Option Trading 0070704015, 9780070704015

Table of contents :
Cover
Contents
I. INTRODUCTION
1.1 Objectives
1.2 Conceptual Frame
1.3 Structure of this Book
1.4 How to use this Book
Summary
Keywords
2. INTRODUCTION TO DERIVATIVES
2.1 Objective
2.2 History and Evolution
2.3 Stock Exchanges in India
2.4 Types of Derivatives
Summary
Keywords
3. OPTION CONCEPTS
3.1 Objective
3.2 What are Options?
3.3 Different Forms of Options
3.4 Need for Options
3.5 Risks in Option Trading
Summary
Keywords
4. STRUCTURE OF INDIAN OPTIONS MARKET
4.1 Objective
4.2 Stock and Index Options
4.3 National Stock Exchange (NSE)
4.4 Bombay Stock Exchange (BSE)
4.5 Participants
4.6 Contract Cycle
4.7 Types of Orders
4.8 Leverage of Options
4.9 Writing an Option
4.10 Contract Structure
4.11 The Clearing and Settlement Process
4.12 Role of Broker in Options Trading
4.13 Why Indian Options Market Became More Complex than any Other Market in the World?
4.14 Futures and Options as Leveraged Instruments
4.15 Management of Long Put Option
4.16 Conversion of American in-the-money Put Options to Short Stock Futures
4.17 Calculation of Margins
4.18 Open Interest
Summary
Keywords
5. OPTION PRICING IN DIFFERENT SCENARIOS
5.1 Objective
5.2 Option Pricing Concepts
5.3 Calculation of Call Option Premium
5.4 Calculation of Put Option Premium
5.5 Put-Call Parity
5.6 Option Price Calculation in Different Scenarios
Summary
Keywords
6. OPTION GREEKS
6.1 Objective
6.2 Introduction to Greek Letters
6.3 Delta
6.4 Gamma
6.5 Theta
6.6 Vega or Kappa or Epsilon
6.7 Rho
6.8 Lambda
6.9 Calculation of Option Greeks
Summary
Keywords
7. OPTION STRATEGIES IN A BULL MARKET
7.1 Objective
7.2 Why Derivative Strategies?
7.3 Bullish Strategies
7.4 Strategies Suitable for Stock
7.5 Low Risk Stock Option Strategies
7.6 High Risk Stock Option Strategies
7.7 Complex Trading Strategies in a Bull Market
7.8 Combination Strategies
7.9 Calendar Spread
7.10 Intermonth Combinations
Summary
Keywords
8. RISK PERCEPTIONS IN OPTION TRADING
8.1 Objective
8.2 Introduction to Risk
8.3 Various Forms of Risk
8.4 Risk Management
8.5 Risk Identification
8.6 Managing Risks
8.7 Portfolio Hedging Through Nifty Options
8.8 Case Study: The LTCM Fiasco(ii)
Summary
Keywords
9. MARKET INDrCATORS
9.1 Objective
9.2 Put CalI Ratio
9.3 Rollover of Positions
9.4 Volatility
9.5 Bullish Characteristics
9.6 Option Premium
Summary
Keywords
10. FREQUENTLY ASKED QUESTIONS
10.1 Objective
10.2 What are the Key Differences Between Options and Futures?
10.3 Who Can Buy Options?
10.4 Why do European Options Trade below Intrinsic Value?
10.5 Who Fixes Option Premium?
10.6 Do the American Options Trade at a Discount?
10.7 Who Can be a Writer of an Option?
10.8 Why do We Need to Develop Option Strategies?
10.9 What are the Key Factors to be Considered While Purchasing an Option?
10.10 How CanWe Manage a Long Option Position?
10.11 How Can an Option Writer Reduce Risks in His Short Position?
10.12 How Can a Call Option Buyer lncur Loss even if the Underlying Asset is on aRise?
10.13 Is it Advisable to Average an Option?
10.14 What is Meant by Naked Call Writing?
10.15 How Can We Open a Trading Account with a Broker/Sub-broker and What are the Important Norms Followed?
10.16 What is the Maximum Brokerage that the Broker/Sub-broker Can Charge?
Summary
11. FUTURE AND OPTIONS SEGMENT STOCKS
11.1 Objective
11.2 Available Opl\on Instruments and Its Lots
Glossary
Index

Citation preview

OPTION TRADING BULL MARKET STRATEGIES

Other title of interest............................................

TRADING Bear Market Strategies Sasidharan K Alex K Mathews ISBN: 978-0-07-014855-0

OPTION TRADING BULL MARKET STRATEGIES

K Sasidharan Dean, School of Asset Management, Kochi, Kerala

Alex K Mathews Head, Research, Geojit-BNP Paribas Financial Services Ltd., Kochi, Kerala

Tata McGraw Hill Education Private Limited NEW DELHI

McGraw-Hill Offices New Delhi New York St Louis San Francisco Auckland Bogotá Caracas Kuala Lumpur Lisbon London Madrid Mexico City Milan Montreal San Juan Santiago Singapore Sydney Tokyo Toronto

Published by Tata McGraw Hill Education Private Limited, 7 West Patel Nagar, New Delhi 110 008 Copyright © 2011, by Tata McGraw Hill Education Private Limited No part of this publication may be reproduced or distributed in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise or stored in a database or retrieval system without the prior written permission of the publishers. The program listings (if any) may be entered, stored and executed in a computer system, but they may not be reproduced for publication. This edition can be exported from India only by the publishers, Tata McGraw Hill Education Private Limited. ISBN (13): 978-0-07-070401-5 ISBN (10): 0-07-070401-5 Vice President and Managing Director—Asia-Pacific Region: Ajay Shukla Executive Publisher—Professional: R Chandra Sekhar Manager—Production: Sohan Gaur Manager—Sales and Marketing: S Girish Asst. Product Manager—Business & General Reference: Priyanka Goel General Manager—Production: Rajender P Ghansela Asst. General Manager—Production: B L Dogra Information contained in this work has been obtained by Tata McGraw-Hill, from sources believed to be reliable. However, neither Tata McGraw-Hill nor its authors guarantee the accuracy or completeness of any information published herein, and neither Tata McGraw-Hill nor its authors shall be responsible for any errors, omissions, or damages arising out of use of this information. This work is published with the understanding that Tata McGraw-Hill and its authors are supplying information but are not attempting to render engineering or other professional services. If such services are required, the assistance of an appropriate professional should be sought. Typeset at Shubham Composer, WZ-437 Madipur Village, New Delhi 110063 and printed at Sai Printo Pack, A-102/4, Okhla Industrial Area, Phase – II, New Delhi – 110 020 Cover Printer: Sai Printo Pack RZXCRDLZRALAR

To Our Beloved Parents

Preface Financial markets across the world have become highly volatile since 2007. The financial crisis triggered by the US sub-prime crisis engulfed the financial markets across the world pulling down the confidence of investors. The worst affected were the stock markets which plummeted to a historically low level. Indian capital market also suffered extensively due to the contagious crisis. The BSE Sensex, and NSE-Nifty touched the historical bottom level consequent to the heavy outflow of FIIs and practically negative inflows of foreign investments. Though the government of India intervened timely and brought out extensive stimulus packages and pumped around Rs. 80000 crore to maintain liquidity, the response from the market was slow. Bulls and bears dominated the market simultaneously and made the market virtually unpredictable. The market moved to the two extreme ends within a day and made day trading the most difficult one. While the bulls gave opportunities for infinite profit, the bears stole the savings and at times wealth too. Derivatives are considered to be one of the mechanisms to hedge against the market risk among which future and options played the pivotal role. Option trading in stock market brought fortunes to many. However, the scenario that prevailed in the market since 2007 was extremely deceitful and those who took position believing the prevailing market conditions had to suffer substantial losses. Options which were considered to be effective risk management tools proved that they were risky. This was the background when we wrote our book Option Trading: Bear Market Strategies. At that time, bears dominated the market. However, since the second half of this year, the market showed symptoms of recovery. The BSE Sensex crossed the 20000 mark and NSE Nifty crossed the 6000 mark. Though the market continues to be volatile, bulls have started appearing in the market more frequently. Hence, we felt that a book on Option Trading Strategies for bull market would be appropriate at this moment. Options are leverage instruments. Hence, taking positions in options carries heavy risk. Traditionally, people considered derivatives as equivalent to gambling. Even now there are certain fund managers who hate derivatives and advise their clients against F&O segment. However, options are excellent wealth creators. A person who has Rs. 1 lakh with him can buy shares worth that amount or he can create much bigger position in options market. If the trading is done cautiously, the investment will gradually grow while on the other hand the original investment will be intact. This inherent risk in option trading prompted us to bring out a book on option trading which exclusively covers strategies specific to bull market.

viii Preface The book is divided into 12 chapters. In the first chapter we provide a brief introduction, the background, and how to use the book. In the second chapter we explain the basics of derivatives. The third chapter presents the structure of Indian option market. The fourth chapter presents certain facts relating to options and also explains various types of options. The fifth chapter explains the option pricing under different scenarios. Options are priced based on various parameters. The upward or downward movements of these parameters influence the option prices. In this chapter we have shown the computation of option prices when each parameter moves upward or downward. The option Greeks are explained in the sixth chapter. We present around 45 strategies suitable to bull market in the seventh chapter. The strategies are presented graphically to enable the readers to understand the concept easily. As already explained, option trading is risky and this aspect is discussed in chapter eight suggesting measures to avoid the risks. Certain market indicators like put call parity, volatility, etc., are explained in chapter nine. Around 15 questions relating to option trading strategies under bull market condition are answered in Chapter 10. Chapter 11 contains the list of stocks included in F&O segment. The common terminologies used in option trading with their meanings are listed in Chapter 12. The book is written as per the Indian market conditions and the examples represent the scrips traded in Indian stock market. The price information used in this book is time specific. Hence, the same condition need not prevail in another time zone. Therefore, we would like to advise our investors that they should rework these strategies using the current data available in the market before taking any decision. Though options give opportunity to earn high profits, they are equally risky. Hence, the models given in this book may be used as a guide and own strategies may be worked out. Neither the authors nor the publishers will be responsible for the consequence of blind application of these strategies. We have taken extreme care to ensure that all the presentations are true to the facts. However, there can be some errors or omissions due to various reasons. We would highly appreciate if our beloved readers could bring any errors or omissions noticed by them to our attention to help us to rectify them in our next edition. This book is aimed at professionals, traders and those who are at the dealing desk. However, the book will be highly useful to investors also. We also recommend this book to the students who are pursuing courses on behavioural finance. We would be highly satisfied and motivated if our readers find this book useful for managing their portfolios more efficiently. K SASIDHARAN ALEX K MATHEWS

Acknowledgements This book, Option Trading: Bull Market Strategies is our second book on option trading specific to the market conditions. The requests received from various quarters have motivated us greatly to structure this book. A number of persons have associated with us in this work. Since the time was short, we had to work hard to meet the deadlines. Hence, we needed the cooperation of our colleagues, friends and family members to complete the book on time. The motivation and encouragement received form Mr. C.J. George, MD, Geojit BNP Paribas needs special mention. We are deeply thankful to Mr. George for his valuable support and guidance for completing this work on time. We are also thankful to Mr. Girish Warrier and Mr. Vineeth Jose who helped us in compiling the data and structuring the graphic presentations. This book would not have reached the hands of our readers but for the encouragement received from our publishers, Tata McGraw Hill Education. We are highly thankful to Mr. Ajay Shukla, Vice President and Managing Director, Tata McGraw Hill Education for undertaking publishing of this work. We also wish to place on record our sincere thanks to the Editorial Team led by Mr. R. Chandra Sekhar, Executive Publisher, Professional, Ms. Sindhu Ullas and Mr. Sohan Gaur, Manager and others. We are grateful to the production team led by Mr. Rajendar P. Ghansela, General Manager, Mr. B.L. Dogra, Assistant General Manager, and other members in the production team whose efforts helped to materialize this project in excellent shape. We are also thankful to the Sales and Marketing team led by Mr. S. Girish, Manager, Sales and Marketing, Ms. Priyanka Goel, Assistant Product Manager, Business and General Reference and the other members in the team for their efforts to ensure that the book reaches our beloved readers on time. Finally we would like to thank our colleagues, friends and family members for their excellent support in completing the work. We would be failing in our duty if we do not remember the Almighty who gave us health and intelligence to complete this work. We profusely thank the God for His blessings on us. K SASIDHARAN ALEX K MATHEWS

Contents Preface Acknowledgements

1.

INTRODUCTION 1.1 1.2 1.3 1.4

2.

3.

4.

11

Objective 11 What are Options? 11 Different Forms of Options 12 Need for Options 13 Risks in Option Trading 13 Summary 14 Keywords 14

STRUCTURE OF INDIAN OPTIONS MARKET 4.1 4.2 4.3 4.4 4.5 4.6

4

Objective 4 History and Evolution 4 Stock Exchanges in India 5 Types of Derivatives 6 Summary 10 Keywords 10

OPTION CONCEPTS 3.1 3.2 3.3 3.4 3.5

1

Objectives 1 Conceptual Frame 1 Structure of this Book 2 How to use this Book 2 Summary 3 Keywords 3

INTRODUCTION TO DERIVATIVES 2.1 2.2 2.3 2.4

vii ix

Objective 15 Stock and Index Options 15 National Stock Exchange (NSE) 15 Bombay Stock Exchange (BSE) 17 Participants 17 Contract Cycle 18

15

xii Contents 4.7 4.8 4.9 4.10 4.11 4.12 4.13 4.14 4.15 4.16 4.17 4.18

5.

OPTION PRICING IN DIFFERENT SCENARIOS 5.1 5.2 5.3 5.4 5.5 5.6

6.

61

Objective 61 Introduction to Greek Letters 61 Delta 61 Gamma 63 Theta 64 Vega or Kappa or Epsilon 65 Rho 66 Lambda 66 Calculation of Option Greeks 66 Summary 69 Keywords 69

OPTION STRATEGIES IN A BULL MARKET 7.1

31

Objective 31 Option Pricing Concepts 31 Calculation of Call Option Premium 31 Calculation of Put Option Premium 32 Put-Call Parity 33 Option Price Calculation in Different Scenarios 35 Summary 59 Keywords 60

OPTION GREEKS 6.1 6.2 6.3 6.4 6.5 6.6 6.7 6.8 6.9

7.

Types of Orders 20 Leverage of Options 21 Writing an Option 21 Contract Structure 22 The Clearing and Settlement Process 25 Role of Broker in Options Trading 27 Why Indian Options Market Became More Complex than any Other Market in the World? 27 Futures and Options as Leveraged Instruments 28 Management of Long Put Option 28 Conversion of American in-the-money Put Options to Short Stock Futures 28 Calculation of Margins 29 Open Interest 30 Summary 30 Keywords 30

Objective

70

70

Contents

7.2 7.3 7.4 7.5 7.6 7.7 7.8 7.9 7.10

8.

102

RISK PERCEPTIONS IN OPTION TRADING 8.1 8.2 8.3 8.4 8.5 8.6 8.7 8.8

9.

Why Derivative Strategies? 70 Bullish Strategies 71 Strategies Suitable for Stock 87 Low Risk Stock Option Strategies 87 High Risk Stock Option Strategies 96 Complex Trading Strategies in a Bull Market Combination Strategies 112 Calendar Spread 117 Intermonth Combinations 117 Summary 125 Keywords 125

145

Objective 145 Put Call Ratio 145 Rollover of Positions 146 Volatility 147 Bullish Characteristics 151 Option Premium 151 Summary 151 Keywords 151

10. FREQUENTLY ASKED QUESTIONS 10.1 10.2 10.3 10.4 10.5 10.6 10.7

127

Objective 127 Introduction to Risk 127 Various Forms of Risk 127 Risk Management 134 Risk Identification 134 Managing Risks 135 Portfolio Hedging Through Nifty Options 135 Case Study: The LTCM Fiasco(ii) 137 Summary 144 Keywords 144

MARKET INDICATORS 9.1 9.2 9.3 9.4 9.5 9.6

xiii

152

Objective 152 What are the Key Differences Between Options and Futures? 152 Who Can Buy Options? 152 Why do European Options Trade below Intrinsic Value? 152 Who Fixes Option Premium? 153 Do the American Options Trade at a Discount? 153 Who Can be a Writer of an Option? 153

xiv Contents 10.8 10.9 10.10 10.11 10.12 10.13 10.14 10.15 10.16

Why do We Need to Develop Option Strategies? 153 What are the Key Factors to be Considered While Purchasing an Option? 153 How Can We Manage a Long Option Position? 153 How Can an Option Writer Reduce Risks in His Short Position? 154 How Can a Call Option Buyer Incur Loss even if the Underlying Asset is on a Rise? 154 Is it Advisable to Average an Option? 154 What is Meant by Naked Call Writing? 154 How Can We Open a Trading Account with a Broker/Sub-broker and What are the Important Norms Followed? 154 What is the Maximum Brokerage that the Broker/Sub-broker Can Charge? 155 Summary 155

11. FUTURE AND OPTIONS SEGMENT STOCKS 11.1 11.2 Glossary Index

Objective 156 Available Option Instruments and Its Lots

156

156 163 183

AUTHORS’ PROFILES Dr K Sasidharan is currently Dean, School of Asset Management, Kochi. He is also the Director of Derivative Research Forum and the Chairman of Centre for Resource Development and Research (CRDR), Kochi, Kerala. He has over 27 years of banking experience, primarily in credit and foreign exchange (especially currency derivatives), and nine years of teaching experience in Kerala’s premier business schools. He is an approved research guide with the Faculty of Management Studies, University of Kerala. Besides, he is a life member of the Institute of Banking and Finance, Mumbai; the Indian Society for Training and Development, New Delhi; and the Institute of Management Development and Research, Trivandrum. He has also been a Professor of Finance at TKM Institute of Management Kollam—Teaching Derivatives, Financial Services, Strategic Corporate Finance and International Finance, and was the Principal of Bhavan’s Royal Institute of Management. Dr Sasidharan is also a corporate trainer with numerous training programmes to his credit. He has presented papers in national and international seminars, contributed to other books, published research-based and general articles and authored books like Financial Services and System and Option Trading: Bear Market Strategies published by Tata McGraw Hill Education. Dr Sasidharan is an Associate Editor of Management Researcher published from Trivandrum. Alex K Mathews is currently Research Head at Geojit BNP Paribas Financial Services Ltd, one of the leading brokerage houses in India based in Kochi, Kerala. He has over 20 years of experience in trading in financial market. As a renowned financial analyst with over two decades of industry experience, Mathews is an empanelled analyst for channels like NDTV, UTVi, CNBC, CNBC Awaz, Zee News, Manorama News and Doordarshan. He has written several articles in leading newspapers and magazines like Business Line, Business Standard and The Economic Times among others. His views on financial markets and economics have been cited by many international news agencies like Reuters, Bloomberg and Dow Jones. He has co-authored books titled Financial Services and System and Option Trading: Bear Market Strategies published by Tata McGraw Hill Education and presented many research papers in international conferences. He is a life member and an Academic Council Member of the Centre for Resource Development and Research, and is an honorary member of the Derivative Research Forum, Aluva, Kerala.

Chapter 1

INTRODUCTION

1.1 OBJECTIVES Options have assumed a greater role in protecting assets from loss of value. Options trading commenced in Chicago Board of Trade and in India, trading was started in National Stock Exchange (NSE). Though they are basically risk management tools, they do carry a high risk. Unless these hybrid financial instruments are handled with utmost care, the investor may incur substantial losses. Essentially, those who trade in options should possess substantive knowledge and skill. Trading strategies are different for different market conditions. The objective of this book is to give the readers a detailed view about options, trading in options and various strategies to be adopted in suitable bull market conditions.

1.2

CONCEPTUAL FRAME

Options are leveraged instruments. With a small investment, the investor can hold a large position and earn good profit. For example, an investor who has Rs. 200,000 with him can buy only 100 shares of Infosys at a price of Rs. 2000, whereas using this amount as margin and paying upfront premium he can buy a large number of call Option of Infosys. The broker reveals various option strategies for bull market conditions. Options give leverage to traders. Proper study and management is needed for options trading, because while creating strategies, even a minor error can cause immense loss to the trader. Sometimes complicated strategies reduce the risk and margin requirements. Improper strategies, instead of giving profits to the investor, will give losses and additional burden of margins. A properly adopted strategy will reduce cost, reduce margins, increase profits and at any time allow investors to evaluate where they stand. In India, adoption of strategies get less response and a majority of traders use

2 Option Trading long-call/long-put strategies. Few investors adopt selling strategies, because of high margin requirements. The aim of this book is to motivate the investors to use extensive trading strategies, which may reduce the risk of trading to a certain extent.

1.3

STRUCTURE OF THIS BOOK

The main objective of this book is to make the readers aware of certain strategies that can be used in bull market conditions. However, we start this book by explaining the concept of derivatives, its origin and growth, especially in the Indian market. Besides, the structure of Indian options market is also included. This book also gives emphasis on various options’ pricing, which will help investors in finding the option premiums to a great extent. A brief description on option Greeks, which is the backbone for all knowledgeable traders, is also given. We have explained 40 strategies applicable to the bull market. Another area covered in this book is the risk and risk aversion techniques. The book explains various market indicators such as put-call parity, roll over positions, volatility trade, etc. A chapter is included to cover frequently asked questions specific to the bull market. We have also listed the stocks, which are included in the Futures and Options segment. Finally, we have given the common terminologies used in options trading in the Glossary. The book creates awareness about options trading in bull markets and establishes the need for successful adoption of trading strategies.

1.4

HOW TO USE THIS BOOK

As already stated elsewhere, this book explains strategies applicable to the bull market. We have explained the concept of options, options pricing, etc., specific to the bull market. However, readers are encouraged to go through the relevant chapters in our book on Options Trading: Strategies for Bear Market for a better understanding about options. The strategies explained in this book are developed using data collected from the Indian stock market. Similarly, the data used to formulate the strategies are time-specific. Hence the diagrams and computations have to be considered as information for guidance and should not be adopted without reworking under the prevailing market conditions. Those who are interested to invest in options have to consult with their brokers and formulate their own strategies. The computations in this book will enable them to develop their own strategies best suitable to the conditions prevailing in the market at that time.

Introduction

3

Summary In this chapter we have briefly explained the conceptual framework of this book and introduced options trading in the bull market. We have also explained the structure of this book and how the information in this book could be utilized by the readers in a better manner. Options are highly profitable investment tools, at the same time they are highly risky also. One will end up in losses unless the intricacies of options trading are understood properly. The objective of this book is to provide a deeper knowledge on options trading in bull market conditions. We feel that it would be highly useful if we start our discussion by understanding the derivatives, their evolution and functions. There are different types of derivatives. But we are not using all of them. We are discussing these aspects in the second chapter.

Keywords Derivatives

Options

Strategies

Premium

Margin

Greeks

Chapter 2

INTRODUCTION TO DERIVATIVES

2.1 OBJECTIVE The objective of this chapter is to provide a basic understanding about the derivatives in general, and various types of derivatives in particular. In this chapter we shall discuss the concept of derivatives, their origin globally and more particularly in India, types of derivatives and their uses, major stock exchanges in India, etc. More details about stock market derivatives are dealt with in the subsequent chapters.

2.2 HISTORY AND EVOLUTION Derivatives are contracts entered into by two parties to protect an underlying asset from the sensitivity to price changes. In other words, “a derivative instrument is an asset whose performance is based on the behavior of the value of an underlying asset (usually referred to simply as the underlying)”. The underlying asset can be a commodity or a financial instrument. The derivatives structured to protect the price movement in the commodity market are known as commodity derivatives. Examples of commodity derivatives are pepper and coffee futures. Financial derivatives are contracts, the performance of which is based on an underlying financial asset like shares, bonds, currencies, interest rates, etc. The financial derivatives are structured on price indices like equity and stock index. The derivatives are contracts which give the right, and sometimes the obligations. The derivative instruments are in existence for more than two thousand years. The history of derivatives dates back to the ancient Olive growers in Greece. The Olive growers were unwilling to accept the risk of a low price for their crop when harvested months later. They entered into contracts whereby,

Introduction to Derivatives

5

a price was agreed for delivery at a specific time. This reduced uncertainty for both the growers and purchasers of the olives. In the middle ages, forward contracts were traded in a secondary market, particularly for wheat in Europe. A futures market in rice was in existence in Osaka, Japan, in the seventeenth century. In Amsterdam, Tulip bulb options were traded in the seventeenth century. The establishment of Chicago Board of Trade (CBT) in the nineteenth century gave a sudden push to the growth of derivative trading. Subsequently, the London Metal Exchange (LME) was also started. While the CBT regulated trading of grains and other futures and options, the LME dominated in the metal trading

2.3

STOCK EXCHANGES IN INDIA

There are mainly two stock exchanges in India, namely Bombay Stock Exchange (BSE) and National Stock Exchange (NSE). Besides this there are various other regional stock exchanges. Derivative contracts are mainly dealt via the NSE. Though the BSE had started trading in futures and options (F&O), the volume was substantially low. Now they have initiated certain steps to expand the F&O segment. Apart from NSE and BSE, there are 21 regional stock exchanges in India. A list of these exchanges together with their date of establishment, date of commencement of operation and constitution is given in Table 2.1. Table 2.1 Name of Stock Exchange

List of Exchanges

Year of Establishment

Year of Recognition

Type of Organization

1. Ahmedabad

1894

1957

Voluntary non-profit making association

2. Calcutta

1908

1957

Public limited company

3. Madras

1908

1957

Public limited company

4. Indore

1930

1958

Voluntary non-profit making association

5. Hyderabad

1943

1958

Company limited by guarantee

6. Delhi

1947

1957

Public limited company

7. Bangalore

1957

1963

Public limited company

8. Cochin

1978

1979

Public limited company

9. Kanpur (UP)

1982

1982

Public limited company

6 Option Trading Name of Stock Exchange

Year of Establishment

Year of Recognition

Type of Organization

10. Pune

1982

1982

Company limited by guarantee

11. Ludhiana

1983

1983

Public limited company

12. Jaipur

1983

1989

Public limited company

13. Guwahati

1984

1984

Public limited company

14. Mangalore

1985

1985

Public limited company

15. Magadh

1986

1986

Company limited by guarantee

16. Bhuvaneshwar

1989

1989

Company limited by guarantee

17. Saurashtra

1989

1989

Company limited by guarantee

18. OTCEI

1989

1989

Company limited by guarantee

19. Vadodara (Baroda)

1990

1990

Public limited company

20. Coimbatore

1991

1991

Public limited company

21. Meerut

1991

1991

Public limited company

The introduction of online trading system almost pulled down trading operations of the regional stock exchanges and many of them now function as extension centers of BSE/NSE.

2.4 TYPES OF DERIVATIVES Derivatives can be classified into commodity derivatives, financial derivatives, weather derivatives, etc. Innovations in the market may give rise to a further class of derivatives based upon the customer demand.

Commodity derivatives Commodity derivatives are those contracts where the underlying assets are commodities. The best example for commodity derivatives in India is pepper futures, oil futures, jute futures, hessian futures, etc. Recently in Kerala, rubber derivatives were introduced to hedge the risk arising out of the price movement in the rubber market. This mechanism will enable the growers to get a fair return for the investments they have made.

Financial derivatives As has already been mentioned, a financial derivative is a contract based on a financial asset. The asset can be a loan or deposit. Financial derivatives are traded in the financial market. The major financial markets where the derivatives are traded are Mumbai and Chennai.

Introduction to Derivatives

7

Financial derivatives can further be classified into: Equity derivatives, which are those contracts where the underlying assets are shares. Interest rate derivatives (IRD), which are hedging tools used to manage the risk arising out of interest rate movements. IRDs can be based on debentures or bonds or simple plain vanilla derivatives like bond futures, treasury bill futures, interest rate options, interest rate swaps, etc. Credit derivatives are structured based on credit instruments or loans where the payoff is decided based on a credit event. These contracts are linked to a third-party reference asset. Credit default swaps, credit default options, collatized bond obligations, etc. Index derivatives are contracts structured on indices. The payoff is determined based on the movement of indices. The indices can be that of stock, commodities, etc. Examples of index derivatives are CNX Nifty futures, CNX Nifty options, etc. Currency derivatives represent contracts covering foreign currency obligations or claims. The payoff is decided based on the price of the currency. The important types of currency derivatives are currency futures, currency options, currency swaps, etc. Weather derivatives are financial products that enable an organization to offset the financial risk due to a weather variable. They allow companies to control effects of the weather on demand for their products. This hedging reduces volatility of future revenue to a more predictable cash flow. Hence, profit earnings to shareholders because of adverse weather conditions are less frequent. This steadies the share price and keeps the directors on the board. A common measure of temperature that has arisen from the market is a degree-day. A degree-day is the deviation of a day’s average temperature from the reference temperature. This was found to be a useful measure that the energy suppliers could use to hedge their supply in adverse temperature conditions. Specifically, a heating degree-day is equal to the greater of the reference temperature, minus the average of the daily high and daily low temperatures and zero. A cooling degree-day is equal to the greater of the reference temperature, minus the average of the daily high and daily low temperatures and zero. Temperatures derivatives are extremely transparent because of this simple explanation, and because they are measured independently with forecasts that are widely available. This transparency has quickly enabled an over-the-counter market to develop in the US, and also helped to promote a similar growth in the UK. The common forms of weather derivatives are call options, put options, caps, floors, collars and swaps. Some of the exotic varieties like one-touch,

8 Option Trading digitals, barrier and basket options are also structured to meet specific needs. Futures are contract structured for delivery of the underlying assets on an agreed future date; the delivery may or may not take place. Where the cash settlement is there, the counterparty will take delivery or give delivery. Otherwise the contract will be wound up by settling the difference between the contract value and spot price at the time of maturity. The futures can be equity futures, index futures, interest rate futures, currency futures, commodity futures or weather futures. Futures are generally exchange traded. Therefore they are less risky and highly liquid. The advantage of futures contract is that the investor can liquidate his position at any time since the exchange is the counterparty. The exchange ensures the settlement under the contract. For this purpose they are collecting margins from the contracting parties. In India futures are traded in commodity as well as financial markets. Futures traded in financial markets are financial futures and those traded in commodity exchange are known as commodity futures. The hedgers use futures to hedge price and interest rate risk. The arbitrageurs use futures for taking advantage of price differentials between cash market and future market or market at different centers. Speculators use futures for taking positions price movements. The futures are used for hedging by taking a directional position of the spot asset. Options are financial contracts entered into between two parties, where one party has a right to give or take delivery of an underlying asset, but has no obligation to do so, whereas the other party has the obligation to give or take delivery. Options can be a call option, where a person bullish on the underlying asset buys the option. In the case of put option, a person holding long position buys an option to hedge against the downward movement of price. The seller of the option is otherwise known as writer and the counterparty is known as the option buyer. The process is known as writing of option. Options can be American or European. In the case of an American option, the buyer can exercise the contract at any point of time before the maturity. In the case of an European option, the contact can be exercised only on the expiry date. All index options are European options, whereas all equity options are American options. The option can be a plain vanilla option, compound options or complex options like futures with option, swaptions, exotic options, etc. Swaps: A swap is a contract entered into between two parties for exchange of cash flows with identical maturities for the purpose of taking advantage of comparative advantage enjoyed by either one or both. The swap contract under derivatives is different from the swaps in foreign exchange dealings,

Introduction to Derivatives

9

where swapping is done to rectify maturity mismatches. The swap can be an interest swap or a currency swap. In the case of an interest rate swap, the contracting parties exchange a floating rate with a fixed rate, or a fixed with fixed, or a floating with floating. The currency swaps enables the contracting parties to exchange the cash flows in two different currencies for taking advantage of the interest rate differentials as well as the exchange rate differentials. The principals under swap contracts are notional and only the interest rate differentials are exchanged by the contracting parties. Unlike options or futures, the swaps can be liquidated only on maturity. Therefore, swaps are illiquid. The swaps can be equity swaps, commodity swaps, currency swaps or compound swaps like swaptions. Forward Rate Agreement (FRA) is a derivative contract, which protects the buyer of FRA from changes in interest rate. Normally FRAs are long-term contracts, say for three years, five years, etc., with intermittent reset dates. For example, a forward rate agreement with maturity of three years can have interest rate reset dates at the end of every six months. A forward rate agreement entered into by a company which has decided to avail of a loan from a bank for a period of six months on a date three months from today, ensures an interest rate which is mutually agreed upon by the FRA buyer and the seller. In this contract the FRA seller, normally a bank, agrees to pay the interest rate differential in case the interest rate prevailing at the time of availing of the loan as well as on the reset dates are more than the agreed rate. If the interest rate happens to be less than the agreed rate the buyer has to pay the differential to the seller. Caps and Floors are set of option contracts entered into to hedge the risk arising out of movement of interest rates. When there is more than one cap or floor it is known as caplets or floorlets. The caps protect the cap buyer from upward movement of the interest rate. The cap differs from FRA because in the case of cap the buyer can abandon the contract if the rate moves downwards, in which case his maximum loss is the upfront premium paid by him. Whereas in the case of FRA the FRA buyer cannot abandon the contract, but has to pay the difference. A floor is an option contract which protects the floor buyer from downward movement of the interest rate. In the event of a fall in the interest rate, the floor seller will pay the difference to the floor buyer, whereas if the rate moves up the buyer need not pay anything to the seller. His maximum loss is the upfront premium paid by him to the seller at the time of writing the option. A collar is a combination of caps and floors. The collar helps the investor to hedge against both upward and downward movement of interest rates.

10 Option Trading

Summary Derivatives are financial contracts between two parties structured on an underlying asset, which can be a loan, investment, a commodity or currency. The pay off under a derivative contract depends on the performance of the underlying asset. The derivatives can be financial derivatives, commodity derivatives, equity derivatives, or weather derivatives. They can be futures, options, swaps, caps, floors, collars, forward rate agreements, etc. In this book we are dealing with options only. A basic understanding about options and certain commonly used terminologies in options trading are essential for understanding the strategies. In the next chapter we discuss more about options.

