Chapter 4

Introduction to Basic Option strategies

 Derivative Financial Market

● Hedging
● Derivatives are used to hedge individual positions (micro
hedge) or a number of financial instruments (macro hedge).
● Speculation
● Derivatives can be used to consciously take on market-price
risks in order to achieve a return.
● Arbitrage
● Derivatives enable the exploitation of differences between
the price of a given capital asset in different markets. This is
called "arbitrage".
● Leverage
 Option

Premium: The upfront payment made by the buyer to the seller to

enjoy the privileges of an option contract.

Strike Price Intervals: These are the different strike prices at which
an options contract can be traded. These are determined by the
exchange on which the assets are traded.

There are typically at least 11 strike prices declared for every

type of option in a given month
- 5 prices above the spot price
-5 prices below the spot price and one price equivalent to the
spot price.
 Option- Types
1 According to the option rights
● Call options give you the right—but not the obligation—to buy
something at a specific price for a specific time period.
● Put options give you the right—but not the obligation—to sell
something at a specific price for a specific time period.
2 According to whether underlying is owned-
● A naked option is a trading position where the seller of an option
contract does not own any, or enough, of the underlying security
to act as protection against adverse price movements.
● Covered options when the underlying is owned
 Option- Types
3 According to the underlying assets
● Equity option
● Bond option
● Index option-A financial derivative that gives the holder the right,
but not the obligation, to buy or sell a basket of stocks, such as
the S&P 500, at an agreed-upon price and before a certain date
● Commodity option-A contract permitting the option buyer the
right, without obligation, to buy or sell an underlying asset in the
form of a commodity, such as precious metals, oil, or
agricultural products, at a designated price until a designated
date.
Currency option-Currency options are one of the best ways for
corporations or individuals to hedge against adverse
movements in exchange rates.
 Option- Types
4 According to the trading markets
● Exchange-traded options (also called "listed options") are a
class of exchange-traded derivatives.
● Exchange traded options have standardized contracts, and are
settled through a clearing house with fulfillment guaranteed by
the Options Clearing Corporation (OCC).
● Since the contracts are standardized, accurate pricing models
are often available.
Or OTC options
 Option- Strategies

● Hedging – through purchase or sale of

options
● Speculation- through purchase or

sale of options
 A Hedging with options

Hedging strategies can be useful, especially for large

institutions.
● Even the individual investor can benefit.
● to limit any losses.
● By using options, you would be able to restrict your
downside while enjoying the full upside in a cost-effective
way.
 1 Hedging through purchase and sale of options

1 Hedging through purchase of options

● Buying options is done only when lot of volatality is
expected in the market
● Otherwise hedge with forward contract

2 Hedging through sale of options

● When volatility is only marginal
 B Speculation with options
Purchase of options
● Speculation, by definition, requires a trader to take a position in
a market, where he is anticipating whether the price of a
security or asset will increase or decrease.
● Speculators try to profit big, and one way to do this is by using
derivatives that use large amounts of leverage.
● This is where options come into play.
Options provide a source of leverage because they are quite a
bit cheaper to purchase in comparison to the actual stock.
● This allows a trader to control a larger position in options,
compared with owning the underlying stock
 B Speculation with options
● Speculators make profit out of purchase of options
● Call option – hedgers profit when spot is greater than
strike price...speculators want price to fall ie opposite
direction than hedging

● Put option – hedgers profit when spot is less than strike

price...again speculators want price to rise
 Derivatives-
TermsPayoff
Payoff
The value (amount received by the investor) of an option when it is
exercised.
A Payoff diagram is a graphical representation of the potential outcomes
of a strategy.
A payoff is the likely profit/loss that would accrue to a market
participant with change in the price of the underlying asset.

This is generally depicted in the form of payoff diagrams which show the
price of the underlying asset on the X–axis and the profits/losses on the
Y–axis.
 Positions- Derivatives

●
Long Position: The term used when a person owns/buys
a security or commodity
●
If a person is long in a security then he wants it to go up in
price.

●
Short position: The term used to describe the selling of
a security, commodity, or currency.
●
The investor's sales exceed holdings because they
believe the price will fall.
Derivatives- Payoff
Buy call
Buy call Buy Put

Sell call Sell put

 Payoff for option contracts
Options payoffs

The optionality characteristic of options results in a non-linear payoff for

options.

