Options Trading

Options Trading Basics Rahul Patel, Ajab Gandhi and Smitha Ramachandran Introduction Trading of stock, commodity, foreign currency and index is widely popular in world and provides far greater possible returns than trading in equities. Individual investors trade most in options than any other financial instrument. It can be in spot market or derivative market. Derivative market consists of trading in forward, futures and options. Derivatives are helpful to guard against the uncertain risk arising from fluctuation in asset prices. According to National Stock Exchange (NSE) Derivative is a product whose value is derived from the value of one or more basic variables called bases (underlying asset, index, or reference rate), in a contractual manner . Underlying asset includes equity, forex, commodity or any other asset. Option is defined as the right, but not the obligation, to buy or sell a specific amount of a given stock, commodity, currency, index, or debt, at a specified price during a specified period of time. Options are differentiated by the underlying asset, option type, strike price and expiry date. Options are different from forward and future contracts. An option gives the right to do something, but not necessarily exercise this right. In forward and future contract two parties are committed to do something and this has to be done at a certain time in future. For entering into a futures contract cost involved is minimal while in options contract there is a fee, normally an up-front fee, involved in entering into this position. Brief History of Options Literatures failed to record the first option contract traded. However it has been recorded that similar to modern options contract the Romans and the Phoenicians did contracts in shipping as early as 17th century. Evidences suggest that the Greek mathematician and 1 of 16 philosopher, Thales used options to enter into a contract to obtain olive presses at a low price in advance before the harvest season anticipating that the harvest will be good. At the time of good harvest the demand for olive presses increased and he lent those for higher prices than he had given to secure these presses. This type of securing things at lower prices and selling at higher prices is the basic idea behind options trading. Similar situation prevailed in Holland where tulip options were traded and in London also options were traded. But all these were done by speculators and in unregulated markets. Hence in the early 18th century options were declared illegal in London. Options in USA In US, earlier options were traded not on regulated exchanges but buyers and sellers had to mutually find each other. Here options market came under surveillance after the Great Depression. The Investment Act of 1934 legitimized options and it came under the vigilance of Securities and Exchange Commission (SEC) which was newly formed then. Options under the SEC were traded as over-the counter (OTC) product. Due to the cumbersome procedures and illiquidity of the OTC products, options failed to attract investors and traders. Other issue which was in the way of failure of options trading was non availability of information about the real market scene and the lack of professionals in this field of trading. Earlier the investor himself had to exercise the option within the time limit otherwise the options expired worthless. The volume traded was very low and almost was stagnant in early part of 20th century and in late 1960s the Chicago Board of Trade (CBOT) decided to diversify into options market. But the then vice-president of planning Joseph Sullivan observed that the key ingredients for success were missing in options market. In his opinion the options contained too many parameters and to correct this he tried standardizing the strike price, expiration, size and other relevant variables (Ref: A Brief History of Options, http://www.optionsxpress.com/educate/investing101/history.aspx). Another proposal was about the creation of an intermediary to issue contracts and guarantee settlement and 2 of 16 performance. This led to the establishment of what is now known as the Options Clearing Corporation (OCC) in US. Types of Options Broadly, options are divided into two types i.e. call option and put option. A call option is defined as an option contract which gives the buyer the right, but not the obligation, to buy shares of an underlying security at a specific price for a specified time. The seller of a call option has the obligation to sell the underlying security if and only the buyer exercises his option to buy. For example, a buyer of one AAA April 50 call options has the right to buy 100 shares of AAA at $50 till April expiration date. The buyer may purchase these shares by filing an exercise notice through a broker prior to the expiration date of the call option. An option contract which gives the holder the right, but not the obligation, to sell a certain quantity of an underlying security to the writer of the option, at a specified price up to a specified date is called as put option. The writer of a put option has the obligation to buy the underlying security if the holder of the put option exercises his option to sell. For example, the buyer of one AAA April 50 put option has the right to sell 100 share of AAA at $50 till April expiration date. The buyer may sell these shares by filing an exercise notice with the OCC through a broker prior to the expiration date of the put option. Basic Concepts in Options Entering into an option contract means the investor is taking a position on a stock (or related option) in a derivative market. With the basic types of options available several variations of options positions are made. The position entered is either termed as long or short. The long position is taken by those investors who are bullish about the market while the short position is entered by those who are bearish about the market. 