Keywords Financial Derivatives

Contract

Commodity Derivatives

Stock Exchange

Chicago Board of Trade

London Metal Exchange

Bombay Stock Exchange

National Stock Exchange

Regional Stock Exchange

F&O Segment

Equity Derivative

Interest Rate Derivative

Credit Derivative

Index Derivative

Currency Derivative

Weather Derivative

Hedging

Temperature

Cooling Degree Day

Reference Temperature

Futures

Speculators

Commodity Exchange

European Option

American Option

Index Option

Forward Rate Agreement

Caps and Floors

Chapter 3

OPTION CONCEPTS

3.1 OBJECTIVE In the last chapter we discussed derivatives in general. We also found that options are one form of derivatives. This chapter highlights different forms of options, and helps to understand the concept of call and put options. It also covers the risk involved in options trading.

3.2

WHAT ARE OPTIONS?

Options are financial contracts which protect the buyer from adverse movement of the price of the underlying asset with right to exercise the option, even if the price moves according to his expectation and with no obligation if otherwise happens. In order to enjoy this facility of abandoning the option, the option buyer has to pay an upfront fee known as premium. In effect, put options are like insurance, where we pay premium and sell the risk to the insurance company. In the event of a loss the insurance company will pay the value of the insured asset as compensation. If there is no loss, the premium paid will be lost. Hence, the maximum loss in the case of insurance is the premium paid. In the case of options also, the maximum loss is the premium paid, whereas the gains are unlimited. Hence, options are leverage instruments. While the option buyer has the right to abandon, the option seller does not have this right. Hence, the option writer carries unlimited risk whereas his gain is limited to the upfront premium received. Options can be exchange-traded options or OTC options. In India we have only exchangetraded options in the stock market. The Futures and Options (F&O) segment of the exchanges facilitates trading in option contracts by taking the position as counterparty and thus, eliminating the risk of default.

12 Option Trading

3.3

DIFFERENT FORMS OF OPTIONS

Options are mainly classified into two kinds:

American options These options can be assigned on any day before the expiry date. All assignments are settled at the weighted closing price of that particular day. In India, all stock options are American.

European options These options can be assigned only on the last day of expiry. They are settled on the weighted average price of the underlying. All index options are European in nature, which cannot be assigned during the contract cycle except on the expiry day.

3.3.1 Call Option Concept Call option is an option which gives the option buyer the right, but not the obligation to buy an underlying asset at a fixed price on a future date. The buyer of a call option pays a premium to the seller (writer) of the call option. His risk is limited to the extent of the premium paid. The seller, however, has an unlimited risk (Fig. 3.1).

Buyer of call option

Seller of call option

Pays premium

Risk is limited to the extent of the premium paid

Receives premiumrisk is unlimited

Fig. 3.1 Call option

3.3.2 Put Option Concept Put option is an option which gives the option buyer the right, but not the obligation to sell an underlying asset at a fixed price on a future date. The buyer of a put option pays a premium to the seller (writer) of the put option. His risk is limited to the extent of the premium paid. But the seller has an unlimited risk (Fig. 3.2).

Option Concepts

Buyer of put option

13

Seller of put option

Pays premium

Risk is limited to the extent of the premium paid

Fig. 3.2

Receives premiumrisk is unlimited

Put option

The premium for the contract is calculated by using Black-Scholes option pricing and binomial models. The option premium is determined by both the buyer and seller of the option.

3.4 NEED FOR OPTIONS · Risk management Options enable how to manage the risk. For example, imagine that an investor is holding 100 shares of Infosys, which he had acquired at a price of Rs. 3500. He decided to hold it for three months, but is not sure whether the price will go up or down. If the price goes up he earns a profit. But if the price goes below Rs. 3500, he may incur loss. A put option can save him from a potential loss. By buying a put option he pays upfront premium to the seller and locks in at a strike price. If the price of the share goes below the strike price, he receives the difference as option pay-off. Thus, options are excellent risk management tools. · Leverage Options are leveraging tools because they are bought at a premium. The gains can be infinite. · Hedging Options help to hedge a portfolio held by an investor by taking an opposite position. · Arbitrage Options help to take advantage of the price differentials between two markets.

3.5 RISKS IN OPTION TRADING In India, stock options are settled in cash and not in stock. If your sold options got assigned, you will be informed by the broker only on the next day. If the stock opens the next day in a downside gap, even if you are holding the stock, you may incur a loss. In international markets, assignment is followed by

14 Option Trading stock delivery. The option buyer’s risk is limited and option writer’s risk is unlimited. If the memberwise open interest limit is exhausted on a security, then it will be difficult for investors to initiate fresh positions. If the market wide limit of a security is above a stipulated percentage, creation of new positions is banned.

Summary In this chapter we could understand certain basic concepts like the term option and its meaning in financial context, different types of options, need for options, risk in option trading, etc. Before proceeding further, essentially, we must understand the structure of Indian options market. We are discussing the characteristics and dealing system of options trading in the next chapter.

Keywords OTC options

F&O segment

Call option

Put option

Put-call parity

Black-scholes

Risk

Investment

Leverage

Hedging

Arbitrage

Chapter 4

STRUCTURE OF INDIAN OPTIONS MARKET

4.1 OBJECTIVE In the previous chapters we introduced the concept of derivatives as a tool for hedging and arbitrage in the process of wealth maximization, types of derivatives, basics of options and types of options. In India, trading in options in the capital market commenced only in 2001. Within a short span of eight years the market grew multifold. Hence, an understanding about the Indian options market will enable readers to acquire better knowledge about this hybrid financial instrument. This chapter broadly covers structure of the options market in India, types of options, clearing mechanisms and enriches the reader’s knowledge of options.

4.2 STOCK AND INDEX OPTIONS Options can be divided into two parts—individual stocks options or index options. While the underlying asset of stock options is individual stock, that of index options is the stock index. For example, an investor can buy or sell options on the stock of Infosys, ACC or SBI individually. Similarly, he can also buy or sell options on Nifty or Sensex, which include these stocks also in it. In the case of stock options the price of individual shares decides the pay off, whereas in the case of index options, the changes in the index value decides the option price. More about the stock and index options, lot size and contractual terms followed by BSE and NSE are given in the course of this book.

4.3 NATIONAL STOCK EXCHANGE (NSE) NSE was promoted by leading financial institutions and was incorporated in November 1992 to provide access to investors from all across the country.

16 Option Trading It commenced operations in Wholesale Debt Market in June 1994 after its recognition under the Securities Contracts (Regulation) Act, 1956, in April 1993. The Capital Market (Equities) segment commenced operations in November 1994 and operations in derivatives segment commenced in June 2000. The S&P CNX Nifty, which is a collection of 50 stocks in the order of increasing market capitalization, was launched in April 1996. The Nifty is the benchmark index for the stocks traded in NSE. Later on many other indices like Bankex, CNX IT, CNX 500, MiniNifty, CNX 100, etc., were launched. NSE revises the indices periodically by adding new shares or removing those shares, which have low trading volume. Trading in futures and options on index and individual securities commenced in 2001. The list of shares is included in the F&O Segment (see Chapter 11). This year paved the way for the much-touted derivative trading, which has gained great importance over the years. The growth of F&O trading was so vivid that the daily turnover as on July 29, 2009, was Rs. 116,508 crore, and that of the capital market (equities) segment as on May 19, 2009, was Rs. 40.151.9 crore. Henceforth, there was a rapid development with a variety of products, such as Internet trading, exchange traded funds (ETF’s), volatility index, etc. Lately, currency and interest rate derivatives were introduced by NSE, the former in August 2008, and the latter on August 31, 2009. With these new advancements, retail as well as institutional investors have a variety of products to invest in.

4.3.1 Technological Powerhouse NSE stresses on innovation and sustained investment in technology to remain ahead of competition. NSE’s IT set-up is the largest by any company in India. It uses satellite communication technology to energize participation from around 200 cities spread all over the country. With upgradation of trading hardware, NSE can now handle up to 15 million trades per day in the capital market segment. In order to capitalize on in-house expertise in technology, NSE set up a separate company, NSE Technology Services Ltd., which is expected to provide a platform for taking up all IT-related assignments of NSE. NEAT is a state-of-the-art client server-based application. NSE is one of the largest interactive VSAT-based stock exchanges in the world. Today it supports more than 2000 VSATs and 3000 leased lines across the country. NSE allows members to provide Internet trading facility to their clients through the use of NOW (NSE on web).

Structure of Indian Options Market

4.4

17

BOMBAY STOCK EXCHANGE (BSE)

BSE is the oldest stock exchange in Asia spanning over a period of 133 years, being established in 1875. It obtained permanent recognition from Government of India under Securities Contract Regulation Act in 1956. In early days, an open out-cry system was the form of trading which later gave way to the online trading system (BOLT) in 1995. Today, BSE is the world’s number one exchange in terms of the number of listed companies and the world’s fifth in transaction numbers. The market capitalization as on July 10, 2010, stood at USD 1390.08 billion. The BSE index, SENSEX is India’s first stock market index. It is an index of 30 stocks representing 12 sectors. Apart from the SENSEX, BSE offers 21 indices, including 12 sectoral indices. BSE provides an efficient and transparent market for trading in equity, debt instruments and derivatives. It has a nation-wide reach with a presence in more than 359 cities and towns of India.

4.5

PARTICIPANTS

Dealers: Dealers merely place the buy and sell orders on behalf of the clients. Speculators: Speculators capture profits on an intra-day basis, depending on news/instinct. The speculators give the liquidity to the market.

Arbitrageurs: Arbitrageurs monitor the price variations or movements of the same underlying asset in different markets, i.e., NSE and BSE, Stock and options market, Options and futures market, future and spot market. One important point to be noted is that through arbitrage, the investors gain only by a small amount, is the variations in price because between the two markets are only minimal. As such they can trade in bulk in these markets.

Hedgers: These are investors who use various strategies in futures and options market for reducing their risk.

Volatility Traders: These traders buy options with low implied volatility and sell with high volatility. The volatility may differ in each strike price of an underlying with the same maturity. Every stock or option has a historic volatility. Implied volatility is the amount over and above historic volatility. The volatility changes usually arise in tandem with any major incident like election, union budget, etc. For example, suppose the historic volatility of a TCS stock is 42%. At the onset of elections, the volatility tends to rise and attains a peak either the day before election results are out, or on the day of the election results. After the election results are out, the volatility usually falls. The knowledgeable investor buys options before the election, and sells when the implied volatility reaches the maximum.

18 Option Trading

Mr. A sold INFY Futures

Hedging Strategy ∑ Buy INFY call, Sell INFY put ∑ Buy INFY stocks ∑ Buy far month INFY futures Alternative Strategy ∑ Buy NIFTY futures ∑ Buy NIFTY Call, Sell NIFTY Put

Mr. B bought INFY Futures

Hedging Strategy ∑ Sell INFY call, Buy INFY put ∑ Sell INFY stocks ∑ Sell far month INFY futures Alternative Strategy ∑ Sell NIFTY futures ∑ Sell NIFTY Call, Buy NIFTY Put

Fig. 4.1

The process

Market makers: They are individuals or corporate entities operating in the market to reduce the bid ask spread. They quote bid and ask prices at different time intervals on every trading day.

4.6

CONTRACT CYCLE

A contract cycle is the time from the start of the contract till its expiry. Each underlying has three contract cycles—near month, middle month and far month. For example, in the month of March, the contract cycles would be March, April, and May (Fig. 4.2). March contract (near month)

April contract (middle month)

March 2010

May contract (far month)

Fig. 4.2

Contract cycle

Each contract cycle expires on the last Thursday of the particular month. For example, the March contract, expires on March 25, i.e., the last Thursday.

Structure of Indian Options Market

19

On the next day after expiry, the April contract will be available for trading, which would then expire on the last Thursday of April, and so on. Figure 4.3 will explain this clearly. March contract: Expiry on March 25

April contract: From March 26 to April 29

May contract: From April 30 to May 27

Fig. 4.3

Expiry of contract cycle

Investors can hold on to this position till the last Thursday or he can book profit/loss before. If he does not square off his position before 3:30 p.m. on the expiry date, then the exchange automatically squares off all open positions. As an example consider the following case: An investor buys one lot of Nifty call options of May contract. He can square off his position either on the expiry date or before.

Pays premium/takes position

Buyer of the contract

May contract Expiry date—May 27

Profit/Loss/Neutral

Fig. 4.4

Squaring off

In-the-money, At-the-money and Out-of-the-money Options The options premium consists of intrinsic value and time value. The intrinsic values cannot be negative in American options. In case of European options, (Nifty options) it can trade with negative intrinsic value. Any option which has an intrinsic value is said to be an in-the-money option. Options which do not carry intrinsic values, but only time values are out-of-the-money options. When the option strike price and spot price of the underlying option are the same, then it is an at-the-money option.

20 Option Trading For example, suppose an investor is buying a call option, and the strike price is less than the spot price, then it is said to be an in-the-money option. If the strike price is above the spot price, it is an out-of-the-money option. Strike prices which are very close to the underlying asset price are known as at-the-money options. Spot Price = 5000 Call Option

Premium

Strike Price

15

25

35

50

125

280

375

450

5300 5200 5100 5000 4900 4800 4700 4600 Out-of-the-money

In-the-money

Put Option

Premium

350

Strike Price

5300 5200 5100 5000 4900 4800 4700 4600

250

150

In-the-money

Fig. 4.5

50

35

25

15

5

Out-of-the-money

In-the-money and Out-of-the-money options

4.7 TYPES OF ORDERS The trading members are allowed to enter into different types of orders based on certain conditions. The following are the type of orders:

Day order: This order is valid for the day. If by the end of the trading day, the order does not get executed, then the order gets cancelled. This can happen in case a particular order does not get a buyer or seller for the stated price. Then by the end of the trading session, the order gets cancelled.

Immediate order or cancel (IOC): As the name suggests, this type of order permits the trader to buy or sell as soon as the order is released, failing which the order stands cancelled. Partial match for an order can happen. In such a case the unmatched portion immediately cancelled. For example, a trader places a buy order for two lots of 150 each of Infosys stock, one for a price of Rs. 2213 and the other for Rs. 2010. If there is no seller at both these prices the order will not be executed. If there is seller available at Rs. 2213, that order will be executed and the other order will be immediately cancelled.

Structure of Indian Options Market

21

Stop loss order: A stop loss order is used to restrict the amount of loss that one can bear to a certain extent. This facility allows a trader to release an order once the market price of a security has breached a trigger or threshold price. For a stop loss buy order, the trigger price has to be less than the limit price, whereas, for a stop loss sell order the trigger price has to be greater than the limit price. For example, suppose the market price for a stock is Rs. 134. An investor wants to sell 500 share of that stock on expectation of a fall in price. If his calculation goes wrong, the stock can move up sharply. Hence the short seller places a stop loss buy order above the selling price at Rs. 137. After the stop loss placement if the stock moves above Rs. 137 the sold position will automatically get squared off.

4.8

LEVERAGE OF OPTIONS

One of the major attractions of trading in derivatives is the leverage, which is inherent in options. Options can be bought by simply paying the option premium. A small investor who can accurately predict the price of an underlying can buy options with low investments than buying stocks which need huge capital investments.

4.9 WRITING AN OPTION Important points need to be noted by option writers: 1. One should never write in-the-money options, because they can be assigned by the buyers. (American options can be exercised early). 2. Holding the stock and writing out-of-the-money call options are safe. 3. One should never try to write an option when the implied volatility is low. 4. It is safe to write a strangle/straddle than writing a call/put option alone. 5. Selling near month out-of-the-money calls are safer than far month options, because the time value of near month options will decay faster. 6. While selling an at-the-money option, it is safe to buy an out-of-themoney option as a hedge 7. If one is writing a strangle/straddle, it is advisable to find out the upper and lower break even point using the premiums (BEP). For instance, if NIFTY moves above the upper side BEP, buy NIFTY futures for protection. If NIFTY falls below the downside BEP, sell NIFTY futures for protection.

22 Option Trading

4.10 CONTRACT STRUCTURE Option contracts are standardized products. The price, lot size, tick size, time to maturity, etc., are pre-fixed by the exchange. The contract specifications of BSE and NSE are given below:

4.10.1 BSE Index Futures The underlying asset of BSE Index futures is SENSEX. Market Lot size is 50 times of SENSEX. The contracts are available for three nearest serial months, i.e., at a time three contracts will be available for trading. Tick size is 0.1 point and the tick value is Rs. 5. Price quotations are SENSEX points. All futures contracts expire on the Thursday falling two weeks prior to the last Thursday of the contract month. If that Thursday happens to be a holiday, the immediately preceding business day will be considered as the expiry date. The contracts are to be cash settled on the last trading day and the closing value of the underlying assets would be the final settlement price of the expiring futures contract.

4.10.2 BSE Stock Futures The underlying asset is the corresponding stock in the cash market. The market lot is stock specific and varies from scrip to scrip. For example, the market lot of Infosys is 125. As in the case of Index Futures, stock futures contracts are also available for three consecutive months. Price quotations are the value of the underlying shares in rupees. Tick size is 0.05. There is no physical settlement. The settlement terms are the same that are followed in the case of settlement of Index futures contracts.

4.10.3 BSE Index Options The underlying asset is SENSEX and the market lot is 100 times of SENSEX. Contracts are available for three consecutive months at a time. Weekly contracts for one or two weeks are also available for trading. BSE also offers long dated option contracts. All index options are European Options. Tick size is Rs.1.00. A minimum of three strike prices are available at a time, i.e., one in-the-money, one at-the-money and one out-of-the-money. Weekly options contracts are also available at BSE. The contracts are to be settled on the Thursday falling two weeks prior to the last Thursday of the month in which the contract expires. In the case of weekly options contracts, the contract cycle is Friday to Thursday and the weekly option contracts are to be settled on the last Thursday of the contract week. If the settlement day happens to be a holiday, the settlement would take place on the immediate preceding business day. All index options are to be settled on cash basis.

Structure of Indian Options Market

4.10.4

23

BSE Stock Options

The underlying asset of stock options is the corresponding shares in the cash market. As in the case of stock futures, market lot for stock options are also stock specific. Stock option contacts are available for one, two and three months. Weekly options contracts for one or two weeks are also available. All stock options are American options and hence can be exercised on any time before maturity. The exchange offers minimum of three strikes; one inthe-money, one at-the-money and one out-of-the-money. The settlement is on the Thursday falling two weeks prior to the last Thursday of the month in which the contract expires. In the case of weekly contracts the expiry date is the last Thursday of the week in which the contract expires. If the settlement day happens to be a holiday, the settlement would take place on the immediate preceding business day. Options contracts are cash settled. The final settlement of the option contracts is based on the closing price of the underlying stock in the cash segment. The closing price is decided based on the weighted average of all trades in the last 30 minutes of the continuous trading session. If there are no trading sessions in the last 30 minutes, the last traded price in the continuous trading session would be taken as the official closing price. Every day exercise sessions are specified. All in-the money options would be deemed to be exercised on the expiry day unless the participant communicates otherwise in the manner specified by the derivative segment.

4.10.5

NSE Index Futures

The underlying asset of NSE Nifty futures is S&P CNX Nifty. The security in descriptor is N FUTIDX NIFTY. Lot size is 50 and minimum value is Rs. 2 lakhs. Tick size is 0.05. Nifty futures are available for a maximum of three months—near month, middle month and far month. The new contract will be introduced on the next trading day following expiry of the near month contract. Nifty futures contracts will expire on the last Thursday of the expiry month or previous trading day if the last Thursday is a trading holiday. The contracts will be marked to market daily till settlement. The contracts are cash settled on T+1 basis. The daily settlement price is decided based on closing price of the futures contracts for the trading day, and final settlement price is closing value of the underlying index on the last trading day.

4.10.6

NSE Index Options

The underlying asset of NSE Index option is S&P CNX Nifty. List of NSE indices available futures trading is given in Table 11.1 of Chapter 11. The security descriptor is N OPTIDX NIFTY. The lot size is 50 and the minimum value is Rs. 2 lakh. Strike price level is Rs. 20 and tick size is 0.05. Stock options are European style. The contracts are available for consecutive three months;

24 Option Trading i.e., first month (near), second month (middle) and third month (far). The option contracts will expire on the last Thursday of the expiry month or previous trading day if the last Thursday is a trading holiday. The contracts are cash settled on T+1 basis. Daily settlement price is the premium value (net). Final settlement price is the closing value of the index on the last trading day.

4.10.7

NSE Stock Futures

The underlying assets in case of NSE Stock Futures are the individual stocks traded in NSE. The list stocks included in NSE stock futures trading is given in Table 11.1 of Chapter 11. The security descriptor is N FUTSTK. Contract size is 100 or its multiples thereof. Minimum value is Rs. 2 lakh. Tick size is 0.05. A maximum of three months contract cycle is available for futures trading at NSE with contract maturing in first month, second month and third month. As in the case of index futures, a new contract will be introduced on the next trading day following expiry of the near month contract. Stock futures contracts will expire on the last Thursday of the expiry month or the previous trading day if the last Thursday happens to be a trading holiday. The contracts are marked to market daily and final settlement will be cash settled on T+1 basis. Daily settlement price is the closing price of the futures contracts for the trading day and the final settlement price is the closing value of the underlying security on the last trading day.

4.10.8

NSE Stock Options

Individual stock option contracts are structured on individual stocks traded in NSE. The list of scrips included for writing option contracts are given in Table 11.1 in Chapter 11. The security descriptor is N OPTSTK. Contract size is 100 or its multiples thereof. Minimum value is Rs. 2 lakh. Tick size is 0.05. The contract is of American style. The strike price level is between Rs. 2.5 and Rs. 50 depending on the price of the underlying. A maximum of three months contract cycle is available for futures trading at NSE with the contract maturing in the first, second and third months. The option contracts will expire on the last Thursday of the expiry month or the previous trading day if the last Thursday happens to be a trading holiday. Daily settlement price is the premium value (net). Daily settlement is decided on T+1 basis and final option exercise settlement is on T+3 basis. The final settlement price of the option contract is decided based on the closing price of underlying on exercise day or expiry day. Last trading day is the settlement day.

Structure of Indian Options Market

4.11

25

THE CLEARING AND SETTLEMENT PROCESS

National Securities Clearing Corporation Limited (NSCCL) is the prime body in charge of the clearing and settlement process for all trading members.

4.11.1 The Clearing Mechanism In the F&O segment, there are self-clearing members, trading-cum-clearing members and professional clearing members. Funds settlements take place through clearing banks. For this purpose, the clearing members are required to open an account with an NSCCL designated clearing bank. The clearing mechanism basically involves working out the open positions and obligations of the clearing members. This can be done by finding out the open positions of the trading members and custodial participants clearing through them. The proprietary (self trade) and client open positions for the trading members are separately found out. The proprietary and client open positions are calculated on a net basis for each contract. For example, consider the case of trader A, who does the clearing and settlement process through NSCCL. Table 4.1 shows his proprietary and client positions. Table 4.1 Trader A’s Proprietary and Client Positions Proprietary position

Buy

Sell

300 @ 130

500 @ 156

Client X

200 @ 234

100 @ 245

Client Y

400 @ 324

200 @ 335

Client Position

At the end of day 1, the trading member’s net proprietary position is (300–500), i.e., 200 short. For client X, the position is (200–100), i.e., 100 long, and for client Y it is (400–200), i.e., 200 long. Therefore, total open position for the clearing member is 200 short + 100 long + 200 long = 500. Similarly, the positions are calculated on a daily basis. The open positions are also carried forward to the next day and net position is similarly found out.

4.11.2

The Settlement Mechanism for Options

All settlement is done in cash as the delivery method is not possible in case of F&O segment. There are mainly four types of settlement of option contracts:

26 Option Trading

Daily premium settlement: An option buyer is required to pay a premium amount for taking up position. The option seller is supposed to receive the premium from the option buyer. A net settlement of the premium is done on a daily basis to find out how much is payable or receivable.

Exercise settlement: Usually the option buyers and sellers close out their open positions by netting off, rather than exercising the option. The right for exercising an option usually lies with the buyer of an option. When such a right has been assigned, the seller is obliged to the cash settlement of the option, thereby exercising it.

Interim exercise settlement: This is available only for stock options. All the investors who have taken in-the-money options can net off their positions the same day with their trading members.

Final exercise settlement: This is affected for all open long in-the-money options existing at the close of trading hours, on the expiration day of an option contract. All such long positions are exercised and automatically assigned short positions in option contracts with the same expiry date, same strike price, and same underlying. National Stock Exchange

Trade details from NSE

Depositaries

Pay-in/Payout of securities

Pay-in/Payout NSCCL

of funds

Clearing Banks

Trade details given to clearing members who affirm. Obligation and pay-in details are downloaded Instructions to depositaries for details of DP holdings, and back

Fig. 4.6

Clearing members

Instructions to banks for availability of funds who inform back

Settlement process for F&O segment

4.11.3 Settlement Schedule T day = Day on which the position has been taken T+1 = (Next day of the trading day) pay-in/payout of funds

Structure of Indian Options Market

27

4.12 ROLE OF BROKER IN OPTIONS TRADING A broker is an individual entity, institution, or corporate body that functions as an intermediate between the exchange and clients. Clients (investors) can take position through the broker for which the broker charges a brokerage fee from clients. Percentage of brokerage is fixed by the exchange. An individual who attains 18 years of age can open a trading account with a broker. For this purpose, the individual has to provide two passport size photographs, ID proof, address proof and is also required to sign the brokerclient agreement. After submitting the necessary requirements, his trading account will be opened with the broker. Sometimes, brokers provide research reports that are prepared for all class of investors. These reports are exclusively tailor-made for each of its clients’ requirements. Such reports were not available in India previously. In most of the cases, the broker provides high-risk strategies as against moderately risky strategies. The broker collects upfront margins from clients for trading in options and futures. Buying an option requires payment of premium amount only as margin, whereas selling option attracts high amount as margin. The broker at the end of the day debits/credits the variations in margins. Sometimes he also collects additional margins as and when required by the National Stock Exchange.

4.13 WHY INDIAN OPTIONS MARKET BECAME MORE 4.13 COMPLEX THAN ANY OTHER MARKET IN THE 4.13 WORLD? · In majority of world markets, options and futures are settled in stocks, whereas, in India, they are settled in cash. · Arbitrage opportunities cannot be exploited extensively in India. In other world markets, if there is a price mismatch investors will exploit it by way of assignment. · The far month contracts have less volume in India, whereas in international markets, volumes are extensively distributed over all contracts which help arbitrageurs and hedgers to a certain extent. · In major world markets, stock options, index options and index futures are available, whereas in India options and futures on stock as well as index are available.

28 Option Trading

4.14

FUTURES AND OPTIONS AS LEVERAGED INSTRUMENTS

Futures and options are extensively used as leveraged products in India. Even though these products carry high risk, investors don’t take appropriate steps to handle these risks. Compared with stock and NIFTY futures, options carry high risks, because of their leverage. Institutions and investors of different nature extensively use this leverage in their portfolio. Options are said to be complex. Without proper knowledge and proper risk management, a simple (call option buyer/put option buyer) option buyer’s chance to gain would have less probability. Study of risk reward ratios always helps options traders. For buying options, we usually spend less money as compared to buying stock/stock futures. In other words, we pay less money and hence, carry less risk. If a person takes less business risk, his rewards would also be less. It is evident from the above mentioned logic that option buyers may make money on lesser times than writer of the options.

4.15

MANAGEMENT OF LONG PUT OPTION

If an investor is bearish on a particular stock, he can buy a put option of that stock. After his purchase, if the stock does not move according to his expectation, it is advisable to switch the position from a near month to a far month contract where he gets more time value. Generally if a particular put holder doesn’t make a profit instantaneously, it is always preferable to move out from a near month to a far month contract. Purchase of high beta stocks provide a put option buyer higher probability of making profits, whereas low beta stocks provides little chance of making profits. In-the-money put options are most suitable for investors. Out-of-themoney put options are very low delta and high theta, which will not give opportunities to make profit, unless the buyer gets a strong recommendation of the fundamentals of the company/insider information, etc.

4.16

CONVERSION OF AMERICAN IN-THE-MONEY PUT OPTIONS TO SHORT STOCK FUTURES

We have seen many times the anomaly of illiquidity in deep in-the-money American options, where options buyers always bargain by their bid price below the intrinsic value. In such circumstances, investors are forced to assign their long put options at the weighted closing price which happens only after 3:30 pm. Here investors won’t get the full benefit.

Structure of Indian Options Market

29

For example, an investor bought Infosys 2000 put option at Rs. 50, when Infosys spot was at Rs. 2010. After purchase of the put option, the stock moved down to Rs. 1800. So his put option premium moved to Rs. 200, but due to the market situations there were buyers only at Rs. 180. If he does not sell at the bid price, the Infosys price can move up from Rs. 1800 to Rs. 1900 before 3:30 pm. Many times investors are forced to sell below intrinsic values. In such cases, it is always preferable to square off the long put option before it reaches deep in-the-money (when liquidity remains low) and investors can sell futures of the same stock.

4.17 CALCULATION OF MARGINS Initial margin: In the F&O segment, it is necessary to collect a certain amount of money as upfront fees for taking positions. This is known as the initial margin. It is calculated and specified by NSE from time to time. The brokers have to intimate this to clients and collect the fees before taking positions. The calculation is done by using NSCCL-SPAN for computation of online margins as per the parameters specified by SEBI. For example, suppose an investor wants sell Nifty call options (1 lot = 50 units) with strike price of Rs. 5100 and premium value of Rs. 120. The margin amount specified was 21%. Therefore, the investor should pay an amount of Rs. 54,810 (i.e., (50*(5100+120))*21%) as margin for taking the position.

Additional margin: The investors are required to keep a minimum margin in their account. If for any investor the balance in his trading account falls below the minimum margin, he would receive a margin call, which would require him to pay up an additional amount so that he maintains the sufficient margin level. This additional amount is known as additional margin. For example, if Nifty futures have an initial margin of 21%, it may have a minimum margin of 15%. The investor needs to maintain a minimum margin of 15%. If it falls below that, he would have to pay an additional amount to bring it to the initial margin of 21%.

Mark to market margin: The margin calculation is done on a daily basis by the NSE. It calculates the weighted average closing price of the option at the end of the day, and if there is a difference between the price bought and weighted average price, that difference amount is to be paid by the investor as mark-to-market margin. For example, if an investor sells 50 Nifty call options (1 lot = 50 units) with strike price of Rs. 5000 at a premium value of Rs. 135, then at the end of the day, NSE computes the weighted average price as Rs. 143. The clients are then required to pay an amount of Rs. 400 (50*8) as mark to market margin.

30 Option Trading

SPAN margin: This is specified by the NSE by means of NSCCL-SPAN. SPAN is actually an approach for calculating the initial margins. Its objective is to identify the overall risk in a portfolio of option contracts for each member. The SPAN constructs 16 possible scenarios of changes in the underlying asset prices and volatilities to identify the largest loss that a portfolio will suffer from one day to the next. It then calculates the margin requirement at a sufficient level to recover this loss.

4.18 OPEN INTEREST It is the total number of outstanding contracts (long/short) at any point of time. The open interest is a good indicator of liquidity of the contract. Based on studies it has been found that the open interest is maximum in near month contracts.

Member-wise open interest limit: Position limits have been specified by SEBI for trading member, client, market and FII levels. Member-wise position limit in case of index option contracts is higher of Rs. 500 crores or 15% of total open interest in the market in index option contracts.

Client-wise open interest limit: Client-wise position limit should not exceed 1% of the free float market capitalization (in terms of number of shares) or 5% of the open interest in all derivative contracts in the same underlying stock, whichever is higher.

Summary In this chapter on structure of Indian options market, we discussed the major exchanges involved in options trading, their contract specifications, clearing and settlement system, participants in options trading, contract cycle, margin requirements and different types of margin and computation process, open interest, etc. Another important area connected with options trading is pricing of options. Options pricing is a mathematical process. Though there are various methods of calculation in India, we generally follow put-call parity. In the next chapter we will discuss options pricing system.

Keywords Stock Option Arbitrageurs Market Makers Immediate Order or Cancel At-the-Money Option Nifty Long Put Option Margin Call Open Interest

Dealers Hedgers Contract Cycle Stop Loss Order Out-of-the-Money Option Contract Structure Initial Margin Mark to Market Margin

Speculators Volatility Traders Day Order In-the-Money Option BEP Clearing and Settlement Additional Margin SPAN Margin

Chapter 5

OPTION PRICING IN DIFFERENT SCENARIOS

5.1 OBJECTIVE From the previous chapters the readers might have understood the basic concept of derivatives, and more particularly, fundamentals of options trading. It is essential for readers to know how premium for options and how option prices are calculated. This chapter charts out the concept of option pricing and calculation of option premiums with suitable examples.

5.2

OPTION PRICING CONCEPTS

Investors usually use Black Scholes option pricing model to find out the theoretical price of option premium. The major inputs for finding out the premiums are implied volatility, underlying asset price, strike price, time to expiry and risk-free interest rate. One of the major assumptions of Black Scholes pricing model is that the implied volatility of all strike prices of underlying assets is equal. But in reality, it changes on different strike price of both call and put option of an underlying.

5.3 CALCULATION OF CALL OPTION PREMIUM Assume that NSE Nifty is at 5120. Implied Volatility (s) of Nifty 5200 call option is 37%, time to expiry (T–t) of the contract is 19 days, and risk-free interest rate(r) is 6.5% (Table 5.1). Table 5.1

Calculation of Call Option Premium

S = 5120 X = 5200

(Contd.)

32 Option Trading (Contd.) R = 0.065 s = 0.37 T = 19 (T– t) = 0.0528 s2/2 = 0.0685 s´

T - t = 0.0850 é ln (S / X ) + r + s 2 /2 ´ (T - t ) ù û d1 = ë s ´ T -t

(

)

é æ 5120 ö ù ê ln èç 5200 ø÷ + (0.065 + 0.0685) + ( 0.0528 ) ú ë û = 0.0850 = – 0.0995 d2 = d1 - éës ´

T - t ùû

= 0.1289 – 0.0850 = – 0.1845 N(d1) = 0.4604 N(d2) = 0.4268 Call option premium = [S ´ N(d1)] – [X ´ e– r (T – t) ´ N(d2)] = [5120 ´ 0.4604] – [5200 ´ e– 0.065 ´ 0.528 ´ 0.4268] = 145.29

5.4

CALCULATION OF PUT OPTION PREMIUM

Assume that NSE Nifty is at 5120. Implied Volatility (s) of Nifty 5100 put option is 37%, time to expiry (T – t) of the contract is 19 days, and risk-free interest rate(r) is 6.5% (Table 5.2). Table 5.2

Calculation of Put Option Premium

S = 5120 X = 5100 R = 0.065 s = 0.37 T = 19

(Contd.)

