Derivatives

Derivatives can be defines as a security whose price is dependent upon or derived from one or more
underlying assets.
The derivative itself is merely a contract between two or more parties. Its value is determined by
fluctuations in the underlying asset. The most common underlying assets include stocks,
bonds, commodities, currencies, interest rates and market indexes. Most derivatives are characterized
by high leverage.

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nrauilo vl ea prnct e dst ys es s
Forward Contract
In finance, a forward contract or simply a forward is a non-standardized contract between two parties
to buy or sell an asset at a specified future time at a price agreed today. This is in contrast to a spot
contract, which is an agreement to buy or sell an asset today. It costs nothing to enter a forward
contract.
The party agreeing to buy the underlying asset in the future assumes a long position, and the party
agreeing to sell the asset in the future assumes a short position. The price agreed upon is called the
delivery price, which is equal to the forward price at the time the contract is entered into.
Features of Forward contracts are:

Custom tailored

Traded over the counter

Counterparty Risk

Futures Contracts
A contractual agreement, generally made on the trading floor of a futures exchange, to buy or sell a
particular commodity or financial instrument at a pre-determined price in the future. Futures
contracts detail the quality and quantity of the underlying asset; they are standardized to facilitate
trading on a futures exchange.
Some futures contracts may call for physical delivery of the asset, while others are settled in cash.
OPTIONS
What is an Option contract?
An Option is a security contract which conveys to its owner the rights, but not the obligation, to buy
or sell a particular stock at a specified price on or before the given date. The right is granted by the
seller of the option.
In the simplest of words, An Option contract is a contract that gives the buyer of an option the right
but not the obligation to buy or sell an option at a particular price and on or before the specified date.
Important terms used in Options
1) Arbitrage - A trading technique that involves the simultaneous purchase and sale of identical
assets or of equivalent assets in two different markets with the intent of profiting by the price
discrepancy.
2) Ask / Ask price - The price at which a seller is offering to sell an option or a stock.
3) Bearish - An adjective describing the opinion that a stock, or a market in general, will
decline in price -- a negative or pessimistic outlook.
4) Bear (or bearish) spread - One of a variety of strategies involving two or more options (or
options combined with a position in the underlying stock) that will profit from a fall in the
price of the underlying stock.
5) Bid / bid price - The price at which a buyer is willing to buy an option or a stock.
6) Black-Scholes formula - The first widely-used model for option pricing. This formula can be
used to calculate a theoretical value for an option using current stock prices, expected
dividends, the option's strike price, expected interest rates, time to expiration and expected
stock volatility. While the Black-Scholes model does not perfectly describe real-world
options markets, it is still often used in the valuation and trading of options.

7) Broker - A person acting as an agent for making securities transactions. An "Account

Executive" or a "broker" at a brokerage firm deals directly with customers. A "Floor Broker"
on the trading floor of an exchange actually executes someone else's trading orders.
8) Bullish - An adjective describing the opinion that a stock, or the market in general, will rise
in price. It is a positive or optimistic outlook.
9) Bull (or bullish) spread - One of a variety of strategies involving two or more options (or
options combined with an underlying stock position) that will profit from a rise in the price
of the underlying stock.
10) Class of options - A term referring to all options of the same type either Calls or Puts
covering the same underlying stock.
11) Contract size - The amount of the underlying asset covered by the option contract. This is
100 shares for one equity option unless adjusted for a special event, such as a stock split or a
stock dividend.
12) Equity option - An option on shares of an individual common stock.
13) Exercise - To invoke the rights granted to the owner of an option contract. In the case of a
Call, the option owner buys the underlying stock. In the case of a Put, the option owner sells
the underlying stock.
14) Expiration cycle - The expiration dates applicable to the different series of options.
Traditionally, there were three cycles:
cycle
available expiration months
January
January / April / July / October
February February / May / August / November
March
March / June / September / December
15) Expiration date - The date on which an option and the right to exercise it cease to exist.
16) Expiration month - The month during which the expiration date occurs.
17) Index - A compilation of several stock prices into a single number. Example: the S&P 100
Index.
18) Index option - An option whose underlying entity is an index. Generally, index options are
cash-settled.
19) Margin / margin requirement - The minimum equity required to support an investment
position. To buy on margin refers to borrowing part of the purchase price of a security from
a brokerage firm.
20) Mark-to-market - An accounting process by which the price of securities held in an account
are valued each day to reflect the closing price, or market quote if the last sale is outside of
the market quote. The result of this process is that the equity in an account is updated daily
to properly reflect current security prices.
21) Option writer - The seller of an option contract who is obligated to meet the terms of
delivery if the option owner exercises his or her right. This seller has made an opening sale
transaction, and has not yet closed that position.

22) Volatility - A measure of stock price fluctuation. Mathematically, volatility is the annualized
standard deviation of a stock's daily price changes.

