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Options Trading Strategy Guide: Introduction to Basics

Hiten Jhaveri/StockWhizo

WHAT IS AN OPTION?

We all know many opportunities exist in trading today. Everywhere you turn, someone is waiting to inform you of the tremendous profits to be realized in the stock and futures markets. However, many people are unaware of the derivative trading possibilities that are available within and across several different markets. Option trading is just one of the many ways to participate in these secondary markets. And contrary to popular belief, this potential trading arena is not limited strictly to the practice of selling or writing options.

Options are an important element of investing in markets, serving a function of managing risk and generating income. Unlike most other types of investments today, options provide a unique set of benefits. Not only does option trading provide a cheap and effective means of hedging one's portfolio against adverse and unexpected price fluctuations, but it also offers a tremendous speculative dimension to trading.

One of the primary advantages of option trading is that option contracts enable a trade to be leveraged, allowing the trader to control the full value of an asset for a fraction of the actual cost. And since an option's price mirrors that of the underlying asset at the very least, any favorable return in the asset will be met with a greater percentage return in the option provides limited risk and unlimited reward.

With options, the buyer can only lose what was paid for the option contract, which is a fraction of what the actual cost of the asset would be. However, the profit potential is unlimited because the option holder possesses a contract that performs in sync with the asset itself. If the outlook is positive for the security, so too will the outlook be for that asset's underlying options. Options also provide their owners with numerous trading alternatives. Options can be customized and combined with other options and even other investments to take advantage of any possible price dislocation within the market. They enable the trader or investor to acquire a position that is appropriate for any type of market outlook that he or she may have, be it bullish, bearish, choppy, or silent.

While there is no disputing that options offer many investment benefits, option trading involves risk and is not for everyone. For the same reason that one's returns can be large, so too can the losses - leverage. Also, while the potential for financial success does exist in option trading, the means of realizing such opportunities are often difficult to create and to identify. With dozens of variables, several pricing models, and hundreds of different strategies to choose from, it is no wonder that options and option pricing have been a mystery to the majority of the trading public.

Most often, a great deal of information must be processed before an informed trading decision can be reached. Computers and sophisticated trading models are often relied upon to select trading candidates. However, as humans, we like things to be as simple as possible. This often creates a conflict when deciding what, when, and how to trade a particular investment. It is much easier to buy or sell an asset outright than to contend with the many extraneous factors of these derivative markets.* If an investor thinks an asset's value will appreciate, he or she can simply buy the security; if an investor thinks an asset's value will depreciate, he or she can simply sell the security. In these scenarios, the only thing an investor must worry about is the value of the investment relative to the value of the prevailing market. If only options were that easy!

* A derivative security is any security, in whole or in part, the value of which is based upon the performance of another (underlying) instrument, such as an option, a warrant, or any hybrid securities.

Typically, option trading is more cumbersome and complicated than stock trading because traders must consider many variables aside from the direction they believe the market will move. The effects of the passage of time, variables such as delta, and the underlying market volatility on the price of the option are just some of the many items that traders need to gauge in order to make informed decisions. If one is not prudent in one's investment decisions, one could potentially lose a lot of money trading options. Those who disregard careful consideration and sound money management techniques often find out the hard way that these factors can quickly and easily erode the value of their option portfolios.

Because of these risks and benefits, options offer tremendous profit potential above and beyond trading in any other instrument, including the underlying security itself. This is the juncture at which option theoreticians enter the picture. Once the benefits have been defined, it is now a matter of determining how to best attain them. Up to now, the vast majority of option techniques have been elaborate mathematical models designed to help identify when option-writing or -selling opportunities exist. However, we hope to break new ground by introducing simple market-timing techniques that will enable traders to buy options with greater confidence and with greater success.

TYPE OF OPTIONS

Call Options

A call option gives the holder (buyer/ one who is long call), the right to buy specified quantity of the underlying asset at the strike price on or before expiration date.

The seller (one who is short call) however, has the obligation to sell the underlying asset if the buyer of the call option decides to exercise his option to buy.

Example: An investor buys One European call option on Infosys at the strike price of Rs. 3500 at a premium of Rs. 100. If the market price of Infosys on the day of expiry is more than Rs. 3500, the option will be exercised.

The investor will earn profits once the share price crosses Rs. 3600 (Strike Price + Premium i.e. 3500+100).

Suppose stock price is Rs. 3800, the option will be exercised and the investor will buy 1 share of Infosys from the seller of the option at Rs 3500 and sell it in the market at Rs 3800 making a profit of Rs. 200 {(Spot price - Strike price) - Premium}.

In another scenario, if at the time of expiry stock price falls below Rs. 3500 say suppose it touches Rs. 3000, the buyer of the call option will choose not to exercise his option. In this case the investor loses the premium (Rs 100), paid which should be the profit earned by the seller of the call option.

Put Options

A Put option gives the holder (buyer/ one who is long Put), the right to sell specified quantity of the underlying asset at the strike price on or before an expiry date.

The seller of the put option (one who is short Put) however, has the obligation to buy the underlying asset at the strike price if the buyer decides to exercise his option to sell.

Example: An investor buys one European Put option on Reliance at the strike price of Rs. 300/- , at a premium of Rs. 25/-. If the market price of Reliance, on the day of expiry is less than Rs. 300, the option can be exercised as it is 'in the money'. The investor's Break-even point is Rs. 275/ (Strike Price - premium paid) i.e., investor will earn profits if the market falls below 275.

Suppose stock price is Rs. 260, the buyer of the Put option immediately buys Reliance share in the market @ Rs. 260/- & exercises his option selling the Reliance share at Rs 300 to the option writer thus making a net profit of Rs. 15 {(Strike price - Spot Price) - Premium paid}.

In another scenario, if at the time of expiry, market price of Reliance is Rs 320/ -, the buyer of the Put option will choose not to exercise his option to sell as he can sell in the market at a higher rate. In this case the investor loses the premium paid (i.e. Rs 25/-), which shall be the profit earned by the seller of the Put option. (Please see table)

The Options Game

	Call Option	Put Option
Option buyer or option holder	Buys the right to buy the underlying asset at the specified price	Buys the right to sell the underlying asset at the specified price
Option seller or option writer	Has the obligation to sell the underlying asset (to the option holder) at the specified price	Has the obligation to buy the underlying asset (from the option holder) at the specified price

Options are different from Futures

There are significant differences in Futures and Options.

