9. Options

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Value of an OptionValue of an Option

The two components are,The two components are,

Intrinsic Value:Intrinsic Value: of call = Max [Aof call = Max [A--S, 0]S, 0]

of put = Max [Sof put = Max [S--A, 0]A, 0]

Time value:Time value: It is the value in excess ofIt is the value in excess ofthe intrinsic value and indicates optionsthe intrinsic value and indicates options

potential to become more valuable beforepotential to become more valuable beforeit expires. It decays with passage of time.it expires. It decays with passage of time.

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How is Value of Options Affected*?How is Value of Options Affected*?

FactorFactor Call ValueCall Value Put ValuePut Value

Increase in asset valueIncrease in asset value IncreaseIncrease DecreaseDecrease

Increase in strike priceIncrease in strike price DecreaseDecrease IncreaseIncrease

Increase in variance ofIncrease in variance ofunderlying assetunderlying asset

IncreaseIncrease IncreaseIncrease

Increase in time toIncrease in time to

expirationexpiration

IncreaseIncrease IncreaseIncrease

Increase in interest rateIncrease in interest rate IncreaseIncrease DecreaseDecrease

Increase in dividend paidIncrease in dividend paid DecreaseDecrease IncreaseIncrease

*American Options

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Call OptionCall Option

PayPay--off Diagram:off Diagram:Net payoffNet payoff

on callon call

StrikeStrike

PricePrice

Price of underlyingPrice of underlyingassetasset

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Put OptionPut Option

PayPay--off Diagram:off Diagram:Net payoffNet payoff

on puton put

StrikeStrike

PricePrice

Price of underlying assetPrice of underlying asset

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Options other than Calls and PutsOptions other than Calls and Puts

Convertible in bonds: purchaser buysConvertible in bonds: purchaser buysa straight bond and a call optiona straight bond and a call option

Callable bonds: purchaser buys aCallable bonds: purchaser buys astraight bond and sells a call option tostraight bond and sells a call option toissuerissuer

An equity share can be viewed as aAn equity share can be viewed as acall option on the assets of a company.call option on the assets of a company.

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Buying and Selling Stock:Buying and Selling Stock:Short PositionShort Position

MP (T)

Profit240

Loss

0240

E

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Elementary InvestmentElementary Investment

StrategiesStrategies

Long CallLong Call

Short CallShort Call Long PutLong Put

Short PutShort Put

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Long CallLong Call

MP (T)

Profit

Loss

0400

440

E

(-) 40

This refers to the purchase of a call

These are cash flows when a bullishInvestor buys a 3-month call on theStock with an exercise price of Rs.400Per share by paying a premium of Rs.40

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Short CallShort Call

MP (T)

Profit

Loss

0

400

440

E

(+) 40

This involves writing a call without owning theunderlying asset

These cash flows relate to writing a3-month call on a stock at an exerciseprice of Rs.400 per share

by receiving a premium of Rs.40.

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Short PutShort Put

MP (T)

Profit

Loss

0240216

E

(-) 216

This involves writing a put

These cash flows relate to a bullish investorWriting a put at an exercise price of Rs.240Per share receiving a premium of Rs.24.

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Complex Investment StrategiesComplex Investment Strategies

Covered Call WritingCovered Call Writing

Protective PutProtective Put

StraddlesStraddles

StranglesStrangles

SpreadsSpreads

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Covered Call WritingCovered Call Writing

It involves buying the stock and writing call on that.It involves buying the stock and writing call on that.

Profit

MP (T)

(+)48

(-)302

302 350

E

These are cash flows when we buy100 shares @310 and write a May350 call for Rs.8 so that initialInvestment is Rs.302

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Covered Call Writing:Covered Call Writing:CFCF00 = (Rs.302)= (Rs.302)

MP (T)MP (T) At Time TAt Time T NCFNCF

Sell StockSell Stock Buy CallBuy Call CF(T)CF(T)

270270 270270 00 270270 --3232290290 290290 00 290290 --1212

310310 310310 00 310310 8 8

330330 330330 00 330330 28 28

350350 350350 00 350350 48 48370370 370370 --2020 350350 48 48

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Covered Call:Covered Call:Why better than stock or only short calls?Why better than stock or only short calls?

Reduces the risk of uncovered call writing.Reduces the risk of uncovered call writing.

