call and put only point

8/12/2019 Call and Put only point..

1/38

INTRODUCTION TO CALL OPTIONS AND PUT OPTION

An option contract is an agreement between two parties to buy/sell an asset (stock

or futures contract as an example) at a fixed price and fixed date in the future.

It is called an option because the buyer is not obliged to carry out the transaction.

If, over the life of the contract, the asset value decreases, the buyer can simply

elect not to exercise his/her right to buy/sell the asset.

There are two types of option contracts - Call options and Put options. A Calloption gives the buyer the right to buy the underlying asset, while a Put option

gives the buyer the right to sell the underlying asset.

EXAMPLE

A simple example: Peter buys a Call option contract from Sarah. The contractstates that Peter will buy 100 Microsoft shares from Sarah on the 5th May for $25.

The current share price for Microsoft is $30.

Note: this is an example of a Call option as it gives Peter the right to buy the

underlying asset.

If the share price of Microsoft is trading above $25 on the 5th May, then Peter will

exercise the option and Sarah will have to sell him Microsoft shares for $25. With

Microsoft trading anywhere above $25 Peter can make an instant profit by taking

the shares from Sarah at the agreed price of $25 and then selling the shares on the

open market for whatever the current share price is and making a profit.


2/38

The $25 value, which is stated in the agreement, is referred to as the Exercise (or

Strike) Price. This is the price at which the asset will be exchanged.

The date (in this case 5th May) is known as the Expiry (or Maturity) Date. Thisdate is the deadline for the option contract. At this date, the option buyer is to

decide if a transaction of the underlying asset is to occur.

Outcomes: Let's imagine that at the expiration date, Microsoft is trading at $30,

then Peter will buy the shares from Sarah at the agreed $25 and then he can sell

them back on the open market for $30 and make an instant $5.

Alternatively, if Microsoft is trading at $20, then buying the shares from Sarah at

$25 is too expensive as he can buy them on the open market for $20 and save $5.

In this situation, Peter would choose not to exercise his right to buy the shares and

let the options contract expire worthless. His only loss would be the amount that he

paid to Sarah when he bought the contract, which is called the Option Premium -

more on that a little later. Sarah would, however, keep the option premium

received from Peter as her profit.

In the real world of exchange traded options, transactions don't really take place

between two people. The process of Novation actually removes the identity of who

is on the other side of the trade. You simply Buy or Sell an option contract from

the exchange without knowing who is on the other side


3/38

Birth of the Modern Option

In 1973, the modern financial options market came into existence. The ChicagoBoard of Trade (CBOT) opened the Chicago Board Options Exchange (CBOE).

The CBOE instituted a new "exchange traded options contract". This contract was

standardized in its terms and conditions. An options buyer and seller no longer had

to sit down and negotiate terms of the contract every time he or she sought to buy

an option. Thus, the CBOE could publish quoted options prices for the first time,

and could establish a market maker system to make sure that there was a secondary

or resell market for options.

At the same time, the Options Clearing Corporation was formed to make sure that

the contract would be honored by all members. Lastly, the whole process came

under the regulatory control of the Securities and Exchange Commission.

Thus, the trading of the modern option, "exchange traded options contract" had

begun. On the first day the contracts traded, April 26, 1973, a total of 911 contracts

were traded.

Since that time, options trading has grown enormously. In 2007, there were over

2.8 billion contracts cleared by the Options Clearing Corporation.

Options are now widely traded in variety of financial instruments: from stocks and

bonds to exchange-traded funds, commodities and currency futures.


4/38

Next, we will take a closer look at what options are, why they are so popular and

why every trader and investors should include them as part of their

trading/investing toolkit.

John Emery has been a professional trader for more than a decade, trading in

stocks, options and stock indexes on a daily basis. A former proprietary trader,

Emery has written numerous articles for TradingMarkets over the years on topics

ranging from trading basics to his own trading methods and strategies. Emery uses

options both to trade and as a risk reduction tool.


5/38

OPTIONS TERMINOLGY

Call option: A call option gives the holder the right but not the obligation to buy

an asset at a certain date for a certain price.

Put option: A put option gives the holder the right but not the obligation to sell

an asset by a certain date for a certain price.

Index options: These options have the index as the underlying. In India, they

have a European style settlement. E.g. Nifty options, Mini Nifty options, etc.

