Options Strategies-Jan2011_NMIMS

8/7/2019 Options Strategies-Jan2011_NMIMS

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Options - Basics

Jan 2011


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What is a derivative?

A derivative instrument is a financial contract whose payoff

structure is determined by the value of underlying

commodity, security , interest rate, share price index,exchange rate, oil price, or the like.


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Derivatives

Futures Options Forwards Swaps

Call Put


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Options

Options grants the right, but not the obligation, to buy or

sell a futures contract at a predetermined price for a

specified period of time.


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Basic types of Options

PUT OPTION

Gives buyer right to sell underlying futures contract.

CALL OPTION

Gives buyer right to buy underlying futures contract.

Note: In both cases the underlying commodity is a futures contract, not the physical commodity


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Strike Price (Exercise price)

The predetermined price of the futures contracti.e. price at which the futures contract can be bought or sold.

Premium

The cost of the right to buy or sell a futures contract cost of the option.

The buyer loses the premium regardless of whether the option is used or not.

Terms used


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Terms used

Option Writer :

Person selling the option, and is exposed to margin requirements

Underlying Futures :

It is corresponding Future Contract which can

be transacted by exercise in the transaction.

Exercise:

Action taken by the buyer of an option whose intention is to deliver

Or

take delivery of the underlying futures

Expiration Date:

Last date on which an option can be exercised or offset


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Terms used

Open interest

1. The total number of options and/or futures contracts that are not closed or delivered on a

particular day.

2. The number of buy market orders before the stock market opens.

A common misconception is that open interest is the same thing as volume of options and

futures trades. This is not correct, as demonstrated in the following example:

-On January 1, A buys an option, which leaves an open interest and also creates trading volume of 1.-On January 2, C and D create trading volume of 5 and there are also five more options left open.

-On January 3, A takes an offsetting position, open interest is reduced by 1 and trading volume is 1.

-On January 4, E simply replaces C and open interest does not change, trading volume increases by 5.


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Open Interest indicators

What are the other combinations and impact of them?


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A call option gives the holder the right, but not the obligation, to buy a

specific futures contract at a specific price

To call from them

Call Option


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Gold Example (Call)

Suppose that on June 1, a farmer is approached by a goldsmith for purchasing 1 tola of gold atRs.9,000/10gm. The Goldsmith is almost certain that he wants the gold but is unable to arrangefinance for six months. The farmer propose to grant a six-month option at Rs.9,000/10gm inexchange for a Rs.90/10gm.

Purchaser = The Goldsmith (Option-Call buyer)

Grantor = The Farmer (Option-Call seller)

Exercise price = Rs.9,000 /10gm (Strike price)

Expiration date = December 1

Call Premium = Rs.90 (paid by goldsmith call buyer)


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A put option gives the holder the right, but not the obligation, to sell aspecific futures contract at a specific price

To put it on them

Put Option


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Gold Example (Put)

Suppose that on June 1, a farmer approaches a goldsmith for selling 1 tola of gold atRs.9,000 /10gm . The Farmer is almost certain that he wants to sell the gold but isunable to arrange the delivery for six months. The Goldsmith proposes to grant asix-month option at Rs.9,000 /10gm in exchange for a Rs.90 /10gm.

Purchaser = The Goldsmith (Option-Put seller)

Grantor = The Farmer (Option-Put buyer)

Exercise price = Rs.9,000 /10gm (Strike price)

Expiration date = December 1Put Premium = Rs.90 (paid by farmer-option buyer)


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Options are popular because

Price Insurance.

Limited financial obligation.

Marketing flexibility.


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Factors affecting Option Premium

Changes in the price of the underlying futures contract- E.g. gold futures

Strike Price E.g. Rs.10,000 /10gm

Time until expiration

Volatility of the underlying futures contract

Dividends

Risk free interest rates.


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Components of Premium

Intrinsic Value

+

Time Value

=

Premium


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Intrinsic Value

Positive difference between the strike price and the underlying commodity futures price.

FOR A CALL OPTIONstrike price below futures price

FOR A PUT OPTIONstrike price exceeds futures price

Note: Futures price means current price of underlying futures contract.


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May Corn Futures Price= Rs.329

What is the Intrinsic Value for a:

Q: Rs.310 Call Option?

A: Rs. 19

Q: Rs.340 Put Option?

A: Rs. 11

Q: Rs.340 Call Option?

