Options Strategies-Jan2011 - NMIMS

Options - Basics
Jan 2011
1
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.
2
Derivatives
Futures Options Forwards Swaps
Call Put
3
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.
4
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
5
Terms used
Strike Price (Exercise price)
The predetermined price of the futures contract

i.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.
6
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

7
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.
8
Open Interest indicators
•What are the other combinations and impact of them?
9
Call Option
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”
10
Gold Example (Call)
Suppose that on June 1, a farmer is approached by a goldsmith for purchasing 1 tola of gold at
Rs.9,000/10gm. The Goldsmith is almost certain that he wants the gold but is unable to arrange
finance for six months. The farmer propose to grant a six-month option at Rs.9,000/10gm in
exchange 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)
11
Put Option
A put option gives the holder the right, but not the obligation, to sell a
specific futures contract at a specific price
“To put it on them”
12
Gold Example (Put)
Suppose that on June 1, a farmer approaches a goldsmith for selling 1 tola of gold at
Rs.9,000 /10gm . The Farmer is almost certain that he wants to sell the gold but is
unable to arrange the delivery for six months. The Goldsmith proposes to grant a
six-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 1
Put Premium = Rs.90 (paid by farmer-option buyer)
13
Options are popular because
• Price Insurance.
• Limited financial obligation.
• Marketing flexibility.
14
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.
15
Components of Premium
Intrinsic Value
Time Value
Premium
16
Intrinsic Value
“Positive” difference between the strike price and the underlying commodity futures price.
¾ FOR A CALL OPTION –

strike price below futures price
¾ FOR A PUT OPTION –

strike price exceeds futures price
Note: Futures price means current price of underlying futures contract.
17
Intrinsic Value: An Example
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
18
Time Value for Mar 11 and Apr 11 Options on Jan 1, 2011
Mar 11 Futures = 209.25 Apr 11 Futures = 237
Mar 11 210 Call Option Apr 11 240 Call Option

Premium = 8.625 Premium = 20.5
Intrinsic Value = 0 Intrinsic Value = 0
Time Value = 8.625 Time Value = 20.5
Mar 11 210 Put Option Apr 11 240 Put Option

Premium = 9.5 Premium = 23.25
Intrinsic Value = 0.75 Intrinsic Value = 3
Time Value = 8.75 Time Value = 20.25
19
TIME DECAY
Time value
0.50
0.25
0
180 90 0
Days to expiration
20
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
21
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
22
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
23
Options – Exercise Mode
¾ American Style Options –

Buyer of the options can
choose to exercise, prior to the expiry date.
¾ European Style Options –

Buyer of the options can
choose to exercise only on the date of expiry.
¾ American Premium ≥ European Premium
24
Interest rate – continuous compounding
A = P (1 + r ) t
r nt
A = P (1 + )
n
n
r r rt
A = P{(1 + ) }
n
r nr rt
A = lim P{(1 + ) }
n →∞ n
r nr rt
A = P{lim (1 + ) } where
n →∞ n P is principal, r is rate of interest (annual), n is
A = Pe rt frequency of compounding, t is time, A is amount.
25
Stochastic Process
•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 φ(0,1)
•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
φ (0, 2 )
•Hence we have φ (0, T )
26
Wiener Process
•A Wiener process with zero drift and variance rate of 1.0
δ z =∈ δt
•A generalised Wiener process can be written down as:
dx = adt + bdz
•Now for a small time interval we can say:
δx = aδt + b ∈ δt
δs = µ sδt
δt → 0 S T = S 0 e µt
dS
= µ dt + σ ∈ δt
S
27
Ito’s Lemma
dx = a ( x, t ) dt + b( x, t ) dz
∂G ∂G 1 ∂ 2 G 2 ∂G
dG = ( a+ + b ) dt + bdz
∂x ∂t 2 ∂x 2 ∂x
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.
28
Options Pricing
C = S 0 N ( d 1 ) − Ke − rt N ( d 2 )
P = Ke − rt N ( − d 2 ) − S 0 N ( − d 1 )
S0 σ2 S0 σ2
ln( ) + ( r + )T ln( ) + (r − )T
d1 = K 2 d2 = K 2
σ T σ T
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
29
Option Greeks
¾ Delta :First derivative, considers sensitivity of options to price of future

