zero since the current price of the stock is equal to that of the mid strike
(straddle’s strike price). Therefore, the butterfly maximizes its value when the price of the stock is
at the middle strike and if the price of the stock is below the middle strike, it has to rise for the
butterfly to make money; hence the positive deltas. But if the price of the stock is above the middle
strike, it has to fall for the butterfly to make money; so the deltas are negative.

The position is having a positive theta and a negative vega. Therefore, a long butterfly will profit
from time decay. If the underlying is near about ` 60, the profits are maximum and will accelerate
most rapidly in the last few days before expiry. For instance, net theta before three days is 0.259. It
is important to note that theta will be positive when the price of the stock is at the middle strike,
indicating that elapsing time helps the long butterfly realize its maximum benefit and at the outer
strikes theta is negative, indicating that the butterfly is losing value as time passes. However, the
position is vega negative. Hence any increase in implied volatility will be unfavorable. The impact
is felt more on the two ATM options than those that are OTM.

The extent of losses will depend to a large extent on the amount of time to expiry and how near is
the price of the underlying to the exercise price. When the underling’s price is at the middle strike,
the vega of the long butterfly is negative, meaning that any rise in the implied volatility will be a
losing proposition. This is intuitively appealing since a butterfly’s value depends on the likelihood
that the stock price will be at its middle strike at expiration and higher volatility decreases the
possibility of the stock remaining at the middle strike price. As a result, the butterfly will lose out
when implied volatility rises. Considering the vega, a long butterfly will be initiated by a trader
when the implied volatility is near to historic highs. Finally, looking at the butterfly’s structure it
can be understood that a butterfly is nothing but a combination ot
➢ Short straddle + Long strangle, or
➢ Bear call spread + Bull put spread

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Long butterfly = Short straddle +Long Strangle

A short butterfly strategy is just the opposite. It is a limited-risk, limited-gain strategy to translate
a bullish view (betting on an increase in) on the volatility of the underlying. A short butterfly is
established by buying a put and a call that are ATM and selling a put and a call that are OTM. By
buying the ATM options and selling OTM options, the position has its greatest loss when the
underlying does not move, and gains are maximized when the underlying moves beyond either of
the outside exercise prices. Therefore, a short butterfly strategy profits as equally from a large move
up as it does from a large move down. The profit/loss diagram for a short butterfly with the
following data is depicted by Figure

Stock price 60
Time to expiry 90 days
Volatility 25%
Interest rate 5%
55 put 1.78
60 call 4.51
60 put 3.84
6
5 call 2.53

The short butterfly is established by going long in the 60 ATM call and put options while selling the
55 put and 65 call OTM options. Short butterfly can also be constructed using only call options or
only put options. These strategies are termed as regular butterflies. A regular call butterfly involves
a long position in two ATM 60 call options and a short position in one 55 call and a 65 call option.
Similarly, the regular butterfly from only put options include long position in two ATM 60 puts and

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a short position in one 55 put (OTM) and one 65 put which is an ITM put option The profit/loss
diagrams of regular butterflies will be the same as that of iron butterflies and is shown in Figure.

Short butterfly profit/(loss) diagram

A short butterfly can also be visualized as a combination of short strangles and a short straddle.
This will become obvious if we juxtapose the profit/loss diagrams of these two strategies and
compare it with the diagram of short butterfly. Figure shows the same.

Short butterfly = Long straddle + Short strangle

Condors
A condor is nothing but a modified butterfly. The major difference between a butterfly and a condor
is that while the butterfly’s body (the trapezoidal shape of the option profit/loss diagram shown in
Figure) consists of buying two units of ATM options, the condor’s body uses separate strikes and is
therefore wider. This means that it has a wider area in which its body produces a profit. Therefore,
by using a condor rather than a butterfly, the range in which the maximum profit can be realized is
stretched out and in the process, the breakeven points also get extended

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Stock price 60
Time to expiry 90 days
Volatility 25%
Interest rate 5%
50 put 0.261
55 put 0.875
65 call 1.42
70 call 0.33

A long condor is established by:

➢ Selling 55 put option
➢ Selling 65 call option
➢ Buying 50 put option
➢ Buying 70 call option

The two options that make up the body of the condor are the first OTM call and first OTM put options
instead of the ATM options while the wings of the condor are made up of deep OTM options.

