Financial markets and Institution options.pptx

Financial markets and Institution options

1. OPTIONS

2. Types of options Based on right Call option Put option Based on style of exercise European option American option Bermuda option Based on nature of underlying asset Commodity option Currency option

3. Contd. 3. Stock option 4. Index option Based on place of trading Exchange traded options Over the counter options Other types Real options(investing in real economy) Vanilla and exotic option Warrants, LEAPS

4. Pay-off in option Based on spot price and exercise price – any time before expiration ITM (In the money option) ATM (At the money option) OTM (Out of the money option) In the money option For call option- when SP exceeds EP buyer will exercise it and make profit it generates positive cash flows(stock price or UA price is greater than agreed strike price) For put option- when SP less than EP

5. Contd. Out of the money option Option cannot be exercised once it has no value or out of the money It generates negative cash flows For call option - When SP is less than EP of the underlying asset For put option - When EP is less than SP of the underlying asset At the money option When both EP and SP are same(SP=EP) whether call or put Generate zero cash flows

6. Pricing of options Option price means option premium Option premium(price) = Intrinsic value + Time value INTRINSIC VALUE Value contained in the asset The value that the buyer of an option would receive if it is exercised immediately IV of CALL means amount by which an option is ITM - Max (S-E,0) IV of PUT means amount by which an option is ITM - Max (E-S,0)

7. Contd. Zero IV when option is OTM and ATM and IV cannot be negative(either 0 or + ve ) because buyer cannot be forced to exercise It is the current value of option TIME VALUE It is the difference between option premium and IV Also called extrinsic value/speculative value/volatile value Amount by which MP of option exceeds IV(Option premium – IV) When call is OTM or ATM has only Time value(no IV) Maximum Time value when call or put is ATM but ITM option has both IV and TV

8. Pay off pofile of call and put option

9. Fundamental option strategies 1. Long call 2. Short call 3. Long put 4. Short put Long call(Buy call)- Purchase of call option- right to buy the UA at EP on expiry- bullish expectation – buy a call option instead of buying stock – (BEP=EP+P) Profit results when SP exceeds EP more than premium paid – otherwise let the contract expire- expects bullish on market direction and market volatility.

10. Contd. Short call (sell call) Sale of call option – trader believes that decrease in price can short sell the stock Selling a call has an obligation to sell the stock to call buyers option When MP decreases call option buyer will not exercise option and vice versa thus, When price decreases generate profit else suffer loss(MP-EP-P) (BEP=EP+P) Unlimited loss when MP rises ( bearish market direction and market volatility) Gain is limited to premium received-

11. Contd. Long put(Buy put) Purchase of one put option Trader believes that price will decrease can buy the right to sell the stock at EP- No obligation to sell the stock but has a right to do till expiry (BEP=EP-P)- Profit generates when MP decreases below the EP by more than premium(EP-MP-P)- expects bearish on market direction and bullish on market volatility.

12. Contd. Short Put Sale of put option(selling right to sell) Seller of put option has an obligation to buy the UA at EP If the MP increases trader can sell the right to sell and can generate profit upto premium If the MP decreases EP by more than premium loss results(BEP=EP-P) Expects bullish on market direction and bearish on market volatility

13. option trading strategies Bullish strategies Long put Short put Call bull spread Put bull spread Call back spread Covered call Protective put

14. Contd. Bearish strategies Short call Long put Call bear spread Put bear spread Put back spread

15. Contd. Natural strategies Long straddle Short straddle Long strangle long put butterfly Short strangle short put butterfly Butterfly spread Time( calender ) spread Long call butterfly call time and put time spread Short call butterfly condors long and short condor

16. Contd. Combining options to apply hedging(risk elimination) strategies Straddle Buying a put and a call option with same EP and Expiry Will be suitable for high price variation on either direction Long straddle and short straddle Long straddle(Buy 1ATM call and buy 1 ATM Put) Buying a call and a put option on the same stock with same EP and Expiry When price of stock increases call option and decreases then put option may be exercised

17. Contd. Maximum loss- total premium paid for call and put options Maximum profit – unlimited based on market moves up and down 2 BEPs for long straddle position Upper BEP = (Strike price of long call + Net premium received) Lower BEP = (Strike price of long put - Net premium received) Suitable when high volatility in the prices of the UA. Short straddle Selling a call option and put option on the same UA at same EP and expiry