Option Pricing in Different Scenarios

33

(Contd.) (T – t) = 0.0528 s2/2 = 0.0685 s´

T - t = 0.0850 é ln (S / X ) + r + s 2 / 2 ´ (T - t ) ù û d1 = ë s ´ T -t

(

)

é æ 5120 ö ù ê ln çè 5200 ÷ø + (0.065 + 0.0685) + ( 0.0528 ) ú û = ë 0.0850 = 0.1289 d2 = d1 - éës ´

T - t ùû

= 0.1289 – 0.0850 = 0.0439 N(d1) = 0.5513 N(d2) = 0.5175 N(– d1) = 0.4487 N(– d2) = 0.4825 Put option premium = [X ´ e– r (T – t) ´ N(– d2)] – [S ´ N(– d1)] = [5100 ´ e– 0.065 ´ 0.528 ´ 0.4825] – [5120 ´ 0.4487] = 154.85

5.5 PUT-CALL PARITY There is always a relationship between call and put option which is generally known as put call parity. The difference between call and put option shall be almost equal to the difference between spot price and strike price (even without considering the rate of interest). C – P = S – K(1 + r)– (T – t) Where,

C = Call Option Premium P = Put Option Premium S = Spot Price K = Strike Price (T – t) = Time to expiry R = Risk–free interest rate If the call is expensive than the theoretical option price, then investors should sell the expensive call and buy the stock/futures and its put option to

34 Option Trading create arbitrageurs strategy. Instead, if the put is expensive, investors should sell the expensive put, sell the futures and buy the call to exploit the arbitrage opportunity. Consider the case where an investor purchases a call option at strike price Rs. 5200 when the spot price is Rs. 5120. The time to expiry is taken as 19 days and risk-free interest rate as 6.5%. Assume the put option premium to be 207.48. The call option premium is calculated as shown in Table 5.3. Table 5.3

Calculation of Call Option and Put Option Premium Calculation of Call Option Premium S = 5120 K = 5200 T – t = 19/360* = 0.0528 R = 0.065 P = 207.48 C – P = S – K(1 + r)– (T – t) C = P + S – K(1 + r)– (T – t) = 144.74 Calculation of Put Option Premium S = 5120 K = 5200 T – t = 19/360* = 0.0528 R = 0.065 C = 144.74 C – P = S – K(1 + r)– (T – t) P = C – S + K(1 + r)– (T – t) = 207.48

*Sometimes practitioners consider 255 days as a full year. For put call parity, the following equation should be satisfied as explained in the table. C – P = S – K(1 + r)– (T – t) i.e., C – P = 144.74 – 207.48 = – 62.74 S – K(1 + r)– (T – t) = 5120 – 5200(1 + 0.065)– 0.0528 = – 62.74 Hence, the put call parity is satisfied.

Option Pricing in Different Scenarios

35

Now if the put option premium becomes 250 instead of 207.48, the strategy would be to sell put option, sell the stock and buy call option. The sales proceeds from selling the stock can be lent. The investor would reap a profit of (250 – 207.48), i.e., 42.52 (without considering rate of interest).

5.6 OPTION PRICE CALCULATION IN DIFFERENT 5.6 SCENARIOS 5.6.1 Effect of Change in Underlying Asset Price on Call 5.6.1 Option Premium First we will find out option premium of Infosys, when Infosys is at Rs. 2190, strike price is at Rs. 2200, interest rate is at 6.5%, implied volatility is at 38% and expiration period is 20 days (Table 5.4). Table 5.4 Effect of Change in Underlying Asset Price on Call Option Premium S = 2190 X = 2200 R = 0.065 s = 0.38 T = 20 (T – t) = 0.0556 s2/2 = 0.0722 s´

T - t = 0.0896 é ln (S / X ) + r + s 2 /2 ´ (T - t ) ù û d1 = ë s ´ T -t

(

)

é æ 2190 ö ù ê ln èç 2200 ø÷ + (0.065 + 0.0722) ´ 0.0556 ú û = ë 0.0896 = 0.0342 d2 = d1 - éës ´

T - t ùû

= – 0.0553 N(d1) = 0.5137 N(d2) = 0.4779 Call option premium = [S ´ N(d1)] – [X ´ e– r (T – t) ´ N(d2)] = [2190 ´ 0.5137] – [2200 ´ e– 0.065 ´ 0.556 ´ 0.4779] = 77.23

36 Option Trading Now, we will change the price of Infosys from Rs. 2190 to Rs. 2310, when all other parameters remain same. INFOSYS S = 2310 X = 2200 R = 0.065 s = 0.38 T = 20 (T – t) = 0.0556 s2/2 = 0.0722 s´

T - t = 0.0896 é ln (S / X ) + r + s 2 /2 ´ (T - t ) ù û d1 = ë s ´ T -t

(

)

é æ 2310 ö ù ê ln èç 2200 ø÷ + (0.065 + 0.0722) ´ 0.0556 ú ë û = 0.0896 = 0.6298 d2 = d1 - éës ´

T - t ùû

= 0.5403 N(d1) = 0.7356 N(d2) = 0.7055 Call option premium = [S ´ N(– d1)] – [X ´ e– r (T – t) ´ N(– d2)] = [2310 ´ 0.7356] – [2200 ´ e– 0.065 ´ 0.0556 ´ 0.7055] = 152.74

Now, we will change the price of Infosys from Rs. 2310 to Rs. 2060, when all other parameters remain same. INFOSYS S = 2060 X = 2200 R = 0.065 s = 0.38 T = 20 (T – t) = 0.0556 s2/2 = 0.0722 s´

T - t = 0.0896

(Contd.)

Option Pricing in Different Scenarios

37

(Contd.) é ln (S / X ) + r + s 2 /2 ´ (T - t )ù û d1 = ë s ´ T -t

(

)

é æ 2060 ö ù ê ln èç 2200 ø÷ + (0.065 + 0.0722 ) ´ 0.0556 ú ë û = 0.0896 = – 0.6490 d2 = d1 - éës ´

T - t ùû

= – 0.7386 N(d1) = 0.2582 N(d2) = 0.2301 Call option premium = [S ´ N(d1)] – [X ´ e– r (T – t) ´ N(d2)] = [2060 ´ 0.2582] – [2200 ´ e– 0.065 ´ 0.0556 ´ 0.2301] = 27.47

From these examples one can understand that the call option premium will change if the underlying asset price changes. If the asset price increases the call premium increases and vice versa. Now let us check the impact of put options if the underlying asset price changes.

5.6. 2 Effect of Change in Underlying Asset Price on Put 5.6. 2 Option Premium First we will find out put option premium of Infosys, when Infosys is at Rs. 2190, strike price is at 2200, interest rate is at 6.5%, implied volatility is at 38% and expiration period is 20 days (Table 5.5). Table 5.5 Effect of Change in Underlying Asset Price on Put Option Premium INFOSYS S = 2190 X = 2200 R = 0.065 s = 0.38 T = 20 (T – t) = 0.0556 s2/2 = 0.0722 s´

T - t = 0.0896

(Contd.)

38 Option Trading (Contd.) é ln (S / X ) + r + s 2 / 2 ´ (T - t ) ù û d1 = ë s ´ T -t

(

)

é æ 2190 ö ù ê ln çè 2200 ÷ø + (0.065 + 0.0722) ´ 0.0556 ú ë û = 0.0896 = 0.0342 d2 = d1 - éës ´

T - t ùû

= – 0.0553 N(d1) = 0.5137 N(d2) = 0.4779 N(– d1) = 0.4863 N(– d2) = 0.5221 Put option premium = [X ´ e– r (T – t) ´ N(– d2)] – [S ´ N(– d1)] = [2200 ´ e– 0.065 ´ 0.0556 ´ 0.5221] – [2190 ´ 0.4863] = 79.30

The price of Infosys is now changed from Rs. 2190 to Rs. 2310, when all other parameters remain same, and the new premium is calculated here. INFOSYS S = 2310 X = 2200 R = 0.065 s = 0.38 T = 20 (T – t) = 0.0556 s2/2 = 0.0722 s´

T - t = 0.0896 é ln (S / X ) + r + s 2 /2 ´ (T - t ) ù û d1 = ë s ´ T -t

(

)

é æ 2310 ö ù ê ln èç 2200 ø÷ + (0.065 + 0.0722) ´ 0.0556 ú û = ë 0.0896 = 0.6298 d2 = d1 - éës ´

T - t ùû

(Contd.)

Option Pricing in Different Scenarios

39

(Contd.) = 0.5403 N(d1) = 0.7356 N(d2) = 0.7055 N(– d1) = 0.2644 N(– d2) = 0.2945 Put option premium = [X ´ e– r (T – t) ´ N(– d2)] – [S ´ N(– d1)] = [2200 ´ e– 0.065 ´ 0.0556 ´ 0.2945] – [2310 ´ 0.2644] = 34.81

The underlying asset price of Infosys is reduced from Rs. 2310 to Rs. 2060, and put option premium is calculated. INFOSYS S = 2060 X = 2200 R = 0.065 s = 0.38 T = 20 (T – t) = 0.0556 s2/2 = 0.0722 s´

T - t = 0.0896 é ln (S / X ) + r + s 2 /2 ´ (T - t )ù û d1 = ë s ´ T -t

(

)

é æ 2060 ö ù ê ln çè 2200 ÷ø + ( 0.065 + 0.0722) ´ 0.0556ú û = ë 0.0896 = – 0.6490 d2 = d1 - éës ´

T - t ùû

= – 0.7386 N(d1) = 0.2582 N(d2) = 0.2301 N(– d1) = 0.7418 N(– d2) = 0.7699 Put option premium = [X ´ e– r (T – t) ´ N(– d 2)] – [S ´ N(– d1)] = [2200 ´ e– 0.065 ´ 0.0556 ´ 0.7699] – [2060 ´ 0.7418] = 159.54

40 Option Trading Thus, the put option premium value changes with varying underlying asset prices. It increases when the asset price is decreased and decreases when the asset price is increased. Let us now analyze the effect of change in strike price on option premium value.

5.6.3 Effect of Change in Strike Price on Call Option Premium First we will find out call option premium of ICICI Bank, when ICICI Bank is at Rs.956, strike price is at Rs. 960, interest rate is at 6.5%, implied volatility is at 60%, and expiration period is 20 days (Table 5.6). Table 5.6

Effect of Change in Strike Price on Call Option Premium

ICICI BANK S = 956 X = 960 R = 0.065 s = 0.6 T = 20 (T – t) = 0.0556 s2/2 = 0.1800 s´

T - t = 0.1414 é ln (S / X ) + r + s 2 /2 ´ (T - t ) ù û d1 = ë s ´ T -t

(

)

é æ 956 ö ù ê ln çè 960 ÷ø + (0.065 + 0.1800) ´ 0.0556 ú ë û = 0.1414 = 0.0667 d2 = d1 - éës ´

T - t ùû

= – 0.0747 N(d1) = 0.5266 N(d2) = 0.4702 Call option premium = [S ´ N(d1)] – [X ´ e– r (T – t) ´ N(d2)] = [956 ´ 0.5266] – [960 ´ e– 0.065 ´ 0.0556 ´ 0.4702] = 53.64

Now, we will change the strike price of ICICI Bank from Rs. 960 to Rs. 1000 when all other parameters remain same and find out the new premium.

Option Pricing in Different Scenarios

41

ICICI BANK S = 956 X = 1000 R = 0.065 s = 0.6 T = 20 (T – t) = 0.0556 s2/2 = 0.1800 s´

T - t = 0.1414 é ln (S / X ) + r + s 2 /2 ´ (T - t ) ù û d1 = ë s ´ T -t

(

)

é æ 956 ö ù ê ln çè 1000 ÷ø + (0.065 + 0.1800) ´ 0.0556 ú û = ë 0.1414 = – 0.2219 d2 = d1 - éës ´

T - t ùû

= – 0.3634 N(d1) = 0.4122 N(d2) = 0.3582 Call option premium = [S ´ N(d1)] – [X ´ e– r (T – t) ´ N(d2)] = [956 ´ 0.4122] – [1000 ´ e– 0.065 ´ 0.0556 ´ 0.3582] = 37.17

The strike price is reduced to Rs. 900 and call option premium is calculated in a similar way. ICICI BANK S = 956 X = 900 R = 0.065 s = 0.6 T = 20 (T – t) = 0.0556 s2/2 = 0.1800 s´

T - t = 0.1414 é ln (S / X ) + r + s 2 /2 ´ (T - t ) ù û d1 = ë s ´ T -t

(

)

(Contd.)

42 Option Trading (Contd.) é æ 956 ö ù ê ln çè 900 ÷ø + ( 0.065 + 0.1800) ´ 0.0556ú û = ë 0.1414 = 0.5231 d2 = d1 - éës ´

T - t ùû

= 0.3817 N(d1) = 0.6995 N(d2) = 0.6486 Call option premium = [S ´ N(d1)] – [X ´ e– r (T – t) ´ N(d2)] = [956 ´ 0.6995] – [900 ´ e– 0.065 ´ 0.0556 ´ 0.6486] = 87.09

Thus, the option premium value varies with change in the strike price. It follows a similar pattern as when the underlying asset price was changed. Consider the next case where effect of change on the put option premium is calculated.

5.6.4

Effect of Change in Strike Price on Put Option Premium

First, we will find out put option premium of ICICI Bank, when ICICI Bank is at Rs. 956, strike price is at Rs. 960, interest rate is at 6.5%, implied volatility is at 60% and expiration period is 20 days (Table 5.7). Table 5.7

Effect of Change in Strike Price on Put Option Premium

ICICI BANK S = 956 X = 960 R = 0.065 s = 0.6 T = 20 (T – t) = 0.0556 s2/2 = 0.1800 s´

T - t = 0.1414 é ln (S / X ) + r + s 2 /2 ´ (T - t ) ù û d1 = ë s ´ T -t

(

)

é æ 956 ö ù ê ln çè 960 ÷ø + (0.065 + 0.1800) ´ 0.0556 ú û = ë 0.1414

(Contd.)

Option Pricing in Different Scenarios

43

(Contd.) = 0.0667 d2 = d1 - éës ´

T - t ùû

= – 0.0747 N(d1) = 0.5266 N(d2) = 0.4702 N(– d1) = 0.4734 N(– d2) = 0.5298 Put option premium = [X ´ e– r (T – t) ´ N(– d2)] – [S ´ N(– d1)] = [960 ´ e– 0.065 ´ 0.0556 ´ 0.5298] – [956 ´ 0.4734] = 54.18

The strike price of ICICI Bank is increased to Rs. 1000 when all other parameters remain same and the new premium is calculated. ICICI BANK S = 956 X = 1000 R = 0.065 s = 0.6 T = 20 (T – t) = 0.0556 s2/2 = 0.1800 s´

T - t = 0.1414 é ln (S / X ) + r + s 2 /2 ´ (T - t ) ù û d1 = ë s ´ T -t

(

)

é æ 956 ö ù ê ln çè 1000 ÷ø + (0.065 + 0.1800) ´ 0.0556 ú û = ë 0.1414 = – 0.2219 d2 = d1 - éës ´

T - t ùû

= – 0.3634 N(d1) = 0.4122 N(d2) = 0.3582 N(– d1) = 0.5878 N(– d2) = 0.6418

(Contd.)

44 Option Trading (Contd.) Put option premium = [X ´ e– r (T – t) ´ N(– d2)] – [S ´ N(– d1)] = [1000 ´ e– 0.065 ´ 0.0556 ´ 0.6418] – [956 ´ 0.5878] = 77.56

The strike price is now lowered to Rs. 900 from Rs. 1000 and similar effects on option premium are found out. ICICI BANK S= X= R= s= T= (T – t) =

956 900 0.065 0.6 20 0.0556

s2/2 = 0.1800 s´

T - t = 0.1414 é ln (S / X ) + r + s 2 /2 ´ (T - t ) ù û d1 = ë s ´ T -t

(

)

é æ 956 ö ù ê ln çè 900 ÷ø + (0.065 + 0.1800) ´ 0.0556 ú û = ë 0.1414 = 0.5231 d2 = d1 - éës ´

T - t ùû

= 0.3817 N(d1) = 0.6995 N(d2) = 0.6486 N(– d1) = 0.3005 N(– d2) = 0.3514 Put option premium = [X ´ e– r (T – t) ´ N(– d2)] – [S ´ N(– d1)] = [900 ´ e– 0.065 ´ 0.0556 ´ 0.3514] – [956 ´ 0.3005] = 27.84

Though the strike price causes variations in the premium values, the value is directly proportional to changes in it.

5.6.5

Effect of Change in Volatility on Call Option Premium

First we will find out call option premium of Reliance, when Reliance is at Rs. 2216, strike price is at Rs. 2250, interest rate is at 6.5%, implied volatility is at 32% and expiration period is 25 days (Table 5.8).

Option Pricing in Different Scenarios

45

Table 5.8 Effect of Change in Volatility on Call Option Premium RELIANCE S = 2216 X = 2250 R = 0.065 s = 0.32 T = 25 (T – t) = 0.0694 s2/2 = 0.0512 s´

T - t = 0.0843 é ln (S / X ) + r + s 2 /2 ´ (T - t ) ù û d1 = ë s ´ T -t

(

)

é æ 2216 ö ù ê ln èç 2250 ø÷ + (0.065 + 0.0512) ´ 0.0694 ú û = ë 0.1414 = – 0.0849 d2 = d1 - éës ´

T - t ùû

= – 0.1692 N(d1) = 0.4662 N(d2) = 0.4328 Call option premium = [S ´ N(d1)] – [X ´ e– r (T – t) ´ N(d2)] = [2216 ´ 0.4662] – [2250 ´ e– 0.065 ´ 0.0694 ´ 0.4328] = 63.60

Now, we will change the implied volatility of Reliance from 0.32 to 0.44, when all other parameters remain same and calculate the new premium. RELIANCE S = 2216 X = 2250 R = 0.065 s = 0.44 T = 25 (T – t) = 0.0694 s2/2 = 0.0968 s´

T - t = 0.1160

(Contd.)

46 Option Trading (Contd.) é ln (S / X ) + r + s 2 /2 ´ (T - t ) ù û d1 = ë s ´ T -t

(

)

é æ 2216 ö ù ê ln çè 2250 ÷ø + (0.065 + 0.0968) ´ 0.0694 ú ë û = 0.1160 = – 0.0344 d2 = d1 - éës ´

T - t ùû

= – 0.1504 N(d1) = 0.4863 N(d2) = 0.4402 Call option premium = [S ´ N(d1)] – [X ´ e– r (T – t) ´ N(d2)] = [2216 ´ 0.4863] – [2250 ´ e– 0.065 ´ 0.0694 ´ 0.4402] = 91.51

The implied volatility is now decreased to 0.20, and the new premium value is calculated. RELIANCE S = 2216 X = 2250 R = 0.065 s = 0.2 T = 25 (T – t) = 0.0694 s2/2 = 0.0200 s´

T - t = 0.0527 é ln (S / X ) + r + s 2 /2 ´ (T - t ) ù û d1 = ë s ´ T -t

(

)

é æ 2216 ö ù ê ln èç 2250 ø÷ + (0.065 + 0.0200) ´ 0.0694 ú û = ë 0.0527 = – 0.1769 d2 = d1 - éës ´

T - t ùû

= – 0.2296 N(d1) = 0.4298

(Contd.)

Option Pricing in Different Scenarios

47

(Contd.) N(d2) = 0.4092 Call option premium = [S ´ N(d1)] – [X ´ e– r (T – t) ´ N(d2)] = [2216 ´ 0.4298] – [2250 ´ e– 0.065 ´ 0.0694 ´ 0.4092] = 35.87

Thus, the option premium value is directly proportional to implied volatility. Let us now find out the effect of implied volatility on put option premium values.

5.6.6 Effect of Change in Volatility on Put Option Premium First we will find out put option premium of Reliance, when Reliance is at Rs. 2216, strike price is at Rs 2250, interest rate is at 6.5%, implied volatility is at 32% and expiration period is 25 days Table 5.9). Table 5.9

Effect of Change in Volatility on Put Option Premium

RELIANCE S = 2216 X = 2190 R = 0.065 s = 0.32 T = 25 (T – t) = 0.0694 s2/2 = 0.0512 s´

T - t = 0.0843 é ln (S / X ) + r + s 2 /2 ´ (T - t ) ù û d1 = ë s ´ T -t

(

)

é æ 2216 ö ù ê ln èç 2190 ø÷ + (0.065 + 0.0512) ´ 0.0694 ú û = ë 0.0843 = 0.2356 d2 = d1 - éës ´

T - t ùû

= 0.1513 N(d1) = 0.5931 N(d2) = 0.5601 N(– d1) = 0.4069

(Contd.)

48 Option Trading (Contd.) N(– d2) = 0.4399 Put option premium = [X ´ e– r (T – t) ´ N(– d2)] – [S ´ N(– d1)] = [2190 ´ e– 0.065 ´ 0.0694 ´ 0.4399] – [2216 ´ 0.4069] = 57.37

Now, let us change implied volatility to 0.44 and then calculate the option premium value. RELIANCE S = 2216 X = 2190 R = 0.065 s = 0.44 T = 25 (T – t) = 0.0694 s2/2 = 0.0968 s´

T - t = 0.1160 é ln (S / X ) + r + s 2 /2 ´ (T - t ) ù û d1 = ë s ´ T -t

(

)

é æ 2216 ö ù ê ln èç 2190 ø÷ + (0.065 + 0.0968) ´ 0.0694 ú ë û = 0.1160 = 0.1987 d2 = d1 - éës ´

T - t ùû

= 0.0827 N(d1) = 0.5787 N(d2) = 0.5330 N(– d1) = 0.4213 N(– d2) = 0.4670 Put option premium = [X ´ e– r (T – t) ´ N(– d2)] – [S ´ N(– d1)] = [2190 ´ e– 0.065 ´ 0.0694 ´ 0.4670] – [2216 ´ 0.4213] = 84.69

As a second case, volatility is reduced to 0.20 and again premium value is calculated.

Option Pricing in Different Scenarios

49

RELIANCE S = 2216 X = 2190 R = 0.065 s = 0.2 T = 25 (T – t) = 0.0694 s2/2 = 0.0200 s´

T - t = 0.0527 é ln (S / X ) + r + s 2 /2 ´ (T - t ) ù û d1 = ë s ´ T -t

(

)

é æ 2216 ö ù ê ln èç 2190 ø÷ + (0.065 + 0.0200) ´ 0.0694 ú û = ë 0.0527 = 0.3359 d2 = d1 - éës ´

T - t ùû

= 0.2832 N(d1) = 0.6315 N(d2) = 0.6115 N(– d1) = 0.3685 N(– d2) = 0.3885 Put option premium = [X ´ e– r (T – t) ´ N(– d2)] – [S ´ N(– d1)] = [2190 ´ e– 0.065 ´ 0.0694 ´ 0.3885] – [2216 ´ 0.3685] = 30.38

Thus, it can be seen that the option premium follows an almost similar pattern to that of call option premium. In both cases, premium value is directly proportional to the change in implied volatility.

5.6.7

Effect of Change in Risk-free Interest Rate on Call Option Premium

First we will find out call option premium of Nifty, when Nifty is at Rs.5120, strike price is at Rs. 5100, interest rate is at 6.5%, implied volatility is at 26%, and expiration period is 20 days (Table 5.10).

50 Option Trading Table 5.10

Effect of Change in Risk-free Interest Rate on Call Option Premium

NIFTY S = 5120 X = 5190 R = 0.065 s = 0.26 T = 20 (T – t) = 0.0556 s2/2 = 0.0338 s´

T - t = 0.0613 é ln (S / X ) + r + s 2 /2 ´ (T - t ) ù û d1 = ë s ´ T -t

(

)

é æ 5120 ö ù ê ln èç 5100 ø÷ + (0.065 + 0.0338) ´ 0.0556 ú û = ë 0.0613 = 0.1534 d2 = d1 - éës ´

T - t ùû

= 0.0922 N(d1) = 0.5610 N(d2) = 0.5367 Call option premium = [S ´ N(d1)] – [X ´ e– r (T – t) ´ N(d2)] = [5120 ´ 0.5610] – [5100 ´ e– 0.065 ´ 0.0556 ´ 0.5367] = 144.82

Now, we will change risk-free interest rate from 6.5% to 10%, when all other parameters remain same and calculate the new premium. NIFTY S = 5120 X = 5100 R = 0.1 s = 0.26 T = 20 (T – t) = 0.0556 s2/2 = 0.0338 s´

T - t = 0.0613

(Contd.)

Option Pricing in Different Scenarios

51

(Contd.) é ln (S / X ) + r + s 2 /2 ´ (T - t ) ù û d1 = ë s ´ T -t

(

)

é æ 5120 ö ù ê ln èç 5100 ø÷ + (0.1 + 0.0338 ) ´ 0.0556 ú ë û = 0.0613 = 0.1852 d2 = d1 - éës ´

T - t ùû

= 0.1239 N(d1) = 0.5734 N(d2) = 0.5493 Call option premium = [S ´ N(d1)] – [X ´ e– r (T – t) ´ N(d2)] = [5120 ´ 0.5734] – [5100 ´ e– 0.1 ´ 0.0556 ´ 0.5493] = 150.18

The risk-free rate is reduced to 3.5% and premium is calculated. NIFTY S = 5120 X = 5100 R = 0.035 s = 0.26 T = 20 (T – t) = 0.0556 s2/2 = 0.0338 s´

T - t = 0.0613 é ln (S / X ) + r + s 2 /2 ´ (T - t ) ù û d1 = ë s ´ T -t

(

)

é æ 5120 ö ù ê ln èç 5100 ø÷ + (0.035 + 0.0338) ´ 0.0556 ú û = ë 0.0613 = 0.1262 d2 = d1 - éës ´

T - t ùû

= 0.0650 N(d1) = 0.5502 N(d2) = 0.5259

(Contd.)

52 Option Trading (Contd.) Call option premium = [S ´ N(d1)] – [X ´ e– r (T – t) ´ N(d2)] = [5120 ´ 0.5502] – [5100 ´ e– 0.035 ´ 0.0556 ´ 0.5259] = 140.31

It can be seen that there is a limited change in the call option premium value, when risk-free interest rate is decreased and increased. Let us now find out the effect of change of put option premium to change in interest rate.

5.6.8 Effect of Change in Risk-free Interest Rate on Put 5.6.8 Option Premium First we will find out put option premium of Nifty, when Nifty is at Rs. 5120, strike price is at Rs. 5100, interest rate is at 6.5%, implied volatility is at 26% and expiration period is 20 days (Table 5.11). Table 5.11

Effect of Change in Risk-free Interest Rate on Put Option Premium

NIFTY S = 5120 X = 5100 R = 0.065 s = 0.26 T = 20 (T – t) = 0.0556 s2/2 = 0.0338 s´

T - t = 0.0613 é ln (S / X ) + r + s 2 /2 ´ (T - t ) ù û d1 = ë s ´ T -t

(

)

é æ 5120 ö ù ê ln èç 5100 ø÷ + (0.065 + 0.0338) ´ 0.0556 ú û = ë 0.0613 = 0.1534 d2 = d1 - éës ´

T - t ùû

= 0.0922 N(d1) = 0.5610 N(d2) = 0.5367 N(– d1) = 0.4390

(Contd.)

Option Pricing in Different Scenarios

53

(Contd.) N(– d2) = 0.4633 Put option premium = [X ´ e– r (T – t) ´ N(– d2)] – [S ´ N(– d1)] = [5100 ´ e– 0.065 ´ 0.0556 ´ 0.4633] – [5120 ´ 0.4390] = 106.43

Firstly, the put option premium is found out by increasing risk-free interest rate to 10%. NIFTY S = 5120 X = 5100 R = 0.1 s = 0.26 T = 20 (T – t) = 0.0556 s2/2 = 0.0338 s´

T - t = 0.0613 é ln (S / X ) + r + s 2 /2 ´ (T - t ) ù û d1 = ë s ´ T -t

(

)

é æ 5120 ö ù ê ln èç 5100 ø÷ + (0.1 + 0.0338) ´ 0.0556 ú ë û = 0.0613 = 0.1852 d2 = d1 - éës ´

T - t ùû

= 0.1239 N(d1) = 0.5734 N(d2) = 0.5493 N(– d1) = 0.4266 N(– d2) = 0.4507 Put option premium = [X ´ e– r (T – t) ´ N(– d2)] – [S ´ N(– d1)] = [5100 ´ e– 0.1 ´ 0.0556 ´ 0.4507] – [5120 ´ 0.4266] = 101.92

In the second case, risk-free interest rate is reduced to 3.5%, and new premium is calculated.

54 Option Trading NIFTY S = 5120 X = 5100 R = 0.035 s = 0.26 T = 20 (T – t) = 0.0556 s2/2 = 0.0338 s´

T - t = 0.0613 é ln (S / X ) + r + s 2 /2 ´ (T - t ) ù û d1 = ë s ´ T -t

(

)

é æ 5120 ö ù ê ln èç 5100 ø÷ + (0.035 + 0.0338) ´ 0.0556 ú û = ë 0.0613 = 0.1262 d2 = d1 - éës ´

T - t ùû

= 0.0650 N(d1) = 0.5502 N(d2) = 0.5259 N(– d1) = 0.4498 N(– d2) = 0.4741 Put option premium = [X ´ e– r (T – t) ´ N(– d2)] – [S ´ N(– d1)] = [5100 ´ e– 0.035 ´ 0.0556 ´ 0.4741] – [5120 ´ 0.4498] = 110.41

Thus, put option premium varies with risk-free interest rate, and is inversely proportional to it.

5.6.9 Effect of Change In Time To Expiry on Call Option 5.6.9 Premium First, we will find out call option premium of Reliance Communication, when it is at Rs. 238, strike price is at Rs. 250, interest rate is at 3.5%, implied volatility is at 48% and expiration period is 15 days (Table 5.12).

Option Pricing in Different Scenarios

55

Table 5.12 Effect of Change In Time To Expiry on Call Option Premium RCOM S = 238 X = 250 R = 0.035 s = 0.48 T = 15 (T – t) = 0.0417 s2/2 = 0.1152 s´

T - t = 0.0980 é ln (S / X ) + r + s 2 /2 ´ (T - t ) ù û d1 = ë s ´ T -t

(

)

é æ 238 ö ù ê ln èç 250 ø÷ + (0.035 + 0.1152) ´ 0.0417 ú û = ë 0.0980 = – 0.4382 d2 = d1 - éës ´

T - t ùû

= – 0.5362 N(d1) = 0.3306 N(d2) = 0.2959 Call option premium = [S ´ N(d1)] – [X ´ e– r (T – t) ´ N(d2)] = [238 ´ 0.3306] – [250 ´ e– 0.035 ´ 0.0417 ´ 0.2959] = 4.82

Let us calculate the call option premium when time to expiry is increased from 15 to 25 days. RCOM S = 238 X = 250 R = 0.035 s = 0.48 T = 25 (T – t) = 0.0694 s2/2 = 0.1152 s´

T - t = 0.1265

(Contd.)

56 Option Trading (Contd.) é ln (S / X ) + r + s 2 / 2 ´ (T - t ) ù û d1 = ë s ´ T -t

(

)

é æ 238 ö ù ê ln çè 250 ÷ø + (0.035 + 0.1152 ) ´ 0.0694 ú ë û = 0.1265 = – 0.3064 d2 = d1 - éës ´

T - t ùû

= – 0.4329 N(d1) = 0.3796 N(d2) = 0.3325 Call option premium = [S ´ N(d1)] – [X ´ e– r (T – t) ´ N(d2)] = [238 ´ 0.3796] – [250 ´ e– 0.035 ´ 0.0694 ´ 0.3325] = 7.42

In the second situation, we reduce the time to expiry to five days and then find the option premium. RCOM S = 238 X = 250 R = 0.035 s = 0.48 T= 5 (T – t) = 0.0139 s2/2 = 0.1152 s´

T - t = 0.0566 é ln (S / X ) + r + s 2 /2 ´ (T - t ) ù û d1 = ë s ´ T -t

(

)

é æ 238 ö ù ê ln èç 250 ø÷ + (0.035 + 0.1152) ´ 0.0139ú û = ë 0.0566 = – 0.8327 d2 = d1 - éës ´

T - t ùû

= – 0.8893 N(d1) = 0.2025

(Contd.)

Option Pricing in Different Scenarios

57

(Contd.) N(d2) = 0.1869 Call option premium = [S ´ N(d1)] – [X ´ e– r (T – t) ´ N(d2)] = [238 ´ 0.2025] – [250 ´ e– 0.035 ´ 0.0139 ´ 0.1869] = 1.49

Thus, the call option premium value varies with change in time to expiry and is directly proportional to it. Let us now see how the put option premium responds to change in time to expiry.

5.6.10 Effect of Change in Time to Expiry on Put Option 5.6.10 Premium First, we will find out put option premium of Reliance Communication, when it is at Rs. 238, strike price is at Rs. 250, interest rate is at 3.5%, implied volatility is at 48% and expiration period is 15 days (Table 5.13). Table 5.13

Effect of Change in Time to Expiry on Put Option Premium

RCOM S = 238 X = 230 R = 0.035 s = 0.48 T = 15 (T – t) = 0.0417 s2/2 = 0.1152 s´

T - t = 0.0980 é ln (S / X ) + r + s 2 /2 ´ (T - t ) ù û d1 = ë s ´ T -t

(

)

é æ 238 ö ù ê ln èç 250 ø÷ + (0.035 + 0.1152) ´ 0.0417 ú û = ë 0.0980 = 0.4128 d2 = d1 - éës ´

T - t ùû

= 0.3149 N(d1) = 0.6601

(Contd.)