However, in the case of a butterfly, the options used to insure are just OTM options. As can be noted,
the two long positions will give rise to a long strangle and the two short positions will give rise to a
short strangle. In other words, a condor can be understood as the combination of a long strangle
plus a short strangle shown in Figure.

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Long condor profit/(loss diagram ) Long condor = long strangle + short strangle

Price Delta Gamma Theta Vega

Buy 50 put -0.17 -0.057 0.015 -0.004 0.031
Sell 55 put 0.875 0.205 -0.038 0.01 -0.082
Sell 65 call 1.42 -0.323 -0.047 0.017 -0.106
Buy 70 call -0.495 0.149 0.03 -0.009 0.066
Net 1.63 -0.026 -0.04 0.014 -0.091

From Table one can note that the long condor involves a cash inflow of ` 1.63 per condor which is
the maximum profit and occurs when the stock ends up between ` 55 and ` 65. The position suffers
the maximum loss when the stock is at or below ` 50 and at or above ` 70. At ` 50, all the options
excepting the 55 put will expire worthless and since this option is written by the condor owner, he
has to buy the stock at ` 55 when the spot market price is ` 50. In the bargain he will be losing ` 5
but since he received ` 1.63 as the premium, his net loss will equal ` 337 (-5 + 1.63 = ` -3.37).
Similarly, if the stock ends up at ` 70, all the options will be allowed to lapse except the 65 call which
was sold.

The condor buyer will be assigned this option and he has to deliver the underlying at ` 65 when the
going price is ` 70, resulting in a loss of ` 5. But since he received ` 1.63 as premium, his losses will
be pared to ` 3.37 (-5 + 1.63 ` -3.37). The breakeven point on the lower side is at ` 53.37 (55 - 1.63
= ` 53.37) and ` 66.63 (65 + 1.63 = ` 66.63) on the other side. In essence, a condor buyer expects that
stock prices remain range-bound more clearly between the strikes of the short strangle. i.e., ` 55

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and ` 65 since only in this area his profits are maximum. But if the stock ends up outside this range,
it is certain that one of the options will be in-the-money and he will start losing money beyond the
breakeven points.
Table presents the Greeks and the net delta of the position is almost negligible but the gamma is
almost five times that of a butterfly, which makes the condor more sensitive to price swings.
Since the position involves selling less OTM options, and buying deep OTM options, the position will
be benefited if implied volatility decreases and the benefits are more than that for a butterfly since
the vega is more negative for condor than for a butterfly. In addition to this, the position will benefit
from positive theta and theta benefits will increase as the spread’s expiry date nears by. However,
the profits are generally low since it involves selling OTM options that are traded at low prices.
A short condor involves the following:
➢ Buying 55 put option
➢ Buying 65 call option
➢ Selling 50 put option
➢ Selling 70 call option

The profit/loss diagram is as shown in Figure, with the maximum loss being limited to the premium
paid while the profits are also limited on either side equaling to ` 3.37 when the stock ends up at or
falls below ` 50 and at or over ` 70, i.e, the strike prices of the sold options become a key reference
point from where profits will be maximum. Therefore, the seller will make money if there is a
drastic fall or rise in the stock price.
Short condor profit/(loss) diagram

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Since we have seen almost all of the important volatility strategies, let us try to compare each of
them against the profits and risks involved with them. To facilitate our analysis, let us bring all the
profit/loss diagrams together:

Comparison of voltality strategies

It is clear that the straddles are most rewarding strategies for trading volatility, followed by
strangles, butterflies and then condors. The higher profits with straddles are associated with higher
risks also and theoretically the risks are unlimited for straddles and strangles. Infact with strangles,
the profitable zone was extended but the probability of higher losses is also increased. While
butterflies cut down the unlimited losses, they also reduce the potential profits. And finally, the
condor is a low-risk and low-profit strategy. Similar inferences can also be drawn for volatility
buying strategies too.

