UNIT 1: OPTION CONTRACT

1.1: INTRODUCTION

Options are financial instruments that can provide you, the individual investor, with the flexibility
you need in almost any investment situation you might encounter. Options give you options.
You're not just limited to buying, selling or staying out of the market. With options, you can tailor
your position to your own situation and stock market outlook. Consider the following potential
benefits of options: · You can protect stock holdings from a decline in market price · You can
increase income against current stock holdings · You can prepare to buy stock at a lower price ·
You can position yourself for a big market move even when you don't know which way prices will
move · You can benefit from a stock price's rise or fall without incurring the cost of buying or
selling the stock outright A stock option is a contract which conveys to its holder the right, but not
the obligation, to buy or sell shares of the underlying security at a specified price on or before a
given date. After this given date, the option ceases to exist. The seller of an option is, in turn,
obligated to sell (or buy) the shares to (or from) the buyer of the option at the specified price upon
the buyer's request. Options are currently traded on the following U.S. exchanges: The American
Stock Exchange, Inc. (AMEX), the Chicago Board Options Exchange, Inc. (CBOE), the New York
Stock Exchange, Inc. (NYSE), The Pacific Stock Exchange, Inc. (PSE), and the Philadelphia Stock
Exchange, Inc. (PHLX). Like trading in stocks, option trading is regulated by the Securities and
Exchange Commission (SEC). The purpose of this publication is to provide an introductory
understanding of stock options and how they can be used. Options are also traded on indexes
(AMEX, CBOE, NYSE, PHLX, PSE), on U.S. Treasury securities (CBOE), and on foreign
currencies (PHLX); information on these option products is not included in this document but can
be obtained by contacting the appropriate exchange (see pages 40 and 41 for addresses and phone
numbers). These exchanges which trade options seek to provide competitive, liquid, and orderly
markets for the purchase and sale of standardized options. All option contracts traded on U.S.
securities exchanges are issued, guaranteed and cleared by The Options Clearing Corporation
(OCC). OCC is a registered clearing corporation with the SEC and has received a 'AAA' credit
 “OPTION CONTRACT AND ITS STRATEGIES”

rating from Standard & Poor's Corporation. The 'AAA' credit rating relates to OCC's ability to
fulfill its obligations as counter-party for options trades. This introductory document should be
read in conjunction with the basic option disclosure document, titled

1.2: MEANING AND DEFINITION

Options are a type of derivative security. They are a derivative because the price of an option is
intrinsically linked to the price of something else. Specifically, options are contracts that grant the
right, but not the obligation to buy or sell an underlying asset at a set price on or before a certain
date. The right to buy is called a call option and the right to sell is a put option. People somewhat
familiar with derivatives may not see an obvious difference between this definition and what a
future or forward contract does. The answer is that futures or forwards confer both the right and
obligation to buy or sell at some point in the future. For example, somebody short a futures contract
for cattle is obliged to deliver physical cows to a buyer unless they close out their positions before
expiration. An options contract does not carry the same obligation, which is precisely why it is
called an “option.”

1.3: FEATURES OF OPTION CONTRACTS

1. Highly flexible: On one hand, option contract is highly standardized and so they can be
traded only in organized exchanges. Such option instruments cannot be made flexible according
to the requirements of the writer as well as the user. On the other hand, there are also privately
arranged options which can be traded ‘over the counter’. These instruments can be made according
to the requirements of the writer and user. Thus, it combines the features of ‘futures’ as well as
‘forward’ contracts.

2. Down Payment: The option holder must pay a certain amount called ‘premium’ for holding
the right of exercising the option. This is considered to be the consideration for the contract. If the

[AUTHOR NAME] 2
 “OPTION CONTRACT AND ITS STRATEGIES”

option holder does not exercise his option, he has to forego this premium. Otherwise, this premium
will be deducted from the total payoff in calculating the net payoff due to the option holder.

3. Settlement: No money or commodity or share is exchanged when the contract is written.

Generally, this option contract terminates either at the time of exercising the option by the option
holder or maturity whichever is earlier. So, settlement is made only when the option holder
exercises his option. Suppose the option is not exercised till maturity, then the agreement
automatically lapses and no settlement is required.

4. Non – Linearity: Unlike futures and forward, an option contract does not posses the property
of linearity. It means that the option holder’s profit, when the value of the underlying asset moves
in one direction is not equal to his loss when its value moves in the opposite direction by the same
amount. In short, profits and losses are not symmetrical under an option contract. This can be
illustrated by means of an illustration:

Mr.X purchase a two-month call option on rupee at Rs. 100=3.35 $. Suppose, the rupee appreciates
within two months by 0.05 $per one hundred rupees, then the market price would be Rs. 100=3.40
$. If the option holder Mr.X exercises his option, he can purchase at the rate mentioned in the
option ie., Rs. 100=3.53 $. He gets a payoff at the rate of 0.05 $ per every one hundred rupees. On
the other hand, if the exchange rate moves in the opposite direction by the same amount and
reaches a level of Rs. 100=3.30 $. the option holder will not exercise his option. Then, his loss will
be zero. Thus, in an option contract, the gain is not equal to the loss.

5. No Obligation to Buy or Sell: In all option contracts, the option holder has a right to buy
or sell an underlying asset. He can exercise this right at any time during the currency of the
contract. But, in no case, he is under an obligation to buy or sell. If he does not buy or sell, the
contract will be simply lapsed.

[AUTHOR NAME] 3
 “OPTION CONTRACT AND ITS STRATEGIES”

1.4: ADVANTAGES AND DISADVANTAGES OF OPTION

CONTRACT

Advantage Disadvantage Effect on

Holder/Writer

Cost Options are an As a form of Holder may be

inexpensive way to insurance, an option disadvantaged due to
gain access to the contract may expire expiry. Writer would
underlying investment worthless. This risk be advantaged as s/he
without having to buy increases the greater need not make
stock the extent to which delivery once the
the option is out of option has expired.
the money and the
shorter the time until
expiration.