58 Option Trading (Contd.) N(d2) = 0.6236 N(– d1) = 0.3399 N(– d2) = 0.3764 Put option premium = [X ´ e– r (T – t) ´ N(– d2)] – [S ´ N(– d1)] = [230 ´ e– 0.035 ´ 0.0417 ´ 0.3764] – [238 ´ 0.3399] = 5.57

Now, we change the time to expiry from 15 to 25 days, when all other parameters remain same and calculate the new premium. When the time to expiry is higher, calculate the option premium. RCOM S = 238 X = 230 R = 0.035 s = 0.48 T = 25 (T – t) = 0.0694 s2/2 = 0.1152 s´

T - t = 0.1265 é ln (S / X ) + r + s 2 /2 ´ (T - t ) ù û d1 = ë s ´ T -t

(

)

é æ 239 ö ù ê ln çè 230 ÷ø + (0.035 + 0.1152) ´ 0.0694ú ë û = 0.1265 = 0.3528 d2 = d1 - éës ´

T - t ùû

= 0.2263 N(d1) = 0.6379 N(d2) = 0.5895 N(– d1) = 0.3621 N(– d2) = 0.4105 Put option premium = [X ´ e– r (T – t) ´ N(– d2)] – [S ´ N(– d1)] = [230 ´ e– 0.035 ´ 0.0694 ´ 0.4105] – [238 ´ 0.3621] = 8.00

Option Pricing in Different Scenarios

59

Time to expiry is now reduced to five days and premium is calculated. RCOM S = 238 X = 230 R = 0.035 s = 0.48 T= 5 (T – t) = 0.0139 s2/2 = 0.1152 s´

T - t = 0.0566 é ln (S / X ) + r + s 2 /2 ´ (T - t ) ù û d1 = ë s ´ T -t

(

)

é æ 238 ö ù ê ln èç 250 ø÷ + (0.035 + 0.1152) ´ 0.0139ú û = ë 0.0566 = 0.6413 d2 = d1 - éës ´

T - t ùû

= 0.5847 N(d1) = 0.7393 N(d2) = 0.7206 N(– d1) = 0.2607 N(– d2) = 0.2794 Put option premium = [X ´ e– r (T – t) ´ N(– d2)] – [S ´ N(– d1)] = [230 ´ e– 0.035 ´ 0.0139 ´ 0.2794] – [238 ´ 0.2607] = 2.18

Thus, the option premium value is directly proportional to the expiration time, i.e., it increases when the time is increased to 25 days and decreases when the time is decreased to five days.

Summary In this chapter we discussed the effect of changes in spot price, strike price, implied volatility, risk-free interest rate, and time to maturity on the option prices. We calculated the call and put option prices and examined the impact on each of these options. It may be observed that the impact varies between parameter to parameter as well as call prices and put prices. In some cases the variation is intense whereas in some other cases the variation is marginal. However, it is a fact

60 Option Trading that changes in the parameter can bring changes to the option prices also. The relationship between the parameters and the option prices are reflected through the option Greeks. What are these options Greeks? The next chapter explains the Greek letters in options trading.

Keywords Implied Volatility

Strike Price

Time to Expiry

Underlying Asset

Risk Free Interest

Chapter 6

OPTION GREEKS

6.1 OBJECTIVE In the last chapter we discussed option pricing under different scenarios and found that parameters like asset price, strike price, volatility, risk-free interest rate and time to maturity affect option prices. We also found that the relationship between option price and these parameters are reflected through option Greeks. From earlier text it is clear that option Greeks influence volatility to a great extent. This chapter attempts to familiarize the readers with various option Greeks used in options trading, namely delta, gamma, theta, vega, rho, kappa, epsilon, etc.

6.2 INTRODUCTION TO GREEK LETTERS Greeks of options are used to find out how the premium value changes with strike price depending upon how the option is in-the-money, at-the-money, or out-of-the-money. It includes delta, gamma, theta, and vega. Out-of-the-money options have only time and no intrinsic value. As time passes, premium value also falls. Time decay increases when the strike price is higher. On the other hand, in-the-money options have an intrinsic value in addition to time value, and are less prone to time decay. Deep in-the-money options have almost zero time value.

6.3

DELTA

Delta shows how fast the premium value changes with respect to the strike price of the underlying asset. The value of delta varies from 0 to 1 for call options and 0 to – 1 for put options. For example, an out-of-the-money option has a low delta and a deep outof-the-money option has a delta of almost zero value. An at-the-money option has a delta of approximately 0.5, and it increases as the option becomes inthe-money. It approaches unity, when the option is deep in-the-money.

62 Option Trading The delta of a call and put option will change in accordance with the underlying asset price. In the case of call, its delta increases when the underlying asset price increases and vice versa. Whereas, the delta of put option increases when the underlying asset price declines. The deep out-ofthe-money call/put options have almost zero delta. Deep in-the-money call/ put options have maximum delta of 1. Thereby, these options are said to be as good as stock in hand. One rupee change in the underlying asset price will have an equal amount of movement on the stock/index options. Now let us examine the following example and find out the delta changes. The Nifty spot price is 5000 and on November 14, 2009, 5100 call option was available with a premium of Rs. 43.70 and 5100 put option with a premium of Rs. 131.90. The November contract expires on 27/11/2009. The riskless interest rate would be 6.5% per annum and implied volatility would be 25%. With all the conditions remaining same except for the strike price, we plot the delta positions of call/put option and find that the delta of an underlying call and put option are correlated (Figures 6.1 and 6.2).

DELTA OF CALL OPTION

DELTA OF CALL 1 0.9 0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1 0

DELTA VALUES

4700 4800 4900 5000 5100 5200 5300 STRIKE PRICE FOR CALL OPTION

Fig. 6.1

Delta for call

DELTA FOR PUT

DELTA OF PUT OPTION

4700 4800 4900 5000 5100 5200 5300 0 – 0.1 – 0.2 – 0.3 – 0.4 – 0.5 – 0.6 – 0.7 – 0.8 – 0.9 –1

DELTA VALUES

STRIKE PRICE FOR PUT OPTION

Fig. 6.2

Delta for put

Option Greeks

63

Creation of Deltas Holding stock = Positive Delta Buying Call = Positive Delta Selling Put = Positive Delta Selling Stock = Negative Delta Selling Call = Negative Delta Buying Put = Negative Delta Thumb rule for Delta At-the-money call options = 0.5 delta Out-of-the-money call options = 0.25 delta In-the-money call options = 0.75 delta Deep in-the-money call options = 1 delta Deep out-of-the-money call options = 0.1 delta If we change the interest rate value, we can find the corresponding variation in the value of delta. CHANGE IN DELTA WITH CHANGE IN INTEREST RATE 0.6 0.5

DELTA

0.4 DELTA PUT DELTA CALL

0.3 0.2 0.1 0 4.5

5.5 6.5 7.5 INTEREST RATE

8.5

Fig. 6.3 Change in delta with change in interest rate

6.4 GAMMA Gamma gives an indication of how fast the value of delta changes, i.e., how fast the option becomes in-the-money. At-the-money options have a high gamma, whereas out-of-the-money options have a low gamma. In-the-money options have almost zero gamma. This indicates that a higher gamma would be an ideal condition for buying a call or put option. Figure 6.4 clearly indicates gamma movement on various strike prices with all other option elements remaining the same. On November 14, 2009, Nifty was at 5000 and Nifty 5100 call premium was available at Rs. 43.70. The risk-free interest rate would be 6.5% per annum and volatility would be 25%.

64 Option Trading

GAMMA VALUES

GAMMA OF OPTIONS 0.0018 0.0016 0.0014 0.0012 0.001 0.0008 0.0006 0.0004 0.0002 0

GAMMA

4700 4800 4900 5000 5100 5200 5300 STRIKE PRICE OF NIFTY

Fig. 6.4

Gamma of options

In the chart, we can easily understand that gamma remains very high in at-the-money options. Out-of-the-money and in-the-money options have very low gamma. If an option has a gamma of 0.0009, for each point rise/fall in the underlying price, the option will gain/lose by 0.0009 delta.

6.5 THETA Theta reveals how fast an option price changes in accordance to its time decay. This is usually applicable to out-of-the-money options, which have only time value and no intrinsic value. We can find that in case of deep out-ofthe-money options the value of theta approaches zero. The following example clearly shows thetas on various strike prices, when all other option input remains the same. On 14th November, 2009, Nifty spot was at 5000 and the risk free interest rate at 6.5%. The implied volatility was at 25% and the expiry of the contract was on 27th November, 2009. THETA FOR CALL

THETA VALUES

4700 4800 4900 5000 5100 5200 5300 0 – 0.5 –1 – 1.5 –2 – 2.5 –3 – 3.5 –4 – 4.5

THETA VALUES

STRIKE PRICE

Fig. 6.5

Theta for call

Option Greeks

65

THETA FOR PUT 4700 4800 4900 5000 5100 5200 5300 0 THETA VALUES

– 0.5 –1 – 1.5

THETA VALUES

–2 – 2.5 –3 – 3.5 STRIKE PRICE

Fig. 6.6 Theta for put

From the above charts it is clear that for the at-the-money options the theta attains the maximum value.

6.6 VEGA OR KAPPA OR EPSILON The study of vega reveals how the option price changes with implied volatility. In-the-money options have almost zero vega, whereas at-the-money options are having high vega. This indicates that the premium for the strike price with high Vega may not fall drastically. There is also a possibility that at-themoney options can change into in-the-money options. As an example, we consider a Nifty November option expiring on 27th. The risk free interest rate is assumed to be 6.5% and the implied volatility as 25%. Then the chart would look like: VEGA OF OPTIONS 4 3.5

VEGA

3 2.5 2 1.5

VEGA VALUES

1 0.5 0 4700 4800 4900 5000 5100 5200 5300 STRIKE PRICE

Fig. 6.7

Vega of options

66 Option Trading In the above chart it can be seen that the value of vega is maximum for atthe-money options. Let us see how the value of vega responds to the change in the time to expiry

CHANGE IN VEGA WITH CHANGE IN TIME TO EXPIRY 6

VEGA

5 4 VEGA

3 2 1 0 30

25

20

15

10

TIME TO EXPIRY

Fig. 6.8

Change in vega with change in time to expiry

From the above chart it is clear that the value of vega shows a decreasing trend when the time to expiry changes.

6.7 RHO The sensitivity of an option’s theoretical value to changes in the interest rate is denoted by rho. It depends on the type of underlying instrument and the settlement procedure for options. The options having the highest rho are deep in-the-money as they require large cash outlay. The greater the time to expiration, the greater will be the rho.

6.8 LAMBDA Lambda is the option leverage, which can be computed by dividing the percentage changes in the option price by the percentage changes in underlying asset price. In effect it is the vega. Though lambda, kappa, epsilon, etc., are option greeks they are not widely used in option trading. Hence, they have little importance.

6.9

CALCULATION OF OPTION GREEKS

An investor bought Nifty 5000 call option on 1st October, 2009 when Nifty was at 5100 level. The call option expires on 30th October, 2009. The call option

Option Greeks

67

has an implied volatility of 26% and the risk free interest rate of 7%. Find out the various option Greek values. S = 5100 X = 5000 R = 0.07 s = 0.026 T = 20 (T – t) = 0.082

é ln (S / X ) + r + s 2 /2 ´ (T - t ) ù ë û d1 = s ´ T -t

(

)

é æ 5100 ö ù ê ln çè 5000 ÷ø + (0.07 + 0.0338) ´ 0.082 ú û = ë 0.026 ´ 0.2864 = 0.3798

é ln (S / X ) + r - s 2 /2 ´ (T - t ) ù ë û d2 = s ´ T -t

(

)

é æ 5100 ö ù ê ln çè 5000 ÷ø + (0.07 - 0.0338) ´ 0.082 ú û = ë 0.026 ´ 0.2864 = N(d1) = N(d2) = N(– d1) = N(– d2) =

0.3056 0.6479 0.62 0.3521 (Delta) 0.38 (Delta)

6.9.1 Theta Theta of a call =

=

- S ´ N (d1 ) ´ s 2 T-t

- rXe - r (T - t) N( d2 )

- 5100 ´ 0.6479 ´ 0.26 2 0.082

- 859 - 215.76 0.5728 = – 1499.65 – 215.76 = – 1715.61 =

- 0.07 ´ 5000 ´ 0.9943 ´ 0.62

68 Option Trading Theta of a put =

- S ´ N ( d1 ) ´ s - rXe - r (T - t ) N (- d2 ) 2 T -t

- 859

+ 132.244 0.5728 = – 1499.65 + 132.24 = – 1367 =

6.9.2

Vega

Vega of call and put = S ´ N (d1 ) ´

T-t

= 5100 ´ 0.6479 ´

0.082

= 946.3

6.9.3

Rho

Rho for a call = X(T – t)e– r (T – t) N(d2) = 5000 ´ 0.082 ´ 0.9943 ´ 0.62 = 252.7 = 2.52% Rho for a put = – X(T – t)e– r (T – t) N(– d2) = – 5000 ´ 0.082 ´ 0.9943 ´ 0.38 = – 154.9 = – 1.54% Note: Rho is in % terms

6.9.4

Gamma

Gamma for call/put =

=

N (d1 ) Ss

T -t

0.6479 5100 ´ 0.26 ´ 0.2864

= 0.0001706

6.9.5

Delta Delta for a call = = Delta for a put = =

N(d1) 0.6479 N(d1) – 1 – 0.3521

Option Greeks

69

Summary In this chapter we discussed about the option greeks. The important Greeks used in option trading are delta, gamma, vega, theta and rho. Though there are other Greeks like lambda, kappa, epsilon, etc., they are not widely used in option trading. Now we are moving to the most significant part of this book, i.e., the strategies suitable to bull market. The next chapter unveils 45 strategies which are applicable to bull market condition.

Keywords Greek Letters

Delta

Gamma

Theta

Vega

Kappa

Epsilon

Rho

Lambda

Chapter 7

OPTION STRATEGIES IN A BULL MARKET

7.1 OBJECTIVE The last chapters contained information necessary to understand the strategies used in option trading. Starting from the basics of derivatives, we discussed the various aspects of option trading and concluded the discussion in the last chapter by understanding the option Greek letters. In this chapter, we will discuss the strategies used in option trading, which are specific to bull market condition. These strategies are standard formats developed using data obtained under a specific market condition. Investors are advised that while using these strategies they should work out their own strategies using the data prevailing at the time of trading. Neither the authors nor the publishers will be responsible for the consequences of using these strategies.

7.2 WHY DERIVATIVE STRATEGIES? Buying call option and put option may not give investors high return. Most of the time investors do lose their option premiums due to time sensitivity of options. A good strategy will help the investors to protect the time erosion of options. A combination sometimes helps the investors to attain breakeven faster than holding along position, i.e., a long call and a short put combination gives the investor breakeven much faster. A good strategy reduces risk, margin requirement and pays a reasonable amount of returns at the earliest. Strategies often used by arbitrageurs help them to capture riskless profits. A hedge wrapper is a classical example for that. While writing option, investors carry high risk, which can be eliminated to a certain extent by creating a tailor made strategy. Strategies are extensively used by market makers.

Option Strategies in a Bull Market

7.3

71

BULLISH STRATEGIES

7.3.1 Long Call Buying a call option is said to be a long call. The buyer pays the premium and his risk is limited to the premium amount.

Who can buy a long call? A person bullish on an underlying can buy a call option. The option buyer has a choice of strike price; high premium to low premium. He can select any strike price of that asset. Generally investors buy call option, which are very close to the asset price (i.e., at-the-money). The risk reward ratio would be minimal in this case. There are investors who preferably buy in-the-money call options, where one rupee change in the underlying will have an equal impact on option price. There are institutional investors who always buy in-the-money options, rather than the underlying asset or futures. For example, an investor decides to hedge his risk by buying a Nifty call option of strike price of 5000 having a premium value of Rs. 170. He takes the position in the hope that the market would rise. As you can see from the second table below, the premium value till 5000 is negative and he attains the breakeven point at 5170. Above this level, he would have profit. Table 7.1 Strike Price

Premium

Buy Call

5000

170

Break Even

5170

Pay off Table Stock Price Range

Buy Call

4600

–170

4700

–170

4800

–170

4900

–170

5000

–170

5100

–70

5200

30

72 Option Trading Pay off Table Stock Price Range

Buy Call

5300

130

5400

230

5500

330

5600

430

5700

530

5800

630

5900

730

6000

830

BUY CALL 1000

PROFIT/LOSS

800 600 400 200 0 – 200 4500

5500

6000

– 400 NIFTY PRICE RANGE BUY CALL

Fig. 7.1

Buy call

Few investors even track the gamma of options on a regular basis and they will buy the high gamma strike price call options. As the gamma remains very high, the probability of the strike price to become in-the-money is very high. Often they buy high gamma call options and sell low gamma options on a regular basis.

7.3.2 Synthetic Long Buying a call and selling its put option at the same strike price and expiry is known as synthetic long. It is said to be as good as holding the future position. Sometimes this combination gives the option trader more benefit than holding the futures. It happens when the markets are bearish. Synthetic long strategy holder makes quick money, if the market moves according to his expectation, i.e., bullish. The risk associated with the strategy would be very high and unlimited due to the writing of the put option. The profit is also unlimited if the stock/index is bullish.

Option Strategies in a Bull Market

73

Table 7.2 Strike Price

Premium

Sell Put

5000

51

Buy Call

5000

170

Break Even

5119 Pay off Table

Stock Price Range

Sell Put

Buy Call

Net Pay off

4600

–349

–170

–519

4700

–249

–170

– 419

4800

–149

–170

–319

4900

– 49

–170

–219

5000

51

–170

–119

5100

51

–70

–19

5200

51

30

81

5300

51

130

181

5400

51

230

281

5500

51

330

381

5600

51

430

481

5700

51

530

581

5800

51

630

681

5900

51

730

781

6000

51

830

881

SYNTHETIC LONG 1000 PROFIT/LOSS

800 600 400 200 0 – 2004500

5100

5300

5500

5700

5900

6100

– 400 – 600 NIFTY PRICE RANGE SELL PUT

Fig. 7.2

BUY CALL

NET PAY OFF

Synthetic long

Consider a case wherein a trader buys a call option and sells a put option of the same strike price. Here the trader buys Nifty 5000 call at Rs. 170 and sells Nifty

74 Option Trading 5000 put at Rs. 51. He would attain breakeven when the stock price becomes 5119. If his expectation of the market turns wrong, his loss would be substantial, whereas if the market moves up further his payoff would be very high.

7.3.3

Short Put

In a bear market, an investor usually buys put options. In a bull market, he sells put option on the assumption that the market will not fall. Some investors use technical tools like Bollinger bands and others use moving averages for support. For put options below the Bollinger bands, the strikes can be written with much risk in a bull market. Like that put options below the value of 200 day simple moving average can also be written without much risk. Technical analysis helps the investors to a certain extent to find out the support levels of the stock. Far month put option writing is the more advisable than the near month options. A knowledgeable trader always prefers to sell options rather than buying options, even though the risk element is very high in it. Instead of buying a call option during a bull market, selling of put option is also advisable. Here in this case the investor gets only the put option premium when he takes the position, whereas his loss would be unlimited when his expectation turns wrong. The following chart shows unlimited loss for the trader below 4949, if he sells the Nifty put option of 5000 at a premium of Rs. 51 Table 7.3 Strike Price Sell Put

5000

Break Even

4949

Premium 51

Pay off Table Stock Price Range

Sell Put

4600

–349

4700

–249

4800

–149

4900

– 49

5000

51

5100

51

5200

51

5300

51

5400

51

5500

51

5600

51

Option Strategies in a Bull Market

75

Pay off Table Stock Price Range

Sell Put

5700

51

5800

51

5900

51

6000

51

SELL PUT

PROFIT/LOSS

100 0 4500 – 100

4700

4900

5100

5300

5500

5700

5900

6100

– 200 – 300 – 400 NIFTY PRICE RANGE SELL PUT

Fig. 7.3

Sell put

7.3.4 Bull Spread Buying a call at lower strike price and selling an out-of-the-money call option is said to be bull spread. Sometimes, investors prefer to buy high gamma options and sell low gamma options. The premium from selling the call option will reduce the cost of purchase of the call option. Long call traders pay only premium as margin, but the bull spread holder has to pay additional margin for writing the call option. Even though it involves high margin requirement, it is advisable to write the out-of-themoney call option. It helps the trader to attain early breakeven. The investor buys Nifty 5000 call at Rs. 170 and sells Nifty 5300 call at Rs. 27. Here the investor attains breakeven at 5143. His profit and loss are limited. Table 7.4 Strike Price

Premium

Buy Call

5000

170

Sell Put

5300

27

Break Even

5143

76 Option Trading Pay off Table Stock Price Range

Buy Call

Sell Call

Net Pay off

4600

–170

27

–143

4700

–170

27

–143

4800

–170

27

–143

4900

–170

27

–143

5000

–170

27

–143

5100

–70

27

–43

5200

30

27

57

5300

130

27

157

5400

230

–73

157

5500

330

–173

157

5600

430

–273

157

5700

530

–373

157

5800

630

–473

157

5900

730

–573

157

6000

830

–673

157

BULLS SPREAD

PROFIT/LOSS

1000 500 0 4500

4700

4900

5100

5300

5500

5700

5900

6100

– 500 – 1000 NIFTY PRICE RANGE BUY CALL

Fig. 7.4

SELL CALL

NET PAY OFF

Bull spread

7.3.5 Long Put Christmas Tree Here the option trader buys an at-the-money put option and sells two equally distant out-of-the-money put options. Sometimes investors call this strategy as a delta neutral strategy. The strategy gives maximum profit at 4800 and 4900, whereas if the index moves below 4696, his loss would be unlimited. The trader buys Nifty 5000 put at Rs. 49, sells Nifty 4900 put at Rs. 32 and sells Nifty 4800 put at Rs. 21. The breakeven is at 4696.

Option Strategies in a Bull Market

Table 7.5 Strike Price

Premium 49

Buy Call

5000

Sell Put

4900

32

Sell Put

4800

21

Break Even

4696 Pay off Table

Stock Price Range

Buy Put

Sell Put

Sell Put

Net Pay off

4300

651

–568

–479

–396

4400

551

–468

–379

–296

4500

451

–368

–279

–196

4600

351

–268

–179

–96

4700

251

–168

–79

4

4800

151

–68

21

104

4900

51

32

21

104

5000

–49

32

21

4

5100

–49

32

21

4

5200

–49

32

21

4

5300

–49

32

21

4

5400

–49

32

21

4

5500

–49

32

21

4

5600

–49

32

21

4

5700

–49

32

21

4

LONG PUT CHRISTMAS TREE 800 PROFIT/LOSS

600 400 200 0 – 200 4200

4400

4600

4800

5000

5200

5400

5600

5800

– 400 – 600 – 800 NIFTY PRICE RANGE BUY PUT

SELL PUT

Fig. 7.5

SELL PUT

NET PAY OFF

Long put Christmas tree

77

78 Option Trading

7.3.6

Long Fence Split Strike Price

Buying the future or stock and simultaneously buying its at-the-money put option and selling an out-of-the-money call is termed as long fence split strike price strategy. Here the trader buys Nifty future at 5120 and buys Nifty 5100 put option at Rs. 84 and sells Nifty 5300 call option at Rs. 27. His loss and profit are limited and he will attain the breakeven at 5177. Table 7.6 Buy Underlying

5120 Strike Price

Premium

Buy Put

5100

84

Sell Call

5300

27

Break Even

5177 Pay off Table

Stock Price Range

Buy Underlying

Buy Put

Sell Put

Net Pay off

4300

–820

716

27

–77

4400

–720

616

27

–77

4500

–620

516

27

–77

4600

–520

416

27

–77

4700

–420

316

27

–77

4800

–320

216

27

–77

4900

–220

116

27

–77

5000

–120

16

27

–77

5100

–20

–84

27

–77

5200

80

–84

27

23

5300

180

–84

27

123

5400

280

–84

–73

123

5500

380

–84

–173

123

5600

480

–84

–273

123

5700

580

–84

–373

123

5800

680

–84

–473

123

5900

780

–84

–573

123

Option Strategies in a Bull Market

79

LONG FENCE SPLIT STRIKE PRICE

PROFIT/LOSS

1000 500 0 4200

4700

5200

5700

– 500 – 1000 NIFTY PRICE RANGE BUY UNDERLYING

Fig. 7.6

BUY PUT

SELL CALL

NET PAY OFF

Long fence split strike price

7.3.7 Put Ratio Spread This strategy can be created by buying an at-the-money put option and selling two out-of-the-money put options at the same expiry. Here the investor is bullish on the market and buys the Nifty 5100 put option at Rs.84 and sells two Nifty 5000 put options at Rs. 51. If the market is bullish he will earn the maximum profit of Rs. 11800 at 5000. If market moves above 5000, he will earn only a minimum profit of Rs. 1800. He will incur unlimited loss below 4882. Table 7.7 Strike Price

Premium

Buy Put 1 Lot

5100

84

Sell Put 2 Lots

5000

51

Break Even

4882 Pay off Table

Stock Price Range

Buy Put

Sell Put

Net Pay off

4400

616

–1098

–482

4500

516

–898

–382

4600

416

–698

–282

4700

316

–498

–182

4800

216

–298

–82

4900

116

–98

18

5000

16

102

118

5100

–84

102

18

80 Option Trading Pay off Table Stock Price Range

Buy Put

Sell Put

Net Pay off

5200

–84

102

18

5300

–84

102

18

5400

–84

102

18

5500

–84

102

18

5600

–84

102

18

5700

–84

102

18

5800

–84

102

18

PUT RATIO SPREAD

PROFIT/LOSS

1000 500 0 4300 – 500

4500

4700

4900

5100

5300

5500

5700

5900

– 1000 – 1500 NIFTY PRICE RANGE BUY PUT

Fig. 7.7

7.3.8

SELL PUT

NET PAY OFF

Put ratio spread

Bulls Spread with Puts

Selling in-the-money/at-the-money put option and buying an out-of-themoney put option is said to be bull spread with put. Basically, we can say that selling the higher strike put and buying lower put is bull spread with put. The option trader finds out the low gamma strike price for selling his put option and low theta strike price for buying the put option. The bull spread with put option is extensively used in index options. It is not advisable for stock options because they are American in nature. In the below case, the investor sells an in-the-money 5300 put option for a premium of Rs. 206 and buys an out-of-the-money 5000 put option at Rs. 51. He will make limited profit and limited loss.

Option Strategies in a Bull Market

Table 7.8 Strike Price

Premium

Buy Put

5000

51

Sell Put

5300

206

Break Even

5145 Pay off Table

Stock Price Range

Buy Put

Sell Put

Net Pay off

4600

349

–494

–145

4700

249

–394

–145

4800

149

–294

–145

4900

49

–194

–145

5000

–51

–94

–145

5100

–51

6

–45

5200

–51

106

55

5300

–51

206

155

5400

–51

206

155

5500

–51

206

155

5600

–51

206

155

5700

–51

206

155

5800

–51

206

155

5900

–51

206

155

6000

–51

206

155

BULL SPREAD WITH PUTS

PROFIT/LOSS

400 200 0 4500 – 200

4700

4900

5100

5300

5500

5700

– 400 – 600 NIFTY PRICE RANGE BUY PUT

Fig. 7.8

SELL PUT

NET PAY OFF

Bull spread with puts

5900

81

82 Option Trading

7.3.9 Buy Futures with Protective Put While buying futures of a stock/Nifty, the investors are carrying unknowingly the market risk. This risk can be eliminated by buying stock/Nifty put options. Even though the cost of purchase of put option eats away your profit to a certain extent, it is advisable to have the put option in your portfolio. It will help the investors in reduction of margin and reduction of risk The investor buys Nifty futures at 5120 and simultaneously buys at-themoney Nifty 5100 put option for a premium of Rs. 84. He will attain the breakeven at 5204. The strategy involves low risk and high reward in a bullish market. Table 7.9 Buy Future

5120 Strike Price

Buy Put

5100

Break Even

5204

Premium 84

Pay off Table Stock Price Range

Buy Put

Buy Futures

Net Pay off

4500

516

–620

–104

4600

416

–520

–104

4700

316

–420

–104

4800

216

–320

–104

4900

116

–220

–104

5000

16

–120

–104

5100

–84

–20

–104

5200

–84

80

–4

5300

–84

180

96

5400

–84

280

196

5500

–84

380

296

5600

–84

480

396

5700

–84

580

496

5800

–84

680

596

5900

–84

780

696

Option Strategies in a Bull Market

83

1000 BUY FUTURES WITH PROTECTIVE PUT 800

PROFIT/LOSS

600 400 200 0 – 200 500 600 700 800 900 000 100 200 300 400 500 600 700 800 900 4 4 4 4 4 5 5 5 5 5 5 5 5 5 5 – 400 NIFTY PRICE RANGE – 600 BUY PUT BUY FUTURES NET PAY OFF – 800

Fig. 7.9

7.3.10

Buy futures with protective put

Covered Call

Holding of futures and selling the options of the same stock is said to be a covered call. A covered call writer makes risk less profit if the underlying asset remains firm or bullish. The covered call writer buys the underlying stock or futures and sells its out-of-the-money call at a good premium. In the following example, the investor buys the futures of Nifty at 5120 and sells 5200 call at Rs. 56. He will attain lower side breakeven at 5064. He will make limited profits and unlimited loss if the underlying falls below the breakeven. Table 7.10 Buy Future

5120 Strike Price

Sell Call

5200

Break Even

5064

Premium 56

Pay off Table Stock Price Range

Sell Call

Stock Pay off

Net Pay off

4600

56

–520

–464

4700

56

–420

–364

4800

56

–320

–264

4900

56

–220

–164

5000

56

–120

–64

5100

56

–20

36

84 Option Trading Pay off Table Stock Price Range

Sell Call

Stock Pay off

Net Pay off

5200

56

80

136

5300

–44

180

136

5400

–144

280

136

5500

–244

380

136

5600

–344

480

136

5700

–444

580

136

5800

–544

680

136

5900

–644

780

136

6000

–744

880

136

COVERED CALL

PROFIT/LOSS

1000 500 0 4500 – 500

4700

5100

5300

5700

5900

6100

– 1000 NIFTY PRICE RANGE SELL CALL

Fig. 7.10

STOCK PAY OFF

NET PAY OFF

Covered call

7.3.11 Naked Call Writing: A High Risk Strategy for Bull Market Selling call options without having the possession of the same underlying stock/future is called as naked call writing. Naked call writers have to pay high margins, because this strategy contains high risk. If an investor writes his call option without protection, he can incur substantial loss especially in a bull market. If any unforeseen risk arises out of naked call writing, the writer generally adopts the following hedging strategies: · Buy far month call options of the same underlying · Buy futures of the same stock · Sell put option of the same underlying · Buy out-of-the-money call of the same underlying

Option Strategies in a Bull Market

85

However, naked call writing is a high risk strategy in bull market and hence is not advisable.

7.3.12

Delta Neutral

Here the option trader will take two opposite positions which reduce the net delta to zero. The investor sells 5120 Nifty futures and buys two lots of Nifty 5200 call with a delta of 0.5. His upside breakeven point is at 5486 and downside breakeven level is at 4914. He will incur a maximum loss of Rs. 28600 at 5200 and his profit is unlimited. Table 7.11 Strike Price

Premium

Buy Call 2 Lots

5200

103

Sell Futures

5120

Upside Break Even

5486

Downside Break Even

4914 Pay off Table

Stock Price Range

Buy Call 2 Lots

Sell Futures

Net Pay off

4700

–206

420

214

4800

–206

320

114

4900

–206

220

14

5000

–206

120

–86

5100

–206

20

–186

5200

–206

–80

–286

5300

–6

–180

–186

5400

194

–280

–86

5500

394

–380

14

5600

594

–480

114

5700

794

–580

214

5800

994

–680

314

5900

1194

–780

414

6000

1394

–880

514

6100

1594

–980

614

86 Option Trading DELTA NEUTRAL 2000 1500 PROFIT/LOSS

1000 500 0 4600 – 500

4800

5000

5200

5400

5600

5800

6000

6200

– 1000 – 1500 NIFTY PRICE RANGE BUY CALL 2 LOTS

SELL FUTURES

NET PAY OFF

Fig. 7.11 Delta neutral

7.3.13 Delta Hedging and Market Makers Market making is an art of creating a market place. The market makers are traders/institutions who place bid-ask orders for a security or stock. In other words, they are creating liquidity to a stock/security. The market makers usually calculate their net delta position on an hourly/ daily basis and also try to bring down the delta to zero. Delta of stock and option Holding 1000 shares of common stock = + 1000 delta Selling 1000 shares of common stock = – 1000 delta Buy call option = + delta Sell call option = – delta Sell put option = + delta Buy put option = – delta

7.3.14 Zero Delta Portfolios Model 1 Holding 1000 stock ABB = + 1000 delta (Selling 1000 ABB call with delta of 1) = – 1000 delta Net delta = 0 Model 2 Holding 1000 stock = + 1000 delta (Holding 1000 put option with delta of 1) = – 1000 delta Net delta = 0

Option Strategies in a Bull Market

87

Model 3 Holding 1000 stock = + 1000 delta (Holding 2000 put option with delta of 0.5) = – 1000 delta Net delta = 0 Model 4 Selling 1000 stock = – 1000 delta (Buying 100 call option with delta of 1) = + 1000 delta Net delta = 0 Model 5 Selling 1000 stock = – 1000 delta (Selling 1000 put option with a delta of 1) = + 1000 delta Net delta = 0 Model 6 Selling 1000 stock = – 1000 delta (Buying 2000 call option with delta of 0.5) = + 1000 delta Net delta = 0

7.4 STRATEGIES SUITABLE FOR STOCK We had studied various strategies and combinations which can be extensively used in index options (European in nature). In the case of stocks, all strategies and combinations are not suitable because they are American. Early assignments can be taken place. The data of assignments will be known to the writer of that option only on the next day.