Horizontal Spreads
These spreads allow investors to gain from the time decay of options with minimal risks. These
spreads are also termed as calendar spreads or time spreads. To fix our thoughts we know that all
long option contracts lose their value as expiry date draws by and this is captured by theta.
Similarly, option writers benefit from time decay. Another important aspect about theta is that it is
higher when the option is closer to maturity and lower when it is far from maturity.

For instance, the Theta - Time to expiry diagram is given in Figure for an ATM call option with (S
60, X = 60, r = 5%, o7= 35%) it can be noted that loss of value when the option is to expire in 90
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days is ` 0.027 while it becomes 0.037 when the maturity is 45 days and it is 0. 105 if the time to
expiry is just 5 days. We can infer that if the price of the underlying remains more or less unchanged
the price decline for long options is less than that for a short dated option. So it appears that it will
be profitable by selling options, which are close to maturity, and buying options that are far from
maturity.

Theta vs time to expiry

Long time spreads or long calendar spreads use the same principle - write an option that is expiring
in a short period of time, simultaneously buying’ an option with the same exercise price and with a
life that is longer than the option written. In a neutral market, i.e., when the market is moving in a
narrow range, time spreads will be a good strategy to make money without the risk of naked sold
position. Assume we established a long calendar spread with the following options:

Stock price 60
Volatility 35%
Interest rate 5%
Long 60 call option 90 days to expiry Short 60 call option 30 days to expiry

We will understand the time spread with the help of profit/loss diagram and greeks. As the time
spread involves two expiry months, it is not possible to construct an accurate profit/loss profile at
the expiry of the written option. At the time of initiation, the value of the purchased option, as at
expiry of the sold option, can only be estimated using BSOPM or similar such pricing models.

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Long calendar speed

Option Greeks for the long calendar spread

Price Delta Gamma Theta Vega
Buy 90 day call -4.51 0.565 0.037 -0.027 0.117
Sell 30 day call 2.52 -0.538 -0.065 0.044 -0.068
Net -1.99 0.027 -0.028 0.017 0.049

At the time of initiation of the spread, it is also difficult to predict exactly the maximum profit from
the spread for the reason mentioned above. But the maximum loss is the net premium paid at the
time of constructing the spread. This will be incurred when the long call has little time value at
expiry, i.e., when the stock has risen/fallen very sharply. The spread has two breakeven points - one
point is to the left of the strike price and the other to the right of the strike price. If the stock moves
significantly, the spread will lose money.

The profit will be maximum when the stock price remains more or less unchanged from the strike
price till expiry of the short-dated call. Then the written call will not be exercised and the buyer will
capture fully the time value of the sold call option. Generally there is a misconception with time
spreads, i.e., some investors think that the long call option’s value will remain unchanged but it is
not so. Infact what happens is that the value of the long call will depreciate at a lower rate than the
theta gains of the written option Figure presents the profit/loss diagram.

From Table we can note that the delta of the spread is negligibly negative at 0.027. This is because
the spread involves two ATM call options and for ATM options, deltas are around 0.5. However,

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since one option is long and the other is short to a large extent, the deltas are offsetting each other.
Therefore, the net delta is almost zero and the spread can be construed as almost delta-neutral. If
the stock price is less than the exercise price, the spread will have positive deltas and when the
stock price is greater than the exercise price, the spread delta will be negative (to be profitable, the
stock price has to come down near to its strike price). The gamma of the spread is negative and this
means the spread will be a losing proposition for price swings in either direction.