Futures are agreements/contracts to buy or sell specified quantity of the underlying assets at a price agreed upon by the buyer and seller, on or before a specified time. Both the buyer and seller are obligated to buy/sell the underlying asset. Futures Contracts have symmetric risk profile for both buyers as well as sellers, whereas options have asymmetric risk profile.

In options the buyer enjoys the right and not the obligation, to buy or sell the underlying asset. In case of Options, for a buyer (or holder of the option), the downside is limited to the premium (option price) he has paid while the profits may be unlimited. For a seller or writer of an option, however, the downside is unlimited while profits are limited to the premium he has received from the buyer.

The futures contracts prices are affected mainly by the prices of the underlying asset. Prices of options are however, affected by prices of the underlying asset, time remaining for expiry of the contract and volatility of the underlying asset.

It costs nothing to enter into a futures contract whereas there is a cost of entering into an options contract, termed as Premium.

BASIC OPTION TERMINOLOGY

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

Option Premium - This is the price paid by the buyer to the seller to acquire the right to buy or sell.

Strike Price or Exercise Price - The strike or exercise price of an option is the specified/ 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)

Assignment - When the holder of an option exercises his right to buy/ sell, a randomly selected option seller is assigned the obligation to honor the underlying contract, and this process is termed as Assignment.

Open Interest - The total number of options contracts outstanding in the market at any given point of time.

Option Holder - is the one who buys an option which can be a call or a put option. He enjoys the right to buy or sell the underlying asset at a specified price on or before specified time. His upside potential is unlimited while losses are limited to the Premium paid by him to the option writer.

Option seller/ writer - is the one who is obligated to buy (in case of Put option) or to sell (in case of call option), the underlying asset in case the buyer of the option decides to exercise his option. His profits are limited to the premium received from the buyer while his downside is unlimited.

Option Class - All listed options of a particular type (i.e., call or put) on a particular underlying instrument, e.g., all Sensex Call Options (or) all Sensex Put Options

Option Series - An option series consists of all the options of a given class with the same expiration date and strike price. E.g. BSXCMAY3600 is an options series which includes all Sensex Call options that are traded with Strike Price of 3600 & Expiry in May.

(BSX Stands for BSE Sensex (underlying index), C is for Call Option, May is expiry date and strike Price is 3600)

HOW TO START TRADING OPTIONS?

Before we devote our attention to more sophisticated option applications, it is important that we introduce a basic option foundation. While this introduction to options will be descriptive in its scope, its coverage will by no means be exhaustive. The sheer magnitude of option terminology and strategy could comprise an entire book on its own, and that is not our primary focus. For us to give our interpretation of existing material is much like making an entire career out of singing covers of popular songs of the past. Therefore, we will only be addressing the items necessary to understanding option basics and the techniques we will be presenting throughout the book. This simple introduction is tailored to those who are unfamiliar with options.

Whether they apply to stocks, indices, or futures, all options work in the same manner. Simply stated, an option is a financial instrument that allows the owner the right, but not the obligation, to acquire or to sell a predetermined number of shares of stock or futures contracts in a particular asset at a fixed price on or before a specified date. With each option contract, the holder can make any of three possible choices: exercise the option and obtain a position in the underlying asset; trade option, closing out the trader's position in the contract by performing an offsetting trade; or let the option expire if the contract lacks value at expiration, losing only what was paid for the option. We will discuss the benefits and implications of each action later in this chapter.

Option contracts are identified using quantity, asset expiration date, strike price, type, and premium. With the exception of the option's premium, each of these items is standardized upon issuance of a listed option contract. In other words, once an option contract is created, its rights are static; the price that one would pay for those rights is not; it is dynamic and determined by market forces. Seeing as there are many items which make up the definition of an option contract, it is important that each be addressed before moving on.

The first aspects of an option contract is the option's quantity. The number of shares or contracts that can be obtained upon exercising an exchange-listed option contract is standardized. Each stock option contract allows the holder of that option to control 100 shares of the underlying security while each futures option contract can be exercised to obtain one contract in the underlying futures contract.*

*Futures are leveraged assets typically representing a large, standardized quantity of an underlying security which expire at some predetermined date in the future. Each futures option contract allows the holder to control the total number of units that comprise the futures contract until the option is liquidated, but no later than its expiration date.

Another item that identifies the option contract is the asset itself. The asset refers to the type of investment that can be obtained by the option holder. This asset could be a futures contract, shares of stock in a company, or a cash settlement in the case of an index contract.

The type of option is critical in determining the trader's market outlook. Unlike trading stocks or futures themselves, option trading is not simply being long a particular market or short a particular market. Rather, there are two types of options, call options and put options, and two sides to each type, long or short, allowing the trader to take any of four possible positions. One can buy a call, sell a call, buy a put, sell a put, or any combination thereof. It is important to understand that trading call options is completely separate from trading put options. For every call buyer there is a call seller; while for every put buyer there is a put seller. Also keep in mind that option buyers have rights, while option sellers have obligations. For this reason, option buyers have a defined level of risk and option sellers have unlimited risk.

A call option is a standardized contract that gives the buyer the right, but not the obligation, to purchase a specific number of shares or contracts of an underlying security at the option's strike prices, or exercise price, sometime before the expiration date of the contract. Buying a call contract is similar to taking a long position in the underlying asset, and one would purchase a call option if one believed that the market value of the asset was going appreciate before the date the option expires. The most trader can lose by purchasing a call option is simply the price that he or she pays for the option; the most the trader can make is unlimited.

On the other side of the transaction, the seller, or writer, of a call options has the obligation, not the right, to sell a specific number of shares or contracts of an asset to the option buyer at the strike price, if the option is exercised prior to its expiration date. Selling a call contract acts as a proxy for a short position in the underlying asset, and one would sell a call option if one expected that the market value of the asset would either decline or move sideways. (See Payoff Diagram)

The most an option seller can make on the trade is the price he or she initially receives for the option contract; the most the trader can lose is unlimited. In order to offset a long position in a call option contract, one must sell a call option of the same quantity, type, expiration date, and strike price. Similarly, in order to offset a short position in a call option contract, one must buy a call option of the same quantity, type, expiration date, and strike price.