Types of Options
There are two types of Options:
1) CALL Option and
2) PUT Option
CALL OPTION
Call Option is an option contract that gives the owner the right to buy the underlying stock at a
specified price (its strike price) for a certain, fixed period of time (until its expiration). For the writer
of a Call option, the contract represents an obligation to sell the underlying stock if the option is
assigned.
Buyer of the Call option expects the price to go up. Call option buyer is getting the right to purchase
from call option seller and pays the premium to call option seller. The Maximum loss to the buyer of
the Option is limited up to premium paid. If price rises than Call buyer earns unlimited profit. The
maximum profit to the call seller is up to premium received when market falls and he may make
unlimited loss if market rises.
A trader that has bought a Call option is in a long position of that call option and a trader that has
sold a call option is in a short position of that call option.
The Pay-off for buying a call

From the above diagram, we can see that by buying a call option, its buyer makes a loss only up to
the premium and the profit that he arrives at is unlimited.
The Pay-off for selling or writing a call

From the above diagram, we can see that by

selling

call option, its buyer cooks profit only up to the premium and the loss he incurs is unlimited.
Example: Mr. X has purchased the Nifty 24 June 2010, 5000 Call option at Rs. 200.
Here,
Nifty The Underlying
Strike Price 5000
Option type CALL (right to purchase)
Maturity/Expiry date 24 June 2010
Premium Rs. 200
So when spot price goes up above 5000, Mr. X will exercise his right to purchase Nifty at 5000. So
he will get benefit when market rises above 5000. So if Market goes up to 5100 he will get Rs.100
back but as he has paid Rs.200 as premium so his net loss would be Rs.100.
Now, when the market moves, the payoff of the buyer is as follows:
Payoff for Call Buyer

Spot
Price

Payoff

4600

-200

4700

-200

4800

-200

4900

-200

5000

-200

5100

-100

5200

5300

100

5400

200

5500
300
Pay off for

Call

seller
Now suppose Mr. X
has sold the above option. Now his maximum profit is upto the premium he relieved and his loss is
unlimited.
Now when the market moves, the payoff of the seller is as follows:

Spot
Price

Payoff

4600

200

4700

200

4800

200

4900

200

5000

200

5100

100

5200

5300

-100

5400

-200

5500

-300

What is Break-even?
The Break-even point is the stock price(s) at which an option strategy results in neither a profit nor a
loss. While a strategy's break-even point(s) are normally stated as of the option's expiration date, a
theoretical option pricing model can be used to determine the strategy's break-even point(s) for other
dates as well.
Therefore, BEP is a point when Options seller and buyer arrive at no profit and no loss situation. It is
the price where trader is neither earning nor losing any money. Here, both buyer and seller remain at
cost to cost.
For a Call Option,
BEP = Strike Price + Premium.
In the examples demonstrated above,
The Strike price = 5000 and
The Premium is = Rs. 200
Therefore,
The Break-even point is
5000 + 200 = 5200.

It means that when the Spot reaches 5200, Mr. X reaches the Break-even point i.e. he neither makes
profit nor suffers any loss.
PUT OPTIONS
Put Options is an option contract giving the owner the right, but not the obligation, to sell a specified
amount of an underlying security at a specified price within a specified time. This is the opposite of a
Put option, which gives the holder the right to buy shares.
Buyer of the Put option expects the price to go down. The Maximum loss to the buyer of the Option
is limited up to premium paid. If prices falls than Put buyer earns unlimited profit.
A trader that has bought a Put option is in a long position of that Put option and a trader that has sold
a Put option is in a short position of that Put option.
The Pay-off for buying a Put

From the above diagram, we can see that by buying a Put option, its buyer makes a loss only up to
the premium and the profit that he arrives at is unlimited.
The Pay-off for selling or writing a Put

From the above diagram, we can see that by selling a Put option, its buyer cooks profit only up to the
premium and the loss he incurs is unlimited.
Example:
For Put buyer:
Mr. Y has purchased the Nifty 24 June 2010, 5100 Put option at Rs. 100.
Here,
Nifty The Underlying
Strike Price 5100
Option type PUT (right to sell)
Maturity/Expiry date 24 June 2010
Premium Rs. 100
So when spot price falls below 5100, Mr. Y will exercise his right to sell Nifty at 5100. So he will get
benefit when market falls below 5100. So if Market falls to 4900 he will get Rs.200 back but as he
has paid Rs. 100 as premium so his net profit would be Rs.100.
Now, when the market moves, the payoff of the buyer is as follows:

Payoff for Put Buyer

Spot
Price

Payoff

4600

400

4700

300

4800

200

4900

100

5000

5100

-100

5200

-100

5300

-100

5400

-100

5500

-100

For Put seller:

Now suppose Mr. Y has sold the above option. Now his maximum profit is up to premium he
received and his loss is unlimited.
Now when market moves the payoff of seller is as follows:

Payoff for Put Buyer

Spot
Price

Payoff

4600

-400

4700

-300

4800

-200

4900

-100

5000

5100

100

5200

100

5300

100

5400

100

5500

100

Break-even Point for the Put option

BEP is a point when Options seller and buyer arrive at no profit and no loss situation. It is the price
where traderis neither earning nor losing any money. Here, both buyer and seller remain at cost to
cost.
For a Put Option,
BEP = Strike Price - Premium.
In the examples demonstrated above,
The Strike price = 5100 and
The Premium is = Rs. 100
Therefore,
The Break-even point is
5100 100 = 5000.
It means that when the Spot reaches 5000, Mr. X reaches the Break-even point i.e. he neither makes

profit nor suffers any loss.

Styles of Options
I.

As per the right to exercise:

1) American style Options and
2) European style Options
American style Option: American options are options that can be exercised at any time up to
expiration date. In NSE all stock options are American type options.
European style Option: European options are options that can be exercised at the time of maturity
only. In NSE all indices options are European type options.

