Risk Management using Options

Options

Options are the most recent and evolved derivative contracts.

They have non linear or asymmetrical profit profiles making
them fundamentally very different from futures and forward
contracts.
An option gives the holder of the option the right to do
something in future. The holder does not have to exercise this
right.
An option is a legal contract which gives the holder the
right to buy or sell a specific amount of underlying asset at a
fixed price within a specified period of time.

Options

Call Option

Buyer

Put Option

Seller

Buyer

Seller

Right to buy Obligations to sell Right to sell

Obligation to bu

Pays premiumReceives the premiumPays premiumReceives the prem

3

OPTION TYPES

Stock Options

Index Options

Foreign currency options

Interest rate options

Futures options
4

PARTIES TO THE OPTIONS

CONTRACT

BUYER
Long Position

Option Exchange
-----------------------OTC

SELLER
Short Position

Option Terminology

Index options: Have the index as the underlying. They can be European or
American. They are also cash settled.
Stock options: They are options on individual stocks and give the holder
the right to buy or sell shares at the specified price. They can be European
or American.
Buyer of an option: The buyer of an option is the one who by paying the
option premium buys the right but not the obligation to exercise his option
on the seller/writer.
Writer of an option: The writer of a call/put option is the one who
receives the option premium and is thereby obliged to sell/buy the asset if
the buyer exercises on him.

Call option: It gives the holder the right but not the obligation to buy an
asset by a certain date for a certain price.
Put option: It gives the holder the right but not the obligation to sell an
asset by a certain date for a certain price.
Option price/premium: It is the price which the option buyer pays to the
option seller. It is also referred to as the option premium.
Expiration date: The date specified in the options contract is known as
the expiration date, the exercise date, the strike date or the maturity.

Strike price: The price specified in the options contract is known as the
strike price or the exercise price.
American options: These can be exercised at any time up to the expiration
date.
European options: These can be exercised only on the expiration date
itself. European options are easier to analyze than American options.

OPTION POSITIONS

Buy call

Buy put

Write call

Write put

PROFITABILITY OF OPTIONS
S=Stock price
&
x= exercise price

Price
S>X
S=X

S<X

Call Option

Put Option

In the Money

Out of the Money

At the Money

At the Money

Out of the Money

In the Money
10

EXERCISE FOR OTM, ITM & ATM

Stock
Price (S)

Strike
Price (X)

Condition

Status for
call

Status for
put

270

360

S<X

OTM

ITM

300

360

S<X

OTM

ITM

360

360

S=X

ATM

ATM

400

360

S>X

ITM

OTM

450

360

S>X

ITM

OTM

500

360

S>X

ITM

OTM
11

Option Terminology

In-the-money option: An in-the-money (ITM) option would lead to a

positive cash flow to the holder if it were exercised immediately. A call
option on the index is said to be in-the-money when the current index
stands at a level higher than the strike price (i.e. spot price > strike price).
If the index is much higher than the strike price, the call is said to be deep
ITM. In the case of a put, the put is ITM if the index is below the strike
price.
At-the-money option: An at-the-money (ATM) option would lead to zero
cash flow if it were exercised immediately. An option on the index is atthe-money when the current index equals the strike price (i.e. spot price =
strike price).

Option Terminology

Out-of-the-money option: An out-of-the-money (OTM) option would

lead to a negative cash flow if it were exercised immediately. A call
option on the index is out-of-the money when the current index stands at a
level which is less than the strike price (i.e. spot price < strike price).
If the index is much lower than the strike price, the call is said to be deep
OTM. In the case of a put, the put is OTM if the index is above the strike
price.

Option Terminology

The option premium has two components intrinsic value

and time value.
Intrinsic value of an option at a given time is the amount the
holder of the option will get if he exercises the option at that
time.
The intrinsic value of a call is Max[0, (St K)] which means
that the intrinsic value of a call is the greater of 0 or (St K).
Similarly, the intrinsic value of a put is Max[0, K St],i.e.
the
greater of 0 or (K St).
K is the strike price and St is the spot price.

Option Terminology

Time value of an option: The time value of an option is the difference

between its premium and its intrinsic value. Both calls and puts have time
value.
The longer the time to expiration, the greater is an options time value, all
else equal.
At expiration, an option should have no time value.

