Basic of Pay-Off@ Option

8/8/2019 Basic of Pay-Off@ Option

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Understanding Call Options

Understanding call options is not difficult. The difficulty comes when its time to learn how toprice break-even points on transactions in conjunction with timing of expirations. The

calculations get even more complicated when hedging calls and puts in order to maximize profitand reduce potential losses.

A call option is a right given to a buyer and that is the right to purchase an underlying asset likestocks or commodity futures contracts. When you look at a financial table that lists call optionsyou will discover multiple options with a variety of strike prices. The number of options reflectsthe fact that the market never sleeps and prices of underlying instruments will regularly change.

It is not just strike prices that can vary either. The expiration dates will also vary. LEAPS optionsare considered to be long term and expiration dates can be up to 3 years in the future. But manycall options have expiration dates stated in months.

Buying Call Options

When buying call options, you are said to go long, meaning you hope to buy an underlyinginstrument at a profitable price compared to the strike price. You have until the option expirationdate to exercise the option. What you pay for the option is called a premium and the premiumgoes to the option seller.

The long call can be profitable when the option is in the money. This means the strike price ofthe underlying asset is less than the market price. For example, a stock option strike price is $25and the market stock price rises to $28. The $3 is potential profit after including the premium and

transaction fees in the net profit calculation.

When the market price is higher than the strike price, you have several options. You can exercisethe call option and take ownership of the underlying asset whether its stock or a futures contract.After exercising the long call, you now own an asset you can resell in the marketplace at thehigher market price. Since the market price is higher than what you paid for the underlying assetafter exercising the long call, you now have made a profit.

Another option you have when the option is in the money is to sell a call for the same underlyingasset with the same strike price and the same expiration date. The call option you sell will have ahigher premium value. You can continue to do this as long as the market prices are rising. Its

easy to see how profitable call options can be in a bull market.

Selling Call Options

If you sell call options, it means you are selling a right to buy an underlying asset at a specificstrike price and by a specified exercise date. If the option expires, you earn the premium paid bythe buyer. If the buyer exercises the right, then you are obligated to sell the underlying asset.


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Unfortunately, the only reason a buyer would exercise the option is because the market price ofthe underlying asset is higher than the strike price

Selling a call option is called going short. When the market price of an asset rises above a strikeprice, the option will be matched with an option buyer. The buyer is going to exercise the option

under these conditions. If the seller does not own the underlying asset, he or she will have to gointo the marketplace and pay the higher price to gain possession of the asset to sell to the buyer.

That is why they say there is theoretically unlimited loss risk when you go short. A coveredoption is one where the seller owns the underlying asset supporting the option contract. This canlimit the amount of risk depending on what the market price is doing.

Call options offer much potential as profit makers as long as you understand how thetransactions work. It is important to first learn the terms and market operations before trading.Its simple advice that can earn you a lot of money while also limiting your risk of loss.

The Call OptionGetting StartedA call option is a particular type of option trade. When you read about options trading, the firsttwo terms you learn are often call and put. These are like the yin and yang of options investing.A call lets you speculate that underlying asset prices are going to go up. The put lets you bet thatthe prices of underlying assets are going to fall.

Many options traders begin their trading career in this type of investment by purchasing calloptions. A call option gives you the right, but not the obligation, to buy or sell an underlyingfutures contract or stock at a future date for a specified price. You go long when you have the

right to purchase. You go short when you have an obligation to sell.

When a call option is exercised, the seller of the option must give up control of the stock orfutures contract. If the call option is allowed to expire, the seller gets control of the underlyingasset back. So you can see that a call option is an actual contract between a buyer and seller andthere are specific terms in the contract.

Two of the key words in the definition of a call option are right and obligation. The calloption gives you a right to exercise the option, but you are under no obligation to do so. On theother hand, the seller has an obligation to sell you the underlying asset if you decide to exerciseyour right.

The Goal

The goal of an investor buying a call option is to make money on rising asset market prices. Thehope is that the price of the asset will rise and the option price will enable the buyer to purchasethe asset below market price. If the market price never reaches the strike price, then the optioncan simply expire. The buyer loses the premium and the transactions costs but that is all.


