Options
• Basics of call options
• Basics of options jargon
• How to buy a call option
• How to buy/sell call option
• Buying put option
• Selling put option
• Call & put options
• Greeks & calculator
• Option contract
• The option greeks
• Delta
• Gamma
• Theta
• All volatility
• Vega
7.1 – Remember these graphs
Over the last few chapters, we have looked at two basic option type’s, i.e. the ‘Call Option’ and the ‘Put Option’. Further, we looked at four different variants originating from these 2 options –
- Buying a Call Option
- Selling a Call Option
- Buying a Put Option
- Selling a Put Option
By combining these 4 variations, a trader can develop a wide range of effective strategies, which are often referred to as “Option Strategies.” Consider it this way: Just as a talented artist can produce intriguing paintings when given a colour scheme and a blank canvas, a talented trader can use these four option variants to produce trades of exceptional quality. The only prerequisites for making these option trades are creativity and intelligence. Therefore, it is crucial to have a solid understanding of these four options variants before we delve further into options. This is the case, so let’s quickly review what we’ve learned so far in this module.
Please find below the pay off diagrams for the four different option variants –
Let’s start from the left side. You’ll notice that the call option (buy) and call option (sell) pay off diagrams are stacked one on top of the other. They both appear to be a mirror image if you pay close attention to the payoff diagram. The opposite risk-reward characteristics of an option buyer and seller are highlighted by the payoff’s mirror image. The call option seller makes the most money when the call option buyer suffers the greatest loss. Similar to how the call option seller can lose as much as they want, so too does the call option buyer have limitless potential for profit.
The call option (buy) and put option (sell) payoffs are next to one another. This is to emphasise that only when the market is expected to rise do either of these option variants yield a profit. In other words, avoid buying or selling options when you believe there is a chance that the markets will decline. In other words, you will definitely lose money in such circumstances and won’t make any money doing it. Of course, there is a volatile aspect to this that we have not yet discussed; we will do so in the future. I’m talking about volatility because it affects option premiums, which is why it matters.
The pay off diagrams for the Put Option (sell) and the Put Option (buy) are finally stacked one below the other on the right. It is obvious that the payoff diagrams are mirror images of one another. The fact that the maximum loss of the put option buyer is also the maximum profit of the put option seller is highlighted by the payoff’s mirror image. Similar to how the put option seller has the greatest chance of losing money, so does the put option buyer.
Here is a table that summarises the option positions furthermore.
It would be beneficial if you kept in mind that purchasing an option also constitutes taking a “Long” position. Accordingly, purchasing a call option and purchasing a put option are referred to as long calls and long puts, respectively.
Similar to how selling an option is referred to as a “Short” position. Accordingly, selling a call option and selling a put option are both referred to as short positions, short calls and short puts.
Another crucial point to remember is that there are two situations in which you can purchase an option:
You purchase to establish a new option position.
You buy with the intention of covering an open short position.
Only when you are opening a new buy position is the position referred to as a “Long Option.” It is simply referred to as a “square off” position if you are purchasing with the aim of covering an existing short position.
Similarly, there are two situations in which you can sell an option:
You sell with the intention of opening a new short position.
You sell with the intention of closing an open long position.
Only when you are writing a new sell (option) position is the position referred to as a “Short Option.” It is simply referred to as a “square off” position if you are selling with the goal of closing an existing long position.
7.2 – Option Buyer in a nutshell
I’m confident that by this point, you are familiar with the call and put option from both the buyer’s and seller’s perspectives. Before we continue with this module, I believe it is best to go over a few important points once more.
Only when we anticipate the market to move strongly in a particular direction does buying an option (call or put) make sense. In fact, the market should move away from the chosen strike price for the option buyer to profit. We will discover later that choosing the proper strike price to trade is a significant task. For now, keep in mind the following important details:
The formula for P&L (Long call) at expiration is P&L = Max [0, (Spot Price – Strike Price)] – Paid Premium
P&L (Long Put) is calculated as [Max (0, Strike Price – Spot Price)] at expiration. – Paid Premium
Only when the trader intends to hold the long option until expiration is the aforementioned formula applicable.
Only on the expiry day is the intrinsic value calculation that we looked at in the previous chapters applicable. Throughout the series, we CANNOT use the same formula.
When the trader intends to close the position out well before expiration, the P&L calculation is altered.
The amount of the premium paid determines how much risk the option buyer is exposed to. He does, however, have limitless potential for profit.
7.2 – Option seller in a nutshell
Option writers are another name for option sellers (call or put). The P&L experiences of buyers and sellers are completely different. When you anticipate that the market will remain stable, fall below the strike price (for calls), rise above the strike price, selling an option makes sense (in case of put option).
I want you to recognise that markets are marginally in favour of option sellers, all things being equal. This is due to the fact that the market must be either flat or moving in the desired direction for the option sellers to be profitable (based on the type of option). However, the market must move in a specific direction for the option buyer to be profitable. There are undoubtedly two favourable market circumstances.