Long

With respect to this booklet's usage of the word, long describes a position (in stock and/or options) in which you have purchased and own that security in your brokerage account. For example, if you have purchased the right to buy 100 shares of a stock, and are holding that right in your account, you are long a call contract. If you have purchased the right to sell 100 shares of a stock, and are holding that right in your account, you are long a put contract. If you have purchased 1,000 shares of stock and are holding that stock in your brokerage account, or elsewhere, you are long 1,000 shares of stock.

When you are long an equity option contract:

You have the right to exercise that option at any time prior to its expiration.

Your potential loss is limited to the amount you paid for the option contract.

PAYOFF DIAGRAM: Profit diagrams for a Long Call and a Long Put
LONG CALL
OUTLOOK = BULLISH
S = STRIKE PRICE
BEP = BREAK-EVEN-POINT = S+DR
DR = DEBIT = INITIAL OPTION COST = MAXIMUM LOSS
MAXIMUM GAIN = UNLIMITED

                                            Stock Price
                                <------Lower      Higher ------>
LONG PUT
OUTLOOK = BEARISH
S = STRIKE PRICE
BEP = BREAK-EVEN-POINT = S-DR
DR = DEBIT = INITIAL OPTION COST = MAXIMUM LOSS
MAXIMUM GAIN = UNLIMITED
                                        Stock Price
                            <------Lower      Higher ------>

Short

With respect to this booklet's usage of the word, short describes a position in options in which you have written a contract (sold one that you did not own). In return, you now have the obligations inherent in the terms of that option contract. If the owner exercises the option, you have an obligation to meet. If you have sold the right to buy 100 shares of a stock to someone else, you are short a call contract. If you have sold the right to sell 100 shares of a stock to some-one else, you are short a put contract. When you write an option contract you are, in a sense, creating it. The writer of an option collects and keeps the premium received from its initial sale.

When you are short (i.e., the writer of ) an equity option contract:

• You can be assigned an exercise notice at any time during the life of the option contract. All option writers should be aware that assignment prior to expiration is a distinct possibility.
• Your potential loss on a short call is theoretically unlimited. For a put, the risk of loss is limited by the fact that the stock cannot fall below zero in price. Although technically limited, this potential loss could still be quite large if the underlying stock declines significantly in price.

PAYOFF DIAGRAM Profit diagrams for a Short Call and a Short Put
SHORT CALL
OUTLOOK = BEARISH
S = STRIKE PRICE
BEP = BREAK-EVEN-POINT = S+CR
CR = CREDIT = INITIAL OPTION PAYMENT RECEIVED = MAXIMUM GAIN
MAXIMUM LOSS = UNLIMITED
                                        Stock Price
                            <------Lower      Higher ------>
SHORT PUT
OUTLOOK = BULLISH
S = STRIKE PRICE
BEP = BREAK-EVEN-POINT = S-CR
CR = CREDIT = INITIAL OPTION PAYMENT RECEIVED = MAXIMUM GAIN
MAXIMUM LOSS = UNLIMITED
                                        Stock Price
                            <------Lower      Higher ------>

A put option is a standardized contract that gives the buyer the right, but not the obligation, to sell a predetermined number of shares or contracts of an underlying security at the option's strike price, or exercise price, sometime before the expiration date of the contract.

A put contract is similar to taking a short position in the underlying asset, and one could purchase a put option contract if one believed that the market price of the asset was going to decline at some point before the date the option expires. The most a trader can lose by purchasing a put option is simply the price that he or she pays for the option; the most the trader can make is unlimited (in reality, it is the full value of the underlying asset which is realized if its price declines to zero).

Conversely, the seller, or writer, of a put option has the obligation, not the right, to buy a specific number of shares or contracts of an asset to the option buyer at the strike price, assuming the option is exercised prior to its expiration date. Selling a put contract acts as a substitute for a long position in the underlying asset, and a trader would sell a put contract if he or she expected the market value of the asset to either increase or move sideways. Again, the most an option seller can make on the trade is the price he or she initially receives for the option contract; the most the seller can lose is unlimited (in reality, the most one can lose is the full value of the underlying asset which is realized if its price declines to zero). (See Payoff Diagram)

In order to offset a long position in a put option contract, one must sell a put option of the same quantity, type, expiration date, and strike price. Similarly, in order to offset a short position in a put option contract, one must buy a put option of the same quantity, type, expiration date, and strike price.

Open

An opening transaction is one that adds to, or creates a new trading position. It can be either a purchase or a sale. With respect to an option transaction, consider both:

• Opening purchase - a transaction in which the purchaser's intention is to create or increase a long position in a given series of options.
• Opening sale - a transaction in which the seller's intention is to create or increase a short position in a given series of options.

Close
A closing transaction is one that reduces or eliminates an existing position by an appropriate offsetting purchase or sale. With respect to an option transaction:

• Closing purchase - a transaction in which the purchaser's intention is to reduce or eliminate a short position in a given series of options. This transaction is frequently referred to as "covering" a short position.
• Closing sale - a transaction in which the seller's intention is to reduce or eliminate a long position in a given series of options.

Note: An investor does not close out a long call position by purchasing a put, or vice versa. A closing transaction for an option involves the purchase or sale of an option con-tract with the same terms, and on any exchange where the option may be traded. An investor intending to close out an option position must do so by the end of trading hours on the option's last trading day.

Just remember, call buyers want the market price of the underlying security to go higher so the option will gain in value and they can make money; and call writer want the market to go sideways or lower so the option will expire worthless and they can make money. Put buyers want the market price of the underlying security to go lower so the option can gain in value and they can make money; and put sellers want the market price to go higher or sideways so the option will expire worthless and they can make money. Also remember, option buyers can choose whether they wish to exercise their options; option sellers cannot.

The strike price or exercise price is simply the price at which the underlying security can be obtained or sold if one were to exercise the option. For a call option, the strike price is the price at which the holder can buy the security from the option writer upon exercising the option. For a put option, the strike price is the price at which the holder can sell the security to the option writer upon exercising the option. These option strike prices are standardized, with the strike increments determined by the asset's price. Newly created contracts can only be issued with strike prices that straddle the current market price of the security; however, at any one time, several different previously existing strike prices trade on the open option market. Which of the standardized strike prices the trader chooses depends upon his or her investment needs and capital outlay. Obviously, depending upon the prevailing underlying market price, the rights to some option strike prices will cost more than others.

