Commodity and Derivatives Markets

Unit 3: Options, Option Pricing Models

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Contents: Module 1: All about Options
● Introduction
● Basic terminologies of options
● Various underlying assets for option contracts
● Option contract specifications

● Comparison between Market price and the Exercise price of the

options (ITM, ATM and OTM)
● Problems on (ITM, ATM and OTM)

● The Intrinsic value (IV) and Time value of the options (TV)
● Problems on IV and TV

● Differences and similarities between Futures and Options

● Types of Options in detail (Call and Put)

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● Option pay off strategies:

▪Long Call; Short Call; Long Put and Short Put
● Problems on Option pay off strategies

● Option strategies :
Hedging
Problems on hedging

Spreads
Problems on spread

Combinations
Problems on combinations

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Contents: Module 2: Option Contract Valuation

Models
● Binomial Model
● Problems on Binomial Model

● Risk Neutral Model

● Problems on Risk Neutral Model

● Black and Scholes Model

● Problems on Black and Scholes Model

● Factors affecting price oh the options

● Option Greeks: Delta, Gamma, Theta, Rho and Vega.

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Introduction
● An option is a Privileged legal contract which gives the holder the
right to buy or sell a specified amount of underlying asset at a fixed
price within a specified period of time.

● It gives the holder the right to buy (or sell) a designated asset. The
holder is, however, not obliged to sell (or buy) the same.

● This is in contrast to forward and futures contracts where both the

parties have a binding commitment.

● There are two parties in an options contract—one party takes a long

position, that is, it buys the option, while the other one takes a short
position, that is, it sells the option.

● The one who takes a short position is the one who writes the option,
and is called the writer of the option.
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SOME BASIC OPTION

TERMINOLOGIES

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● Call options: Call option gives the buyer or the holder of the option the right but
not the obligation to buy the underlying asset at a certain price by a specified date.

● Put options: Put option gives the buyer or the holder of the option the right but
not the obligation to sell the underlying asset at a certain price by a specified date.

● Exercise of option: It is the action taken by the buyer of an option who intends to
deliver (sell)/take delivery (buy) of the underlying asset. NOTE: Only the buyer
has the right to exercise the option. The seller of the option (the option writer) is
obliged to deliver/take delivery of the underlying asset as and when the buyer
wishes to exercise his options.

● Exercise price: Also called as strike price, is the price at which the buyer or the
seller of the option may buy or sell the underlying asset by a specified date

● Expiration date: It is the last day on which an option can be either exercised or
offset. It is the date specified on the option contract, also known as the expiration
date, the exercise date, the strike date or the maturity date. After the expiration
date, the option is worthless. Excellence and Service
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● Options premium: It is the amount paid to buy an option at a specified strike

price/exercise price. It is also called as the options price. The option premium to be paid
depends on several factors which are discussed at the later part of this unit.

● Buyer of the option: Also called the owner of the options is the one who pays the
option premium to buy the right but not the obligation to exercise his option on the
seller.

● Writer of an option: Also called the seller of the options is the one who receives the
option premium and is thereby obliged to sell/buy the asset if the buyer exercises on
him.

● Over-the-counter (OTC) options: These are the customised option contracts traded
one to one (bilaterally) between a buyer and a seller. OTC option contracts match the
specific needs of the participants, as these are not standardised contracts and are not
traded on regulated exchanges.

● Exchange-traded options: These are standardized option contracts traded on regulated

F&O exchanges with participation from large number of buyers and sellers. They have
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● American-style options: These are the types of options in which the

buyer of the option can choose to exercise his option a any time
between the purchase date and the expiry date of the option contract.
Most exchange-traded options are American.

● European-style options: These are the types of options in which the

buyer of the option can choose to exercise his option only on the date
of expiration of the option contract.

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Various Underlying's for Options Contract

There is a wide variety of assets on which options are traded the world over.

● (i) Commodities including Agri-based like wheat or CPO, bullion like gold
and silver, energy like crude oil and base metals like copper or aluminium etc.

● (ii) Foreign currencies including the British pound, Canadian dollar, French
franc, Japanese yen, Swiss franc, Deutsche mark, Australian dollar, Currency
Forward etc.,

● (iii) Interest rates including Eurodollar, Euro mark, 90-day Treasury bill,
one-year Treasury bill etc,

● (iv) Stock indices covering S&P 500 Index, S&P Midcap 400 Index, Nikkei
225 Index, Nifty 50, Bank Nifty, Russel 2000 Index and FT-SE 100 Share
Index.

● (v) Stock Options options onExcellence

stocks (shares of individual companies), HDFC
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Options Contract Specifications

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The standardized option contracts traded on regulated F&O exchanges
with participation from large number of buyers and sellers. They have
pre-determined specifications which are as follows:

● like lot size (or) quantity,

● quality (in case of commodity),
● fixed contract expiration date,
● option price,
● option type (CE or PE),
● trading cycle,
● settlement mode and
● strike price.

For stock options:

https://www.nseindia.com/getquotes/derivatives?symbol=INFY

For index options:

https://www.nseindia.com/get-quotes/derivatives?symbol=BANKNIFTY
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COMPARISON OF MARKET PRICE OF THE ASSET AND THE

EXERCISE PRICE

In-the-money,
At-the-money,
Out-of-the money

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At any time, an option may be in-the-money, at-the-money or out-of-the

money.

● In-the-money (ITM): It is an option that would lead to a

positive cashflow to the holder of the option if it is exercised
immediately.

● At-the-money (ATM): It is an option that would lead to ZERO

cashflow to the holder of the option if it is exercised
immediately.

● Out-of-the money (OTM): It is an option that would lead to a

negative cashflow to the holder of the option if it is exercised
immediately.
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● A call option is said to be in-the-money if the stock price is greater than the
exercise price,

● The call option is said to be out-of-the-money, if the stock price is smaller

than the exercise price.

● For the put options, if the stock price is lower than the exercise price then
the put is said to be in-the-money

● In the put options, if the stock price is greater than the exercise price then
the put is said to be out-of-the-money.

● In each case, however, the option is said to be at-the-money if the stock

price matches with the exercise price.

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● These concepts are tabulated below, wherein S0 indicates the present

value of the stock (i.e. the value at a given point of time) and E is the
exercise price:
Condition Call Option Put Option

S0 > E In-the-Money Out-of-the-Money

S0 < E Out-of-the-Money In-the-Money

S0 = E At-the-Money At-the-Money

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https://www.nseindia.com/option-chain

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You are given below information on some options.

State whether each one of these is in-the-money,
out-of-the-money or at-the-money.

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Solutions:

● 1. In-the-money
● 2. Out-of-money

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Intrinsic Value and Time Value

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The premium or the price of an option is made up of two components,

namely, the intrinsic value and the time value.

● The intrinsic value is also termed as the parity value,

● the time value is also termed as the premium over parity.

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The intrinsic value

● For an option, the intrinsic value refers to the amount by which it is in
money if it is in-the-money.

NOTE: THEREFORE, AN OPTION WHICH IS OUT-OF-MONEY OR

AT-THE-MONEY HAS A ZERO INTRINSIC VALUE.

● In simple terms, Intrinsic value of an option will always be a

positive value. If there is any negative value, it has to be taken as
zero.

● Intrinsic Value of a Call Option = Stock price (S0) – Exercise price

(E).

● Intrinsic Value of a Put Option = Exercise price (E) – Stock price

(S0).
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The time value

● The time value of an option is the difference between the premium of

the option and the intrinsic value of the option.

TIME VALUE = PREMIUM – INTRINSIC VALUE

● In case of a call which is in-the-money, the time value exists if the call
price, C, is greater than the intrinsic value i.e., (S0 – E).

● For the put options, the in-the-money put option has a time value if its
premium exceeds the intrinsic value i.e., (E – S0).