In simple words, it means that the losses for the buyer of an option are
limited, however the profits are potentially unlimited.

For a writer/seller , the payoff is exactly the opposite.

His profits are limited to the option premium, however his losses are
potentially unlimited.

These non-linear payoffs are fascinating as they lend themselves to be

used to generate various payoffs by using combinations of options and
the underlying.
 1 Long call

The long call option strategy is the most basic option

trading strategy whereby the options trader buy call
options with the belief that the price of the underlying
security will rise significantly beyond the strike price
before the option expiration date.
 1 Long call

Leverage

Compared to buying the underlying shares outright, the call option

buyer is able to gain leverage since the lower priced calls appreciate
in value faster percentage wise for every point rise in the price of the
underlying stock

However, call options have a limited lifespan.

If the underlying stock price does not move above the strike price
before the option expiration date, the call option will expire
worthless.
 1 Long call

Unlimited Profit Potential

Since they can be no limit as to how high the stock price can be at
expiration date, there is no limit to the maximum profit possible
when implementing the long call option strategy.

The formula for calculating profit is given below:

Maximum Profit = Unlimited

Profit Achieved When Price of Underlying >= Strike Price of Long

Call + Premium Paid

Profit = Price of Underlying - Strike Price of Long Call - Premium

Paid
 1 Long call

Limited Risk

Risk for the long call options strategy is limited to the price paid for
the call option no matter how low the stock price is trading on
expiration date.

The formula for calculating maximum loss is given below:

Max Loss = Premium Paid + Commissions Paid

Max Loss Occurs When Price of Underlying <= Strike Price of

Long Call
Suppose the stock of XYZ company is trading at $40. A call option contract with a
strike price of $40 expiring in a month's time is being priced at $2. You believe that XYZ
stock will rise sharply in the coming weeks and so you paid $200 to purchase a single
$40 XYZ call option covering 100 shares. Create a payoff and find the profit if stock
rallied to 50 and loss if it fell to 30.
Solution-
• Say you were proven right and the price of XYZ stock rallies to $50 on option
expiration date.
• With underlying stock price at $50, if you were to exercise your call option, you
invoke your right to buy 100 shares of XYZ stock at $40 each and can sell them
immediately in the open market for $50 a share.
• This gives you a profit of $10 per share. As each call option contract covers 100
shares, the total amount you will receive from the exercise is $1000.
• Since you had paid $200 to purchase the call option, your net profit for the entire
trade is therefore $800.
• However, if you were wrong in your assessment and the stock price had instead
dived to $30, your call option will expire worthless and your total loss will be the
$200 that you paid to purchase the option.
 2 Long put
The long put option strategy is a basic strategy in options trading
where the investor buy put options with the belief that the price
of the underlying security will go significantly below the
striking price before the expiration date.

The risk is capped to the premium paid for the put options, as
opposed to unlimited risk when short selling the underlying stock
outright.

Put options have a limited lifespan.

If the underlying stock price does not move below the strike price
before the option expiration date, the put option will expire
worthless.
 2 Long put
Unlimited" Potential of profit

Since stock price in theory can reach zero at expiration date, the
maximum profit possible when using the long put strategy is only
limited to the striking price of the purchased put less the price paid for
the option.

The formula for calculating profit is given below:

Maximum Profit = Unlimited

Profit Achieved When Price of Underlying = 0
Profit = Strike Price of Long Put - Premium Paid
 2 Long put

Limited Risk

Risk for implementing the long put strategy is limited to the price
paid for the put option no matter how high the stock price is trading
on expiration date.

The formula for calculating maximum loss is given below:

Max Loss = Premium Paid + Commissions Paid
Max Loss Occurs When Price of Underlying >= Strike Price of Long
Put
Suppose the stock of XYZ company is trading at $40. A put option contract with a strike
price of $40 expiring in a month's time is being priced at $2. You believe that XYZ stock
will fall sharply in the coming weeks and so you paid $200 to purchase a single $40 XYZ
put option covering 100 shares. If the stock crashed to 30$ or rallied to 50 what will be
your position?