Strike prices for futures options contracts are different than those for stock options. Much like options on stock, the trader can choose from any of the standardized futures option strike prices that are issued. However, the strike prices that are set for the futures options are more contract-specific, contingent upon the market price of the underlying contract, how the future is priced, and how it trades. For obvious reasons, the issued strike prices for Treasury bond options will be different than those for soybean options. Because strikes vary depending on the commodity, it is important that traders familiarize themselves with the option contract and the underlying security before they initiate an option position.

The expiration date refers to the length of time through which the option contract and its rights are active. At any time up to and including the expiration date, the holder of an option is entitled to the contract's benefits, which include exercising the option (taking a position in the underlying asset), trading the option (closing one's position in the contract by trading it away to another individual), or letting it expire worthless (if the contract lacks value at expiration). While the trader can choose from any of the listed option expiration months he or she wishes to purchase (or sell), the trader cannot choose the specific date the option will expire. This date is standardized and is determined when the option is listed on the exchange on which it is traded. For most options on equity securities, the final trading day occurs on the third Friday of each month. The actual expiration occurs the following day, the Saturday following the third Friday of the month. The expiration date for futures options is more complicated than that for stock options and depends upon the contract that is being traded. Some futures option contracts expire the Saturday before the third Wednesday of the expiration month while others expire the month before the expiration month. Since an option's expiration date depends upon the type of asset that is traded, it is important for a trader to know the specific date the contract will expire before investing in the option.

The majority of listed options are issued with expiration dates approximately nine months into the future. In addition to these standard options, there are also options that possess a longer life than the nine-month maximum for regular stock options. These are called long-term equity anticipation options, or LEAPS. LEAPS are issued each January with an expiration up to 36 months into the future. LEAPS allow traders to position themselves for market movement that is expected over a longer period of time: weeks, months, even years. They are more expensive than standard options because the added life increases the likelihood that the option will have value at some point prior to expiration. However, LEAPS can be traded only on stocks, indices, and interest rate classes and not every security offers them and currently are available in United States and not in India.

American Style of options

An American style option is the one which can be exercised by the buyer on or before the expiration date, i.e. anytime between the day of purchase of the option and the day of its expiry.

European Style of options

The European kind of option is the one which can be exercised by the buyer on the expiration day only & not anytime before that.

Leverage and Risk

Options can provide leverage. This means an option buyer can pay a relatively small premium for market exposure in relation to the contract value (usually 100 shares of underlying stock). An investor can see large percentage gains from comparatively small, favorable percentage moves in the underlying index. Leverage also has downside implications. If the underlying stock price does not rise or fall as anticipated during the lifetime of the option, leverage can magnify the investment's percentage loss. Options offer their owners a predetermined, set risk. However, if the owner's options expire with no value, this loss can be the entire amount of the premium paid for the option. An uncovered option writer, on the other hand, may face unlimited risk.

In-the-money, At-the-money, Out-of-the-money

An option is said to be 'at-the-money', when the option's strike price is equal to the underlying asset price. This is true for both puts and calls.

A call option is said to be in-the-money when the strike price of the option is less than the underlying asset price. For example, a Sensex call option with strike of 3900 is 'in-the-money', when the spot Sensex is at 4100 as the call option has value.

The call holder has the right to buy a Sensex at 3900, no matter how much the spot market price has risen. And with the current price at 4100, a profit can be made by selling Sensex at this higher price.

On the other hand, a call option is out-of-the-money when the strike price is greater than the underlying asset price. Using the earlier example of Sensex call option, if the Sensex falls to 3700, the call option no longer has positive exercise value. The call holder will not exercise the option to buy Sensex at 3900 when the current price is at 3700. (Please see table)

Striking the price

	Call Option	Put Option
In-the-money	Strike Price less than Spot Price of underlying asset	Strike Price greater than Spot Price of underlying asset
At-the-money	Strike Price equal to Spot Price of underlying asset	Strike Price equal to Spot Price of underlying asset
Out-of-the-money	Strike Price greater than Spot Price of underlying asset	Strike Price less than Spot Price of underlying asset

A put option is in-the-money when the strike price of the option is greater than the spot price of the underlying asset. For example, a Sensex put at strike of 4400 is in-the-money when the Sensex is at 4100. When this is the case, the put option has value because the put holder can sell the Sensex at 4400, an amount greater than the current Sensex of 4100.

Likewise, a put option is out-of-the-money when the strike price is less than the spot price of underlying asset. In the above example, the buyer of Sensex put option won't exercise the option when the spot is at 4800. The put no longer has positive exercise value.

Options are said to be deep in-the-money (or deep out-of-the-money) if the exercise price is at significant variance with the underlying asset price.

The amount by which an option, call or put, is in-the-money at any given moment is called its intrinsic value. Thus, by definition, an at-the-money or out-of-the-money option has no intrinsic value; the time value is the total option premium. This does not mean, however, these options can be obtained at no cost. Any amount by which an option's total premium exceeds intrinsic value is called the time value portion of the premium.

It is the time value portion of an option's premium that is affected by fluctuations in volatility, interest rates, dividend amounts and the passage of time. There are other factors that give options value, therefore affecting the premium at which they are traded. Together, all of these factors determine time value.

Option Premium = Intrinsic Value + Time Value

FACTORS THAT AFFECT THE VALUE OF AN OPTION PREMIUM

There are two types of factors that affect the value of the option premium:

Quantifiable Factors:

• Underlying stock price,
• The strike price of the option,
• The volatility of the underlying stock,
• The time to expiration and;
• The risk free interest rate.

Non-Quantifiable Factors:

• Market participants' varying estimates of the underlying asset's future volatility
• Individuals' varying estimates of future performance of the underlying asset, based on fundamental or technical analysis
• The effect of supply & demand- both in the options marketplace and in the market for the underlying asset
• The "depth" of the market for that option - the number of transactions and the contract's trading volume on any given day.