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That is another reason why beginning investors choose call options at first. The upside profitpotential is virtually unlimited. Of course, the strike price and the timing of the contract willdetermine if the call option buyer is successful.

Naturally the seller hopes that the option stays out of the money. In that case the seller gets to

keep the underlying asset plus the premium and fees paid by the seller.

Call options can be purchased for stocks, bonds, agricultural commodities, precious metals,interest rates and many others. Once the call option is in place, the seller cannot sell theunderlying asset included in the option terms to anyone else.

Watching the Market

Investors learning how to complete successful call option transactions can watch the market for aperiod of time and witness how the big investors perform. When the market indicates largevolumes of call options during the day for a particular asset then you can probably assume the

investors expect the price to rise in the near future. The charts indicate expiration dates so youcan even see how soon the investors expect the prices to rise.

Call options naturally play a role in options strategies. For example, call options are used in longand short straddles. A straddle is a trading strategy that is a spread. For example, a long straddlebalances a call option and a put option in a way that minimizes risk of loss while maximizingspeculation.

Preparing for Trading Options

People interested in trading options may be talking about trading stock options or trading optionson futures contracts. But the concepts underlying these types of financial trades are the same. Anoption is simply a right, but not an obligation, to buy or sell some sort of financial product. Thefinancial product may be a stock or it may be a contract that has an underlying asset that is beingbought and sold in the marketplace. The future contract itself is an obligation that is placed onthe buyer and the seller like any other contract, but when trading options on futures contracts youare talking about the buying and selling of the futures contract and not the commodity.

When comparing stock options to options on futures contracts, there are some similarities andthere are some differences. A stock option represents a contract to buy 100 shares of stock thatserves as the underlying instrument. An option on a futures contract represents one futures

contract that also gets its value from the price of the underlying instrument which are non-equityassets like commodities.

Options for both stocks and futures contracts must outline the specifics of the transaction whichincludes naming the underlying commodity or equity, delivery and price among others. Bothtypes of options also have calls and puts which indicate the equivalent of bets on whether theprice of the underlying asset will rise or fall. A call option means you expect the price to go up.A put option means you expect the price to go down.


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Both types of options also have a premium attached. The futures contract itself does not have apremium, but the options on the futures contract does. The term premium refers to an amount abuyer pays a seller for gaining the privilege of not having to buy the underlying asset in the eventthe price movements are not beneficial to the buyer. It is the most a buyer can lose on a contractno matter what the price of the asset does in the marketplace because the buyer can choose to not

exercise the right on a losing transaction.

Learning About Volatility

The amount of volatility in options refers to price action. Volatility addresses the propensity ofthe price of the underlying security to go up or down in the marketplace. In a nutshell, there is arelationship between the market conditions that affect the volatility of an asset and the volatilityof the option itself but that relationship may not be an exact correlation.

Estimating the possible price swings over the life of an option is one of the most complexcalculations in options trading. There is software available that can simplify the process, but

investors need to understand the concept of volatility. The desirability of volatility depends onyour option position. For example, if you are long in the option then volatility is a benefit forboth put and call options.

The more volatility there is in the marketplace, the more likely the option will be in the money.That is why more volatility leads to higher premiums.

Two measures used to determine the relationship between the price of the option and the price ofthe underlying asset are delta and theta. The terms are called Greeks.

Delta a formula to measure the relationship between a change in an options price and a

change in the price of the underlying asset of the futures contract. Delta represents thepercentage rate of change between prices. Values can range from -100 to 0 of talkingabout put options. Delta values range from 0 to 100 if talking about calls. Sometimes thedelta ranges are expressed in decimal form.

Theta a formula that measures time decay. Time decay is the rate of change in the timepremium. The time premium is the value to the option price due to the remaining timebefore contract expiration. Theta values increase from zero. The higher the Thetameasure the more volatility exists due to time decay.

There are many option pricing models including the Black-Scholes and Cox-Ross-Rubinsteinmodels. You dont have to complete the calculations yourself but you do need to understand the

potential impact of volatility in the buying of stock options and options on futures contracts.

Factors that Affect Options Value

The following factors affect the value of an option:

Spot price of the underlying asset


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Strike price of the option Time to the expiration date of the option Risk-free interest rate Volatility of the underlying asset Option Pricing Model

The following option pricing models are often used to evaluate the fair value of the options:

The Binomial model The black & Scholes model

Option Valuation

The competitive bids and offers in the marketplace affect the option premium. The price of anoption is a function of supply and demand. Stronger demand will drive the option price up.