II.

As per the Intrinsic value:

1) In The Money Options
2) At The Money Options and
3) Out of The Money Options
In The Money Options: In The Money Options is the acronym to its short form ITM. A call option is
said to be In the Money Option when spot price is higher than strike price,
ITM Call = Spot Price > Strike Price
While a put option is said to be In the Money Option when Spot price is below the Strike price,
ITM Put = Spot Price < Strike Price.
In the Money options lead to a positive cash flow if it were exercised immediately.
At The Money Options
At The Money Options is the acronym to its short form ATM. An option is said to be At the Money
Option when spot price and strike price are equal.
ATM Option = Spot Price = Strike Price

At the Money options lead to a zero cash flow if it were exercised immediately.

Out of The Money Options

Out The Money Options is the acronym to its short form OTM. A call options is said to be Out of
the Money Option when spot price is below than strike price,
OTM Call = Spot Price < Strike Price.
While a put option is said to be Out of the Money Option when Spot price is higher Strike price,
ITM Put = Spot Price > Strike Price
In the Money options lead to a negative cash flow if it were exercised immediately.
ITM vs. OTM
Choosing which specific option to buy can often be a complicated process, and there are literally
hundreds of optionable companies to choose from. The interesting thing about options is that
the various strike prices of each series accommodate all types of traders and strategies.
When it comes to buying options that are in the money or out of the money, the choice depends on
your outlook for the underlying security and your risk tolerance level. Out-of-the-money options are
less expensive than in-the-money options, which in turn makes them more desirable to investors with
little capital. However, out-of-the-money options are also regarded as bearing higher risk
because there

is

a greater

probability

that

they

will

end

up

being

worthless

upon

expiration. Generally speaking, traders who use out-of-the-money options have a higher expectation
of a larger move in the price of the underlying than traders who use in-the-money options.
When it comes to returns, the out-of-the-money options often experience larger percent gains/losses
than the in-the-money options, which again is due to the higher amount of risk. Since out-of-themoney options have a lower price, a small change in their price can translate into very large percent
returns. For example, it is not uncommon to see the price of an out-of-the-money call option go from
$0.10 to $0.15 in one day, which is equivalent to a 50% price increase. These high returns make

these options attractive to novice traders, but you should keep in mind that many out-of-the-money
options

also

fall

50% or

more

in

one

day.

The options you choose to trade should be determined by your risk tolerance, investment strategy
and overall view on the direction of the underlying asset.
Put Call Parity
Put-call parity is a financial relationship between the price of a put option and a call option. The putcall parity is a concept related to European call and put options. The put-call parity is an option
pricing concept that requires the values of call and put options to be in equilibrium to prevent
arbitrage.

Thus the following relationship exists between the values of the various instruments at a general time
t,
C ( t )+ K B ( t ,T )=P ( t )+ S (t)

Where,
C (t) = the value of the call at time t,
P (t) = the value of the Put
S (t) = the value of the share
K = the Strike price
B (t,T) = value of the bond that matures at time T. if a stock pays dividends, they should be included
in B (t,T) because options prices are typically not adjusted for ordinary dividends.
Put Call Parity and American Options
For American options, where you have the right to exercise before expiration, this affects the B(t, T)

term in the above equation. Put-call parity only holds for European options or American options if
they are not exercised early.

There are two types of Triangles:

1) Buy call + Sell put + Sell future and
2) Sell call + Buy Put + Buy Future.
Options Pricing
There are mainly 5 factors, which affects the pricing of an Option.
1) Spot price
2) Strike price
3) Volatility
4) Time to Maturity
5) Rate of Interest
Spot Price
Spot price is the price of the Underlying. For example, the Nifty Value is the spot price to work in
Options in India. These price changes have opposite effects on calls and puts. For instance, as the
value of the underlying security rises, a call will generally increase and the value of a put will
generally decrease in price. A decrease in the underlying security's value will generally have the
opposite effect.
Strike Price
The price at which the owner of an option can purchase (Call) or sell (Put) the underlying stock.
Used interchangeably with striking price, strike, or exercise price. An option's premium (intrinsic
value plus time value) generally increases as the option becomes further in the money, and decreases
as the option becomes more deeply out of the money.

Volatility
A measure of stock price fluctuation. Mathematically, volatility is the annualized standard deviation
of a stock's daily price changes. Volatility is simply a measure of risk (uncertainty), or variability of
price of an option's underlying security. Higher volatility estimates reflect greater expected
fluctuations (in either direction) in underlying price levels. This expectation generally results in
higher option premiums for puts and calls alike, and is most noticeable with at-the-money options.
Time to Maturity
The date on which an option and the right to exercise it cease to exist. Generally, as expiration
approaches, the levels of an option's time value, for both puts and calls, decreases or "erodes." This
effect is most noticeable with at-the-money options.
Rate of Interest
The effect of an underlying security's dividends and the current risk-free interest rate have a small
but measurable effect on option premiums. This effect reflects the "cost of carry" of shares in an
underlying security.
A

simple hierarchy showing the branching of the Options Pricing.

