What is an option

An option gives you the right, but not the obligation to either buy (Call Option) or sell (Put Option) an asset at a certain price (known as the strike) on a certain date. For this right to buy or sell the underlying asset, you pay a premium upfront to the seller of the option. Whether you choose to use, or exercise, this right, is dependent upon the market conditions at the time the option expires.

Important Terminology
Underlying - The specific security / asset on which an options contract is based

Option Premium - This is the price paid by the buyer to the seller to acquire the right to buy or sell
Strike Price or Exercise Price - The strike or exercise price of an option is the specified/ pre-determined price of the underlying asset at which the same can be bought or sold if the option buyer exercises his right to buy/ sell on or before the expiration day Expiration date - The date on which the option expires is known as Expiration Date. On Expiration date, either the option is exercised or it expires worthless Exercise Date - is the date on which the option is actually exercised. In case of European Options the exercise date is same as the expiration date while in case of American Options, the options contract may be exercised any day between the purchase of the contract and its expiration date (see European/ American Option)

Important Terminology (Contd)

Open Interest - The total number of options contracts outstanding in the market at any given point of time Option Holder: is the one who buys an option which can be a call or a put option. He enjoys the right to buy or sell the underlying asset at a specified price on or before specified time. His upside potential is unlimited while losses are limited to the Premium paid by him to the option writer Option seller/ writer: is the one who is obligated to buy (in case of Put option) or to sell (in case of call option), the underlying asset in case the buyer of the option decides to exercise his option. His profits are limited to the premium received from the buyer while his downside is unlimited Option Class: All listed options of a particular type (i.e., call or put) on a particular underlying instrument, e.g., all Sensex Call Options (or) all Sensex Put Options

American & European Options

An American style option is the one which can be exercised by the buyer on or before the expiration date, i.e. anytime between the day of purchase of the option and the day of its expiry The European kind of option is the one which can be exercised by the buyer on the expiration day only & not anytime before that

At the Money, In the Money, Out of the Money

An option is said to be at-the-money, when the option's strike price is equal to the underlying asset price. This is true for both puts and calls A call option is said to be in-the-money when the strike price of the option is less than the underlying asset price. For example, a Sensex call option with strike of 3900 is in-the-money, when the spot Sensex is at 4100 as the call option has value. The call holder has the right to buy a Sensex at 3900, no matter how much the spot market price has risen. And with the current price at 4100, a profit can be made by selling Sensex at this higher price On the other hand, a call option is out-of-the-money when the strike price is greater than the underlying asset price. Using the earlier example of Sensex call option, if the Sensex falls to 3700, the call option no longer has positive exercise value. The call holder will not exercise the option to buy Sensex at 3900 when the current price is at 3700

At the Money, In the Money, Out of the Money

A put option is in-the-money when the strike price of the option is greater than the spot price of the underlying asset. For example, a Sensex put at strike of 4400 is in-the-money when the Sensex is at 4100. When this is the case, the put option has value because the put holder can sell the Sensex at 4400, an amount greater than the current Sensex of 4100 Likewise, a put option is out-of-the-money when the strike price is less than the spot price of underlying asset. In the above example, the buyer of Sensex put option won't exercise the option when the spot is at 4800. The put no longer has positive exercise value Options are said to be deep in-the-money (or deep out-of-the-money) if the exercise price is at significant variance with the underlying asset price

At the Money, In the Money, Out of the Money

CALL OPTION PUT OPTION

In-the-money

Strike price < Spot price of Strike price > Spot price of underlying asset underlying asset

At-the-money
Out-of-themoney

Strike price = Spot price of Strike price = Spot price of underlying asset underlying asset
Strike price > Spot price of Strike price < Spot price of underlying asset underlying asset

A Trading Scenario
You expect the Dollar to strengthen against the Rupee. The Current Rate is 44.0000 You Buy the 1 month USD/INR call option at a strike of 44.0100 You pay a premium of Rs. 90 for the option on $1000 On expiry the price is at 44.6000 Profit = 44.6000-44.0100 - .09 = 0.5 You make a profit of Rs. 500 on the trade of $1000

Payoff diagram
3

2.5
2 1.5 1 0.5 0 39 -0.5 40 41 42 43 44 45 46 47 48

Premium = 0.5 Strike = 44

Underlying Spot
-1

All Payoff Diagrams

Pricing of Option
Intrinsic Value
Price of the underlying asset minus the strike of the option as the option's intrinsic value (for a Call option, for a Put it is just the opposite)

Time Value
The amount by which the value of the option exceeds the intrinsic value. The volatility of the underlying asset has a significant bearing on the time value. Time value increases as volatility increases because of the Profit/Loss scenario for an option. An option on an asset which is more likely to take on extreme values is much more valuable than on a less volatile asset. Interest rates differentials in the two currencies involved in a currency option trade must also be taken into consideration when pricing an option, and these are also a function of time.