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From the following data, determine for each option,

the intrinsic value and the time value.

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Solutions:

● Call option 1: Intrinsic Value = 83.50 – 80 = 3.50.

Time Value = 6.75 -- 3.50 = 3.25.

● Call option 2: Intrinsic Value = 83.50 – 85 = 0.

Time Value = 2.50 – 0 = 2.50.

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Difference between futures and options
FUTURES OPTIONS
Meaning In a forward or futures contract, An option gives the holder of the
the two parties have committed option the right to do something,
themselves to some action (Buy or but the holder does not have to
sell a certain quantity of exercise this right.
underlying at a pre-determined
price in a future date).
Up-front It costs a trader the margin/ whereas the purchase of an option
payment collateral requirements to enter requires an up-front payment i.e.,
into a forward or futures contract premium amount.
Execution of a A futures contract is put into The buyer of an option may
Contract effect on the predetermined date. exercise it at any time before the
The buyer purchases the expiration date. As a result, a
underlying asset on this specific person is willing to purchase the
day. asset anytime the circumstances
look favourable.
Obligation The buyer is required/obliged to In this, neither the buyer nor the
purchase the item on the specified contract's execution are required.
future date.
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Risk Involved They are exposed to greater risks. The limited risk applies to them.
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Difference between futures and options (Contd.)

FUTURES OPTIONS

Profits and losses Unlimited upside & Limited downside (to the
downside for both buyer extent of premium paid)
and seller. for buyer and unlimited
upside. For seller (writer)
of the option, profits are
limited whereas losses can
be unlimited.

Factors affecting the price Futures contracts prices Prices of options are
are affected mainly by the however, affected by
prices of the underlying a)prices of the underlying
asset asset,
b)time remaining for
expiry of the contract and
c)volatility of the
underlying asset.
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Similarities between futures and options

● The following are the parallels between futures and options that
maintain the fundamentals of these contracts:

1. Both are stock exchange-traded derivative contracts.

2. Key information on the trade, price, quantity, and date is specified
while creating the contract.
3. The settlement of both futures and options occurs every day.
4. Both contracts are standardized and call for a margin account.
5. These contracts' underlying assets include financial instruments
including currencies, commodities, bonds, equities, etc.

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TYPES OF OPTIONS

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Types of Options

● Options may be categorized as call options and put options.

● A call option is a contract which gives the owner the right to buy an
asset for a certain price on or before a specified date.

● On the other hand, a put option gives its owner the right to sell
something for a certain predetermined price on or before a specified
date.

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What are Call Options?

● A call option gives the holder (buyer/ one who is long call),
the right to buy specified quantity of the underlying asset at
the strike price on or before expiration date.

● The seller of the call options, however, has the obligation

to sell the underlying asset if the buyer of the call option
decides to exercise his option to buy.

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Call option example: when the option will be exercised

● An investor buys One call option on Infosys at the strike
price of Rs. 3500 at a premium of Rs. 100. If the market
price of Infosys on the day of expiry is more than Rs. 3500,
the option will be exercised.
● The investor will earn profits once the share price crosses
Rs. 3600 (Strike Price + Premium i.e. 3500+100).
● Suppose stock price is Rs. 3800, the option will be
exercised and the investor will buy 1 share of Infosys from
the seller of the option at Rs 3500 and sell it in the market
at Rs 3800 making a profit of Rs. 200 { (Spot price - Strike
price) - Premium}.

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Call option example: when the option will not be

exercised
● In another scenario, if at the time of expiry stock price falls
below Rs. 3500 say suppose it touches Rs. 3000, the buyer
of the call option will choose not to exercise his option.

● In this case the investor loses the premium (Rs 100), paid
which shall be the profit earned by the seller of the call
option.

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What are Put Options?

● A Put option gives the holder (buyer/ one who is long Put),
the right to sell specified quantity of the underlying asset at
the strike price on or before a expiry date.

● The seller of the put option (one who is short Put) however,
has the obligation to buy the underlying asset at the strike
price if the buyer decides to exercise his option to sell.

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Put option example: when the option will be exercised

● An investor buys one Put option on Reliance at the strike

price of Rs. 300/-, at a premium of Rs. 25/-. If the market
price of Reliance, on the day of expiry is less than Rs. 300,
the option can be exercised as it is profitable.
● The investor's Break even point is Rs. 275/ (Strike Price -
premium paid) i.e., investor will earn profits if the market
falls below 275.
● Suppose stock price is Rs. 260, the buyer of the Put option
immediately buys Reliance share in the market @ Rs. 260/-
& exercises his option selling the Reliance share at Rs 300
to the option writer thus making a net profit of Rs. 15
{(Strike price - Spot Price) - Premium paid}.
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Put option example: when the option will not be exercised

● In another scenario, if at the time of expiry, market price of

Reliance is Rs 320/ - , the buyer of the Put option will
choose not to exercise his option to sell as he can sell in the
market at a higher rate.

● In this case the investor loses the premium paid (i.e Rs

25/-), which shall be the profit earned by the seller of the
Put option.

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The positions of the buyer and seller in call and put

options
OPTION Buyer of Option Writer/seller of Option
TYPE (Long Position) (Short Position)
CALL Right to buy asset Obligation to sell asset

PUT Right to sell asset Obligation to buy asset

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When to buy or sell Call and Put Options??

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Option Payoff Strategies

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Long Call Option
● A long call option position
involves buying a call option.
● Characteristics –
○ Limited Risk: The
maximum loss is the
premium paid for the call
option.
○ Unlimited Potential
Profit: Profits increase as
the underlying asset's price
40

rises.
Short Call Option
● A short call option position involves
selling a call option.
● Characteristics –

○ Limited Potential
Profit: The maximum
profit is the premium
received for the call
option.
○ Unlimited Risk: Losses
41
increase as the
underlying asset's price
Long Put Option
● A long put option position
involves buying a put option.
● Characteristics –
○ Limited Risk: The
maximum loss is the
premium paid for the put
option.
○ Potential Profit: Profits
increase as the 42

underlying asset's price

falls.
Short Put Option
● A short put option position involves
selling a put option.
● Characteristics –

○ Limited Potential
Profit: The maximum
profit is the premium
received for the put
option.
○ Limited Risk: The
potential loss is up to the
strike price minus the 43

premium received.
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SUMMARY OF THE PROFITS AND LOSSES

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Options Pay off charts, Diagrams and

Problems

1. Call Buy
2. Call Sell

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Call Options: Buy and Sell Problem

● Consider a call option on a certain share, say ABC. Suppose the

contract is made between two investors X and Y, who take,
respectively, the short and long positions. The other details are given
below:

● Exercise price = Rs 120

● Expiration month = March, 2003
● Size of contract = 100 shares
● Date of entering into contract = January 5, 2003
● Price of share on the date of contract = Rs 124.50
● Price of option on the date of contract = Rs 10
● Calculate the profit/loss made by each of the investors for some
selected values of the share price of ABC which are as follows: RS
90, 100, 110, 120, 130, 140, 150, 160.
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Pay off charts and Diagram for CALL

BUYER INVESTOR Y

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Solution:
At the time of entering in to the contract,
● Investor X writes a contract and receives Rs 1000 (= 10 x 100)
● Investors Y takes a long position and pays Rs 1000 for it.

● On the date of maturity, the profit or loss to each investor would depend
upon the price of the share ABC prevailing on that day.
● The buyer would obviously not call upon the call writer to sell shares if the
price happens to be lower than Rs 120 per share.
● Only when the price exceeds Rs 120 per share will a call be made.
● Having paid Rs 10 per share for buying an option, the buyer can make a
profit only in case the share price is at a point higher than Rs 120 + Rs 10 =
Rs 130.
● At a price equal to Rs 130 a break-even point is reached.