Since the theta is positive, the spread gains from passage of time. The positive theta indicates that
this ATM time spread will benefit if the stock stays where it is (equal to the strike price) and time
flies away. This ATM time spread is having a positive vega, signifying that the spread benefits if
implied volatility rises, and if volatility decreases, the value decreases. Since the time spread deals
with two expiry months, it is important to note that if volatility rises in the short option (near dated
option) and either remains unchanged or falls in the long option (far dated option), a time spread
might lose value. Therefore, one should have a fair idea of how volatility can change from expiration
month to expiration month, as it is a significant source of risk.

Therefore, a long time spread will be profitable only if the stock price is near to the strike price at
the time of expiry of the short dated option. It is immaterial if the price is above or below but should
be as near as possible to the strike price. Time spreads can be established with put option; also and
the principles that apply in the case of call time spreads hold here also. A time spread made up of
put options, the investor will buy the long dated put option and write a short dated put option. Both
options have the same strike price. Since the put prices are generally lower than the call option
prices, it may appear a bit inexpensive to buy put spreads. However, the percentage returns are not
as attractive as that of call time spreads since at the time of expiry of the sold option the spread may
not he as valuable as a call spread. In this case also, the profit/loss diagram will have a similar
profile. The maximum risk is the amount he pays initially, as the premium and the spread will be
beneficial when the stock remains unchanged or above the exercise price till the expiry of the
written option.

Short calendar spread is exactly opposite to that of the long calendar spread. Instead of buying a far
dated option, the option is sold and another option with the same exercise price but of near maturity
is purchased. So, a short time spread using call options involve purchasing a call option that will be
expiring in a short period of time and selling a call option that has a longer period of time for
expiration but both of them have the same strike price. Through this spread, one expects to gain

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from a decline in the underlying stock price before the expiration of the sold call option. Actually
the near term call option that is purchased will protect the trader from any price rises over the short
term. The profit loss diagram for a short time spread is shown in Figure.

Short time spread

When the spread is established, there is a cash inflow of ` 1.99 and the delta of the spread is slightly
negative at 0.027 shown in Table. But as discussed earlier, the delta value is dependent on. where
the stock price is relative to the strike price. Since the spread involves two ATM calls (in opposite
directions), the delta is almost zero. Gamma of the spread is positive, meaning the spread will make
money when the underlying stock price changes steeply. The theta for the short call spread is
negative. This is because the spread includes a long position in an option which will expire in a few
days of time and for such options theta is highest. Hence the seller loses money even if the stock
price remains unchanged. The spread is having a negative Vega. So the seller will benefit if implied
volatility reduces after the position is initiated and if the implied volatility increases, the spread will
start losing out. Time spreads also reveal another interesting aspect probably. For the first time, we
came across a position where the gamma and the vega are working to each other, i.e., they
have opposite signs for long and short time spreads whereas in all other strategies that were
discussed thus far have these two working together i.e., have the same sign.

Option Greeks for the Short calendar spread

Price Delta Gamma Theta Vega
Sell 90 day call 4.51 –0.565 –0.037 0.027 –0.117
Buy 30 day call –2.52 0.538 0.065 –0.044 0.068

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Net 1.99 –0.027 0.028 –0.017 –0.049

Other Important Strategies

We will see some more volatility strategies that are popular with traders but the main feature of
these strategies is that their profit/loss profiles that are not symmetrical. Unlike the strategies we
have already considered viz., straddles, butterflies.

Ratio and Back Spreads

These involve buying one option contract and selling another option contract but of different
features or more precisely of different strike prices but of the same expiry month. They can be set
up using exclusively call options or put options. In this way, they can be considered as an extension
of the vertical trades, namely bull call spreads etc.