Leverage Options enable Investors should Writers of naked calls

investors to stump up realize that options\' are exposed to
less money and obtain leverage can impact unlimited risk.
additional gain. performance on the
down side as well.

Marketability Option terms trade on Regulatory Both parties to an

an exchange and as intervention can options transaction
such are standardized. prevent exercise benefit from
which may not be standardized and
desirable. enforceable terms.

[AUTHOR NAME] 4
 “OPTION CONTRACT AND ITS STRATEGIES”

Hedging Options may be used The investor may end Both the holder and
to limit losses. up being incorrect as the writer may be
to the direction and (dis)advantaged
timing of a stock\'s depending upon
price and may which side of the
implement a less than trade they assume
perfect hedge. and the ultimate
direction of the
underlying security.

Return Options may be used The investor may end Both the holder and

enhancement to enhance a up being incorrect as the writer may be

portfolio\'s return. to the direction and (dis)advantaged
timing of a stock\'s depending upon
price, rendering the which side of the
attempt at enhanced trade they assume
portfolio return and the ultimate
worthless. direction of the
underlying security.

Diversification One can replicate an Diversification

actual stock portfolio cannot eliminate
with the options on systematic risk.
those very stocks.

[AUTHOR NAME] 5
 “OPTION CONTRACT AND ITS STRATEGIES”

Regulation Terms of listed Restrictions upon While in some cases

options are regulated. exercise may occur necessary, regulatory
by regulatory fiat fiat can disrupt what
(OCC, SEC, court, may be a profitable
other regulatory trade, affecting
agency). holder and writer
alike.

1.5: TYPES OF OPTION CONTRACT

1. CALL OPTION:

A call option, often simply labelled a "call", is a financial contract between two parties, the buyer
and the seller of this type of option. The buyer of the call option has the right, but not the obligation,
to buy an agreed quantity of a particular commodity or financial instrument (the underlying) from
the seller of the option at a certain time (the expiration date) for a certain price (the strike price).

[AUTHOR NAME] 6
 “OPTION CONTRACT AND ITS STRATEGIES”

The seller (or "writer") is obligated to sell the commodity or financial instrument to the buyer if
the buyer so decides. The buyer pays a fee (called a premium) for this right. The term "call" comes
from the fact that the owner has the right to "call the stock away" from the seller.

When you buy a call option, you are buying the right to buy a stock at the strike price, regardless
of the stock price in the future before the expiration date. Conversely, the seller can short or "write"
the call option, giving the buyer the right to buy that stock from you anytime before the option
expires. To compensate you for that risk taken, the buyer pays you a premium, also known as the
price of the call. The seller of the call is said to have shorted the call option, and keeps the premium
(the amount the buyer pays to buy the option) whether or not the buyer ever exercises the option.

1. PUT OPTION

In finance, a put or put option is a stock market device which gives the owner of a put the right,
but not the obligation, to sell an asset (the underlying), at a specified price (the strike), by a
predetermined date (the expiry or maturity) to a given party (the seller of the put). The purchase of
a put option is interpreted as a negative sentiment about the future value of the underlying. The
term "put" comes from the fact that the owner has the right to "put up for sale" the stock or index.

Put options are most commonly used in the stock market to protect against the decline of the price
of a stock below a specified price. If the price of the stock declines below the specified price of
the put option, the owner/buyer of the put has the right, but not the obligation, to sell the asset at
the specified price, while the seller of the put has the obligation to purchase the asset at the strike
price if the owner uses the right to do so (the owner/buyer is said to exercise the put or put option).
In this way the buyer of the put will receive at least the strike price specified, even if the asset is
currently worthless

[AUTHOR NAME] 7
 “OPTION CONTRACT AND ITS STRATEGIES”

3. EUROPEAN OPTION:

A European option is an option that can only be exercised at the end of its life, at its maturity.
European options tend to sometimes trade at a discount to their comparable American option
because American options allow investors more opportunities to exercise the contract. European
options normally trade over the counter, while American options usually trade on standardized
exchanges.

4. AMERICAN OPTION:

An American option is an option that can be exercised anytime during its life. American options
allow option holders to exercise the option at any time prior to and including its maturity date, thus
increasing the value of the option to the holder relative to European options, which can only be
exercised at maturity. The majority of exchange-traded options are American.

[AUTHOR NAME] 8
 “OPTION CONTRACT AND ITS STRATEGIES”

UNIT 2: OPTION CONCEPT/TERMINOLOGY

2.1: TERMINOLOGY OF OPTIONS

1. Long:

This term can be pretty confusing. On this site, it usually doesn’t refer to time. As in, “Trade King
never leaves me on hold for long.” Or distance, as in, “I went for a long jog.”

When you’re talking about options and stocks, “long” implies a position of ownership. After you
have purchased an option or a stock, you are considered "long" that security in your account.

2. Short:

Short is another one of those words you have to be careful about. It doesn’t refer to your hair after
a buzz cut, or that time at camp when you short-sheeted your counsellor’s bed.

If you’ve sold an option or a stock without actually owning it, you are then considered to be “short”
that security in your account. That’s one of the interesting things about options. You can sell
something you don’t actually own. But when you do, you may be obligated to do something at a
later date. Read on to get a clearer picture of what that something might be for specific strategies.

3. Strike Price:

The pre-agreed price per share at which stock may be bought or sold under the terms of an option
contract. Some people refer to the strike price as the “exercise price”.

4. In-The-Money (ITM):

For call options, this means the stock price is above the strike price. So, if a call has a strike price
of $50 and the stock is trading at $55, that option is in-the-money.