7.5 LOW RISK STOCK OPTION STRATEGIES 7.5.1 Long Call One of the simple strategies that can be adopted by a trader could be long call. Buy the call option of a stock and wait for a few days. Option traders will consider the following Greeks before purchasing the call option – gamma, theta, delta, vega and rho. Of these Greeks, knowledge of gamma, delta and theta are vital for a successful option trader. If the gamma is positive, then the chances of gaining money are very high. If the delta is above 0.5, a rupee change in the underlying will give the option trader at least 50 paise. Here the investor buys 460 strike call option of DLF at Rs. 6.55. He will make profit if DLF moves above 466.55. His maximum loss would be Rs. 6.55 * lot size.

88 Option Trading Table 7.12 Strike Price

Premium

460

6.55

Buy DLF Call

466.55

Break Even

Pay Off Table Stock Price Range

Buy Call

420

–6.55

430

–6.55

440

–6.55

450

–6.55

460

–6.55

470

3.45

480

13.45

490

23.45

500

33.45

510

43.45

520

53.45

530

63.45

540

73.45

550

83.45

560

93.45 BUY CALL

PROFIT/LOSS

100 80 60 40 20 0 – 20

410

430

450

470

490

510

530

550

570

STOCK PRICE RANGE BUY CALL

Fig. 7.12

Buy call

7.5.2 Bull Spread Buying a call option and selling an out-of-the-money call option is said to be a bull spread. Here the investor buys a cheap call option and sells an expensive one. In the following example, the investor buys ICICI 940 call option at

Option Strategies in a Bull Market

89

Rs 21.20 and sells 980 call option at Rs. 9.55. He can attain breakeven at 951.65. Below that he incurs a loss of Rs. 11.65. Table 7.13 Strike Price

Premium

Buy ICICI Bank Call

940

21.2

Sell ICICI Bank Call

980

9.55

951.65

Break Even

Pay off Table Stock Price Range

Buy Call

Sell Call

Net Pay off

910

–21.2

9.55

–11.65

920

–21.2

9.55

–11.65

930

–21.2

9.55

–11.65

940

–21.2

9.55

–11.65

950

–11.2

9.55

–1.65

960

–1.2

9.55

8.35

970

8.8

9.55

18.35

980

18.8

9.55

28.35

990

28.8

–0.45

28.35

1000

38.8

–10.45

28.35

1010

48.8

–20.45

28.35

1020

58.8

–30.45

28.35

1030

68.8

–40.45

28.35

1040

78.8

–50.45

28.35

1050

88.8

–60.45

28.35

BULL SPREAD

PROFIT/LOSS

100 50 0 900

920

940

960

980

1000

1020

1040

– 50 – 100 STOCK PRICE RANGE BUY CALL

Fig. 7.13

SELL CALL

Bull spread

NET PAY OFF

1060

90 Option Trading

7.5.3

Bull Spread with Puts

The investor sells an at-the-money Infosys put option and buys deep out-ofthe-money put option, assuming that the stock doesn’t fall below a certain extent. In the example, he buys Infosys 2160 put option at Rs. 25 and sells in the money put options at Rs. 40.45, when Infosys trades at Rs. 2228. The investor makes a minimum profit if Infosys is above Rs. 2204.55 and may incur loss of Rs. 44.55 per share if it moves below Rs. 2204.55. Table 7.14 Strike Price Sell Infosys Put Buy Infosis Put Break Even

Premium

2160

40.45

2130

25

2144.55 Pay off Table

Stock Price Range

Sell Put

Buy Put

Net Pay off

1920

–109.55

185

–14.55

1950

–169.55

155

–14.55

1980

–139.55

125

–14.55

2010

–199.55

95

–14.55

2040

–79.55

65

–14.55

2070

–49.55

35

–14.55

2100

–19.55

5

–14.55

2130

10.45

–25

–14.55

2160

40.45

–25

15.45

2190

40.45

–25

15.45

2220

40.45

–25

15.45

2250

40.45

–25

15.45

2280

40.45

–25

15.45

2310

40.45

–25

15.45

2340

40.45

–25

15.45

2370

–40.45

–25

15.45

Option Strategies in a Bull Market

91

BULL SPREAD WITH PUTS 300

PROFIT/LOSS

200 100 0 1900 – 100

2000

2100

2200

2300

– 200 – 300 STOCK PRICE RANGE SELL CALL

Fig. 7.14

BUY PUT

NET PAY OFF

Bull spread with puts

7.5.4 Buy Futures with Protective Put One of the safest strategies that can be adopted in a bull market is long futures/ stock with protective puts. The investors make unlimited profits and incur minor loss if the stock falls. The following chart shows the purchased futures position of ICICI bank at Rs. 921 and long put of 880 strike price at Rs. 13.95 in the same expiry month. Investors can make profit if ICICI bank stock moves above Rs. 934.95. Table 7.15 921

Buy ICICI Bank Futures

Strike Price Buy Put

Premium

880

13.95

934.95

Break Even

Pay off Table Stock Price Range

Buy Put

Sell Put

Net Pay off

800

66.05

–121

–54.95

820

46.05

–101

–54.95

840

26.05

–81

–54.95

860

6.05

–61

–54.95

880

–13.95

–41

–54.95

900

–13.95

–21

–34.95

920

–13.95

–1

–14.95

940

–13.95

19

5.05

960

–13.95

39

25.05

980

–13.95

59

45.05

92 Option Trading Pay off Table Stock Price Range

Buy Put

Sell Put

Net Pay off

1000

–13.95

79

65.05

1020

–13.95

99

85.05

1040

–13.95

119

105.05

1060

–13.95

139

125.05

1080

–13.95

159

145.05

BUY FUTURES WITH PROTECTIVE PUT

100 BUY PUT 0

900 920 940 960 980 1000 1020 1040 1060 1080

– 100

800

PROFIT/LOSS

200

BUY FUTURES NET PAY OFF

– 200 STOCK PRICE RANGE

Fig. 7.15

Buy futures with protective put

7.5.5 Covered Call In a firm market, an investor buys stock/futures and he sells call option, preferably an out-of-the-money option. If the stock remains stable or bullish, the investor makes profit. The following chart show the purchased position of Reliance futures at Rs. 2184 and sales position of 2250 call option at Rs. 25. While doing so, the investor gets early breakeven at Rs. 2159 and makes a profit of Rs. 91 per share. Table 7.16 2184

Buy Reliance Futures

Strike Price

Premium

Sell Call

2250

25

Break Even

2159 Pay off Table

Stock Price Range

Sell Call

Stock Pay off

Net Pay off

2010

25

–174

–149

2040

25

–144

–119

2070

25

–114

–89

2100

25

–84

–59

Option Strategies in a Bull Market

93

Pay off Table Stock Price Range

Sell Call

Stock Pay off

Net Pay off

2130

25

–54

–29

2160

25

–24

1

2190

25

6

31

2220

25

36

61

2250

25

66

91

2280

–5

96

91

2310

–35

126

91

2340

–65

156

91

2370

–95

186

91

2400

–125

216

91

2430

–155

246

91

COVERED CALL 300

PROFIT/LOSS

200 100 0 2000 – 100

2060

2120

2180

2240

2300

2360

2420

– 200 STOCK PRICE RANGE SELL CALL

Fig. 7.16

STOCK PAY OFF

NET PAY OFF

Covered call

7.5.6 Long Straddle Buying a call option and a put option of a stock at the same expiry and the same strike is known as long straddle. The trader can also benefit from a volatility increase after the purchase. The investor who expects a sharp rise or fall in the future can also buy long straddles. Here the investor buys DLF 430 call option at Rs. 18 and sells 430 put option at Rs. 14, on expectation of quarterly results, when he expects a sharp one sided movement from the stock. He makes profit, if it falls below Rs. 38 or rise above Rs. 462. If it stays between the two breakeven points, he may incur loss provided the implied volatility doesn’t do much favour. Buying stock’s long straddle ahead of quarterly numbers and selling before the announcement of the results is a good strategy.

94 Option Trading Table 7.17 Strike Price Buy DLF Call

Premium 18

4300

Buy DLF Put Upside Break Even

462

Downside Break Even

398

14

Pay off Table Stock Price Range

Buy Call

Buy Put

Net Pay off

300

–18

116

98

320

–18

96

78

340

–18

76

58

360

–18

56

38

380

–18

36

18

400

–18

16

–2

420

–18

–4

–22

430

–18

–14

–32

440

–8

–14

–22

460

12

–14

–2

480

32

–14

18

500

52

–14

38

520

72

–14

58

540

92

–14

78

560

112

–14

98

LONG STRADDLE 150 100 50 0 290

330

370

410

450

490

530

– 50 BUY CALL

Fig. 7.17

BUY PUT

NET PAY OFF

Long straddle

570

Option Strategies in a Bull Market

7.5.7

95

Long Strangle

Usually this strategy is used when the trader expects large move in the stocks i.e. if it breaks the key support and resistance levels. For example, DLF’s 100 daily simple moving average is Rs. 440 and 200 day simple moving average is at Rs. 410. If the stock moves sharply in either direction, the investors make money. The upper side breakeven would be Rs. 460.55 and lower side breakeven would be Rs. 389.45, if the stock remains steady between 410–440, the investor incurs heavy loss. Table 7.18 Strike Price

Premium

440

13.05

410

7.5

Buy DLF Call Buy DLF Put Upside Break Even

460.55

Downside Break Even

389.45 Pay off Table

Stock Price Range

Buy Call

Buy Put

Net Pay off

350

–13.05

52.5

39.45

360

–13.05

42.5

29.45

370

–13.05

32.5

19.45

380

–13.05

22.5

9.45

390

–13.05

12.5

–0.55

400

–13.05

2.5

–10.55

410

–13.05

–7.5

–20.55

420

–13.05

–7.5

–20.55

430

–13.05

–7.5

–20.55

440

–13.05

–7.5

–20.55

450

–3.05

–7.5

–10.55

460

6.95

–7.5

-0.55

470

16.95

–7.5

9.45

480

26.95

–7.5

19.45

490

36.95

–7.5

29.45

96 Option Trading LONG STRANGLE 60 PROFIT/LOSS

40 20 0 340

460

480

500

– 20 – 40 STOCK PRICE RANGE BUY CALL

BUY PUT

Fig. 7.18

NET PAY OFF

Long strangle

7.6 HIGH RISK STOCK OPTION STRATEGIES 7.6.1 Synthetic Long If the trader believes that Reliance will move up from the current level, then the trader should buy the Reliance call option. But if the outlook is extremely bullish, the trader can sell the put option of Reliance together with the purchased position of call option. Here the investor is bullish and he buys the Reliance 2190 call option at Rs. 46.50 and sells 2190 put option at Rs. 61.40, when the stock was at 2190. If the underlying moves according to his expectation, he will start making profit above 2175.10. This strategy is good in a bull market and will give unlimited loss in a weak market. Table 7.19 Strike Price

Premium

Sell Reliance Put

2190

61.4

Buy Reliance Call

2190

46.5

Break Even

2175.1 Pay off Table

Stock Price Range

Sell Put

Buy Call

Net Pay off

2010

–118.6

–46.5

–165.1

2040

–88.6

–46.5

–135.1

2070

–58.6

–46.5

–105.1

Option Strategies in a Bull Market

97

Pay off Table Stock Price Range

Sell Put

Buy Call

Net Pay off

2100

–28.6

–46.5

–75.1

2130

1.4

–46.5

–45.1

2160

31.4

–46.5

–15.1

2190

61.4

–46.5

14.9

2220

61.4

–16.5

44.9

2250

61.4

13.5

74.9

2280

61.4

43.5

104.9

2310

61.4

73.5

134.9

2340

61.4

103.5

164.9

2370

61.4

133.5

194.9

2400

61.4

163.5

224.9

2430

61.4

193.5

254.9

SYNTHETIC LONG

PROFIT/LOSS

300 200 100 0 2000 – 100

2060

2120

2180

2240

2300

2360

2420

– 200 STOCK PRICE RANGE SELL PUT

Fig. 7.19

BUY CALL

NET PAY OFF

Synthetic long

7.6.2 Synthetic Long Split Strike Buying call option and selling put option of the same stock/index on the same expiry at different strike prices is known as synthetic long with split strike rate. As the trader sells his put option slightly at a lower strike price, indirectly it reduces his risk in writing. But the speed to get quick money is far distant than the synthetic long. Here the trader buys at-the-money call option and writes his out-of-the-money at the same expiry. Some aggressive traders even buy in-the-money call option and sell out-of-the-money put option at

98 Option Trading the same expiry date. The view of the strategy holder would be bullish but he wouldn’t want to take high risk. If the option trader’s risk appetite is low, instead of creating a strategy in the at-the-money, he would create an out-of-the-money strike price. Here the investor buys 2220 call option of Reliance at Rs. 35.20 and sells an out-of-themoney 2190 put option at Rs. 61.40, when Reliance is at 2190. If the stock moves above, he will make potential profits. On the other hand he may incur loss if the stock price goes below 2163.80. Table 7.20 Strike Price Sell Reliance Put Buy Reliance Call Break Even

Premium

2190

61.4

2220

35.2

2163.8 Pay off Table

Stock Price Range

Sell Put

Buy Call

Net Pay off

2010

–118.6

–35.2

–153.8

2040

–88.6

–35.2

–123.8

2070

–58.6

–35.2

–93.8

2100

–28.6

–35.2

–63.8

2130

1.4

–35.2

–33.8

2160

31.4

–35.2

–3.8

2190

61.4

–35.2

26.2

2220

61.4

–35.2

26.2

2250

61.4

–5.2

56.2

2280

61.4

24.8

86.2

2310

61.4

54.8

116.2

2340

61.4

84.8

146.2

2370

61.4

114.8

176.2

2400

61.4

144.8

206.2

2430

61.4

174.8

236.2

Option Strategies in a Bull Market

99

SYNTHETIC LONG SPLIT STRIKE

PROFIT/LOSS

300 200 100 0 2000 – 100

2180

2240

2300

2360

2420

– 200 STOCK PRICE RANGE SELL PUT

Fig. 7.20

BUY CALL

NET PAY OFF

Synthetic long split strike

7.6.3 Synthetic Long in Deep Out-Of-The-Money Options Here the option buyer is confident about the price movement. He expects a sharp uptrend in price of Infosys’s stock price. So he buys an out-of-themoney 2350 call option at Rs. 5 and sells 2050 put option at Rs. 7. Even if the stock doesn’t move above 2342, still he gets Rs. 2 as profit. His loss starts only below 2042. Table 7.21 Strike Price

Premium

Sell Infosys Put

2050

7

Buy Infosys Call

2350

5

Pay off Table Stock Price Range

Short Put

Long Call

Net Pay off

2010

–33

–5

–38

2040

–3

–5

–8

2070

7

–5

2

2100

7

–5

2

2130

7

–5

2

2160

7

–5

2

2190

7

–5

2

2220

7

–5

2

2250

7

–5

2

2280

7

–5

2

100 Option Trading Pay off Table Stock Price Range

7.6.4

Short Put

Long Call

Net Pay off

2310

7

–5

2

2340

7

–5

2

2370

7

15

22

2400

7

45

52

2430

7

75

82

Short Put

Selling put option in a rising market is advisable. But the risk would be very high if the stock declines. If the stock declines substantially, then even assignment would happen. Put option writer generally sells stocks, if the put option moves below the breakeven. The maximum profit for the put option writer would be the premium value. Here it would be Rs. 40.45. Table 7.22 Strike Price Sell Infosys Put

Premium

2220

40.45

2179.55

Break Even

Pay off Table Stock Price Range

Sell Put

2070

–109.55

2100

–79.55

2130

–49.55

2160

–19.55

2190

10.45

2220

40.45

2250

40.45

2280

40.45

2310

40.45

2340

40.45

2370

40.45

2400

40.45

2430

40.45

2460

40.45

2490

40.45

Option Strategies in a Bull Market

101

SELL PUT 100 PROFIT/LOSS

50 0 – 50 1970

2030

2090

2150

2210

2270

2330

2390

– 100 – 150 – 200 – 250 STOCK PRICE RANGE SELL PUT

Fig. 7.22

Sell put

7.6.5 Put Ratio Spread The option trader buys an at-the-money put option and sells two lots of outof-the-money put option of the same expiry date. Here he buys one lot of ICICI bank put option of 900 strike price at Rs. 20.50 and sells two lots of 880 put option for Rs. 13.95. If the stock closes at Rs. 880 on expiry, he will make maximum profit. He will gain Rs. 7.50 at or above Rs. 900 and will incur unlimited loss below Rs. 852.60. Table 7.23 Strike Price

Premium

Buy ICICI Bank Put

900

20.5

Sell ICICI Bank Put 2 Lots

880

13.95

852.6

Break Even

Pay off Table Stock Price Range

Buy Put

Sell Put

Net Pay off

830

49.5

–72.1

–22.6

840

39.5

–52.1

–12.6

850

29.5

–32.1

–2.6

860

19.5

–12.1

7.4

870

9.5

7.9

17.4

880

–0.5

27.9

27.4

890

–10.5

27.9

17.4

900

–20.5

27.9

7.4

102 Option Trading Pay off Table Stock Price Range

Buy Put

Sell Put

Net Pay off

910

–20.5

27.9

7.4

920

–20.5

27.9

7.4

930

–20.5

27.9

7.4

940

–20.5

27.9

7.4

950

–20.5

27.9

7.4

960

–20.5

27.9

7.4

970

–20.5

27.9

7.4

PUT RATIO SPREAD 60 PROFIT/LOSS

40 20 0 – 20 820

840

860

880

900

920

940

960

980

– 40 – 60 – 80 STOCK PRICE RANGE BUY CALL

Fig. 7.23

SELL PUT

NET PAY OFF

Put ratio spread

7.7 COMPLEX TRADING STRATEGIES IN A BULL 7.7 MARKET 7.7.1 Long Straddle with Short Call An investor buys a long straddle and sells an out-of-the-money call option of the same expiry. The investor expects a large move in either direction, but according to him the upside is capped, thereby, he sells the out-of-the-money call option. Here the investor buys 5100 long straddle of Nifty and sells 5400 Nifty call option at Rs. 8. He attains maximum profit at Rs. 174 if Nifty closes at 5100 on expiry. He would have a minimum profit above 5274 and unlimited profit below 4926.

Option Strategies in a Bull Market

Table 7.24 Strike Price Buy Call

Premium 97

5100

Buy Put Sell Call

5400

Upside Break Even

5274

Downside Break Even

4926

85 8

Pay off Table Stock Price Range

Buy Call

Buy Put

Sell Call

Net Pay off

4500

–97

515

8

426

4600

–97

415

8

326

4700

–97

315

8

226

4800

–97

215

8

126

4900

–97

115

8

26

5000

–97

15

8

–74

5100

–97

–85

8

–174

5200

3

–85

8

–74

5300

103

–85

8

26

5400

203

–85

8

126

5500

303

–85

–92

126

5600

403

–85

–192

126

5700

503

–85

–292

126

5800

603

–85

–392

126

5900

703

–85

–492

126

LONG STRADDLE WITH SHORT CALL 800

PROFIT/LOSS

600 400 200 0 – 200 4400

4600

4800

5000

5200

5400

5800

– 400 – 600 NIFTY PRICE RANGE BUY CALL

BUY PUT

SELL CALL

NET PAY OFF

Fig. 7.24 Long straddle with short call

6000

103

104 Option Trading

7.7.2 Short Straddle with Long Call The investor decides to sell the long straddle, because he feels that the volatility may drop in the coming day. But fears of an upside if it breaks a certain level, so he buys an out-of-the-money call option. An investor sells Nifty 5100 call and put at Rs. 97 and Rs. 85 respectively and simultaneously buys Nifty 5400 call at Rs. 8. He makes a maximum profit of Rs. 174 if Nifty closes at 5100 and minimum loss of Rs. 126 if Nifty closes above 5274. He will incur an unlimited loss below 4926. Table 7.25 Strike Price Sell Call

Premium 97

5100

Sell Put Buy Call

5400

Upside Break Even

5274

Downside Break Even

4926

85 8

Pay off Table Stock Price Range

Sell Call

Sell Put

Buy Call

Net Pay off

4500

97

–515

–8

–426

4600

97

–415

–8

–326

4700

97

–315

–8

–226

4800

97

–215

–8

–126

4900

97

–115

–8

–26

5000

97

–15

–8

74

5100

97

85

–8

174

5200

–3

85

–8

74

5300

–103

85

–8

–26

5400

–203

85

–8

–126

5500

–303

85

92

–126

5600

–403

85

192

–126

5700

–503

85

292

–126

5800

–603

85

392

–126

5900

–703

85

492

–126

Option Strategies in a Bull Market

105

SHORT STRADDLE WITH LONG CALL 600

PROFIT/LOSS

400 200 0 4400 – 200

4600

4800

5000

5200

5400

5600

5800

6000

– 400 – 600 – 800 NIFTY PRICE RANGE SELL CALL

SELL PUT

Fig. 7.25

7.7.3

BUY CALL

NET PAY OFF

Short straddle with long call

Long Strangle with Short Call

The option trader expects higher volatility and subsequent movement for Nifty. But he feels that the upside is capped due to various reasons, thereby buys long strangle and sells an out-of-the-money call option. He attains minimum profit and minimum loss if the index stays firm to flat, whereas he may incur unlimited loss in a weak market. Here the trader buys Nifty 5200 call at Rs. 51 and buys Nifty 5000 put at Rs. 52 and sells Nifty 5400 call at Rs. 8. His upside breakeven is at 5295 and his downside breakeven is at 4905, wherein he would be getting a minimum payoff of Rs. 5. Table 7.26 Strike Price

Premium

Buy Call

5200

51

Buy Put

5000

52

Sell Call

5400

8

Upside Break Even

5295

Downside Break Even

4905 Pay off Table

Stock Price Range

Buy Call

Buy Put

4400

–51

548

Sell Call 8

Net Pay off 505

4500

–51

448

8

405

4600

–51

348

8

305

106 Option Trading Pay off Table Stock Price Range

Buy Call

Buy Put

Sell Call

Net Pay off

4700

–51

248

8

205

4800

–51

148

8

105

4900

–51

48

8

5

5000

–51

–52

8

–95

5100

–51

–52

8

–95

5200

–51

–52

8

–95

5300

49

–52

8

5

5400

149

–52

8

105

5500

249

–52

–92

105

5600

349

–52

–192

105

5700

449

–52

–292

105

5800

549

–52

–392

105

LONG STRANGLE WITH SHORT CALL 600

PROFIT/LOSS

400 200 0 – 200

4300

4500

4700

4900

5100

5300

5500

5700

5900

– 400 – 600 NIFTY PRICE RANGE BUY CALL

Fig. 7.26

7.7.4

BUY PUT

SELL CALL

NET PAY OFF

Long strangle with short call

Short Strangle with Long Call

Here the trader sells both the options at different strike price, but buys an out-of-the-money call option to protect from unforeseen uproar of Nifty. This strategy provides minimum loss and minimum profit. In a weak market the loss is unlimited. The trader sells Nifty 5200 at Rs. 51, sells Nifty 5000 call at Rs. 52 and buys Nifty 5400 call at Rs. 8.

Option Strategies in a Bull Market

Table 7.27 Strike Price

Premium

Sell Call

5200

51

Sell Put

5000

52

Buy Call

5400

8

Upside Break Even

5295

Downside Break Even

4905 Pay off Table

Stock Price Range

Sell Call

Sell Put

Buy Call

Net Pay off

4400

51

–548

–8

–505

4500

51

–448

–8

–405

4600

51

–348

–8

–305

4700

51

–248

–8

–205

4800

51

–148

–8

–105

4900

51

–48

–8

–5

5000

51

52

–8

95

5100

51

52

–8

95

5200

51

52

–8

95

5300

–49

52

–8

–5

5400

–149

52

–8

–105

5500

–249

52

92

–105

5600

–349

52

192

–105

5700

–449

52

292

–105

5800

–549

52

392

–105

SHORT STRANGLE WITH LONG CALL 600

PROFIT/LOSS

400 200 0 – 200

4300

4500

4900

5100

5300

5500

5700

5900

– 400 – 600 NIFTY PRICE RANGE SELL CALL

Fig. 7.27

SELL PUT

BUY CALL

NET PAY OFF

Short strangle with long call

107

108 Option Trading

7.7.5 Long Straddle with Short Put The investor buys long straddle and simultaneously sells an out-of-the-money put option. Here he doesn’t expect a major downside. Sometimes the investors even sell two lots of put options. Profit and loss is limited. If the market is on a rise, then the profit is unlimited. Table 7.28 Strike Price Buy Call

Premium 97

5100

Buy Put Sell Put

4700

Upside Break Even

5272

Downside Break Even

4928

87 12

Pay off Table Stock Price Range

Buy Call

Buy Put

Sell Put

Net Pay off

4500

–97

513

–188

228

4600

–97

413

–88

228

4700

–97

313

12

228

4800

–97

213

12

128

4900

–97

113

12

28

5000

–97

13

12

–72

5100

–97

–87

12

–172

5200

3

–87

12

–72

5300

103

–87

12

28

5400

203

–87

12

128

5500

303

–87

12

228

5600

403

–87

12

328

5700

503

–87

12

428

5800

603

–87

12

528

5900

703

–87

12

628

Option Strategies in a Bull Market

109

LONG STRADDLE WITH SHORT PUT PROFIT/LOSS

1000 500 0 4400 – 500

4600

4800

5000

5200

5400

5600

5800

6000

NIFTY PRICE RANGE BUY CALL

BUY PUT

Fig. 7.28

SELL PUT

NET PAY OFF

Long straddle with short put

7.7. 6 Short Straddle with Long Put Here the investor sells both call option and put option of Nifty and buys an out-of-the-money put option to protect unlimited loss if Nifty falls to a certain extent. The trader sells Nifty 5100 call at Rs. 97, 5100 put at Rs. 87 and buys Nifty 4700 put at Rs. 12. If the Nifty closes on expiry at around 5100, he will make maximum profit, whereas he may incur unlimited loss above 5272 and limited loss below 4928. Investors often use this strategy to encash the volatility. Table 7.29 Strike Price Sell Call

Premium 97

5100

Sell Put Buy Put

4700

Upside Break Even

5272

Downside Break Even

4928

87 12

Pay off Table Stock Price Range

Sell Call

Sell Put

Buy Put

Net Pay off

4400

97

–613

288

–228

4500

97

–513

188

–228

4600

97

–413

88

–228

4700

97

–313

–12

–228

4800

97

–213

–12

–128

4900

97

–113

–12

–28

110 Option Trading Pay off Table Stock Price Range

Sell Call

Sell Put

Buy Put

Net Pay off

5000

97

–13

–12

72

5100

97

87

–12

172

5200

–3

87

–12

72

5300

–103

87

–12

–28

5400

–203

87

–12

–128

5500

–303

87

–12

–228

5600

–403

87

12

–328

5700

–503

87

–12

–428

5800

–603

87

–12

–528

SELL CALL

4400 4500 4600 4700 4800 4900 5000 5100 5200 5300 5400 5500 5600 5700 5800

PROFIT/LOSS

SHORT STRADDLE WITH LONG PUT 400 300 200 100 0 – 100 – 200 – 300 – 400 – 500 – 600 – 700

SELL PUT BUY PUT NET PAY OFF

NIFTY PRICE RANGE

Fig. 7.29 Short straddle with long put

7.7.7 Long Strangle with Short Put The traders buy a long strangle and sell an out-of-the-money put option. Generally, the selection of the strike price is determined by the implied volatility and gamma. The investors expect a large move especially on the higher side but a small move on the lower side. Profit is unlimited on an upside movement and minimum loss at lower levels. The trader buys Nifty 5200 call at Rs. 51, buys Nifty 5000 put at Rs. 52 and sells Nifty 4700 put at Rs. 12.

Option Strategies in a Bull Market

Table 7.30 Strike Price

Premium

Buy Call

5200

51

Buy Put

5000

52

Sell Put

4700

12

Upside Break Even

5291

Downside Break Even

4909 Pay off Table

Stock Price Range

Buy Call

Buy Put

Sell Put

Net Pay off

4400

–51

548

–288

209

4500

–51

448

–188

209

4600

–51

348

–88

209

4700

–51

248

12

209

4800

–51

148

12

109

4900

–51

48

12

9

5000

–51

–52

12

–91

5100

–51

–52

12

–91

5200

–51

–52

12

–91

5300

49

–52

12

9

5400

149

–52

12

109

5500

249

–52

12

209

5600

349

–52

12

309

5700

449

–52

12

409

5800

549

–52

12

509

LONG STRANGLE WITH SHORT PUT 600

PROFIT/LOSS

400 200 0 4300

4500

4700

4900

5100

5300

5500

5700

5900

– 200 – 400 NIFTY PRICE RANGE BUY CALL

BUY PUT

SELL PUT

NET PAY OFF

Fig. 7.30 Long strangle with short put

111

112 Option Trading

7.8

COMBINATION STRATEGIES

7.8.1 Delta Hedge The investors buy futures and sell a deep-in-the-money call option. While selecting the strike, investors look into the expensive in-the-money call option with low gamma. Buying of futures and selling of call should be done simultaneously; a delay in execution can cause huge loss. The investor buys Nifty futures at 5109 and sells Nifty 4900 call at Rs. 241. Table 7.31 Buy Nifty Futures

5109 Strike Price

Premium

Sell Nifty Call

4900

241

Break Even

4868 Pay off Table

Stock Price Range

Sell Call

Stick Pay off

Total

4300

241

–809

–568

4400

241

–709

–468

4500

241

–609

–368

4600

241

–509

–268

4700

241

–409

–168

4800

241

–309

–68

4900

241

–209

32

5000

141

–109

32

5100

41

–9

32

5200

–59

91

32

5300

–159

191

32

5400

–259

291

32

5500

–359

391

32

5600

–459

491

32

5700

–559

591

32

Option Strategies in a Bull Market

113

800 600

PROFIT/LOSS

400 200 0 – 200

4200

4400

4600

4800

5200

5400

5600

5800

– 400 – 600 – 800 – 1000 NIFTY PRICE RANGE SELL CALL

STOCK PAY OFF

Fig. 7.31

7.8.2

TOTAL

Delta hedge

Delta Hedge on Nifty with Calls

Buying futures of Nifty and selling two lots of its at-the-money call options can be said to be delta neutral. But the trader buys a deep at-the-money call option at the same expiry to protect himself from sharp upside movement of Nifty. Preferably investors sell only low gamma call options with high premiums and buy low premium call options. Here the trader buys Nifty at 5109 and sells two lots of Nifty 5300 call option at Rs. 23 and buys Nifty 5500 call option at Rs. 3. The lower side breakeven point would be at 5066 and he will make maximum profit at 5300 and limited profit above 5500. Table 7.32 Buy Nifty Futures

5109 Strike Price

Premium

Sell Nifty Call 2 Lots

5300

23

Buy Nifty Call

5500

3

Break Even

5066 Pay off Table

Stock Price Range

Stock Pay off

Sell Call

Buy Call

Total

4600

–509

46

–3

–466

4700

–409

46

–3

–366

4800

–309

46

–3

–266

4900

–209

46

–3

–166

114 Option Trading Pay off Table Stock Price Range

Stock Pay off

Sell Call

Buy Call

Total

5000

–109

46

–3

–66

5100

–9

46

–3

34

5200

91

46

–3

134

5300

191

46

–3

234

5400

291

–154

–3

134

5500

391

–354

–3

34

5600

491

–554

97

34

5700

591

–754

197

34

5800

691

–954

297

34

5900

791

–1154

397

34

6000

891

–1354

497

34

1500

PROFIT/LOSS

1000

500

0 4500

4700

4900

5100

5300

5500

5700

5900

6100

– 500

– 1000

– 1500 NIFTY PRICE RANGE STOCK PAY OFF

Fig. 7.32

7.8.3

SELL CALL

BUY CALL

TOTAL

Delta hedge on Nifty with calls

Delta Hedge on Nifty with Puts

Buying Nifty futures at 5109 and buying two lots of its 5000 strike put option can be called as delta neutral. Here the investors sell an out-of-the-money put option, thereby he gets Rs. 33 as premium. He will incur a maximum loss of Rs. 180. He will attain breakeven at 5180 and unlimited profit in a major bull market. As the delta positions are low, margins are low and risk would be minimal in all of these delta hedge strategies.

Option Strategies in a Bull Market

Table 7.33 Buy Future

5109 Strike Price

Premium

Buy Put 2 Lots

5000

52

Sell Put

4900

33

Break Even

5180 Pay off Table

Stock Price Range

Buy Future

Buy Put 2 Lots

Sell Put

Net Pay off

4500

–609

896

–367

–80

4600

–509

696

–267

–80

4700 4800

–409 –309

496 296

–167 –67

–80 –80

4900 5000

–209 –109

96 –104

33 33

–80 –180

5100 5200 5300

–9 91 191

–104 –104 –104

33 33 33

-80 20 120

5400 5500

291 391

–104 –104

33 33

220 320

5600 5700 5800

491 591 691

–104 –104 –104

33 33 33

420 520 620

5900

791

–104

33

720

1000 800

PROFIT/LOSS

600 400 200 0 – 200 4400

4600

4800

5000

5200

5400

5600

5800

6000

– 400 – 600 – 800 NIFTY PRICE RANGE BUY FUTURE

BUY PUT 2 LOTS

SELL PUT

NET PAY OFF

Fig. 7.33 Delta hedge on Nifty with puts

115

116 Option Trading

7.8.4 Hedge Wrappers Here the investors hold Nifty futures which he bought at 5109. He buys an out-of-the-money put option and sells an out-of-the-money call option. The long put option protects the investor’s downside risk and the written call option gives him premium, which helps him attain early breakeven. This strategy provides minimum risk and minimum profits. Here the investor buys Nifty 4900 put at Rs. 33 and sells Nifty 5300 call at Rs. 23 and buys Nifty futures at 5109. Table 7.34 Buy Nifty Futures

5109 Strike Price

Premium

5300

23

Buy Nifty Put

4900

33

Break Even

5119

Sell Nifty Call

Pay off Table Stock Price Range

Stock Pay off

Sell Call

Buy Nifty Put

Net Pay off

4500

–609

23

367

–219

4600

–509

23

267

–219

4700

–409

23

167

–219

4800

–309

23

67

–219

4900

–209

23

–33

–219

5000

–109

23

–33

–119

5100

–9

23

–33

–19

5200

91

23

–33

81

5300

191

23

–33

181

5400

291

–77

–33

181

5500

391

–177

–33

181

5600

491

–277

–33

181

5700

591

–377

–33

181

5800

691

–477

–33

181

5900

791

–577

–33

181

Option Strategies in a Bull Market

117

1000 800

PROFIT/LOSS

600 400 200 0 – 200

4400

4600

4800

5000

5200

5400

5600

5800

6000

– 400 – 600 – 800 NIFTY PRICE RANGE STOCK PAY OFF

SELL CELL

Fig. 7.34

BUY PUT

NET PAY OFF

Hedge wrappers

7.9 CALENDAR SPREAD It is extensively used in agri-commodity trading. During harvest season, the price of a produce is on a decline as compared to the far month contract. If a commodity’s harvest season starts at September, price close to that harvest season remains weak comparing with the far month contracts. Traders and spread traders usually sell the September contract and buy the far month contract, i.e., January or February contract, assuming that there could be a shortage of produce. Selling/buying in the near month contract and buying/selling the same in the far month contract is known spreading.