contract. (Hedge Ratio)
¾ Gamma : Considers sensitivity of options to changes in Delta (Curvature)
¾ Theta : Considers sensitivity of options to time factor (time decay)
¾ Vega : Considers sensitivity of options to market volatility.
¾ Rho : Considers sensitivity of portfolio to interest rates.
30
Types of Options - Exotics
•Barrier options:
•Path dependent exotics
•Become active when underlying reaches a predetermined level (barrier)
•“In” options
•start 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
31
•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
32
•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.
33
Options - Strategies
November 2010
34
Strategy Guide - Table
35
Risk-Return Profile
36
Long Call
View Comment
Profit Unlimited, Increases as the Spot Price increase
Loss Limited to the premium paid
Breakeven Strike price + premium
Time Decay Hurts
Use Very Bullish Outflow
Volatility Volatility increase helps the position
Margin No
37
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: Black-Scholes European
Risk Free Rate 5.75%
Action: Option No. Trade Override Days to Option Greeks:
Option Trades: Buy/Sell Type Opt'ns Strike Volatility Expiry Price Expiry Value Debit/ Credit Delta Net
Option Trade 1 b c 1 10900.00 31 462.3096 (462) 0.58 In' money
Option Trade 2 9999
Option Trade 3 9999
Option Trade 4 9999
Option Trade 5 9999
Option Trade 6 9999
(462) (462)
Action: No.
Stock Trades: Buy/Sell Shares Price
Stock Trade 1 11000
Stock Trade 2 11000
11000
Days to expiry: 32 Totals: (462) (462)
38
Long Call - Payoff
39
Long Futures
View Comment
Profit Increases as the Spot Price increase
Loss Increases as the Spot Price increase
Breakeven Purchase price + Brokerage
Time Decay No impact
Use Very Bullish outlook
Volatility No Impact
Margin Yes
40
Long Futures - Payoff
41
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.
42
Bull Call Spread
View Comment
Profit Limited, Maximum Profit = (B – A) – Net Premium
Loss Limited, Maximum Loss = Net Premium
Breakeven Strike A + Max Loss
Time Decay Mixed – Hurts for long call and helps for short Call
Use Bullish outlook
Volatility Neutral
Margin Yes
43
An example of Bull Spread

Option 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)
44
Bull Call Spread - Payoff
45
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.
Example
Buy Gold Feb PA 10800 @ Rs. 50 and,
Sell Gold Feb PA 11200 @ Rs. 250.
46
Bull Put Spread
View Comment
Profit Limited, Maximum Profit = Net Premium
Loss Limited, Maximum Loss = (B – A) - Net Premium
Breakeven Strike A + Max Loss
Time Decay Mixed – Hurts for long Put and helps for short Put
Use Bullish outlook
Volatility Neutral
Margin Yes
47
Bull Put Spread - Example

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
48
Bull Put Spread - Payoff
49
Short Put
View Comment
Profit Limited to the premium received
Loss Unlimited, increase as the spot price decrease
Breakeven Strike price - Premium
Time Decay Helps
Use Bullish outlook
Volatility Volatility decreases helps the position
Margin Yes
50
Short Put - Variant
Covered Call
Have 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
51
Short Put- Example

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
52
Short Put - Payoff
53
Long Straddle
54
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
55
Long Straddle - Example
Option Trade 1 b c 1 10800.00 50 31 518.7498 (50) 0.62 In' money
Option Trade 3 9999
Option Trade 4 9999
Option Trade 5 9999
Option Trade 6 9999
(120) (120)
Action: No.
Stock Trade 1 11000
Stock Trade 2 11000
11000
56
Long Straddle - Payoff
57
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
58
Long Strangle
59
Long Strangle - Example
Option Trade 1 b c 1 11200.00 150 31 317.7105 (150) 0.46 Out' money
Option Trade 3 9999
Option Trade 4 9999
Option Trade 5 9999
Option Trade 6 9999
(200) (200)
Action: No.
Stock Trade 1 11000
Stock Trade 2 11000
11000
60
Long Strangle Payoff
61
Long Strap
Formation
Buy 2 Calls A and,
Buy Put A
Variants
Buy 3 Calls A & Short Futures
Example
Buy 2 Gold Feb CA 11000 @ Rs. 50
62
Long Strap
63
Long Strap - Example

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 3 9999
Option Trade 4 9999
Option Trade 5 9999
Option Trade 6 9999
(150) (150)
Action: No.
Stock Trade 1 11000
Stock Trade 2 11000
11000
64
Long Strap Payoff
65
Long Strip
Formation
Buy 2 Puts A and,
Buy Call A.
Variant
Buy 3 Puts A & Long Futures
66
Long Strip
67
Long Strip - Payoff
68
Short Straddle
Formation
Sell Call A and,
Sell Put A.
Variant
Sell 2 Calls A & Long Futures or
Sell 2 puts A and Short Futures..
69
Short Straddle
View Comment
Profit Limited to the Net premium received
Loss Unlimited
Low BEP = Middle Strike - Profit

Breakeven High BEP = Middle Strike + Profit
Time Decay Helps
Expecting a tight sideways movement

