Basics & Single leg Options StrategiesEXPLORING FUNDAMENTALS

Amit Shankercontactamipro@gmail.com

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Introduction• Can you describe Stock Options in your own words?

• How much percent would you be willing pay to secure your portfolio from downside risk?

• Do you hedge your investments? If yes, can you give an example?

Formulating a winning tradeDiscipline: • Maintain separate accounts for your trading activity and treat it as your business• Be very clear with the Risk in every trade. Ideally, each trade should never risk more than 5% of your capital• Make sure you are not skewed or over diversifying your portfolio

Identifying opportunities:• What is the rationale behind the trade? Is it an impulsive trade or you are convinced with the opportunity• Do you have a clearly defined Entry and Exit criteria

Recovering from unexpected move:• Do you have a ‘Plan B’ if the market moves against you?

Bad habits• Averaging a position that’s gone against you (usually should not be your ‘Plan B’)

Concept of Forward ContractsTHE PROBLEM

• The market values of wheat and other crops fluctuate constantly as supply and demand for them vary, with occasional large moves in either direction.

• Based on current prices and forecast levels at harvest time, the farmer might decide that planting wheat is a good idea one season, but the price of wheat might change over time.

• Once the farmer plants wheat, he is committed to it for an entire growing season. If the actual price of wheat rises greatly between planting and harvest, the farmer stands to make a lot of unexpected money, but if the actual price drops by harvest time, he is going to lose the invested money.

THE SOLUTION

Forward contracts are mutual agreements to deliver a certain amount of a commodity at a certain date for a specified price and each contract is unique to the buyer and seller.

• For this example, the farmer can sell a number of forward contracts equivalent to the amount of wheat he expects to harvest and essentially lock in the current price of wheat.

• Once the forward contracts expire, the farmer will harvest the wheat and deliver it to the buyer at the price agreed to in the forward contract.

Risks with Forward Contract• if the farmer has a low yield year and he

harvests less than the amount specified in the forward contracts, he must purchase the bushels elsewhere in order to fill the contract.

• This becomes even more of a problem when the lower yields effect the entire wheat industry and the price of wheat increases due to supply and demand pressures.

• Also, while the farmer hedged all of the risks of a price decrease away by locking in the price with a forward contract, he also gives up the right to the benefits of a price increase

Options in context of Stocks

Options are essentially made up of three things:• Option Type

◦ Call◦ Put

• Strike Price• Exercise Price• Expiration Date

Important TermsInstruments Instrument

AttributesEconomy Option Types Option Attributes

Stocks Volatility Interest Rate CALL ITM

Futures Dividend Inflation PUT ATM

Options Growth Political News European Style OTM

Warrants American Style Intrinsic Value

Premium

Strike Price

Underlying

Expiration Date

Spot Price

CALL Options A call option is an option contract in which the holder (buyer) has the right (but not the obligation) to buy a specified quantity of a security at a specified price (strike price) within a fixed period of time (until its expiration).

For the writer (seller) of a call option, it represents an obligation to sell the underlying security at the strike price if the option is exercised. The call option writer is paid a premium for taking on the risk associated with the obligation.

PUT Options A put option is an option contract in which the holder (buyer) has the right (but not the obligation) to sell a specified quantity of a security at a specified price (strike price) within a fixed period of time (until its expiration). For the writer (seller) of a put option, it represents an obligation to buy the underlying security at the strike price if the option is exercised. The put option writer is paid a premium for taking on the risk associated with the obligation.

Example 1: Long CALL Rationale

Buying long CALL is a directional trade and you are expecting the market to move up further

Analysis• How do you decide the strike price?• How do you decide the Expiration Date?• What’s the maximum profit/loss possible on the position?• What is the Entry/Exit criteria? • How much am I expecting the market to move for me to make a decent profit?

Best Case

The stock climbs above (strike price + premium paid)

Worst Scenario

On expiration date, if market closes below ‘strike price’, you lose premium paid to buy the option

Example 2: Long PUT Rationale

Buying long PUT is a directional trade and you are expecting the market to fall from here on. PUT is usually purchased as an insurance (hedge) for your long term portfolio

Analysis• How do you decide the strike price?• How do you decide the Expiration Date?• What’s the maximum profit/loss possible on the position?• What is the Entry/Exit criteria? • How much am I expecting the market to move for me to make a decent profit?

Best Case

The stock drops below (strike price + premium paid). If you owned the underlying, the profit from PUT option will compensate the loss made on the underlying. You will still lose the amount paid as premium to by the PUT option.

Worst Scenario

On expiration date, if market closes above 'strike price’, you lose premium paid to buy the option. If you owned the underlying and the stock moves above strike price, you can possibly make a profit (and even go on to recover the premium paid to be the option)

Example 3: Sell PUT Rationale

Writing a PUT option can be part of an effective strategy when you plan to buy stocks. You can buy stocks at a discounted price!

Analysis• How do you decide the strike price?• How do you decide the Expiration Date?• What’s the maximum profit/loss possible on the position?• What is the Entry/Exit criteria? • How much am I expecting the market to move for me to make a decent profit?

Best Case

The stock closes above strike price. You will pocket the premium amount.

Worst Scenario

WARNING: Writing an naked option is a risky trade. There is a potential for unlimited loss. On expiration date, if market closes below ‘strike price’, you will lose the difference between Spot price and Strike price.

Debit Spread (Best case) BUY 6000 CALL @ 347

SELL 6350 CALL @ 70

DEBIT: 347 – 70 = 277

CASE 1 Expiration: Underlying closes @ 6400

PROFIT FROM BUY @CREDIT: 6400 – 6000 = +400

LOSS FROM SELL @DEBIT: 6400-6350 = 50

NET PROFIT: 400 -277 – 50 = 73 PROFIT

Debit Spread (Worst case) BUY 6000 CALL @ 347

SELL 6350 CALL @ 70

DEBIT: 347 – 70 = 277

CASE 2 Expiration: Underlying closes @ 6000

LOSS FROM BUY @CREDIT: 347

PROFIT FROM SELL @DEBIT: 70

NET LESS: -277

What we have lined up?◦ Pricing Option Contracts

◦ Option Spreads

◦ Formulating Basic Strategy

◦ Discussing Real trade examples

Debit Spread (Breakeven) BUY 6000 CALL @ 347

SELL 6350 CALL @ 70

DEBIT: 347 – 70 = 277

CASE 2 Expiration: Underlying closes @ 6280

LOSS FROM BUY @CREDIT: 70

PROFIT FROM SELL @DEBIT: 70

NET LESS: 0

Beer O’ Clock