7.10 INTERMONTH COMBINATIONS 7.10.1

Multiple Leg Spreading — Type I

Buying two lots of October call option, selling one lot of November call option and selling one lot of December call option can be called as spreading. Here the trader expects an uptrend in October price and expects gradual fall from November to December. The trader will remain in safe till the last day of expiry in October, but his risk will be very high as the October contract gets expired. The margin requirement would be very high in November and December contracts. Most of the time investors liquidate all the three positions simultaneously on the day of October expiry itself.

118 Option Trading Table 7.35 Strike Price

Premium

Buy October Call 2 Lots

5100

97

Sell November Call 1 Lot

5100

182

Sell December Call 1 Lot

5100

250

Pay off Table Stock Price Range

Buy October Call 2 Lots

Sell November Call 1 Lot

Sell December Call 1 Lot

4600

–194

182

250

4700

–194

182

250

4800

–194

182

250

4900

–194

182

250

5000

–194

182

250

5100

–194

182

250

5200

6

82

150

5300

206

–18

50

5400

406

–118

–50

5500

606

–218

–150

5600

806

–318

–250

5700

1006

–418

–350

5800

1206

–518

–450

5900

1406

–618

–550

6000

1606

–718

–650

2000

PROFIT/LOSS

1500 1000 500 0 4500 – 500

4700

4900

5100

5300

5500

5700

5900

6100

– 1000 NIFTY PRICE RANGE BUY OCTOBER CALL 2 LOTS

SELL NOVEMBER CALL 1 LOT

SELL DECEMBER CALL 1 LOT

Fig. 7.35

Multiple leg spreading — Type I

Option Strategies in a Bull Market

119

7.10.2 Multiple Leg Spreading — Type II Selling two lots of October call option and simultaneously buying one lot of November and one lot of December call option can be said to be the TYPE-II form of multiple leg spreading. Comparing with the previous strategy, the risk associated and margin required would be low. Here the trader expects a fall in asset price in October, but expects a recovery from November to December. While selecting the November and December contracts, he will ensure to buy high gamma strike calls and for selling he sells expensive calls with low gamma. The trader sells two lots of Oct Nifty 5100 call at Rs. 97, buys one lot of Nov Nifty call at Rs. 182 and buys one lot of Dec Nifty 5100 call at Rs. 250. Table 7.36 Strike Price

Premium

Sell October Call 2 Lots

5100

97

Buy November Call 1 Lot

5100

182

Buy December Call 1 Lot

5100

250

Pay off Table Stock Price Range

Sell October Call 2 Lots

Buy November Call 1 Lot

Buy December Call 1 Lot

4600

194

–182

–250

4700

194

–182

–250

4800

194

–182

–250

4900

194

–182

–250

5000

194

–182

–250

5100

194

–182

–250

5200

–6

–82

–150

5300

–206

18

–50

5400

–406

118

50

5500

–606

218

150

5600

–806

318

250

5700

–1006

418

350

5800

–1206

518

450

5900

–1406

618

550

6000

–1606

718

650

120 Option Trading 1000

PROFIT/LOSS

500 0 4500 – 500

4700

4900

5100

5300

5500

5700

5900

6100

– 1000 – 1500 – 2000 NIFTY PRICE RANGE BUY OCTOBER CALL 2 LOTS

BUY NOVEMBER CALL 1 LOT

BUY DECEMBER CALL 1 LOT

Fig. 7.36

7.10.3

Multiple leg spreading—Type II

Multiple Leg Spreading — Type III

This strategy involves buying of two lots of put option in the near month and subsequently selling two different far month contracts. Here the trader takes high risk, because after the near month expiry he holds only two put written contracts. Generally, it is created mostly in index options. The investor expects short to firm trend, but expects weak outlook for Nifty. Sometimes, volatility traders also create same type of strategies on the expectation of increased volatility from near to far month. Table 7.37 Strike Price

Premium

Buy October Put 2 Lots

5100

85

Sell November Put 1 Lot

5100

175

Sell December Put 1 Lot

5100

250

Pay off Table Stock Price Range

Buy October Put 2 Lots

Sell November Put 1 Lot

Sell December Put 1 Lot

4600

830

–325

–250

4700

630

–225

–150

4800

430

–125

–50

4900

230

–25

50

5000

30

75

150

Option Strategies in a Bull Market

121

Pay off Table Stock Price Range

Buy October Put 2 Lots

Sell November Put 1 Lot

Sell December Put 1 Lot

5100

–170

175

250

5200

–170

175

250

5300

–170

175

250

5400

–170

175

250

5500

–170

175

250

5600

–170

175

250

5700

–170

175

250

5800

–170

175

250

5900

–170

175

250

6000

–170

175

250

1000

PROFIT/LOSS

800 600 400 200 0 4500 – 200

4700

4900

5100

5300

5500

5700

5900

6100

– 400 NIFTY PRICE RANGE BUY OCTOBER PUT 2 LOTS

SELL NOVEMBER PUT 1 LOT

SELL DECEMBER PUT 1 LOT

Fig. 7.37

Multiple leg spreading — Type III

7.10.4 Multiple Leg Spreading — Type 1V The investors sell two lots of put option in the near month and conversely buy one lot of put option each in the far months. The investor expects a drop in volatility in the near month, but expects a trend reversal in the far month contracts. The risk in this strategy would be very low in all occasions, because it will act as a delta neutral till the last expiry day of the near month and after expiry it will lie as two long put options. This strategy can also be used for directional call i.e. bullish to bearish. The investor sells two lots of Oct Nifty 5100 put at Rs. 85, buys one lot of Nov Nifty 5100 put at Rs. 175 and buys one lot of Dec Nifty 5100 put at Rs. 250.

122 Option Trading Table 7.38 Strike Price

Premium

Sell October Put 2 Lots

5100

85

Buy November Put 1 Lot

5100

175

Buy December Put 1 Lot

5100

250

Pay off Table Stock Price Range

Sell October Put 2 Lots

Buy November Put 1 Lot

Buy December Put 1 Lot

4600

–830

325

250

4700

–630

225

150

4800

–430

125

50

4900

–230

25

–50

5000

–30

–75

–150

5100

170

–175

–250

5200

170

–175

–250

5300

170

–175

–250

5400

170

–175

–250

5500

170

–175

–250

5600

170

–175

–250

5700

170

–175

–250

5800

170

–175

–250

5900

170

–175

–250

6000

170

–175

–250

400

PROFIT/LOSS

200 0 4500 – 200

4700

4900

5100

5300

5500

5700

5900

6100

– 400 – 600 – 800 – 1000 NIFTY PRICE RANGE SELL OCTOBER PUT 2 LOTS

BUY NOVEMBER PUT 1 LOT

BUY DECEMBER PUT 1 LOT

Fig. 7.38

Multiple leg spreading — Type IV

Option Strategies in a Bull Market

7.10.5

123

Multiple Leg Spreading — Type V

The investors expect the market to fall from the month of December due to various reasons. So he sells a December futures and buys a November cheap call as protection to the short futures. At the end of the November expiry, he holds the single short futures position, which attracts high premium. The investor sells Dec futures at 5125 and buys Nov Nifty 5100 call at Rs. 182. Table 7.39 Sell December Futures Buy November Call

5125 Strike Price

Premium

5100

182

Pay off Table Stock Price Range

Sell December Futures

Buy November Call

4600

525

–182

4700

425

–182

4800

325

–182

4900

225

–182

5000

125

–182

5100

25

–182

5200

–75

–82

5300

–175

18

5400

–275

118

5500

–375

218

5600

–475

318

5700

–575

418

5800

–675

518

5900

–775

618

6000

–875

718

124 Option Trading 800 600 PROFIT/LOSS

400 200 0 – 200

4500

4700

4900

5300

5100

5500

5700

5900

– 400 – 600 – 800

– 1000 NIFTY PRICE RANGE SELL DECEMBER FUTURES

Fig. 7.39

BUY NOVEMBER CALL

Multiple leg spreading — Type V

7.10.6 Multiple Leg Spreading — Type V1 This strategy acts as a covered call with multiple expiries. The investor sells the near month call and buys December futures of the same underlying. His short call will give a certain protection for the long futures. Sometimes investors expect the near month volatility to fall and consequently the underlying to rise in the far month. The investor buys Dec Nifty futures at 5125 and sells Nov Nifty 5100 call at Rs. 182. Table 7.40 Buy December Futures Sell November Call

5125 Strike Price

Premium

5100

182

Pay off Table Stock Price Range

Buy December Futures

Sell November Call

4600

–525

182

4700

–425

182

4800

–325

182

4900

–225

182

5000

–125

182

5100

–25

182

5200

75

82

Option Strategies in a Bull Market

125

Pay off Table Stock Price Range

Buy December Futures

Sell November Call

5300

175

–18

5400

275

–118

5500

375

–218

5600

475

–318

5700

575

–418

5800

675

–518

5900

775

–618

6000

875

–718

1000 800 PROFIT/LOSS

600 400 200 0 – 200

4500 4700 4900 5100 5300 5500 5700 5900 6100

– 400 – 600 – 800 NIFTY PRICE RANGE BUY DECEMBER FUTURES

Fig. 7.40

SELL NOVEMBER CALL

Multiple leg spreading — Type VI

Summary In this chapter we discussed various strategies suitable to bull market. These strategies were spread under bullish strategies, strategies suitable for stock, low risk stock option strategies, high risk stock option strategies, complex trading strategies in bull market, combination strategies and inter month combinations. These strategies are built up using the data collected from Indian capital market. Trading in option market involves certain amount of risk. In the next chapter we discuss about the risk and risk aversion.

Keywords Strategy

Bullish

Long Call

Synthetic Long

Short Put

Bull Spread

126 Option Trading Long Put Christmas Tree

Long Fence Split Strike Price

Put Ratio Spread

Bulls Spread with Puts

Buy Futures with Protective Put

Covered Call

Naked Call

Delta Neutral

Delta Hedging

Market Making

Zero Delta Portfolios

Long Call

Bull Spread

Bull Spread with Puts

Covered Call

Long Straddle

Synthetic Long

Synthetic Long Split Strike

Synthetic Long

Short Put

Put Ratio Spread

Short Straddle

Short Call

Hedge Wrappers

Calendar Spread

Multiple Leg Spreading

Chapter 8

RISK PERCEPTIONS IN OPTION TRADING

8.1 OBJECTIVE Risk is an integral part of any product/venture. A proper differentiation of risk is hence, imperative. Option trading is not an exception to this rule. In the previous chapter we discussed about various strategies used in option trading under bull market condition. This chapter throws light upon the various risks arising in option trading and suggests appropriate hedging strategies.

8.2 INTRODUCTION TO RISK Risk is associated with any business. Risk can be defined as the uncertainty in changes in prices of an asset in future. If risk is high, then usually reward will be very high and vice versa. Options and futures are extensively used as risk mitigating instruments. But at the same time, it is used as instruments of leveraging. Basically, high leverage of options quantifies high risk.

8.3 VARIOUS FORMS OF RISK Broadly, risk is classified into macro and micro risk. Risk can arise due to various market conditions, interest rate changes, miscalculation of portfolio risks (modal risk), etc. Let us now discuss the common and prominent risks associated with options. These are market risk and interest rate risks.

8.3.1 Market Risk Elimination of market risk can be termed as hedging. A perfectly hedged position reduces the market risks to a great extent. Let us now examine various hedging strategies.

128 Option Trading 8.3.1 Long Stock Infosys (200 Stock) ∑ Sell Infosys stock futures ∑ Buy Infosys put option ∑ Sell Infosys call option ∑ Sell Nifty futures ∑ Buy Nifty put option ∑ Sell Nifty IT index ∑ Sell Nifty mini futures

8.3.2 Long 200 Infosys Sep Futures

Short 200 Infosys Oct futures

8.3.3 Sell Infosys Futures ∑ Buy Infosys stock ∑ Buy Infosys call option ∑ Sell Infosys put option ∑ Buy Nifty call option ∑ Buy Nifty futures ∑ Sell Nifty put option ∑ Sell Nifty mini futures ∑ Buy an IT stock which has high correlation with Infosys

8.3.4 Sell Infosys 200 October Futures

Buy Infosys 200 November futures

8.3.5 Long Infosys Call

∑ Sell futures ∑ Sell call ∑ Buy put

Risk Perceptions in Option Trading

8.3.6 Short Infosys Call

∑ Buy call ∑ Sell put ∑ Buy futures

8.3.7 Buy Infosys Put

∑ Sell Infosys put ∑ Buy Infosys call ∑ Buy Infosys futures

8.3.8 Sell Infosys Put

∑ Buy put ∑ Sell futures ∑ Sell call

8.3.9 Long Infosys September Call

∑ Sell Oct Infosys call ∑ Sell Oct Nifty call

129

130 Option Trading 8.3.10 Short Infosys Sep call

∑ Buy Infosys Oct call ∑ Buy Infosys Oct futures

8.3.11 Long Infosys Sep Put

∑ Sell Infosys Oct put ∑ Sell Infosys Oct futures

8.3.12 Short Infosys Sep Put

∑ Buy Infosys Oct put ∑ Buy Infosys Oct futures

8.3.2 Interest Rate Risks A minor change in the interest rate can affect the option premiums. In the case of call options, if interest rate rises, the call option premium will rise and it will fall with reduction in interest rate. The put option premium is inversely proportional to the interest rate change, i.e., put option premium will fall with rise in interest rate and vice versa.

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131

8.3.3 Reputation Risk A company’s reputation will affect the prices. Corporate scandals can pull down the prices substantially. The best example is the Satyam fiasco. Satyam’s Ramalinga Raju’s revelations pulled down its share prices to as low as Rs.12. Similar is the cases with a leading private sector bank. Certain rumours spread in the market about the Bank’s over exposure to certain risky portfolios could pull down its share prices temporarily. Reputation risk is generally the product of investor sentiments. Reputation risk can be mitigated by squaring up the position immediately on getting the smell than holding the asset long. The scrip can be repurchased at a lower level and held, if the company initiates steps to regain its reputation. In the case of Satyam the government initiated steps to save the company and the price of the scrip picked up immediately. Those who bought these shares at Rs.12 could gain later on substantially.

8.3.4

Human Risk

Human activities can create havoc in the market. The human activities can be intentional or accidental. Intentional activities are better known as frauds. When frauds are detected and the size of loss is divulged, the market reacts quickly and the investors suffer heavily. The fraud committed by Harshad Mehta is the best example. Mr. Mehta defrauded the State Bank of India and manipulated Rs. 3000 crores which was pumped into the capital market resulting into artificially inflating stock prices. Subsequently when the fraud was detected, the prices came down heavily. In order to mitigate the human element in risk, the supervisory system has to be tightened.

8.3.5 Equity Risk Equity risk is depreciation of one’s investment due to the stock market dynamics, which causes the loss of money. Stock market indices are indicators of stock market price movements. For example in India, SENSEX of Bombay Stock Exchange and NIFTY of National Stock Exchange Ltd provide valid information about the price movement in the stock market. A downward trend indicates loss to investors because they may have to sell at a price lower than that at which they acquired the stock. The stock market crash can be gradual or sudden giving little time for investors for correction. The measure of risk used in the equity markets is typically the standard deviation of a security’s price over a number of periods. The standard deviation will delineate the normal fluctuations one can expect in that particular security above and below the mean, or average. However, since most investors would not consider fluctuations above the average return as “risk”, some economists prefer other means of measuring it.

132 Option Trading

8.3.6 Commodity Risk Commodity risk refers to the uncertainties of future market values and of the size of the future income, caused by the fluctuation in the prices of commodities. These commodities may be grains, metals, gas, electricity, etc. A Commodity enterprise needs to deal with the following kinds of risks: Price risk is the risk arising out of adverse movements in the world prices, exchange rates, basis between local and world prices etc. Quantity risk is the risk in delivery of an asset. The contract may be for a particular measure of quantity, but when the delivery takes place, the seller may not have sufficient quantity for delivery or there may be market shortage. Cost risk (Input price risk) is the changes in prices due to the changes in the price of the inputs. For example a steep rise in rubber prices can result into increase in tyre prices.

8.3.7 Political Risk Political risk arises when the administration in a country become uncertain due to lack of majority for any party to rule the country. Countries which are prone to frequent internal war and change of administration through a coup are also exposed to political risk. Such countries are experiencing transfer delay due to scarcity of foreign exchange and exporters from other countries may have to wait for a considerable time for getting their payment despite the importers in those countries having made the payment in local currency. Another political risk is frequent changes in administration and the new administration refusing to meet the commitments under a contract made by the previous government. The best example is the case of Enron in India. Enron entered into a contract with the Congress led government and when the BJP-Shiv Sena alliance came to power in Maharashtra, they refused to accept the contract with Enron. Consequently, Enron had to abandon their project and the lenders to this project like ICICI Bank, IDBI Bank etc. had to proceed legally to recover their dues.

8.3.8

Legal Risk

The risk that a contract may not be enforceable due to legal issues, which result in a default. This often happens due to lack of adequate knowledge about legal practices and procedures

8.3.9 Operational Risk The risk of loss due to operational shortcomings, like trading in different underlying thinking they had traded the same underlying, traded in different

Risk Perceptions in Option Trading

133

quantities etc. Basle Committee on Banking Supervision has defined operational risk as “the risk of loss resulting from inadequate or failed internal processes, people and systems. This includes legal risk, but excludes strategic and reputational risk.” (i) Banks and financial institutions are facing a number of risks on account of the growing sophisticated financial technology and complexity of activities. The major risks faced by banks now are on account of highly automated technology, emergence of E-commerce, failure of internal control and back-up systems, outsourcing, large scale mergers, demergers and consolidations, use of complex products for mitigating risks like collaterals, derivatives, netting arrangements, asset securitization, etc. Basle Committee has identified that internal fraud, external fraud, employment practices and work place safety, clients, products and business practices, damage to physical assets, business disruption and system failures and execution, delivery and process management as the potential events leading to substantial losses. Frauds can be internal or external. Internal frauds include malpractices by employees, intentional misreporting of positions, theft by employees and insider trading on the employees’ own account. External frauds occurs on account of the activities by outsiders, which include theft, robbery, cheque kiting and damage from computer hacking. Employment practices and work place safety is another area, which may contribute risk to the bank. These include workers compensation claims, violation of employee health and safety rules, organized labour activities discrimination claims and general liability. Clients, products and business practices include fiduciary breaches, misuse of confidential customer information, improper trading activities on the bank’s account, money laundering and sale of unauthorized products. Damages to physical assets happen due to terrorism, vandalism, earthquakes, fire and flood. Business disruption and system failures are hardware and software failures, telecommunication problems and utility outages. Execution delivery and process management include data entry errors, collateral management failures, incomplete legal documentation, unauthorized access given to client accounts, non-client counterparty performance and vendor disputes.

8.3.10

Model Risk

Different models are used in financial operations for valuation of assets, pricing of products, measuring risk, etc. The risk is normally associated with complex derivatives models, due to wrong values. For example LTCM suffered substantial losses due to the failure of model they selected.

134 Option Trading

8.4

RISK MANAGEMENT

Risk management involves various steps such as risk identification, risk measurement and risk management. In risk management, risk is not eliminated, but risk is transferred. The principles of risk management advise that: (i) Do not risk more than you can afford to lose. (ii) Always consider the odds. (iii) Do not risk a lot, for a little. Various strategies are adopted to manage the risk. Some of these strategies are insurance, hedging through forwards, hedging through derivatives, asset liability management and collateral security.

8.5 RISK IDENTIFICATION One of the most important steps in risk management is the risk identification. The process of identification of risk involves locating the assets, endeavours, processes, etc., that at risk and the threats to which, these risks are exposed to. Since the risk is the probability of incurring a loss, the identification process also includes quantifying the potential loss and the source of such loss. The techniques used for identifying the risks are (a) Preparation of check-lists of risks and the factors that contribute to these risks (b) Brainstorming on the risk factors and noting down these factors (c) Collecting the views of cross functional teams. Involving cross functional teams enables to get multiple views so that any omission of points can be eliminated (d) Referring to documented studies of risk identification conducted in the organization and also previous risk management plans (e) Incremental development of risks and their factors (f) Interview with stakeholders and operational experts (g) Checking with the system weather the previously identified risks are still in existence (h) Checking the financial statements and the related reports and identifying the assets which are declining in value and the areas and are producing losses. (i) Closely watching suspected human activities involving financial transaction, which could turn out to be potential risk These are only certain indicative list. As the operation expands new risks may emerge and fresh techniques may have to be developed.

Risk Perceptions in Option Trading

8.6

135

MANAGING RISKS

The common form of risk management is by booking forwards. The modern risk management gives much emphasis on asset liability management, hedging, insurance, etc. The tools used differ according to the type of risk. One of the major requirements in risk management is the organizational preparedness to undertake this task. The top management should be aware of the importance of the risk management and frame a risk management policy for the whole organization. The success of the risk management depends on proper implementation of the policy, monitoring and evaluation. For this purpose, the firm should have a proper organizational structure and reporting system. The internal control and supervisor system should be strengthened and independent evaluation of operation by people who are not connected with that activity, should be periodically done and the reports should be studied. Reposing overconfidence on any individual may invite heavy risk. Barings Bank case is the best example, where their Singapore dealer Nike Leason defrauded the bank with billions of dollars resulting into the closure of the bank being unable to meet the liability.

8.7 PORTFOLIO HEDGING THROUGH NIFTY OPTIONS A fund manager holds a portfolio of securities from Nifty as given below. Total portfolio value is Rs. 1 crore. Their corresponding weightage in Nifty and their beta values are also given in the table below. The beta of the portfolio is found to be 1.07, i.e., his portfolio moves 1.07 times corresponding to that of the index movement. Now it has been predicted that there would be a 10% correction in Nifty, the spot price being at 5000. How would the fund manager hedge his position? Sl No.

Stock name

Sector

Weightage (%)

1.

RELIANCE

Refineries

15

2.

SBI

Banks

15

3.

BHEL

Electrical Equipment

12

4.

TCS

IT

10

5.

ONGC

Oil Exploration

10

6.

HDFC

Finance

10

7.

ICICI BANK

Banks

10

8.

MARUTI

Automobiles

8

9.

STERLITE

Metals

5

10.

GRASIM

Cement

5

136 Option Trading

Sl No.

Stock Name

Weightage of Stocks in the Portfolio (in Rs. lakh)

Total Portfolio Value (in Rs. crore)

Proportion of Stock in the portfolio

(A)

(B)

(C) = A/B

Stock Beta

Product of Stock Beta and Stock Proportion

Portfolio Beta

(E) = C ´ D

(F) = Sum of (E)

1.

RELIANCE

1500000

10000000

0.15

1.24

0.186

2.

SBI

1500000

10000000

0.15

1.07

0.1605

3.

BHEL

1200000

10000000

0.12

0.96

0.1152

4.

TCS

1000000

10000000

0.1

0.86

0.086

5.

ONGC

1000000

10000000

0.1

0.87

0.087

6.

HDFC

1000000

10000000

0.1

1.15

0.115

7.

ICICI BANK

1000000

10000000

0.1

1.52

0.152

8.

MARUTI

800000

10000000

0.08

0.68

0.0544

9.

STERLITE

500000

10000000

0.05

1.47

0.0735

10.

GRASIM

500000

10000000

0.05

0.8

0.04

1.07

Solution: For an investor, three scenarios can be followed by utilizing options and futures for hedge. Scenario 1: Referring to the following table the fund manager tries to analyze whether to buy a put option or write call option, so that he can properly hedge his position. Call

Premium

Put

Premium

5300

22

5300

320

5200

38

5200

250

5100

50

5100

165

5000

75

5000

65

4900

165

4900

55

4800

255

4800

32

4700

340

4700

20

4600

430

4600

12

4500

520

4500

6

Spot price of Nifty = 5000 It has been predicted that there would be correction of 10% in Nifty, i.e., the market would fall to 4500. In that case the fund manager decides to sell 4500 (i.e., 10% of 5000) call option. His portfolio has an exposure of Rs. 1,07,00,000 (1,00,00,000*1.07).

Risk Perceptions in Option Trading

137

Since there is a 10% correction, his hedge should be for 10,70,000 ( 10% of 1,07,00,000). No. of lots that he should sell to hedge his position = ((10,70,000/520)/50) = 41 lots. Scenario 2: If he had purchased 5100 put option for Rs. 165, his premium would amount to Rs. 3,38,250 (41*165*50). The premium paid is irrecoverable. Therefore, it would be ideal for him to write the call option rather than purchasing the put option. Scenario 3: In the third case the fund manager decide to sell futures of Nifty at 5010 when the spot price is at 5000. In case of futures, the hedge would be taken for the entire portfolio of Rs. 1,07,00,000. Therefore, for hedging his exposure of Rs. 1,07,00,000 he should sell 42 lots ((1,07,00,000/5010)/50)equivalent of Nifty futures.

8.8

CASE STUDY: THE LTCM FIASCO(ii)

One of the best examples of risk in option trading is the case of Long Term Capital Partners, better known as LTCM. The firm was hedge fund constituted by prominent persons in the financial world. But the firm suffered substantial loss and eventually had to be closed down on account of wrong strategies in trading positions. We are giving you a brief picture of what happened in LTCM. John Meriwether, who founded Long-Term Capital Partners in 1993, had been head of fixed income trading at Salomon Brothers. He was forced to leave Salomon in 1991, in the wake of the firm’s treasury auction rigging scandal. Meriwether continued to command huge loyalty from a team of highly cerebral relative-value fixed income traders, and considerable respect from the street. Teamed up with a handful of these traders, two Nobel laureates, Robert Merton and Myron Scholes, and former regulator David Mullins, Meriwether and LTCM had more credibility than the average broker/dealer on Wall Street. It was a game, in that LTCM was unregulated, free to operate in any market, without capital charges and only light reporting requirements to the US Securities & Exchange Commission (SEC). It traded on its good name with many respectable counterparties, as if it was a member of the same club. That meant an ability to put on interest rate swaps at the market rate for no initial margin — an essential part of its strategy. It meant being able to borrow 100% of the value of any top-grade collateral, and with that cash to buy more securities and post them as collateral for further borrowing: in theory it could leverage itself to infinity. In LTCM’s first two full years of operation it

138 Option Trading produced 43% and 41% return on equity and had amassed an investment capital of $7 billion. Meriwether was renowned as a relative-value trader. In theory relative value means taking little outright market risk, since a long position in one instrument is offset by a short position in a similar instrument or its derivative. The strategy was to bet on small price differences, which are likely to converge over time as the arbitrage is spotted by the rest of the market and eroded. Trades typical of early LTCM were, for example, to buy Italian government bonds and sell German Bond futures; to buy theoretically underpriced off-the-run US treasury bonds (because they are less liquid) and go short on-the-run (more liquid) treasuries. It played the same arbitrage in the interest-rate swap market, betting that the spread between swap rates and the most liquid treasury bonds would narrow. They played long-dated callable Bonds against DM swaptions. LTCM was one of the biggest players in the world’s futures exchanges, not only in debt but also equity products. In order to make 40% return on capital, however, leverage had to be applied. In theory, market risk isn’t increased by stepping up volume, provided you stick to liquid instruments and don’t get so big that you yourself become the market. Some of the big macro hedge funds had encountered this problem and reduced their size by giving money back to their investors. When, in the last quarter of 1997 LTCM returned $2.7 billion to investors, it was assumed to be for the same reason: a prudent reduction in its positions relative to the market. But it seemed the positions were not reduced relative to the capital reduction, so the leverage increased. Moreover, other risks had been added to the equation. LTCM played the credit spread between mortgage-backed securities (including Danish mortgages) or double-A corporate bonds and the government bond markets. Then it ventured into equity trades. It sold equity index options, taking big premium in 1997. It took speculative positions in takeover stocks, according to press reports. One such was Tellabs, whose share price fell over 40% when it failed to take over Ciena, says one accountant. A filing with the SEC for June 30 1998 showed that LTCM had equity stakes in 77 companies, worth $541 million. It also got into emerging markets, including Russia. One report said Russia was “8% of its book” which would come to $10 billion! Some of LTCM’s biggest competitors, the investment banks, had been clamoring to buy into the fund. Meriwether applied a formula which brought in new investment, as well as providing him and his partners with a virtual put option on the performance of the fund. During 1997, under this formula, UBS put in $800 million in the form of a loan and $266 million in straight equity. Credit Suisse Financial Products put in a $100 million loan and $33 million in equity. Other loans may have been secured in this way, but they

Risk Perceptions in Option Trading

139

haven’t been made public. Investors in LTCM were pledged to keep in their money for at least two years. LTCM entered 1998 with its capital reduced to $4.8 billion. A New York Sunday Times article says the big trouble for LTCM started on July 17 when Salomon Smith Barney announced it was liquidating its dollar interest arbitrage positions: “For the rest of the that month, the fund dropped about 10% because Salomon Brothers was selling all the things that Long-Term owned.” On August 17, 1998 Russia declared a moratorium on its Rouble debt and domestic dollar debt. Hot money, already jittery because of the Asian crisis, fled into high quality instruments. Top preference was for the most liquid US and G-10 government bonds. Spreads widened even between on-the-run and off-the-run US treasuries. Most of LTCM’s bets had been variations on the same theme, convergence between liquid treasuries and more complex instruments that commanded a credit or liquidity premium. Unfortunately convergence turned into dramatic divergence. LTCM’s counterparties, marking their LTCM exposure to market at least once a day, began to call for more collateral to cover the divergence. On one single day, August 21, the LTCM portfolio lost $550 million, writes Lewis. Meriwether and his team, still convinced of the logic behind their trades, believed all they needed was more capital to see them through a distorted market. Perhaps they were right. But several factors were against LTCM. 1. Who could predict the time-frame within which, rates would converge again? 2. Counterparties had lost confidence in themselves and LTCM. 3. Many counterparties had put on the same convergence trades, some of them as disciples of LTCM. 4. Some counterparties saw an opportunity to trade against LTCM’s known or imagined positions. In these circumstances, leverage is not welcome. LTCM was being forced to liquidate to meet margin calls. On September 2, 1998 Meriwether sent a letter to his investors saying that the fund had lost $2.5 billion or 52% of its value that year, $2.1 billion in August alone. Its capital base had shrunk to $2.3 billion. Meriwether was looking for fresh investment of around $1.5 billion to carry the fund through. He approached those known to have such investible capital, including George Soros, Julian Robertson and Warren Buffett, chairman of Berkshire Hathaway and previously an investor in Salomon Brothers (LTCM incidentally had a $14 million equity stake in Berkshire Hathaway), and Jon Corzine, then co-chairman and co-chief executive officer at Goldman Sachs, an erstwhile

140 Option Trading classmate at the University of Chicago. Goldman and JP Morgan were also asked to scour the market for capital. But offers of new capital weren’t forthcoming. Perhaps these big players were waiting for the price of an equity stake in LTCM to fall further. Or they were making money just trading against LTCM’s positions. Under these circumstances, if true, it was difficult and dangerous for LTCM to show potential buyers more details of its portfolio. Two Merrill executives visited LTCM headquarters on September 9, 1998 for a “due diligence meeting”, according to a later Financial Times report (on October 30, 1998). They were provided with “general information about the fund’s portfolio, its strategies, the losses to date and the intention to reduce risk”. But LTCM didn’t disclose its trading positions, books or documents of any kind, Merrill is quoted as saying. The US Federal Reserve system, particularly the New York Fed, which is closest to Wall Street, began to hear concerns about LTCM from its constituent banks. In the third week of September, Bear Stearns, which was LTCM’s clearing agent, said it wanted another $500 million in collateral to continue clearing LTCM’s trades. On Friday September 18, 1998, New York Fed chairman Bill McDonough made “a series of calls to senior Wall Street officials to discuss overall market conditions”, he told the House Committee on Banking and Financial Services on October 1. “Everyone I spoke to that day volunteered concern about the serious effect the deteriorating situation of Long-Term could have on world markets.” Peter Fisher, executive vice president at the NY Fed, decided to take a look at the LTCM portfolio. On Sunday September 20, 1998, he and two Fed colleagues, assistant treasury secretary Gary Gensler, and bankers from Goldman and JP Morgan, visited LTCM’s offices at Greenwich, Connecticut. They were all surprised by what they saw. It was clear that, although LTCM’s major counterparties had closely monitored their bilateral positions, they had no inkling of LTCM’s total off balance sheet leverage. LTCM had done swap upon swap with 36 different counterparties. In many cases it had put on a new swap to reverse a position rather than unwind the first swap, which would have required a mark-to-market cash payment in one direction or the other. LTCM’s on balance sheet assets totaled around $125 billion, on a capital base of $4 billion, a leverage of about 30 times. But that leverage was increased tenfold by LTCM’s off balance sheet business, whose notional principal ran to around $1 trillion. The off balance sheet contracts were mostly nettable under bilateral International Swaps & Derivatives Association (ISDA) master agreements. Most of them were also collateralized. Unfortunately the value of the collateral had taken a dive since August 17.