A: Rs. 0

Intrinsic Value:An Example


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Time Value for Mar 11 and Apr 11 Options on Jan 1, 2011

Mar 11 Futures = 209.25

Mar 11 210 Call Option

Premium = 8.625

Intrinsic Value = 0

Time Value = 8.625

Mar 11 210 Put Option

Premium = 9.5

Intrinsic Value = 0.75

Time Value = 8.75

Apr 11 Futures = 237

Apr 11 240 Call Option

Premium = 20.5

Intrinsic Value = 0

Time Value = 20.5

Apr 11 240 Put Option

Premium = 23.25

Intrinsic Value = 3

Time Value = 20.25


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TIME DECAY

0

0.25

0.50

0180 90

Days to expiration

Time value


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CALL OPTION In-the-Money (ITM)

Strike price < Futures price

At-the-Money (ATM)

Strike price = Futures price

Out-of-the-Money (OTM)

Strike price > Futures price


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PUT OPTION In-the-Money (ITM)

Strike price > Futures price

At-the-Money (ATM)

Strike price = Futures price

Out-of-the-Money (OTM)

Strike price < Futures price


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CALL/PUT OPTIONS Deep-In-the-Money (DITM)

No Chance of Out-of-the-Money

Close-to-the-Money (CTM)

Strike price near Futures price

Deep-Out-of-the-Money (DOTM)

No Chance of In-the-Money


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American Style Options

Buyer of the options can

choose to exercise, prior to the expiry date.

European Style Options

Buyer of the options can

choose to exercise only on the date of expiry.

American Premium European Premium

Options Exercise Mode


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Interest rate continuous compounding

rt

rtr

n

n

rtrn

n

rtr

n

nt

t

PeA

n

rPA

n

rPA

n

rPA

n

rPA

rPA

=

+=

+=

+=

+=

+=

})1(lim{

})1{(lim

})1{(

)1(

)1(

where

P is principal, r is rate of interest (annual), n is

frequency of compounding, t is time, A is amount.


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Stochastic Process

)2,0(

)1,0(

),0( T

Any variable whose value changes over time in an uncertain way is said to follow a

stochastic process.

Markov process:

Present Value of a variable is relevant for predicting the future.

Weak form of market efficiency

Change of value can be given by probability distribution

Change in variable in two years is sum of two independent normal distributions

Mean is sum of the means

Variance is sum of the variances

Hence we have


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Wiener Process

tz =

bdzadtdx +=

tbtax +=

tss =

0tt

T eSS

0=

tdtS

dS +=

A Wiener process with zero drift and variance rate of 1.0

A generalised Wiener process can be written down as:

Now for a small time interval we can say:


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Itos Lemma

dztxbdttxadx ),(),( +=

bdzxGdtb

xG

tGa

xGdG

+

+

+

= )2

1( 22

2

Value of a stock follows log normal distribution.

This result by Japanese Mathematician was used by Black Scholes to solve

the Black Scholes Merton PDE.


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Options Pricing

Black Scholes Formulae

Where,

S = Spot Price

N(d) = probability that a deviation less than d will occur in a normal distribution with a mean zero &

standard deviation is 1

E = Exercise Price or Strike Price

e = 2.71828

)()( 210 dNKedNSCrt

=

)()( 102 dNSdNKePrt

=

T

TrKS

d

)2

()ln(20

2

+

=T

TrKS

d

)2

()ln(20

1

++

=


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Delta :First derivative, considers sensitivity of options to price of future

contract. (Hedge Ratio)

Gamma : Considers sensitivity of options to changes in Delta (Curvature)

Theta : Considers sensitivity of options to time factor (time decay)

Vega : Considers sensitivity of options to market volatility.

Rho : Considers sensitivity of portfolio to interest rates.

Option Greeks


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Types of Options - Exotics

Barrier options:

Path dependent exotics

Become active when underlying reaches a predetermined level (barrier)

In optionsstart worthless and become active if predetermined level is breached

Out options

Start active and become worthless if predetermined level is breached

Lookback options

Path dependent exotics

Exercise price = previous high/low (over preceding period)

Russian options

Lookback option till perpetuity


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Binary option

Cash or nothing; asset or nothing

Bermuda option

Where buyer of the option has the right to exercise the option at a set (always

discretely spaced) number of times.