Ratio Call Spread

A 1 by 2 ratio call spread involves buying one call option and selling two call options at a higher
strike price. So, the long option is actually financed by the short position in two options. This
strategy benefits if the underlying is likely to move slightly or is relatively stable over the short
term; then these spreads are not without much risk. But if the stock moves up sharply, the extra
short option exposes the trader to unlimited risk since by definition a ratio spread involves shorter
than long options. Let us see this more closely with the help of an example

Stock price 155

Time to expiry 90 days
Volatility 23%
Interest rate 6%
150 call ` 11.12
165 call ` 4.08

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Option Greeks for the ratio call spread

Price Delta Gamma Theta Vega
Buy 1 150 call –11.12 0.68 0.02 –0.051 0.274
Sell 2 165 calls 8.16 –0.74 –0.042 0.092 –0.576
Net –2.96 –0.06 –0.022 . 0.041 –0.3020

Ratio call spread profit/ (loss) diagram

At the time of establishing the spread, there is a cash outflow of ` 2.96 from Table and the maximum
profit occurs to the trader when the stock ends up at ` 165 (the strike price of the sold options) see
Figure. At this price, the sold call options will not be exercised and the bought option will be in-the-
money by an amount of ` 15.00. If we deduct the premium paid for initiating the spread, the
maximum profit works out to ` 15 - 2.96 = ` 12.04. If the stock price falls, there is a limited loss of `
2.96, being the premium paid to initiate the spread. There are two breakeven points, i.e., 165 ±
maximum profit. If the underling’s price moves up, the trader faces unlimited losses. The more the
number of naked options, the larger will be the amount of losses. Therefore, the spread will be
profitable only if the stock is expected to move slightly but if a strong upward move is expected, the
trader may incur serious losses.

The delta of the spread is slightly negative at 0.06, but is of no concern since it is negligibly low. So
the position can be construed as delta neutral. This call viewed from another perspective also -
buying a 150 call and selling a 165 call is nothing but a 150/165 bull call spread which has bullish
bias. To this we added a short 165 call which has a bearish bias neutralizing the bullish view of the
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bull call spread. Therefore, the resultant spread will be neutral to the market direction. The spread
is having a negative gamma and it indicates that delta will move to hurt the trader when stock price
moves up or down. Forinstance, when the stock price moves up by ` 2, the short calls will lose ` 2.96
while the long call will gain only ` 1.36, resulting in a loss of ` 1.60. And if the stock price falls, the
trader will neither be gaining nor losing as his losses in the event of stock decline are capped at `
2.96. The spread is having a negative Vega. Therefore, the spreader would like the implied volatility
to stay still or to decline and if implied volatility increases, the spread will lose out at the rate of `
0.302 per 1% increase in implied volatility. As with all the volatility selling strategies, this will be
beneficial when the volatility is at historic highs. The trader will also benefit from time decay since
the theta is positive for the ratio call spread but it has to be noted that the more closer the current
price of the stock to the short’s strike price, the less will he the theta value and hence lower will be
the time decay gains.

Ratio Put Spread

A ratio put spread involves buying the higher strike price put option and selling two lower strikes
priced put options, resulting in a net short position. If the stock price rises sharply, there will be less
risk since all the puts will expire worthless but if the stock price declines, the spread will result in
unlimited losses. As with ratio call spread, this spread is likely to benefit when a slight down trend
in the stock is expected. Since the maximum profit occurs when the stock is at lower strike, the
trader desires the stock to move more towards the strike price of the short put; nothing higher and
nothing lower is desired. Figure shows the profit/loss diagram for a Ratio put spread.

Ratio put spread profit/(loss) diagram

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Option Greeks for the ratio put spread

Price Delta Gamma Theta Vega
Buy 1 165 put -12.18 -0.678 0.024 -0.024 0.288
Sell 2 150 puts 8.06 0.668 -0.042 0.056 -0.548
Net -4.12 -0.01 -0.018 0.032 -0.26

From Table one can see that a put ratio spread is also a debit spread, meaning there is a cash outflow
when the spread is initiated and the spread is neutral to the market since the delta is almost zero.
The gamma of the spread is negative, which implies that the spread will have positive deltas when
stock price declines and will have negative deltas when stock price rises resulting in loses for the
trader. This is another volatility selling strategy.

Since the Vega is negative, any increase in implied volatility will impact the spread unfavorably but
the trader will gain from positive theta. Here again, if the stock price is near to the long strike price,
theta benefits will be lower.

Back Spreads
A back spread is established by buying more options than the number of sold options while a ratio
spread involves more number of options written than the number of options purchased.

