What is Option? Let's Learn From the Basics...

Options Trading  is always a fascinating style of trading and overly famed within the retail traders community for some reasons.. 

May be because Option trading is branded like a magic stick to retail novice traders that they can make huge money by putting less capital in the stock market.. or May be they are really cheap to start trading... But do you think, is that the reason why option trading are introduced in any financial market?
Let me elucidate here that, I am not judging whether option trading is a right or a wrong tool of trading.. The reason for explaining the options here to reveal the real reason of why Options exists, what is the fundamental of options... We can go along with very simple examples to get things clear from the basics..

Let's understand the conceptual framework of Options :

1. Consider the situation,

 There were two good friends “A” & “B”. “A” is actively evaluating an opportunity to buy 1 acre of land that “B” owns. The land is valued at Rs. 5,00,000/- . “A” has been informed that in the next 6 months a new highway’s project is likely to be sanctioned near the land. If the highway indeed comes up the valuation of land is bound to increase therefore “A” would be benefitted from investment. However if the “highway news” turns out to be a Rumors so “A” would be stuck with a useless price of land.

So Now What Should “A” do? 

It is dilemma situation for “A” either he takes the risk to buy the land from “B” else loose the opportunity to speculate on the land prices. 

“A” wants to play it safe & finally proposed a special structure arrangement. 

1. “A” pays on upfront fees of Rs.1,00,000/- today which is consider to be non-refundable agreement fees. 

2. Against this fees, “B” Agrees to sell the land after 6months to “A”. 

3. The price of land is fixed today at Rs.5,00,000/-. 

4. Because “A” has paid an upfront for, only he can call of the deal at the end of 6 months (If he wants to), “B” cannot. But If “A” calls off the deal, “B” keeps the upfront fees. 

It is a tricky arrangement for “B”. Whom it will be benefit, no one can analyze. “A” proposes such a clever deal to “B”. Let’s break up the proposal to understand it better. 

  v By paying an agreement fee of Rs.1lakh. “A” is binding “B” into an obligation. He is forcing “b” to lock the land for him for the next 6months.

v “A” is fixing the sale price of the land based on today’s price Rs 5lacs irrespective of what could be the price after six month. 

  v If After 6month “A” doesn’t want to buy the land he has the right to say no to “B” but “B” takes the agreement fee so he cannot say no to “A”. 

  v The agreement fee is non-refundable, non-negotiable. 

  v After initiating the agreement both “A” & “B” have to wait to 6 months to figure out what actually would happen. There are only 3 possible outcomes. 

  (a) If the highway project comes up , the price of land would go up. Suppose it shoots up to Rs.10,00,000/-. In this condition “A” Exercise his rights and buy the land at RS 5Lakh fixed in the agreement. His payoff will be….. 

  5,00,000 + 1,00,000 = 6,00,000/- 

  Land price Adv. Total cost 

  10,00,000 – 6,00,000 = 4,00,000/- 

  Market Price cost = Profit. 

  (b) The high way project doesn’t come up and the people are disappointed so price of the land collapse, assume that now the price is 3,00,000/-. In this condition it doesn’t make sense to buy the land because the current market price is quite lower than the agreement price 5,00,000/- so if “A” exercise the deal his pay off would be….. 

  5,00,000 + 1,00,000 = 6,00,000/- 

  Price of land adv Total cost of the land 

  3,00,000 – 6,00,000 = -3,00,000/- Loss from the deal 

  Because A is the buyer of an option so he can exercise his right & can call off the deal and for “B” The advance he collects is the profit. 

  (c) If the price of the land is not increase also doesn’t make the sense to buy the land for 5,00,000/- because the total cost for the land would be 

  5,00,000 + 1,00,000 = 6,00,000/-

Agreement price adv = Total cost 

  So in this condition “A” can exercise his rights to call off the deal and “B” will make the profit of 1,00,000(adv. Received).

So if you look clearly on this scenario. You can easily understand that how an option agreement function. Both the parties involved in this agreement are in win-win condition. “A” Speculate on the price of land with deal with the maximum loss of RS 1,00,000/- but the profit of unlimited. And for this agreement “B” have a 2/3 chance to be profited. So now we summarize the agreement to know more about the terminology used in option agreement. 

  è Premium: “A” Pays to “B” to ensure the right to call off the deal if it would not suit to “A”. In this case the premium was RS 1,00,000/- that is non refundable.

è Strike price: Strike price is the price of asset where buyer & seller agreed to deal (either purchase or sell) in future at certain time. In the alone case the strike price was Rs 5, 00,000/- . 