For put options, it means the stock price is below the strike price. So, if a put has a strike price of
$50 and the stock is trading at $45, that option is in-the-money.

[AUTHOR NAME] 9
 “OPTION CONTRACT AND ITS STRATEGIES”

This term might also remind you of a great song from the 1930s that you can tap dance to whenever
your option strategies go according to plan.

5. Out-of-The-Money (OTM):

For call options, this means the stock price is below the strike price. For put options, this means
the stock price is above the strike price. The price of out-of-the-money options consists entirely of
“time value.”

6. At-The-Money (ATM):

An option is “at-the-money” when the stock price is equal to the strike price. (Since the two values
are rarely exactly equal, when purchasing options, the strike price closest to the stock price is
typically called the “ATM strike.”)

7. Exercise:

This occurs when the owner of an option invokes the right embedded in the option contract. In
layman’s terms, it means the option owner buys or sells the underlying stock at the strike price,
and requires the option seller to take the other side of the trade.

Interestingly, options are a lot like most people, in that exercise is a fairly infrequent event. (See
Cashing Out Your Options.)

8. Assignment:

When an option owner exercises the option, an option seller (or “writer”) is assigned and must
make good on his or her obligation. That means he or she is required to buy or sell the underlying
stock at the strike price.

9. Index Options vs. Equity Options:

There are quite a few differences between options based on an index versus those based on
equities, or stocks. First, index options typically can’t be exercised prior to expiration, whereas
equity options typically can.

[AUTHOR NAME] 10
 “OPTION CONTRACT AND ITS STRATEGIES”

Second, the last day to trade most index options is the Thursday before the third Friday of the
expiration month. (That’s not always the third Thursday of the month. It might actually be the
second Thursday if the month started on a Friday.) But the last day to trade equity options is the
third Friday of the expiration month.

Third, index options are cash-settled, but equity options result in stock changing hands.

NOTE: There are several exceptions to these general guidelines about index options. If you’re
going to trade an index, you must take the time to understand its characteristics. See What is an
Index Option? or ask a TradeKing broker.

10. Stop-Loss Order:

An order to sell a stock or option when it reaches a certain price (the stop price). The order is
designed to help limit an investor’s exposure to the markets on an existing position.

Here’s how a stop-loss order works: first you select a stop price, usually below the current market
price for an existing long position. By choosing a price below the current market, you’re basically
saying, “This is the downside point where I would like to get out of my position.”

Past this price, you no longer want the cheese; you just want out of the trap. When your position
trades at or through your stop price, your stop order will get activated as a market order, seeking
the best available market price at that time the order is triggered to close out your position.

Any discussion of stop orders isn’t complete without mentioning this caveat: they do not provide
much protection if the market is closed or trading is halted during the day. In those situations,
stocks are likely to gap — that is, the next trade price after the trading halt might be significantly
different from the prices before the halt. If the stock gaps, your downside “protective” order will
most likely trigger, but it’s anybody’s guess as to what the next available price will be.

[AUTHOR NAME] 11
 “OPTION CONTRACT AND ITS STRATEGIES”

2.2: TIME VALUE AND INTRINSIC VALUE

1. Time Value:

In finance, the time value (TV) (extrinsic or instrumental value) of an option is the premium a
rational investor would pay over its current exercise value (intrinsic value), based on the
probability it will increase in value before expiry. For an American option this value is always
greater than zero in a fair market, thus an option is always worth more than its current exercise
value For a European option, the extrinsic value can be negative. As an option can be thought of
as 'price insurance' (e.g., an airline insuring against unexpected soaring fuel costs caused by a
hurricane), TV can be thought of as the risk premium the option seller charges the buyer—the
higher the expected risk TV decays to zero at expiration, with a general rule that it will lose of its
value during the first half of its life and in the second half. As an option moves closer to expiry,
moving its price requires an increasingly larger move in the price of the underlying security.

2. Intrinsic value:

The intrinsic value (IV) of an option is the value of exercising it now. If the price of the underlying
stock is above a call option strike price, the option has a positive monetary value, and is referred
to as being in-the-money. If the underlying stock is priced cheaper than the call option's strike
price, the call option is referred to as being out-of-the-money. If an option is out-of-the-money at
expiration, its holder simply abandons the option and it expires worthless. Hence, a purchased
option can never have a negative value.[3] This is because a rational investor would choose to buy
the underlying stock at market rather than exercise an out-of-the-money call option to buy the same
stock at a higher-than-market price.

For the same reasons, a put option is in-the-money if it allows the purchase of the underlying at a
market price below the strike price of the put option. A put option is out-of-the-money if the
underlying's spot price is higher than the strike price.

[AUTHOR NAME] 12
 “OPTION CONTRACT AND ITS STRATEGIES”

As shown in the below equations and graph, the Intrinsic Value (IV) of a call option is positive
when the underlying asset's spot price S exceeds the option's strike price K.

3. Option Value:

Option value (i.e.,. price) is estimated via a predictive formula such as Black-Scholes or using a
numerical method such as the Binomial model. This price incorporates the expected probability of
the option finishing "in-the-money". For an out-of-the-money option, the further in the future the
expiration date—i.e. the longer the time to exercise—the higher the chance of this occurring, and
thus the higher the option price; for an in-the-money option the chance of being in the money
decreases; however the fact that the option cannot have negative value also works in the owner's
favor. The sensitivity of the option value to the amount of time to expiry is known as the option's
theta. The option value will never be lower than its IV.

As seen on the graph, the full call option value (IV + TV), at a given time t, is the red line.

[AUTHOR NAME] 13
 “OPTION CONTRACT AND ITS STRATEGIES”

Time value is, as above, the difference between option value and intrinsic value, i.e.