Interrelationship between Options price and its variables:

Particulars

Call Option

Put Option

Spot

Positive

Negative

Strike

Negative

Positive

Time

Negative

Negative

Volatility

Positive

Positive

Rate of Interest

Positive

Negative

Understanding Intrinsic Value and Time Value

Intrinsic Value
An option is said to have intrinsic value if the option is in-the-money (ITM). Intrinsic value reflects
the amount, if any, by which an option is In-the-money (ITM). In fact, an option may not have any
intrinsic value at all. By definition, at-the-money (ATM) and out-of-the-money (OTM) options do
not
For

have

intrinsic

value.
example:

Call's

intrinsic

value

ABC's

stock

price

Call's

strike

price

If a call option has a strike price of $25, and the stock price is $24, then the price of the option has no
intrinsic value; its only value is time value. If, having bought the option, the stock price goes up to
$26, you now have $1 worth of intrinsic value. The remainder of the option price is time value.
Put's

intrinsic

value

Put's

strike

price

ABC's

stock

price

If a put option has a strike price of $25, and the stock price is $26, then the price of the option has no
intrinsic value. It gains intrinsic value when the stock price falls to below $25. So, if the stock falls to
$24, then the option has $1 worth of intrinsic value. The remainder is time value.

Time

Value

Time Value is the amount of money you pay for the length of time until the option expires. If you
buy an OTM option (Call or Put), you pay only for the time value. If you buy an ITM option, you
pay for the time value PLUS the intrinsic value. The further away from the strike date that you buy
or

sell

the

option,

the

more

you

pay

for

that

option.

As you get closer to expiration, the value of the option decreases more and more rapidly, until it is at
zero

on

the

strike

date.

Time value increases as volatility increases, because if the stock is more volatile, it has a greater
chance of moving into desired prices during the time period; it is therefore more valuable; it is also
more risky.
When you BUY option calls and puts, Time Value is your ENEMY!! This is why Swing Trading is
so important. Because you are planning to hold the option (either a call or a put) for two to 10 days,
you

can

minimize

the

effect

of

time

value.

When you SELL calls, puts and spreads, Time Value is ON YOUR SIDE, and is some other guy's
enemy (the guy that bought your option).

The bottom Line

A stock investor who is interested in using options to capture a potential move in a stock must
understand how options are priced. Besides the underlying price of the stock, the key determinates of
the price of an option are its intrinsic value - the amount by which the strike price of an option is inthe-money - and its time value.
Time value is related to how much time an option has until it expires and the option's volatility.
Volatility is of particular interest to a stock trader wishing to use options to gain an added advantage.
Historical volatility provides the investor a relative perspective of how volatility impacts options
prices, while current option pricing provides the implied volatility that the market currently expects
in the future.
Knowing the current and expected volatility that is in the price of an option is essential for any
investor

that

wants

to

take

advantage

of

the

movement

of a

stock's

price.

Option GREEKS
The mathematical characteristics of the Black-Scholes model are named after the greek letters used
to represent them in equations. These are known as the Option Greeks. The 5 Option Greeks measure

the sensitivity of the price of stock options in relation to 4 different factors; Changes in the
underlying

stock

price,

interest

rate,

volatility,

time

decay.

Option Greeks allow option traders to objectively calculate changes in the value of the option
contracts in their portfolio with changes in the factors that affects the value of stock options. The
ability to mathematically calculate these changes gives option traders the ability to hedge their
portfolio or to construct positions with specific risk/reward profiles.

DELTA
Delta value is the most well known and the most important of the option greeks. It is the degree to
which an option price will move given a change in the underlying stock price, all else being equal.
Delta calculates the change in the price of an Option due to One Rupee change in Price of an
Underlying.
Knowing the delta value of your options is important for option traders who do not hold stock
options until expiration. In fact, few options traders hold speculative positions to expiration in
options trading.
Option delta is also important for option traders who uses complex position trading option strategies.

If an option trader is planning to profit from the time decay of his short term stock options, then that
option trader needs to make sure that the overall delta value of his position is near to zero so that
changes in the underlying stock price do not affect the overall value of his position. This is known as
Delta Neutral in options trading.
Example,
With respect to Call Option, Delta of 0.60 means for every change of Rs.1 in underlying Stock will
change the price of Call Option by 0.60.

Explanation of Delta

Delta of Call Option always comes in Positive figure while Delta of Put comes in Negative

So when you buy Call Option, Positive Delta multiplies by Positive Quantity, Hence gives
Positive Portfolio Delta which signifies that buying Call Option means Bullish Position

When you Sell Call Option, Positive Delta multiplies by Negative Quantity, Hence gives
Negative Portfolio Delta which signifies that Selling Call Option means Bearish Position

When you buy Put Option, Negative Delta multiplies by Positive Quantity, Hence gives
Negative Portfolio Delta which signifies that buying Put Option means Bearish Position

When you sell Put Option, Negative Delta multiplies by Negative Quantity, Hence gives
Positive Portfolio Delta which signifies that Selling Put Option means Bullish Position

Value of Delta increases as the Option moves from Out of the money to At the money and
from At the money to In the money Option

Call Delta ranges from 0 to 1 and Put Delta ranges from 0 to -1

Total of absolute value of Call Delta and Put Delta always comes to 1

Delta of Future is 1

Relationship of Delta with Option Variables:

VARIABLES
SPOT
STRIKE
VOLATILY
TIME

CHANGE
Increases
Increases
Increases
Increases

CALL DELTA
Increases
Decreases
Increases
OTM moves towards

PUT DELTA
Decreases
Increases
Decreases
OTM moves towards

0
0
ATM moves towards ATM moves towards

RATE

OF Increases

0.5
ITM moves towards 1

-0.5
ITM moves towards

Increases

-1
Decreases

INTEREST

GAMMA
Gamma calculates the change in the Delta of an Option due to One Rupee change in Price of an
Underlying. In other words, the Gamma shows the option delta's sensitivity to market price changes.
Gamma is important because it shows us how fast our position delta changes in relation to the market
price of the underlying asset, however, it is not normally needed for calculation for most option
trading strategies. Gamma is particularly important for delta neutral traders who wants to predict
how to reset their delta neutral positions as the price of the underlying stock changes.
Example:
With respect to Call Option, Gamma of 0.02 means for every change of Rs.1 in underlying Stock
will change the delta of Call Option by 0.02.

