Derivatives - Options

Mahesh Gujar

Options

An option is a contract written by a seller that conveys to the buyer the right but not the obligation to buy or to sell a particular asset, at a particular price in future. In return for granting the option, the seller collects a payment (the premium) from the buyer. Options can be used for hedging, taking a view on the future direction of the market, for arbitrage or for implementing strategies which can help in generating income for investors under various market conditions.

Real Life Example

Imagine you want to purchase this piece of jewellery for $50,000 but you do not have the cash upfront. However, 6 months later, you will have enough cash to afford the jewellery.

So you make a deal with the owner, giving you the option of purchasing this piece of jewellery for $50,000 in exactly 6 months from now. However, to give you the right or this "Option", the owner charges you $2500. From here, you stand to either gain from the transaction or lose from it.

Scenario I This piece of jewellery actually turns out to be one worn by a famous celebrity many years ago! Therefore, its fair market value skyrockets to $200,000. Since you have the contractual right or option to purchase this item for $50,000, you will make a profit of $200,000 - ($50,000 + $2500) = $147,500.

Scenario II
This piece of jewellery actually turns out to be fake and the owner cheated on you! The actual worth of the item is only $20,000! Since you realize this last minute, you let the expiration date go by and do NOT purchase the item for $50,000. However, you would still lose the $2500 you paid to acquire the option.

Type Of Options
The 2 types of Options are called Calls and Puts. Call: A call gives the holder the right but not the obligation to acquire or buy an asset at a certain price within a specified period of time. Holders of Calls hope that their asset goes up in value substantially for them to make big profits. Put: A put gives the holder the right but not the obligation to dispose of or sell an asset at a certain price within a specified period of time. Holders of Puts hope that value of the asset goes down in value substantially for them to make big profits

There are 4 types of Options Participants: Buyers of Calls Sellers of Calls Buyers of Puts Sellers of Puts Buyers of options are called Holders while sellers of options are known as Writers..

OPTION TERMINOLOGY
Option Buyer - One who buys the option. He has the right to exercise the option but no obligation.

Option Seller - One who gives/writes the option. He has an obligation to perform, in case option buyer desires to exercise his option.

Option Premium - The price paid by the option buyer to the option seller for granting the option. American Option - An option which can be exercised anytime on or before the expiry date.

European Option - An option which can be exercised only on expiry date. Strike Price/ Exercise Price - Price at which the option is to be exercised.

OPTION TERMINOLOGY
Expiration Date - Date on which the option expires. Exercise Date - Date on which the option gets exercised by the option holder/buyer.

In-the-money option: An in-the-money (ITM) option is an option that would lead to a positive cash flow to the holder if it were exercised immediately. At-the-money option: An at-the-money (ATM) option is an option that would lead to zero Cash flow if it were exercised immediately. Out-of-the-money option: An out-of-the-money (OTM) option is an option that would lead to a negative cash flow if it were exercised immediately.

Illustration on Call Option

An investor buys one Call option at a premium of Rs.2 per share at a strike price is Rs.60. In the worst case scenario, the investor would only lose a maximum of Rs.2 per share which is paid for the premium. The upside to it has an unlimited profits opportunity. On the other hand the seller of the call option has a payoff chart completely reverse of the call options buyer. Lets look at the payoff Chart for the Buyer of the Call option

Illustration on Put Options

An investor buys a Put option of one share of Reliance Petroleum at a premium of Rs. 2 per share at a strike price of Rs.60. The adjoining graph shows the fluctuations of net profit with a change in the spot price.

Options

STRATEGIES

Strategy 1 Long Call

Buying a call is the most basic of all options strategies. Buying a call is an easy strategy to understand. Buying a Call means you are very bullish and expect the underlying stock / index to rise in future.

When to Use: Investor is very bullish on the stock / index.

Risk: Limited to the Premium.(Maximum loss if market expires at or below the option strike price).