An option premium is made up of two separate components:

Intrinsic value: Intrinsic value of an option is based on the difference between itsexercise price and the current price of the underlying asset. Intrinsic value is part of thepremium which could be realized if the option were exercised. A put option has anintrinsic value only if the asset price is above the exercise price. A put option has anintrinsic value only if the asset price is below the exercise price.

Time value: Time value represents the value placed on the possibility that the option maybecome profitable to exercise at some time before the expiry date. The entire premium ofat-the-money options and out-of-the-money options represent time value. In-the-money

options have time value in addition to intrinsic value. Time value declines over time as anoption nears expiry. Expired option has zero time value. Hence the longer the time untilthe expiration date, the higher an options time value premium.

Factors that Affect the Value of an Option

The following factors affect the time value of an option:

Price of the Underlying Asset

The price of the underlying asset is the most important factor in determining the option premium.

Exercise Price of the Option

The premium for an option which is deeply out-of-the-money will be less than an option which isslightly out-of-the-money.

Time to Expiry


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All other thing beings equal, the greater the time to the expiry date, the higher the time value ofthe option. Expired option has zero time value.

Market Volatility

The volatility of the underlying asset plays an important role in the valuation of an option. Ingeneral, the more volatile the market, the higher will be the premiums for option in that market.

Interest Rates

If there is a high cost of holding the asset due to high interest rates, there will be more demandfor call options on that asset. This is because the purchase of an call option involves a far smallercash outlay than buying the asset outright.

Cash Dividends

Any monetary return earned by holding the underlying asset will have effect on the price of anoption. For example, dividends of an equity stock.

Key Elements of an Option

There are five key elements of an exchange-traded option contract:

1. Types of Options

An option can be a call option or a put option.

A call option gives the option buyer the right to buy a specified asset at a specified price at orbefore a specified date. The option seller is obliged to sell the underlying asset to the optionbuyer if the buyer decides to exercise this right.

A put option gives the option buyer the right to sell a specified asset at a specified price at orbefore a specified date. The option seller is obliged to buy the underlying asset to the optionbuyer if the buyer decides to exercise this right.

2. Underlying Asset of an Option

An underlying asset of an option contract can be

an asset (such as s specific stock) or an index or a particular futures contract or a debt instrument or a foreign currency or a commodity (such as gold)


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3. Strike Price or Exercise Price of an Option

The strike price is also called the exercise price. It is the agreed price at which the underlyingasset will be traded if the option is exercised.

A call option is in-the-money if the price of the underlying asset is higher than the strike priceA call option is out-of-the-money if the price of the underlying asset is lower than the strikeprice

A put option is in-the-money if the price of the underlying asset is lower than the strike priceA put option is out-of-the-money if the price of the underlying asset is higher than the strikeprice

4. Expiry Date and Exercise Style of an Option

The expiry date of an option is also known as maturity date or exercise date or the declaration of

an option. It is the last day on which the option may be exercised.

An option can either be:

American style: Option can be exercised by the buyer at any time from the date of purchase upuntil (and including) expiry date.

European style: Option can be exercised by the buyer only on the specified expiry date.

5. Option Premium

Option premium is the cost or price of the option. It is the amount paid by the buyer of an optionto the seller of an option.

Types of Options

Options have been there for more than a century. Options on equity stocks were available on theLondon Stock Exchange more than a century ago. Chicago Board Options Exchange (CBOE)was the first formalized options market that offered exchange-traded options on US listed equitystocks. It was established in 1973. Since then, several stock exchanges, such as Australia StockExchange, emulated the CBOE market and offered exchange-traded options market on equity

stocks. There exists a great diversity of exchange-traded options markets on equities, currencies,debt instruments, stock index instruments.

There are two types of options:

Exchange-traded options Over-the-counter options


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The differences between these two types of options are listed in the table below:

Exchange-traded options (ET

options)

Over-the-counter options (OTC Options)

Options that are originated and tradedon a formalized exchanged

OTC options are not traded at a centralizedmarket place or through a formalized tradingsystem.