Different pricing models for options

The theoretical option pricing models are used by option traders for calculating the fair value of an option on the basis of the earlier mentioned influencing factors. An option pricing model assists the trader in keeping the prices of calls & puts in proper numerical relationship to each other & helping the trader make bids & offer quickly. The two most popular option pricing models are:

• Black Scholes Model which assumes that percentage change in the price of underlying follows a normal distribution.
• Binomial Model which assumes that percentage change in price of the underlying follows a binomial distribution.

Options Premium is not fixed by the Exchange. The fair value/ theoretical price of an option can be known with the help of pricing models and then depending on market conditions the price is determined by competitive bids and offers in the trading environment.

An option's premium / price is the sum of Intrinsic value and time value (explained above). If the price of the underlying stock is held constant, the intrinsic value portion of an option premium will remain constant as well. Therefore, any change in the price of the option will be entirely due to a change in the option's time value.

The time value component of the option premium can change in response to a change in the volatility of the underlying, the time to expiry, interest rate fluctuations, dividend payments and to the immediate effect of supply and demand for both the underlying and its option.

Covered and Naked Calls

A call option position that is covered by an opposite position in the underlying instrument (for example shares, commodities etc), is called a covered call. Writing covered calls involves writing call options when the shares that might have to be delivered (if option holder exercises his right to buy), are already owned.

For example, a writer writes a call on Reliance and at the same time holds shares of Reliance so that if the call is exercised by the buyer, he can deliver the stock.

Covered calls are far less risky than naked calls (where there is no opposite position in the underlying), since the worst that can happen is that the investor is required to sell shares already owned at below their market value.

When a physical delivery uncovered/ naked call is assigned an exercise, the writer will have to purchase the underlying asset to meet his call obligation and his loss will be the excess of the purchase price over the exercise price of the call reduced by the premium received for writing the call.

Intrinsic Value of an option

The intrinsic value of an option is defined as the amount by which an option is in-the-money, or the immediate exercise value of the option when the underlying position is marked-to-market.

For a call option: Intrinsic Value = Spot Price - Strike Price

For a put option: Intrinsic Value = Strike Price - Spot Price

The intrinsic value of an option must be a positive number or 0. It cannot be negative. For a call option, the strike price must be less than the price of the underlying asset for the call to have an intrinsic value greater than 0. For a put option, the strike price must be greater than the underlying asset price for it to have intrinsic value.

Time Decay

Generally, the longer the time remaining until an option's expiration, the higher its premium will be. This is because the longer an option's lifetime, greater is the possibility that the underlying share price might move so as to make the option in-the-money. All other factors affecting an option's price remaining the same, the time value portion of an option's premium will decrease (or decay) with the passage of time.

Note: This time decay increases rapidly in the last several weeks of an option's life. When an option expires in-the-money, it is generally worth only its intrinsic value.

Expiration Day

The expiration date is the last day an option exists. For list-ed stock options, this is the Saturday following the third Friday of the expiration month. Please note that this is the deadline by which brokerage firms must submit exercise notices to Stock Exchange Clearing; however, the exchanges and brokerage firms have rules and procedures regarding deadlines for an option holder to notify his brokerage firm of his intention to exercise. This deadline, or expiration cut-off time, is generally on the third Friday of the month, before expiration Saturday, at some time after the close of the market. Please contact your brokerage firm for specific deadlines. The last day expiring equity options generally trade is also on the third Friday of the month, before expiration Saturday. If that Friday is an exchange holiday, the last trading day will be one day earlier, Thursday.

Exercise

If the holder of an American-style option decides to exercise his right to buy (in the case of a call) or to sell (in the case of a put) the underlying shares of stock, the holder must direct his brokerage firm to submit an exercise notice to Stock Exchange Clearing. In order to ensure that an option is exercised on a particular day other than expiration, the holder must notify his broker-age firm before its exercise cut-off time for accepting exercise instructions on that day.

Note: Various firms may have their own cut-off times for accepting exercise instructions from customers. These cut-off times may be specific for different classes of options and different from Stock Exchange Clearing's requirements. Cut-off times for exercise at expiration and for exercise at an earlier date may differ as well.

Once Stock Exchange Clearing has been notified that an option holder wishes to exercise an option, it will assign the exercise notice to a Clearing Member - for an investor, this is generally his brokerage firm - with a customer who has written (and not covered) an option contract with the same terms. Stock Exchange Clearing will choose the firm to notify at random from the total pool of such firms. When an exercise is assigned to a firm, the firm must then assign one of its customers who has written (and not covered) that particular option. Assignment to a customer will be made either randomly or on a "first-in first-out" basis, depending on the method used by that firm. You can find out from your brokerage firm which method it uses for assignments.

Assignment

The holder of a long American-style option contract can exercise the option at any time until the option expires. It follows that an option writer may be assigned an exercise notice on a short option position at any time until that option expires. If an option writer is short an option that expires in-the-money, assignment on that contract should be expected, call or put. In fact, some option writers are assigned on such short contracts when they expire exactly at-the-money. This occurrence is generally not predictable.

To avoid assignment on a written option contract on a given day, the position must be closed out before that day's market close. Once assignment has been received, an investor has absolutely no alternative but to fulfill his obligations from the assignment per the terms of the contract. An option writer cannot designate a day when assignments are preferable. There is generally no exercise or assignment activity on options that expire out-of-the-money. Owners generally let them expire with no value.

What's the Net?

When an investor exercises a call option, the net price paid for the underlying stock on a per share basis will be the sum of the call's strike price plus the premium paid for the call. Likewise, when an investor who has written a call contract is assigned an exercise notice on that call, the net price received on a per share basis will be the sum of the call's strike price plus the premium received from the call's initial sale.

When an investor exercises a put option, the net price received for the underlying stock on per share basis will be the sum of the put's strike price less the premium paid for the put. Likewise, when an investor who has written a put contract is assigned an exercise notice on that put, the net price paid for the underlying stock on per share basis will be the sum of the put's strike price less the premium received from the put's initial sale.

Early Exercise / Assignment

For call contracts, owners might exercise early so that they can take possession of the underlying stock in order to receive a dividend. Check with your brokerage firm and/or tax advisor on the advisability of such an early call exercise. It is therefore extremely important to realize that assignment of exercise notices can occur early - days or weeks in advance of expiration day. As expiration nears, with a call considerably in-the-money and a sizeable dividend payment approaching, this can be expected. Call writers should be aware of dividend dates, and the possibility of an early assignment.