3 of 16 The following type of investors depending on their financial goals and investment objectives should consider options trading. Investors who wish to participate in the market without trading or holding a large stock portfolio Investors with strong market views and its future movement and want to take the advantage of the situation Investors who follow the equity market closely Investors who want to protect the value of their diversified equity portfolio Risk in Options Two types of risks are associated with options the price movement of the underlying and the changes in volatility. Factors contributing to these risks are many and varied. Some of the prominent factors are the state of economy, supply and demand factors in the options market and in other related markets. The factors affecting the values of the various underlying assets and those affecting the volatility, liquidity and efficiency of the markets or other markets also contributes to the risk. Other factors that may affect the pricing of particular options, the quality or operations of the various options markets at any particular time and the procedures of the various options markets etc also affects the risk associated with options. Risks are generally of same type to all underlying assets. The options holder has to encounter some of the following risk like the risk of losing the premium paid to purchase the option in a short period or if the investor enters into short position time decay will have tremendous effect and it so happens that the out of the money options with shorter time expiry will suffer more. Risks associated with an option writer will be the assignment of exercise of the options at any time during the period of the life of option. Writer of the covered call has to forgo the opportunity of gaining more money from the increase in the value of the underlying stock. The naked call writer is highly in risk state and may incur unlimited loss if the underlying price increases above the strike price. 4 of 16 Volatility in Options Market Volatility is an important factor to be considered in options trading. Volatility is a measure of the rate of change in the market movement in a given time either in the upward or downward direction. If volatility is high then the premium on the option will be high and volatility is low the premium will be relatively low. Two types of volatility are the statistical volatility and the implied volatility. While statistical volatility is the measure of actual price changes over the specified period of time, the implied volatility is the measure of how much the market expects the asset price to move for an option price. Volatility is one of the variables in option-pricing formulas showing the extent to which the return of the underlying asset will fluctuate between now and the option's expiration. A good understanding about the volatility is required for options trading. Profit Potential in Options Market The elementary investment strategies associated with options and its profit diagrams are discussed here. Long Call Strategy The most basic trading position is the Long Call Position. Here the investor purchases a call option. Say an investor buys an option at a strike price of X paying a premium of x. Then the investor will breakeven if the strike price at expiration is X+x. Any price beyond X+x gives profit for the investor. The graph1 depicts the long call position. The long position in the underlying asset and the long call position are similar in the sense that the investor is bullish on the underlying asset and thus enters into the long call position. 5 of 16 Source: Compiled by Ajab Gandhi Short (Naked) Call Strategy Short Call Strategy is also referred to as naked as the option writer does not actually own the underlying security for which he is writing off the contract. The option writer thus enters into an obligation of selling the underlying asset if the buyer exercises the option. This position is depicted in graph 2. Source: Compiled by Ajab Gandhi Here x is the premium the investor gets on selling the call option at a strike price of X. If the market price decreases below the strike price then the writer will earn a profit equal to the premium. But if the market price increases above the strike price then the writer 6 of 16 incurs a loss. The loss becomes unlimited if the market price goes beyond the X+x which is the breakeven for this position. Long Put Strategy Long Put Strategy is more suited to investors who are bearish about the market. They anticipate gaining from the downward trend of the options market. To enter into this position the investor purchases puts i.e. the right to sell the underlying asset at a specified price without actually owning the stock. The graph 3 represents the long put position of an option. Source: Compiled by Ajab Gandhi Here x is the premium offered to buy a put option at strike price X. When the market goes bearish, the strike price decrease and the investor can gain the maximum profit of the premium paid when the market price is X-x which is the breakeven point. When the market price increases beyond the strike price the investor will not exercise the option and he loses the premium paid. Here the loss is limited to the premium paid and profit limited only by the market price waning to zero. Short Put Strategy 7 of 16 In Short Put Strategy, the investor writes a put option. Here the investor has a firm belief that the market will not go down. He is bullish on the underlying security. Though the risk involved is high compared to other positions, many investors choose this position to receive the premium amount as well as to acquire stock at a value below the current market price. Source: Compiled by Ajab Gandhi Here x is the premium he gets when he writes the put option at a strike price of X. Say at the time of expiration the market price is X or higher, then the put expires worthless and the investor enjoys the premium. If at the expiration date market price is less than X, then his profit decreases and he breakevens at X-x. If the market price goes below the breakeven point then the investor incurs unlimited loss. Option Trading Basics