Option Strategy Education

[Prashanth]

I shall in this thread, explain using real data a large variety of Option Strategies. To prevent clutter, this thread will NOT be open to comments. You can comment on any thing here by starting a new thread.

Prashanth

[Prashanth]

A call option is a financial contract between two parties, the buyer and the seller.

The buyer of the option has the right, but not the obligation to buy an agreed quantity of a particular commodity or financial instrument (the underlying instrument) from the seller of the option at a certain time (the expiration date) for a certain price (the strike price).

The seller (or "writer") is obligated to sell the commodity or financial instrument should the buyer so decide. The buyer pays a fee (called a premium) for this right.

Source & More Info : Wiki (http://en.wikipedia.org/wiki/Call_option)

[Prashanth]

A put option (sometimes simply called a "put") is a financial contract between two parties, the seller (writer) and the buyer of the option.

The buyer acquires a short position offering the right, but not obligation, to sell the underlying instrument at an agreed-upon price (the strike price). If the buyer exercises the right granted by the option, the seller has the obligation to purchase the underlying at the strike price.

In exchange for having this option, the buyer pays the writer a fee (the option premium). The terms for exercise differ depending on option style. A European put option allows the holder to exercise the put option for a short period of time right before expiration, while an American put option allows exercise at any time before expiration.

Source and more info: Wiki (http://en.wikipedia.org/wiki/Put_option)

[Prashanth]

In India, we are having 2 types of Option Styles - American & European.

All Stock Options are American Exercise Options and hence you see CA or PA when dealing with Stock Options (Call American or Put American).

All Index Options are European Exercise Options and hence you see CE or PE when dealing with Index Options (Call European or Put European).

The chief difference between the two is that while you can exercise your option any day in American style option, you can do the same only on expiry date.

So, how does it impact you as a Buyer of Option.

Lets assume you buy a Call Option on Infosys with strike 1500.00 in anticipation of the fact that Infosys will move strongly upwards. Lets further assume that Infosys has moved to 1800.00. At 1800.00 while you will be having a good notional profit, booking the profit is difficult since option will not be very liquid (i.e., Spread is wide) since its Deep in the Money.

Other than selling the option to the buyer at the price he is asking, another way to close out the option and book your profits is by exercising your option. For this you need to intimate your broker to Exercise your option. What that means is that your broker will intimate the exchange that the client wishes to close off the option.

Assuming that Infosys on the day you requested for exercise closed at 1800.00, your payout will be 1800 - 1500 (Strike) = 300 multiplied by Quantity.

Now lets see how it differs from a European style option.

Lets assume that on the same day, you bought a Nifty Call Option of strike 3500 (which assume was the rate of nifty on that day) and Nifty has moved to 4000. Since Nifty is a Index and its options are European, the only way you can close out is by selling the same in the market.

American style exercise is used for stocks since its deliverable (of course, here we are following the American system without actually having stock delivery).

Since, one cannot possibly deliver a Index, closure is financial and hence style is European where one cannot close out till expiry (other than by selling to another buyer).

[Prashanth]

In the strategies I shall put forward in this thread, you shall come across terms such as Delta, Vega, Gamma, etc. So, I shall first try to explain as to what they mean and how it affects your option.

Delta: The delta of an option is the sensitivity of an option price relative to changes in the price of the underlying asset. It tells option traders how fast the price of the option will change as the underlying stock/future moves.

http://www.optiontradingtips.com/images/call-put-delta.gif

The above graph illustrates the behaviour of both call and put option deltas as they shift from being out-of-the-money (OTM) to at-the-money (ATM) and finally in-the-money (ITM). Note that calls and puts have opposite deltas - call options are positive and put options are negative.

Option delta is represented as the price change given a 1 point move in the underlying asset and is usually displayed as a decimal value. Delta values range between 0 and 1 for call options and -1 to 0 for put options.

Source & more info: Link (http://www.optiontradingtips.com/greeks/delta.html)

[Prashanth]

Theta shows how much value the option price will lose for every day that passes.

An option contract has a finite life, defined by the expiration date. As the option approaches its maturity date, an option contract's expected value becomes more certain with each day.

This Time Value, also called Extrinsic Value, represents the uncertainty of an option.

Theta is the calcuation that shows how much of this time value is eroding as each trading day passes - assuming all other inputs remain unchanged. Because of this negative impact on an option price, the Theta will always be a negative number.

http://www.optiontradingtips.com/images/time-decay.gif

The above graph illustrates the effect on a OTM call option as it approaches maturity date. The increment as each day passes is what the Theta calculates.

You will notice that in the last remaining days of an option's life, it looses it's value quite rapidly.

This is one of the concepts traders use as a reason to short option contracts - to take advantage of this rapid rate of decay in an option's value as each trading day passes.

Source (http://www.optiontradingtips.com/greeks/theta.html)

[Prashanth]

The gamma of an option indicates how the delta of an option will change relative to a 1 point move in the underlying asset. 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 will change as the market price of the underlying asset changes.

Remember: One of the things the delta of an option tells us is effectively how many underlying contracts we are long/short. So, the Gamma is telling us how fast our "effective" underlying position will change.

In other words, Gamma shows how volatile an option is relative to movements in the underlying asset. So, by watching your gamma will let you know how large your delta (position risk) changes.

http://www.optiontradingtips.com/images/gamma-vs-underlying-price.gif

The above graph shows Gamma vs Underlying price for 3 different strike prices. You can see that Gamma increases as the option moves from being in-the-money reaching its peak when the option is at-the-money. Then as the option moves out-of-the-money the Gamma then decreases.

Note: The Gamma value is the same for calls as for puts. If you are long a call or a put, the gamma will be a positive number. If you are short a call or a put, the gamma will be a negative number.

When you are "long gamma", your position will become "longer" as the price of the underlying asset increases and "shorter" as the underlying price decreases.

Conversely, if you sell options, and are therefore "short gamma", your position will become shorter as the underlying price increases and longer as the underlying decreases.

This is an important distinction to make between being long or short options - both calls and puts. That is, when you are long an option (long gamma) you want the market to move. As the underlying price increases, you become longer, which reinforces your newly long position.

If being "long gamma" means you want movements in the underlying asset, then being "short gamma" means that you do not want the price of the underlying asset to move.

A short gamma position will become shorter as the price of the underlying asset increases. As the market rallies, you are effectively selling more and more of the underlying asset as the delta becomes more negative.

Source & more info: Link (http://www.optiontradingtips.com/greeks/gamma.html)

[Prashanth]

The Vega of an option indicates how much, theoretically at least, the price of the option will change as the volatility of the underlying asset changes.

Vega is quoted to show the theoretical price change for every 1 percentage point change in volatility. For example, if the theoretical price is 2.5 and the Vega is showing 0.25, then if the volatility moves from 20% to 21% the theoretical price will increase to 2.75.

Vega is most sensitive when the option is at-the-money and tapers off either side as the market trades above/below the strike.

http://www.optiontradingtips.com/images/vega-vs-underlying-price.gif

The above graph plots the option Vega vs Underlying price for 3 different strike prices. Notice that the behaviour of an option Vega is similar to Gamma: increasing as the option moves from being in-the-money to at-the-money where it reaches its peak and then decreases as the option moves out-of-the-money.

Note: like the Gamma, Vega is the same value for calls and puts.

Source (http://www.optiontradingtips.com/greeks/vega.html)