Stock options: Stock options are options on individual stocks. A stock option

contract gives the holder the right to buy or sell the underlying shares at the

specified price. They have an American style settlement.

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 / seller of an option: The writer / seller 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.

Option price/premium: Option price is the price which the option buyer pays

to the option seller. It is also referred to as the option premium.


6/38

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 exercise price.

American options: American options are options that can be exercised at any

time up to the expiration date.

European options: European options are options that can be exercised only on

the expiration date itself.

In-the-money option: An in-the-money (ITM) option is an option that 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 is an option that would

lead to zero cash-flow if it were exercised immediately. An option on the index isat-the-money when the current index equals the strike price (i.e. spot price = strike

price).


7/38


8/38

OPTION GREEK

When learning Option Greeks there are four words you need to know. These wordsare delta, gamma, theta and vega. Option Greeks are measurements of risk that

explain several variables that influence option prices.

Before we can begin understanding what Option Greeks are, we should first

understand the factors which influence the change in the price of an option. Then

we can better understand how this fits in with the Option Greeks.

Here are the 3 main factors that influence the change in the price of an option:

1: Volatility Amount

If you are long in the option, increases in volatility are normally positive for both

calls and puts. However, an increase in volatility is typically negative if you are the

writer of the option.

2: Changes in the time to expiration

If an option gets nearer to the expiration time it will become more and more

negative and the profit potential will be become less and less. The nearer the option

is to expiration, the faster the time value evaporates.

Another way of saying this is that the rate of loss of time value for an option with

three months left to expiration is faster than that of an option with six months

remaining.

Time is running out for the option to get in-the-money (when the strike price is less

than the market price of the underlying security). The less time, the less value. The

closer and closer options get to expiration, the less chance there is that it will

happen, and there are generally fewer buyers and more sellers.


9/38

3: When the underlying asset changes in price

If a holder of an option has a call option, an increase in the price of the underlying

asset is typically a positive situation. If you have a put option and there is a

decrease in the price of the underlying instrument this is typically a positivesituation.

There is another influence which is interest rates. A lot of the time these are less

important. With interest rates being higher this means that the call options will be

more expensive and the put options will be less expensive.

Once you understand the influences that change the price of an option you can

then, advance to learning about the Option Greeks

1: Delta

A option delta is the sensitivity of an options theoretical value to a change in the

price of the underlying stock or entity.

Delta is described as the price relationship or the amount of change in price of the

underlying entity to the option based on 1 point, or a dollar price move.

Delta values range from -100 to 0 for put options and from 0 to 100 for calls, or -1

to 0 and 0 to 1, if you use the more commonly used expression in decimals.

If the underlying entity moves $1 higher and the option follows penny for penny,

the option has a delta of 1, which is the case for an in-the-money-option option. If

the option increases in value only 50 cents for each dollar gained by the underlying

entity, the delta is 50 or 50 percent.

2: Gamma

This is the sensitivity of an options delta to a change in the price of the underlying

entity. In other words, gamma measures the rate of change of delta in relation to

the change in the price of the underlying entity.

From this information you can make a more informed decision on predicting how

much can be made or lost based on the movement of the underlying position.


10/38

3: Theta

This is the sensitivity of an options theoretical value to a change in the amount of

time to expiration.

4:Vega

Vega refers to the sensitivity of an options theoretical value to a change in

volatility. It measures the risk exposure to changes in implied volatility and tells

traders how much an options price will rise or fall as the volatility of the option

varies.


11/38

FOUR BASIC OPTIONS POSITIONS

CallOptions

(1) Call options give the holder (buyer)the right(but not the obligation) tobuythe underlying asset at the strike price any time until the expiry date.

(2) Call options obligate the writer (seller)to sellthe underlying asset at the strikeprice any time until the expiry date.

Note: the writer has the exact opposite position in comparison to the holder, this isbecause they are on opposite sides of the same contract.

Put Options

(3) Put options give the holder (buyer)the right(but not the obligation) to selltheunderlying asset at the strike price any time until the expiry date.

(4) Put options obligate the writer (seller)to buythe underlying asset at the strikeprice any time until the expiry date.