10 yr swap or 9 yr 6 month swap

Canary option

Where buyer can exercise at quarterly dates but only after a fixed period of time

has elapsed. (eg. 1 year)

Compound option

Option on an option


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Swing option

A Bermudan option where on exercise you bet a put or call.

Parisian option

the payoff is dependent by time spent above or below the strike price.

Asian option

Payoff determined by average trading price over a defined period of time.

Eg: average price over last 3 months.


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Options - Strategies

November 2010


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Strategy Guide - Table


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Risk-Return Profile

L C ll


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Long Call

NoMargin

Volatility increase helps the positionVolatility

Very Bullish OutflowUse

HurtsTime Decay

Strike price + premiumBreakeven

Limited to the premium paidLoss

Unlimited, Increases as the Spot Price increaseProfit

CommentView

Details of Call Option


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Details of Call Option

Deal Details: SAMPL 10 Analysis Parameters:

Stock Price 11000.00 Deal Date 28-Jan-08 Centre Price on Graph 11200.00 Days to Expiry 32

Initial Debit/Credit Deal Expiration 28-Feb-08 Graph Increment 100.000 Analysis Date 27-Jan-08

Volatility 30.00% Dividend

Underlying Type Spot Ex Date Pricing Model:

Risk Free Rate 5.75%

Option Trades:

Action:

Buy/Sell

Option

Type

No.

Opt'ns Strike Volatility

Trade

Expiry

Override

Price

Days to

Expiry

Option

Value Debit/ Credit

Greeks:

Delta Net

Option Trade 1 b c 1 10900.00 31 462.3096 (462) 0.58 In' money

Option Trade 2 9999Option Trade 3 9999

Option Trade 4 9999

Option Trade 5 9999

Option Trade 6 9999

(462) (462)

Stock Trades:

Action:

Buy/Sell

No.

Shares Price

Stock Trade 1 11000

Stock Trade 2 11000

11000Days to expiry: 32 Totals: (462) (462)

Black-Scholes European


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Long Call - Payoff

Long Futures


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Long Futures

YesMargin

No ImpactVolatility

Very Bullish outlookUse

No impactTime Decay

Purchase price + BrokerageBreakeven

Increases as the Spot Price increase

Loss

Increases as the Spot Price increaseProfit

CommentView

Long Futures - Payoff


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Long Futures - Payoff


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Bull Call Spread

Formation

Buy Call A and,

Sell Call B.

Variant

Buy Call A, Sell Put B and,

Short futures.

Example

Buy Gold Feb Call 10800 @ Rs. 250 and,

Sell Gold Feb Call 11200 @ Rs. 100.

Bull Call Spread


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Bull Call Spread

YesMargin

NeutralVolatility

Bullish outlookUse

Mixed Hurts for long call and helps for short CallTime Decay

Strike A + Max LossBreakeven

Limited, Maximum Loss = Net Premium

Loss

Limited, Maximum Profit = (B A) Net PremiumProfit

CommentView

An example of Bull Spread


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p p







Option Trades:

Action:

Buy/Sell

Option

Type

No.


Trade

Expiry

Override

Price

Days to

Expiry

Option

Value Debit/ Credit

Greeks:

Delta NetOption Trade 1 b c 1 10800.00 250 31 518.7498 (250) 0.62 In' money

Option Trade 2 s c 1 11200.00 100 31 317.7105 100 0.46 Out' money

Option Trade 3 9999

Option Trade 4 9999

Option Trade 5 9999

Option Trade 6 9999

(150) (150)



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Bull Call Spread - Payoff


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Bull Put Spread

Formation

Buy Put A of lower strike price and,

Sell Put B of higher strike price.

Variant

Buy Put A, Sell Call B and,

Long Futures.

ExampleBuy Gold Feb PA 10800 @ Rs. 50 and,

Sell Gold Feb PA 11200 @ Rs. 250.

Bull Put Spread


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p

YesMargin

NeutralVolatility

Bullish outlookUse

Mixed Hurts for long Put and helps for short PutTime Decay

Strike A + Max LossBreakeven

Limited, Maximum Loss = (B A) - Net PremiumLoss

Limited, Maximum Profit = Net PremiumProfit

CommentView

Bull Put Spread - Example


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Deal Details: SAMPL 10 Analysis Parameters:Stock Price 11000.00 Deal Date 28-Jan-08 Centre Price on Graph 11200.00 Days to Expiry 32





Option Trades:

Action:

Buy/Sell

Option

Type

No.


