OPTIONS TRADING

Welcome to the world of option trading. A major advantage of options is their versatility. They can be as conservative or as speculative as your investing strategy dictates. Options enable you to tailor your position to your own set of circumstances. Consider the following benefits of options:

* You can protect stock holdings from a decline in market price

* You can increase income against current stock holding

* You can prepare to buy a stock at a lower price

* You can position yourself for a big market move even when you don't know which way prices will move

* You can benefit from a stock price rise without incurring the cost of buying the stock outright

**|**** BASIC CONCEPTS**** | ****ADVANCED CONCEPTS**** | ****OPTION STRATEGIES**** |**

Basic Concepts

**What is an option?**

An option is a contract which gives the buyer the right, but not the obligation, to buy or sell shares of the underlying security or index at a specific price for a specified time. Stock option contracts generally are for 100 shares of the underlying stock. There are two types of options: calls and puts.

**Call option**

A call option gives the buyer the right, but not the obligation, to buy the underlying security at a specific price for a specified time. The seller of a call option has the obligation to sell the underlying security should the buyer exercise his option to buy. The buyer of an equity call option has purchased the right to buy 100 shares of the underlying stock at the stated exercise price. Thus, the buyer of one ACC April 30 call option has the right to purchase 100 shares of ACC at Rs30 up until April expiration. The buyer may do so by filing an exercise notice through his broker prior to the expiration date of the option. All calls covering ACC are referred to as an "option class." Each individual option with a distinctive trading month and strike price is an "option series."

**Put option**

A put option gives the buyer the right, but not the obligation, to sell an underlying security at a specific price for a specified time. The seller of a put option has the obligation to buy the underlying security should the buyer choose to exercise his option to sell. The buyer of a put option has purchased the right to sell 100 shares of the underlying stock at the contracted exercise price. Thus, the buyer of one ACC April 25 put has the right to sell 100 shares of ACC at Rs. 25 any time prior to the expiration date. In order to exercise the option and sell the underlying at the agreed upon exercise price, the buyer must file a proper exercise notice with the ACC through a broker before the date of expiration. All puts covering ACC stock are referred to as an "option class." Each individual option with a distinctive trading month and strike price is an "option series."

**Strike price**

The strike, or exercise, price of an option is the specified share price at which the shares of stock can be bought or sold by the buyer if he exercises the right to buy (in the case of a call) or sell (in the case of a put). A strike price is the actual numeric value of the option. For example, a April option may have strike prices of 25, 30 and 35. Strike prices are determined when the underlying reaches a certain numeric value and trades consistently at or above that value. If, for example, GMRINFRA stock was trading at 29, hit a price of 30 and traded consistently at this level, the next highest strike may be added.

**Option premium**

The premium is the price at which the contract trades. The premium is the price of the option and is paid by the buyer to the writer, or seller, of the option. In return, the writer of the call option is obligated to deliver the underlying security to an option buyer if the call is exercised or buy the underlying security if the put is exercised. The writer keeps the premium whether or not the option is exercised.

The option price is constituted of 2 price components, the intrinsic value and the time value.

**(****Option price = intrinsic value + time value)**

__Intrinsic value:__ The intrinsic value of an option is the difference between the actual price of the underlying security and the strike price of the option. The intrinsic value of an option reflects the effective financial advantage which would result from the immediate exercise of that option. The intrinsic value of an option reflects the effective financial advantage which would result from the immediate exercise of that option.

**Condition** | **Call** | **Put** |

Strike price < underlying security price | In-the-money Intrinsic value >0 | Out-of-the-money Intrinsic value = 0 |

Strike price > underlying security price | Out-of-the-money Intrinsic value = 0 | In-the-money Intrinsic value >0 |

Strike price = underlying security price | At-the-money Intrinsic value = 0 | At-the-money Intrinsic value = 0 |

__Time value__: It is determined by the remaining lifespan of the option, the volatility and the cost of refinancing the underlying asset (interest rates).