Pricing Illustrated

Example
Let's say that you hold a Call option with a 44.2000 strike price, and that the market price of USD/INR has risen to 44.2155. Your option is worth 225 pips thirty days before the option's expiration date. The intrinsic value is the difference between the strike price for the underlying asset in the option contract (44.2000) and the market price (44.2155). If you hold a call option, which gives you the right to buy USD/INR at 44.2000 and the market price is 44.2155 the intrinsic value of the option is 155 pips. So the price of the option is the intrinsic value plus the time value (in this case 70 pips).

Why Options
You can limit your risks (maximum potential loss is the premium if you are the buyer) and you will still have unlimited profit potential. Options require less money up front than if, for example, you take a regular spot position. This is because you don't buy the asset itself but only a contract that gives you the right to either buy or sell the asset at a given price. Therefore, if you are the buyer, you will only have to pay the premium upfront. On the other hand, if you are the seller of an option, you receive the premium upfront, but then you have the possibility of an unlimited loss. An option offers you some important hedging opportunities.

Long Call
SCENARIO
You want to capitalize on an increasing trend in the spot market. The trend could be either short or long term.

ACTION
Buy Call with strike A (see Long Call graph). Any strike price is bullish, however, the higher you set the strike , the more out-of-the-money the option is, thus the higher the leverage.

Example Long Call

You believe USD/INR will rise towards the 47.22 level in about a month's time. The spot is currently 47.1720. You buy USD/INR Call for one month with a strike of 47.1750. The price is 108 pips. UPSIDE
The profit region for this option is any spot price above 47.1858(the option's break-even point) and is potentially unlimited.

DOWNSIDE
The risk is limited to the cost of the premium (108 pips), which will be lost if the options are worthless at the time of expiry.

Short Call
SCENARIO
You expect minor changes in the spot, and these will more than likely result in a decrease in the spot. You can also use this strategy if you believe that the option is priced too high, i.e. the market expects the price to move more than you think it will. Sell Call with strike A (See Short Call graph). Any strike price you select should be bearish, reflecting your view of how the currency will perform over the period of the option.

ACTION

Example Short Call

EXAMPLE
You expect USD/INR to remain fairly stable at the current market levels for the next month. The spot is 47.1720. You sell a USD/INR Call with a strike of 47.18 for a premium of 86 pips.

UPSIDE
This strategy's profit potential is the premium received, 86 pips.

DOWNSIDE
The risk region for this strategy is any price above 47.1886 at the time the option expires.

Long Straddle
SCENARIO
You anticipate a large move in the spot, perhaps in connection with a certain event, but you are not sure of the direction of the move. Buy a Put and a Call with the same strike price. The strike price should be roughly at-the-money (equal or nearly equal to the market price).

ACTION

Example Long Straddle

EXAMPLE
You believe that USD/INR will move significantly in either direction in the next month. The spot is 47.1730 and the forward price is app. 47.1750. You buy a USD/INR Call and a USD/INR Put for one month with a strike of 47.1750 for a premium of 128 pips and 127 pips, respectively. The total premium is 255 pips. The profit region is any price above 47.2005 or below 47.1495. The risk is limited to the cost of the premiums (255 pips), which will be lost if the options are worthless at the time of expiry.

UPSIDE

DOWNSIDE

Long Strangle
SCENARIO
You anticipate a large move in the spot, in either direction, if the spot price breaches certain levels.

ACTION
Buy a Put with strike price A and a Call with strike price B (see Long Strangle graph). Choose the strike prices according to which levels you believe will trigger large moves in the spot.

Example Long Strangle

EXAMPLE
You believe USD/INR will have a large swing in price if certain levels are breached. The spot is 47.1730. You buy a one-month USD/INR Call with a strike of 47.19 for a premium of 67 pips and a USD/INR Put with a strike of 47.16 for a premium of 67 pips.