Risk Perceptions in Option Trading

141

Surely LTCM, with two of the original masters of derivatives and option valuation among its partners, would have put its portfolio through stress tests, to match recent market turmoil. But, like many other value-at-risk (Var) modellers on the street, their worst-case scenarios had been outplayed by the horribly correlated behaviour of the market since August 17. Such a flight to quality hadn’t been predicted, probably because it was so clearly irrational. According to LTCM managers their stress tests had involved looking at the 12 biggest deals with each of their top 20 counterparties. That produced a worst-case loss of around $3 billion. But on that Sunday evening it seemed the mark-to-market loss, just on those 240-or-so deals, might reach $5 billion. And that was ignoring all the other trades, some of them in highly speculative and illiquid instruments. The next day, Monday September 21, 1998, bankers from Merrill, Goldman and JP Morgan continued to review the problem. It was still hoped that a single buyer for the portfolio could be found — the cleanest solution. According to Lewis’s article LTCM’s portfolio had its second biggest loss that day, of $500 million. Half of that, says Lewis, was lost on a short position in five-year equity options. Lewis records brokers’ opinion that AIG had intervened in thin markets to drive up the option price to profit from LTCM’s weakness. At that time, AIG was part of a consortium negotiating to buy LTCM’s portfolio. By this time LTCM’s capital base had dwindled to a mere $600 million. That evening, UBS, with its particular exposure on an $800 million credit, with $266 million invested as a hedge, sent a team to Greenwich to study the portfolio. The Fed’s Peter Fischer invited those three banks and UBS to breakfast at the Fed headquarters in Liberty Street the following day. The bankers decided to form working groups to study possible market solutions to the problem, given the absence of a single buyer. Proposals included buying LTCM’s fixed income positions, and “lifting” the equity positions (which were a mixture of index spread trades and total return swaps, and the takeover bets). During the day a third option emerged as the most promising: seeking recapitalization of the portfolio by a consortium of creditors. But any action had to be taken swiftly. The danger was a single default by LTCM would trigger cross-default clauses in its ISDA master agreements precipitating a mass close-out in the over-the-counter derivatives markets. Banks terminating their positions with LTCM would have to rebalance any hedge they might have on the other side. The market would quickly get wind of their need to rebalance and move against them. Mark-to-market values would descend in a vicious spiral. In the case of the French equity index, the CAC 40, LTCM had apparently sold short up to 30% of the volatility of the entire underlying market. The Banque de France was worried that a rapid

142 Option Trading close-out would severely hit French equities. There was a wider concern that an unknown number of market players had convergence positions similar or identical to those of LTCM. In such a one-way market, there could be a panic rush for the door. A meltdown of developed markets on top of the panic in emerging markets seemed a real possibility. LTCM’s clearing agent Bear Stearns was threatening to foreclose the next day if it didn’t see $500 million more collateral. Until then, LTCM had resisted the temptation to draw on a $900 million standby facility that had been syndicated by Chase Manhattan Bank, because it knew that the action would panic its counterparties. But the situation was now desperate. LTCM asked Chase for $500 million. It received only $470 million since two syndicate members refused to chip in. To take the consortium plan further, the biggest banks, either big creditors to LTCM, or big players in the over-the-counter markets, were asked to a meeting at the Fed that evening. The plan was to get 16 of them to chip in $250 million each to recapitalize LTCM at $4 billion. The four core banks met at 7pm and reviewed a term sheet, which had been drafted by Merrill Lynch. Then at 8.30 bankers from nine more institutions showed. They represented: Bankers Trust, Barclays, Bear Stearns, Chase, Credit Suisse First Boston, Deutsche Bank, Lehman Brothers, Morgan Stanley, Credit Agricole, Banque Paribas, Salomon Smith Barney, Societe Generale. David Pflug, head of global credit risk at Chase warned that nothing would be gained a) by raking over the mistakes that had got them in this room, and b) by arguing about who had the biggest exposure: they were all in this equally and together. The delicate question was how to preserve value in the LTCM portfolio, given that banks around the room would be equity investors, and yet, at the same time, they would be seeking to liquidate their own positions with LTCM to maximum advantage. It was clear that John Meriwether and his partners would have to be involved in keeping such a complex portfolio a going concern. But what incentive would they have if they no longer had an interest in the profits? Chase insisted that any bailout would first have to return the $470 million drawn down on the syndicated standby facility. But nothing could be finalized that night, since few of the representatives present could pledge $250 million or more of their firm’s money. The meeting resumed at 9.30 a.m. the next morning. Goldman Sachs had a surprise—its client, Warren Buffett, was offering to buy the LTCM portfolio for $250 million, and recapitalize it with $3 billion from his Berkshire Hathaway group, $700 million from AIG and $300 million from Goldman. There would be no management role for Meriwether and his team. None of

Risk Perceptions in Option Trading

143

LTCM’s existing liabilities would be picked up, yet all current financing had to stay in place. Meriwether had until 12.30 p.m. to decide. By 1 p.m. it was clear that Meriwether had rejected the offer, either because he didn’t like it, or, according to his lawyers, because he couldn’t do so without consulting his investors, which would have taken him over the deadline. The bankers were somewhat flabbergasted by Goldman’s dual role. Despite frequent requests for information about other possible bidders, Goldman had dropped no hint at previous meetings that there was something in the pipeline. Now the banks were back to the consortium solution. Since there were only 13 banks, not 16, they’d have to put in more than $250 million each. Bear Stearns offered nothing, feeling that it had enough risk as LTCM’s clearing agent. Their special relationship may have been the source of some acrimony: LTCM had an $18 million equity stake in Bear Stearns, matched by investments in LTCM of $10 million each by Bear Stearns principals James Cayne and Warren Spector. Lehman Brothers also declined to participate. In the end 11 banks put in $300 million each, Societe Generale $125 million, and Credit Agricole and Paribas $100 million each, reaching a total fresh equity of $3.625 billion. Meriwether and his team would retain a stake of 10% in the company. They would run the portfolio under the scrutiny of an oversight committee representing the new shareholding consortium. The message to the market was that there would be no fire-sale of assets. The LTCM portfolio would be managed as a going concern. In the first two weeks after the bail-out, LTCM continued to lose value, particularly on its dollar/yen trades, according to press reports, which put the loss at $200 million to $300 million. There were more attempts to sell the portfolio to a single buyer. According to reports, the new LTCM shareholders had further talks with Buffett, and with Saudi prince Alwaleed bin talal bin Abdelaziz. But there was no sale. By mid-December, 1998 the fund was reporting a profit of $400 million, net of fees to LTCM partners and staff. In early February, 1999 there were press reports of divisions between banks in the bailout consortium, some wishing to get their money out by the end of the year, others happy to “stay for the ride” of at least three years. There was also a dispute about how much Chase was charging for a funding facility to LTCM. Within six months there were reports that Meriwether and some of his team wanted to buy out the banks, with a little help from their friend Jon Corzine, who was due to leave Goldman Sachs after its flotation in May, 1999. By June 30, 1999 the fund was up 14.1%, net of fees, from last September. Meriwether’s plan approved by the consortium was apparently to redeem the fund, now valued at around $4.7 billion, and to start another fund concentrating on buyouts and mortgages. On July 6, 1999, LTCM repaid $300 million to its original investors, who had a residual stake in the fund of

144 Option Trading around 9%. It also paid out $1 billion to the 14 consortium members. It seemed Meriwether was bouncing back. The losers in the game were: · LTCM partners — $1.1 billion ($1.5 billion at the beginning of 1998, offset by their $400 million stake in the rescued fund) · Liechtenstein Global Trust — $30 million · Bank of Italy — $100 million · Credit Suisse — $55 million · UBS — $690 million · Merrill Lynch (employees’ deferred payment) — $22 million · Donald Marron, chairman, PaineWebber — $10 million · Sandy Weill, co-CEO, Citigroup — $10 million · McKinsey executives — $10 million · Bear Stearns executives — $20 million · Dresdner Bank — $145 million · Sumitomo Bank — $100 million · Prudential Life Corp — $5.43 million LTCM fiasco teaches us many dimensions in risk management.

Summary In this chapter we found that though options are hedging tools, they also carry some element of risk with them and discussed some of the strategies to mitigate the risk. The case study on LTCM provides ample information about the inherent risks in option trading. In the next chapter we are discussing about some of market indicators.

Keywords Risk

Mitigating Instruments

Market Risk

Interest Rate Risk

Reputation Risk

Human Risk

Equity Risk

Commodity Risk

Political Risk

Legal Risk

Operational Risk

Model Risk

i

International Convergence of Capital Measurement and Capital Standards— A Revised Framework, Bank for International settlement, June 2004

ii

This case is compiled from various internet sources.

Chapter 9

MARKET INDICATORS

9.1 OBJECTIVE So far we have covered the basics of option trading, option pricing, option Greeks, strategies for bull market condition, etc. However, knowing about the market is essential for trading successfully and earn profit. The market can be understood with the help of certain indicators. This chapter gives an idea about market indicators like put call ratio, volatility and few other details that could be helpful in understanding options.

9.2 PUT CALL RATIO Analysis of put call ratio gives us the clear picture of the mentality of option traders. In general, the rising put call ratio in a moderately weak market indicates firmness of the market. Rising put call ratio in a bull market indicates the further uptrend to continue. Declining put call ratio in a weak market shows further weakness. Declining put call ratio in a bull market indicates loss of uptrend momentum. Put call ratio is calculated by the total open interest of all strike price of a security in a particular month/total open interest of all strike price of call options in a particular month. If the ratio is below 0.4, it suggests that most of the traders are bullish on the market. There is no major support for the market, and therefore it is advisable to purchase put options or exit long call options. If the ratio is above 1.2, then it shows that the market is rising. It indicates that more put options are being bought or there is an expectation of a fall in the market. Hence, buy call options or exit long put positions.

146 Option Trading NIFTY AND PUT CALL RATIO 6000

4 3.5

5000

3 4000

2.5 2

3000

1.5

2000

1 1000

0.5

0

0

07. May.09 27.May.09 16.Jun.09 06.Jul.09 26.Jul.09 15.Aug.09 04.Sep.09 24.Sep.09 14.Oct.09

NIFTY

PUT CALL RATIO

Fig. 9.1 Nifty and put call ratio

9.3 ROLLOVER OF POSITIONS Rollover is the process by which an investor squares off his position in the existing contract cycle and takes the same position in the near month contract, in anticipation of some event. Eg: An investor buys one lot (50 units) of Nifty Futures September 2010 contract at 5100 on September 5th, 2010. He finds that even at expiry, he is at a no profit situation. As such he decides to rollover his position to October 2010 contract. So he sold the contract at the prevailing rate of 5090, thereby being at a loss of 500 (10*50). He takes up the October 2010 contract at 5200. While rolling over his position, he incurs an additional cost of 5000 (100*50) over and above the loss of 500. Along with these costs, additional brokerage, and taxes add to his expense. Loss of 10 per lot, i.e., 10*50

Expiry – 24th Sep 5090

October contract 5100 September contract

Expiry – 29th Oct 5200

Loss of 100 per lot, i.e., 100*50

Fig. 9.2

Rollover of positions

Market Indicators

147

9.3.1 Significance of Rollover A large volume of rollover to the middle month contract indicates that the investors are anticipating a bullish trend in the near future. Whereas, if the volume tends to be low, most of the investors have squared off their positions, in view of some bearish trend. Hence, it is imperative to devise a method to calculate the rollover percentage so as to predict the future trend.

9.3.2 Calculation of Rollover Rollover = open interest in the middle month/(sum of open interest in the current, middle and far month contracts) * 100 Eg: Contract Open Interest (in lakhs) FUTDIX WIPRO APRIL 2009 FUTDIX WIPRO MAY 2009

2342 5647

FUTDIX WIPRO JUNE 2009 42 Rollover for May 2009 — 5647/(2342 + 5647 + 42)*100 — 70.3% This shows that the investors are highly bullish of the market.

9.4 VOLATILITY Volatility usually quantifies risk involved while trading in an instrument over a period of time. It is measured in terms of annualized standard deviation of continuously compounded returns of the asset. For example, if the daily returns of a stock has a standard deviation of 0.01 and there are 252 trading days in a year, then the time period of the returns is 1/252 and annualized volatility is calculated as, s=

s SD P

i.e, s = 0.01/ (1/252) = 0.1587. The monthly volatility (i.e T = 1/12 of a year) would be, smonth = 0.1587

(1/12) = 0.0458[mps1]

9.4.1 Volatility Trade In all markets there are three groups: hedgers, speculators and arbitrageurs. In the case of options, there is one more group known as volatility traders. The main aim of these traders is to buy cheap options and sell the expensive ones. For exploiting the volatility, they even use butterfly spreads. They sell the expensive calls/puts and buy the cheap ones.

148 Option Trading

NIFTY VOLATILITY October 29, 2008 90.27

36.54 August 18, 2008

Fig. 9.3

Nifty volatility

NIFTY

4393 August 18, 2008

2697

October 29, 2008

Fig. 9.4

Nifty movement

Market Indicators

NIFTY 3 MONTHS

Fig. 9.5

Nifty after 3 months

BSE IT

Fig. 9.6

BSE IT

149

150 Option Trading

BSE BANKEX

Fig. 9.7

BSE Bankex

MINI NIFTY

Fig. 9.8

Mini Nifty

Market Indicators

151

9.5 BULLISH CHARACTERISTICS The following points can be noted as the characteristics of a bullish trend: · Volatility remains low. · Implied volatility remains low. · Nifty volatility index remains low. · Put implied volatility remains low · Open interest of call options decline as market advances. · Open interest of at-the-money call options remain high. · Open interest of in-the-money and deep in-the-money call options declines on a daily basis. · Open interest of out-of-the-money put options remain firm. · Index heavy weight stocks show positive trend, like moving above yearly highs, all time highs and trading above 200 day moving average.

9.6

OPTION PREMIUM

Option premium = Intrinsic value + Time value Intrinsic value = Stock price – Strike price Thus option premium = Stock price – Strike price + Time value Actual option premium – theoretical premium = Implied volatility premium. Option premium thus depends upon time value, volatility, stock price, strike price and interest rate.

Summary In this chapter we discussed about the major parameters like put-call ratio, volatility and option premium. The movement of parameters indicates, whether the market is bull or bear. Many times people have raised several questions on this subject. We have consolidated the frequently asked questions in the next chapter.

Keywords Put Call Ratio

Roll Over

Volatility

Standard Deviation

Volatility Trade

Implied Volatility

Open Interest

C h a p t e r 10

FREQUENTLY ASKED QUESTIONS

10.1 OBJECTIVE During the past we had received a number of questions relating to option trading. This chapter attempts to clear the doubts related to various F&O transactions mainly that of options, put up by people from time to time.

10.2 WHAT ARE THE KEY DIFFERENCES BETWEEN OPTIONS AND FUTURES? Ans: Option buyers pay premium, whereas option writers pay margin like futures, but the amount of margin required is less as compared to that of futures. The option buyers risk is limited to the extent of the premium he pays, whereas the option writer has high risk like futures. The option buyer has unlimited profit and minimal loss, whereas, the option writer gets only the premium and is subjected to unlimited loss. In futures, the seller is entitled to unlimited profits and losses.

10.3

WHO CAN BUY OPTIONS?

Ans: Any individual or corporate who has an account with a broking firm can buy options.

10.4

WHY DO EUROPEAN OPTIONS TRADE BELOW INTRINSIC VALUE?

Ans: European options can be exercised only on the last day of the expiry, whereas American options can be exercised on any date before expiry.

Frequently Asked Questions

153

10.5 WHO FIXES OPTION PREMIUM? Ans: There are various methods for calculating option premiums. However, bid and ask quotes are placed by the buyer and his seller; in fact they fix the option premium.

10.6 DO THE AMERICAN OPTIONS TRADE AT A DISCOUNT? Ans: No; sometimes they can trade at a discounted price below the theoretical value. A knowledgeable trader will buy the discounted option and they will assign the option.

10.7 WHO CAN BE A WRITER OF AN OPTION? Ans: An individual who has a trading account and has the capability to pay margins can write options.

10.8 WHY DO WE NEED TO DEVELOP OPTION 10.8 STRATEGIES? Ans: Option strategies generally reduce the risk and margin requirements. It also protects the investors against capital erosion.

10.9 WHAT ARE THE KEY FACTORS TO BE 10.9 CONSIDERED WHILE PURCHASING AN OPTION? Ans: The investor should if possible calculate the theoretical premium, compare with the actual premium and select the strike price. He also should give importance to gamma. If he can earn positive gamma, it is well appreciated. He should also consider the strike price and time value of the option.

10.10 HOW CAN WE MANAGE A LONG OPTION 10.10 POSITION? Ans: Time decay is the major concern of an option buyer. The option buyer has to shift his existing option to a far month contract, if it does not give him profit in a desired period of time.

154 Option Trading

10.11 HOW CAN AN OPTION WRITER REDUCE RISKS 10.11 IN HIS SHORT POSITION? Ans: It is always advisable to buy an out-of-the-money option if he writes an at-the-money or out-of-the-money option. He can even use futures to protect his risks.

10.12 HOW CAN A CALL OPTION BUYER INCUR LOSS 10.12 EVEN IF THE UNDERLYING ASSET IS ON A RISE? Ans: Implied volatility is one of the key factors which determines the premium. It reaches a peak and then falls. If an option buyer buys a call option during this period, even if the underlying asset price is on a rise, the purchased option premium may not give him a profit.

10.13

IS IT ADVISABLE TO AVERAGE AN OPTION?

Ans: It is not at all advisable to cost average a purchased option position. However, it is a good strategy for a stock. Options are worthless after the expiry date.

10.14

WHAT IS MEANT BY NAKED CALL WRITING?

Ans: Holding a stock and selling its call option is said to be covered call writing. If the investor does not have stock in hand, but sells the call option, it is then said to be naked call writing, which is a risky strategy in nature.

10.15 HOW CAN WE OPEN A TRADING ACCOUNT 10.15 WITH A BROKER/SUB-BROKER AND WHAT ARE 10.15 THE IMPORTANT NORMS FOLLOWED? Ans: Trading accounts should be opened with a SEBI approved broker/subbroker. As a first step, the client should fill in the client registration form while opening the account with the broker/sub-broker. The client should also read through the Risk Disclosure Document and agree to all the terms and conditions highlighted in it. This document is issued by the stock exchange before trading in equities or derivatives segment. A signed copy of the same would be obtained by the trading member from the clients. Secondly, the client should thoroughly go through the broker/sub-broker agreement and then sign wherever required, before executing them on a valid

Frequently Asked Questions

155

stamp paper. This agreement should also be signed by the witnesses along with their names and addresses. And finally the client is required to submit details, such as name, address, copy of client’s PAN card, address proof, photo ID documents, details of bank account, etc.

10.16 WHAT IS THE MAXIMUM BROKERAGE THAT THE 10.17 BROKER/SUB-BROKER CAN CHARGE? Ans: A maximum amount of 2.5% of the contract price can be charged by the broker/sub-broker as brokerage. Additional charges that the broker/subbroker can charge are securities transaction tax, service tax on brokerage, stamp duty charges, etc., all of which should be shown separately on the contract note provided to the clients.

Summary In this chapter we covered some of the frequently asked question by investors. These questions covered the difference between futures and options, option premiums, option positions, strategies, opening of trading account, brokerage, etc. We shall add more questions as and when we answer queries from our readers. In the next chapter we are presenting the list of stocks included in the F&O segment.

C h a p t e r 11

FUTURE AND OPTIONS SEGMENT STOCKS

11.1 OBJECTIVE From the previous chapters we understood what are options, how trading takes place, what different strategies suitable to bull market, etc. The objective of this chapter is to provide information relating to the stocks included in the F & O segment.

11.2

AVAILABLE OPTION INSTRUMENTS AND ITS LOTS

Traditionally NSE has provided index and stock options with a particular lot size. Stocks like Reliance, Tisco, Infosys, etc., are being traded frequently. NSE can change the lot size of stock and index options and even introduce new instruments at its own discretion. The market lot size of index and stock options as on September, 2009 is given below: Table 11.1 INDEX DERIVATIVES (AS ON SEPTEMBER 2009) Sl. No:

UNDERLYING

SYMBOL

MARKET LOT

1

BANK Nifty

BANKNIFTY

2

CNX 100

CNX100

100

3

CNX IT

CNXIT

100

4

CNX Nifty Junior

JUNIOR

100

5

Nifty Midcap 50

NFTYMCAP50

300

6

S&P CNX Nifty

NIFTY

50

7

S&P CNX Nifty

MINIFTY

20

8

S&P CNX Defty

DEFTY

50

150

Future and Options Segment Stocks

157

DERIVATIVES ON INDIVIDUAL SECURITIES (AS ON SEPTEMBER 2009) Sl. No:

UNDERLYING

SYMBOL

MARKET LOT

1

Aban Offshore Ltd

ABAN

400

2

ABB Ltd

ABB

500

3

Aditya Birla Nuvo Ltd

ABIRLANUVO

400

4

Adlabs Films Ltd

ADLABSFILM

5

Allahabad Bank

ALBK

2450

6

Alstom Projects India Ltd

APIL

600

7

Ambuja Cements Ltd

AMBUJACEM

4124

8

Andhra Bank

ANDHRABANK

2300

9

Ashok Leyland Ltd

ASHOKLEY

9550

10

Asian Paints Ltd

ASIANPAINT

200

11

Associated Cement Co. Ltd

ACC

376

12

Aurobindo Pharma Ltd

AUROPHARMA

700

13

Axis Bank Ltd

AXISBANK

450

14

Bajaj Auto Ltd

BAJAJ-AUTO

200

15

Bajaj Hindustan Ltd

BAJAJHIND

1425

16

Balrampur Chini Mills Ltd

BALRAMCHIN

2400

17

Bank of Baroda

BANKBARODA

700

18

Bank of India

BANKINDIA

950

19

Bharat Earth Movers Ltd

BEML

375

20

Bharat Electronics Ltd

BEL

276

21

Bharat Forge Co. Ltd

BHARATFORG

22

Bharat Heavy Electricals Ltd

BHEL

150

23

Bharat Petroleum Corporation Ltd

BPCL

550

24

Bharti Airtel Ltd

BHARTIARTL

250

25

Bhushan Steel & Strips Ltd

BHUSANSTL

26

Biocon Ltd

BIOCON

1800

27

Bombay Rayons & Fashions Ltd

BRFL

1150

28

Cairn India Ltd

CAIRN

1250

29

Canara Bank

CANBK

800

30

Century Textiles Ltd

CENTURYTEX

848

31

Cesc Ltd

CESC

1100

32

Chambal Fertilizers Ltd

CHAMBLFERT

3450

33

Chennai Petroleum Corporation Ltd

CHENNPETRO

1800

34

Cipla Ltd

CIPLA

1250

35

Colgate Palmolive Ltd

COLPAL

900

2000

500

550

158 Option Trading DERIVATIVES ON INDIVIDUAL SECURITIES (AS ON SEPTEMBER 2009) Sl. No:

UNDERLYING

SYMBOL

MARKET LOT

36

Container Corporation of India Ltd

CONCOR

37

Crompton Greaves Ltd

CROMPGREAV

1000

250

38

Cummins India Ltd

CUMMINSIND

950

39

Dabur India Ltd

DABUR

2700

40

Deccan Chronicle Holdings Ltd

DCHL

3400

41

Dena Bank

DENABANK

5250 5150

42

Dish TV India Ltd

DISHTV

43

DivisLaboratories Ltd

DIVISLAB

310

44

DLF Ltd

DLF

800

45

Dr. Reddy’s Laboratories Ltd

DRREDDY

400

46

Educomp Solutions Ltd

EDUCOMP

75

47

Essar Oil Ltd

ESSAROIL

1412

48

Everest Kanto Cylinder Ltd

EKC

2000

49

Federal Bank Ltd

FEDERALBNK

851

50

Financial Technologies Ltd

FINANTECH

150

51

Firstsource Solutions Ltd

FSL

9500

52

Gail India Ltd

GAIL

1125

53

Glaxosmithkline Pharma Ltd

GLAXO

54

GMR Infrastructure Ltd

GMRINFRA

55

Grasim Industries Ltd

GRASIM

56

Great Offshore Ltd

GTOFFSHORE

1000

57

GTL Infrastructure Ltd

GTLINFRA

4850

58

GTL Ltd

GTL

750

59

Gujarat State Petronet Ltd

GSPL

6100

60

GVK Power & Infrastructure Ltd

GVKPIL

4750

61

HCL Technologies Ltd

HCLTECH

1300

62

HDFC Bank Ltd

HDFCBANK

63

Hero Honda Motors Ltd

HEROHONDA

64

Hindalco Industries Ltd

HINDALCO

3518

65

Hindustan Construction CO.

HCC

2100

66

Hindustan Petroluem Corporation Ltd

HINDPETRO

67

Hindustan Unilever Ltd

HINDUNILVR

68

Hindustan Zinc Ltd

HINDZINC

69

Hotel Leela Venture Ltd

HOTELEELA

300 1250 176

200 200

650 1000 500 7500

Future and Options Segment Stocks

159

DERIVATIVES ON INDIVIDUAL SECURITIES (AS ON SEPTEMBER 2009) Sl. No:

UNDERLYING

SYMBOL

MARKET LOT

70

Housing Development & Infrastructure Ltd

HDIL

774

71

Housing Development Finance Corporation Ltd

HDFC

150

72

ICICI Bank Ltd

ICICIBANK

350

73

ICSA(India) Ltd

ICSA

1200

74

IDEA Cellular Ltd

IDEA

2700

75

IFCI Ltd.

IFCI

7880

76

India Cements Ltd

INDIACEM

1450

77

India Infoline Ltd

INDIAINFO

2500

78

Indiabulls Real Estate Ltd

IBREALEST

1300

79

Indian Bank

INDIANB

2200

80

Indian Hotels Co. Ltd

INDHOTEL

3798

81

Indian Oil Corporation Ltd

IOC

600

82

Indian Overseas Bank

IOB

2950

83

Industrial Development Bank of India Ltd

IDBI

2400

84

Infosys Technologies Ltd

INFOSYSTCH

85

Infrastructure Development Finance Company Ltd

IDFC

86

Ispat Industries Ltd

ISPATIND

87

ITC Ltd

ITC

1125

88

IVRCL Infrastructure & Projects Ltd

IVRCLINFRA

1000

89

Jaiprakash Associates Ltd

JPASSOCIAT

1125

90

Jaiprakash Hydro Power Ltd

JPHYDRO

3125

91

Jindal Saw Ltd

JINDALSAW

1000

92

Jindal Steel & Power Ltd

JINDALSTEL

160

93

JSW Steel Ltd

JSWSTEEL

412

94

KS Oils Ltd

KSOILS

5900

95

Kingfisher Airlines Ltd

KFA

4250

96

Kotak Mahindra Bank Ltd

KOTAKBANK

97

Lanco Infratech Ltd

LITL

638

98

Larsen & Toubro Ltd

LT

200

99

LIC Housing Finance Ltd

LICHSGFIN

425

100

Lupin Ltd

LUPIN

350

200 2950 12450

550

160 Option Trading DERIVATIVES ON INDIVIDUAL SECURITIES (AS ON SEPTEMBER 2009) Sl. No:

UNDERLYING

SYMBOL

MARKET LOT

101

Mahanagar Telephone Nigam Ltd

MTNL

3200

102

Mahindra & Mahindra Ltd

M&M

312

103

Mangalore Refinery & Petrochemicals Ltd

MRPL

4450

104

Maruti Udyog Ltd

MARUTI

105

Mercator Lines Ltd

MLL

4900

106

Moser-Baer(I) Ltd

MOSERBAER

2475

107

Motor Industries Company Ltd

BOSCHLTD.

100

108

Mphasis Ltd

MPHASIS

800

109

Nagarjuna Construction Co. Ltd

NAGARCONST

2000

110

Nagarjuna Fertilizer & Chemicals Ltd

NAGARFERT

5250

111

LTd

NATIONALUM

112

National Thermal Power Corporation Ltd

NTPC

1625

113

Neyveli Lignite Corporation Ltd

NEYVELILIG

1475

114

Noida Toll Bridge Company Ltd

NOIDATOLL

8200

115

Oil & Natural Gas Corp. Ltd

ONGC

116

Opto Circuits (India) Ltd

OPTOCIRCUI

117

Oracle Financial Services Software Ltd

OFSS

118

Orchid Chemicals Ltd

ORCHIDCHEM

2100

119

Oriental Bank Of Commerce

ORIENTBANK

1200

120

Pantaloon Retail (I) Ltd

PANTALOONR

850

121

Patel Engg Ltd

PATELENG

200

575

225 2040 300

1000

122

Patni Computer Systems Ltd

PATNI

1300

123

Petronet LNG Ltd

PETRONET

4400

124

Piramal Healthcare Ltd

PIRHEALTH

1500

125

Polaris Software Lab. Ltd

POLARIS

2800

126

Power Finance Corp. Ltd

PFC

1200

127

Power Grid Corp. of India Ltd

POWERGRID

1925

128

Praj Industries Ltd

PRAJIND

2200

129

PTC India Ltd

PTC

2350

130

Punj Lloyd Ltd

PUNJLLOYD

1500

131

Punjab National Bank

PNB

300

132

Ranbaxy Lab. Ltd

RANBAXY

800

133

Reliance Natural Resources Ltd

RNRL

3576

Future and Options Segment Stocks

161

DERIVATIVES ON INDIVIDUAL SECURITIES (AS ON SEPTEMBER 2009) Sl. No:

UNDERLYING

SYMBOL

MARKET LOT

134

Reliance Capital Ltd

RELCAPITAL

276

135

Reliance Communications Ltd

RCOM

700

136

Reliance Industries Ltd

RELIANCE

150

137

Reliance Infrstructure Ltd

RELINFRA

138

Reliance Power Ltd

RPOWER

2000

139

Rolta India Ltd

ROLTA

1800

140

Rural Electrification Corp Ltd

RECLTD.

1950

141

Sesa Goa Ltd

SESAGOA

1500

142

Shipping Corp. of India Ltd

SCI

2400

143

Shree Renuka Sugars Ltd

RENUKA

2500

144

Siemens Ltd

SIEMENS

752

145

Sintex Industries Ltd

SINTEX

146

State Bank of India

SBIN

132

147

Steel Authority of India Ltd

SAIL

1350

148

Sterling Biotech Ltd

STERLINBIO

2500

149

Sterlite Industries (I) Ltd

STER

438

150

Sun Pharmaceuticals India Ltd

SUNPHARMA

225

151

Sun TV Network Ltd

SUNTV

1000

152

Suzlon Energy Ltd

SUZLON

3000

153

Syndicate Bank

SYNDIBANK

3800

154

Tata Chemicals Ltd

TATACHEM

1350

155

Tata Communications Ltd

TATACOMM

525

156

Tata Consultancy Services Ltd

TCS

500

157

Tata Motors Ltd

TATAMOTORS

850

158

Tata Power Co. Ltd

TATAPOWER

200

159

Tata Steel Ltd

TATASTEEL

764

160

Tata Tea Ltd

TATATEA

550

161

Tata Teleserv (Maharastra)

TTML

162

Tech Mahindra Ltd

TECHM

163

Television Eighteen India Ltd

TV-18

1700

164

The Great Eastern Shipping Co. Ltd

GESHIP

1200

165

Titan Industries Ltd

TITAN

206

166

Triveni Engg. & Inds. Ltd

TRIVENI

167

Tulip IT Services Ltd

TULIP

168

UCO Bank

UCOBANK

276

1400

10450 600

3850 500 5000

162 Option Trading DERIVATIVES ON INDIVIDUAL SECURITIES (AS ON SEPTEMBER 2009) Sl. No:

UNDERLYING

SYMBOL

MARKET LOT

169

Ultratech Cement Ltd

ULTRACEMCO

170

Union Bank of India Ltd

UNIONBANK

1050

171

Unitech Ltd

UNITECH

4500

172

United Phosphorous Ltd

UNIPHOS

1400

173

United Spirits Ltd

MCDOWELL-N

174

Vijaya Bank

VIJAYABANK

175

Voltas Ltd

VOLTAS

2700

176

Welspun Gujarat St. Ro. Ltd

WELGUJ

1600

177

Wipro Ltd

WIPRO

178

Yes Bank Ltd

YESBANK

2200

179

Zee Entertainment Enterprises Ltd

ZEEL

1400

400

250 6900

600

GLOSSARY

OBJECTIVE This section gives a clear understanding of the various terms generally used in derivatives market and enriches the reader’s knowledge in a better way.

Adjustments Certain events, such as a stock split or a stock dividend. An adjusted option may cover more than the usual one hundred shares.

All-or-none order (AON) A type of option order, which requires that the order be executed completely, or not at all.

American-style option An option that can be exercised at any time prior to its expiration date. See also European-style option.

Arbitrage A trading technique that involves the simultaneous purchase and sale of identical assets or of equivalent assets in two different markets with the intent of profiting by the price discrepancy.

Ask/Ask price The price at which, a seller is offering to sell an option or a stock. See also Assignment.

Assigned Received notification of an assignment by the Options Clearing Corporation. See also Assignment.

At-The-Money A term that describes an option with a strike price that is equal to the current market price of the underlying stock.

164 Option Trading

Averaging down Buying more of a stock or an option at a lower price than the original purchase so as to reduce the average cost.

Backspread A delta-neutral spread composed of more long options than short options on the same underlying instrument.

Bear (or bearish) spread One of a variety of strategies involving two or more options (or options combined with a position in the underlying stock) that can potentially profit from a fall in the price of the underlying stock.

Bear spread (call) The simultaneous writing of one call option with a lower strike price and the purchase of another call option with a higher strike price.

Bear spread (put) The simultaneous purchase of one put option with a higher strike price and the writing of another put option with a lower strike price.

Bearish An adjective describing the opinion that a stock, or a market in general, will decline in price—a negative or pessimistic outlook.

Beta A measure of how closely the movement of an individual stock tracks the movement of the entire stock market.

Bid/Bid Price The price at which a buyer is willing to buy an option or a stock.

Black-Scholes formula The first widely-used model for option pricing. This formula can be used to calculate a theoretical value for an option using current stock prices, expected dividends, the option’s strike price, expected interest rates, time to expiration and expected stock volatility.

Box spread A four-sided option spread that involves a long call and a short put at one strike price as well as a short call and a long put at another strike price.