Most commonly traded ET options areequity options and futures options

OTC markets exist in commodities, equities,stock indices, debt instruments and foreignexchange.

ET transactions are settled through aclearing house, associated with theexchange.

There is no clearing house.

ET options are floor traded on a

physical floor or traded on a screen-based trading system.

OTC options are traded through face-to-face

meetings or over the telephone.

ET options are highly standardized asto the type and maturity of theunderlying instrument.

OTC options are tailor-made optionagreements between two or more parties. Thecontracts are not standardized.

Basic Option Strategies

The four basic strategies of options are:

Long call Long put Short call Short put

Calls and Puts Diagrams


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Call Options and Put Options Diagram

How do we use them and how can they be replicated synthetically?

Long Call

The long call is one of the most simple and popular basic strategies for options. Long call is abullish strategy since it involves in buying a call option in the expectation that price will rise.

A long call can be replicated synthetically by a long underlying asset transaction and a long putoption.

As time passes, the value of a long call option erodes toward expiration value. If the volatilityincreases, erosion slows. Conversely, as volatility decreases, erosion speeds up.

Long Put

If the trader expects the market is on the fall, he will make profit by buying a put option. As themarket falls, the profit of the put option increases.

A long put can be replicated synthetically by a short underlying asset transaction and a long calloption.

Short Call
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A short call is the opposite position to the long call. The seller sells the option because hebelieves the market is going down.

A long call can be replicated synthetically by a short underlying asset transaction and a short putoption.

Short Put

A short put is implemented by traders who believe that market is going up. It is the oppositeposition of people who is bearish about the market.

A short put can be replicated synthetically by a long underlying asset transaction and a short calloption.

Natural Vs Synthetic Strategies

Natural Strategy Synthetic Strategy

Long Call = Long underlying and long put

Long Put = Short underlying and long call

Short Call = Short underlying and short put

Short Put = Long underlying and short call

Long underlying = Long call and short put

Short underlying = Short call and long put

Pay-off Diagrams for Option

Pay-off diagrams can be used as a means of illustrating the risk/return profile of an optionposition. Pay-off diagrams allow you to visualize any trading strategy in a static form.

The x-axis (horizontal line) of a pay-off diagram represents the price of the underlying assetThe y-axis (vertical line) of a pay-off diagram represents the profit/loss on the option position.

Pay-off Diagrams for Options

There are four basic pay-off diagrams for options:

The Option Buyer

1. Long Call


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Pay-off diagram below represents the effective pay-off of a long call position of an option at thetime of the expiry date. It looks at the option from the point of view of buyer.

Pay-off Diagram for Long Call Options

If a trader believes the share of a company is on the rise, he can purchase a call option withoutbuying the share. Assume he bought a call option (strike price is $5 and premium is 50 cent). Thebreak even point for this trade is $5.50. If at expiry date, the underlying share is trading at a pointbetween $5 and $5.50, he will be able to recover portion of the premium by exercising theoption. If the share is above $5.50 at this time, there will be a linear relationship between the

share price and the profit. If the share price has moved up to $6 by the option expiry date, theprofit on the option will be $0.50 (the different between the exercise price, which is $5, and thecurrent share price, less the option premium, which is $0.50)

2. Long Put

Pay-off diagram below represents the effective pay-off of a long put position of an option at thetime of the expiry date. It looks at the option from the point of view of buyer.
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Pay-off Diagram for Long Put Position

If a trader believes the share of a company is on the decline, he can make money by buying putoptions. Assume he bought a long option (strike price is $5 and premium is 50 cent). Two weeklater, the share price falls to $4.5. The put option now has intrinsic value of $0.50. It will alsohave a time value, likely to be $0.30. The option can now be sold in the marketplace for apremium value of $0.80. The profit would be $0.30.

If at expiry date, the underlying share is traded at or above $5, there will be a loss of the fullpremium. The break even point for this option is $4.50, which is equal to the strike price minus

the premium. If the share is trading below $4.50 by option expiry date, the option buyer wouldmake a profit. There will be a linear relationship between the share price and the option profit.

The Option Seller

3. Short Call

Option seller has limited profit potential and potentially unlimited risk. Pay-off diagram belowrepresents the effective pay-off of a short call position of an option at the time of the expiry date.It looks at the option from the point of view of seller.