● The profit/loss made by each of the investors for some selected values of the
share price of ABC is indicated in next slide.
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Spot I.V = S0 – EP Premium P&L LOT SIZE NET P&L
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Price RS. (I.V -- PREMIUM) Deemed to be University
90 90 – 120 = 0 10 0 – 10 = -- 10 100 --1000
100 100 – 120 = 0 10 0 – 10 = -- 10 100 --1000
110 110 – 120 = 0 10 0 – 10 = -- 10 100 --1000
120 120 – 120 = 0 10 0 – 10 = -- 10 100 --1000
130 130 – 120 = +10 10 +10 – 10 = 0 100 0
140 140– 120 = +20 10 +20 -- 10 = 10 100 +1000
150 150 – 120 = +30 10 +30 – 10 = 20 100 +2000
160 160 – 120 = +40 10 +40 – 10 = 30 100 +3000

Pay off charts and

Diagram FOR CALL
BUYER i.e.,
INVESTOR
Y A/C.

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Pay off charts and Diagram for CALL

SELLER INVESTOR X

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Spot I.V = S0 – EP Premium P&L LOT SIZE NET P&L
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Price RS. (PREMIUM -- IV) Deemed to be University

90 90 – 120 = 0 10 10 – 0 = 10 100 +1000

100 100 – 120 = 0 10 10 – 0 = 10 100 +1000
110 110 – 120 = 0 10 10 – 0 = 10 100 +1000
120 120 – 120 = 0 10 10 – 0 = 10 100 +1000
130 130 – 120 = +10 10 10 – 10 = 0 100 0
140 140– 120 = +20 10 10 – 20 = -10 100 --1000
150 150 – 120 = +30 10 10 – 30 = -20 100 --2000
160 160 – 120 = +40 10 10 – 40 = -30 100 --3000

Pay off charts and

Diagram FOR CALL
SELLER i.e.,
INVESTOR X A/C.

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● It is evident that the call writer’s profit is limited to the amount of

call premium but, theoretically, there is no limit to the losses if the
stock price continues to increase and the writer does not make a
closing transaction by purchasing an identical call.

● The situation is exactly the opposite for the call buyer, for whom the
loss is limited to the amount of premium paid. However, depending
on the stock price, there is no limit on the amount of profit which
can result for the call buyer.

● Being a ‘zero-sum’ game, a loss (gain) to one party implies an equal

amount of gain (loss) to the other party.

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Options Pay off charts and Diagrams

1. Put Buy
2. Put sell

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Put Options: Buy and Sell Problem

● Consider a put option contract on a certain share, PQR. Suppose, two

investors X and Y enter into a contract and take short and long
positions respectively. The other details are given below:

● Exercise price = Rs 110

● Expiration month = March, 2003
● Size of contract = 100
● shares Date of entering into contract = January 6, 2003
● Share price on the date of contract = Rs 112
● Price of put option on the date of contract = Rs 7.50
● Calculate the profit/loss made by each of the investors for some
selected values of the share price of PQR as follows: RS 80, 90, 100,
110, 120, 130, 140, 150.

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Pay off charts and Diagram for PUT

BUYER INVESTOR Y

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Spot I.V = EP – S0 Premium P&L LOT SIZE NET P&L
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Price RS. (I.V -- PREMIUM) Deemed to be University

80 110 – 80 = 30 7.5 30 – 7.5 = 22.5 100 2250

90 110 – 90 = 20 7.5 20 – 7.5 = 12.5 100 1250
100 110 – 100 = 10 7.5 10 – 7.5 = 2.5 100 250
110 110 – 110 = 0 7.5 0 – 7.5 = -- 7.5 100 --750
120 110 – 120 = 0 7.5 0 – 7.5 = -- 7.5 100 --750
130 110 – 130 = 0 7.5 0 – 7.5 = -- 7.5 100 --750
140 110 – 140 = 0 7.5 0 – 7.5 = -- 7.5 100 --750
150 110 – 150 = 0 7.5 0 – 7.5 = -- 7.5 100 --750

Pay off charts and

Diagram FOR PUT
BUYER i.e.,
INVESTOR Y A/C.

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Pay off charts and Diagram for PUT

SELLER INVESTOR X

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● Now, as the contract is entered into, the writer of the option, X, will receive Rs
750 (= 7.50 *100) from the buyer, Y.
● At the time of maturity, the gain/loss to each party depends on the ruling price of
the share.
● If the price of the share is Rs 110 or greater than that, the option will not be
exercised, so that the writer pockets the amount of put premium—the maximum
profit which can accrue to a seller.
● At the same time, it represents the maximum loss that the buyer is exposed to. If
the price of the share falls below the exercise price, a loss would result to the
writer and a gain to the buyer.
● The maximum loss that the writer may theoretically be exposed to is limited by the
amount of the exercise price. Thus, if the value of the underlying share falls to
zero, the loss to the writer is equal to Rs 110 – Rs 7.50 = Rs 102.50 per share.
● The profit/loss for some selected values of the share are given in Table.
● The break-even share price would be Rs 102.50 (= Rs 110 – Rs 7.50).
● If the price of the share happens to be lower than this, the writer would make a
loss—and the buyer makes a gain.
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Spot I.V = EP – S0 Premium P&L LOT SIZE NET P&L
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Price RS. (PREMIUM -- IV) Deemed to be University

90 110 – 80 = 30 7.5 7.5 – 30 = -- 22.5 100 --2250

100 110 – 90 = 20 7.5 7.5 – 20 = -- 12.5 100 --1250
110 110 – 100 = 10 7.5 7.5 – 10 = -- 2.5 100 --250
120 110 – 110 = 0 7.5 7.5 – 0 = 7.5 100 750
130 110 – 120 = 0 7.5 7.5 – 0 = 7.5 100 750
140 110 – 130 = 0 7.5 7.5 – 0 = 7.5 100 750
150 110 – 140 = 0 7.5 7.5 – 0 = 7.5 100 750
160 110 – 150 = 0 7.5 7.5 – 0 = 7.5 100 750

Pay off charts and

Diagram FOR PUT
SELLER i.e.,
INVESTOR X A/C.

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Problems

1.An investor buys a call option on 1200 shares with an exercise price
of Rs 80 for Rs 7.75.
● What is the maximum loss that he could possibly incur on this?
● What is the maximum profit which could accrue to him?
● Also, determine the break-even stock price.

2. An investor purchases a put option involving 300 shares with an

exercise price of Rs 180 for Rs 9.50.
● What is the maximum loss that the investor could possibly incur?
● What is the maximum profit which could accrue to him?
● Calculate the break-even stock price.

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Solutions

SOL for Problem 1:

● Maximum loss: Rs 9300, i.e., (7.75 x 1200 shares)

● Maximum profit: No limit
● BEP = Rs 87.75 per share (80+ 7.75).

SOL for Problem 2:

● Maximum loss: Rs 2850, i.e., (9.50 x 300 shares)

● Maximum profit: Rs 51,150, i.e., (180 – 9.50 x 300 shares = 51,150).
● BEP = Rs 170.5 per share i.e., (180 – 9.50).

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OPTIONS STRATEGIES

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OPTIONS
HEDGING STRATEGIES

COMBINATIONS
SPREADS
BUYING WRITING
CALL & PUT CALL & PUT
OPTIONS OPTIONS
BULL STRADDLE
SPREAD
LONG STOCK LONG STOCK
LONG PUT SHORT CALL STRIPS &
BEAR STRAPS
SPREAD
SHORT STOCK SHORT STOCK
LONG CALL SHORT PUT
STRANGLES
BUTTERFLY
SPREAD

CONDORS

BOX SPEADS
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OPTIONS STRATEGIES: HEDGING

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Hedging

● Hedging represents a strategy by which an attempt is made to limit the

losses in one position by simultaneously taking a second offsetting
position.

● The offsetting position may be in the same or a different security.