Here are a few key points you need to remember when it comes to selling options –
- P&L for a short call option upon expiry is calculated as P&L = Premium Received – Max [0, (Spot Price – Strike Price)]
- P&L for a short put option upon expiry is calculated as P&L = Premium Received – Max (0, Strike Price – Spot Price)
- Of course the P&L formula is applicable only if the trader intends to hold the position till expiry
- When you write options, margins are blocked in your trading account
- The seller of the option has unlimited risk but minimal profit potential (to the extent of the premium received)
Perhaps this is the case with Nassim Nicholas Taleb’s statement that “Option writers eat like a chicken but shit like an elephant” in his book “Fooled by Randomness”. In other words, option writers sell options for small, consistent returns, but they typically lose a lot of money when a catastrophe strikes.
I do, however, hope that you now have a solid understanding of how a call and put option operate. You should be aware that this module will now concentrate on the moneyness of an option, premiums, option pricing, option Greeks, and strike choice. Once we are familiar with these concepts, we will go over the call and put option once more. When we do, I’m sure you’ll view the calls and puts in a new way and maybe even get the idea to start options trading professionally.
Let’s say that while trading this specific option intraday, you were only able to gain 2 points during this significant swing. Given that the lot size is 1000, this results in sweet profits of Rs 2000. (highlighted in green arrow). In reality, this is exactly what takes place. Trade in premiums occurs. Almost no traders keep options open until they expire. The majority of traders are interested in starting a trade now, square it off in a short period of time (intraday or possibly for a few days), and then profit from changes in the premium. The options are not really exercised until they expire.
In fact, you might find it interesting to know that an average return of 100% while trading options is not at all unusual. Don’t, however, let what I just said get you too excited; in order to consistently enjoy such returns, you must gain a keen understanding of your available options.
This is an option contract for IDEA Cellular Limited with a strike price of 190, an expiration date of April 30, 2015, and a European Call Option as the option type. These specifics are denoted by a blue box. The OHLC data, which is obviously very interesting, can be seen below this.
The 190CE premium hit a low of Rs. 0.30 and closed the day at Rs. 8.25. I’ll skip the percent calculation because it produces an absurd number for intraday trading. The 2 point premium capture translates to Rs. 4000 in intraday profits, which is enough for that nice dinner at a restaurant. However, suppose you were a seller of the 190 call option intraday and you managed to capture just 2 points again.
I’m trying to make the point that most traders only trade options to profit from variations in premium. Holding until expiration is not really a concern. By no means do I mean to imply that you do not need to hold until expiration; in some circumstances, I do hold options until expiration. In general, option sellers rather than option buyers tend to hold contracts until expiration. This is due to the fact that if you write an option for Rs. 8/-, you will only benefit from the full premium, or Rs. 8/-, at expiration.
Having said that, you might have a few fundamental questions now that you know that traders prefer to trade only the premiums. How come premiums change? What is the reason behind the premium change? How can I forecast how premiums will change? Who determines what a particular option’s premium price should be?
The core of option trading, then, is determined by these questions and the answers to them. Let me assure you that if you can master these aspects of an option, you will put yourself on a professional path to trading options.
To give you a heads up, understanding the four forces that simultaneously exert their influence on option premiums and cause the premiums to vary will help you find the answers to all of these questions. Imagine this as a ship travelling through the ocean. The speed of the ship depends on a number of factors, including wind speed, sea water density, sea pressure, and the ship’s power (assuming it has an equivalent to the option premium). Some forces tend to make the ship move faster, while others tend to make it move slower. The ship struggles against these forces until it attains the ideal sailing speed.
Likewise the premium of the option depends on certain forces called as the ‘Option Greeks’. Crudely put, some Option Greeks tends to increase the premium, while some try to reduce the premium. A formula called the ‘Black & Scholes Option Pricing Formula’ employs these forces and translates the forces into a number, which is the premium of the option.
Try and imagine this – the Option Greeks influence the option premium; however, the Option Greeks itself are controlled by the markets. As the markets change on a minute by minute basis, therefore the Option Greeks change and therefore the option premiums!
In the future, in this module, we will understand each of these forces and their characteristics. We will understand how the force gets influenced by the markets and how the Option Greeks further influence the premium
Therefore, the ultimate goal would be to be –
To understand the impact of the Option Greeks on premiums
To determine how the premiums are set while accounting for Option Greeks’ impact
Finally, we must choose strike prices to trade carefully while keeping the Greeks and pricing in perspective.
Learning about the “Moneyness of an Option” is one of the most important things we should understand before attempting to learn the option Greeks. The same will be done in the following chapter.
Just a quick reminder that while we’ll do our best to simplify, the topics in the future will likely become a little more complicated. Please be thorough with all the concepts as we do that, as we would appreciate it.