Say you were proven right and the price of XYZ stock crashes to $30 at option expiration date.
With underlying stock price now at $30, your put option will now be in-the-money with an
intrinsic value of $1000 and you can sell it for that much.

Since you had paid $200 to purchase the put option, your net profit for the entire trade is
therefore $800.

However, if you were wrong in your assessement and the stock price had instead rallied to $50,
your put option will expire worthless and your total loss will be the $200 that you paid to
purchase the option.
 3 short call
The short call is an intriguing position to open, if only because so
many traders see it as way too risky to even consider

When an investor takes a short call position, the security’s price

must fall in order for the strategy to be profitable.

Not only must the price fall, it must fall by at least the price of the
call option. The farther the fall, the greater the profit.

Conversely, should the investor’s hunch fail and the security’s price
thus rise, the strategy loses money for the investor.

As there is no boundary for how high the price can rise, the
potential losses are unlimited.

Profit amount is having very low profit potential.

 short call

Potential Profit: Limited to premium received from call's initial sale

Potential Loss: Unlimited as the underlying stock price increases
 short call
You own of 100 shares of The XYZ Company which is trading at $35/share. You don't
want to sell the shares at the current price, and you don't think the stock is going to be
moving significantly higher any time soon. But you want to try and earn a little extra profit
out of your position. You decided to sell a call option that expires in 2 months at the $40
strike price for $1.50.

Solution

Since each contract represents 100 shares of the underlying stock, that equates to $150
excluding commissions ( 1.5* 100= 150)

By selling the call, or writing it, you have essentially given someone else the right to purchase
your stock at any point over the next two months for $40/share.

In exchange, you've received $150 in cash.

If the stock is trading below $40/share at expiration, the call option you sold expires worthless

And if the stock is trading significantly higher, say $50/share? Since you were obligated to
sell at $40/share, you missed out on $10/share in capital gains.

In this example, you do still get a $5/share gain (selling the $35 stock for $40/share), and the
original $150 premium you collected is yours to keep.
Basic payoff function for Short Call Option without considering the price or premium of
the call option. (in pink)

Microsoft stock (not the microsoft option) is currently trading at $30

per share. You are of the opinion that in 2 months time, the
Microsoft share price will come down to $25 or below. Create a
payoff
 short call
● SHORT (or sell) Microsoft call option with a strike price of $30 and from
this sale you receive $5.(profit)

● Hence, as shown in the payoff function above, The PINK colored graph
then shifts upwards by $5 - the RED colored payoff function.

●
What this tells you is that if the microsoft stock remains below the
strike price of $30 on the expiry day, then you will keep the entire $5
you got from the sale of Microsoft call option - as indicated by the
horizontal flat line of the RED graph.

● However, If the price of microsoft on the expiry day is higher then

the strike price of $30, then your profits will start coming down in a
linear fashion - as indicated by the 2nd part of the slanting RED graph.
 4 short put

A trader who believes that a stock price will increase can sell the stock or instead sell, or "write", a
put.
The trader selling a put has an obligation to buy the stock from the put buyer, at the buyer's option.
If the stock price at expiration is above the exercise price, the short put position will make a
profit in the amount of the premium.
If the stock price at expiration is below the exercise price by more than the amount of the
premium, the trader will lose money, with the potential loss being up to the full value of the
stock.
 4 short put
When the investor enters a short put position, the security’s price must
rise in order for the strategy to turn a profit.
Furthermore, the price must rise by at least the price of the put option
(the “premium”).
The higher the price rises, the more money the investor makes.

Conversely, should the investor have initially erred and the security’s
price then fall, the strategy would lose money.

The upper bound on the losses is the value of the stock.

When an investor enters into a short put strategy, he or she is locking the
price of an underlying security at the strike price and keeping the
premium for writing the put option.

Entering into a short put position is considered a risky strategy because

an investor is bound by a profit limited to the premium received for selling
the put option, but exposed to a higher potential loss only bounded by
the underlying security going to zero minus the premium received
Company XYZ just came out with the latest and greatest gadget. The price of the stock soars to
$100 after the announcement. You want to buy the stock but feel that the price has gone too high
because of the hype around. You'd be willing to buy the stock for $95.
The following are quotes for XYZ put options.
The put contract obligates the put seller to buy the shares of stock at the strike price of
the put.
On the surface you'd think you should look to the $95 strike price put. However, you need to
take into consideration the $2 per share premium received when selling the put.