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BUYING CALL & PUT OPTIONS:LONG STOCK LONG PUT

(Protective
An investorPut)
buying a common stock expects that its price would increase.
However, there is a risk that the price may in fact fall. In such a case, a hedge
could be formed by buying a put, i.e., buying the right to sell.

Problem: Consider an investor who buys a share for Rs 100. To guard against the
risk of loss from a fall in its price, he buys a put for Rs 16 for an exercise price of,
say, Rs 110. Tabulate, depict and calculate:

(i) The profit/loss on Exercise of the put option for some selected values of the
share price such as 70, 80, 90, 100, 110, 120,130 and 140.

(ii) The profit/loss on long stock for the same selected values of the share price as
given above.

(iii) The profits/loss resulting from the hedging (i.e.,) strategy of holding a long
position in stock and long put.

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Solution:
● The investor would, obviously, exercise the option only if the price of
the share were to be less than Rs 110.
Share Price Exercise Profit on Exercise of the put Profit/Loss on Net Profit
Price option (i) Share Held (ii) (i) + (ii) = (iii)
(EP – Share Price – premium) (short on stock)
70 110. 110 – 70 – 16 = 24 -30 -6

80 110. 110.- 80 -16 = 14 -20 -6

90 110. 110.- 90 – 16 = 4 -10 -6

100 110. 110.- 100 – 16 = -6 0 -6

110 110. 110.- 110 – 16 = -16 +10 -6

120 110. 110.- 120 – 16 = -16 +20 4

130 110. 110. – 130 – 16 = -16 +30 14

140 110. 110.- 140 – 160 = -16 +40 24

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Hedging: Long Stock Long Put: Diagram

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BUYING CALL & PUT OPTIONS: SHORT STOCK LONG

CALL
● Unlike an investor with a long position in stock, a short seller of stock
anticipates a decline in the stock price.

● By shorting the stock now and buying it at a lower price in the future,
the investor intends to make a profit.

● Any price increase can bring losses because of an obligation to

purchase at a later date.

● To minimize the risk involved, the investor can buy a call option with
an exercise price equal to or close to the selling price of the stock.

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Problem: An investor shorts a share at Rs 100 and buys a call

option for Rs 4 with a strike price of Rs 105. some selected prices
of the share are 90, 95, 100, 105, 110, 115, 120. Tabulate, depict
and calculate:

(i) The profit/losses on Exercise of the call option for some

selected values of the share price such as given above.

(ii) The profit/loss on short stock for the same selected values of
the share price as given above.

(iii) The profits/losses resulting from the hedging (i.e.,) strategy of

shorting position in stock and long call.

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Solution:
Share Price Exercise Profit on Exercise of the put Profit/Loss Net Profit
Price option (i) on Share (i) + (ii) = (iii)
(Share Price -- EP – premium) Held (ii)
90 105 90 – 105 = 0 – 4 = - 4 +10 -4 + 10 = 6

95 105 95 – 105 = 0 – 4 = - 4 +5 -4 + 5 = 1

100 105 100 – 105 = 0 – 4 = - 4 0 -4 + 0 = -4

105 105 105 – 105 = 0 – 4 = - 4 -5 -4 + (-5) = -9

110 105 110 – 105 = 5 – 4 = 1 -10 1 + (-10) = -9

115 105 115 – 105 = 10 – 4 = 6 -15 6 + (-15) = -9

120 105 120 – 105 = 15 – 4 = 11 -20 11 + (-20) = -9

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Hedging: SHORT STOCK LONG CALL: Diagram

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WRITING CALL & PUT OPTIONS: LONG STOCK

SHORT CALL (Covered Call)
Problem: Consider an investor who has bought a share for Rs 100, and
who writes a call with an exercise price of Rs 105, and receives a premium
of Rs 3. The prices of the underlying share such as 90, 95, 100, 105, 110,
115, 120. You are required to calculate and depict the following:

(i) The profit/losses on the call option for some selected values of the share price
as given above.

(ii) The profit/loss on long stock for the same selected values of the share price as
given above.

(iii) The net profits/losses resulting from the hedging (i.e.,) strategy of long
position in stock and short call.

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Solution: LONG STOCK SHORT CALL
Share Exercis Profit on Exercise of the call option Profit/L Net Profit
Price e Price (i) oss on (i) + (ii) = (iii)
(Share Price – EP = IV), (Prem.- IV) Share
Held (ii)
90 105 90 – 105 = - 15, 3 – 0 = 3 - 10 -7
95 105 95 – 105 = - 10, 3 – 0 = 3 -5 -2
100 105 100 – 105 = - 5, 3 – 0 = 3 0 3
105 105 105 – 105 = 0, 3 – 0 = 3 5 8
110 105 110 – 105 = 5, 3 – 5 = -2 10 8
115 105 115 – 105 = 10, 3 – 10 = -7 15 8
120 105 120 – 105 = 15, 3 – 15 = -12 20 8

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LONG STOCK SHORT CALL: PAYOFF CHART

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WRITING CALL & PUT OPTIONS: SHORT STOCK

● SHORT
An investorPUT
who shorts stock can hedge by writing a put option. By undertaking to ‘be
the buyer’, the investor hopes to reduce the magnitude of loss that would be occurring
from an increase in the stock price, by limiting the profit that could be made when the
stock price declines.

Problem: suppose that you short a share at Rs 100 and write a put option for Rs 3, having
an exercise price of Rs 100. calculate The prices of the underlying share such as 90, 95,
100, 105, 110, 115, 120. You are required to calculate and depict the following:

(i) The profit on the Exercise of the put option for some selected values of the share price
as given above.

(ii) The profit/loss on short stock for the same selected values of the share price as given
above.

(iii) The net profits resulting from the hedging (i.e.,) strategy of short position in stock
and short put.
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Solution: SHORT STOCK SHORT PUT

● Clearly, the buyer of the put will exercise the option only if the share
price does not exceed the exercise price.
Share Exercis Profit on Exercise of the call option Profit/Loss Net Profit
Price e Price (i) on Share (i) + (ii) =
(EP -- Share Price = IV), (Prem.- IV) Held (ii) (iii)
90 100 100 – 90 = 10, 3 – 10 = -7 10 3
95 100 100 – 95 = 5, 3–5=-2 5 3
100 100 100 – 100 = 0, 3–0=3 0 3
105 100 100 – 105 = -5, 3 -- 0 = 3 -5 -2
110 100 100 – 110 = -10, 3–0=3 - 10 -7
115 100 100 – 115 = -15, 3-0 =3 - 15 - 12
120 100 100 – 120 =-20, 3–0 =3 - 20 - 17

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SHORT STOCK SHORT PUT: PAY OFF CHART

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OPTIONS STRATEGIES: SPREADS

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Spreads
● Options can be combined in several ways— multiple calls, multiple puts or
calls and puts together. Some of the more generally used combinations are as
follows:

● Spreads: A spread trading strategy involves taking a position in two or more

options of the same type.

● Bull Spreads: One of the most popular spread strategies is a bull spread. A
bull spread reflects the bullish sentiment of a trader and can be created by
purchasing a call option on a stock and selling another call on the stock and
with the same expiry but a higher exercise price.

● Bear Spreads: In contrast to the bull spreads, bear spreads are used as a
strategy when one is bearish on the market, believing that it is more likely to
go down than up. Like a bull spread, a bear spread may be created by buying
a call with one exercise price and selling another one with a different
exercise price. Unlike in a bull spread, however, the exercise price of the call
option purchased is higher than that ofandthe
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● Butterfly Spreads: While bull and bear spreads involve taking

positions in two options, a butterfly spread results from positions in
options with three different strike prices.

● This involves buying a call option with a relatively low exercise price,
E1, buying another call option with a relatively large exercise price,
E3, and selling two call options with a strike price, E2 which is
halfway between E1 and E3.

