Class Notes by Dr.

Anurag Agnihotri
For Student Use only

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

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 QQQ April 30 call option has the right to purchase 100 shares of QQQ 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 QQQ 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 QQQ April 25 put has the right to sell 100 shares of QQQ 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 OCC through a broker before the
date of expiration. All puts covering QQQ 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, XYZ 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 constitued 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
In-the-money Intrinsic value >0 Out-of-the-money Intrinsic value = 0
security price
Strike price > underlying
Out-of-the-money Intrinsic value = 0 In-the-money Intrinsic value >0
security price
Strike price = underlying
At-the-money Intrinsic value = 0 At-the-money Intrinsic value = 0
security price

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
Intrinsic Time
Option Strike Option Premium Stock
Value 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:
 Option exercise price
 Current underlying price
 Remaining life of the option
 Volatility
 Interest rates
 Dividend
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
At-the-money
Option Strike Stock 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

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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.
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Option Strategies
Single Options
Long Call ( Call Purchase ) Anticipations - A Put ( Put Purchase )Anticipations -A strong,
strong, upward move in the underlying asset is downward move in the underlying asset is
anticipated.Characteristics -Unlimited profit / anticipated. Characteristics -Limited profit /
limited loss. limited loss.
Max profit - unlimited. Max profit - unlimited.
Max loss - limited to the net debit required to Max loss - limited to the net debit required to
establish the position. establish the position.

Example Example
Security(IBM) price - Rs. 100 Security(IBM) price - Rs. 100
Long 1 IBM 100 Call - Rs. 6.5 Long 1 IBM 100 Put - Rs. 5.8
Max profit = unlimited Max profit = unlimited
Max loss = Rs. 6.5 * 100 = Rs. 650 Max loss = Rs. 5.8 * 100 = Rs. 580
Buy OTM put option if very bearish, Buy ITM put
Buy OTM call option if very bullish, Buy ITM call option if less.
option if less
Short Call ( Uncovered Call ) Short Put ( Naked Put )
Anticipations -A downward move in the underlying Anticipations - An upward move in the underlying
asset is anticipated. Characteristics - Limited profit asset is anticipated. Characteristics -Limited profit
/ unlimited loss. / unlimited loss.
Max profit - limited to the net credit received. Max profit - limited to the net credit received.
Max loss - unlimited. Max loss - unlimited.
Example Example
Security(IBM) price - Rs. 100 Security(IBM) price - Rs. 100
Short 1 IBM 110 Call - Rs. 3 Short 1 IBM 90 Put - Rs. 2
Max profit = Rs. 3 * 100 = Rs. 300 Max profit = Rs. 2 * 100 = Rs. 200
Max loss = unlimited Max loss = unlimited

Sell ITM call option if very bearish, Sell OTM call Sell ITM put option if very bullish, sell OTM put
option if less. 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 (QQQ) - Rs. 35
Short 1 QQQ 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 ) Bear Debit Spread ( Bear Put Spread )
Anticipations - A downward move in the
Anticipations - An upward move in the underlying underlying asset, but the extent of the move is
asset, but the extent of the move is uncertain. uncertain. Characteristics - Limited profit / limited
Characteristics - Limited profit / limited loss. loss.
Max profit - limited to difference between the
Max profit - difference between the strike prices strike prices less net debit of the spread.
less net debit of spread. Max loss - limited to the net debit required to
Max loss - limited to the net debit required to establish the position.
establish the position.
Example
Example Security(IBM) price - Rs. 100
Security(IBM) price - Rs. 100 Short 1 IBM 90 Put - Rs. 2
Long 1 IBM 100 Call - Rs. 6.5 Long 1 IBM 100 Put - Rs. 5.8
Short 1 IBM 110 Call - Rs. 2.8 Max profit = Rs. [(100 - 90) - (5.8 - 2)] *
Max profit = Rs. [(110 - 100) - (6.5 - 2.8)] * 100 100= Rs. 620
= Rs. 630 Max loss = Rs. (5.8 - 2) * 100 = Rs. 380
Max loss = Rs. (6.5 - 2.8) * 100 = Rs. 370
If a fall in implied volatility is expected: buy ITM
If a rise in implied volatility is expected : buy ATM put / sell ATM put.
call / sell OTM call. If a rise in implied volatility is expected: buy ATM
If a fall in implied volatility is expected: buy ITM put / sell OTM put.
call / sell ATM call.
Bull Put Spread ( Bull Credit Spread ) Bear Credit Spread ( Bear Call Spread )
Anticipations - An upward move in the underlying Anticipations - A downward move in the
asset, but the extent of the move is underlying asset, but the extent of the move is
uncertain. Characteristics - Limited profit / limited uncertain. Characteristics - Limited profit / limited
loss. loss.
Max profit - limited to the net credit received
Max loss - difference between the strike prices
less net credit received
Example
Security(IBM) price - Rs. 100
Long 1 IBM 100 Put - Rs. 5.5
Short 1 IBM 110 Put - Rs. 12
Max profit = Rs. (12 - 5.5) * 100 = Rs. 650
Max loss = Rs. [(110 - 100) - (12 - 5.5)] * 100
= Rs. 350
Max profit - limited to the net credit received.
Max loss - difference between the strike prices
less net credit received.
Example
Security(IBM) price - Rs. 100
Short 1 IBM 90 Call - Rs. 12.8
Long 1 IBM 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 rise in implied volatility is expected : buy ATM If a fall in implied volatility is expected:sell ATM
put / sell ITM put call / buy OTM call
If a fall in implied volatility is expected: buy OTM If a rise in implied volatility is expected:sell ITM
put / sell ATM put call / buy ATM call.

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

Needs a large market move in either direction.

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
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(IBM) price - Rs. 100
loss. Short 1 IBM 110 Call - Rs. 2.8
Max profit - unlimited. Short 1 IBM 90 Put - Rs. 2
Max loss - limited to the net debit required Max profit = Rs. (2.8 + 2) * 100 = Rs. 480
to establish the position Max loss = unlimited

Example Needs market direction stability.

Security(IBM) price - Rs. 100
Long 1 IBM 110 Call - Rs. 2.8
Long 1 IBM 90 Put - Rs. 2
Max profit = unlimited
Max loss = Rs. (2.8 + 2) * 100 = Rs. 480

Needs a large market move in either

direction.

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(QQQ) price - Rs. 35
Short 1 QQQ 35 Jan Call - Rs. 1.8
Long 1 QQQ 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(QQQ) price - Rs. 35
Short 1 QQQ 35 Jan Put - Rs. 1.6
Long 1 QQQ 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.