Note: the writer has the exact opposite position in comparison to the holder, this is

because they are on opposite sides of the same contract

Summary of the Four Basic Options Positions

Holder

(Buyer)Writer

(Seller)

Call Options Right to Buy Obligation to Sell

Put Options Right to Sell Obligation to Buy


12/38

HOW TO APPROACH OPTIONS

For a trader to become successful at trading options he/she will have to become

disciplined and focused and will need to stay in touch with the outside world and

current events. An investor will need to have some sort of way or method offorecasting the price of the underlying stock to have good success in this game.

Investors and trader must become clued into reality. It is not possible to win all the

time and nor is it possible for everyone to have the same amount of success as

other traders. It is unrealistic for everyone to achieve the exact same results as the

best traders. This is just pointing out a few obvious pieces of information.

Many professional traders make sure that they have more winners than losers.

They have many trades that only break even or lose a little and they have some

others that are winners. Their trading plans incorporate the possibility that not all

trades will be successful.

When a beginner option trader is designing out a trading plan they should take intoaccount that many trades will be unsuccessful. Being real about your chances will

allow them to design a workable system that makes more profits from the winners

than the losers. As an option trader, you will need to get a good handle on your

money management to succeed in this game. Sometimes this can be a dynamic

process where you need to update from time to time.

An options trader must take their trading seriously. If a trader is not in the mood on

one particular day, that is fine. Just make sure that when you head is in the wrong

place, that you dont start making trades, otherwise you can have heart stopping

losses.


13/38

Many option traders have said that traders should never be afraid of selling to soon.

If an investors goals have been met almost right away, some experts

recommended that they should stick to the rules they have set out for themselves in

their trading system. If the objective of the investor good hit, many investors would

encourage them to consider taking their profits.

Who Trades Options?

Two broad categories of players exist in the option markets: risk seekersand risk

avoider's.

Risk seeker

A risk seeker, also known as a speculator, is the type of trader that is trying to

profit from a prediction in market direction. A speculator will have his or her own

method of analysing the market and then use the options market to make a bet on

his/her analysis.

Risk avoider

A risk avoider, also known as a hedger is in the market because s/he is trying to

transfer risk to the speculator. A hedger will use the option market to create

insurance for his/her physical position against an adverse market movement.


14/38

Options Trading

As an options trader you will need to learn how to judge price movements or

volatility for the underlying stock. With stock options, the trader should consider

the exchange on which the stock trades. The volatility of a stock and the volatilityof the options on that stock are very much influenced by the volatile state of the

overall exchange.

Often times, calm markets calm down volatile stocks. However, an individual

stock can often be very volatile in the calmest of markets. There are can be many

reasons why this may be the case, but these can be sometimes a good candidate for

a short term option trade.

Sometimes volatility can affect lots of traders negatively. Often times this there can

be volatility that strikes down very harsh on a lot of traders very suddenly. Other

times it can involve volatility (whether it is higher or lower) which is negative for

traders that can build up very gradually and incrementally until it soon begins to

sweep up more and more traders in its sights.

Volatility is a very important factor for many market analytic tools for helping to

predict fair market value of options. It also plays a big role in the key indices you

study to get a fix on market trends.

As an options trader it is important that you are aware of the 2 basic types of stock

exchanges in order to get a good comprehension and understanding of their impact

on the volatility of the underlying asset you trade.

The first and oldest type of exchange involves having a physical trading floor

where buyers and sellers meet via their representative brokerage firms.


15/38

Many people think of this as being an auction where people call out a bid and ask

for offers on the floor of the exchange. This metaphor will help you to understand

somewhat how prices are set.

Some examples of these types of exchanges are Chicago Board of Options

Exchange (CBOE), Pacific Stock Exchange (PSE), Midwest Stock Exchange

(MWSE), Philadelphia Stock Exchange (PHLX), New York Stock Exchange

(NYSE), and American Stock Exchange (AMEX)

The second basic type of stock exchange is the electronic or screen-based, as in

computer monitor, exchanges.

The type of exchange the underlying stock trades on goes back to volatility and

which type of exchange has a propensity to be more or less volatile. This type of

information that can affect volatility can be very important for an option trader to

know.


16/38

FEATURES OF OPTION

1. High flexible:On one hand, option contracts are high ly standardized and so they can be traded

only in organized exchanges. Such option instrument cannot be made flexible

according to the requirement of the writer as well as the user. On the other hand,

there are also privately arranged options, which can be, traded Over the Counter.