Time Value = Option Value − Intrinsic Value

More specifically, TV reflects the probability that the option will gain in IV — become (more)
profitable to exercise before it expires.[5] An important factor is the option's volatility. Volatile
prices of the underlying instrument can stimulate option demand, enhancing the value.
Numerically, this value depends on the time until the expiration date and the volatility of the
underlying instrument's price. TV of American option cannot be negative (because the option value
is never lower than IV), and converges to zero at expiration. Prior to expiration, the change in TV
with time is non-linear, being a function of the option price.

2.3: MONEYNESS OF OPTION

In finance, moneyness is the relative position of the current price (or future price) of an underlying
asset (e.g., a stock) with respect to the strike price of a derivative, most commonly a call option or
a put option. Moneyness is firstly a three-fold classification: if the derivative would make money
if it were to expire today, it is said to be in the money, while if it would not make money it is said
to be out of the money, and if the current price and strike price are equal, it is said to be at the
money. There are two slightly different definitions, according to whether one uses the current price
(spot) or future price (forward), specified as "at the money spot" or "at the money forward", etc.

This rough classification can be quantified by various definitions to express the moneyness as a
number, measuring how far the asset is in the money or out of the money with respect to the strike
– or conversely how far a strike is in or out of the money with respect to the spot (or forward) price
of the asset. This quantified notion of moneyness is most importantly used in defining the relative
volatility surface: the implied volatility in terms of moneyness, rather than absolute price. The
most basic of these measures is simple moneyness, which is the ratio of spot (or forward) to strike,

[AUTHOR NAME] 14
 “OPTION CONTRACT AND ITS STRATEGIES”

or the reciprocal, depending on convention. A particularly important measure of moneyness is the

likelihood that the derivative will expire in the money, in the risk-neutral measure. It can be
measured in percentage probability of expiring in the money, which is the forward value of a binary
call optionwith the given strike, and is equal to the auxiliary N(d2) term in the Black–Scholes
formula. This can also be measured in standard deviations, measuring how far above or below the
strike price the current price is, in terms of volatility; this quantity is given by d2. (Standard
deviations refer to the price fluctuations of the underlying instrument, not of the option itself.)
Another measure closely related to moneyness is the Delta of a call or put option. There are other
proxies for moneyness, with convention depending on market.

2.4: OPTION SENSTIVITIES

Tools which measure how an option's price and risk are affected by the underlying parameter on
which the value of the option depends. The most popular of these sensitivities are often symbolized
by Greek letters, and hence the name the greeks. Each greek measures the sensitivity of an option
or a portfolio of options to a small change in a specific underlying parameter, such as the price or

[AUTHOR NAME] 15
 “OPTION CONTRACT AND ITS STRATEGIES”

volatility of an underlying asset, interest rates, etc. The most common greeks are the first-order
greeks such as delta, vega, theta, lambda, and rho. Higher-order greeks encompass second-order
and third-order greeks. Second-order Greek’s, which are based on the notion of stochastic
volatility, include: vanna, vomma, and volga, vera, charm (delta decay), and gamma.

There are still higher order Greek’s, or third-order Greek’s, among which are: color (gamma
decay), speed, ultima, and zomma. If the value of an option depends on two or more underlying,
as is the case with multi-asset options or rainbow options, its Greek’s are extended to account for
any cross-effects between the underlying. Examples of "cross Greek’s" include: cross gamma,
cross vanna, cross volga, and correlation delta.

Investors and traders use option sensitivities to capture the risks of financial options/derivatives.

[AUTHOR NAME] 16
 “OPTION CONTRACT AND ITS STRATEGIES”

UNIT 3: PAYOFF DIAGRAM AND EXPLANATION

3.1 Diagrams and Explanations

1. Call Option:

A call option, often simply labelled a "call", is a financial contract between two parties, the buyer
and the seller of this type of option. In call option there are two types of call option payoff.

(a). Long Call:

The following figure shows an example of a long call using a payoff diagram.

The prices assumed in the following figure are as follows -

Strike Price – 400

Option Premium – 100

Therefore, Break-even price = 400 + 100 = 500

[AUTHOR NAME] 17
 “OPTION CONTRACT AND ITS STRATEGIES”

Let us assume a buyer purchases a call option and pays an option premium of 100 for the same
purpose. Thus, his initial cash flow is a negative 100 i.e. He immediately suffers a loss of 100.

As we have assumed, the strike price of the option contract is 400. Thus, his profit begins when
the price of the contract rises by 100 above the strike price of 400. This is what is termed as the
Break-even price which marks a no-profit no-loss situation for the investor. Now, the moment this
price crosses the 500 marks, the investor enters into the profit realm, which can virtually end up
being unlimited depending on how high the price actually rises.

As far as his loss is concerned, there is an important point to keep in mind when we consider call
Option contracts that is, a call option is exercised only when the price of the contract increases,

[AUTHOR NAME] 18
 “OPTION CONTRACT AND ITS STRATEGIES”

that is, when the market goes bullish which is exactly what the investor's initial view is. Thus,
when he pays the option premium of 100, and if the price moves down, the call option won't be
executed in the first place which shall lead to the investor suffering a loss of only the amount of
premium he/she has paid while purchasing the contract.

(b). Short Call:

The prices assumed in the following figure are as follows -

Strike Price – 400

Option Premium – 100

Therefore, Break-even price = 400 + 100 = 500

The following diagram depicts a diagrammatic representation of a short position in a call option
contract which puts the investor under the obligation to sell the call option contract on or before
the expiration date.

[AUTHOR NAME] 19
 “OPTION CONTRACT AND ITS STRATEGIES”

As the definition itself suggests, selling the asset first would naturally result in the investor
receiving the option premium, which we have assumed to be 100 in these examples.