Reward: Unlimited
Breakeven: Strike Price + Premium

Strategy 2 Short Call

A Call option means an Option to buy. Buying a Call option means an investor expects the underlying price of a stock /index to rise in future. Selling a Call option is just the opposite of buying a Call option. Here the seller of the option feels the underlying price of a stock /index is set to fall in the future. When to use: Investor is very aggressive and he is very bearish about the stock / index. Risk: Unlimited Reward: Limited to the amount of premium Break-even Point: Strike Price + Premium

Strategy 3 Synthetic Long Call:

Buy Stock, Buy Put.

In this strategy, we purchase a stock since we feel bullish about it. But what if the price of the stock went down. You wish you had some insurance against the price fall. So buy a Put on the stock.

In case the price of the stock rises you get the full benefit of the price rise. In case the price of the stock falls, exercise the Put Option

It is a strategy with a limited loss and (after subtracting the Put premium) unlimited profit (from the stock price rise). The result of this strategy looks like a Call Option Buy strategy and therefore is called a Synthetic Call!

Mr. XYZ is bullish about ABC Ltd stock. He buys ABC Ltd. at current market price of Rs. 4000. To protect against fall in the price of ABC Ltd. (his risk), he buys an Put option with a strike price Rs. 3900 at a premium of Rs. 143.80.

ANALYSIS: This is a low risk strategy. This is a strategy which limits the loss in case of fall in market but the potential profit remains unlimited when the stock price rises. A good strategy when you buy a stock for medium or long term, with the aim of protecting any downside risk. The pay-off resembles a Call Option buy and is therefore called as Synthetic Long Call.

Strategy 4 Long Put.

A long Put is a Bearish strategy. To take advantage of a falling market an investor can buy Put options Example

Mr. XYZ is bearish on Nifty, when the Nifty is at 2694. He buys a Put option with a strike price Rs. 2600 at a premium of Rs. 52. If the Nifty goes below 2548, Mr. XYZ will make a profit on exercising the option. In case the Nifty rises above 2600, he can forego the option (it will expire worthless) with a maximum loss of the premium.

Strategy 5 Short Put.

An investor Sells Put when he is Bullish about the stock expects the stock price to rise or stay sideways at the minimum. When you sell a Put, you earn a Premium (from the buyer of the Put). Example Mr. XYZ is bullish on Nifty sells a Put option with a strike price of Rs. 4100 at a premium of Rs. 170.50. If the Nifty index stays above 4100, he will gain the amount of premium as the Put buyer wont exercise his option. In case the Nifty falls below 4100, Put buyer will exercise the option and the Mr. XYZ will start losing money.

Strategy 6 Covered Call

This strategy is usually adopted by a stock owner who is Neutral to moderately Bullish about the stock.

An investor buys a stock or owns a stock which he feel is good for medium to long term but is neutral or bearish for the near term.

The covered call is a strategy in which an investor Sells a Call option on a stock he owns (netting him a premium). The Call Option which is sold in usually an OTM Call. The Call would not get exercised unless the stock price increases above the strike price. Example Mr A bought XYZ Ltd for Rs 3850 and simultaneously sells a Call option at a strike price of Rs 4000. Which means Mr A doesnt think the price will rise above 4000.

1) The price of XYZ Ltd. stays at or below Rs. 4000. The Call buyer will not exercise the Call Option. Mr. A will keep the premium of Rs. 80. This is an income for him. So if the stock has moved from Rs. 3850 (purchase price) to Rs. 3950, Mr. A makes Rs. 180/- [Rs. 3950 Rs. 3850 + Rs. 80 (Premium)] = An additional Rs. 80, because of the Call sold.

Suppose the price of XYZ Ltd. moves to Rs. 4100 and above, then the Call Buyer will exercise the Call Option and Mr. A will have to pay him Rs. 100 (loss on exercise of the Call Option).

Strategy 7 Long Combo

A Long Combo is a Bullish strategy. If an investor is expecting the price of a stock to move up he can do a Long Combo strategy. It involves selling an OTM (lower strike) Put and buying an OTM (higher strike) Call.