When puts become deep in-the-money, most professional option traders will exercise them before expiration. Therefore, investors with short positions in deep in-the-money puts should be prepared for the possibility of early assignment on these contracts.

Volatility

Volatility is the tendency of the underlying security's market price to fluctuate either up or down. It reflects a price change's magnitude; it does not imply a bias toward price movement in one direction or the other. Thus, it is a major factor in determining an option's premium. The higher the volatility of the underlying stock, the higher the premium because there is a greater possibility that the option will move in-the-money. Generally, as the volatility of an under-lying stock increases, the premiums of both calls and puts overlying that stock increase, and vice versa.

OPTION GREEKS-DELTA, GAMMA, VEGA, THETA, RHO

The price of an Option depends on certain factors like price and volatility of the underlying, time to expiry etc. The Option Greeks are the tools that measure the sensitivity of the option price to the above-mentioned factors. They are often used by professional traders for trading and managing the risk of large positions in options and stocks. These Option Greeks are:

• Delta: is the option Greek that measures the estimated change in option premium/price for a change in the price of the underlying.
• Gamma: measures the estimated change in the Delta of an option for a change in the price of the underlying
• Vega: measures estimated change in the option price for a change in the volatility of the underlying.
• Theta: measures the estimated change in the option price for a change in the time to option expiry.
• Rho: measures the estimated change in the option price for a change in the risk free interest rates.

How the greeks help in hedging?

Spreading is a risk-management strategy that employs options as the hedging instrument, rather than stock. Like stock, options have directional risk (deltas). Unlike stock, options carry gamma, vega, and theta risks as well. Therefore, if a position involves any combination of gamma, vega, and/or theta risk, this can be reduced or eliminated by adding one or more options positions. Table 8-4 summarizes the possible hedges and their gamma, vega and theta impact for each of the six building blocks.

Notice that owning option contracts be they puts or calls, means that you are adding positive gamma, positive vega, and negative theta. Being short either of these contracts means acquiring negative gamma, negative vega, and positive theta. This statement points out that as far as these Greeks are concerned, you get a package deal.

By owning options, your position responds favorably to stock-price movement (the position gets longer as the stock price increases and gets shorter as the stock price decreases). The position responds positively to increases in implied volatility (and negatively to decreases in implied volatility) and will lose value over time. By being short options, your position responds adversely to stock-price movement (the position gets shorter as the stock price increases and gets longer as the stock price decreases). The position also responds negatively to increases in implied volatility (and positively to decreases in implied volatility) and will gain value over time as the time premium of the short option decays. POSSIBLE HEDGING STRATEGIES WITH THE GREEKS

BENEFITS OF OPTIONS TRADING

Besides offering flexibility to the buyer in form of right to buy or sell, the major advantage of options is their versatility. They can be as conservative or as speculative as one's investment strategy dictates.

Some of the benefits of Options are as under:

• High leverage as by investing small amount of capital (in form of premium), one can take exposure in the underlying asset of much greater value.
• Pre-known maximum risk for an option buyer
• Large profit potential and limited risk for option buyer
• One can protect his equity portfolio from a decline in the market by way of buying a protective put wherein one buys puts against an existing stock position.

This option position can supply the insurance needed to overcome the uncertainty of the marketplace. Hence, by paying a relatively small premium (compared to the market value of the stock), an investor knows that no matter how far the stock drops, it can be sold at the strike price of the Put anytime until the Put expires.

E.g. An investor holding 1 share of Infosys at a market price of Rs 3800/-thinks that the stock is over-valued and decides to buy a Put option' at a strike price of Rs. 3800/- by paying a premium of Rs 200/-

If the market price of Infosys comes down to Rs 3000/-, he can still sell it at Rs 3800/- by exercising his put option. Thus, by paying premium of Rs 200,his position is insured in the underlying stock. How can you use options for short-term trading?

If you anticipate a certain directional movement in the price of a stock, the right to buy or sell that stock at a predetermined price, for a specific duration of time can offer an attractive investment opportunity. The decision as to what type of option to buy is dependent on whether your outlook for the respective security is positive (bullish) or negative (bearish).

If your outlook is positive, buying a call option creates the opportunity to share in the upside potential of a stock without having to risk more than a fraction of its market value (premium paid). Conversely, if you anticipate downward movement, buying a put option will enable you to protect against downside risk without limiting profit potential.

Purchasing options offer you the ability to position yourself accordingly with your market expectations in a manner such that you can both profit and protect with limited risk.

Risks of an options buyer

The risk/ loss of an option buyer is limited to the premium that he has paid.

Risks for an Option writer

The risk of an Options Writer is unlimited where his gains are limited to the Premiums earned. When a physical delivery uncovered call is exercised upon, the writer will have to purchase the underlying asset and his loss will be the excess of the purchase price over the exercise price of the call reduced by the premium received for writing the call.

The writer of a put option bears a risk of loss if the value of the underlying asset declines below the exercise price. The writer of a put bears the risk of a decline in the price of the underlying asset potentially to zero.

Option writing is a specialized job which is suitable only for the knowledgeable investor who understands the risks, has the financial capacity and has sufficient liquid assets to meet applicable margin requirements. The risk of being an option writer may be reduced by the purchase of other options on the same underlying asset thereby assuming a spread position or by acquiring other types of hedging positions in the options/ futures and other correlated markets. In the Indian Derivatives market, SEBI has not created any particular category of options writers. Any market participant can write options. However, margin requirements are stringent for options writers.

STOCK INDEX OPTIONS

The Stock Index Options are options where the underlying asset is a Stock Index for e.g. Options on NSE Nifty Index / Options on BSE Sensex etc.

Index Options were first introduced by Chicago Board of Options Exchange in 1983 on its Index 'S&P 100'. As opposed to options on Individual stocks, index options give an investor the right to buy or sell the value of an index which represents group of stocks.

Uses of Index Options

Index options enable investors to gain exposure to a broad market, with one trading decision and frequently with one transaction. To obtain the same level of diversification using individual stocks or individual equity options, numerous decisions and trades would be necessary. Since, broad exposure can be gained with one trade, transaction cost is also reduced by using Index Options. As a percentage of the underlying value, premiums of index options are usually lower than those of equity options as equity options are more volatile than the Index.