Intrinsic value
Intrinsic value of call option = Max (0, So - E)
Intrinsic value of put option = Max (0, E - So)
Time value
Time value of a call option = C [Max(0, So - E)]
Time value of a put option = P [Max(0, E - So)]

Futures Vs Options
1.Linear pay off
2.Both long and short are at risk
3.Price of the asset is determined
by the market forces
4.Buyer and seller need not pay
premium
5.Both the parties must deposit
margin money
6.Maximum loss to both buyer and
seller is unlimited
7.Futures do not have different
strike prices

1.Non linear payoff

2. Only short is at risk
3.Price of the option is determined
by market forces
4. Buyer must pay the premium to
the seller
5.Only the seller must pay the
margin money
6.Maximum loss to the buyer is
limited to the premium paid.
7.Options are available at different
strike prices.

1. Payoff profile of buyer of asset: Long asset

In this basic position, an investor buys the underlying asset,
Nifty for instance, for 2220, and sells it at a future date at an
unknown price, St. Once it is purchased, the investor is said to
be long the asset. If the index goes up there is a profit else
losses.

2. Payoff profile for seller of asset: Short asset

In this basic position, an investor shorts the underlying asset,
Nifty for instance, for 2220, and buys it back at a future date at
an unknown price, St. Once it is sold, the investor is said to be
short the asset. If the index falls, there are profits, else losses

3. Payoff profile for buyer of call options: Long call

4. Payoff profile for writer of call options: Short call

5. Payoff profile for buyer of put options: Long put

6. Payoff profile for writer of put options: Short put

Option trading strategies

1. Long stock long put

Consider an investor who buys a share for

Rs.100. To guard against the risk of loss from
a fall in price, he buys a put for Rs.16 for an
exercise price of Rs.110. Explain how this
position will perform in different price
scenarios on expiration.

Solution:
Share price Rs.100
Net profit = P/L on option + P/L on share- premium
Share
price

Exercise
price

P/L on option

P/L on share

Premium

Net profit

70

110

110-70 = 40

70-100 = -30

16

-6

80

110

30

-20

16

-6

90

110

20

-10

16

-6

100

110

10

16

-6

110

110

10

16

-6

120

110

--

20

16

130

110

--

30

16

14

140

110

--

40

16

24

Option trading strategies

2. Short stock long call
An investor shorts a share at Rs. 100 and buys
a call option for Rs. 4 with a strike price of
Rs.105. How will this position perform?

Solution:
Share price

Exercise
price

P/L on
option

P/L on
share

Premium

Net profit

90

105

--

10

95

105

--

100

105

--

-4

105

105

--

-5

-9

110

105

-10

-9

115

105

10

-15

-9

120

105

15

-20

-9

Option trading strategies

3. long stock Short call
An investor who has bought a share for Rs.100
and who writes a call with a exercise price of
Rs.105 and receives a premium of Rs.3. How
will this position perform?

Solution:
Share price

Exercise
price

P/L on
option

P/L on
share

Premium

Net profit

90

105

--

-10

-7

95

105

--

-5

-2

100

105

--

105

105

--

110

105

-5

10

115

105

-10

15

120

105

-15

20

Option trading strategies

4. Short stock Short put
An investor short a share at Rs. 100 and write
a put option for Rs.3 having an exercise price
of Rs.100. Prepare a profit/Loss profile for this
position.

Solution:
Share price

Exercise
price

P/L on
option

P/L on
share

Premium

Net profit

90

100

-10

10

95

100

-5

100

100

105

100

--

-5

-2

110

100

--

-10

-7

115

100

--

-15

-12

120

100

--

-20

-17

Spreads and combinationsTrading strategies

Spread: A spread position is taken by taking position

in two or more options of the same type (call or put
options). Imp. Spread strategies are bull spread, bear
spread, butterfly spreads, box spread, calendar spread
etc.

Combinations: In combination trading strategies one

takes position in both calls and puts on the same
stock. Imp. Combination strategies are straddles,
strips, straps and strangles.
32

Combinations- trading strategies

Combinations are trading strategies where the trader
takes positions in both call and put options on the
same stock.
1.
2.
3.
4.
5.