Explanation of Gamma

Gamma of Call Option and Put Option always comes in Positive figure

So when you buy Call Option, Positive Gamma multiplies by Positive Quantity, Hence gives
Positive Portfolio Gamma which signifies that buying Call Option means Long Gamma
Position

When you Sell Call Option, Positive Gamma multiplies by Negative Quantity, Hence gives
Negative Portfolio Gamma which signifies that Selling Call Option means Short Gamma
Position

When you buy Put Option, Positive Gamma multiplies by Positive Quantity, Hence gives
Positive Portfolio Gamma which signifies that buying Put Option means Long Gamma
Position

When you sell Put Option, Positive Gamma multiplies by Negative Quantity, Hence gives
Negative Portfolio Gamma which signifies that Selling Put Option means Short Gamma
Position

Value of Gamma increases as the Option moves from Out of the money to At the money and
decreases as the Option moves from At the money to In the money Option

Gamma of Call Option and Put Option will always be same

Gamma of Future is 0

Relationship of Gamma with Option Variables

VARIABLES
SPOT

CHANGE
Increases

CALL GAMMA
Gamma Increases as
option moves from
OTM to ATM

PUT GAMMA
Gamma Increases as
option moves from
ITM to ATM

Gamma
will
be Gamma
will
be
Highest when Option Highest when Option
is ATM
is ATM
Gamma Decreases as Gamma Decreases as
option moves from option moves from
ATM to ITM
ATM to OTM
STRIKE

Increases

Gamma Increases as Gamma Increases as

option moves from option moves from
ITM to ATM
OTM to ATM
Gamma
will
be Gamma
will
be
Highest when Option Highest when Option
is ATM
is ATM
Gamma Decreases as Gamma Decreases as
option moves from option moves from
ATM to OTM
ATM to ITM

VOLATILITY

Increases

Decreases

Decreases

TIME

Increases

Increases

Increases

Decreases

Decreases

RATE
INTEREST

OF Increases

VEGA
Vega calculates the change in the Premium of an Option due to One Percent change in Volatility of
an Underlying. Vega is quoted to show the theoretical price change for every 1 percentage point
change in implied volatility.
Vega is most sensitive when the option is at-the-money and tapers off either side as the market trades
above/below the strike. Some option trading strategies that are particularly vega sensitive are Long
Straddle (where a profit can be made when volatility increases without a move in the underlying
asset) and a Short Straddle (where a profit can be made when volatility decreases without a move in

the underlying asset).

Example:
With respect to Call Option, Vega of 6 means for every change of 1% Volatility in underlying Stock
will change the Premium of Call Option by Rs.6.

Explanation of VEGA

Vega of Call Option and Put Option always come in Positive figure

So when you buy Call Option, Positive Vega multiplies by Positive Quantity, Hence gives
Positive Portfolio Vega which signifies that buying Call Option means Long Vega Position

When you Sell Call Option, Positive Vega multiplies by Negative Quantity, Hence gives
Negative Portfolio Vega which signifies that Selling Call Option means Short Vega Position

When you buy Put Option, Positive Vega multiplies by Positive Quantity, Hence gives
Positive Portfolio Vega which signifies that buying Put Option means Long Vega Position

When you sell Put Option, Positive Vega multiplies by Negative Quantity, Hence gives
Negative Portfolio Vega which signifies that Selling Put Option means Short Vega Position

Value of Vega increases as the Option moves from Out of the money to At the money and
decreases as the Option moves from At the money to In the money Option

Vega of Call Option and Put Option will always be same

VARIABLES
SPOT

CHANGE
Increases

CALL VEGA
Vega Increases

PUT VEGA
as Vega Increases

as

option moves from option moves from

OTM to ATM

ITM to ATM

Vega will be Highest Vega will be Highest

when Option is ATM
Vega

Decreases

when Option is ATM

as Vega

Decreases

as

option moves from option moves from

ATM to ITM
STRIKE

Increases

Vega

Increases

ATM to OTM
as Vega

Increases

as

option moves from option moves from

ITM to ATM

OTM to ATM

Vega will be Highest Vega will be Highest

when Option is ATM
Vega

Decreases

when Option is ATM

as Vega

Decreases

as

option moves from option moves from

ATM to OTM

ATM to ITM

VOLATILITY

Increases

Decreases

Decreases

TIME

Increases

Decreases

Decreases

RATE

OF Increases

Decreases

Decreases

INTEREST
Relationship of Vega with Option variables
THETA
Theta calculates the change in the Premium of an Option due to One day change in Time to Maturity.
By Time Decay, it means the depreciation of the premium value of a stock option contract.
The theta value indicates how much value a stock option's price will diminish per day with all other
factors being constant. The nearer the expiration date, the higher the theta and the farther away the

expiration date, the lower the theta.