Conventionally, the ‘ratio’ is defined as the number of options written divided by the number of
options bought and it is generally represented as ‘1 against 2’ or ‘I by 2’, meaning two options are
sold against one bought option. There is no limit to the ratio, hence innumerable ratio spreads are
possible but for our discussion we will make use of the 1 by 2 spreads. Tompkins (1994) refer to
these as leaning volatility strategies since at inception they may be delta neutral and appear as
volatility trades but the spread inherently involves some speculation on the underling’s volatility.

Call back spread: Call back spreads are just the mirror images of the ratio call spreads. In the case
of ratio call spread, the position will lose if the underlying moves sharply but in the case of call back
spreads; the trader desires the stock to make a large jump so that his profits will be maximized.
These are established with two long options and one short call option. The strike price of the long
options is higher than that of the short option. Consider the call back spread created with the
following data:

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Stock price 155

Time to expiry 90 days
Volatility 23%
Interest rate 6%
150 call ` 11.12
165 call ` 4.08

The profit/loss diagram is shown in Figure and the greeks are given by Table. One can note that the
spread is a credit spread, as at the time of initiation there is a cash inflow and this is because the
sold option is in-the-money. Therefore, there is a higher intrinsic value and hence a cash inflow. If
the stock price declines to ` 150 or even below the trader have nothing to worry as all the options
will expire without being exercised and the trader keeps the premium lie received at the time of
initiation. The spread will have maximum loss of ` 12.04 occurring when the stock ends up at the
strike price of the long options. At
` 165, both the long calls will expire worthless and the sold call will be exercised by the counterparty
to the short call. So the stock has to be delivered at ` 150 when the price at expiry is ` 165, entailing
a loss of ` 15. But since he received ` 2.96 as the premium, his net losses will amount to ` -15.00 +
2.96 -12.04. There are two breakeven points at long strike price ± maximum loss, i.e., 165 ± 12.04.
The breakeven points are at 152.96 and 177.04.

Call back spread profit /(loss) diagram

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From the Greeks of the call back spread, it is clear that the spread is delta neutral though the delta
is positive at 0.06. The gamma is positive at 0.022, implying that the spread will benefit if the stock
experiences price upswings, and if the stock jumps down, there is no harm but the profits will be
limited to the premium received. The spread will benefit from an increase in implied volatility as is
evident from the positive vega. Assuming the spread is initiated to gain from volatility increases,
the spread will benefit more if the stock price is close to the long option’s strike price because the
vega will be higher and the position will benefit more if the implied volatility rises as expected.

However, the spread’s main threat is from theta. Since there are more long options than short
options, theta will be more negative. The closer the stock price is to the strike price of the long call
option, the more will be the theta effect. So, near to expiry, the position will benefit from vega but
will suffer from theta. Hence a call back strategy involves vega- theta tradeoff.

Option Greeks for the call back spread

Price Delta Gamma Theta Vega

Buy 2 165 calls -8.16 0.74 0.042 -0.092 0.576
Sell 1 150 call 11.12 -0.68 -0.020 0.051 -0.274
Net 2.96 0.06 0.022 -0.041 0.3020

Put Back Spread

A put back spread involves buying two put options and selling one put option—all with the same
expiry months, but the strike price of the short option will be higher than that of the long options.
A put back spread will gain the maximum when the stock is likely to move down substantially from
Figure. The put back spread has the following features:

➢ The maximum loss occurs when the stock ends up at the strike price of the long options
and it will be equal to:
(Long strike - Short strike) - Premium received Accordingly, the maximum loss in this case will be `
10.88.
➢ When the stock price ends up above the short strike price, the puts will expire worthless
and the net gain will be equal to the premium received.

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➢ But the gains are unlimited when the stock ends below the lower breakeven point,
which is given by (Long strike price - Maximum loss). In this case, the gains will be
unlimited when the stock ends below ` 139.12.