The strike price of the option contract is 400, similar to that in the previous example. Since it is a
call option, the Break-even is calculated as 400 + 100 = 500. However, the Break-even point in a
short option contract plays a completely opposite role in the profit/loss gained or incurred by the
investor.

In a short call, or in a short contract in general, the investor's view while entering into one is
obviously bearish meaning he/she expects the price to fall down. Thus, here the investor begins to
suffer losses as soon as the price crosses the Break-even point since at expiry he/she has to buy the
contract back at a higher price that the premium he/she has received.

As for the profit, a call option contract is executable only when the price goes up. Hence, it is safe
to say that the investor wishes that the contract does not get executed as the investor has to buy the
contract back.

Therefore, if the contract does not get executed at all, he/she can safely pocket the premium of 100
which ultimately ends up being the only profit the investor can gain.

2. Put Option:

(a) Long Put:

The prices assumed in the following figure are as follows -

[AUTHOR NAME] 20
 “OPTION CONTRACT AND ITS STRATEGIES”

Strike Price – 400

Option Premium – 100

Therefore, Break-even price = 400 - 100 = 300

A long put option contract refers to the contract entered into by an investor which allows him the
choice of selling the underlying on or before the expiration date of the contract.

When an investor purchases, that is, takes a long position in a put options contract, the first cash
flow is the same as that in the case of a long call option contract which is a cash outflow of the
option premium of 100.

When the strike price of the option, 400, moves down, the investor enters into the profit region
because of the existence of the choice to sell the underlying at a lower price than the strike price
of the contract.

However, if the contract price exceeds the strike price the put option contract becomes invalid for
execution thus ending up in restricting the loss incurred by the investor only up to the extent of the
premium he/she paid.

[AUTHOR NAME] 21
 “OPTION CONTRACT AND ITS STRATEGIES”

(b) Short Put:

The prices assumed in the following figure are as follows -

Strike Price – 400

Option Premium – 100

Therefore, Break-even price = 400 - 100 = 300

Finally, we arrive at the explanation for a short put option contract. This contract puts the seller of
this contract under the obligation to sell this option contract on or prior to the maturity date.

In a short put option contract, the investor initially receives the premium of 100 since he/she sells
the contract at the time of entering into it.

The strike price of this contract, is assumed to be 400 which the investor expects to increase if
he/she wishes to make a profit. If the price does indeed increase as per the investor's expectations,
the put option contract as mentioned in the earlier example can be executed only if the price
increases so that the investor can soundly walk away with the received premium.

On the other hand, if the price of the contract moves down, that is below the Break-even point, the
trader shall suffer a loss since the contract then becomes valid for execution requiring him/her to
buy the put option contract back.

[AUTHOR NAME] 22
 “OPTION CONTRACT AND ITS STRATEGIES”

UNIT 4: OPTION TRADING STRATEGIES

LEARNING OBJECTIVES:

After studying this chapter, you should know about the following option trading strategies:

Option spreads

Straddle

Strangle

Covered call

Protective Put

Collar

Butterfly Spread

Having understood the risk/ return profiles for vanilla call/ put options, now we turn to using these
products to our advantage – called option strategies. The only limiting factor for strategies is the
thought of the trader/ strategy designer. As long as the trader can think of innovative combinations
of various options, newer strategies will keep coming to the market. Exotic products (or ‘exotics’)
are nothing but a combination of different derivative products. In this section, we will see
some of the most commonly used strategies.

4.1 Option Spreads

Spreads involve combining options on the same underlying and of same type (call/ put) but with
different strikes and maturities. These are limited profit and limited loss positions. They are
primarily categorized into three sections as:

Vertical Spreads

Horizontal Spreads

Diagonal Spreads

[AUTHOR NAME] 23
 “OPTION CONTRACT AND ITS STRATEGIES”

Vertical Spreads

Vertical spreads are created by using options having same expiry but different strike prices.
Further, these can be created either using calls as combination or puts as combination. These can
be further classified as:

Bullish Vertical Spread O Using Calls o Using Puts

Bearish Vertical Spread O Using Calls o Using Puts

1. Bullish Vertical Spread using Calls :

A bull spread is created when the underlying view on the market is positive but the trader would
also like to reduce his cost on position. So he takes one long call position with lower strike and
sells a call option with higher strike. As lower strike call will cost more than the premium earned
by selling a higher strike call, although the cost of

position reduces, the position is still a net cash outflow position to begin with. Secondly, as higher
strike call is shorted, all gains on long call beyond the strike price of short call would get negated
by losses of the short call. To take more profits from his long call, trader can short as high strike
call as possible, but this will result in his cost coming down only marginally, as higher strike call
will fetch lesser and lesser premium.

Say, for example, a trader is bullish on market, so he decides to go long on 5800 strike call option
by paying a premium of 300 and he expects market to go not above 6200, so he shorts a 6200 call
option and receives a premium of 1

As can be seen from the above pay off chart, it is a limited profit and limited loss position.
Maximum profit in this position is 245 and maximum loss is 155. BEP for this spread is 5955

[AUTHOR NAME] 24
 “OPTION CONTRACT AND ITS STRATEGIES”

2. Bullish Vertical Spread using Puts:

Here again, the call on the market is bullish, hence, the trader would like to short a put option. If
prices go up, trader would end up with the premium on sold puts. However, in case prices go down,
the trader would be facing risk of unlimited losses. In order to put a floor to his downside, he may
buy a put option with a lower strike. While this would reduce his overall upfront premium, benefit
would be the embedded insurance against unlimited potential loss on short put. This is a net
premium receipt strategy.