The table shows that selling the $97 strike put for $2 gives us an effective buying price on the
stock of $95.

Payoff-
The blue line represents the profit or loss of a stock-only position, and assumes you buy the
stock at $100 per share.

The red line represents the profit or loss of a short put position.
If the stock is below $97 at the contract expiration, you will be obligated to buy shares of stock
from the put owner for the $97 contract strike price.

The effective purchase price on the shares is $95 since you received a $2 payment up front.

At $95 per share, you have the same downside risk of stock ownership. This is evident by the
parallel red and blue lines.

If the stock price is above $97 at time of the contract expiration, the owner of the contract would
not exercise the contract since he would able to sell the stock at a higher price in the open
market. The contract would expire worthless.

This leaves the put seller with a $2 per share profit from the premium received. Of course, the
seller would not own the stock, and would not profit from the increase in the price of the stock.
 Option Strategy- Sum 3

Formula-

If S is a final price of the option underlying security, X is a strike price

and OP is an option price, than the profit is

Long Call: P = S - X - OP
Short Call: P = X - S + OP
Long Put: P = X - S - OP
Short Put: P = S - X + OP

OP=2 X= 53 S= 56

36
 Option Strategy
The stock price of Nestle is $50.00, suppose you bought a
European call option with strike $53.00 and you paid $2.00 for this
option. If option price is less than $53.00,will you exercise the
option?

(will not exercise the option to buy the stock, because it doesn't make
sense to buy security for higher price than it costs on the market. In this
case we lose all initial investment equal to the option price $2.00. If stock
price is more than $53.00, we will exercise the option.)

Type- long call

1 If the stock price is $56.00, after exercising the option and
immediately reselling, what will be your profit?

the acquired stock our profit will be: 37

P = $56.00 - $53.00 - $2.00 = $1.00
 Option Strategy

2 if the stock price is $54.00, What is the profit?

than the profit is:P = $54.00 - $53.00 - $2.00 = - $1.00

As we see in latter case we lose money.

The reason is that increase of stock price just by $1.00 above the strike
($53.00) doesn't cover our initial investment of $2.00, although we still
exercise the option to recover at least $1.00 of initial investment.

3 If the stock price at exercise time is $55.00 than we exercise the

option to cover our initial expenses(equal to option price):

P = $55.00 - $53.00 - $2.00 = $0.00

38
 Option Strategy
● Option strategies are the simultaneous, and often mixed, buying or
selling of one or more options that differ in one or more of the
options' variables.

● This is often done to gain exposure to a specific type of opportunity

or risk while eliminating other risks as part of a trading strategy.

● A very straight forward strategy might simply be the buying or selling

of a single option, however option strategies often refer to a
combination of simultaneous buying and or selling of options.

● Options strategies allow to profit from movements in the underlying

that are bullish, bearish or neutral.

● In the case of neutral strategies, they can be further classified into

those that are bullish on volatility and those that are bearish on
volatility. 39
● The option positions used can be long and/or short positions in calls
 Option Strategy- sum 4

XYZ has purchased today July 21,2015 a call in reliance stock at a

strike price of Rs 310 and also a put in Bajaj Auto at Rs 450 for
January 2016 option contract. Suppose in the month of January 2016,
the prices of both the stocks are as under

Situation Reliance Bajaj Auto

1 295 458
2 310 450
3 320 440
Find out whether the call and put options are 'in the money', 'out of the
money' or 'at the money'. 40
 Option Strategy
1 The spot value of the call is lower than the strike price as 295 <
310 and the spot value of the put is higher than the strike price 458
> 450. In both the cases, options cannot be exercised, so they are
out of money.

2 the strike price and spot price for both call and put are the same,
so both options are at the money.

3 The spot price of the call is higher than the strike price 320 > 310
and the spot price of the put is less than the strike price 440 < 450
so both options are in the money.

The call is in the money when the spot price is greater than the strike
price.
Put is in the money when spot price is lower than strike price. In both
situations it is beneficial to exercise the option.
When the strike price and the spot price are the same, the option are at
the money. 41