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Option Greeks for the put back spread

Price Delta Gamma Theta Vega

Buy 2 150 puts -8.06 -0.668 0.042 -0.056 0.548
Sell 1 165 put 12.18 0.678 4.024 0.024 4.288
Net 4.12 0.01 0.018 -0.032 0.26

The Greeks in Table indicate that the spread is delta neutral since the short put’s delta offsets more
than the negative delta of the two long put options. The gamma of the spread is positive. Hence it
might be beneficial if the price swings down; the delta will also move in the same direction and the
spread will benefit. For instance, if the stock price moves down to say ` 130 before five days to
expiry, both the put options will become in- the-money and the long options will generate a positive
inflow of ` 40 and the short put will make the trader to pay ` 35 to the counterparty, leading to a net
profit of ` 5 per spread and the net delta will be -1 (-1 x 2 + I = -1). Negative delta for a put option
means that the position will benefit if the stock price declines.

Similarly, the spread will benefit if the) implied volatility increases as the spread is having a positive
vega. But the only greek that is working against the put back trader is the theta. Since the spread
involves buying more options, the trader has to put up with time decay losses.

Ratio or the back spreads may not be initiated directly but they may evolve from the basic strategies
see Table. For instance, if a trader has established a bull put spread which is initially neutral to
volatility and the trader expects to benefit from upward stock price movement, after the stock has
moved up and if the trader believes volatility will come down, subsequently he can adapt the bull
put spread to a put back spread by adding one more put option, as ratio and back spreads are
nothing but a combination of the vertical spreads and basic options.

Ratio/back spread equivalence

Ratio/hack spread Vertical spread plus basic building

block
Ratio call Bull call plus short call
Ratio put Bear put pills short put
Call back Bear call plus long call
Put back Bull put plus long put

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Summary of option strategies

View on view on
Option Description Remarks volatility underlying’s
price
Buy a call Strongest bullish option Loss limited to premium ↑ ↓
position paid
Sell a call Neutral bearish option Profit limited to premi- ↓ ↑
position um received
Buy a put Strongest bearish option Loss limited to premium ↓ slight
position paid upward
Sell a put Neutral bullish option Profit limited to premi- ↑ ↓
position um received
Covered Buy future/stock & sell Collect premium on calls ↔ ↑
Call put. sold.
Covered Sell future / Stock & sell Collect premium of puts ↑ ↓
Put put sold.
Bull Call Buy a call of lower strike Limited loss and profit
Spread & sell a call of higher strategy ↔ ↑
strike price.
Bull Put Buy put of lower strike Limited loss and profit
Spread and sell another put with strategy ↔ ↑
higher strike price
Bear Call Buy a call of higher strike Limited loss and profit
spread price & sell a call of strategy ↔ ↓
lower
strike rice
Bear Put Buy a put of higher strike Limited loss and profit
Spread price & sell a put of strategy ↔ ↓
lower
strike price
Straddle Buy put & call Options will lose time ↑ ↔
Purchase value premium quickly.
Sell Sell call & put Profit limited to premi- ↓ ↔

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Straddle um received

Sell a Sell out of the money put Maximum use of time ↓ ↔

Strangle & call value decay
Buy a Buy an OTM call and a Can be held for longer ↑ ↔
Strangle put time vis-a-vis straddles
Calendar Sell near month, but far Near month time value ↔ ↔
month, same strike price. decays faster.
Buy at the money Call
(Put) & Sell 2 out of the Profit certain if done at
Butterfly money calls (Puts) & buy credit ↓ ↔
out of the money Call
(put)
Buy Call & Sell Calls of Movement to
Ratio Call higher strike price Neutral, slightly bullish ↔ the strike of
short call
Buy put and sell two puts Movement to
Ratio Put of lower strike price Neutral, slightly bearish ↔ the strike of
short put
Long call and two short Limited losses and un-
Call Back calls with lower strikes limited gains if ↑ ↑
stock
moves up
Long put and two short Limited losses and un-
Put Back puts of higher strikes limited profits if stock ↑ ↓
moves down

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