Downside risk is reduced by the premium amount.Downside risk is reduced by the premium amount.

Loss of upward gains can be minimized by rolling up theLoss of upward gains can be minimized by rolling up theexercise price.exercise price.

When call ends up outWhen call ends up out--ofof--thethe--money, profits increase bymoney, profits increase byevery dollar by which the stock price exceeds the originalevery dollar by which the stock price exceeds the originalprice.price.

Has a lower B.E.P. compared to only stock.Has a lower B.E.P. compared to only stock.

Writing a covered call at lower exercise price isWriting a covered call at lower exercise price isconservative, it reduces the loss but also the upward gains.conservative, it reduces the loss but also the upward gains.

Writing at higher exercise price is risky. Downside loss isWriting at higher exercise price is risky. Downside loss ishigher (less protective) and also gains are higher.higher (less protective) and also gains are higher.

A short holding period reduces the stock movementA short holding period reduces the stock movementpossibility and is the best.possibility and is the best.

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It involves buying the stock and buying put on that.It involves buying the stock and buying put on that.

Profit

Loss

(-)42

MP (T)270 312

E

These are cash flows when buy100 shares @ Rs.310 and buy a

Jun 270 put for Rs.2 so that initialInvestment is Rs.312

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Guards against fall and also participate in gains. PutGuards against fall and also participate in gains. Putensures min. selling price for stock.ensures min. selling price for stock.

Gain on upside movement is restricted by the premium.Gain on upside movement is restricted by the premium.

Smaller downside risk and smaller upward gains andSmaller downside risk and smaller upward gains andhigher BEP.higher BEP.

Higher strike price costs maximum but also providesHigher strike price costs maximum but also providesmaximum protection. Reduces the profits maximum.maximum protection. Reduces the profits maximum.

Lower strike price costs less, less protective and reducesLower strike price costs less, less protective and reduces

profits less.profits less. Long holding period has chances of recovery of timeLong holding period has chances of recovery of time

value due to more chances of price movements.value due to more chances of price movements.

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Synthetic Put and CallSynthetic Put and Call

AA synthetic putsynthetic putinvolves long calls andinvolves long calls andshort sale of an equal number of shares ofshort sale of an equal number of shares of

stock.stock. Synthetic callSynthetic call involves buying stock and aninvolves buying stock and an

equal number of puts and isequal number of puts and is nothing butnothing but

protective put.protective put.

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Long StraddleLong Straddle

Involves buying a put and a call, each with same exercise priceInvolves buying a put and a call, each with same exercise price

and same time to expiration.and same time to expiration.

Profit247

Loss

(-)63

MP (T)247 373

E1

Buying a Jun 310 call for Rs.21And Jun 310 put for Rs.42 perShare. Initial investment Rs63.

310

E2

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Short StraddleShort StraddleInvolves selling a put and a call, each with same exercise priceInvolves selling a put and a call, each with same exercise price

and same time to expiration.and same time to expiration.

Profit

Loss(-)247

(63)

MP (T)247 310

E2

373

E1

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Straddle VariantsStraddle Variants

Straps:Straps:

A bullish variation of straddle, involves two callsA bullish variation of straddle, involves two callsand one put. Investors are more bullish thanand one put. Investors are more bullish than

bearish and therefore increase calls.bearish and therefore increase calls.

Strips:Strips:

It is a slightly bearish variation of straddle, hasIt is a slightly bearish variation of straddle, has

long position in two puts and one call andlong position in two puts and one call andinvolves ones bet that the market will go down.involves ones bet that the market will go down.

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Long StrangleLong Strangle

Involves buying a call and a put on the same underlying assetInvolves buying a call and a put on the same underlying asset

for same expiration period atfor same expiration period at different exercise pricesdifferent exercise prices

Profit

247

-23

Loss

E1 E2333247

270 310

Buy Jun 310 call for Rs.21 and Jun 270Put for Rs. 2. Initial investment Rs.23.Usually one in-the-money and anotherOut-of-the-money. Initial investmentCan be less than straddle

MP (T)

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SpreadsSpreads

Involve buying of one option and selling ofInvolve buying of one option and selling ofanother.another.

Offer potential for small profit and limit the risk.Offer potential for small profit and limit the risk. VerticalVertical Spreads also calledSpreads also called StrikeStrike oror MoneyMoney

spreads. Could be written as say, July 120/125spreads. Could be written as say, July 120/125Spread.Spread.