Diagram below shows a call option with a premium of 50 points. This position is the reverse ofthe buyers. If the share price is below $5 at the expiry date, the seller will earn the full premium50 point, which is $0.50. This is the most he can earn. The break even point for this option is thesame as the buyer, which is $5.50. At this price, the premium earned will be exactly offset by thelosses on the option position. If the share price moves above $5.50, the option sellers loss movesin a linear relationship with the share price. At $6, the option sellers loss will be $0.50 (made upof $1 loss on the option position less the premium earned of $0.50).
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Pay-off Diagram for Short Call Position

4. Short Put

Pay-off diagram below shows the effective pay-off of a short put position of an option at the timeof the expiry date. It looks at the option from the point of view of seller.

Pay-off Diagram for Short Put Position

In this example, the seller will receive full premium if the share price is at or above $5 strikeprice. However if the share price drops, there is a linear relationship between the index and theloss made on this position. The break even point is $4.50, where the profit is equal to the lossincurred.
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Pay-off Diagrams for the Underlying

Example 1: Long Stock:

Pay-off diagram below represents the pay-off of a long position in the cash market. Assume you

purchase an ABC Co. share at $5. You are long stock. If the price of the stock remains at $5,there is no profit or loss. If the price increases to $5.25, you earn $0.25 in profit. However if theprice drops to $4.75, your loss will be $0.25.

Pay-off Diagram for Long Stock

Example 2: Short Stock:

Pay-off diagram below represents the pay-off of a short position in the cash market. Assume youpurchase an ABC Co. share at $5. You are now short the market. If the price of the stock dropsto $4.75, you earn a profit of $0.25. However, if the price of the stock rises to $5.25, you make aloss of $0.25.
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Pay-off Diagram for Short Stock

Option Strategies Spreads

Spreads are often used when the market is mildly bullish or mildly bearish. Trader who uses thisstrategy expects the price of the underlying asset will move in a particular direction but isunlikely to move very far. The profit and loss of spreads are limited.

There are two types of spreads:

The bull spread The bear spread

Bull Call Spread

A bull call spread is made up of a long call and a short call.

The following diagram shows a bull call spread that is consist of a short 550 call with 25 pointspremium and a long 450 call with 75 points premium.
http://www.theoptions.net/wp-content/uploads/2010/04/pay-off-diagram-for-short-stock.gif


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Pay-off Diagram for Bull Call Spread

Maximum Profit Maximum Loss Break Even at Expiry

Difference in strike price lessdifference in premium

(550-450) (75-25)

= 100 50

= 50

Difference inpremium

75-25

= 50

Lower strike price plusdifference in premium

450 + (75-25)

= 450 + 50

= 500

As shown in the diagram, the profit and loss are limited. The break-even point is $5 and themaximum profit on the bull call position is 50 point, which is $0.50. On the other hand, thelosses are limited to a maximum of 50 point, which is $0.50.

Bull Put Spread

A bull put spread consists of a short put and a long put.

The following diagram shows a bull put spread that is consist of a short 450 put with 25 pointspremium and a long 550 put with 75 points premium.
http://www.theoptions.net/wp-content/uploads/2010/04/pay-off-diagram-for-bull-call-spread.gif


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Pay-off Diagram for Bull Put Spread



75-25

= 50


(550-450) (75-25)

= 100 50

= 50

Higher strike price lessdifference in premium

550 (75-25)

= 550 50

= 500

Bear Call Spread

Bear spread is the opposite of the bull spread position. High strike price is bough and the lowerstrike price is sold.

A bear call spread is made up of a short call and a long call.

The following diagram shows a bear call spread that is consist of a short 450 call option with 75points premium and a long 550 call with 25 points premium.
http://www.theoptions.net/wp-content/uploads/2010/04/pay-off-diagram-for-bull-put-spread.gif


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Pay-off Diagram for Bear Call Spread



75-25

= 50


(550-450) (75-25)

= 100 50

= 50

Lower strike price plusdifference in premium

450 + (75-25)

= 450 + 50

= 500

Bear Put Spread

A bear put spread is made up of a short put and a long put.