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Problems on Spreads

Bull Spreads Bear Spreads

Bull Call Bull Put Bear Call Bear

Put

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1. BULL CALL SPREAD

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BULL CALL SPREAD: NUMERICAL PROBLEM

From the given information on bull call spread strategy:

The net cash flow is the difference between the 35.40 – 170.45 = -135.05. since this is a negative
cashflow, there is a net debit to the account.

● Calculate the P&L from Long call.

● Calculate the P&L from Short call.
● Calculate the net P&L from the strategy.
● Depict the payoff chart for the spot prices on the date of expiry such as Rs: 3900,
4000, 4100, 4200, 4300, 4400, 4500 and 4600.
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BULL CALL SPREADS: Solution

SPOT PRICE P&L ON LONG CALL P&L ON SHORT CALL NET P&L
AT EXPIRY (1) + (2)
IV = SP - EP P&L IV = SP - EP P&L
= IV – PRE = PRE – IV
(1) (2)
3900 0 -170.45 0 35.40 -135.05

4000 0 -170.45 0 35.40 -135.05

4100 0 -170.45 0 35.40 -135.05

4200 100 -70.45 0 35.40 -35.05

4300 200 29.55 0 35.40 64.95

4400 300 129.55 0 35.40 164.95

4500 400 229.55 100 -64.40 164.95

4600 500 329.55 200 -164.40 164.95

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BULL CALL SPREADS: Payoff charts

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2. BULL SPREADS: BULL PUT SPREAD

● Similar to the Bull Call Spread, the Bull Put Spread is a two leg option strategy
invoked when the view on the market is ‘moderately bullish’.

● The Bull Put Spread is similar to the Bull Call Spread in terms of the payoff structure;
however there are a few differences in terms of strategy execution and strike
selection.

● The bull put spread involves creating a spread by employing ‘Put options’ rather than
‘Call options’ (as is the case in bull call spread).

● The bull put spread is a two leg spread strategy traditionally involving ITM and OTM
Put options. To implement the bull put spread –

1. Buy 1 OTM Put option at lower exercise price and lower premium
2. Sell 1 ITM Put option at higher exercise price and higher premium

● When you do this ensure –

1. All strikes belong to the same underlying
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2. Belong to the same expiry series
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BULL PUT SPREAD: NUMERICAL PROBLEM
● Date – 7th December 2015
● Outlook – Moderately bullish (expect the market to go higher)
● Nifty Spot – 7805
● Bull Put Spread, trade set up –

1. Buy 7700 PE by paying Rs.72/- as premium; do note this is an OTM

option.

2. Sell 7900 PE and receive Rs.163/- as premium, do note this is an ITM

option.

● Calculate the P&L from Long PUT.

● Calculate the P&L from Short PUT.
● Calculate the net P&L from the strategy.
● Depict the payoff chart for the spot prices on the date of expiry such as
Rs:7000, 7100; 7200; 7300; 7400; 7500; 7600; 7700; 7800; 7900; 8000;
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BULL PUT SPREAD: SOLUTION

● The net cash flow is the difference between the debit and credit i.e
163 – 72 = +91, since this is a positive cashflow, there is a net credit
to the account.

● Generally speaking in a bull put spread there is always a ‘net credit’,

hence the bull put spread is also called referred to as a ‘Credit spread’.

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BULL PUT SPREAD: SOLUTION
P&L ON LONG PUT P&L ON SHORT PUT NET
STRATEGY
P&L
SP on expiry IV = EP - SP P&L = IV - PRE IV = EP - SP P&L = PRE - IV (1) + (2)

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BULL PUT SPREAD: Payoff chart

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3. BEAR CALL SPREADS
● The Bear Call Spread is a two leg option strategy invoked when the view on the
market is ‘moderately bearish’.

● The Bear Call Spread is similar to the Bear Put Spread in terms of the payoff
structure; however there are a few differences in terms of strategy execution and
strike selection.

● The Bear Call spread involves creating a spread by employing ‘Call options’ rather
than ‘Put options’ (as is the case in bear put spread).

● The Bear Call Spread is a two leg spread strategy traditionally involving ITM and
OTM Call options. To implement the bear call spread –

1. Buy 1 OTM Call option at higher exercise price and lower premium.
2. Sell 1 ITM Call option at lower exercise price and higher premium

● Ensure –
1. All strikes belong to the same underlying
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2. Belong to the same expiry series
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BEAR CALL SPREAD: Numerical problem

● Date – February 2016
● Outlook – Moderately bearish
● Nifty Spot – 7222
● Bear Call Spread, trade set up –

1. Buy 7400 CE by paying Rs.38/- as premium; do note this is an OTM

option.

2. Sell 7100 CE and receive Rs.136/- as premium, do note this is an ITM

option.

● Calculate the P&L from Long Call.

● Calculate the P&L from Short Call.
● Calculate the net P&L from the strategy.
● Depict the payoff chart for the spot prices on the date of expiry
such as Rs:6600, 6700;Excellence
6800; 6900; 7000; 7100; 7202; 7302;
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BEAR CALL SPREAD: SOLUTION

1. The net cash flow is the difference between the debit and credit i.e
136 – 38 = +98, since this is a positive cashflow, there is a net credit
to my account.

2. Generally speaking in a bear call spread there is always a ‘net credit’,

hence the bear call spread is also called referred to as a ‘credit
spread’.

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BEAR CALL SPREAD: SOLUTION

P&L ON LONG CALL P&L ON SHORT CALL

SP ON EXPIRY IV = SP - EP P&L = IV - PRE IV = SP - EP P&L = PRE - IV NET P&L = (1) + (2)

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BEAR CALL SPREAD: SOLUTION

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4. BEAR PUT SPREADS

● One would implement a bear put spread when the market outlook is moderately
bearish, i.e, you expect the market to go down in the near term while at the same
time you don’t expect it to go down much. If I were to quantify ‘moderately
bearish’, a 4-5% correction would be apt.

● A conservative trader (risk averse trader) would implement Bear Put Spread
strategy by simultaneously:

1. Buying an In the money Put option at higher exercise and higher premium
2. Selling an Out of the Money Put option at lower exercise and lower premium

● There is no compulsion that the Bear Put Spread has to be created with an ITM
and OTM option.
● The Bear Put spread can be created employing any two put options.
● The choice of strike depends on the aggressiveness of the trade.

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BEAR PUT SPREADS: Numerical problem

● As of today Nifty is at 7485,

● Sell 7400 PE: The premium received (PR) is Rs.73.

● Purchase of the 7600 PE: The premium paid (PP) is Rs.165.

● Calculate the P&L from Long Put.

● Calculate the P&L from Short Put.
● Calculate the net P&L from the strategy.
● Depict the payoff chart for the spot prices on the date of expiry such as
Rs:6600, 6700; 6800; 6900; 7000; 7100; 7200; 7300; 7400; 7500; 7600;
7700; 7800; 7900; 8000 and 8100.

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BEAR PUT SPREADS: Solution

P&L ON LONG PUT P&L ON SHORT PUT

SP ON THE IV = EP -SP P&L = IV - PRE IV = EP - SP P&L = PRE – IV NET P & L (1) + (2)
EXPIRY

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BEAR PUT SPREADS: Solution

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OPTIONS STRATEGIES:
COMBINATIONS

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Combinations
● While spreads involve taking positions in call or put options only, combinations
represent option trading strategies which involve taking positions in both calls
and puts on the same stock. Important combination strategies include straddles,
strips, straps, and strangles.

● Straddle: A straddle involves buying a call and a put option with the same
exercise price and date of expiration. Since a call and a put are both purchased, it
costs to buy a straddle and, to that extent, a loss is incurred if the price does not
move away from the exercise price since none of them will be exercised. Buying
a straddle is an appropriate strategy to adopt when large price changes are
expected in the stock—for lower prices of the stock, the put option will be
exercised and for higher prices, the call option will be exercised.