HorizontalHorizontal Spreads also called asSpreads also called as TimeTime ororCalendarCalendar Spreads. Could be written asSpreads. Could be written asJune/July 120 Spread.June/July 120 Spread.

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SpreadsSpreads

For Vertical Spreads:For Vertical Spreads:

A July 120/125 call spread is a net longA July 120/125 call spread is a net long

position and is called Buying the Spread,position and is called Buying the Spread,sometimes referred to as Debit Spread.sometimes referred to as Debit Spread.

A July 120/125 put spread is a net shortA July 120/125 put spread is a net short

position and is called Selling the Spread,position and is called Selling the Spread,sometimes referred to as Credit Spread.sometimes referred to as Credit Spread.

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SpreadsSpreads

For Horizontal Spreads:For Horizontal Spreads:

A June/July 120 call spread is a net shortA June/July 120 call spread is a net short

position and is called Selling the Spread,position and is called Selling the Spread,sometimes referred to as Credit Spread.sometimes referred to as Credit Spread.

A July/June 120 call spread is a net longA July/June 120 call spread is a net long

position and is called Buying the Spread,position and is called Buying the Spread,sometimes referred to as Debit Spread.sometimes referred to as Debit Spread.

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Vertical SpreadVertical Spread(Across Strike Prices)(Across Strike Prices)

Involves buying an option and selling another option of theInvolves buying an option and selling another option of the

same type and time to expiration but with different exercise pricesame type and time to expiration but with different exercise price

MP (T)

Profit

Loss

E

+ 30

- 50

270 320 350

Bullish vertical spread using calls wherein weBuy Mar 270 calls for Rs.58 and sell Mar 350Calls for Rs.8 i.e. buy lower strike price andSell higher strike price calls.

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Vertical SpreadVertical SpreadInvolves buying an option and selling another option of theInvolves buying an option and selling another option of the

same type and time to expiration but with different exercise pricesame type and time to expiration but with different exercise price

MP (T)

Profit

Loss

E

+ 68

- 12

282270 350

Bullish vertical spread using puts whereinWe buy Mar270 put for Rs.2 and sellMar 350 put for Rs.70.

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Vertical SpreadVertical Spread

..

MP (T)E

Profit

Loss

+59

-21

270 329 350

Bearish vertical spread wherein SellJun 270 call for Rs.71 and buyJun 350 call for Rs.12.

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Vertical SpreadVertical Spread

..

MP (T)E

Profit

Loss

+12

-68

270 282 350

Bearish vertical spread usingPuts wherein Buy Mar 350 putfor Rs.70 and sell Mar 270 putfor Rs.2

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Horizontal SpreadsHorizontal Spreads (Across Expiration Months)(Across Expiration Months)

Involve buying an option and selling another ofInvolve buying an option and selling another ofsame type with same exercise price but withsame type with same exercise price but withdifferent expiration time.different expiration time.

In a horizontal bull spread, we buy back monthIn a horizontal bull spread, we buy back monthand sell the front month. In a horizontal bearand sell the front month. In a horizontal bearspread, we buy front month and sell back month.spread, we buy front month and sell back month.

Horizontal bull spread has similar payHorizontal bull spread has similar pay--off as thatoff as that

of a short straddle and horizontal bear spread hasof a short straddle and horizontal bear spread hassimilar payoff as that of a long straddle.similar payoff as that of a long straddle.

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Diagonal SpreadsDiagonal Spreads

They are vertical and horizontal atThey are vertical and horizontal atthe same time i.e. the are across boththe same time i.e. the are across both

strike price and expiration month.strike price and expiration month.

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Reverse Butterfly or Sandwich SpreadsReverse Butterfly or Sandwich Spreads

This is strategy reverse of theThis is strategy reverse of thebutterfly spread.butterfly spread.

The two middle strike price optionsThe two middle strike price optionsare purchase and the two end strikeare purchase and the two end strikeprice options are sold.price options are sold.

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Evaluation of the StrategiesEvaluation of the Strategies

Transaction costs have not been consideredTransaction costs have not been consideredand should be kept in mind.and should be kept in mind.

BidBid--ask spreads may affect payoffs.ask spreads may affect payoffs.