Let us see this with the help of an example, where the trader goes short in a put option of strike
6200 and receives a premium of 220 and goes long in a put option of strike 6000 and pays a
premium of 170:

As can be seen from the picture above, it is a limited profit and limited loss position. Maximum
profit in this position is 50 and maximum loss is 150. BEP for this position is 6150.

[AUTHOR NAME] 25
 “OPTION CONTRACT AND ITS STRATEGIES”

4.2 Straddle Strategy

This strategy involves two options of same strike prices and same maturity. A long straddle
position is created by buying a call and a put option of same strike and same expiry whereas a
short straddle is created by shorting a call and a put option of same strike and same expiry.

Let us say a stock is trading at Rs 6,000 and premiums for ATM call and put options are 257 and
136 respectively.

1. Long Straddle:

If a person buys both a call and a put at these prices, then his maximum loss will be equal to the
sum of these two premiums paid, which is equal to 393. And, price movement from here in either
direction would first result in that person recovering his premium and then making profit. This

[AUTHOR NAME] 26
 “OPTION CONTRACT AND ITS STRATEGIES”

position is undertaken when trader’s view on price of the underlying is uncertain but he thinks that
in whatever direction the market moves, it would move significantly in that direction.

Now, let us analyze his position on various market moves. Let us say the stock price falls to 5300
at expiry. Then, his pay offs from position would be:

Long Call: ‐ 257 (market price is below strike price, so option expires worthless) Long Put: ‐ 136
‐ 5300 + 6000 = 564

Net Flow: 564 – 257 = 307

As the stock price keeps moving down, loss on long call position is limited to premium paid,
whereas profit on long put position keeps increasing. Now, consider that the stock price shoots up
to 6700.

Long Call: ‐257 – 6000 + 6700 = 443

Long Put: ‐136

Net Flow: 443 – 136 = 307

As the stock price keeps moving up, loss on long put position is limited to premium paid, whereas
profit on long call position keeps increasing.

Thus, it can be seen that for huge swings in either direction the strategy yields profits. However,
there would be a band within which the position would result into losses. This position would have
two Break even points (BEPs) and they would lie at “Strike – Total Premium” and “Strike + Total
Premium”. Combined pay‐off may be shown as follows:

It may be noted from the table and picture, that maximum loss of Rs. 393 would occur to the trader
if underlying expires at strike of option viz. 6000. Further, as long as underlying expires between
6393 and 5607, he would always incur the loss and that would depend on the level of underlying.
His profit would start only after recovery of his total premium of Rs. 393 in either direction and
that is the reason there are two breakeven points in this strategy.

[AUTHOR NAME] 27
 “OPTION CONTRACT AND ITS STRATEGIES”

2. Short Straddle:

This would be the exact opposite of long straddle. Here, trader’s view is that the price of underlying
would not move much or remain stable. So, he sells a call and a put so that he can profit from the
premiums. As position of short straddle is just opposite of long straddle, the pay off chart would
be just inverted, so what was loss for long straddle

would become profit for short straddle. Position may be shown as follows:

Option Call Put

Long/Short Short Short

Strike 6000 6000

Premium 257 136

Spot 6000

[AUTHOR NAME] 28
 “OPTION CONTRACT AND ITS STRATEGIES”

It should be clear that this strategy is limited profit and unlimited loss strategy and should be
undertaken with significant care. Further, it would incur the loss for trader if market moves
significantly in either direction – up or down.

4.3 Strangle Strategies

This strategy is similar to straddle in outlook but different in implementation, aggression and cost.

1. Long Strangle:

As in case of straddle, the outlook here (for the long strangle position) is that the market will move
substantially in either direction, but while in straddle, both options have same strike price, in case
of a strangle, the strikes are different. Also, both the options (call and put) in this case are out‐of‐
the‐money and hence the premium paid is low.

[AUTHOR NAME] 29
 “OPTION CONTRACT AND ITS STRATEGIES”

Let us say the cash market price of a stock is 6100. 6200 strike call is available at 145 and 6000
put is trading at a premium of 140. Both these options are out‐of‐the‐money.

If a trader goes long on both these options, then his maximum cost would be equal to the sum of
the premiums of both these options. This would also be his maximum loss in worst case situation.
However, if market starts moving in either direction, his loss would remain same for some time
and then reduce. And, beyond a point (BEP) in either direction, he would make money. Let us
see this with various price points.

If spot price falls to 5700 on maturity, his long put would make profits while his long call option
would expire worthless.

Long Call: ‐ 145

Long Put: ‐140 – 5700 + 6000 = 160

Net Position: 160 – 145 = 15

As price continues to go south, long put position will become more and more profitable and long
call’s loss would be maximum limited to the premium paid.

In case stock price goes to 6800 at expiry, long call would become profitable and long put would
expire worthless.

Long Call: ‐145 – 6200 + 6800 = 455

Long Put: ‐140

Net Position: 455 – 140 = 315

In this position, maximum profit for the trader would be unlimited in both the directions up or
down and maximum loss would be limited to Rs. 285, which would occur if underlying expires
at any price between 6000 and 6200. Position would have two BEPs at 5715 and 6485. Until
underlying crosses either of these prices, trader would always incur loss

[AUTHOR NAME] 30
 “OPTION CONTRACT AND ITS STRATEGIES”

The payoff chart for long strangle is shown below:

2. Short Strangle:

This is exactly opposite to the long strangle with two out‐of‐the‐money options (call and put)
shorted. Outlook, like short straddle, is that market will remain stable over the life of options. Pay
offs for this position will be exactly opposite to that of a long strangle position. As always, the
short position will make money, when the long position is in loss and vice versa.

In this position, maximum loss for the trader would be unlimited in both the directions – up or
down and maximum profit would be limited to Rs. 285, which would occur if underlying expires

[AUTHOR NAME] 31
 “OPTION CONTRACT AND ITS STRATEGIES”

at any price between 6000 and 6200. Position would have two BEPs at 5715 and 6485. Until
underlying crosses either of these prices, trader would always make profit.