  è Spot price: Spot price is the current price of the asset. Either it would be greater than strike price are less than strike price are to be equal. 

  è Option expiry: Option expiry means the time to describe the option contract. In this example 6months was the option expiry. 

  è Underlying asset: Underlying asset is the asset on which the agreement is based on. Here is the example the under lying asset the land in option always derived its value from the underlying asset. 

  Now you are clear about the basic conceptual framework of two options so what is difference in the both. 

  There are two types of options called call option & put option so what is difference in both. 

  Call option:- The buyer of the call option has the right, but not the obligation to buy an agreed quantity of a particular Underlying asset from the seller of the option at a certain price (the strike price). The seller is obligated to sell the agreed quantity of an underlying asset if the buyer decided. The buyer’s pays the fees (premium) for this right. 

  Put option:- The buyer of the put option buys the right to sell the underlying at your predetermine price (strike price) from the seller of the option at your certain time (expiry). 

  The seller as obligated to buy the underlying asset if the buyer of the option decided to sell the underlying. 

Confused?? 

  Now make it clear..... 

  The Buyers of an option is always has the right. And the seller of the option is always has the obligation.

For having a right buyer of an option pays a premium to seller that is non-refundable means if you are buyer of an option you always pays the premium and if you are seller of option you always receive premium. 

  So the basic concept of call and put option is clear now. Now it is time to proceed further for more interesting studies of options. 

  Now I guess few questions are running in your mind. 

What will we get when we buy or sell an option? 

Who decided the premium? 

Are the options agreement regulated or not? 

What are the financial assets underlying in options Contracts? 

What is the expiry? 

So now I'll try to answer you on some practical ground of the options trading. The options are traded on different exchanges. In Industry it was introduced in 2000 and 2001. In India there is vastly traded the derivatives are options or I must say there are 80% of the derivatives traded in India is option, rest 20% is futures. 

Mostly the underlying Assets are Index, equity, commodity & currency in an options contract. Buyer & seller are available on exchanges. The regulated body of this setup is SEBI (Security Exchanges Board of India) who regulate the trading. 

The options contacts are available in three time format, current month, mid-month, far month. The expiry of each format is the last Thursday of the respective month. 

What are the payoffs for the options? 

To know more about the payoffs we have to know about intrinsic value of an option. 

Intrinsic value:- 

  The Intrinsic value of an option upon expiry is defined as a non-negative Number which the option buyer is entitles to, 

if he were to exercise the Option. 

  For the call option it is, 

IV = spot price - Strike price 

For the put option it is, 

IV = Strike price - spot price. 

                                Payoffs or P&L of an option 

  1 payoffs of a call option Buyer 

  As this graph we easily illustrate the few things about the payoff of an option call buyer. 

1 The maximum loss the buyer of a call option experiences is to the extent the premium paid. 

2 The call option buyer has the potential to realize unlimited profits provided the spot price moves higher than the strike price. 

3 Through the call option is supposed to make a profit when the spot price moves above the strike price, the call option buyer first need to recover the premium he has paid. Which spot price he recovers the premium is called Break-even point mean there is no profit so no loss. So the call option buyer truly starts making profit beyond the break on point. So the conclusion: A call option buyer has a limited risk but unlimited profit potential.

Generalizing the P&L for a call option buyer 

  P&L = max [0, (spot price - Strike Price)]-Premium 

Break even = Strike Price + Premium paid. 

  Key takeaways, - It makes sense to be a buyer of a call option when you expect the underlying price to increase. 

- If the underlying price remains flat or goes down then the buyer of the call option loses money. 

  2 payoffs of a call option seller 

  The call option seller payoff looks like a mirror image of the call option buyer. 

  1 The maximum loss a call option seller experiences is unlimited. 

  2 The profit for call option seller is limited to premium received. 

  3 The call option seller making a loss when Spot price crosses the break-even point. 

Generalizing the P&L for a call option seller

P&L = Premium received – max [0, (spot price - strike price)] 

  Break even = strike price + premium received. 

  3 Payoff of a put option buyer 

  Clear from the graphs above that 

  1 Put option buyer experience a loss only when the spot price goes about the strike price & loss is limited to the extent of premium paid. 

  2 Put option buyer experience gain when the spot price traded below from the strike price & the gain can be potentially unlimited. 

  Generalizing the P & L for a put option buyer 

  P & L = [MAX (0, Strike price – spot price)] – Premium paid 

  Break then point = Strike price – premium paid point 

  Key takeaways

Buy a put option when we bearish about the prospects of the underlying or we can say that a put option buyer is profitable when the underlying declines in value. 