These instruments can be made according to the requirements of the writer and

user. Thus, it combines the feature of futures as well as forward contracts.

2. Down Payment:

The option holder must pay a certain amount called premium for holding the

right of exercising the option. This is considered to be the consideration for the

contract. If the option holder does not exercise will be deduction from the total

payoff in calculating the net payoff due to the option holder.

3. Settlement:

No money or commodity or shares is exchanged when the contract is written.

Generally this option contract terminates either at the time of exercising the option

holder or maturity whichever is earlier. So, settlement is made only when the

option holder exercises his option. Suppose the option is not exercised till maturity,

then the agreement automatically lapses and no settlement is required.


17/38

4. Non-Linearity:

Unlike futures and forward, on option contract does not posses the property of

linearity. It means that the option holders profit, when the value of the underlying

assets moves in one direction is not equal to his loss when its value moves in the

opposite direction by the same amount. In short, profit and losses are not

symmetrical under an option contract. This can be illustrated by means of an

illustration:

Mr. A purchased a two month call option on rupee at Rs100=3.35$. Suppose, the

rupee appreciates within two months by 0.05 $ per one hundred rupees, then the

market price would be Rs.100= 3.40$. If the option holder Mr. A exercises his

option, he can purchases at the rate mentioned in the option i.e., Rs100=3.35$. He

gets a payoff at the rate of 0.05$per every one hundred rupees. On the other hands,

if the exchanges rate moves in the opposite direction by the same amount and

reaches a level of Rs100=3.30$, the option contract, the gain is not equal to the

loss.

5. No Obligation to Buy or Sell:

In all option contracts, the option holder has a right to buy or sell underlying assets.

He can exercise this right at any time during the currency of the contract. But, in

no case, he is under an obligation to buy or sell. If he does not buy or sell, the

contract will be simply lapsed.


18/38

Option Types

The Options can be classified into following types

1: Exchange-traded options.

Exchange-traded options(also called "listed options") are a class ofexchange-

traded derivatives.Exchange traded options have standardized contracts, and are

settled through aclearing housewith fulfillment guaranteed by the Options

Clearing Corporation (OCC). Since the contracts are standardized, accurate pricingmodels are often available. Exchange-traded options include

stock options,

bond options and otherinterest rate options

stock market index options or, simply, index options and

options on futures contracts.

2:Over-the-counter.

Over-the-counteroptions (OTC options, also called "dealer options") are traded

between two private parties, and are not listed on an exchange. The terms of anOTC option are not standardized.They are customized in nature. Option types

commonly traded over the counter include

1 Interest rate options,

2 Currency cross rate options
http://en.wikipedia.org/wiki/Derivative_(finance)#OTC_and_exchange-tradedhttp://en.wikipedia.org/wiki/Derivative_(finance)#OTC_and_exchange-tradedhttp://en.wikipedia.org/wiki/Derivative_(finance)#OTC_and_exchange-tradedhttp://en.wikipedia.org/wiki/Derivative_(finance)#OTC_and_exchange-tradedhttp://en.wikipedia.org/wiki/Clearing_house_(finance)http://en.wikipedia.org/wiki/Clearing_house_(finance)http://en.wikipedia.org/wiki/Clearing_house_(finance)http://en.wikipedia.org/wiki/Stock_optionshttp://en.wikipedia.org/wiki/Bond_optionhttp://en.wikipedia.org/wiki/Interest_rate_derivativehttp://en.wikipedia.org/wiki/Stock_market_index_optionhttp://en.wikipedia.org/wiki/Options_on_futures_contractshttp://en.wikipedia.org/wiki/Over-the-counter_(finance)http://en.wikipedia.org/wiki/Over-the-counter_(finance)http://en.wikipedia.org/wiki/Over-the-counter_(finance)http://en.wikipedia.org/wiki/Options_on_futures_contractshttp://en.wikipedia.org/wiki/Stock_market_index_optionhttp://en.wikipedia.org/wiki/Interest_rate_derivativehttp://en.wikipedia.org/wiki/Bond_optionhttp://en.wikipedia.org/wiki/Stock_optionshttp://en.wikipedia.org/wiki/Clearing_house_(finance)http://en.wikipedia.org/wiki/Derivative_(finance)#OTC_and_exchange-tradedhttp://en.wikipedia.org/wiki/Derivative_(finance)#OTC_and_exchange-traded


19/38

3 Option Styles:

An option style refers to whether the option contract can be exercised before the

expiration date or not.