4.4 Covered Call

This strategy is used to generate extra income from existing holdings in the cash market. If an
investor has bought shares and intends to hold them for some time, then he would like to earn some
income on that asset, without selling it, thereby reducing his cost of acquisition. So how does an
investor continue to hold on to the stock, earn income and reduce acquisition cost? Lets us see:

Suppose an investor buys a stock in the cash market at Rs. 1590 and also sells a call option with a
strike price of 1600, thereby earning Rs. 10 as premium. If the stock price moves up from 1590

[AUTHOR NAME] 32
 “OPTION CONTRACT AND ITS STRATEGIES”

level, he makes profit in the cash market but starts losing in the option trade. For example, if Stock
goes to 1640,

Long Cash: Profit of 1640 – 1590 = 50 Short Call: – 1640 + 1600 + 10 = ‐30

Net Position: 50 – 30 = 20

If the stock moves below 1590 level, he loses in the cash market, but gets to keep the premium as
income. For example, if Stock goes to 1520,

Short Strangle Payoff-

Long Cash: 1520 – 1590 = ‐70

Short Call: + 10 (Long call holder will not exercise his right as he can buy the stock from the
market at a price lower than strike, so he will let the option expire and the seller gets to keep the
premium)

Net Position: ‐70 + 10 = ‐60

Therefore, combined position of long stock and short call would generate the pay‐off as defined
in the table and picture below:

From the table and the pay off chart we can see that the net position of a covered call strategy
looks like ‘short put’ with a strike of 1600. This is called synthetic short put position.

If at that point of time, a 1600 strike put is available at any price other than Rs.20 (let us say Rs.17),
an arbitrage opportunity exists, where the trader can create a synthetic short put position (covered
call), earn a Rs. 20 premia and use the proceeds to buy a 1600 put for Rs.17, thereby making a
risk-free profit of Rs.3. Indeed, one needs to also provide for frictions in the market like brokerage,
taxes, administrative costs, funding costs etc.

The most important factor in this strategy is the strike of the sold call option. If strike is close to
the prevailing price of underlying stock, it would fetch higher premium upfront but would lock the

[AUTHOR NAME] 33
 “OPTION CONTRACT AND ITS STRATEGIES”

potential gain from the stock early. And, if strike is too far from the current price of
underlying,while it would fetch low upfront premium, would provide for longer ride of money on
underlying stock. One has to decide on this subject based on one’s view on the stock and choice
between upfront premium from the option and potential gain from underlying.

A simple perspective on strike choice for covered call is that, till the time the cash market price
does not reach the pre determined exit price, the long cash position can be used to sell calls of that
target strike price. As long as price stays below that target price (let’s say 1600 in our case), we
can write call option of 1600 strike and keep earning the premium. The moment 1600 is reached
in the spot market, we can sell in the cash market and also cover the short call position.

[AUTHOR NAME] 34
 “OPTION CONTRACT AND ITS STRATEGIES”

5.5 Protective Put

Any investor, long in the cash market, always runs the risk of a fall in prices and thereby reduction
of portfolio value and MTM losses. A mutual fund manager, who is anticipating a fall, can either
sell his entire portfolio or short futures to hedge his portfolio. In both cases, he is out of the market,
as far as profits from upside are concerned. What can be done to remain in the market, reduce
losses but gain from the upside? Buy insurance!

By buying put options, the fund manager is effectively taking a bearish view on the market and if
his view turns right, he will make profits on long put, which will be useful to negate the MTM
losses in the cash market portfolio.

Let us say an investor buys a stock in the cash market at 1600 and at the same time buys a put
option with strike of 1600 by paying a premium of Rs. 20.

Now, if prices fall to 1530 from here:

Long Cash: Loss of 1600 – 1530 = ‐ 70

Long Put: Profit of – 20 – 1530 + 1600 = 50

Net Position: ‐20

For all falls in the market, the long put will turn profitable and the long cash will turn loss making,
thereby reducing the overall losses only to the extent of premium paid (if

strikes are different, losses will be different from premium paid) In case prices rise to 1660

Long Cash: Profit of 1660 – 1600 = 60 Long Put: Loss of 20

Net Position: 60 – 20 = 40

As price keeps rising, the profits will keep rising as losses in long put will be maximum to the
extent of premium paid, but profits in long cash will keep increasing. Combined position would
look like as follows:

[AUTHOR NAME] 35
 “OPTION CONTRACT AND ITS STRATEGIES”

A protective put pays off is similar to that of long call. This is called synthetic long call position.

5.6 Collar Strategy

A collar strategy is an extension of covered call strategy. Readers may recall that in case of covered
call, the downside risk remains for falling prices; i.e. if the stock price moves down, losses keep
increasing (covered call is similar to short put). To put a floor to this downside, we long a put
option, which essentially negates the downside of the short underlying/futures (or the synthetic
short put).

[AUTHOR NAME] 36
 “OPTION CONTRACT AND ITS STRATEGIES”

In our example, we had assumed that a trader longs a stock @ 1590 and shorts a call option with
a strike price of 1600 and receives Rs. 10 as premium. In this case, the BEP

was 1580. If price fell below 1580, loss could be unlimited whereas if price rose above 1600, the
profit was capped at Rs. 20.

To prevent the downside, let us say, we now buy an out‐of‐the‐money put option of strike 1580
by paying a small premium of Rs. 7.