Index Options are effective enough to appeal to a broad spectrum of users, from conservative investors to more aggressive stock market traders. Individual investors might wish to capitalize on market opinions (bullish, bearish or neutral) by acting on their views of the broad market or one of its many sectors. The more sophisticated market professionals might find the variety of index option contracts excellent tools for enhancing market timing decisions and adjusting asset mixes for asset allocation. To a market professional, managing risks associated with large equity positions may mean using index options to either reduce risk or increase market exposure.

Options on individual stocks

Options contracts where the underlying asset is an equity stock are termed as Options on stocks. They are mostly American style options cash settled or settled by physical delivery. Prices are normally quoted in terms of the premium per share, although each contract is invariably for a larger number of shares, e.g. 100.

Benefits of options in specific stocks to an investor

• Options can offer an investor the flexibility one needs for countless investment situations. An investor can create hedging position or an entirely speculative one, through various strategies that reflect his tolerance for risk.
• Investors of equity stock options will enjoy more leverage than their counterparts who invest in the underlying stock market itself in form of greater exposure by paying a small amount as premium.
• Investors can also use options in specific stocks to hedge their holding positions in the underlying (i.e. long in the stock itself), by buying a Protective Put. Thus they will insure their portfolio of equity stocks by paying premium.
• ESOPs (Employees' stock options) have become a popular compensation tool with more and more companies offering the same to their employees. ESOPs are subject to lock in periods, which could reduce capital gains in falling markets - Derivatives can help arrest that loss along with tax savings. An ESOPs holder can buy Put Option in the underlying stock & exercise the same if the market falls below the strike price & lock in his sale prices.

The equity options traded on exchange are not issued by the companies underlying them. Companies do not have any say in selection of underlying equity for options. Holder of the equity options contracts do not have any of the rights that owners of equity shares have - such as voting rights and the right to receive bonus, dividend etc. To obtain these rights a Call option holder must exercise his contract and take delivery of the underlying equity shares.

Leaps - Long Term Equity Anticipation Securities (Currently not available in India)

Long-term equity anticipation securities (Leaps) are long-dated put and call options on common stocks or ADRs. These long-term options provide the holder the right to purchase, in case of a call, or sell, in case of a put, a specified number of stock shares at a pre-determined price up to the expiration date of the option, which can be three years in the future.

Exotic Options (Currently not available in India)

Derivatives with more complicated payoffs than the standard European or American calls and puts are referred to as Exotic Options. Some of the examples of exotic options are as under:

Barrier Options: where the payoff depends on whether the underlying asset's price reaches a certain level during a certain period of time.

CAPS traded on CBOE (traded on the S&P 100 & S&P 500) are examples of Barrier Options where the payout is capped so that it cannot exceed $30.

A Call CAP is automatically exercised on a day when the index closes more than $30 above the strike price. A put CAP is automatically exercised on a day when the index closes more than $30 below the cap level.

Binary Options: are options with discontinuous payoffs. A simple example would be an option which pays off if price of an Infosys share ends up above the strike price of say Rs. 4000 & pays off nothing if it ends up below the strike.

Over-The-Counter Options: are options are those dealt directly between counter-parties and are completely flexible and customized. There is some standardization for ease of trading in the busiest markets, but the precise details of each transaction are freely negotiable between buyer and seller.

Contract specifications of BSE Sensex Options

BSE's first index options is based on BSE 30 Sensex. The Sensex options would be European style of options i.e. the options would be exercised only on the day of expiry. They will be premium style i.e. the buyer of the option will pay premium to the options writer in cash at the time of entering into the contract. The underlying for the index options is the BSE 30 Sensex, which is the benchmark index of Indian Capital markets, comprising 30 scrips.

Like stocks, options and futures contracts are also traded on any exchange. In Bombay Stock Exchange, stocks are traded on BSE On Line Trading (BOLT) system and options and futures are traded on Derivatives Trading and Settlement System (DTSS).

The Premium and Options Settlement Value (difference between Strike and Spot price at the time of expiry), will be quoted in Sensex points The contract multiplier for Sensex options is INR 50 which means that monetary value of the Premium and Settlement value will be calculated by multiplying the Sensex Points by 50.

For e.g. if Premium quoted for a Sensex options is 50 Sensex points, its monetary value would be Rs. 2500 (50*50).

There will be at-least 5 strikes (2 In the Money, 1 Near the money, 2 Out of the money), available at any point of time. The expiration day for Sensex option is the last Thursday of Contract month. If it is a holiday, the immediately preceding business day will be the expiration day.

There will be three contract month series (Near, middle and far) available for trading at any point of time. The settlement value will be the closing value of the Sensex on the expiry day. The tick size for Sensex option is 0.1 Sensex points (INR 5). This means the minimum price fluctuation in the value of the option premium can be 0.1.In Rupee terms this translates to minimum price fluctuation of Rs 5. (Tick Size * Multiplier =0.1* 50).

OPTIONS WITH OPTIONS

As we briefly touched upon earlier, an option contract holder is bestowed with three choices - exercise the option, let the option expire, or trade the option. But how does a trader decide which of the three alternatives to choose? A large portion of this decision is contingent upon the value of the option contract (or lack thereof) as well as the amount of time remaining before the option expires. When an option lacks value, meaning it is out-of-the-money, the trader can simply let the option expire worthless. When an option has value, meaning it is in-the-money, the trader can choose whether to trade the contract to another individual or exercise the contract and obtain the underlying asset. The ultimate decision that is made depends upon the individual investor, his or her trading style, his or her trading needs, and the situation at hand.

Exercise the Option

As we just mentioned, one will only exercise a long option contract when one stands to make money from that position, otherwise one could simply let the option expire and lose the premium.* When an option buyer exercises an option, he or she is choosing to take a position in the underlying instrument. Naturally, the position is determined by the option type and whether it is a call or a put. In exercising a stock or futures call option, the holder agrees to purchase standardized quantity of the underlying asset from the option writer at the predetermined strike price. Because of their contract, the writer is obligated to sell the asset to the buyer at the strike price, regardless of the price at which the market is currently trading. This transaction gives the buyer a long position in the asset and gives the writer a short position in the asset.#

Option is a contract which has a market value like any other tradable commodity. Once an option is bought there are following alternatives that an option holder has:

• You can sell an option of the same series as the one you had bought and close out /square off your position in that option at any time on or before the expiration.
• You can exercise the option on the expiration day in case of European Option or; on or before the expiration day in case of an American option. In case the option is 'Out of Money' at the time of expiry, it will expire worthless.