● Strangles: In a strangle, an investor buys a put and a call option with the
same expiration date but with different exercise prices. The exercise price of
the put is lower than the exercise price of the call, so that a profit would
result if the stock price is lower than the exercise price of the put or if the
stock price exceeds the call exercise price.
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1. LONG STRADDLE
● Long straddle is perhaps the simplest market neutral strategy to
implement. Once implemented, the P&L is not affected by the
direction in which the market moves.

● The market can move in any direction, but it has to move. As long as
the market moves (irrespective of its direction), a positive P&L is
generated.

To implement a long straddle all one has to do is –

1. Buy a Call option with the same exercise price.
2. Buy a Put option with the same exercise price.

● Ensure –
1. Both the options belong to the same underlying
2. Both the options belong to the same expiry
3. Belong to the same strikeExcellence and Service
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LONG STRADDLE PROBLEM

● Nifty 50 index option

● Buy 7600CE is trading at 77 and
● Buy 7600 PE is trading at 88.

● Calculate the payoff from Long call.

● Calculate the P&L from Long Put.
● Calculate the net P&L from the strategy.
● Depict the payoff chart for the spot prices on the date of expiry
such as Rs:6500, 6600, 6700; 6800; 6900; 7000; 7100; 7200;
7300; 7400; 7500; 7600; 7700; 7800; 7900; 8000, 8100, 8200,
8300, 8400, 8500, 8600 and 8700.

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LONG STRADDLE: solution

P&L ON LONG CALL P&L ON LONG PUT

SP ON EXPIRY IV = SP - EP P&L = IV - PRE IV = EP - SP P&L = IV - PRE NET P&L FROM

STRATEGY

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LONG STRADDLE: solution

● The idea here is – the trader is long on both the call and put options
belonging to the ATM strike. Hence the trader is not really worried
about which direction the market would move.

● If the market goes up, the trader would expect to see gains in Call
options far higher than the loss made (read premium paid) on the put
option.

● Similarly, if the market goes down, the gains in the Put option far
exceeds the loss on the call option.

● Hence irrespective of the direction, the gain in one option is good

enough to offset the loss in the other and still yield a positive P&L.
Hence the market direction here is meaningless.

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LONG STRADDLE: Payoff chart

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2. SHORT STRADDLE
Setting up a short straddle is quite straight forward – as opposed to
buying the ATM Call and Put options (like in long straddle).

● To implement a long straddle all one has to do is –

● sell the ATM Call option at same exercise price
● Sell the ATM Put option at same exercise price

● Please do note –
● the options should belong to the same underlying,
● same expiry, and
● of course same strike.

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SHORT STRADDLE: PROBLEM

● Consider Nifty is at 7589, so this would make the 7600 strike ATM.
The option premiums are as follows –

• Short 7600 CE is trading at Rs.77

• Short 7600 PE is trading at Rs. 88

● Calculate the payoff from short call.

● Calculate the P&L from short Put.
● Calculate the net P&L from the strategy.
● Depict the payoff chart for the spot prices on the date of expiry such as
Rs:6500, 6600, 6700; 6800; 6900; 7000; 7100; 7200; 7300; 7400; 7500;
7600; 7700; 7800; 7900; 8000, 8100, 8200, 8300, 8400 and 8500.

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SHORT STRADDLE: Solution

● Obviously the short strategy is set up for a net credit, as when you sell
the ATM options, you receive the premium in your account.

● So the short straddle will require us to sell both these options and
collect the net premium of 77 + 88 = 165.

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SHORT STRADDLE: Solution

P&L ON SHORT CALL P&L ON SHORT PUT NET P&L

SPOT PRICE IV= SP - EP P&L = PRE - IV IV = EP - SP P&L = PRE - IV

ON EXPIRY

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SHORT STRADDLE: Payoff chart

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3. LONG STRANGLE
● The strangle is an improvisation over the straddle. The improvisation
mainly helps in terms of reduction of the strategy cost.

To set up a strangle we need to

● Buy OTM Call at higher exercise price,
● Buy OTM Put at lower exercise price.

NOTE:
● both the options should belong to the same expiry and
● same underlying.
● the same ratio (one should buy the same number of call option as that
of put option).

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LONG STRANGLE: PROBLEM

Consider Nifty is at 7921, an investor buys OTM Call and Put options.

● The investor bought 7700 Put option and

● The investor also bought 8100 Call option.
● These options are trading at RS. 28 and RS. 32 respectively.

● Calculate the payoff from long call.

● Calculate the P&L from long Put.
● Calculate the net P&L from the strategy.
● Depict the payoff chart for the spot prices on the date of expiry such as Rs:
7000; 7100; 7200; 7300; 7400; 7500; 7600; 7700; 7800; 7900; 8000, 8100,
8200, 8300, 8400, 8500, 8600, 8700 and 8800.

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LONG STRANGLE: Solution
● The combined premium paid to execute the ‘strangle’ is 60 (28 + 32).
P&L ON LONG CALL P&L ON LONG PUT

SP ON THE IV = SP - EP P&L = IV - PRE IV = EP - SP P&L = IV - PRE NET P&L

EXPIRY (i) + (ii)

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LONG STRANGLE: Payoff chart

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4. SHORT STRANGLE

● The execution of a short strangle is the exact opposite of the long

strangle.

To setup a short strangle:

● sell OTM Call options;
● Sell Put options which are equidistant from the ATM strike.

NOTE:
● both the options should belong to the same expiry and
● same underlying.
● the same ratio (one should sell the same number of call option as that
of put option).

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SHORT STRANGLE: Problem

Consider Nifty is at 7921, an investor sells OTM Call and Put

options.

● The investor sold 7700 Put option and

● The investor also sold 8100 Call option.
● These options are trading at RS. 28 and RS. 32 respectively.

● Calculate the payoff from long call.

● Calculate the P&L from long Put.
● Calculate the net P&L from the strategy.
● Depict the payoff chart for the spot prices on the date of expiry
such as Rs: 7000; 7100; 7200; 7300; 7400; 7500; 7600; 7700;
7800; 7900; 8000, 8100, 8200, 8300, 8400, 8500, 8600, 8700
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SHORT STRANGLE: Solution

SP ON THE P&L ON SHORT CALL P&L ON SHORT PUT NET P&L
EXPIRY
IV = SP - EP P&L = PRE - IV IV = EP - SP P&L =PRE – IV

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SHORT STRANGLE: Payoff chart

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● Strips: A strip results when a long position in one call is

coupled with a long position in two puts, all with the same
exercise price and date of expiration. Here the investor is
expecting that a big price movement in the stock price will take
place but a decrease in the stock price is more likely than an
increase. Since a put option is profitable when a price decrease
occurs, two puts are bought in this strategy.

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● Strap: A strap consists of a long position in two calls and one put with the
same exercise price and expiry date. if the investor is expecting that a big
price change would occur in the stock price but feels that there is a greater
likelihood of the price increasing rather than decreasing, the investor will
consider the strategy of a strap.

● Between the two exercise prices, none of the options is exercised and hence,
a net loss, equal to the sum of the premia paid for buying the two options,
results. It follows, then, that a strangle is an appropriate strategy for adoption
when the price is expected to move sharply.

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MODULE 2
VALUATION OF OPTION CONTRACTS

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Introduction
● The standard DCF (discount cash flow) procedure involves two steps:
○ Estimation of expected future cash flows
○ Discounting of these cash flows using an appropriate cost of capital.

● But there are several problems in applying this approach for option valuation:
○ It is difficult to estimate the expected cashflows
○ Impossible to determine the opportunity cost of capital
○ The risk of the options are virtually indeterminate as its value changes every time as
the stock price varies.