The following diagram shows a bear put spread that is consist of a short 450 put option with 25points premium and a long 550 put with 75 points premium.
http://www.theoptions.net/wp-content/uploads/2010/04/pay-off-diagram-for-bear-call-spread.gif


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Pay-off Diagram for Bear Put Spread



(550-450) (75-25)

= 100 50

= 50


75-25

= 50

Higher strike price plusdifference in premium

550 (75-25)

= 550 50

= 500

Option Strategies Strangles

A strangle is the variation of the option straddle. The strangles involves buying (or selling) anout-of-the-money call and an out-of-the-money put whereas the straddle involves buying (orselling) an at-the-money call and an at-the-money put.

Long Strangle

The following diagram shows a long strangle in which out-of-the-money calls and puts arebought. This strategy works best if the strike prices of the two options are close to equidistantfrom the current market price. The advantage of long strangle over long straddle is that themaximum loss is less. This is due to the fact that out-of-money options are cheaper to purchase.The disadvantage is that the price of the underlying asset must move further than it does under astraddle before a strangle position is profitable. The strangle is subject to the decay of time
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premiums. The sooner the price of the underlying asset moves after the long strangle is inposition, the more like it is to be profitable.

Pay-off Diagram for Long Strangle

The call and put need not be bought at the same premium. The maximum lose is equal to the sumof two premiums.

Short Strangle

Short strangle is the opposite position to the long strangle. This strategy makes money if themarket stagnates. However the potential loss can be unlimited.

The diagram below shows a short strangle, which is consist of selling an out-of-money putoption and an out-of-money call option. Like the short straddle, if the price of the underlyingasset suddenly moves up or down dramatically, the losses are theoretically unlimited. However,the price must move further than it does under a short straddle before losses are made. The trade-off is that the maximum profit of a short strangle is less than a short straddle.
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Pay-off Diagram for Short Strangle

Option Strategies Straddles

Straddles are often used when there is the expectation of a substantial rise or fall in the market.Straddles are popular trading strategy in highly volatile markets.

Long Straddle

A long straddle is made up of a long call and a long put. This strategy is best entered into whenyou expect the market to move buy are unsure which way it will do so. The potential loss ofusing straddle is limited to the sum of the two premiums. However, the potential profit is open-ended in either direction.

A long straddle can be replicated synthetically by:

A long put option and long underlying asset transaction (which represents a long call) A long call option and short underlying asset transaction (which represents a long put)

Example:

Below is an example of a long straddle. It is made up of a long 500 put and a long 500 call, bothwith the same strike price ($5.00) and the expiry date (April). In this case, both being at-the-money, they are also trading at close to the same premium ($0.50, or 50 points)
http://www.theoptions.net/wp-content/uploads/2010/04/pay-off-diagram-for-short-strangle.gif


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Pay-off Diagram for Long Straddle

The following table shows the profit of a long straddle position.

Stock

Price

Long 500 Call (premium

50)

Long 500 Put (premium

50)

Long

Straddle

350 -50 +100 +50

400 -50 +50 0

450 -50 0 -50500 -50 -50 -100

550 0 -50 -50

600 +50 -50 0

650 +100 -50 +50

At the expiration date, this strategy is only profitable when the share price has made a largemove either up or down. It must be above $6 or below $4 for a profit to be made on the optionposition.

Short Straddle

The opposite of long straddle position is a short straddle. A short straddle is made up of a shortcall and a short put with the same strike price. This position would be taken by a trader whoexpects the market to stagnate. The maximum profit is the sum of the two premiums. The loss ispotentially unlimited in either direction.
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A short straddle can be replicated synthetically by:

A short put option and short underlying asset transaction (which represents a short call) short call option and long underlying asset transaction (which represents a short put)

Example:

Below is an example of a short straddle. It is made up of a short 500 put and a short 500 call,both with the same strike price ($5.00) and the expiry date (April). This involves selling both the500 put and the 500 call in the expectation that the share price will not move substantially fromits present level. The short straddle allows option seller to earn time premiums from the twooptions as these premiums decay. The maximum profit will be earned if the market is at, or closeto, the strike price of the two options at the expiration date. If the share price moves substantiallyfrom its current level of $5, it will incur loss. The loss can be unlimited.

Pay-off Diagram for Short Straddle
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Basic of Pay-Off@ Option

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