Options

Session 5

Introduction to Options
An options contract gives the buyer the right, but not the obligation to Buy or Sell a specified underlying at a set price on or before a specified date

eg. Car Purchase, Insurance,Health Insurance, Lottery Ticket

Option Terminology

American Option An option that may be exercised on any day ahead of expiry. These trade primarily on the futures exchanges. European Option An Option that can only be exercised on the date of expiry. These typically trade in the OTC markets and can be liquidated or offset prior to settlement. Index options Stock options

Call Option: Put Option: Buyer of an option Writer of an option

Strike price Option price Expiration date Lot size

CALLS & PUTS RIGHTS AND OBLIGATION

CALLS Buyer RIGHT Buy at the strike price at expiry

Seller

OBLIGATION Sell at the strike price at expiry

PUTS

Buyer

RIGHT Sell at the strike price at expiry

Seller

OBLIGATION Buy at the strike price at expiry

Difference Between Futures and Options

Futures Exchange Traded Exchange defines the product Price is zero, Strike price (futures price) moves Price is zero Linear Payoff Both long and short are at risk Options Same as futures Same as futures Strike price is fixed, Price moves Price is always positive Non Linear Payoff Only short at risk

Premium

Intrinsic Value
Time Value

In-the money option

It is an option that would lead to a positive cash flow to the holder, if it is exercised immediately
An ATM option is an option that would lead to a zero cash flow if it is exercised immediately. An option on the index is ATM when spot price is equal to the strike price

At-the money option

Out-of-the money option

An OTM option is an option that would lead to a negative cash flow if it is exercised immediately

Call option In-the money option Spot price > Strike price Spot price = Strike price Spot price < Strike price

Put option Spot price < Strike price Spot price = Strike price Spot price > Strike price

At-the money option

Out-of-the money option

Options

RIGHTS with the Buyer OBLIGATION : SELLER The Buyer EXERCISES his Rights to buy or sell an asset in future. The Buyer purchases is a RIGHT from the Seller The Seller meets his OBLIGATIONS to sell or buy the asset in future

Options

CALL OPTIONS : Gives the buyer of the Call Option the RIGHT to buy at the STRIKE PRICE CALL OPTIONS : The Seller of the Call Option has to meet his OBLIGATION of selling when the buyer EXERCISES his right The Buyer retains the RIGHT to Exercise or not Exercise Buyer : Unlimited Profits, Limited Losses Seller : Unlimited Losses, Limited Profits Buyer : Losses Limited to the premium (max. loss) Seller : Profits Limited to the premium (max. gain)

Call Option

The Buyer of an Options needs to pay to the Seller the PRICE of the Option.

This is called as the PREMIUM. It is paid immediately on buying the Option. The Seller receives the Premium on T+1 day.

Put Option

A Put Option is a Right to Sell the asset in future The Buyer of an Options needs to pay to the Seller the PRICE of the Option.

This is called as the PREMIUM. It is paid immediately on buying the Option.

The Seller receives the Premium on T+1 day. Buyer : Unlimited Profits, Limited Losses Seller : Unlimited Losses, Limited Profits

Buyer : Losses Limited to the premium (Max. loss) Seller : Profits Limited to the premium (Max profit)

Options

BULLISH : BUY CALLS BULLISH : SELL PUTS

BEARISH : BUY PUTS BEARISH : SELL CALLS

BUYER OF AN OPTION PAYS PREMIUM

PREMIUM IS THE MAXIMUM LOSS THE BUYER CAN SUFFER

SELLER OF AN OPTION

RECEIVES

PREMIUM

PREMIUM IS THE MAXIMUM PROFIT THE SELLER CAN MAKE APPLICABLE FOR BOTH CALLS AND PUTS

Long Call

Outlook

Bullish
Long term period and deep ITM Net debit Maximum risk call premium Maximum reward uncapped Breakeven call strike + call premium

Rationale

Net position

Risk profile

Payoff for buyer of Call Option

Profit

nifty

Loss

Limited Loss Unlimited profit Profit = spot price < strike price Bullish

Example

ACC is trading @ Rs 28.88 on Aug 09 Buy Oct 09 @ Rs 27.50 strike call for 4.38
You pay Max Risk Call premium Rs 4.38 Call premium Rs 4.38 Max risk is 100% of our total cost here

Max Reward
Break even

Unlimited as the stock price rises

27.50 + 4.38 = Rs 31.88

Short (Naked) Call

Outlook

Bearish short term period and OTM Net credit Buy back the option or wait till expiry, so that you can keep premium Maximum risk uncapped Maximum reward call premium Breakeven call strike + call premium

Rationale

Net position

Exit position

Risk profile

Payoff for seller of Call Option

Profit

nifty

Loss

Limited Profit Unlimited Loss Loss = spot price > strike price Bearish

Example

ACC is trading @ Rs 28.20 on Aug 09 Sell Oct 09 @ Rs 30 strike call for Rs 0.90
You Receive Max Risk Max Reward Break even Call premium Rs 0.90 Uncapped Call premium Rs 0.90 28.20 + 0.90 = Rs 30.90

PUT

Nifty CP @ 4556
In The Money At The Money Out of The Money Stock < Call strike price Stock = Call strike price Stock > Call strike price 4700 @ 212 4500 @ 101, 4600@148 4400 @ 64

Nifty @ 4612 strike price 4700 @164 Steps in trading in long put

Buy a put option Pay premium Eg: 212*50 = 10600

Long Put

Outlook

Bearish
Long term and Buy deep ITM Net debit

Rationale

Net position

Risk profile

Maximum risk call premium Maximum reward uncapped Breakeven call strike - call premium

Payoff for buyer of Put Option

Profit

nifty

Loss

Limited Loss Unlimited profit Profit = Spot price < strike price Bearish

Example

ACC is trading @ Rs 28.88 on Aug 09 Buy Oct 09 @ Rs 30 strike call for 4.38
You pay Max Risk Put premium Rs 4.38 Put premium Rs 4.38 Max risk is 100% of our total cost here

Max Reward
Break even

Unlimited as the stock price decreases

30 - 4.38 = Rs 25.62

Short (Naked) Put

Outlook

Bullish

Rationale

short term period and OTM

Net credit

Net position

Exit position

Buy back the option or wait till expiry, so that you can keep premium
Maximum risk capped* (risk uncapped until the stock falls to zero) put strike price premium received Maximum reward put premium Breakeven put strike + put premium

Risk profile

Payoff for seller of Put Option

Profit

nifty

Loss

Loss = spot price < strike price Limited profit Unlimited Loss Bullish

Example

ACC is trading @ Rs 27.35 on Aug 09 Sell Oct 09 @ Rs 25 strike call for Rs 1.05
You Receive Max Risk Max Reward Break even Risk on return Put premium Rs 1.05 25 1.05 = Rs 23.95 Put premium Rs 1.05 25 1.05 = Rs 23.95 4.38%