Example:
With respect to Call Option, Theta of -6 means Premium of Call Option will reduce by Rs.6 if one
day passes.
Explanation of Theta

Theta of Call Option and Put Option always comes in Negative figure

So when you buy Call Option, Negative Theta multiplies by Positive Quantity, Hence gives
Negative Portfolio Theta which signifies that buying Call Option means Short Theta Position

When you Sell Call Option, Negative Theta multiplies by Negative Quantity, Hence gives
Positive Portfolio Theta which signifies that Selling Call Option means Long Theta Position

When you buy Put Option, Negative Theta multiplies by Positive Quantity, Hence gives
Negative Portfolio Theta which signifies that buying Put Option means Short Theta Position

When you sell Put Option, Negative Theta multiplies by Negative Quantity, Hence gives
Positive Portfolio Theta which signifies that Selling Put Option means Long Theta Position

Value of Theta increases as the Option moves from Out of the money to At the money and
decreases as the Option moves from At the money to In the money Option

Theta of Call Option and Put Option will always be same

Theta of Future is 0

VARIABLES
SPOT

CHANGE
Increases

CALL THETA
Theta Increases

PUT THETA
as Theta Increases

as

option moves from option moves from

OTM to ATM

ITM to ATM

Theta will be Highest Theta will be Highest

when Option is ATM

when Option is ATM

Theta Decreases as Theta Decreases as

option moves from option moves from
ATM to ITM
STRIKE

Increases

Theta

Increases

ATM to OTM
as Theta

Increases

as

option moves from option moves from

ITM to ATM

OTM to ATM

Theta will be Highest Theta will be Highest

when Option is ATM

when Option is ATM

Theta Decreases as Theta Decreases as

option moves from option moves from
ATM to OTM

ATM to ITM

VOLATILITY

Increases

Increases

Increases

TIME

Increases

Increases

Increases

RATE

OF Increases

Increases

Decreases

INTEREST
Relationship of Theta with Option variables
RHO
Rho calculates the change in the Premium of an Option due to One Percent change in Rate of
Interest.
Example:
With respect to Call Option, Rho of 6 means Premium of Call Option will increase by Rs.6 if rate of

Interest increases by one Percent.

Explanation of Rho

Rho of Call Option comes in Positive and Put Option comes in Negative figure

So when you buy Call Option, Positive Rho multiplies by Positive Quantity, Hence gives
Positive Portfolio Rho which signifies that buying Call Option means Long Rho Position

When you Sell Call Option, Positive Rho multiplies by Negative Quantity, Hence gives
Negative Portfolio Rho which signifies that Selling Call Option means Short Rho Position

When you buy Put Option, Negative Rho multiplies by Positive Quantity, Hence gives
Negative Portfolio Rho which signifies that buying Put Option means Short Rho Position

When you sell Put Option, Negative Rho multiplies by Negative Quantity, Hence gives
Positive Portfolio Rho which signifies that Selling Put Option means Long Rho Position

Value of Rho increases as the Option moves from Out of the money to At the money and
decreases as the Option moves from At the money to In the money Option

Rho of Call Option and Put Option will always be same

Rho of Future is 0

Relationship of Rho with other Option Variables

VARIABLES

CHANGE

CALL RHO

PUT RHO

SPOT

Increases

Increases

Decreases

STRIKE

Increases

Decreases

Increases

VOLATILITY

Increases

Decreases

Increases

TIME

Increases

Decreases

Decreases

Increases

Increases

Decreases

RATE
INTEREST

OF

OPTION STRATEGIES
Nowadays, many investors' portfolios include investments such as mutual funds, stocks and bonds.
But the variety of securities you have at your disposal does not end there. Another type of security,
called an option, presents a world of opportunity to sophisticated investors.

The power of options lies in their versatility. They enable you to adapt or adjust your position
according to any situation that arises. Options can be as speculative or as conservative as you want.
This means you can do everything from protecting a position from a decline to outright betting on
the movement of a market or index.
There are two main reasons why an investor would want to work with options.
1) Speculation and
2) Hedging

Speculation
You can think of speculation as betting on the movement of a security. The advantage of options is
that you aren't limited to making a profit only when the market goes up. Because of the versatility of
options, you can also make money when the market goes down or even sideways.
Speculation is the territory in which the big money is made - and lost. The use of options in this
manner is the reason options have the reputation of being risky. This is because when you buy an
option, you have to be correct in determining not only the direction of the stock's movement, but also
the magnitude and the timing of this movement. To succeed, you must correctly predict whether a
stock will go up or down, and you have to be right about how much the price will change as well as
the time frame it will take for all this to happen. .
So why do people speculate with options if the odds are so skewed? Aside from versatility, it's all
about using leverage. When you are controlling 100 shares with one contract, it doesn't take much of
a price movement to generate substantial profits.
Hedging
The other function of options is hedging. Think of this as an insurance policy. Just as you insure your
house or car, options can be used to insure your investments against a downturn. Critics of options
say that if you are so unsure of your stock pick that you need a hedge, you shouldn't make the
investment. On the other hand, there is no doubt that hedging strategies can be useful, especially for
large institutions. Even the individual investor can benefit. Imagine that you wanted to take
advantage of technology stocks and their upside, but say you also wanted to limit any losses. By