18. Long straddle

19. Short straddle

20. Contd. It generates profit from premium received on both options Going short on both options If the UA price is close to strike price at expiry both options will expire Then option writer will get the premium If the price move up or down heavily the high losses will also results Sell 1 ATM call, sell 1 ATM Put Maximum loss-unlimited on both direction and maximum gain is net premium received through selling options 2 BEPs (upper BEP=Strike Price of short call + net premium received)

21. Contd. Lower BEP= Strike price of short put- net premium received It is suitable when market is stable or less volatile Strangle Buying a put and a call option with diffrent EP and same Expiry Long and short strangle Long strangle Buying call option with high strike price and buying put option with low strike price Combine 1 OTM call and 1 OTM put option

22. Contd. If the price remains within two strike prices- no option would be exercised If the MP goes above the strike price of the call or goes below the put then long strangle starts paying off the cost and then results profit Buy 1 OTM Call Buy 1 OTM Put Max loss – total premium paid for call and put option Maximum profit – unlimited 2 BEPs upper BEP= strike price of long call + net premium paid lower BEP = Strike price of long put + net premium paid Long strangle investor expects volatility

23. Contd.

24. Contd. Short strangle Trader sells a combination of one call option with high strike price(OTM) and one put option with low strike price (OTM) Sell 1 OTM Call sell 1 OTM Put Max loss – unlimited as market moves any direction Maximum profit- limited to premium received for selling options 2 BEPs upper BEP= Strike price of short call+net premium received Lower BEP = strike price of short put – net premium received Short strangle investor expects low volatility

25. Contd.

26. Contd. Strip (STRIP BUYER AND SELLER) Buying one call with two puts with same strike price and expiry date Suitable when downward movement of prices more than upward move When downward movement happens two puts make profit than loss on call It is the modified bearisg version of straddle Buy 1 ATM call Buy 2 ATM puts Maximum loss= net premium paid+commission paid(limited) Unlimited profit 2 BEPs(upper BEP=SP of call/ puts+NP paid ; lower BEP=SP of call/puts- (NP/2)

27. Contd.

28. STRAP Buying two calls and one put with same strike price and maturity Suitable when chances of upward movement is more than downward move Similiar to long straddle When price increases strap generates more profits(with two calls) Buy 2 ATM calls Buy 1 ATM put Max loss – net premium paid, when UA price = SP of calls/put Max profit- unlimited- when call in the money with 2 options(double effect) 2 BEPs(UBEP=SP of calls/put+(NP paid/2) LBEP= SP of calls/put-(NP paid)

29. Option spreads Spreads are the combination of options having same type(either call or put) with different strike price on same UA We have vertical , horizontal and diagonal spreads Vertical spreads are the combination of same type options with different SP but same maturity horizontal spreads are the combination of same type options with different expiry but same strike price Diagonal spreads are the combination of same type options with different SP –different maturity

30. Bull and bear spreads Subject to the bullish and bearish conditions we have bull spreads and bear spreads Call bull spread , put bull spread, call back spread and put back spreads Investor buying a call option on stock with low SP/EP(high premium) and sells a call opton with high SP with same maturity Suitable when prices are expected to go up If the stock price lies between the SP of two calls, purchased call is in the money and call sold gets expired/un excercised Thus the pay off is the diff between stock price and lower EP or SP

31. Contd. If the stock price is greater than higher EP/SP – Both options ITM Thus pay off is diff between EP of both options Buy 1 ITM call sell 1 OTM call Max loss- limited to premium paid(long call) – premium received(short call) Max profit – limited to the diff bet two strike prices minus NP paid BEP of call bull spread = SP of long call + Net premium paid At expiry, if the stock price remains below lower SP both call would expire unexercised Then loss will be limited to initial cost of the spread(premium paid on both)

32. Contd.

33. Contd. Put bull spread Buying an OTM put at high strike price and selling an ITM put at low strike price on the same stock with same expiry( Buy 1 OTM and sell 1 ITM put ) Premium received on short put(selling) is higher than premium on long put(buying) On expiry, stock price remains below lower strike price – both options will exercise and the position is closed by settling the difference of strike price Then overall loss of initial credit(premium received on short put – premium paid on long put) If the stock price is in between two Eps- put with low EP would expire unexcercised . Net results will be initial credit – diff bet EP and stock price

34. Contd. For the stock price exceeding higher exercise price, both puts expire unexercised- no pay off and net profit is initial credit Max loss- diff bet strike price of two puts – net premium received Max profit – net premium received minus commission paid BEP= strike price of short put – Net premium received This strategy is suitable when price of UA may go up in future