● Since the DCF model cannot be used for options valuation, therefore the financial
economists developed some rigorous models for valuing the options, some of the most
prominent ones are as follows:

● Binomial Model
● Risk Neutral Model
● Black-Scholes Model
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BINOMIAL MODEL

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Introduction
● A useful model of stock option pricing has been developed using the
concept of the binomial tree.

● The price of the stock underlying an option may follow different paths in
the future. It may rise or fall.

● An European option having a one year time; at the end of the year there
are two possible values for the stock: one is higher and the other is the
lower than the current values.

● This model uses probability and future discrete projections through which
a tree of stock prices is initially produced working forward from the
present to expiration.

● The different paths likely to be followed by the stock price may be

represented in the form of a diagram which is known as a binomial tree
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A very simple example of binomial distribution:

● The current market price of a stock is RS. 60. It is expected that

the price may either move up by 10 per cent or move down by
10 per cent by the end of the month. This may be represented
in the form of a diagram

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Two-step Binomial model: When the number of high and low

value projections for the concerned stock are numerous, the tree shall
represent all possible paths that the stock price could take during the
life of the option:
We can now extend the diagram into a two-step binomial tree where, at
each step, the stock price may either move up by 10 per cent or move
down by 10 per cent. The extended diagram is shown below Figure.

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The tree of stock prices

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The Binomial model and the steps
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Binomial model problem 1

Following is a two sub-period tree of 6-months each for the share of CAB
Ltd:

36.30
33.00
29.70
30
27.00
24.30

Using the binomial model, calculate the current fair value of a regular call
option on CAB stock with the following characteristics: X = Rs. 28, Risk
free rate = 5% p.a.
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Solution to problem 1
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Binomial model problem 2

Consider a two-year call option with a strike price of Rs. 50 on a

stock the current price of which is also Rs. 50. Assume that there
are two-time periods of one year and in each year the stock price
can move up or down by equal percentage of 20%. The risk-free
interest rate is 6%. Using binomial option model, calculate the
probability of price moving up and down. Also, draw a two-step
binomial tree showing prices at each node.

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Solution to problem 2

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Solution to problem 2
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Binomial model problem 3

Consider the following data for pioneer’s stock, apply

the binomial model and calculate the value of the call
option:

S = 200;
u. = 1.4;
d. = 0.9;
E = 220;
r = 10% p.a.

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Solution to problem 3

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Binomial model problem 4

Consider the following data for a stock, apply the

binomial model and calculate the value of the call
option:

S = 60;
u. = 1.4;
d. = 0.8;
E = 50;
r = 12% p.a.

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Solution to problem 4
R (Risk-free rate of interest) = Given 10% p.a., 1 + r = 1 + 12 / 100 = 1 + 0.12;
R = 1.12

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RISK NEUTRAL MODEL

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Introduction
● The “risk-neutral” technique can also be used to value derivative
securities.

● It was developed by John Cox and Stephen Ross in 1976.

● The price of the option does not depend on the investor attitude toward
risk (whether they love risk or hate risk).

● This model assumes that investors are risk-neutral (indifferent to risk),

calculate the expected future value of the option, and convert it into its
present value by using risk-free rate.

● Under the risk-neutral valuation model, if the investors are risk neutral,
the expected return on the equity stock is equal to the risk-free rate.

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The value of call option asper risk-neutral model

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Risk-neutral model problem 1

The equity stock of pioneer Ltd. is currently selling for Rs.200. In a

year’s time it can rise by 40% or fall by 10%. The risk-free rate is 10%.
The exercise price of a call option that can be exercised a year from now
is Rs. 220. What is the value of the call option? Use the risk-neutral
method.

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Solution: Risk-neutral model problem 1
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Risk-neutral model problem 2

The equity stock of Hitech Ltd. Is currently selling for Rs.100. In a year’s
time it can rise by 60% or fall by 20%. The risk-free rate is 10%. The
exercise price of a call option that can be exercised a year from now is
Rs. 110. What is the value of the call option ? Use the risk-neutral
method.

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Solution: Risk-neutral model problem 2
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Risk-neutral model problem 3

The equity stock of HCL Ltd. Is currently selling for Rs.420. In a time 3
months it can rise by 19.04% or fall by 5%. The risk-free rate is 8% p.a.
The exercise price of a call option that can be exercised a year from now
is Rs. 450. What is the value of the call option ? Use the risk-neutral
method.

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Solution: Risk-neutral model problem 3
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BLACK-SCHOLES MODEL

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Factors Affecting Option Prices

● There are several factors affecting the price of a stock option. They
include:

● 1. Stock price.
● 2. Exercise price.
● 3. Time to maturity.
● 4. Dividends, if any, expected during the life of the option.
● 5. Risk-free interest rate.
● 6. Volatility in the stock price.

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(1) and (2) Stock Price and Strike Price:

● In the case of a call option, the profit or payoff accruing to the holder is the
excess of the current stock price over the exercise price. Accordingly, call
options become more valuable as the stock price increases and less valuable
as the exercise price increases.

● For a put option, the payoff to the holder is the amount by which the strike
price exceeds the current stock price. Accordingly, put options become more
valuable as the strike price increases and less valuable as the stock price
increases. Thus, changes in the stock price and the exercise price have
opposite effects on the value of the options.

(3) Time to Expiration: An option with longer life (or longer time to expiration)
will have more value than a similar option with a shorter life, because the
long-life option has more time and opportunities to become profitable than a
short-life option. Thus, options become valuable as the time to expiration
increases.
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(4) Volatility of the Stock Price: Volatility gives rise to wide fluctuations in
stock prices. There may be a sharp rise or a steep fall in stock prices. The owner
of a call option benefits from rise in the stock prices. But, even in case of a
decline in the stock prices, the loss is limited to the premium.

● Hence, volatility enhances the probability of getting higher payoffs from call
option. Similar is the case with a put option. The owner of a put option
benefits from decline in the stock prices. But, even when the stock prices
rise, the loss is limited to the premium paid. Thus, both call options and put
options become more valuable as volatility of the underlying stock
increases.

(5) Risk Free Interest Rate: Normally, as interest rates in the economy rise,
stock prices tend to fall. A decline in stock prices will reduce the value of a call
option and enhance the value of a put option.

Fall in interest rates in the economy will be accompanied by a rise in stock prices
which, in turn, tends to enhance the value of a call option and reduce the value of
a put option. Thus, changes in interest rates in the economy have an impact on
the value of both call and put options.
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(6) Dividends: During the Life of an Option On the ex-dividend date,

the stock price declines to the extent of the dividend paid, Such reduction
in stock price on account of dividend reduces the value of the call option,
but enhances the value of the put option. Thus, anticipated dividends
during the life of an option have a positive effect on put option and a
negative effect on call option.

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Summary of determinants of option prices

Determinates Change in the Value of call option Value of put option
determinant
Increases More Valuable Less valuable
Share price
Decreases Less valuable More valuable
Increases Less valuable More Valuable
Exercise price
Decreases More Valuable Less valuable
Longer time More Valuable More Valuable
Time to expiry
Shorter time Less Valuable Less Valuable
Upside Volatility More Valuable Less valuable
Volatility
Down Volatility Less valuable More valuable
Increases Less valuable More valuable
Interest rate (RF)
Decreases More Valuable Less valuable

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Black and Scholes Model

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Fischer Black, Myron Scholes, and Robert Merton

model
● In the early 1970s, Fischer Black, Myron Scholes, and Robert
Merton achieved a major breakthrough in the pricing of
European stock options.
● This was the development of what has become known as the
Black–Scholes–Merton (or Black–Scholes) model.
● The model has had a huge influence on the way that traders
price and hedge derivatives.
● In 1997, the importance of the model was recognized when
Robert Merton and Myron Scholes were awarded the Nobel
prize for economics. Sadly, Fischer Black died in 1995;
● Otherwise he too would undoubtedly have been one of the
recipients of this prize.