They are not dividend protected.They are not dividend protected.

Margin requirements are applicable to optionMargin requirements are applicable to optionwriting.writing.

Possibility of early exercise may pose newPossibility of early exercise may pose newrisks.risks.

Timing of cash flows can make a difference.Timing of cash flows can make a difference.

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Futures vs. Options:Futures vs. Options:PerformancePerformance

Option purchasers do not post margins since theyOption purchasers do not post margins since they

have no obligationshave no obligations

An option clearing house serves the similarAn option clearing house serves the similar

functions as those of clearing associations infunctions as those of clearing associations in

futures tradingfutures trading

Option writers have to post margins to clearingOption writers have to post margins to clearing

houseshouses

Options are also OTC and dealers may requireOptions are also OTC and dealers may require

margins or guarantees.margins or guarantees.

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Illustration 1Illustration 1

Consider the price of the stock atConsider the price of the stock at$165.125. Buy 100 shares of stock and$165.125. Buy 100 shares of stock andwrite one August 170 call contract at awrite one August 170 call contract at apremium of $3.25. Hold the position untilpremium of $3.25. Hold the position untilexpiration. Determine the profits andexpiration. Determine the profits andgraph the results. Identify the breakevengraph the results. Identify the breakeven

stock price at expiration, the maximumstock price at expiration, the maximumprofits, and the maximum loss.profits, and the maximum loss.

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Consider the price of the stock at theConsider the price of the stock at thesame level as in the previous illustrationsame level as in the previous illustrationi.e. $165.125. Now assume that you buyi.e. $165.125. Now assume that you buy

100 shares of stock and buy one August100 shares of stock and buy one August165 put contract at a premium of $4.75.165 put contract at a premium of $4.75.Hold the position till expiration.Hold the position till expiration.Determine the profits and graph theDetermine the profits and graph the

results. Identify the breakeven stockresults. Identify the breakeven stockprice at expiration, the maximum profits,price at expiration, the maximum profits,and the maximum loss.and the maximum loss.

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A call option with a strike price of $50A call option with a strike price of $50costs $2. A put option with a strike pricecosts $2. A put option with a strike priceof $45 costs $3. Explain how a strangleof $45 costs $3. Explain how a stranglecan be created from these two options.can be created from these two options.What is the pattern of profits from theWhat is the pattern of profits from thestrangle?strangle?

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A call with a strike price of $50 costs $6.A call with a strike price of $50 costs $6.A put with the same strike price andA put with the same strike price andexpiration date costs $4. Construct aexpiration date costs $4. Construct atable that shows the profits from atable that shows the profits from astraddle. For what range of stock pricesstraddle. For what range of stock priceswould the straddle lead to a loss?would the straddle lead to a loss?

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1.1. Discuss the main objectives ofDiscuss the main objectives of coveredcoveredcall and protective put viscall and protective put vis----vis simplevis simple

call and put strategies.call and put strategies.2.2. What is synthetic puts and syntheticWhat is synthetic puts and synthetic

calls?calls?

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A Transaction on an Option ExchangeA Transaction on an Option Exchange

..

Buyer BuyersBroker

OptionsExchange

3

Buyers BrokersFloor Broker

OptionsClearingHouse

Buyers BrokersClearing Firm

Buyers BrokersClearing Firm

Sellers BrokersFloor Broker

SellersBroker

Seller

1a 1b Buyer and seller instruct their respective brokers to conduct an option transaction.2a 2b Buyers and sellers brokers request their firms floor brokers execute the transaction.3 Both floor brokers meet in the pit on the floor of the options exchange and agree on a price.4 Information on the trade is reported to the clearinghouse.5a 5b Both floor brokers report the price obtained to the buyers and sellers brokers.6a 6b Buyers and sellers brokers report the price obtained to the buyer and seller.7a 7b Buyer deposits premium with buyers broker. Seller deposits margin with sellers broker.8a 8b Buyers and sellers brokers deposit premium and margin with their clearing firms.9a 9b Buyers and sellers brokers clearing firms deposit premium and margin with clearinghouse.

1a

6a

7a

2a

5a

48a 8b

9a 9b

2b

5b

1b

6b

7b

Note: Either buyeror seller (or both)could be a floortrader, eliminatingthe broker andfloor broker.

Documents

9. Options