Time value = option price - intrinsic value

Examples

**Option** | **Strike** | **Option Premium** | **Stock** | **Intrinsic Value** | **Time Value** |

Call | 3 | Rs.3 | Rs.29 | Rs.1 | Rs.2 |

Put | 50 | Rs.4 | Rs.52 | Rs.2 | Rs.2 |

Call | 25 | Rs.2 | Rs.25 | Rs.0 | Rs.2 |

Put | 100 | Rs.6 | Rs.101 | Rs.1 | Rs.5 |

Call | 15 | Rs.1 | Rs.16 | Rs.0 | Rs.1 |

Put | 40 | Rs.18 | Rs.55 | Rs.15 | Rs.3 |

*Notice in the above examples that the intrinsic value plus the time value equals the total premium of the option.*

**Factors determining the option price**

There are 6 factors which impact on the price of an option. These factors are:

**Factor rises / is higher** | **Price of call** | **Price of put** |

Option exercise price | lower | higher |

Current underlying price | higher | lower |

Remaining life | higher | higher |

Volatility | higher | higher |

Interest rates | higher | lower |

Dividend | lower | higher |

**What is an at-the-money option? An in-the-money option? An out-of-the money option?**

When the price of the underlying security is equal to the strike price, an option is at-the-money.

A call option is in-the-money if the strike price is less than the market price of the underlying security. A put option is in-the-money if the strike price is greater than the market price of the underlying security.

A call option is out-of-the-money if the strike price is greater than the market price of the underlying security. A put option is out-of-the money if the strike price is less than the market price of the underlying security.

Examples **Option** | **Strike** | **Stock** | **At-the-money**
** In-the-money**
** Out-of-the-money** |

Call | 35 | Rs.29 | out-of-the-money |

Put | 45 | Rs. 52 | out-of-the-money |

Call | 25 | Rs.25 | at-the-money |

Put | 100 | Rs.101 | at-the-money |

Call | 10 | Rs.16 | in-the-money |

Put | 40 | Rs.25 | in-the-money |

Advanced Concepts

**Delta**

Option Delta is the change in the price of an option for a one point moves in the underlying.

Call options: 0 < Option Delta < 1

Put options: -1 < Option Delta < 0

In-the-money options: Delta Option approaches 1 (call:+1,put:-1)

At-the-money options: Delta is about 0.5 (call:+0.5, put: -0.5)

Out-of-the-money options: Delta Option approaches 0

Call Option Delta can be interpreted as the probability that the option will finish in the money. An at-the-money option, which has a delta of approximately 0.5, has roughly a 50/50 chance of ending up in-the-money.

Put Option Delta can be interpreted as -1 times the probability that the option will finish in the money.

**Hedge ratio** Since Delta Option is a measure of how sensitive an option's price is to changes in the underlying, it is useful as a hedge ratio. A futures option with a delta of 0.5 means that the option price increases 0.5 for every 1 point increase in the futures price. For small changes in the futures price therefore, the option behaves like one-half of a futures contract. Constructing a delta hedge for a long position in 10 calls, each with a delta of 0.5 would require you to sell 5 futures contracts. (The delta of a futures is always 1).

Delta Option and Time to expiration -As time passes, the delta of in-the-money options increases and the delta of out-of-the-money options decreases. Delta Option and Volatility -As volatility falls, the delta of in-the-money options increases and the delta of out-of-the-money options decreases.

**Gamma**

Option Gamma is the change in an option's delta for a one-point change in the price of the underlying.

The option gamma of a long option position (both calls and puts) is always positive. This means that the delta increases as the underlying price increases and that delta falls as the underlying price falls. At-the-money options have the largest gamma. The further an option goes in-the-money or, out-of-the-money the smaller is gamma.

Gamma Option and Time to expiration -As time passes, the gamma of at-the-money options increases, the gamma of deep in-the-money and out-of-the-money options decreases. Gamma Option and Volatility - As volatility falls, the gamma of at-the-money options increases, the gamma of deep in-the-money and out-of-the-money options decreases.

**Theta**

Option Theta is defined as the change in the price of an option for a 1-day decrease in the time remaining to expiration.

At-the-money options have the greatest time value and the greatest rate of time decay (option theta). The further an option goes in-the-money or out-of-the-money, the smaller is theta.

Theta Option and Time to expiration -As time passes, the theta of at-the-money options increases, the theta of deep in-the-money and out-of-the-money options decreases. Theta Option and Volatility -As volatility falls, time value declines, option theta declines.

**Vega**

Option Vega is the change in the value of an option for a 1-percentage point increase in implied volatility. The vega of a long option position (both calls and puts) is always positive.

At-the-money options have the greatest vega. The further an option goes in-the-money or out-of-the-money, the smaller is vega.