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Assumptions The Black-Scholes Option Pricing

Model (BSOPM)

● The model presents a theoretical formula for calculating the

price of a call option. The assumptions are stated below:

● 1. There are sufficient numbers of market participants to ensure continuous

trading-
● 2. There are no transaction costs or the transaction costs are insignificant.
● 3. All trading profits are subject to the same tax rate.
● 4. Borrowing and lending are possible at the risk-free interest rate, which
remains constant.
● 5. There are no arbitrage opportunities or arbitrage opportunities disappear
quickly.
● 6. There are no dividends on the stock during the life of the option.
● 7. Stock prices follow a random walk. It implies that the stock price at any
future time has a lognormal distribution, i.e. its natural logarithm is normally
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The Black-Scholes-Merton Option Pricing Model

● The Black-Scholes-Merton option pricing model says the value of a

stock option is determined by six factors:

① S, the current price of the underlying stock

② y, the dividend yield of the underlying stock
③ K, the strike price specified in the option contract
④ r, the risk-free interest rate over the life of the option contract
⑤ T, the time remaining until the option contract expires
⑥ σ, (sigma) which is the price volatility of the underlying stock

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According to the Black and Scholes formulation, the value of a call option is calculated as
follows:

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Calculation of Put Option Value using the put-call

parity
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Valuation for stock Options

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Problem 1:
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Problem 2: Dividends anticipating during the life of the

option
●

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● SOLUTION:

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Problem 3: Black-Scholes model
From the following data,
● Stock price = Rs 206
● Exercise price = Rs 200
● Time to expiration = 47 days
● SD of the continuously compounded rate of return on stock = 0.26
● Continuously compounded rate of return = 8%.

(i) Obtain the call and put option values based on Black & Scholes’ formulation, also
state if the option is worth buying for Rs 10.00 ?

(ii) How would the option values change, if a dividend of Rs 12 per share is expected to
be received in 12 days’ time?

(iii) Examine the effect of each of the following changes on the call and put option values

(a) The stock price increases by Rs 8.

(b) The standard deviation of the return is changed to 0.30.
(c) The risk-free rate of return reduces by 2 percent.
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Solution to Problem 3
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Derivatives of Black and Scholes

Formulation
OR
OPTION GREEKS

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Introduction
●

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Delta
This is a very significant by-product of the Black and Scholes model and is used
extensively in the context where options form part of the portfolios. The reason for
this is that the deltas provide multifold information. Deltas are interpreted as

● (i) a measure of volatility of the option premium, (amount by which the

price of an option changes for a unit change in the price of the underlying
security or index).

● (ii) a measure of Probability (the likelihood that an option will be

in-the-money on the expiration day) and

● (iii) a hedge ratio (how many units of the option are necessary to mimic the
returns of the underlying stock)

● Delta is calculated separately for call and put options of the same strike.

● Calls will have positive delta between 0 and 1; while Puts have a negative delta
between -1 and 0.
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DELTA: As a measure of volatility

● As a measure of volatility of the option premium, delta refers
to the amount by which the price of an option changes for a unit
change in the price of the underlying security or index.

● A delta equal to 0.7 for a call option implies that for a one unit change
in the stock price (or index) the option would move 0.7 points.
Similarly, a delta equal to – 0.8 for a put option means that the put
option premium will decline by 80 paise if the underlying stock price
rises by one rupee.

● In terms of the Black and Scholes model, the formula to calculate

delta of a European options are as follows:

● For a call option, the delta = N(d1),

● While for a put option, the delta = N(d1) – 1.
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Gamma
● The gamma represents the amount by which an options delta would move in
response to a unit change (UP or Down) in the underlying stock price or
index.

● Thus, it measures the proportional change in delta for a given change in the
underlying asset value.

● The gamma of a call option is always equal to the gamma of a put option and
it can be either positive or negative.

● In the Black and Scholes formulation, gamma is calculated as follows:

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Theta
● The theta is obtained by considering value of an option as a function of time when all other
parameters of the pricing model remain constant. It is thus known as the time decay of the
option value.

● Theta represents the price decay that affects an option as it ages and loses time value.

● It is nearly always negative for an option because as the time to maturity approaches, the
option tends to become less valuable. In exhibits greatest effect before close to the expiration
of the option.

● Defined as the negative of the derivative of the option price with respect to time remaining
until expiration, theta is obtained as follows:

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Rho
● The rho, which is the first derivative of an option’s price with respect to
the interest rate, measures the sensitivity of an option value to interest
rate.

● This refers to the rate of change of the value of the option with respect
to a unit change (say one per cent) in the interest rate.

● Generally, the option values are not very sensitive to the changes in
interest rates. For call options, rho is always positive while for put
options, it is negative.

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Vega

● Also known as kappa or lambda, vega measures the rate of change of

the value of an option with respect to the volatility of the underlying
stock.

● Vega is always positive and identical for call and put options.

● For the Black and Scholes model, the vega can be obtained as follows:

Where,

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Option Greeks problems

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Option Greeks problem 1:

● Consider the following information with regard to the stock of ABC

company. Obtain the call and put option values based on Black &
Scholes’ formulation:

● Current price of the share, S0 = Rs 120;

● Exercise price of the option, E = Rs 115;
● Time period to expiration, t = 3 months;
● Standard deviation of the distribution of continuously compounded
rates of return, σ = 0.6;
● Continuously compounded risk-free interest rate, r = 10%.

With these inputs, obtain the values of various Greeks.

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Solution: Call and put option values

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● CALCULATION OF DELTA:
○ For a call option, the delta = N(d1), = 0.6443;
○ While for a put option, the delta = N(d1) – 1 = 0.6443 – 1 = -0.3557.

Thus, if the price of the underlying share ABC, rises by Re 1, the price of call
option will rise approximately 64 paise while the price of the put option will fall
by about 35 paise.

● CALCULATION OF GAMMA: we have S0 = 120, , σ = 0.6, t = 0.25 and d1 = 0.37.

Here gamma equal to 0.0103 has the implication that an increase in the stock price of
Re 1.0 will increase the call delta by 0.0103. With S0 = 120, the call delta at present is
0.6443. If the stock price were to rise from Rs 120 a share to Rs 121, the delta would
increase to 0.6546.

Similarly, for the put option, the delta = – 0.3557 would change to – 0.3557 +
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● CALCULATION OF THETA:

Where S0 = 120; SD = 0.6; t = 0.25, E = 115, r = 0.10, d1 = 0.37 and d2 = 0.07.

A theta equal to – 32.74 suggests that if time to expiration were a year longer, then
the value of the call shall be up by about Rs 32.74. The time decay as about Re
0.09 per day (obtained as Rs 32.74/365). It may be interpreted to mean that a day
nearer to maturity would cause a fall of 9 paise in the price of the call option.

Similarly, the put option would experience a fall of about (Rs 21.52/ 365) or 6
paise per day for each passing day towards maturity.
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● CALCULATION OF RHO:

With E = 115, t = 0.25, r = 0.1 and d2 = 0.07, N(d2) = 0.5279, and N(– d2) =
0.4721.

An increase in the risk-less interest rate from 10 to 11 percent would result in an

increase in the value of call equal to Re 0.1480, or about 15 paise.

Similarly, for the put option, the rho value –13.24 implies that an increase in the
risk-free interest rate from 10 to 11 percent would result in a fall in the put option
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● CALCULATION OF VEGA:

● This value indicates that if SD changes from 0.6 to 0.7, the call value
shall be up by Rs 2.235 (since a change from 0.6 to 1.6 causes the
price to increase by Rs 22.35 as given by vega) to Rs 20.35,

● while a decline in SD from 0.6 to 0.5 would cause the price to fall by
Rs 2.235 to Rs 15.88. The put option values would also change
similarly.

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