#Please note that while options provide the right to acquire the underlying instrument, the owner must still produce the necessary funds for the asset itself.

In exercising a stock or futures put option, the option holder agrees to sell the standardized quantity of the underlying asset to the option writer at the predetermined strike price. Because of their contract, the writer must purchase the asset from the option holder at the strike price, regardless of the price at which the market is currently trading. This transaction gives the buyer a short position in the asset and gives the seller long position in the asset.

Exercising an index option, be it a call or a put, is handled differently because index options are settled in cash as opposed to the physical asset. When a call option buyer or put option buyer exercises an index option, the holder is simply credited to the amount by which the option is in-the-money, less any commission that applies. On the other hand, the call option writer or the put option writer is debited the amount by which the option is in-the-money, plus any commission that applies. For obvious reasons, an index option holder would choose to exercise his or her position only if it were profitable to do so, meaning the contract were in-the-money.

The majority of index options today are European-style options, meaning that exercise can only occur at the end of the contract's life. However, the most widely traded index option, the NSE Nifty option which covers the Nifty 30, is an American-style contract, meaning exercise can occur at any point during the life of the option.

On the whole, most traders choose not to exercise an option prior to expiration. Doing so only entitles the investor to the intrinsic value of the option and sacrifices the added effect of time value. Exercising one's option before the expiration date is not common when it comes to futures. Unless the option is deep in-the-money, where time value has a much lower impact, it generally makes more sense to trade out of the position. Exercising before the expiration date does occur more frequently when it comes to equity call options. Because option holders are not entitled to cash dividends, call options are usually exercised right before a stock goes ex-dividend so no contract value will be lost.

Defining the profit

In each of these cases, exercise will only occur when it is profitable to do so - when the option is in-the-money. However, any time an individual exercises an option, that individual loses the full cost of the premium. Because of this, any gains on the trade will be offset by the losses on the cost of the option. One does not really make a profit on the transaction until the premium is recovered. Therefore, there is a break-even-point that occurs with options that are exercised.

With call options, the break-even-point occurs when the underlying asset has increased in price to a point where the intrinsic value is equal to the initial cost of the option - in other words, the strike price of the option plus the call premium. Any price above this break-even-point would produce a profit on the transaction, if exercised, and any price below this break-even-point would produce a loss on the transaction, if exercised.

With put options, the break-even-point occurs when the underlying asset has decreased in price to a point where the intrinsic value is equal to the initial cost of the option - in other words, the strike price of the option minus the put premium. Any price below this break-even-point would produce a profit on the transaction, if exercised, and any price above this break-even-point would produce a loss on the transaction, if exercised. Because the trader must lose money in order to lock-in profits, some people choose to forego the exercising of their options and instead turn to the second option alternative.

Trade the Option

The second choice the holder of an option can make is to trade out of the option position before the option expires. Trading one's option is exactly the same as trading any other asset. To close out a position, one must perform the opposite side of the trade in the same asset. To offset a long position, be it a call or a put, the holder must sell an option of the same type, expiration month, and strike price. To offset a short position, be it a call or a put, holder must buy an option of the same type, expiration month, and strike price.

When one initiates a long option trade, the premium that is paid for the option is the entry price and when one liquidates a long option trade, the premium that is received for the option is the exit price. Obviously, if the exit price is greater than the entry price, the holder will profit on the trade. When one initiates a short option trade, the premium that is received for the option is the entry price and the premium that is paid for the option is closing price. In this case, if the exit price is less than the entry price, the writer will profit on the trade.

Trading versus exercising

There is a common misconception that the most profitable way to make money with options is by exercising the contract when it is in-the-money, when in reality, trading out of one's option can be far more lucrative. There are three reasons why this is so. The primary reason is that exercising an option can only provide the investor with the intrinsic value of the trade, while trading an option position can entitle the investor to the intrinsic value as well as additional time value. How much more the time value will provide is determined by the factors we mentioned earlier, such as time to expiration, volatility, dividend rates, and interest rates. A second reason is that trading one's position does not force the option buyer to incur the full cost of the premium, which is what occurs when one exercises an option. Since the gains from trading an option are not used to cover the cost of the premium, there is no break-even-point, there is simply the entry price and the exit price. Finally, by trading out of one's option(s), the trader saves on commission costs. This is particularly helpful when a trader has a large option position.

With the tremendous growth that will occur in the option markets over the years, it should come as no surprise that options provide an excellent trading opportunity. As you have probably been able to gather thus far, buying options responsibly can provide a greater level of security to traders, allowing them to rest easy during the day and sleep better at night. Options give traders more time to think about their positions without worrying about how much they could potentially lose. As one family friend puts it, buying options enables the trader to leave the computer screen and hit golf balls. If traders were to take positions in the actual security, or sell options, they must closely monitor their positions and only watch others hit golf balls on ESPN.

Let the Option Expire

A final alternative available to the option holder is to let the option expire. Simply put, the trader can do nothing with the option and lose only what he or she paid in premium. Naturally, an option buyer will only let the contract expire if it lacks value at expiration, meaning it is out-of-the-money. Once the expiration occurs, the option buyer no longer controls the underlying asset and loses all rights conveyed by the contract. Doing nothing is a luxury that is afforded only to option traders. This eliminates the necessity of offsetting a losing position, thereby serving as an inherent stop loss on the trade. Trading any other type of asset obligates the investor to eventually offset the position, regardless of whether it is profitable to do so.

In comparison, by trading out of the option position the option holder was able to realize a greater profit on the trade. This is usually the case with options. However, the closer to expiration on the option gets, the less a trader will be able to retrieve in premium by trading out of his or her position. It is important that a trader compare the two processes before making a decision as to what to do with the option position.

Copyright 2001 by Hiten Jhaveri, StockWhizo Investments. All rights reserved worldwide.

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