using options, you would be able to restrict your downside while enjoying the full upside in a costeffective way.
In general, an Option Strategy calls for a simultaneous purchase and/or sale of different option
contracts, also known as an Option Combination. The main reason for doing this is very simple. The
investor never knows the direction in which the market might head. Thus, he buys a call and a put.
By doing this, technically, when the market goes up, he makes a profit from the call he has purchased
but makes a loss with the put. And when the market scoots in the downward direction, he makes a
profit with the put he has purchased but makes a loss with the purchased call.
To understand it even better, lets consider this simple example. Suppose you have bought (long) 1
Rs. 60 March call option and also bought 1 Rs. 60 March put option. Nifty, the underlying is trading
at Rs. 60, the call costs you Rs. 2.00 and the put also costs Rs. 2.00.
Now, when you're the option buyer or going long, you can't lose more than your initial investment
which is the premium that you have paid to buy the particular option. So, you've outlaid a total of Rs.
4.00, which is you're maximum loss if all else goes wrong.
But what happens if the market rallies? The put option becomes less valuable as the market trades
higher because you bought an option that gives you the right to sell the asset - meaning for a long put
you want the market to go down.
However, the call option becomes infinitely valuable as the market trades higher. So, after you break
away from your breakeven point your position has unlimited profit potential.
Below is a detailed explanation of some of the most widely used Options Strategies. These strategies
help the investors earn a lot of money provided that they are applied in the right situations.
1) Straddle
The long straddle, also known as buy straddle or simply "straddle", is a neutral strategy in
options trading that involve the simultaneously buying of a put and a call of the same underlying
stock, striking price and expiration date.
Long Straddle Construction
Buy 1 ATM Call
Buy 1 ATM Put

Long straddle options are unlimited profit, limited risk options trading strategies that are used
when the options trader thinks that the underlying securities will experience significant volatility
in the near term.
Unlimited Profit Potential.
By having long positions in both call and put options, straddles can achieve large profits no
matter which way the underlying stock price heads, provided the move is strong enough.
Limited Risk
Maximum loss for long straddles occurs when the underlying stock price on expiration date is
trading at the strike price of the options bought. At this price, both options expire worthless and
the options trader loses the entire initial debit taken to enter the trade.

The formula for calculating maximum loss is given below:

Maxloss=Net premium paid+Commissions paid

Max Loss Occurs When Price of Underlying = Strike Price of Long Call/Put

From the above diagram, we can see that in whichsoever direction the market heads, the investor
arrives at a profit. Thus, by using this strategy, the investor expects a huge movement either way.

Underlying Price
5200
5300
5400
5500
5600
5700
5800

End Date
09/12/2010
09/12/2010
09/12/2010
09/12/2010
09/12/2010
09/12/2010
09/12/2010

Profit
25599.6285
15984.8358
7302.3633
1033.7019
-803.2280
2528.0574
9631.6287

Profit %
194.08%
121.19%
55.36%
7.84%
-6.09%
19.17%
73.02%

5900
6000

09/12/2010
09/12/2010

18589.5094
28255.7497

140.94%
214.22%

The above table demonstrates to us the profit and loss account of the strategy. At 5600, where the
market is range bound, the investor draws the maximum loss. As the market impresses upwards,
the profits keep on increasing substantially. Same is the case when the market heads in the
downward direction where also the profits considerably increase.

2) Strangle
The short strangle, also known as sell strangle, is a neutral strategy in options trading that involve
the simultaneous selling of a slightly out-of-the-money put and a slightly out-of-the-money call
of the same underlying stock and expiration date.

Short Strangle Construction

Sell 1 OTM Call

Sell 1 OTM Put

The short strangle option strategy is a limited profit, unlimited risk options trading strategy that is
taken when the options trader thinks that the underlying stock will experience little volatility in
the near term. Short strangles are credit spreads as a net credit is taken to enter the trade.
Limited Profit
Maximum profit for the short strangle occurs when the underlying stock price on expiration date
is trading between the strike prices of the options sold. At this price, both options expire
worthless and the options trader gets to keep the entire initial credit taken as profit.
The formula for calculating maximum profit is given below:
Max Profit=Net Premium RecievedCommissions paid

Max Profit is achieved when the price of the Underlying is in between the Strike Price of the
Short Call and the Strike Price of the Short Put
Unlimited Risk
Large losses for the short strangle can be experienced when the underlying stock price makes a
strong move either upwards or downwards at expiration.
The formula for calculating loss is given below:
Maximum Loss=Unlimited

Price of Underlying > Strike Price of s h ort call+ Net premium recieved

OR
Price of Underlying< Strike price of s h ort putNet Premium recieved

Breakeven Point(s)

There are 2 break-even points for the short strangle position. The breakeven points can be
calculated using the following formulae.
Upper Breakeven point=Strike price of s h ort call+ Net premium recieved

Lower Breakeven point=Strike price of s h ort put Net premium recieved

The Strangle graph

The only difference between straddle and strangle is that there are two strike prices used in
strangle, each separate for call and put. While in straddle, there is just one strike price for both,
call and put. This can be clearly seen in the diagram above. The small horizontal line on the top
of the graph indicates two separate strike prices. We can see that in which ever direction the
market moves the investor lands on a profit. Thus, by using this strategy, the investor anticipates
a substantial movement either way.