Trade

Expiry

Override

Price

Days to

Expiry

Option

Value Debit/ Credit

Greeks:

Delta Net

Option Trade 1 b p 1 10800.00 50 31 266.1359 (50) -0.38 Out' money

Option Trade 2 s p 1 11200.00 250 31 463.1479 250 -0.54 In' money

Option Trade 3 9999

Option Trade 4 9999

Option Trade 5 9999

Option Trade 6 9999

200 200


Bull Put Spread - Payoff


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Short Put


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YesMargin

Volatility decreases helps the positionVolatility

Bullish outlookUse

HelpsTime Decay

Strike price - PremiumBreakeven

Unlimited, increase as the spot price decrease

Loss

Limited to the premium receivedProfit

CommentView

Short Put - Variant


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Covered CallHave underlying or Buy Futures, and

Write A Call

Maximum Profit

Futures < Strike = Premium + ( Strike Futures)

Futures > Strike = Premium (Futures Strike)

Breakeven = Call Strike Maximum Profit

Short Put- Example


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Option Trades:

Action:

Buy/Sell

Option

Type

No.


Trade

Expiry

Override

Price

Days to

Expiry

Option

Value Debit/ Credit

Greeks:

Delta Net

Option Trade 1 s p 1 10800.00 50 31 266.1359 50 -0.38 Out' money

Option Trade 2 9999

Option Trade 3 9999

Option Trade 4 9999

Option Trade 5 9999

Option Trade 6 9999

50 50


Short Put - Payoff


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Long Straddle


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Long Straddle


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Long Straddle

Formation

Buy Call A and,

Buy Put A.

Both of the same strike price

Variant

Buy 2 Calls A & Short Futures or

Buy 2 Puts A & Long Futures

Example

Buy Gold Feb CA 10800 @ Rs. 50

Buy Gold Feb PA 10800 @ Rs. 70


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Long Straddle - Payoff


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g y

Long Strangle


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Long Strangle

Formation

Buy out of the money Put A and,

Buy out of the money Call B.

Example


Buy Gold Feb CA 11200 @ Rs. 150

Long Strangle


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Long Strangle - Example


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Option Trades:

Action:

Buy/Sell

Option

Type

No.


Trade

Expiry

Override

Price

Days to

Expiry

Option

Value Debit/ Credit

Greeks:

Delta Net

Option Trade 1 b c 1 11200.00 150 31 317.7105 (150) 0.46 Out' money

Option Trade 2 b p 1 10800.00 50 31 266.1359 (50) -0.38 Out' money

Option Trade 3 9999

Option Trade 4 9999

Option Trade 5 9999

Option Trade 6 9999

(200) (200)

Stock Trades:

Action:

Buy/Sell

No.

Shares Price

Stock Trade 1 11000

Stock Trade 2 11000

11000

Days to expiry: 32 Totals: (200) (200)


Long Strangle Payoff


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Long Strap


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FormationBuy 2 Calls A and,

Buy Put A

Variants

Buy 3 Calls A & Short Futures

Example


Buy 2 Gold Feb CA 11000 @ Rs. 50

Long Strap


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Long Strap - Example


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Stock Price 11000.00 Deal Date 28-Jan-08 Centre Price on Graph 10800.00 Days to Expiry 32Initial Debit/Credit Deal Expiration 28-Feb-08 Graph Increment 100.000 Analysis Date 27-Jan-08




Option Trades:

Action:

Buy/Sell

Option

Type

No.


Trade

Expiry

Override

Price

Days to

Expiry

Option

Value Debit/ Credit

Greeks:

Delta Net

Option Trade 1 b c 2 11000.00 50 31 410.0049 (100) 0.54 At' Money

Option Trade 2 b p 1 11000.00 50 31 356.4167 (50) -0.46 At' Money


Option Trade 5 9999

Option Trade 6 9999

(150) (150)

Stock Trades:

Action:

Buy/Sell

No.

Shares Price

Stock Trade 1 11000

Stock Trade 2 11000

11000

Days to expiry: 32 Totals: (150) (150)


Long Strap Payoff


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Long Strip


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Formation

Buy 2 Puts A and,

Buy Call A.

Variant

Buy 3 Puts A & Long Futures

Long Strip


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Long Strip - Payoff


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Short Straddle


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FormationSell Call A and,

Sell Put A.

Variant

Sell 2 Calls A & Long Futures or

Sell 2 puts A and Short Futures..