UPSIDE
This strategy yields a profit if the spot is below 47.1466 or above 47.2034 at the time of expiry.

DOWNSIDE
The risk is limited to the cost of the premiums (134 pips), which will be lost if the options are worthless at the time of expiry.

Call Spread
SCENARIO
You expect a moderate increase in the spot.

ACTION
Buy a Call with strike price A and sell a Call with strike price B (see Call Spread graph). Strike price A would be selected roughly at-the-money. Strike price B should be placed at the the value you expect the spot to have at the time the option matures.

Example Call Spread

EXAMPLE
USD/INR spot is 47.1730. You expect it to increase to app. 47.20 within a month's time. You buy a USD/INR Call with a strike of 47.18 for a premium of 105 pips. You sell a USD/INR Call with a strike of 47.20 for a premium of 39 pips.

UPSIDE
You profit potential is any price above 47.1866, but with a ceiling of 47.20.

DOWNSIDE
The loss of the net premium paid, or 66 pips (the net value of the premium paid minus the premium received), if the option is worthless at the time of expiry.

Delta
The Delta measure describes how the value of an option changes as a result of small changes in the underlying asset, assuming that all the other factors influencing option pricing are constant. The delta of an option can also be viewed as the required hedge for the option against changes in the underlying spot, i.e. the position in the spot which ensures that the Profit/Loss on the option is offset by the Profit/Loss on the spot position. Delta can also be viewed as the probability that the option will end in the money
If an investor buys a 40 Delta EUR/USD Call for one million, he/she can hedge this position by selling 400,000 in the underlying asset - i.e. the spot. Alternatively, if the investor had bought a 30 Delta EUR/USD Call he/she would have to sell 300,000 in the spot market to become delta neutral.

Gamma
The gamma measure describes how the delta of the option changes when the underlying asset changes. Hence, the gamma also describes how the you should change your hedge to remain delta neutral when the spot moves. All purchased standard options, calls and puts, have positive gamma. The gamma position also provides insight into the investor's view on the volatility of the underlying asset, as a long position shows expectations of a volatile market while a short position indicates that he/she expects a calm market

Vega

Vega is the sensitivity of option price to change in implied volatility Generated by the option pricing model and is theoretical in nature Expected option price change for 1%-point change in implied volatility

Implied volatility 1%-point calls and puts by vega amount

Implied volatility 1%-point calls and puts by vega amount

For example, if the theoretical price is 2.5 and the Vega is showing 0.25, then if the volatility moves from 20% to 21% the theoretical price will increase to 2.75.

Theta
Theta shows how much value the option price will lose for everyday that passes An option contract has a finite life, defined by the expiration date. As the option approaches its maturity date, an option contract's expected value becomes more certain with each day This Time Value, also called Extrinsic Value, represents the uncertainty of an option Theta is the calculation that shows how much of this time value is eroding as each trading day passes - assuming all other inputs remain unchanged. Because of this negative impact on an option price, the Theta will always be a negative number

For example, say an option has a theoretical price of 3.50 and is showing a Theta value of -0.20. Tomorrow, if the underlying market opens unchanged (opens at the same price as the previous days close) then the theoretical value of the option will now be worth 3.30 (3.50 - 0.20)

Rho
Rho is the change in option value that results from movements in interest rates The value is represented as the change in theoretical price of the option for a 1 percentage point movement in the underlying interest rate For example, say you're pricing a call option with a theoretical value of 2.50 that is showing a Rho value of .25. If interest rates increase from 5% to 6%, then the price of the call option, theoretically at least will increase from 2.50 to 2.75 Unlike the other option greeks, Rho is larger for options that are in the money and decreases steadily as the option moves out of the money Option Rho also increases with a greater amount of time to expiration

What the Greeks mean to me

The Greeks and my position Greek Long Short

Gamma
Delta

Long Options position

Bought Call/Sold Put

Short Options position

Sold Call/Bought Put

The Greeks and my profit and loss Long In... Delta Gamma Short In... Delta Gamma Profit Increase in Spot High Real Volatility Profit Decrease in Spot Low Real Volatility Loss Decrease in Spot Low Real Volatility Loss Increase in Spot High Real Volatility