Construction of trading strategies in options is a complex process. The basic requirement for options trading is the deep knowledge about the stock market. In addition to the market knowledge other important factors in options trading are option volatility and the time decay. The main entities in the option trading system are the trading members, clearing members and participants. The buying or selling i.e. the trading depends upon the investor s views. Mainly the investor s view depends upon the nature of market whether it is bullish or bearish. If the 8 of 16 investor is bullish about the market, he anticipates that the price of the options will increase than the spot price and he decides to buy the options (takes long position) and sell the options on later months (takes short position). He buys the options paying a premium. An example to illustrate how the option is traded is given below. Say the spot price of XYZ is at Rs.2250, the investor who is bullish about the market buys a three month XYZ Call with a strike price of Rs. 2290 at Rs. 20 per call (premium). If the market price is at Rs 2330 after three months then the payoff in this position 2330 (2290+20) = 20Rs. But say if the spot price decreases he has the right not to exercise the options. The option may expire worthless but if he exercises the options he will incur loss. In the same example say if the spot price decreases to Rs. 2220 then he will not exercise the option and buy in spot market or face a loss of Rs.20/- the premium. In case the investor feels that the market is going bearish, then he will prefer to enter into a short position by writing to sell the option in the spot market and will buy the options on later months. In the above example, if the investor is of the view that the market is bearish then he will sell the options in the spot market and receives a premium of Rs. 20. If the spot price decreases to Rs. 2230 and if the investor buys the options contract then he will profit by Rs. 40 (Strike price Spot price+ premium). Here also the buyer does not have obligation to exercise the contract. Say if he wishes not to buy the options then he has to pay only the premium and hence his loss is limited. Hence options are very good tool to hedge the risk associated with the movement of the market. While the profit obtained through options can be unlimited the loss can be minimized or limited depending upon the strategies adopted for trading options. Trading Strategies in Options A. Single Options 9 of 16 In single options strategy only one type and one option contract is involved. The most common single options strategies are the covered call and the protective put. 1. Covered Call Strategy In the Covered Call Strategy, the investor takes a long position on the call option and writes a call on the same underlying which he already owns. This helps him to generate income from the same asset. This is often called a buy-write position. Here the investor is having a short-term neutral view about the market and hence will enter into long position. This strategy helps to enter into a hedge position since protection from the decline in stock price is made by writing a covered call. The risk and reward associated with this strategy is low. In this strategy the main two risks involved are the possibility of the stock price going down to zero or to relinquish the profit if the stock price shoots up drastically. This is a single option strategy as only one type of option comes into picture. 2. Protective Put In the Protective Put Strategy, the stockholder (investor) buys protective put for the stocks he already owns. The investor who is more concerned about the downside risk of the market and who does not wish to sell his stock enters into this strategy. By entering into this strategy the investor is trying to protect his unrealized profit (if any). The risk associated with this strategy is limited or the maximum loss is limited to the strike price (stock purchase price + premium paid) and the return or the maximum profit is unlimited as the investor can gain from two-way or rise/fall of market movement. B. Options Combinations 10 of 16 In options combinations either both type of options (put or call) or more than one option contract is involved. Outlined below are some of the strategies which involve options combinations. 1. Straddles and Strangles An investor enters into either the straddle or strangles position when he thinks that the underlying asset is highly volatile but is not sure of the direction of movement of the market. A Straddle Position is entered either by buying a call and a put option with the same strike price and same expiration date (straddle buyer) or by selling a call and a put option with the same strike price and expiry date (straddle seller). A Strangle Position is entered either by buying a call and a put option at two different strike prices but with same expiration date (strangle buyer) or by selling a call and a put option at different strike prices (strangle seller). 2. Strips & Straps A Strip is created by buying one call option and selling two put options with the same exercise price and exercise date. The Strap is created in the opposite way. 3. Spread Strategies Spread Strategies are also option combination strategies. This strategy involves a combination of two or more options on the same underlying but different strike prices. The most common spread strategy positions are discussed below. i. Bull Spread Bull Spread is a strategy which involves the sale and purchase of calls and puts that will produce maximum profit when there is a rise in price of the stock or the underlying asset. 