Underlying Price

End Date

Profit

Profit %

5200.0000
5300.0000

09/29/2010
09/29/2010

-26335.3146
-16335.3146

-26.66%
-16.53%

Butterfly
Spread Construction09/29/2010
5400.0000

-6335.3146

5500.0000
Buy
1 ITM Call

09/29/2010

3089.5341

Sell
2 ATM Calls
5600.0000

09/29/2010

3660.0000

Buy
1 OTM Call
5700.0000

09/29/2010

3660.0000

5800.0000

09/29/2010

3053.4769

3.09%

5900.0000

09/29/2010

-6344.9409

-6.42%

6000.0000

09/29/2010

-16344.9409

-16.54%

-6.41%
3.13%
3.70%
3.70%

As it can be seen in the table above, as the market moves in either direction with substantial amounts,
the investor makes a loss. A range-bound market would do it for the investor.

3) Butterfly
Butterfly is one of the most widely used strategies in the world of Options.
Long butterfly

The butterfly spread is a neutral strategy that is a combination of a bull spread and a bear spread.
It is a limited profit, limited risk options strategy. There are 3 striking prices involved in a
butterfly spread and it can be constructed using calls or puts.
Long Call Butterfly
Long butterfly spreads are entered when the investor thinks that the underlying stock will not rise
or fall much by expiration. Using calls, the long butterfly can be constructed by buying one lower
striking in-the-money call, writing two at-the-money calls and buying another higher striking
out-of-the-money call. A resulting net debit is taken to enter the trade.

Example
Suppose XYZ stock is trading at $40 in June. An options trader executes a long call butterfly by
purchasing a JUL 30 call for $1100, writing two JUL 40 calls for $400 each and purchasing
another JUL 50 call for $100. The net debit taken to enter the position is $400, which is also his
maximum possible loss.
On expiration in July, XYZ stock is still trading at $40. The JUL 40 calls and the JUL 50 call
expire worthless while the JUL 30 call still has an intrinsic value of $1000. Subtracting the initial
debit of $400, the resulting profit is $600, which is also the maximum profit attainable.
Maximum loss results when the stock is trading below $30 or above $50. At $30, all the options
expires worthless. Above $50, any "profit" from the two long calls will be neutralised by the
"loss" from the two short calls. In both situations, the butterfly trader suffers maximum loss
which is the initial debit taken to enter the trade.

As the butterfly strategy is a limited loss limited profit strategy (seen in the graph), the profits in
this strategy is very less. This strategy is employed by investors when they sense that the market
is going to remain range bound. Thus, more the movement in the market, more is the loss
suffered.
Underlying Price
5200.0000
5300.0000

End Date
09/17/2010
09/17/2010

Profit
-9063.86
-7929.9668

Profit %
-30.95%
-27.07%

5400.0000
5500.0000

09/17/2010
09/17/2010

-4822.7031
-645.0955

-16.47%
-2.20%

5600.0000
5700.0000

09/17/2010
09/17/2010

1201.5082
-934.1875

4.10%
-3.19%

5800.0000
5900.0000

09/17/2010
09/17/2010

-4790.8509
-7623.5722

-16.36%
-26.03%

It
can
also
be

6000.0000
09/17/2010
-8861.9252
-30.26%
seen from the table that as the markets keeps on moving in either direction, the investor keeps on
making losses. Thus it is very important for the investor to sufficiently view the market conditions
and then engage into this strategy.
Short butterfly

The short butterfly is a neutral strategy like the long butterfly but bullish on volatility. It is a
limited profit, limited risk options trading strategy. There are 3 striking prices involved in a short
Short Butterfly Construction

butterfly spread and it can be

Sell 1 ITM Call

constructed using calls or puts.

Buy 2 ATM Calls and Sell 1 OTM Call

Short Call Butterfly

Using calls, the short butterfly can be constructed by writing one lower striking in-the-money
call, buying two at-the-money calls and writing another higher striking out-of-the-money call,
giving the trader a net credit to enter the position.

Limited Profit
Maximum profit for the short butterfly is obtained when the underlying stock price rally pass the
higher strike price or drops below the lower strike price at expiration.
If the stock ends up at the lower striking price, all the options expire worthless and the short
butterfly trader keeps the initial credit taken when entering the position.
However, if the stock price at expiry is equal to the higher strike price, the higher striking call
expires worthless while the "profits" of the two long calls owned is canceled out by the "loss"
incurred from shorting the lower striking call. Hence, the maximum profit is still only the initial
credit taken.

This too is a limited profit, limited loss strategy. The only difference between long butterfly and
short butterfly is that the investor is waiting for the market volatility to rise in the short butterfly.
That is, the investor wants the market to move substantially in either direction.
Underlying Price

End Date

Profit

Profit %

5200.0000

09/17/2010

9064.1065

84.63%

5300.0000
5400.0000
5500.0000
5600.0000
5700.0000
5800.0000
5900.0000
6000.0000

09/17/2010
09/17/2010
09/17/2010
09/17/2010
09/17/2010
09/17/2010
09/17/2010
09/17/2010

7927.5215
4803.0299
589.3277
1280.8636
867.7732
4751.7490
7604.8354
8854.7899

74.02%
44.85%
5.50%
-11.96%
8.10%
44.37%
71.01%
82.68%