Now, if price of underlying falls to 1490 on maturity:

Long Stock: ‐1590 + 1490 = ‐100 Short Call: 10

Long Put: ‐7 – 1490 + 1580 = 83

Net Position: ‐100 + 10 + 83 = 7 (in case of covered call this would have been ‐90)

If price rises to 1690 on maturity: Long Stock: ‐1590 + 1690 = 100

Short Call: 10 – 1690 +1600 = ‐ 80 Long Put: ‐ 7

Net Position:

100 – 80 – 7 = 13 (in case of covered call this would have been + 20)

Combined position (i.e. long underlying, short call and long put) is as follows:

It is important to note here is that while the long-put helps in reducing the downside risk, it also
reduces the maximum profit, which a covered call would have generated. Also, the BEP has moved
higher by the amount of premium paid for buying the out‐of‐the‐money put option.

[AUTHOR NAME] 37
 “OPTION CONTRACT AND ITS STRATEGIES”

5.7 Butterfly Spread

As collar is an extension of covered call, butterfly spread is an extension of short straddle. We may
recollect that downside in short straddle is unlimited if market moves significantly in either
direction. To put a limit to this downside, along with short straddle, trader buys one out of
the money call and one out of the money put. Resultantly, a position is created with pictorial
pay‐off, which looks like a butterfly and so this strategy is called “Butterfly Spread”.

Butterfly spread can be created with only calls, only puts or combinations of both calls and puts.
Here, we are creating this position with help of only calls. To do so, trader has to take following
positions in three different strikes and same maturity options:

[AUTHOR NAME] 38
 “OPTION CONTRACT AND ITS STRATEGIES”

Long Call 1 with strike of 6000 and premium paid Rs. 230 Short Call 2 with strike of 6100 and
premium received Rs. 150 Long Call 3 with strike of 6200 and premium paid of Rs. 100

Short Call 2 with strike of 6100 and premium received Rs. 150

Let us see what happens if on expiry price is:

Less than or equal to 6000

Equal to 6100

More than or equal to 6200

Case I: Price at 6000

Long Call 1: ‐230 Short Call 2: 150

Long Call 3: ‐ 100

Short Call 2: 150

Net Position: ‐230 + 150 – 100 + 150 = ‐30

For any price lower than 6000, all calls will be out‐of‐the‐money so nobody will exercise. Hence
buyers will lose premium and sellers/ writers will get to keep the premium. In all these situations,
trader’s loss would be flat Rs. 30.

Case II: Price at 6100

Long Call 1: ‐ 230 – 6000 + 6100 = ‐ 130 Short Call 2: 150

Long Call 3: ‐ 100

Short Call 2: 150

Net Position: ‐ 130 + 150 – 100 + 150 = 70

This is the maximum profit point for thi position. Both the shorted calls earn the premium for the
trader. This entire premium is kept by the trader for all prices less than or equal to 6100.

Case III: Price at 6200 or higher

Long Call 1: ‐ 230- 6000 + 6200 =-30 (This will keep increasing as price rises)

[AUTHOR NAME] 39
 “OPTION CONTRACT AND ITS STRATEGIES”

Short Call 2: 150- 6200 + 6100 = 50 (This will start getting losses as price increases) Long Call 3:
‐ 100

Short Call 2: 150- 6200 + 6100 = 50 (This will start getting losses as price increases) Net Position:
‐ 30 + 50 – 100 + 50 = ‐ 30

From 6200 or higher, the long calls will start making money for the trader whereas the short calls
will be in losses. And, total of all 4 would always be equal to – 30. Following table and picture

explain this position:Cost of creating butterfly spread: ‐230 + 150 – 100 + 150 = ‐ 30 Lower BEP
= 6000 + 30 = 6030

Higher BEP = 6200 – 30 = 6170

[AUTHOR NAME] 40
 “OPTION CONTRACT AND ITS STRATEGIES”

This position can also be created with the help of only puts or combination of calls and puts. To
create this position from puts, one needs to buy one highest strike option, sell two middle strike
options and then again buy one lowest strike option. And, to create this position from combination
of calls and puts, one need to buy one call at lowest strike, sell one call at middle strike, buy one
put at highest strike and sell one put at middle strike. This is limited profit and limited loss strategy.

[AUTHOR NAME] 41
 “OPTION CONTRACT AND ITS STRATEGIES”

UNIT 6: CONCLUSION

An option is a contract giving the buyer the right but not the obligation to buy or sell an underlying
asset at a specific price on or before a certain date. Options are derivatives because they derive
their value from an underlying asset. A call gives the holder the right to buy an asset at a certain
price within a specific period of time. A put gives the holder the right to sell an asset at a certain
price within a specific period of time.

The two main classifications of options are American and European. Options can also be

distinguished as listed/OTC, or vanilla/exotic, among other classification schemes. Long term
options are known as LEAPS

There are four types of participants in options markets: buyers of calls, sellers of calls, buyers of
puts, and sellers of puts. Buyers are often referred to as holders and sellers are also referred to as
writers. The price at which an underlying stock can be purchased or sold is called the strike price.
The total cost of an option is called the premium, which is determined by factors including the
stock price, strike price and time remaining until expiration. The premium of an option increases
as the chances of the event of the option finishing in-the-money increases. A stock option contract
typically represents 100 shares of the underlying stock. Investors use options both
to speculate and hedge risk. Spreads and synthetic positions highlight the versatility of options
contracts. Employee stock options are different from listed options because they are a contract
between the company and the holder. (Employee stock options do not involve any third parties.) .

Option strategies are the simultaneous, and often mixed, buying or selling of one or more options
that differ in one or more of the options' variables. This is often done to gain exposure to a specific
type of opportunity or risk while eliminating other risks as part of a trading strategy. A very straight
forward strategy might simply be the buying or selling of a single option, however option strategies
often refer to a combination of simultaneous buying and or selling of options.

[AUTHOR NAME] 42
“OPTION CONTRACT AND ITS STRATEGIES”

[AUTHOR NAME] 43