Straddle
Strips
Straps
Strangle
Condor
33

Straddle
This is an appropriate strategy when an investor is
expecting a large move in a stock price but does not
know the direction of the move.
One can buy the straddle or sell the straddle.
Sellers position is reverse of that of the buyer.

34

STRADDLE STRATEGY-purchase
Buy both call and put on the same stock and same strike price and expiry
date
(in Rs.)

Stock
price
70

Strike
price
110

Call
premium
5

Put
premium
3

P/L

80

110

22

90

110

12

100

110

02

110

110

-8

120

110

02

130

110

12

140

110

22

150

110

32

32

35

STRADDLE STRATEGY : PAY OFF

(bottom straddle)

36

STRIPS STRATEGY
Long position in one call and two puts
(When we feel greater likelihood of decrease in price)
(in Rs.)

Stock
price

Strike
price

Call
premium

Put
premium

P/L

70
80
90

110
110
110

5
5
5

3X2=6
3X2=6
3X2=6

69
49
29

100
110
120

110
110
110

5
5
5

3X2=6
3X2=6
3X2=6

09
-11
-1

130
140
150

110
110
110

5
5
5

3X2=6
3X2=6
3X2=6

9
19
29

37

STRIPS STRATEGY
Long position in one call and two puts

38

STRAP STRATEGY
Long position in two calls and one put
(When we feel greater likelihood of increase in price)
(in Rs.)

Stock
price

Strike
price

Call
premium

Put
premium

P/L

70
80
90

110
110
110

5X2=10
5X2=10
5X2=10

3
3
3

27
17
7

100
110
120
130

110
110
110
110

5X2=10
5X2=10
5X2=10
5X2=10

3
3
3
3

-3
-13
7
27

140
150

110
110

5X2=10
5X2=10

3
3

47
67
39

STRAP STRATEGY
Long position in two calls and one put

40

STRANGLE STRATEGY
Long position in put and call option with same expiry date different exercise price
Put exercise price(100) < call exercise price(110)

Stock
price

Strike
price

Call
premium

Put
premium

P/L

70
80
90

100/110
100/110
100/110

5
5
5

3
3
3

22
12
2

100
110
120

100/110
100/110
100/110

5
5
5

3
3
3

-8
-8
2

130
140
150

100/110
100/110
100/110

5
5
5

3
3
3

12
22
32

41

STRANGLE STRATEGY
(squeeze neck to kill)

42

Condor

Here the trader takes positions in 4 options at 4 strike

prices. It can be long condor or short condor.

Long condor (using calls): Here the trader buys 2 call

options at the extreme strike prices(E1 and E4) and
sells 2 call options at the middle strike prices(E2 and
E3)

43

Strike prices and premium (Rs.)

E2-E1=E4-E3 and E3-E1=2(E2-E1)
Strike prices

Premium

E1

Strike prices of
calls
90

E2

100

+9 (Sells)

E3

110

+5 (Sells)

E4

120

-2

Net

-17 (Buys)

(Buys)

-5
44

Option Greeks
In mathematical finance, the Greeks are the
quantities representing the sensitivity of the
price of derivatives such as options to a
change in underlying parameters on which the
value of an instrument or portfolio of financial
instruments is dependent.
The name is used because the most common of
these sensitivities are often denoted by Greek
letters.
Collectively these have also been called the

Option Greeks
DELTA
THETA
GAMMA
VEGA
RHO

Option Greeks
DELTA The amount by which the price of an option changes as
compared to a $1 increase in the price of a stock expressed as a
decimal or percentage.
THETA The amount that the price of an option changes as compared
to the passage of time [typically 1 day], which is a negative number
because the value of the option decreases with time.
GAMMA- The amount that DELTA changes as compared to a $1
increase in the price of the stock which may be important where the
DELTA becomes particularly sensitive to changes in the stock price.

Option Greeks
VEGA is the measure of volatility in the underlying
stock, the amount the option price changes with an
increase in volatility.
RHO - the amount that the price of an option changes
as compared to a unit increase in the risk free rate
(i.e., short term US Treasury Bill rate), the least
important Greek because most options are short term
in nature and so interest costs are a smaller
component of the overall change in the option price.