  - If the underlying price remains flat or goes up the buyer of the put option losses money. 

  3 Payoff of you put option seller 

  1 Put option seller experience A Loss only when the spot price goes below the strike price the loss is theoretically unlimited. 

  2 Experience a profit when the spot price traded above the strike price & the gains are restricted to the extent of premium received. 

  Generalizing the P & L for put option seller 

  P&L = premium received – max [0, (strike price – spot price)] 

  Breakeven point = strike price – premium received 

Now after the put off of the option we move to the further study of moneyness of an option. 

We read about the intrinsic value of an option before, remind that? 

  Moneyness of an option is a Classification method which classifies each option strike based on how much money a trader is likely to make if he were to exercise the option contract. There are 3 broad classifications…… 

  1. In the money [ITM] 

  2. At the money [ATM] 

  3. Out the money [OTM] 

  Understanding the option strike classification is very easy. All you need to do is figure out the intrinsic value of a strike price. If the intrinsic is a non zero number, then the option strike considered “In the money”. If the intrinsic value is zero than the option strike is called “out the money “. The strike which is closest to the spot price is called “At the money”. 

  For the remainder of intrinsic value: 

  For call option 

  IV = Spot price - strike price 

  For put option 

  IV = Strike price - Spot price 

  We illustrate an example to clear this: 

  Suppose the spot price is 1005 of an underlying. The closest strike price is 1000. So far any option (call & put) 1000 is considered ATM (At the money) strike price 

  IV for call option 

Spot prices – Strike price
1005 - 750 = 255
1005 - 900 = 105
1005 - 1000 = 5
1005 - 1100 = [-95]0
1005 - 1200 = [-195]0
So from the previous example we can notice easily that if the spot price is gre
So from the previous example we can notice easily that if the spot price is greater than strike price than we get the positive IV for call option. So we can generalize this 

  - All option strike that are higher than the ATM strike are considered OTM (out the money) 

  - All option strike that are below the ATM strike are considered ITM (In the money) 

  IV for put option

Strike prices – Spot price
750 - 1005 = [-255]0
900 - 1005 = [-105]0
1000 - 1005 = [-5]0
1100 - 1005 = 95
1200 - 1005 = 195
So we notice that if strike price is greater than the spot price. We will get the positive IV for put option. So we can generalize this
· All strike higher than ATM options are considered ITM. 

  · All strike lower than ATM options are considered OTM When the spot price changes in the market the premium for each strike either it is ITM, ATM or OTM change. ITM are always expensive than OTM. If you see in the real market option chain you will notice that if we move from the deep ITM to deep OTM the premium falls respectively , So now the question arise that 

  · Who decides the premium? 

  · How much changes can a premium makes according to the option strike & spot price?

· Is the premium related with the option expiry time?

· How can we calculate premium? 

  So first we understand the forces who affect the option market the forces influence on option contract in real time affecting the premium to either increase or decrease on a minute by minute basis. These forces are collectively called the “Option Greeks”. 

  OPTION GREEKS: 

  1. Delta: Measures the rate of change of options premium based on the directional movement of the underlying. 

  When the value of the spot changes so does the option premium. How much changes are on premium when the underlying prices changes 1, is measure by DELTA. 

  Call option delta varies between 0 - 1. 

  Put option delta varies between -1 - 0. 

  2. Gamma: 

  The GAMMA of an option measures the change in delta for the given change in the underlying. In other words for a given change in underlying, what will be the corresponding change in the delta of the option? Answer is given by the gamma. Delta is a first order derivative and Gamma is a second order derivative. 

  3. Theta: All options (Call & put) lose value as the expiration approaches. The THETA is the rate at which an option loses value at time passes. 

  4. VEGA: The VEGA of an option measures the rate of change of options value with every percentage change in the volatility. Options gain value with the increase in the volatility. 

  Bullish Strategies 

1. Bull Call Spread 

2. Bull Put Spread 

3. Call Ratio Back Spread 

4. Bear Call Ladder 

5. Call Butterfly 

6. Synthetic Call 

7. Straps 

Bearish Spreads 

1. Bear Call Spread 

2. Bear Put Spread 

3. Bull Put Ladder 

4. Put Ratio Back spread 

5. Strip 

6. Synthetic Put 

Neutral Strategies 

1. Long & Short Straddles 

2. Long & Short Strangles 

3. Long & Short Iron Condor 

4. Long & Short Butterfly 

5. Box

StockAce Team

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