Short Straddle


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YesMargin

Volatility decrease helps the positionVolatility

Use

HelpsTime Decay

Breakeven

UnlimitedLoss

Limited to the Net premium receivedProfit

CommentView

Low BEP = Middle Strike - ProfitHigh BEP = Middle Strike + Profit

Expecting a tight sideways movement

Short Straddle - Payoff


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Short Strangle


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Formation

Sell Call A and Sell Put B.

VariantsSell Put A and Sell Call B

Sell Put A, Sell Put B and Short Futures

Sell Call A, Sell Call B and Long Futures


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Short Strangle - Payoff


St k P i 1

1000 00 D l D t 28 J 08 C t P i G h 10800 00 D t E i 32


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Initial Debit/Credit Deal Expiration 28-Feb-08 Graph Increment 300.000 Analysis Date 27-Jan-08Volatility 30.00% Dividend



Option Trades:

Action:

Buy/Sell

Option

Type

No.


Trade

Expiry

Override

Price

Days to

Expiry

Option

Value Debit/ Credit

Greeks:

Delta Net

Option Trade 1 s c 1 11200.00 150 31 317.7105 150 0.46 Out' money


Option Trade 3 9999

Option Trade 4 9999


200 200

Stock Trades:

Action:

Buy/Sell

No.

Shares Price

Stock Trade 1 11000

Stock Trade 2 11000

11000

Days to expiry: 32 Totals: 200 200


Short Strangle - Payoff


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Long Put


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NoMargin

Volatility increases helps the PositionVolatility

Use

HurtsTime Decay

Breakeven

Limited to the premium paidLoss

Unlimited, Increases as the Spot price decreasesProfit

CommentView

Strike price - premium

Very Bearish Outlook

Payoff Profile


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Short Futures


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YesMargin

No impactVolatility

Use

No ImpactTime Decay

Breakeven

Loss

Increases as the Spot price decreasesProfit

CommentView

Increases as the Spot price increases

Sell price + Brokerage

Very Bearish Outlook

Bear Put Spread


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YesMargin

NeutralVolatility

Use

Mixed - Hurts for Long Put and helps for Short PutTime Decay

Breakeven

Loss

Limited, Maximum Profit = (B - A) - Net PremiumProfit

CommentView

Limited, Maximum Loss = Net Premium

Strike B - Maximum Loss

Bearish outlook

Bear Put Spread

Formation


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Formation

Buy Put B and Sell Put A.

Variant

Buy Call B, Short Futures & Sell Put A

Example

Buy Gold Feb PE 11200 @ Rs. 250 and,

Sell Gold Feb PE 10800 @ Rs. 50.

Bear Put Spread


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Option Trades:

Action:

Buy/Sell

Option

Type

No.


Trade

Expiry

Override

Price

Days to

Expiry

Option

Value Debit/ Credit

Greeks:

Delta Net


Option Trade 2 b p 1 11200.00 250 31 463.1479 (250) -0.54 In' moneyOption Trade 3 9999

Option Trade 4 9999

Option Trade 5 9999

Option Trade 6 9999

(200) (200)


Bear Put Spread Payoff


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Bear Call Spread


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YesMargin

Neutral

Volatility

Use

Mixed - Hurts for Long Call and helps for Short CallTime Decay

Breakeven

Loss

Limited, Maximum Profit = Net PremiumProfit

CommentView

Limited, Maximum Loss = (B - A) - Net Premium

Strike B - Maximum Loss

Bearish Outlook

Bear Call Spread

Formation


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Buy Call B and Sell Call A.

Variant

Buy Call B, Short Futures & Sell Put A

Example

Buy Gold Nov CA 230 @ Rs. 7.50 and,

Sell Gold Nov CA 210 @ Rs. 18.

Short Call


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YesMargin

Volatility decreases helps the positionVolatility

Use

HelpsTime Decay

Breakeven

Loss

Limited to the premium receivedProfit

CommentView

Unlimited, increases as the spot price increases

Strike price + Premium

Bearish Outlook

Short Call - Payoff


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OPTIONS PRICING

P t C ll P it


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Put Call Parity

Formula:

C + PV (x) = P + S

Where,

C = present value of the callP = present value of the put

S = present value of the underlying

PV(x) = present value of the strike price discounted from the expiration date at a suitable risk free rate.


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Thank Youhank You

Options Strategies-Jan2011_NMIMS

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