Use
Volatility Volatility decrease helps the position
Margin Yes
70
Short Straddle - Payoff
71
Short Strangle
Formation
Sell Call A and Sell Put B.
Variants
Sell Put A and Sell Call B
Sell Put A, Sell Put B and Short Futures
Sell Call A, Sell Call B and Long Futures
72
Short Strangle
73
Short Strangle - Payoff
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
Option Trade 5 9999
Option Trade 6 9999
200 200
Action: No.
Stock Trade 1 11000
Stock Trade 2 11000
11000
Days to expiry: 32 Totals: 200 200
74
Short Strangle - Payoff
75
Long Put
View Comment
Profit Unlimited, Increases as the Spot price decreases
Loss Limited to the premium paid
Breakeven Strike price - premium
Time Decay Hurts
Use Very Bearish Outlook
Volatility Volatility increases helps the Position
Margin No
76
Payoff Profile
77
Short Futures
View Comment
Profit Increases as the Spot price decreases
Loss Increases as the Spot price increases
Breakeven Sell price + Brokerage
Time Decay No Impact
Use Very Bearish Outlook
Volatility No impact
Margin Yes
78
Bear Put Spread
View Comment
Profit Limited, Maximum Profit = (B - A) - Net Premium
Loss Strike B - Maximum Loss
Breakeven Limited, Maximum Loss = Net Premium
Time Decay Mixed - Hurts for Long Put and helps for Short Put
Use Bearish outlook
Volatility Neutral
Margin Yes
79
Bear Put Spread
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.
80
Bear Put Spread

Option Trade 2 b 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)
81
Bear Put Spread Payoff
82
Bear Call Spread
View Comment
Profit Limited, Maximum Profit = Net Premium
Loss Limited, Maximum Loss = (B - A) - Net Premium
Breakeven Strike B - Maximum Loss
Time Decay Mixed - Hurts for Long Call and helps for Short Call
Bearish Outlook
Use
Volatility Neutral
Margin Yes
83
Bear Call Spread
Formation
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.
84
Short Call
View Comment
Profit Limited to the premium received
Loss Unlimited, increases as the spot price increases
Breakeven Strike price + Premium
Time Decay Helps
Bearish Outlook
Use
Volatility Volatility decreases helps the position
Margin Yes
85
Short Call - Payoff
86
OPTIONS PRICING
Put – Call Parity
Formula:
C + PV (x) = P + S
Where,
C = present value of the call
P = 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.
87
Thank You
88

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Options - Basics

A derivative instrument is a financial contract whose payoff

Futures Options Forwards Swaps

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

Gives buyer right to sell underlying futures contract.

Gives buyer right to buy underlying futures contract.

Strike Price (Exercise price)

The predetermined price of the futures contract

Person selling the option, and is exposed to margin requirements

It is corresponding Future Contract which can

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

Last date on which an option can be exercised or offset

•What are the other combinations and impact of them?

“To call from them”

Purchaser = The Goldsmith (Option-Call buyer)

“To put it on them”

Purchaser = The Goldsmith (Option-Put seller)

• Limited financial obligation.

Strike Price – E.g. Rs.10,000 /10gm

Time until expiration

Volatility of the underlying futures contract

Risk free interest rates.

¾ FOR A CALL OPTION –

¾ FOR A PUT OPTION –

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

May Corn Futures Price= Rs.329

Mar 11 Futures = 209.25 Apr 11 Futures = 237

Mar 11 210 Call Option Apr 11 240 Call Option

Mar 11 210 Put Option Apr 11 240 Put Option

¾ American Style Options –

¾ European Style Options –

¾ American Premium ≥ European Premium

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

•Hence we have φ (0, T )

•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:

Value of a stock follows log normal distribution.

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

Black – Scholes Formulae

¾ Delta :First derivative, considers sensitivity of options to price of future

¾ Gamma : Considers sensitivity of options to changes in Delta (Curvature)

¾ Theta : Considers sensitivity of options to time factor (time decay)

¾ Vega : Considers sensitivity of options to market volatility.

¾ Rho : Considers sensitivity of portfolio to interest rates.

Profit Unlimited, Increases as the Spot Price increase

Loss Limited to the premium paid

Breakeven Strike price + premium

Time Decay Hurts

Use Very Bullish Outflow

Volatility Volatility increase helps the position

Deal Details: SAMPL 10 Analysis Parameters:

Profit Increases as the Spot Price increase

Loss Increases as the Spot Price increase

Breakeven Purchase price + Brokerage

Time Decay No impact

Use Very Bullish outlook

Profit Limited, Maximum Profit = (B – A) – Net Premium

Loss Limited, Maximum Loss = Net Premium

Breakeven Strike A + Max Loss

Use Bullish outlook

Deal Details: SAMPL 10 Analysis Parameters: