An option is a contract between two parties giving the taker (buyer) the right, but not the obligation, to buy or sell a parcel of shares at a predetermined price possibly on, or before a predetermined date. To acquire this right the taker pays a premium to the writer (seller) of the contract.

There are two types of options:

• Call Options
• Put Options

Call options

Call options give the taker the right, but not the obligation, to buy the underlying shares at a predetermined price, on or before a predetermined date.

Illustration 1:

Raj purchases 1 Satyam Computer (SATCOM) AUG 150 Call --Premium 8

This contract allows Raj to buy 100 shares of SATCOM at Rs 150 per share at any time between the current date and the end of next August. For this privilege, Raj pays a fee of Rs 800 (Rs eight a share for 100 shares).

The buyer of a call has purchased the right to buy and for that he pays a premium.

Now let us see how one can profit from buying an option.

Sam purchases a December call option at Rs 40 for a premium of Rs 15. That is he has purchased the right to buy that share for Rs 40 in December. If the stock rises above Rs 55 (40+15) he will break even and he will start making a profit. Suppose the stock does not rise and instead falls he will choose not to exercise the option and forego the premium of Rs 15 and thus limiting his loss to Rs 15.

Let us take another example of a call option on the Nifty to understand the concept better.

Nifty is at 1310. The following are Nifty options traded at following quotes.

A trader is of the view that the index will go up to 1400 in Jan 2002 but does not want to take the risk of prices going down. Therefore, he buys 10 options of Jan contracts at 1345. He pays a premium for buying calls (the right to buy the contract) for 500*10= Rs 5,000/-.

In Jan 2002 the Nifty index goes up to 1365. He sells the options or exercises the option and takes the difference in spot index price which is (1365-1345) * 200 (market lot) = 4000 per contract. Total profit = 40,000/- (4,000*10).

He had paid Rs 5,000/- premium for buying the call option. So he earns by buying call option is Rs 35,000/- (40,000-5000).

If the index falls below 1345 the trader will not exercise his right and will opt to forego his premium of Rs 5,000. So, in the event the index falls further his loss is limited to the premium he paid upfront, but the profit potential is unlimited.

Call Options-Long & Short Positions

When you expect prices to rise, then you take a long position by buying calls. You are bullish.

When you expect prices to fall, then you take a short position by selling calls. You are bearish.

A Put Option gives the holder of the right to sell a specific number of shares of an agreed security at a fixed price for a period of time.

eg: Sam purchases 1 INFTEC (Infosys Technologies) AUG 3500 Put --Premium 200

This contract allows Sam to sell 100 shares INFTEC at Rs 3500 per share at any time between the current date and the end of August. To have this privilege, Sam pays a premium of Rs 20,000 (Rs 200 a share for 100 shares).

The buyer of a put has purchased a right to sell. The owner of a put option has the right to sell.

Illustration 2: Raj is of the view that the a stock is overpriced and will fall in future, but he does not want to take the risk in the event of price rising so purchases a put option at Rs 70 on ‘X’. By purchasing the put option Raj has the right to sell the stock at Rs 70 but he has to pay a fee of Rs 15 (premium).

So he will breakeven only after the stock falls below Rs 55 (70-15) and will start making profit if the stock falls below Rs 55.

Illustration 3:

An investor on Dec 15 is of the view that Wipro is overpriced and will fall in future but does not want to take the risk in the event the prices rise. So he purchases a Put option on Wipro.

Quotes are as under:

Spot   Rs 1040

Jan Put at 1050 Rs 10

Jan Put at 1070 Rs 30

He purchases 1000 Wipro Put at strike price 1070 at Put price of Rs 30/-. He pays Rs 30,000/- as Put premium.

His position in following price position is discussed below.

1. Jan Spot price of Wipro = 1020
2. Jan Spot price of Wipro = 1080

In the first situation the investor is having the right to sell 1000 Wipro shares at Rs 1,070/- the price of which is Rs 1020/-. By exercising the option he earns Rs (1070-1020) = Rs 50 per Put, which totals Rs 50,000/-. His net income is Rs (50000-30000) = Rs 20,000.

In the second price situation, the price is more in the spot market, so the investor will not sell at a lower price by exercising the Put. He will have to allow the Put option to expire unexercised. He looses the premium paid Rs 30,000.

Put Options-Long & Short Positions

When you expect prices to fall, then you take a long position by buying Puts. You are bearish.

When you expect prices to rise, then you take a short position by selling Puts. You are bullish.

SUMMARY:

Settlement of options is based on the expiry date. However, there are three basic styles of options you will encounter which affect settlement. The styles have geographical names, which have nothing to do with the location where a contract is agreed! The styles are:

European: These options give the holder the right, but not the obligation, to buy or sell the underlying instrument only on the expiry date. This means that the option cannot be exercised early. Settlement is based on a particular strike price at expiration. Currently, in India only index options are European in nature.

eg: Sam purchases 1 NIFTY AUG 1110 Call --Premium 20. The exchange will settle the contract on the last Thursday of August. Since there are no shares for the underlying, the contract is cash settled.

American: These options give the holder the right, but not the obligation, to buy or sell the underlying instrument on or before the expiry date. This means that the option can be exercised early. Settlement is based on a particular strike price at expiration.

Options in stocks that have been recently launched in the Indian market are "American Options".

eg: Sam purchases 1 ACC SEP 145 Call --Premium 12

Here Sam can close the contract any time from the current date till the expiration date, which is the last Thursday of September.

American style options tend to be more expensive than European style because they offer greater flexibility to the buyer.

Option Class & Series

Generally, for each underlying, there are a number of options available: For this reason, we have the terms "class" and "series".

An option "class" refers to all options of the same type (call or put) and style (American or European) that also have the same underlying.

eg: All Nifty call options are referred to as one class.

An option series refers to all options that are identical: they are the same type, have the same underlying, the same expiration date and the same exercise price.

eg: Wipro JUL 1300 refers to one series and trades take place at different
premiums

All calls are of the same option type. Similarly, all puts are of the same option type. Options of the same type that are also in the same class are said to be of the same class. Options of the same class and with the same exercise price and the same expiration date are said to be of the same series

Options are used as risk management tools and the valuation or pricing of the instruments is a careful balance of market factors.

There are four major factors affecting the Option premium:

• Price of Underlying
• Time to Expiry
• Exercise Price Time to Maturity
• Volatility of the Underlying

And two less important factors:

• Short-Term Interest Rates
• Dividends

Review of Options Pricing Factors

The Intrinsic Value of an Option

The intrinsic value of an option is defined as the amount by which an option is in-the-money, or the immediate exercise value of the option when the underlying position is marked-to-market.

For a put option: Intrinsic Value = Strike Price - Spot Price

The intrinsic value of an option must be positive or zero. It cannot be negative. For a call option, the strike price must be less than the price of the underlying asset for the call to have an intrinsic value greater than 0. For a put option, the strike price must be greater than the underlying asset price for it to have intrinsic value.

Price of underlying

The premium is affected by the price movements in the underlying

instrument. For Call options – the right to buy the underlying at a fixed strike

price – as the underlying price rises so does its premium. As the underlying price falls so does the cost of the option premium. For Put options – the right to sell the underlying at a fixed strike

price – as the underlying price rises, the premium falls; as the underlying price falls the premium cost rises.

The following chart summarises the above for Calls and Puts.

Option	Underlying price	Premium cost
Call
Put

The Time Value of an Option

Generally, the longer the time remaining until an option’s expiration, the higher its premium will be. This is because the longer an option’s lifetime, greater is the possibility that the underlying share price might move so as to make the option in-the-money. All other factors affecting an option’s price remaining the same, the time value portion of an option’s premium will decrease (or decay) with the passage of time.

Note: This time decay increases rapidly in the last several weeks of an option’s life. When an option expires in-the-money, it is generally worth only its intrinsic value.

Option	Time to expiry	Premium cost
Call
Put

Volatility

Volatility is the tendency of the underlying security’s market price to fluctuate either up or down. It reflects a price change’s magnitude; it does not imply a bias toward price movement in one direction or the other. Thus, it is a major factor in determining an option’s premium. The higher the volatility of the underlying stock, the higher the premium because there is a greater possibility that the option will move in-the-money. Generally, as the volatility of an under-lying stock increases, the premiums of both calls and puts overlying that stock increase, and vice versa.

Higher volatility=Higher premium

Lower volatility = Lower premium

Option	Volatility	Premium cost
Call
Put

Interest rates

In general interest rates have the least influence on options and equate approximately to the cost of carry of a futures contract. If the size of the options contract is very large, then this factor may take on

some importance. All other factors being equal as interest rates rise, premium costs fall and vice versa. The relationship can be thought of as an opportunity cost. In order to buy an option, the buyer must either borrow funds or use funds on deposit. Either way the buyer incurs an interest rate cost. If interest rates are rising, then the opportunity cost of buying options increases and to compensate the buyer premium costs fall. Why should the buyer be compensated? Because the option writer receiving the premium can place the funds on deposit and receive more interest than was previously anticipated. The situation is reversed when interest rates fall – premiums rise. This time it is the writer who needs to be compensated.

Option	Interest rates	Premium cost
Call
Put

 How do we measure the impact of change in each of these pricing determinants on option premium we shall learn in the next module.

The options premium is determined by the three factors mentioned earlier – intrinsic value, time value and volatility. But there are more sophisticated tools used to measure the potential variations of options premiums. They are as follows:

• Delta
• Gamma
• Vega
• Rho

Delta

Delta is the measure of an option’s sensitivity to changes in the price of the underlying asset. Therefore, its is the degree to which an option price will move given a change in the underlying stock or index price, all else being equal.

               Change in option premium
Delta = --------------------------------
               Change in underlying price

For example, an option with a delta of 0.5 will move Rs 5 for every change of Rs 10 in the underlying stock or index.

Illustration:

A trader is considering buying a Call option on a futures contract, which has a price of Rs 19. The premium for the Call option with a strike price of Rs 19 is 0.80. The delta for this option is +0.5. This means that if the price of the underlying futures contract rises to Rs 20 – a rise of Re 1 – then the premium will increase by 0.5 x 1.00 = 0.50. The new option premium will be 0.80 + 0.50 = Rs 1.30.

Far out-of-the-money calls will have a delta very close to zero, as the change in underlying price is not likely to make them valuable or cheap. An at-the-money call would have a delta of 0.5 and a deeply in-the-money call would have a delta close to 1.

While Call deltas are positive, Put deltas are negative, reflecting the fact that the put option price and the underlying stock price are inversely related. This is because if you buy a put your view is bearish and expect the stock price to go down. However, if the stock price moves up it is contrary to your view therefore, the value of the option decreases. The put delta equals the call delta minus 1.

It may be noted that if delta of your position is positive, you desire the underlying asset to rise in price. On the contrary, if delta is negative, you want the underlying asset’s price to fall.

Uses: The knowledge of delta is of vital importance for option traders because this parameter is heavily used in margining and risk management strategies. The delta is often called the hedge ratio. e.g. if you have a portfolio of ‘n’ shares of a stock then ‘n’ divided by the delta gives you the number of calls you would need to be short (i.e. need to write) to create a riskless hedge – i.e. a portfolio which would be worth the same whether the stock price rose by a very small amount or fell by a very small amount.

In such a "delta neutral" portfolio any gain in the value of the shares held due to a rise in the share price would be exactly offset by a loss on the value of the calls written, and vice versa.

Note that as the delta changes with the stock price and time to expiration the number of shares would need to be continually adjusted to maintain the hedge. How quickly the delta changes with the stock price is given by gamma, which we shall learn subsequently.

This is the rate at which the delta value of an option increases or decreases as a result of a move in the price of the underlying instrument.

                  Change in an option delta
Gamma =-------------------------------------
                  Change in underlying price

For example, if a Call option has a delta of 0.50 and a gamma of 0.05, then a rise of ±1 in the underlying means the delta will move to 0.55 for a price rise and 0.45 for a price fall. Gamma is rather like the rate of change in the speed of a car – its acceleration – in moving from a standstill, up to its cruising speed, and braking back to a standstill. Gamma is greatest for an ATM (at-the-money) option (cruising) and falls to zero as an option moves deeply ITM (in-the-money ) and OTM (out-of-the-money) (standstill).

If you are hedging a portfolio using the delta-hedge technique described under "Delta", then you will want to keep gamma as small as possible as the smaller it is the less often you will have to adjust the hedge to maintain a delta neutral position. If gamma is too large a small change in stock price could wreck your hedge. Adjusting gamma, however, can be tricky and is generally done using options -- unlike delta, it can't be done by buying or selling the underlying asset as the gamma of the underlying asset is, by definition, always zero so more or less of it won't affect the gamma of the total portfolio.

This is a measure of the sensitivity of an option price to changes in market volatility. It is the change of an option premium for a given change – typically 1% – in the underlying volatility.

                  Change in an option premium
Vega = -----------------------------------------
                      Change in volatility

If for example, XYZ stock has a volatility factor of 30% and the current premium is 3, a vega of .08 would indicate that the premium would increase to 3.08 if the volatility factor increased by 1% to 31%. As the stock becomes more volatile the changes in premium will increase in the same proportion. Vega measures the sensitivity of the premium to these changes in volatility.

What practical use is the vega to a trader? If a trader maintains a delta neutral position, then it is possible to trade options purely in terms of volatility – the trader is not exposed to changes in underlying prices.

The change in option price given a one percentage point change in the risk-free interest rate. Rho measures the change in an option’s price per unit increase –typically 1% – in the cost of funding the underlying.

                      Change in an option premium
Rho = ---------------------------------------------------
                  Change in cost of funding underlying

Example:

Assume the value of Rho is 14.10. If the risk free interest rates go up by 1% the price of the option will move by Rs 0.14109. To put this in another way: if the risk-free interest rate changes by a small amount, then the option value should change by 14.10 times that amount. For example, if the risk-free interest rate increased by 0.01 (from 10% to 11%), the option value would change by 14.10*0.01 = 0.14. For a put option the relationship is inverse. If the interest rate goes up the option value decreases and therefore, Rho for a put option is negative. In general Rho tends to be small except for long-dated options.

Calls in a Bullish Strategy

An investor with a bullish market outlook should buy call options. If you expect the market price of the underlying asset to rise, then you would rather have the right to purchase at a specified price and sell later at a higher price than have the obligation to deliver later at a higher price.

The investor's profit potential buying a call option is unlimited. The investor's profit is the the market price less the exercise price less the premium. The greater the increase in price of the underlying, the greater the investor's profit.

The investor's potential loss is limited. Even if the market takes a drastic decline in price levels, the holder of a call is under no obligation to exercise the option. He may let the option expire worthless.

The investor breaks even when the market price equals the exercise price plus the premium.

An increase in volatility will increase the value of your call and increase your return. Because of the increased likelihood that the option will become in- the-money, an increase in the underlying volatility (before expiration), will increase the value of a long options position. As an option holder, your return will also increase.

A simple example will illustrate the above:

Suppose there is a call option with a strike price of Rs 2000 and the option premium is Rs 100. The option will be exercised only if the value of the underlying is greater than Rs 2000 (the strike price). If the buyer exercises the call at Rs 2200 then his gain will be Rs 200. However, this would not be his actual gain for that he will have to deduct the Rs 200 (premium) he has paid.

The profit can be derived as follows

Profit = Market price - Exercise price - Premium
Profit = Market price – Strike price – Premium.
                 2200 – 2000 – 100 = Rs 100

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Puts in a Bullish Strategy

An investor with a bullish market outlook can also go short on a Put option. Basically, an investor anticipating a bull market could write Put options. If the market price increases and puts become out-of-the-money, investors with long put positions will let their options expire worthless.

By writing Puts, profit potential is limited. A Put writer profits when the price of the underlying asset increases and the option expires worthless. The maximum profit is limited to the premium received.

However, the potential loss is unlimited. Because a short put position holder has an obligation to purchase if exercised. He will be exposed to potentially large losses if the market moves against his position and declines.

The break-even point occurs when the market price equals the exercise price: minus the premium. At any price less than the exercise price minus the premium, the investor loses money on the transaction. At higher prices, his option is profitable.

An increase in volatility will increase the value of your put and decrease your return. As an option writer, the higher price you will be forced to pay in order to buy back the option at a later date , lower is the return.

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Bullish Call Spread Strategies

A vertical call spread is the simultaneous purchase and sale of identical call options but with different exercise prices.

To "buy a call spread" is to purchase a call with a lower exercise price and to write a call with a higher exercise price. The trader pays a net premium for the position.

To "sell a call spread" is the opposite, here the trader buys a call with a higher exercise price and writes a call with a lower exercise price, receiving a net premium for the position.

An investor with a bullish market outlook should buy a call spread. The "Bull Call Spread" allows the investor to participate to a limited extent in a bull market, while at the same time limiting risk exposure.

To put on a bull spread, the trader needs to buy the lower strike call and sell the higher strike call. The combination of these two options will result in a bought spread. The cost of Putting on this position will be the difference between the premium paid for the low strike call and the premium received for the high strike call.

The investor's profit potential is limited. When both calls are in-the-money, both will be exercised and the maximum profit will be realised. The investor delivers on his short call and receives a higher price than he is paid for receiving delivery on his long call.

The investors's potential loss is limited. At the most, the investor can lose is the net premium. He pays a higher premium for the lower exercise price call than he receives for writing the higher exercise price call.
 

The investor breaks even when the market price equals the lower exercise price plus the net premium. At the most, an investor can lose is the net premium paid. To recover the premium, the market price must be as great as the lower exercise price plus the net premium.

An example of a Bullish call spread:

Let's assume that the cash price of a scrip is Rs 100 and you buy a November call option with a strike price of Rs 90 and pay a premium of Rs 14. At the same time you sell another November call option on a scrip with a strike price of Rs 110 and receive a premium of Rs 4. Here you are buying a lower strike price option and selling a higher strike price option. This would result in a net outflow of Rs 10 at the time of establishing the spread.

Now let us look at the fundamental reason for this position. Since this is a bullish strategy, the first position established in the spread is the long lower strike price call option with unlimited profit potential. At the same time to reduce the cost of puchase of the long position a short position at a higher call strike price is established. While this not only reduces the outflow in terms of premium but his profit potential as well as risk is limited. Based on the above figures the maximum profit, maximum loss and breakeven point of this spread would be as follows:

Maximum profit = Higher strike price - Lower strike price - Net premium                                    paid

                              = 110 - 90 - 10 = 10

Maximum Loss = Lower strike premium - Higher strike premium

                             = 14 - 4 = 10

Breakeven Price = Lower strike price + Net premium paid

                               = 90 + 10 = 100

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Bullish Put Spread Strategies

A vertical Put spread is the simultaneous purchase and sale of identical Put options but with different exercise prices.

To "buy a put spread" is to purchase a Put with a higher exercise price and to write a Put with a lower exercise price. The trader pays a net premium for the position.

To "sell a put spread" is the opposite: the trader buys a Put with a lower exercise price and writes a put with a higher exercise price, receiving a net premium for the position.

An investor with a bullish market outlook should sell a Put spread. The "vertical bull put spread" allows the investor to participate to a limited extent in a bull market, while at the same time limiting risk exposure.

To put on a bull spread, a trader sells the higher strike put and buys the lower strike put.
The bull spread can be created by buying the lower strike and selling the higher strike of either calls or put. The difference between the premiums paid and received makes up one leg of the spread.

The investor's profit potential is limited. When the market price reaches or exceeds the higher exercise price, both options will be out-of-the-money and will expire worthless. The trader will realize his maximum profit, the net premium

The investor's potential loss is also limited. If the market falls, the options will be in-the-money. The puts will offset one another, but at different exercise prices.
 

The investor breaks-even when the market price equals the lower exercise price less the net premium. The investor achieves maximum profit i.e the premium received, when the market price moves up beyond the higher exercise price (both puts are then worthless).

An example of a bullish put spread.

Lets us assume that the cash price of the scrip is Rs 100. You now buy a November put option on a scrip with a strike price of Rs 90 at a premium of Rs 5 and sell a put option with a strike price of Rs 110 at a premium of Rs 15.

The first position is a short put at a higher strike price. This has resulted in some inflow in terms of premium. But here the trader is worried about risk and so caps his risk by buying another put option at the lower strike price. As such, a part of the premium received goes off and the ultimate position has limited risk and limited profit potential. Based on the above figures the maximum profit, maximum loss and breakeven point of this spread would be as follows:

Maximum profit = Net option premium income or net credit

                             = 15 - 5 = 10

Maximum loss = Higher strike price - Lower strike price - Net premium received

                          = 110 - 90 - 10 = 10

Breakeven Price = Higher Strike price - Net premium income

                               = 110 - 10 = 100

Puts in a Bearish Strategy

When you purchase a put you are long and want the market to fall. A put option is a bearish position. It will increase in value if the market falls. An investor with a bearish market outlook shall buy put options. By purchasing put options, the trader has the right to choose whether to sell the underlying asset at the exercise price. In a falling market, this choice is preferable to being obligated to buy the underlying at a price higher.

An investor's profit potential is practically unlimited. The higher the fall in price of the underlying asset, higher the profits.

The investor's potential loss is limited. If the price of the underlying asset rises instead of falling as the investor has anticipated, he may let the option expire worthless. At the most, he may lose the premium for the option.

The trader's breakeven point is the exercise price minus the premium. To profit, the market price must be below the exercise price. Since the trader has paid a premium he must recover the premium he paid for the option.
 

An increase in volatility will increase the value of your put and increase your return. An increase in volatility will make it more likely that the price of the underlying instrument will move. This increases the value of the option.

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Another option for a bearish investor is to go short on a call with the intent to purchase it back in the future. By selling a call, you have a net short position and needs to be bought back before expiration and cancel out your position.

For this an investor needs to write a call option. If the market price falls, long call holders will let their out-of-the-money options expire worthless, because they could purchase the underlying asset at the lower market price.

The investor's profit potential is limited because the trader's maximum profit is limited to the premium received for writing the option.

Here the loss potential is unlimited because a short call position holder has an obligation to sell if exercised, he will be exposed to potentially large losses if the market rises against his position.

The investor breaks even when the market price equals the exercise price: plus the premium. At any price greater than the exercise price plus the premium, the trader is losing money. When the market price equals the exercise price plus the premium, the trader breaks even.

An increase in volatility will increase the value of your call and decrease your return.
When the option writer has to buy back the option in order to cancel out his position, he will be forced to pay a higher price due to the increased value of the calls.

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Bearish Put Spread Strategies

A vertical put spread is the simultaneous purchase and sale of identical put options but with different exercise prices.

To "buy a put spread" is to purchase a put with a higher exercise price and to write a put with a lower exercise price. The trader pays a net premium for the position.

To "sell a put spread" is the opposite. The trader buys a put with a lower exercise price and writes a put with a higher exercise price, receiving a net premium for the position.

To put on a bear put spread you buy the higher strike put and sell the lower strike put.
You sell the lower strike and buy the higher strike of either calls or puts to set up a bear spread.

An investor with a bearish market outlook should: buy a put spread. The "Bear Put Spread" allows the investor to participate to a limited extent in a bear market, while at the same time limiting risk exposure.

The investor's profit potential is limited. When the market price falls to or below the lower exercise price, both options will be in-the-money and the trader will realize his maximum profit when he recovers the net premium paid for the options.
 

The investor's potential loss is limited. The trader has offsetting positions at different exercise prices. If the market rises rather than falls, the options will be out-of-the-money and expire worthless. Since the trader has paid a net premium
 

The investor breaks even when the market price equals the higher exercise price less the net premium. For the strategy to be profitable, the market price must fall. When the market price falls to the high exercise price less the net premium, the trader breaks even. When the market falls beyond this point, the trader profits.

An example of a bearish put spread.

Lets assume that the cash price of the scrip is Rs 100. You buy a November put option on a scrip with a strike price of Rs 110 at a premium of Rs 15 and sell a put option with a strike price of Rs 90 at a premium of Rs 5.

In this bearish position the put is taken as long on a higher strike price put with the outgo of some premium. This position has huge profit potential on downside. If the trader may recover a part of the premium paid by him by writing a lower strike price put option. The resulting position is a mildly bearish position with limited risk and limited profit profile. Though the trader has reduced the cost of taking a bearish position, he has also capped the profit portential as well. The maximum profit, maximum loss and breakeven point of this spread would be as follows:

Maximum profit = Higher strike price option - Lower strike price option                                   - Net premium paid

                          = 110 - 90 - 10 = 10

Maximum loss = Net premium paid

                          = 15 - 5 = 10

Breakeven Price = Higher strike price - Net premium paid

                         = 110 - 10 = 100

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Bearish Call Spread Strategies

A vertical call spread is the simultaneous purchase and sale of identical call options but with different exercise prices.

To "buy a call spread" is to purchase a call with a lower exercise price and to write a call with a higher exercise price. The trader pays a net premium for the position.

To "sell a call spread" is the opposite: the trader buys a call with a higher exercise price and writes a call with a lower exercise price, receiving a net premium for the position.

To put on a bear call spread you sell the lower strike call and buy the higher strike call. An investor sells the lower strike and buys the higher strike of either calls or puts to put on a bear spread.

An investor with a bearish market outlook should: sell a call spread. The "Bear Call Spread" allows the investor to participate to a limited extent in a bear market, while at the same time limiting risk exposure.

The investor's profit potential is limited. When the market price falls to the lower exercise price, both out-of-the-money options will expire worthless. The maximum profit that the trader can realize is the net premium: The premium he receives for the call at the higher exercise price.

Here the investor's potential loss is limited. If the market rises, the options will offset one another. At any price greater than the high exercise price, the maximum loss will equal high exercise price minus low exercise price minus net premium.

The investor breaks even when the market price equals the lower exercise price plus the net premium. The strategy becomes profitable as the market price declines. Since the trader is receiving a net premium, the market price does not have to fall as low as the lower exercise price to breakeven.

An example of a bearish call spread.

Let us assume that the cash price of the scrip is Rs 100. You now buy a November call option on a scrip with a strike price of Rs 110 at a premium of Rs 5 and sell a call option with a strike price of Rs 90 at a premium of Rs 15.

In this spread you have to buy a higher strike price call option and sell a lower strike price option. As the low strike price option is more expensive than the higher strike price option, it is a net credit startegy. The final position is left with limited risk and limited profit. The maximum profit, maximum loss and breakeven point of this spread would be as follows:

Maximum profit = Net premium received

                               = 15 - 5 = 10

Maximum loss = Higher strike price option - Lower strike price option -                                  Net premium received

                          = 110 - 90 - 10 = 10

Breakeven Price = Lower strike price + Net premium paid

                               = 90 + 10 = 100

Straddles in a Volatile Market Outlook

Volatile market trading strategies are appropriate when the trader believes the market will move but does not have an opinion on the direction of movement of the market. As long as there is significant movement upwards or downwards, these strategies offer profit opportunities. A trader need not be bullish or bearish. He must simply be of the opinion that the market is volatile.

• A straddle is the simultaneous purchase (or sale) of two identical options, one a call and the other a put.

• To "buy a straddle" is to purchase a call and a put with the same exercise price and expiration date.

• To "sell a straddle" is the opposite: the trader sells a call and a put with the same exercise price and expiration date.

A trader, viewing a market as volatile, should buy option straddles. A "straddle purchase" allows the trader to profit from either a bull market or from a bear market.

Here the investor's profit potential is unlimited. If the market is volatile, the trader can profit from an up- or downward movement by exercising the appropriate option while letting the other option expire worthless. (Bull market, exercise the call; bear market, the put.)

While the investor's potential loss is limited. If the price of the underlying asset remains stable instead of either rising or falling as the trader anticipated, the most he will lose is the premium he paid for the options.

In this case the trader has long two positions and thus, two breakeven points. One is for the call, which is exercise price plus the premiums paid, and the other for the put, which is exercise price minus the premiums paid.

Strangles in a Volatile Market Outlook

A strangle is similar to a straddle, except that the call and the put have different exercise prices. Usually, both the call and the put are out-of-the-money.

To "buy a strangle" is to purchase a call and a put with the same expiration date, but different exercise prices.

To "sell a strangle" is to write a call and a put with the same expiration date, but different exercise prices.

A trader, viewing a market as volatile, should buy strangles. A "strangle purchase" allows the trader to profit from either a bull or bear market. Because the options are typically out-of-the-money, the market must move to a greater degree than a straddle purchase to be profitable.

The trader's profit potential is unlimited. If the market is volatile, the trader can profit from an up- or downward movement by exercising the appropriate option, and letting the other expire worthless. (In a bull market, exercise the call; in a bear market, the put).

The investor's potential loss is limited. Should the price of the underlying remain stable, the most the trader would lose is the premium he paid for the options. Here the loss potential is also very minimal because, the more the options are out-of-the-money, the lesser the premiums.

Here the trader has two long positions and thus, two breakeven points. One for the call, which breakevens when the market price equal the high exercise price plus the premium paid, and for the put, when the market price equals the low exercise price minus the premium paid.
Pic:Opt35

The Short Butterfly Call Spread

Like the volatility positions we have looked at so far, the Short Butterfly position will realize a profit if the market makes a substantial move. It also uses a combination of puts and calls to achieve its profit/loss profile - but combines them in such a manner that the maximum profit is limited.

You are short the September 40-45-50 butterfly with the underlying at 45. You: you are neutral but want the market to move in either direction.
The position is a neutral one - consisting of two short options balanced out with two long ones.

Which of these positions is a short butterfly spread? The graph on the left.
The profit loss profile of a short butterfly spread looks like two short options coming together at the center Calls.

The spread shown above was constructed by using 1 short call at a low exercise price, two long calls at a medium exercise price and 1 short call at a high exercise price.

Your potential gains or losses are: limited on both the upside and the downside.
Say you had build a short 40-45-50 butterfly. The position would yield a profit only if the market moves below 40 or above 50. The maximum loss is also limited.

The Call Ratio Backspread

The call ratio backspread is similar in contruction to the short butterfly call spread you looked at in the previous section. The only difference is that you omit one of the components (or legs) used to build the short butterfly when constructing a call ratio backspread.

When putting on a call ratio backspread, you are neutral but want the market to move in either direction. The call ratio backspread will lose money if the market sits. The market outlook one would have in putting on this position would be for a volatile market, with greater probability that the market will rally.

To put on a call ratio backspread, you sell one of the lower strike and buy two or more of the higher strike. By selling an expensive lower strike option and buying two less expensive high strike options, you receive an initial credit for this position. The maximum loss is then equal to the high strike price minus the low strike price minus the initial net premium received.

Your potential gains are limited on the downside and unlimited on the upside.
The profit on the downside is limited to the initial net premium received when setting up the spread. The upside profit is unlimited.

An increase in implied volatility will make your spread more profitable. Increased volatility increases a long option position's value. The greater number of long options will cause this spread to become more profitable when volatility increases.

The Put Ratio Backspread

In combination positions (e.g. bull spreads, butterflys, ratio spreads), one can use calls or puts to achieve similar, if not identical, profit profiles. Like its call counterpart, the put ratio backspread combines options to create a spread which has limited loss potential and a mixed profit potential.

It is created by combining long and short puts in a ratio of 2:1 or 3:1. In a 3:1 spread, you would buy three puts at a low exercise price and write one put at a high exercise price. While you may, of course, extend this position out to six long and two short or nine long and three short, it is important that you respect the (in this case) 3:1 ratio in order to maintain the put ratio backspread profit/loss profile.

When you put on a put ratio backspread: are neutral but want the market to move in either direction.
Your market expectations here would be for a volatile market with a greater probability that the market will fall than rally.

How would the profit/loss profile of a put ratio backspread differ from a call ratio backspread?

Unlimited profit would be realized on the downside.
The two long puts offset the short put and result in practically unlimited profit on the bearish side of the market. The cost of the long puts is offset by the premium received for the (more expensive) short put, resulting in a net premium received.

To put on a put ratio backspread, you: buy two or more of the lower strike and sell one of the higher strike.
You sell the more expensive put and buy two or more of the cheaper put. One usually receives an initial net premium for putting on this spread. The Maximum loss is equal to: High strike price - Low strike price - Initial net premium received.

For eg if the ratio backspread is 45 days before expiration. Considering only the bearish side of the market, an increase in volatility increases profit/loss and the passage of time decreases profit/loss.

The low breakeven point indicated on the graph is equal to the lower of the two exercise prices... minus the call premiums paid, minus the net premiums received. The higher of this position's two breakeven points is simply the high exercise price minus the net premium.

Straddles in a Stable Market Outlook

Volatile market trading strategies are appropriate when the trader believes the market will move but does not have an opinion on the direction of movement of the market. As long as there is significant movement upwards or downwards, these strategies offer profit opportunities. A trader need not be bullish or bearish. He must simply be of the opinion that the market is volatile. This market outlook is also referred to as "neutral volatility."

• A straddle is the simultaneous purchase (or sale) of two identical options, one a call and the other a put.

• To "buy a straddle" is to purchase a call and a put with the same exercise price and expiration date.

• To "sell a straddle" is the opposite: the trader sells a call and a put with the same exercise price and expiration date.

A trader, viewing a market as stable, should: write option straddles. A "straddle sale" allows the trader to profit from writing calls and puts in a stable market environment.

The investor's profit potential is limited. If the market remains stable, traders long out-of-the-money calls or puts will let their options expire worthless. Writers of these options will not have be called to deliver and will profit from the sum of the premiums received.

The investor's potential loss is unlimited. Should the price of the underlying rise or fall, the writer of a call or put would have to deliver, exposing himself to unlimited loss if he has to deliver on the call and practically unlimited loss if on the put.

The breakeven points occur when the market price at expiration equals the exercise price
plus the premium and minus the premium. The trader is short two positions and thus, two breakeven points; One for the call (common exercise price plus the premiums paid), and one for the put (common exercise price minus the premiums paid).

Strangles in a Stable Market Outlook

A strangle is similar to a straddle, except that the call and the put have different exercise prices. Usually, both the call and the put are out-of-the-money.

To "buy a strangle" is to purchase a call and a put with the same expiration date, but different exercise prices. Usually the call strike price is higher than the put strike price.

To "sell a strangle" is to write a call and a put with the same expiration date, but different exercise prices.

A trader, viewing a market as stable, should: write strangles.
A "strangle sale" allows the trader to profit from a stable market.

The investor's profit potential is: unlimited.
If the market remains stable, investors having out-of-the-money long put or long call positions will let their options expire worthless.

The investor's potential loss is: unlimited.
If the price of the underlying interest rises or falls instead of remaining stable as the trader anticipated, he will have to deliver on the call or the put.

The breakeven points occur when market price at expiration equals...the high exercise price plus the premium and the low exercise price minus the premium.
The trader is short two positions and thus, two breakeven points. One for the call (high exercise price plus the premiums paid), and one for the put (low exercise price minus the premiums paid).

Why would a trader choose to sell a strangle rather than a straddle?

The risk is lower with a strangle. Although the seller gives up a substantial amount of potential profit by selling a strangle rather than a straddle, he also holds less risk. Notice that the strangle requires more of a price move in both directions before it begins to lose money.

Long Butterfly Call Spread Strategy The long butterfly call spread is a combination of a bull spread and a bear spread, utilizing calls and three different exercise prices.

A long butterfly call spread involves:

• Buying a call with a low exercise price,

• Writing two calls with a mid-range exercise price,

• Buying a call with a high exercise price.

To put on the September 40-45-50 long butterfly, you: buy the 40 and 50 strike and sell two 45 strikes.
This spread is put on by purchasing one each of the outside strikes and selling two of the inside strike. To put on a short butterfly, you do just the opposite.

The investor's profit potential is limited.
Maximum profit is attained when the market price of the underlying interest equals the mid-range exercise price (if the exercise prices are symmetrical).

The investor's potential loss is: limited.
The maximum loss is limited to the net premium paid and is realized when the market price of the underlying asset is higher than the high exercise price or lower than the low exercise price.

The breakeven points occur when the market price at expiration equals ... the high exercise price minus the premium and the low exercise price plus the premium. The strategy is profitable when the market price is between the low exercise price plus the net premium and the high exercise price minus the net premium.