Breakeven point(s) The stock price(s) at which an option strategy results in neither a profit nor a loss.

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Broker A person acting as an agent for making securities transactions. Bull (or bullish) spread One of a variety of strategies involving two or more options (or options combined with an underlying stock position) that may potentially profit from a rise in the price of the underlying stock. Bull spread (call) The simultaneous purchase of one call option with a lower strike price and the writing of another call option with a higher strike price. Bull spread (put) The simultaneous writing of one put option with a higher strike price and the purchase of another put option with a lower strike price. Bullish An adjective describing the opinion that a stock, or the market in general, will rise in price—a positive or optimistic outlook. Butterfly spread A strategy involving three strike prices that has both limited risk and limited profit potential. Buy-write A covered call position in which stock is purchased and an equivalent number of calls written at the same time. This position may be transacted as a combined order, with both sides (buying stock and writing calls) being executed simultaneously. Calendar spread An option strategy which generally involves the purchase of a farther-term option (call or put) and the writing of an equal number of nearer-term options of the same type and strike price. Call option An option contract that gives the owner the right to buy the underlying security at a specified price (its strike price) for a certain, fixed period of time (until its expiration). Carry/Carrying cost The interest expense on money borrowed to finance a securities position. Cash settlement amount The difference between the exercise price of the option being exercised and the exercise settlement value of the index on the day the index option is exercised. See also Exercise settlement amount.

166 Option Trading

Class of options A term referring to all options of the same type—either calls or puts—covering the same underlying stock.

Close/Closing transaction A reduction or an elimination of an open position by the appropriate offsetting purchase or sale. An existing long option position is closed by a selling transaction. An existing short option position is closed by a purchase transaction.

Closing price The final price of a security at which a transaction was made.

Collar A protective strategy in which a written call and a long put are taken against a previously owned long stock position. The options may have the same strike price or different strike prices and the expiration months may or may not be the same.

Collateral Securities against which loans are made. If the value of the securities (relative to the loan) declines to an unacceptable level, this triggers a margin call. As such, the investor is asked to post additional collateral or the securities are sold to repay the loan.

Combination A trading position involving out-of-the-money puts and calls on a one-to-one basis. The puts and calls have different strike prices, but the same expiration and underlying stock.

Condor spread A strategy involving four strike prices that has both limited risk and limited profit potential. A long call condor spread is established by buying one call at the lowest strike, writing one call at the second strike, writing another call at the third strike, and buying one call at the fourth (highest) strike.

Contingency order An order to execute a transaction in one security that depends on the price of another security.

Contract size The amount of the underlying asset covered by the option contract.

Conversion An investment strategy in which a long put and a short call with the same strike price and expiration are combined with long stock to lock in a nearly riskless profit.

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Cover To close out an open position. Covered call/Covered call writing An option strategy in which a call option is written against an equivalent amount of long stock. Covered combination A strategy in which one call and one put with the same expiration, but different strike prices, are written against each 100 shares of the underlying stock. Covered option An open short option position that is fully offset by a corresponding stock or option position. That is, a covered call could be offset by long stock or a long call, while a covered put could be offset by a long put or a short stock position. Covered put/Covered cash-secured put Cash secured put is an option stategy in which a put option is written against a sufficient amount of cash. Covered straddle An option strategy in which one call and one put with the same strike price and expiration are written against each 100 shares of the underlying stock. Credit Money received in an account either from a deposit or a transaction that results in increasing the account’s cash balance. Credit spread A spread strategy that increases the account’s cash balance when it is established. A bull spread with puts and a bear spread with calls are examples of credit spreads. Curvature A measure of the rate of change in an option’s delta for a one-unit change in the price of the underlying stock. Day order A type of option order which instructs the broker to cancel any unfilled portion of the order at the close of trading on the day the order is first entered. Day trade A position (stock or option) that is opened and closed on the same day. Debit Money paid out from an account either from a withdrawal or a transaction that results in decreasing the cash balance.

168 Option Trading

Debit spread A spread strategy that decreases the account’s cash balance when it is established. A bull spread with calls and a bear spread with puts are examples of debit spreads. Decay A term used to describe how the theoretical value of an option ‘erodes’ or reduces with the passage of time. Delivery The process of meeting the terms of a written option contract when notification of assignment has been received. Delta A measure of the rate of change in an option’s theoretical value for a one-unit change in the price of the underlying stock. Derivative/Derivative security A financial security whose value is determined in part from the value and characteristics of another security, the underlying security. Diagonal spread A strategy involving the simultaneous purchase and writing of two options of the same type that have different strike prices and different expiration dates. Discount An adjective used to describe an option that is trading at a price less than its intrinsic value. Discretion Freedom given by an investor through his or her Account Executive to use judgment regarding the execution of an order. Discretion can be limited, as in the case of a limit order which gives the Floor Broker 1/8 or 1/4 point from the stated limit price to use his or her judgment in executing the order. Discretion can also be unlimited, as in the case of a market-not-held-order. Early exercise A feature of American-style options that allows the owner to exercise an option at any time prior to its expiration date. Equity In a margin account, this is the difference between the securities owned and the margin loans owed. It is the amount the investor would keep after all positions have been closed and all margin loans paid off. Equity option An option on shares of an individual common stock or exchange traded fund.

Glossary

169

Equivalent strategy A strategy which has the same risk-reward profile as another strategy.

Ex-date/Ex-dividend date The day before which an investor must have purchased the stock in order to receive the dividend.

Exchange traded funds (ETFs) Exchange traded funds (ETFs) are index funds or trusts that are listed on an exchange and can be traded in a similar fashion as a single equity.

Exercise To invoke the rights granted to the owner of an option contract. In the case of a call, the option owner buys the underlying stock. In the case of a put, the option owner sells the underlying stock.

Exercise price The price at which the owner of an option can purchase (call) or sell (put) the underlying stock. Used interchangeably with striking price, strike, or exercise price.

Exercise settlement amount The difference between the exercise price of the option being exercised and the exercise settlement value of the index on the day the index option is exercised.

Expiration date The date on which an option and the right to exercise it cease to exist.

Expiration month The month during which the expiration date occurs.

Fence A protective strategy in which a written call and a long put are taken against a previously owned long stock position. The options may have the same strike price or different strike prices and the expiration months may or may not be the same.

Fill-or-kill order (FOK) A type of option order which requires that the order be executed completely or not at all. A fill-or-kill order is similar to an all-or-none (AON) order.

Floor broker A trader on an exchange floor who executes trading orders for other people.

170 Option Trading

Floor trader An exchange member on the trading floor who buys and sells for his or her own account.

Fundamental analysis A method of predicting stock prices based on the study of earnings, sales, dividends, and so on.

Fungibility Interchangeability resulting from standardization. Options listed on national exchanges are fungible, while over-the-counter options generally are not. Classes of options listed and traded on more than one national exchange are referred to as multiple-listed/multiple-traded options.

Gamma A measure of the rate of change in an option’s delta for a one-unit change in the price of the underlying stock.

Good-till-cancelled (GTC) order A type of limit order that remains in effect until it is either executed (filled) or cancelled, as opposed to a day order, which expires if not executed by the end of the trading day.

Hedge/Hedged position A position established with the specific intent of protecting an existing position.

Historic volatility A measure of actual stock price changes over a specific period of time. See also Standard deviation.

Holder Any person who has made an opening purchase transaction, call or put, and has that position in a brokerage account.

Horizontal spread An option strategy which generally involves the purchase of a farther-term option (call or put) and the writing of an equal number of nearer-term options of the same type and strike price.

Immediate-or-cancel order (IOC) A type of option order which gives the trading crowd one opportunity to take the other side of the trade. After being announced, the order will be either partially or totally filled with any remaining balance immediately cancelled.

Glossary

171

Implied volatility The volatility percentage that produces the ‘best fit’ for all underlying option prices on that underlying stock.

In-the-money option An adjective used to describe an option with intrinsic value. A call option is in the money if the stock price is above the strike price.

Index A compilation of several stock prices into a single number.

Index option An option whose underlying interest is an index. Generally, index options are cash-settled.

Individual volatility The volatility percentage that justifies an option’s price, as opposed to historic or implied volatility. A theoretical option pricing model can be used to generate an option’s individual volatility when the five remaining quantifiable factors (stock price, time until expiration, strike price, interest rates, and cash dividends) are entered along with the price of the option itself.

Institution A professional investment management company. Typically, this term is used to describe large money managers such as banks, pension funds, mutual funds, and insurance companies.

Intrinsic value The in-the-money portion of an option’s price. See also In-the-money option.

Iron butterfly An option strategy with limited risk and limited profit potential that involves both a long (or short) straddle, and a short (or long) combination.

ISE International Securities Exchange.

Kappa A measure of the rate of change in an option’s theoretical value for a one-unit change in the volatility assumption.

Lambda Least-squares Ambiguity Decorrelation Adjustment.

172 Option Trading

Last trading day The last business day prior to the option’s expiration date during which purchases and sales of options can be made. For equity options, this is generally the third Friday of the expiration month.

LEAPS (Long-term Equity Anticipation Securities) In English, this means calls and puts with an expiration as long as thirty-nine months.

Leg A term describing one side of a position with two or more sides. When a trader legs into a spread, he/she establishes one side first, hoping for a favorable price movement so the other side can be executed at a better price.

Leverage A term describing the greater percentage of profit or loss potential when a given amount of money controls a security with a much larger face value.

Limit order A trading order placed with a broker to buy or sell stock or options at a specific price.

Liquidity/liquid market A trading environment characterized by high trading volume, a narrow spread between the bid and ask prices, and the ability to trade larger sized orders without significant price changes.

Listed option A put or call traded on a national options exchange. In contrast, over-thecounter options usually have non-standard or negotiated terms.

Long option position The position of an option purchaser (owner) which represents the right to either buy stock (in the case of a call) or to sell stock (in the case of a put) at a specified price (the strike price) at or before some date in the future (the expiration date). It results from an opening purchase transaction, e.g., long call or long put.

Long stock position A position in which an investor has purchased and owns stock.

Margin/Margin requirement The minimum equity required to support an investment position. To buy on margin refers to borrowing part of the purchase price of a security from a brokerage firm.

Glossary

173

Mark-to-market An accounting process by which the price of securities held in an account are valued each day to reflect the closing price, or market quote if the last sale is outside of the market quote.

Market order A trading order placed with a broker to immediately buy or sell a stock or option at the best available price.

Market quote A quotation of the current best bid/ask prices for an option or stock in the marketplace (an exchange trading floor). This information is usually obtained by the investor from someone at a brokerage firm.

Market-maker An exchange member on the trading floor who buys and sells options for his or her own account and who has the responsibility of making bids and offers and maintaining a fair and orderly market.

Market-not-held order A type of market order which allows the investor to give discretion to the floor broker regarding the price and/or time at which a trade is executed.

Market-on-close order (MOC) A type of option order which requires that an order be executed at or near the close of trading on the day the order is entered.

Married put strategy The simultaneous purchase of stock and put options representing an equivalent number of shares.

Model A mathematical formula used to calculate the theoretical value of an option. See also Black-Scholes formula

Multiple-listed/multiple-traded option Any option contract that is listed and traded on more than one national options exchange.

Naked Uncovered option A short option position that is not fully collateralized if notification of assignment is received.

Neutral An adjective describing the belief that a stock or the market in general will neither rise nor decline significantly.

174 Option Trading

Neutral strategy An option strategy (or stock and option position) expected to benefit from a neutral market outcome.

Ninety-ten (90/10) strategy A conservative option strategy in which an investor buys Treasury bills (or other liquid assets) with 90 percent of his or her funds, and buys call options (or put options or a mixture of both) with the balance.

Non-equity option Any option that does not have common stock as the underlying asset. Nonequity options include options on futures, indexes, foreign currencies, treasury security yields, etc.

Not-held order A type of order which releases normal obligations implied by the other terms of the order. For example, a limit order designated as ‘not-held’ allows discretion to the floor trader in filling the order when the market trades at the limit price of the order. In this case, there is no obligation to provide the customer with an execution if the market trades through the limit price on the order. See also Discretion and Market-not-held order.

Offer/Offer price In the options business this means the same as ask/ask price, or the price at which a seller is offering to sell an option or a stock.

One-cancels-other order (OCO) A type of option order which treats two or more option orders as a package, whereby the execution of any one of the orders causes all the orders to be reduced by the same amount.

Open interest The total number of outstanding option contracts on a given series or for a given underlying stock.

Open outcry The trading method by which competing market makers and floor brokers representing public orders make bids and offers on the trading floor.

Opening transaction An addition to, or creation of, a trading position. An opening purchase transaction adds long options to an investor’s total position, and an opening sale transaction adds short options. An opening option transaction increases that option’s open interest.

Glossary

175

Option A contract that gives the owner the right, but not the obligation, to buy or sell a particular asset (the underlying stock) at a fixed price (the strike price) for a specific period of time (until expiration).

Option period The time from when an option contract is created by a writer of that option to the expiration date; sometimes referred to as an option’s ‘lifetime.’

Option pricing curve A graphical representation of the estimated theoretical value of an option at one point in time, at various prices of the underlying stock.

Option pricing model The first widely-used model for option pricing is the Black-Scholes. This formula can be used to calculate a theoretical value for an option using current stock prices, expected dividends, the option’s strike price, expected interest rates, time to expiration and expected stock volatility.

Option writer The seller of an option contract who is obligated to meet the terms of delivery if the option owner exercises his or her right.

Optionable stock A stock on which listed options are traded.

OTC option An over-the-counter option is one which is traded in the over-the-counter market. OTC options are not listed on an options exchange and do not have standardized terms.

Out-of-the-money An adjective used to describe an option that has no intrinsic value, i.e., all of its value consists of time value. A call option is out of the money if the stock price is below its strike price.

Out-of-the-money option An adjective used to describe an option that has no intrinsic value, i.e., all of its value consists of time value. A call option is out of the money if the stock price is below its strike price. A put option is out of the money if the stock price is above its strike price.

Over-the-counter/Over-the-counter market A national association having many characteristics of an exchange. Rather than a floor or physically central market place, trading takes place via computer terminals.

176 Option Trading

Overwrite An option strategy involving the writing of call options (wholly or partially) against existing long stock positions. This is different from the buy-write strategy which involves the simultaneous purchase of stock and writing of a call.

Owner Any person who has made an opening purchase transaction, call or put, and has that position in a brokerage account.

Parity A term used to describe an option contract’s total premium when that premium is the same amount as its intrinsic value. For example, when an option’s theoretical value is equal to its intrinsic value, it is said to be ‘worth parity.’

Payoff diagram A chart of the profits and losses for a particular options strategy prepared in advance of the execution of the strategy. The diagram is plot of expected profit or loss against the price of the underlying security.

Physical delivery option An option whose underlying entity is a physical good or commodity, like a common stock or a foreign currency. When that option is exercised by its owner, there is delivery of that physical good or commodity from one brokerage or trading account to another.

Pin risk The risk to an investor (option writer) that the stock price will exactly equal the strike price of a written option at expiration, i.e., that option will be exactly at the money. The investor will not know how many of his/her written (short) options he/she will be assigned.

Position The combined total of an investor’s open option contracts (calls and/or puts) and long or short stock.

Position trading An investing strategy in which open positions are held for an extended period of time.

Premium 1. Total price of an option: intrinsic value plus time value. 2. Often (erroneously) this word is used to mean the same as time value. Primary market For securities that are traded in more than one market, the primary market is usually the exchange where trading volume in that security is highest.

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177

Profit/loss graph A graphical presentation of the profit and loss possibilities of an investment strategy at one point in time (usually option expiration), at various stock prices.

Put option An option contract that gives the owner the right to sell the underlying stock at a specified price (its strike price) for a certain, fixed period of time (until its expiration). For the writer of a put option, the contract represents an obligation to buy the underlying stock from the option owner if the option is assigned.

Ratio spread A term most commonly used to describe the purchase of an option(s), call or put, and the writing of a greater number of the same type of options that are out-of-the-money with respect to those purchased. All options involved have the same expiration date.

Ratio write An investment strategy in which stock is purchased and call options are written on a greater than one-for-one basis, i.e., more calls written than the equivalent number of shares purchased

Realized gains and losses The net amount received or paid when a closing transaction is made and matched together with an opening transaction.

Resistance A term used in technical analysis to describe a price area at which rising prices are expected to stop or meet increased selling activity.

Reversal/reverse conversion An investment strategy used by professional option traders in which a short put and long call with the same strike price and expiration are combined with short stock to lock in a nearly riskless profit.

RHO A measure of the expected change in an option’s theoretical value for a 1 percent change in interest rates.

Rolling A trading action in which the trader simultaneously closes an open option position and creates a new option position at a different strike price, different expiration, or both. Variations of this include rolling up, rolling down, rolling out and diagonal rolling.

178 Option Trading

SEC The Securities and Exchange Commission. The SEC is an agency of the federal government which is in charge of monitoring and regulating the securities industry.

Secondary market A market where securities are bought and sold after their initial purchase by public investors.

Sector index An index that measure the performance of a narrow market segment, such as biotechnology or small capitalization stocks.

Secured put/cash-secured put An option strategy in which a put option is written against a sufficient amount of cash (or T-bills) to pay for the stock purchase if the short option is assigned.

Series of options Option contracts on the same class having the same strike price and expiration month.

Settlement The process by which the underlying stock is transferred from one brokerage account to another when equity option contracts are exercised by their owners and the inherent obligations assigned to option writers.

Settlement price The official price at the end of a trading session. This price is established by The Options Clearing Corporation and is used to determine changes in account equity, margin requirements and for other purposes.

Short option position The position of an option writer which represents an obligation on the part of the option’s writer to meet the terms of the option if it is exercised by its owner. The writer can terminate this obligation by buying back (cover or close) the position with a closing purchase transaction.

Short stock position A strategy that profits from a stock price decline. It is initiated by borrowing stock from a broker-dealer and selling it in the open market. This strategy is closed (covered) at a later date by buying back the stock and returning it to the lending broker-dealer.

Specialist/Specialist group/specialist system One or more exchange members whose function is to maintain a fair and orderly market in a given stock or a given class of options. This is accomplished

Glossary

179

by managing the limit order book and making bids and offers for his/her/ their own account in the absence of opposite market side orders. See also Market-maker and Market-maker system, (competing).

Spin-off A stock dividend issued by one company in shares of another corporate entity, such as a subsidiary corporation of the company issuing the dividend.

Spread/Spread order A position consisting of two parts, each of which alone would profit from opposite directional price moves. As orders, these opposite parts are entered and executed simultaneously in the hope of (1) limiting risk, or (2) benefiting from a change of price relationship between the two parts.

Standard deviation A statistical measure of price fluctuation. One use of the standard deviation is to measure how stock price movements are distributed about the mean. See also Volatility.

Standardization Interchangeability resulting from standardization. Options listed on national exchanges are fungible, while over-the-counter options generally are not. Classes of options listed and traded on more than one national exchange are referred to as multiple-listed/multiple-traded options.

Stock dividend A dividend paid in shares of stock rather than cash.

Stock split An increase in the number of outstanding shares by a corporation, through the issuance of a set number of shares to a shareholder for a set number of shares that the shareholder already owns.

Stop order A type of contingency order, often erroneously known as a ‘stop-loss’ order, placed with a broker that becomes a market order when the stock trades, or is bid or offered, at or through a specified price. See also Stop-limit order.

Stop-limit order A type of contingency order placed with a broker that becomes a limit order when the stock trades, or is bid or offered, at or through a specific price.

Straddle A trading position involving puts and calls on a one-to-one basis in which the puts and calls have the same strike price, expiration, and underlying

180 Option Trading stock. A long straddle is when both options are owned and a short straddle is when both options are written.

Strike/Strike price The price at which the owner of an option can purchase (call) or sell (put) the underlying stock. Used interchangeably with striking price, strike, or exercise price.

Suitability A requirement that any investing strategy fall within the financial means and investment objectives of an investor or trader.

Support A term used in technical analysis to describe a price area at which falling prices are expected to stop or meet increased buying activity. This analysis is based on previous price behavior of the stock.

Synthetic long call A long stock position combined with a long put of the same series as that call.

Synthetic long put A short stock position combined with a long call of the same series as that put.

Synthetic long stock A long call position combined with a short put of the same series.

Synthetic position A strategy involving two or more instruments that has the same risk-reward profile as a strategy involving only one instrument.

Synthetic short call A short stock position combined with a short put of the same series as that call.

Synthetic short put A long stock position combined with a short call of the same series as that put.

Synthetic short stock A short call position combined with a long put of the same series.

Technical analysis A method of predicting future stock price movements based on the study of historical market data, such as (among others) the prices themselves, trading volume, open interest, the relation of advancing issues to declining issues, and short selling volume.

Glossary

181

Theoretical option pricing model The first widely-used model for option pricing. This formula can be used to calculate a theoretical value for an option using current stock prices, expected dividends, the option’s strike price, expected interest rates, time to expiration and expected stock volatility. While the Black-Scholes model does not perfectly describe real-world options markets, it is still often used in the valuation and trading of options.

Theoretical value The estimated value of an option derived from a mathematical model. See also Model and Black-Scholes formula.

Theta A measure of the rate of change in an option’s theoretical value for a one-unit change in time to the option’s expiration date.

Tick The smallest unit price change allowed in trading a security. For listed stock, this is generally 1/8th of a point.

Time decay A term used to describe how the theoretical value of an option ‘erodes’ or reduces with the passage of time. Time decay is specifically quantified by theta.

Time spread An option strategy which generally involves the purchase of a farther-term option (call or put) and the writing of an equal number of nearer-term options of the same type and strike price.

Time value The part of an option’s total price that exceeds its intrinsic value. The price of an out-of-the-money option consists entirely of time value.

Trader 1. Any investor who makes frequent purchases and sales. 2. A member of an exchange who conducts his or her buying and selling on the trading floor of the exchange. Trading pit/Pit A specific location on the trading floor of an exchange designated for the trading of a specific option class or stock.

Transaction costs All of the charges associated with executing a trade and maintaining a position. These include brokerage commissions, fees for exercise and/or

182 Option Trading assignment, exchange fees, SEC fees, and margin interest. In academic studies, the spread between bid and ask is taken into account as a transaction cost.

Type of options The classification of an option contract as either a put or a call.

Uncovered call option writing A short call option position in which the writer does not own an equivalent position in the underlying security represented by his option contracts.

Uncovered put option writing A short put option position in which the writer does not have a corresponding short position in the underlying security or has not deposited, in a cash account, cash or cash equivalents equal to the exercise value of the put.

Underlying security The security subject to being purchased or sold upon exercise of the option contract.

Vega A measure of the rate of change in an option’s theoretical value for a one-unit change in the volatility assumption.

Vertical spread Most commonly used to describe the purchase of one option and writing of another where both are of the same type and of same expiration month, but have different strike prices.

Volatility A measure of stock price fluctuation. Mathematically, volatility is the annualized standard deviation of a stock’s daily price changes.

Write/Writer To sell an option that is not owned through an opening sale transaction. While this position remains open, the writer is subject to fulfilling the obligations of that option contract, i.e., to sell stock (in the case of a call) or buy stock (in the case of a put) if that option is assigned.

INDEX A

BSE Bankex 150

Additional margin

BSE Index Futures 22 BSE Index Options 22

29

Adjustments 163 All-or-None Order (AON) American options 12 American-style option

BSE IT 149 BSE Stock Futures

163

22

BSE Stock Options 23 Bull (or bullish) spread

163

165

Arbitrage 13, 163 Arbitrageurs 17

Bull spread 75, 76, 88, 89 Bull spread (call) 165

Ask/Ask price 163 Assigned 163

Bull spread (put) 165 Bull spread with puts 81, 90, 91

At-The-Money 164 Available option instruments and its lots 156

Bullish 165 Bullish characteristics

151

Bullish strategies 71 Bulls spread with puts

80

Average an option 154 Averaging down 164

Business disruption and system failures 133 Butterfly spread 165

B Backspread 164 Bear (or bearish) spread Bear spread (call) Bear spread (put)

Buy call 88 Buy futures with protective put 82, 83, 91, 92 Buy-write 165

164

164 164

Bearish 164 Beta 164

C

Bid/Bid price 164 Black-Scholes formula 164

Calculation of call 31 Calculation of margins

Bombay Stock Exchange (BSE) Box spread 164 Break-even point(s) 165 Broker 165

17

29

Calculation of option Greeks Calculation of put option Premium 32 Calculation of rollover 147

66

184 Index Calendar spread 117, 165 Call option 165 Call option concept

Covered call/Covered call writing 167 Covered combination Covered option 167

12

caplets 9 Caps and floors 9

Covered put/Covered cash-secured put 167 Covered straddle 167

Carry/Carrying cost 165 Case study: The LTCM Fiasco(ii) 137 Cash settlement amount 166 Change in delta with change in interest rate 63

Credit 167 Credit derivatives are

7

Credit spread 167 Currency derivatives

7

Chicago Board of Trade (CBT) 5 Class of options 166

Curvature

Client-wise open interest limit 30 Clients, products and business practices 133 Close/Closing transaction 166

D

Closing price 166 Collar 9, 166

Delivery 168 Delta 61, 68, 168 Delta for call Delta for put

166

Contingency order 166 Contract cycle 18

62 62

Delta hedge 112, 113 Delta hedge on Nifty with calls 113, 114

Contract size 166 Contract structure 22 Conversion 167 Conversion of American in-themoney put 28

83, 84, 92, 93

Damages to physical assets happen 133

Debit spread 168 Decay 168

Commodity risk 132 Complex trading strategies in a bull 102

Covered call

Daily premium settlement 26

Dealers 17 Debit 168

Combination strategies 112 Commodity derivatives 6

Options to short stock futures Cover 167

167

Day order 20, 167 Day trade 168

Collateral 166 Combination 166

Market 102 Condor spread

167

28

Delta hedge on Nifty with puts 114, 115 Delta hedging and market makers 86 Delta neutral 85, 86, 113 Derivative/Derivative security Diagonal spread 168

168

185

Index

Different forms of options Different scenarios Discount 168

12

31

Equivalent strategy

169

European options 12 Ex-date/Ex-dividend date

169

Discretion 168 Do the American options trade at a discount? 153

Exchange Traded Funds (ETFs) 169 Exercise 169

E

Exercise settlement amount 169 Expiration date 169

Early exercise

168

Effect of change in risk-free interest rate on call option premium 49 Effect of change in risk-free interest rate on put option premium 52 Effect of change in strike price on call option premium 40 Effect of change in strike price on put option premium 42 Effect of change in time to expiry on call option premium 54 Effect of change in time to expiry on put option premium 57 Effect of change in underlying asset price on call option premium 35 Effect of change in underlying asset price on put option premium 37 Effect of change in volatility on call option premium 44 Effect of change in volatility on put option premium 47 Employment practices and work place safety 133

Expiration month

169

F Fence

169

Fill-or-Kill Order (FOK) 170 Final exercise settlement 26 Financial derivatives Floor 9

Equity derivatives 7 Equity option 169 131

6, 7

Floor broker 170 Floor trader 170 Floorlets 9 Forward Rate Agreement (FRA) 9 Frauds 133 Frequently Asked Questions Fundamental analysis Fungibility 170

152

170

Future and options segment stocks 156 Futures 8 Futures and options as leveraged instruments 28

G

enable 6 Equity 169

Equity risk

Exercise price 169 Exercise settlement 26

Gamma

63, 68, 170

Gamma of options 64 Glossary 163

186 Index Good-Till-Cancelled (GTC) order 170

Index option

Greek letters 61

Individual volatility

171

Indian options market 27 Initial margin

H

Institution

171

29

171

Interest rate derivatives Hedge wrappers 116, 117 Hedge/Hedged position 170 Hedgers 17 Hedging 13 High risk stock option strategies 96 Historic volatility 170 History and evolution 4 Holder 170 Horizontal spread 170 How can a call option buyer incur loss even if the underlying asset is on a rise? 154 How can an option writer reduce risks in his short position? 154 How can we manage a long option position? 153 How can we open a trading account 154 Human risk 131

130

Interim exercise settlement

26

Intermonth combinations

117

Intrinsic value

171

Introduction to derivatives

Immediate order or cancel (IOC) 20 Immediate-or-cancel order (IOC) 171 Implied volatility 110, 171 In-the-money, At-the-money and Out-of-the-money options 19 In-the-money option Index 171 7

171

4

Introduction to risk 127 Iron butterfly

171

Is it advisable to average an option? 154 ISE 171

K Kappa

171

L Lambda 66, 172 Last trading day 172 LEAPS (Long-term Equity Anticipation Securities)

I

Index derivatives

Interest rate risks

7

Leg 172 Legal risk

172

132

Leverage 13, 172 Leverage of options 21 Leveraged instruments Limit order 172

1

Liquidity/liquid market 172 List of exchanges 5 Listed option 172 Long call 71, 87

Index

Long fence split strike price

78, 79

Long option position 172 Long put Christmas tree 76, 77 Long stock position 172 Long straddle 93, 94 Long straddle with short call 102, 103 Long straddle with short put 108, 109 Long strangle 95, 96 Long strangle with short call 105, 106 Long strangle with short put 110, 111 Low risk stock option strategies 87

M Management of long put option Managing risks 135 Margin/Margin requirement

28

173

Mark to market margin 29 Mark-to-market 173 Market indicators 145 Market makers 18 Market order Market quote

173 173

Market risk 127 Market-maker 173 Market-not-held order 173 Market-On-Close order (MOC) 173 Married put strategy 173 Member-wise open interest limit 30 Mini Nifty 150 Model 173 Model risk 133 Multiple leg spreading — Type IV 121

187

Multiple leg spreading — Type I 117 Multiple leg spreading — Type I 118 Multiple leg spreading — Type II 119 Multiple leg spreading — Type III 120, 121 Multiple leg spreading — Type IV 122 Multiple leg spreading — Type V 123, 124 Multiple leg spreading — Type VI 124, 125 Multiple leg spreading — Type II 120 Multiple-listed/multiple-traded option 173

N Naked call writing

84

Naked uncovered option 174 National Stock Exchange (NSE) Need for options Neutral 174

13

Neutral strategy 174 Nifty 3 months 149 Nifty and put call ratio Nifty movement 148

146

Nifty volatility 148 Ninety-ten (90/10) strategy Non-equity option 174 Not-held order 174 NSE index futures 23 NSE index options 23 NSE stock futures 24 NSE stock options 24

174

15

188 Index

O Offer/Offer price 174 One-cancels-other order (OCO) 174 Open interest 30, 174 Open outcry 174 Opening transaction 175 Operational risk 132 Option 175 Option concepts 11 Option Greeks 2, 61 Option period 175 Option premium 31, 151 Option price calculation in different 35 Scenarios 35 Option pricing concepts 31 Option pricing curve 175 Option pricing in 31 Option pricing model 175 Option strategies 1 Option strategies in a bull market 70 Option writer 175 Optionable stock 175 Options 1, 8 OTC option 11, 175 Out-of-the-money 175 Out-of-the-money option 175 Over-the-counter/Over-the-counter market 176 Overwrite 176 Owner 176

P PAN 152 Parity 176

Participants

17

Payoff diagram 176 Physical delivery option

176

Pin risk 176 Political risk 132 Portfolio hedging through Nifty options 135 Position 176 Position trading 176 Premium 177 Primary market 177 Profit/Loss graph 177 Put call ratio 145 Put option 177 Put option concept 12 Put ratio spread 79, 101 Put ratio spread 80, 102 Put-call parity 33

R Ratio spread 177 Ratio write 177 Realized gains and losses 177 Reputation risk 131 Resistance 177 Reversal/Reverse conversion

177

RHO 177 Rho 66, 68 Risk identification 134 Risk management 13, 134 Risk perceptions in option trading 127 Risks in option trading 13 Role of broker in options trading 27 Rolling 178 Rollover of positions

146

Index

S

Suitability Support

SEC 178

Swaps

Secondary market Sector index 178

178

Secured put/cash-secured put Sell put 75, 101

178

180

180 8

Synthetic long

72, 96

Synthetic long

73, 97

Synthetic long call 180 Synthetic long in deep out-of-themoney options 99

Series of options 178 Settlement 178

Synthetic long put 180

Settlement price 178 Settlement schedule 26

Synthetic long split strike

Short option position Short put 74, 100

Synthetic position

Synthetic long stock

178

Short stock position 178 Short straddle with long call 105, 106, 107 Short straddle with long put 110 Significance of rollover 147

104, 109,

SPAN margin 30 Specialist/Specialist group/Specialist system 179 Spin-off 179 Spread/Spread order 179 Standard deviation 179 Standardization 179 Stock and index options 15 Stock dividend 179 Stock Exchanges in India

5

Stock split 179 Stop loss order 21 Stop order

179

Stop-limit order Straddle

189

180

180

Strategies suitable for stock 87 Strike/Strike price 180 Structure of Indian options market 15

97, 99

180 180

Synthetic short call

180

Synthetic short put

180

Synthetic short stock

181

T Technical analysis 181 Technological powerhouse 16 The clearing and settlement process 25 The clearing mechanism 25 The important norms followed? 154 The settlement mechanism for options 25 Theoretical option pricing model 181 Theoretical value Theta Tick

181

64, 67, 181 181

Time decay 181 Time spread Time value Trader

181 181

181

Trading pit/Pit

182

Transaction costs

182

190 Index Type of options 182 Types of derivatives Types of orders

6

20

U Uncovered call option writing 182 Uncovered put option writing 182 Underlying asset 4 Underlying security 182

V Various forms of risk 127 Vega 68, 182 Vega or Kappa or Epsilon 65 Vertical spread Volatility

182

147, 182

Volatility trade 147 Volatility traders

17

What are the key differences between options and futures? 152 What are the key factors to be considered while purchasing an option? 153 What is meant by naked call writing? 154 What is the maximum brokerage that the broker/Sub-broker can charge? 155 Who can be a writer of an option? 153 Who can buy a long call? 71 Who can buy options? 152 Who fixes option premium 153 Why derivative strategies 70 Why do European options trade below intrinsic value? 152 Why do we need to develop option strategies? 153 Write/Writer 182 Writing an option 21

W Z Weather derivatives 7 What are options? 11

Zero Delta portfolios

86