.There are differnt types of option style they are as follow;

American Option

These option can be exercised on a day between option purchase date and the

expiration date.Thus, these option have as many exercise dates as there are in the

days till expiration.

European option

These option can be exercised on the expiration date only.Thus, these option have

single expiration date,which is same as expiration date.

Bermudan option

These type of option instead of having single exercise date has a set of

predetermined discrete exercise dates and the option can be exercised on those

dates only.They are commonly use in interest rate and foreign exchange markets

]


20/38

The most popular index option markets are:

Symbol Country Description

KOSPI Korea KOSPI 200 Index Options

DAX Germany DAX 30 Index Options

SPX USA S&P 500 Index Options

NDX USA NASDAQ 100 Index Options

OEX USA S&P 100 Index Options

HSI Hong Kong Hang Seng Index Options

N225 Japan Nikkei 225 Index Options

FTSE UK FTSE 100 Index Options


21/38

Factors affecting pricing of an Option

The current price of the underlying is obviously a very important factor thatdetermines the price of an Option. Also the strike price of the contract is

another key factor that affects the price of an Option. The time to expiry isagain another important factor that affects the price of an Option. Theintrinsic value of an option represents the amount of an option that is in-the-money (ITM). Note that OTM and ATM options have no intrinsic value. Inshort all the Greeks affect the pricing of an option contract as describedelaborately later in this chapter.

Price of underlyingThe price of the underlying is the key factor that determines the price of an

option. The price of an option premium for a given strike price will undergochange based on the price of the underlying stock. The closer the marketprice is to the strike price, the rate of change will be the highest. For strikeprices farther away from the market price, the rate of change of optionpremium will be lower.

Strike PriceStrike price is the contracted price that would be exchanged in the event ofthe exercise of the option by the buyer of the contract. Hence strike price

plays a vital role in determining the price of an option contract. Theexercise price will remain the same throughout the life of an option contractand will not undergo any change. However, in the case of a stock splitthere would be change in the strike price.

Time to ExpiryWith more time there is more uncertainty. More the time to expiry, greaterare the chances that there would be fluctuation in the price of theunderlying to the advantage of one of the parties to the contract. Hence

more the time, higher would be the time value of the premium. The optionsprice is directly related to the time remaining till the expiration of the optioncontract. The buyer of an option stands to gain if the option contractfinishes in-the-moneyand greater are the chances that it would do so ifthere is more time to expiry. It should be noted that as the time to expirationof the option contract decreases, the value of the option would erode.


22/38

If an investor buys an option that is three months away from expiration, itwill be more expensive than a similar option that is only five days fromexpiration. All options exhibit time decay and are wasting assets. In otherwords, as time passes, option contracts lose value. If the investor buys an

option that is three months away from expiration and hold it until there areonly five days until expiration, there will be a significant premium loss dueto time depreciation assuming the price of the underlying is more or lessconstant.

Rate of InterestThe cost of carry would depend upon the risk-free rate of interest in themarket concerned. The higher the interest rate, the higher the call optionprice and lower the put option price. The lower the interest rate, the lower

the call option price and higher the put option price.

Volatility of underlyingVolatility is the standard deviation of the price of the underlying over adefined period of time. If a market becomes more volatile, the premium foroption contracts would go up. Someone who bought options earlier wouldbe benefited to the detriment of someone who previously sold options.Buying options prior to such volatility expansion has a high probability ofsuccess. Higher the volatility more would be the premium of options.


23/38

OPTIONS STRATEGIES

STRATEGY 1: LONG CALL

For aggressive investors who are very bullish about the prospects for a stock /

index, buying calls can be an excellent way to capture the upside potential with

limited downside risk.

Buying a Call Option is the basic of all Option strategies. It is an easy strategy to

understand. When you buy a Call Option it means you expect the stock / index to

rise in the future.

When to Use:Investor is very aggressive and he is very bullishabout the stock/

index

Risk:Limited to the premium paid.

Reward:Unlimited

Break-even Point:Strike Price + Premium.