Vega Option and Time to expiration - As time passes, option vega decreases. Time amplifies the effect of volatility changes. As a result, vega is greater for long-dated options than for short dated options. Vega Option and Volatility - As volatility falls, vega decreases for in-the-money and out-of-the-money options; vega is unchanged for at-the-money options. Option Strategies**Single Options** ** Long Call ( Call Purchase )** Anticipations - A strong, upward move in the underlying asset is anticipated.Characteristics - Unlimited profit / limited loss. Max profit - unlimited. Max loss - limited to the net debit required to establish the position.
Example Security(IDFC) price - Rs. 100 Long 1 IDFC 100 Call - Rs. 6.5 Max profit = unlimited Max loss = Rs. 6.5 * 100 = Rs. 650
Buy OTM call option if very bullish, Buy ITM call option if less | **Put ( Put Purchase )**Anticipations -A strong, downward move in the underlying asset is anticipated. Characteristics - Limited profit / limited loss. Max profit - unlimited. Max loss - limited to the net debit required to establish the position. Example Security(IDFC) price - Rs. 100 Long 1 IDFC 100 Put - Rs. 5.8 Max profit = unlimited Max loss = Rs. 5.8 * 100 = Rs. 580 Buy OTM put option if very bearish, Buy ITM put option if less. |

**Short Call ( Uncovered Call )** Anticipations -A downward move in the underlying asset is anticipated. Characteristics - Limited profit / unlimited loss. Max profit - limited to the net credit received. Max loss - unlimited. Example Security(IDFC) price - Rs. 100 Short 1 IDFC 110 Call - Rs. 3 Max profit = Rs. 3 * 100 = Rs. 300 Max loss = unlimited Sell ITM call option if very bearish, Sell OTM call option if less. | **Short Put ( Naked Put )** Anticipations - An upward move in the underlying asset is anticipated. Characteristics -Limited profit / unlimited loss. Max profit - limited to the net credit received. Max loss - unlimited. Example Security(IDFC) price - Rs. 100 Short 1 IDFC 90 Put - Rs. 2 Max profit = Rs. 2 * 100 = Rs. 200 Max loss = unlimited Sell ITM put option if very bullish, sell OTM put option if less. |

** ****Covered Write**** **

**Covered Call ** Anticipations - A downward move in the underlying asset. Characteristics Max profit - limited.Max loss - unlimited. Example Buy 100 shares (SBI) - Rs. 35 Short 1 SBI 40 Call - Rs. 0.65 Max profit = Rs. [(40 - 35) + 0.65] * 100 = Rs. 565 Max loss = unlimited
Covered call writing is where the trader or investor owns an equal amount of the underlying asset for which the calls are written. This strategy benefits from a slight increase or a decrease in the price of the underlying asset. |

**Vertical Spreads** ** Bull Call Spread ( Bull Debit Spread )**
Anticipations - An upward move in the underlying asset, but the extent of the move is uncertain. Characteristics - Limited profit / limited loss.
Max profit - difference between the strike prices less net debit of spread. Max loss - limited to the net debit required to establish the position.
Example Security(IDFC) price - Rs. 100 Long 1 IDFC 100 Call - Rs. 6.5 Short 1 IDFC 110 Call - Rs. 2.8 Max profit = Rs. [(110 - 100) - (6.5 - 2.8)] * 100 = Rs. 630 Max loss = Rs. (6.5 - 2.8) * 100 = Rs. 370
If a rise in implied volatility is expected : buy ATM call / sell OTM call. If a fall in implied volatility is expected: buy ITM call / sell ATM call. | ** Bear Debit Spread ( Bear Put Spread )** Anticipations - A downward move in the underlying asset, but the extent of the move is uncertain. Characteristics - Limited profit / limited loss. Max profit - limited to difference between the strike prices less net debit of the spread. Max loss - limited to the net debit required to establish the position.
Example
Security(IDFC) price - Rs. 100 Short 1 IDFC 90 Put - Rs. 2 Long 1 IDFC 100 Put - Rs. 5.8 Max profit = Rs. [(100 - 90) - (5.8 - 2)] * 100= Rs. 620 Max loss = Rs. (5.8 - 2) * 100 = Rs. 380
If a fall in implied volatility is expected: buy ITM put / sell ATM put. If a rise in implied volatility is expected: buy ATM put / sell OTM put. |