11 of 16 ii. Bear Spread Bear Spread is a strategy which involves the purchase and sale of calls or puts that will produce maximum profits when there is a fall in the price of the stock or the underlying asset. iii. Calendar Spread (Time Spread) A spread involving simultaneous purchase or sale of options on the same underlying stock with different expirations is known as a Calendar Spread. Calendar spread is also known as Time Spread. Calendar spread can be further divided into two specific variations namely Horizontal spread and Diagonal spread. In horizontal spread, the option has identical striking prices but different expiration dates, whereas in diagonal spread, the option has different strike prices and different expiration dates iv. Box Spread The combination of a bull spread and a bear spread opened at the same time on the same underlying stock is known as a Box Spread. This strategy is designed to limit risk as well as potential profits. Also regardless of which direction the stock moves this strategy produces a profit on either side. v. Ratio Spread Ratio Spread is a strategy in options trading that involves buying a number of options and selling more options of the same underlying stock and same expiration date but at a different strike price. This strategy is used when the underlying stock will experience little volatility in the near term. vi. Ratio Calendar Spread A strategy involving a different number of options on the long side of a transaction from the number on the short side, where the expiration dates for each side are different. (This strategy creates two separate profit and loss zone ranges, one of which disappears upon the earlier expiration) 12 of 16 vii. Ratio Calendar Combination Spread A strategy involving both a ratio between purchases and sales and a box spread. (Long and short positions are opened on options with the same underlying stock, in varying number of contracts and with expiration dates extending over two or more periods. This strategy is designed to produce profits in the event of price increases or decreases in the market value of the underlying stock.) viii. Butterfly Spread A strategy involving open options in one striking price range, off-set by transactions at higher and lower ranges at the same time. This strategy offers both limited risk and limited profit potential. ix. Condor Spread A strategy involving four options and four strike prices that has both limited risk and limited profit potential. A long call condor spread is established by buying one call at the lowest strike, writing one call at the second strike, writing another call at the third strike, and buying one call at the fourth (highest) strike. This spread is also referred to as a flat-top butterfly . (Ref: http://www.trader-soft.com/option-trading/option-glossary/c.html) x. Credit Spread A spread strategy which is an outcome of the difference between the values of two options, where the value of the option sold is greater than the value of the option purchased. xi. Debit Spread A spread strategy which is an outcome of the difference between the values of two options, where the value of the option purchase is greater than the value of the option sold. 13 of 16 xii. Diagonal Spread Diagonal spread is an option strategy where the purchase of one option and writing of another with different expiration dates and exercise prices is carried out simultaneously. xiii. Vertical Spread (Money Spread) An option strategy where simultaneous purchase of one option and writing of another with same expiration dates, having different exercise prices creates a vertical spread. Conclusion Options are used especially for hedging purposes. Since the investors are not sure of the market movement they try to protect or hedge their investments. Options are very helpful for this purpose as buying a put will help the investor to protect his investment if the stock price goes down. Option strategies especially buying a put option are basically hedging strategies as the investor invests in the option knowing that the profit will be limited but a safety cap is provided if the market goes down drastically. For successful options trading, the formula is to buy options that are underpriced and sell options that are overpriced. The investor can find the underpriced and overpriced options from the published analytical reports. Though many option trading strategies exist, it is the investor who has to choose between the available strategies as every investor will have his own perception of the market movement and the capability of taking risks. While some of the investors are speculative in nature others are so calculative that they go by the analyzed data and enters into various options contract. Generally when volatility level is very high and decrease in implied volatility is expected by the investor, he enters into either call or put ratio spreads or into short straddles or short strangles. If the case is reverse, i.e. volatility is very low 14 of 16 and increase in implied volatility is expected then the investor enters into call or put ratio backspreads or long straddles or long strangles. While the relatively high volatility period implies premium selling opportunity the low volatility period reflects the premium buying opportunities. Options generally traded in organized markets are popular in developed countries though many developing countries are following the suite. In India also option trading is gaining momentum. References: 1. Dubofsky, David A., Options and Financial Futures Valuation and Uses, McGRAWHILL International Editions, 1992 2. Michael C. Thomsett, Getting Started in Options, 4th Edition, John Wiley & Sons, Inc., 2001 3. Perry J. Kaufman, Trading Systems and Methods, 3rd Edition, John Wiley & Sons, 1998 4. Robert W. Kolb, Futures , Options and Swaps, 4th Edition, Blackwell Publishing, 2003 5. Robert W. Kolb, Understanding Options, John Wiley & Sons, Inc., 1995 (Rahul Patel, Research Associate, ICFAI Business School Research Center, Ahmedabad and can be reached at rahulpatel0308@yahoo.com) (Ajab Gandhi, Research Associate, ICFAI Business School Research Center, Ahmedabad and can be reached at ajab_gandhi@hotmail.com) (Smitha Ramachandran, Faculty Associate, ICFAI Business School Research Center, Ahmedabad and can be reached at smithamohanw@gmail.com) 15 of 16 16 of 16 This document was created with Win2PDF available at http://www.daneprairie.com. 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