Example:

Mr. XYZ is bullish on Nifty on 24thJune, when the Nifty is at 4191. He buys a call

options with a strike price of `4600 at a premium of `36, expiring on 31 st July. If

the Nifty goes above 4636, Mr. XYZ will make a net profit (after deducting the

premium) on exercising the option. In case the Nifty stays at or falls below 4600,he can forego the option (it will expire worthless) with a maximum loss of the

premium.


24/38

The payoff schedule:-

Strategy : Buy Call Option

Current Nifty

index

4191

Call Option Strike Price (`) 4600

Mr. XYZ Pays Premium (`) 36

Break Even Point

(`) (Strike Price

+ Premium)

4636

On expiry Nifty closes at Net payoff from Call option

(`)

4100 -36

4300 -36

4500 -36

4636 0

4700 64

4900 264

5100 464

5300 664


25/38

The payoff profile:-

Analysis

This strategy limits the downside risk to the extent of premium paid. But the

potential return is unlimited in case of rise in Nifty. A long call option is the

simplest way to benefit if you believe that the market will make an upward move.

As the stock price / index rises, the long Call moves into profit more and more

quickly.

-60

-40

-20

0

20

40

60

80

100

120

4000 4300 4636 4700 4900

Long Call

Nifty Profit


26/38

STRATEGY 2: SHORT CALL

When you buy a Call you are hoping that the underlying stock / index would

rise. When you expect the underlying stock / index to fall you do the

opposite. When an investor is very bearish about a stock / index and expects

the prices to fall, he can sell Call options. This position offers limited profit

potential and the possibility of large losses on big advances in underlying

prices. Although easy to execute it is a risky strategy since the seller of the call

is exposed to unlimited risk.

Selling a Call option is the just the opposite of buying a Call option. Here the seller

of the option feels the underlying price of the stock / index to fall in the future.

When to Use:Investor is very aggressive and he isvery bearishabout the stock/

index.

Risk:Unlimited.

Reward:Limited to the amount of the premium.

Break-even Point:Strike Price + Premium.

Example:

Mr. XYZ is bearish about Nifty and expects it to fall. He sells a Call option with a

strike price of `2600 at a premium of `154, when the current Nifty is at 2694. If the

Nifty stays at 2600 or below, the Call option will not be exercised by the buyer of

the option and Mr. XYZ can retain the entire premium of `154.


27/38

Strategy : Sell Call Option

Current Nifty 2694

Call Option Strike Price (`) 2600

Mr.XYZ

receives

Premium (`) 154

Break Even Point

(`) (Strike Price

2754

The Payoff schedule :-

On expiry Nifty closes at Net payoff from Call

option (`)

2400 154

2500 154

2600 154

2700 54

2754 0

2800 -46

2900 -146

3000 -246


28/38


Analysis

This strategy is used when an investor is very aggressive and has a strong

expectation of a price fall (and certainly not a price rise). This is a risky strategy

since as the stock price / index rises, the short call loses money more and more

quickly and losses can be significant if the stock price / index fall below the strike

price.

-350

-300

-250

-200

-150

-100

-50

0

50

100

150

200

2400 2600 2754 2900 3000

Short Call

Nifty Profit


29/38

STRATEGY 3: LONG PUT

Buying a Put is opposite of buying a Call. When an investor buys a Call option, he

is bullish on the stock / index. If an investor is bearish, he can buy a Put option. A

Put option gives a right to the seller to sell the stock (to the Put seller) at a pre-

determined price and thereby limiting his risk.

A Long Put is a Bearish strategy. To take advantage of a falling market an investor

can buy Put options.

When to Use: Investor is bearish about the stock / index.

Risk: Limited to the amount of Premium paid. (Maximum loss if stock / index

expire at or above the option strike price.)

Reward: Unlimited.

Break-even Point: Stock PricePremium.

Example:

Mr. XYZ is bearish on Nifty on 24thJune, when Nifty is at 2694. He buys a Put

option with a strike price of `2600 at a premium of `52 expiring on 31stJuly. If the

Nifty goes below 2548, Mr. XYZ will make a profit on exercising the option. In

case the Nifty rises above 2600, he can forego the option (it will expire worthless)with a maximum loss of the premium.


30/38


31/38


Analysis

A bearish investor can profit from declining stock price by buying Puts. He limits

his risk to the amount of premium paid but his profit potential remains unlimited.