**Bull Put Spread ( Bull Credit Spread )** Anticipations - An upward move in the underlying asset, but the extent of the move is uncertain. Characteristics - Limited profit / limited loss. Max profit - limited to the net credit received Max loss - difference between the strike prices less net credit received Example Security(IDFC) price - Rs. 100 Long 1 IDFC 100 Put - Rs. 5.5 Short 1 IDFC 110 Put - Rs. 12 Max profit = Rs. (12 - 5.5) * 100 = Rs. 650 Max loss = Rs. [(110 - 100) - (12 - 5.5)] * 100 = Rs. 350
If a rise in implied volatility is expected : buy ATM put / sell ITM put If a fall in implied volatility is expected: buy OTM put / sell ATM put | ** Bear Credit Spread ( Bear Call Spread )** Anticipations - A downward move in the underlying asset, but the extent of the move is uncertain. Characteristics - Limited profit / limited loss. Max profit - limited to the net credit received. Max loss - difference between the strike prices less net credit received. Example Security(IDFC) price - Rs. 100 Short 1 IDFC 90 Call - Rs. 12.8 Long 1 IDFC 100 Call - Rs. 6.5 Max profit = Rs. (12.8 - 6.5) * 100 = Rs. 630 Max loss = Rs. [(100 - 90) - (12.8 - 6.5)] * 100 = Rs. 370
If a fall in implied volatility is expected:sell ATM call / buy OTM call If a rise in implied volatility is expected:sell ITM call / buy ATM call. |

**Straddles** **Long Straddle ( Straddle Purchase )**
Anticipations - A very volatile, immediate, and sharp swing in the price of the underlying asset is expected. The actual market direction is uncertain,so the positions of this strategy will benefit if the underlying asset either rises or falls.
Characteristics - Unlimited profit / limited loss.
Max profit - unlimited. Max loss - limited to the net debit required to establish the position.
Example Security(ICICI) price - Rs. 35 Long 1 ICICI 35 Call - Rs. 2.3 Long 1 ICICI 35 Put - Rs. 2 Max profit = unlimited Max loss = Rs. (2.3 + 2) * 100 = Rs. 430
Needs a large market move in either direction.
| **Short Straddle ( Straddle Write )** Anticipations - This market outlook anticipates very little movement in the underlying asset. Characteristics - Limited profit / unlimited loss. Max profit - limited to the net credits received. Max loss - unlimited. Example Security(ICICI) price - Rs. 35 Short 1 ICICI 35 Call - Rs. 2.3 Short 1 ICICI 35 Put - Rs. 2 Max profit = Rs. (2.3 + 2) * 100 = Rs. 430 Max loss = unlimited
Needs market direction stability. |

**Strangles** **Long Strangle ( Strangle Purchase )**
Anticipations - A very volatile, immediate, and sharp swing in the price of the underlying asset is expected. The actual market directionis uncertain, so the positions of this strategy will benefit if the underlying asset either rises or falls.
Characteristics - Unlimited profit / limited loss. Max profit - unlimited. Max loss - limited to the net debit required to establish the position
Example Security(IDFC) price - Rs. 100 Long 1 IDFC 110 Call - Rs. 2.8 Long 1IDFC 90 Put - Rs. 2 Max profit = unlimited Max loss = Rs. (2.8 + 2) * 100 = Rs. 480
Needs a large market move in either direction. | **Short Strangle ( Strangle Write )** Anticipations - This market outlook anticipates little movement in the underlying asset. Characteristics - Limited profit / unlimited loss. Max profit - limited to the net credits received. Max loss - unlimited. Example Security(IDFC) price - Rs. 100 Short 1IDFC 110 Call - Rs. 2.8 Short 1 IDFC 90 Put - Rs. 2 Max profit = Rs. (2.8 + 2) * 100 = Rs. 480 Max loss = unlimited
Needs market direction stability. |

**Calendar Spreads ( Time Spreads )** ** Call Time Spread** Anticipations - A quiet, sideways movement in the underlying asset is anticipated. Characteristics Max profit - limited. Max loss - limited to the net debit required to establish the position. Example Security(GMRINFRA) price - Rs. 35 Short 1 GMRINFRA 35 Jan Call - Rs. 1.8 Long 1 GMRINFRA 35 Feb Call - Rs. 2.3 Max loss = Rs. (2.3 - 1.8) * 100 = Rs. 50 This strategy is based on the theory that over time the value of the near-term option will erode faster than the far-term option. | **Put Time Spread** Anticipations - A quiet, sideways movement in the underlying asset is anticipated. Characteristics Max profit - limited. Max loss - limited to the net debit required to establish the position. Example Security(GMRINFRA) price - Rs. 35 Short 1 GMRINFRA 35 Jan Put - Rs. 1.6 Long 1 GMRINFRA 35 Feb Put - Rs. 2 Max loss = Rs. (2 - 1.6) * 100 = Rs. 40
This strategy is based on the theory that over time the value of the near-term option will erode faster than the far-term option. |