35. Contd.

36. Contd. Call back spread Buying 2 OTM call options and selling 1 ITM call on same underlying stock with same expiration date ( sell 1 ITM call Buy 2 OTM calls ) Max loss – limited to IV of short call + premium paid(or minus premium received) plus commission paid(limited risk) Unlimited profit(unlimited rewards) 2 BEPs(upper BEP= strike price of long call + points of max loss Lower BEP= SP of short call Suitable when upward movement of underlying stock in near future

37. Contd.

38. Contd. Put back spread Selling 1 ITM put option at high strike price and buying 2 OTM put options at lower strike price When market price falls this will generate profit 2 BEPs(UBEP=SP of short put, LBEP=SP of long put-points of max loss) Max loss – limited to IV of short put minus premium received plus commission paid Max profit – unlimited stock price moves downward below the lower BEP Suitable when underlying stock price falls downward

39. Contd.

40. Contd. Bear spreads Investor expects that market will be weak in near future(down ward tendency) Call bear spreads and put bear spreads Call bear spread(call bear credit spread) means buying a call with high strike price and selling a call with low strike price( buy 1 ATM call and sell 1 ITM call) Premium on call sold would be higher than call bought - initiates cashflow Max loss- diffr bet two strike prices minus net premium Max profit – diff bet premium received for short call minus premium paid for long call

41. Contd. BEP= strike price of short call + net premium received

42. Put bear spreads Buying a put with high strike price and sells a put with low strike price Buy 1 ATM put and sell OTM put Generates initial cash out flow because premium for put with high strike price would be greater than premium receivable for the put with low strike price Max loss –limited to net premium paid (premium paid for long position minus premium received for short position) Max profit – limited to the diff bet two strike prices minus net premium paid for the position BEP= Strike price of long put – Net premium paid

43. Butterfly spreads A combination of four options with three different strike prices Buying a call with SP(E1), Buying another call with higher SP (E3) and selling 2 calls with at SP(E2) E2 lies in between E1 and E3 – When stock price close to E2 profit results. Price may move in either direction and hence pay-off results (Buy 1 ITM call, sell 2 ATM calls and Buy 1 OTM Call) Gain on long offsetted by loss on short We have long call, short call,long put,short put butterfly spreads

44. Contd. Long call butterfly Buying a call with lower SP(ITM), buying a call with higher SP(OTM) and selling two ATM calls with a SP in between lower and higher SPs Max loss- limited to ATM SP and ITM SP minus NP paid for spread Maxi profit – limited to the NP received from the spread 2 BEPs (UBEP=Higher SP of long call- Net Premium paid LBEP=Lower strike price long call + NP paid Investor expects that UA price will not vary future and hence, neutral on market direction and bearish on volatility

45. Long call butterfly spread

46. Short call butterfly spread

47. Contd. Short call butterfly Selling one call with high SP(E1), selling another call with lower SP(E3) and Buying two calls with a SP in between lower and higher SPs(E1 & E3) Max loss- limited to the difference between ATM SP and ITM SP minus NP received from the spread Maxi profit – limited to the NP received for the position 2 BEPs (UBEP= SP of highest strike short call- Net Premium received LBEP=SP of lowest strike short call + NP received Investor expects that neutral on market direction and bullish on volatility

48. Contd. Long put butterfly Selling 2 ATM put options, Buying one ITM put option and Buying one OTM put option Max loss – limited to the difference between ATM SP and ITM SP minus NP paid for the spread Max profit – limited to the NP received from the spread Suitable when trader is neutral on market direction and bullish on volatility

49. Long put butterfly spread

50. Short put butterfly spreads

51. Contd. Short put butterfly Selling one OTM put with lower SP, Buying 2 ATM put(in between E1 and E3) and selling one ITM put with higher SP Max loss – limited to the difference between ATM SP and ITM SP minus NP received for the position Max profit – limited to the NP received from the spread 2 BEPs(UBEP=SP of highest strike short put – NP received LBEP= SP of lowest strike short put +NP received

52. Condors Modified version of strangle It uses 4 SPs(E1,E2,E3 and E4) E1<E2<E3 < E4 Combines 4 call options or 4 put options Two parts as inner strike and outer strike We have long condor and short condor Long condor involves call options(buying call with two outer strike prices(E1,E4) and selling two calls with inner strike prices (E2,E3) Short condor involves selling two calls with strike price E1,E4(outer SPs) and buying two calls with strike price E2,E3(Inner SPs)

53. Other strategies Calender spreads Formed by using the options on the same asset with same strike price with different expiration dates Investor can earn through time value of options Bullish investor will buy a long call and sell a short call and bearish investor will do vice versa Settlement of options By excercising , letting to expire, offsetting positions