This is one of the widely used strategy when an investor is bearish.

-100

-50

0

50

100

150

200

250

300

2300 2400 2548 2700 2800

Long Put

Nifty Profit


32/38

STRATEGY 4: SHORT PUT

An investor sells Put when he is Bullish about the stock. When you sell a Put,

you earn a Premium (from the buyer of the Put). You have sold someone the

right to sell you the stock at the strike price. If the stock price increases

beyond the strike price, the short put position will make a profit for the seller

by the amount of the premium, since the buyer will not exercise the Put option

and the Put seller can retain the Premium (which is his maximum profit).

But, if the stock price decreases below the strike price, by more than the

amount of the premium, the Put seller will lose money.

When to Use:Investor is very Bullishabout the stock / index. The main idea is to

make short term income.

Risk: Unlimited.

Reward:Limited to the amount of Premium received.

Break-even Point:Put Strike - Premium.

Example:

Mr. XYZ is bullish on Nifty when it is 4190.10. He sells a Put option with a strike

price of `4100 at a premium of `170 expiring on 31stJuly. If the Nifty index stays

above 4100, he will gain the amount of premium as a Put buyer wont exercise his

option. In case the Nifty falls below 4100, Put buyer will exercise the option and

Mr. XYZ will start losing money. If the Nifty falls below 3930, which is the break-

even point, Mr. XYZ will lose the premium and more depending on the extent of

the fall in Nifty.


33/38

Strategy : Sell Put Option

Current Nifty index 4191.10

Put Option Strike Price (`) 4100

Mr. XYZ

receives

Premium (`) 170

Break Even Point (`)

(Strike Price -

Premium)

3930


On expiry Nifty

Closes at

Net Payoff from the Put

Option (`)

3400 -530

3500 -4303700 -2303900 -30

3930 04100 1704300 170

4500 170


34/38


Analysis

Selling Puts can lead to regular income in a rising or range bound markets. But it

should be done carefully since the potential losses can be significant in case the

price of the stock / index falls. This strategy can be considered as an income

generating strategy.

-600

-500

-400-300

-200

-100

0

100

200

300

3400 3700 3930 4300 4600

Short Put

Nifty Profit


35/38

STRATEGY 5: LONG COMBO

A Long Combo is a Bullish strategy. If an investor is expecting the price of a

stock to move up he can do a Long Combo strategy. It involves selling an

OTM (lower strike) Put and buying an OTM (higher strike) Call. This strategy

simulates the action of buying a stock (or a futures) but at a fraction of the

stock price. It is an inexpensive trade, similar in pay-off to Long Stock, except

there is a gap between the strikes (please see the payoff diagram). As the

stock price rises the strategy starts making profits. Let us try and understand

Long Combo with an example.

When to Use:Investor is Bullishon the stock.

Risk:Unlimited (Lower Strike price + Net Debit)

Reward:Unlimited.

Break-even Point:Higher Strike Price + Net Debit

Example:

A stock ABC Ltd is trading at `450. Mr. XYZ is bullish on the stock. But he does

not want to invest `450. He does a Long Combo. He sells a Put option with a strike

price of `400 at a premium of `1 and buys a Call option with a strike price of `500

at premium of `2. The net cost of the strategy (net debit) is `1.


36/38


ABC Ltd. closes at

(`)

Net Payoff

from the PutSold (`)

Net Payoff from

theCall purchased

Net Payoff

(`)

700 1 198 199

650 1 148 149600 1 98 99

550 1 48 49

501 1 -1 0

500 1 -2 -1450 1 -2 -1

400 1 -2 -1350 -49 -2 -51300 -99 -2 -101

250 -149 -2 -151

For a small investment of `1 (net debit), the returns can be very high in a

Strategy : Sell a Put + Buy a Call

ABC Ltd. Current Market Price (`) 450

Sells Put Strike Price (`) 400

Mr. XYZ Premium (`) 1.00

Buys Call Strike Price (`) 500

Mr. XYZ Premium (`) 2.00

Net Debit (`) 1.00

Break Even Point (`)

(Higher Strike + Net

501


37/38

Long Combo, but only if the stock moves up. Otherwise the potential losses

can also be high.

The payoff chart (Long Combo)

+ =

Sell put Buy call Long Combo


38/38

call and put only point

Documents