Options

Options
• An option is the right to either buy or sell something at a set price, within a set period of time
• Sellers sell (short position) a right to trade to buyers (take long position), and therefore, buyers pay the
price to buy a right to trade option. This price is called option price (value), option premium. While the
buyer has a right, but seller has obligation.
• Call Options: The buyer of a call option has the right but not the obligation to purchase underlying
assets at a set price on and before a specified date. But the seller of a call option has the obligation to
sell.
• Put Options.
• The buyer of a put option has the right but not the obligation to sell underlying assets at a set price on
and before a specified date. But the seller of a put option has the obligation to purchase.
• A European option can be exercised only at the end of its life (on the expiry day)
• An American option can be exercised at any time (on and before the expiry day)
• Options on individual securities available at NSE are American type of options
• All index options traded at NSE are European Options.
2
Option Terminology

• Exercise (or strike) price (X): The price stated in the option contract at which
underlying assets can be bought or sold.
• Option price: The market price of the option contract.
• Expiration date: The date the option matures.
OPTION TYPE STRIKE PRICE UNDERLYING
INSTRUMENT TYPE SYMBOL EXPIRY DATE LAST PRICE VALUE

Index Options NIFTY 11-Nov-21 Put 17,900.00 102.5 17,971.55

Index Options NIFTY 11-Nov-21 Put 18,000.00 143.85 17,971.55
Index Options NIFTY 3-Nov-21 Call 18,700.00 0.6 17,968.85
Index Options NIFTY 25-Nov-21 Call 18,000.00 259.3 17,968.85

Market lot of Nifty is 50. It means that the value of contract will be strike price * 50=
 Options profit-Call option
Call option profit (buyer)=Max(Strike price-Spot price,0)+Call price
Call option
Index
value (T) Strike price Call Price Profit
400
Long Short
17900 18000 259.3 -259.3 259.3 300 Limited profit
17950 18000 259.3 -259.3 259.3 200 Unlimited
18000 18000 259.3 -259.3 259.3 profit
100
18050 18000 259.3 -209.3 209.3

Profit
18100 18000 259.3 -159.3 159.3 0
9 00 950 000 050 100 150 200 250 300 350 400 450 500 550 600
18150 18000 259.3 -109.3 109.3 -10017 17 18 18 18 18 18 18 18 18 18 18 18 18 18
18200 18000 259.3 -59.3 59.3
-200
18250 18000 259.3 -9.3 9.3
18300 18000 259.3 40.7 -40.7 -300
18350 18000 259.3 90.7 -90.7 -400
18400 18000 259.3 140.7 -140.7 Limited loss Index value
18450 18000 259.3 190.7 -190.7
18500 18000 259.3 240.7 -240.7
18550 18000 259.3 290.7 -290.7
18600 18000 259.3 340.7 -340.7
 Options profit-put option
Index Strike
value price Put Price Profit 400
Long Short
300
17500 17900 102.5 297.5 -297.5
17550 17900 102.5 247.5 -247.5 200
17600 17900 102.5 197.5 -197.5
100
17650 17900 102.5 147.5 -147.5

Profit
17700 17900 102.5 97.5 -97.5 0
17750 17900 102.5 47.5 -47.5 5 00 550 600 650 700 750 800 850 900 950 000 050 100 150 200
7 17 17 17 17 17 17 17 17 17 18 18 18 18 18
-1001
17800 17900 102.5 -2.5 2.5
17850 17900 102.5 -52.5 52.5 -200
17900 17900 102.5 -102.5 102.5
17950 17900 102.5 -102.5 102.5 -300

18000 17900 102.5 -102.5 102.5 -400

18050 17900 102.5 -102.5 102.5
Index value
18100 17900 102.5 -102.5 102.5
18150 17900 102.5 -102.5 102.5 Long Short
18200 17900 102.5 -102.5 102.5
Profit of options

• Call option (Buyer): Max(0, S-X)-call value

• Call option (seller): -Max(0,S-X)+call value=min(X-S,0)+call value
• Put option (buyer): Max(0, X-S)- put value
• Put option (seller): -Max(0, X-S)- put value=min(S-X,0)+put value.
 Trading Cycle
Nifty 50 options contracts have 7 weekly expiry contracts, 3 consecutive monthly
contracts, additionally 3 quarterly months of the cycle March / June / September /
December and 8 following semi-annual months of the cycle June / December would be
available, so that at any point in time there would be options contracts with at least 4-
year tenure available. New serial weekly options contract shall be introduced after
expiry of the respective week’s contract. On expiry of the near month contract, new
contracts (monthly/quarterly/ half yearly contracts as applicable) are introduced at new
strike prices for both call and put options, on the trading day following the expiry of the
near month contract.
Expiry day

Nifty 50 options monthly contracts expire on the last Thursday of the expiry
month and weekly contracts expire on every Thursday of the week. If the last
Thursday is a trading holiday, the contracts expire on the previous trading day.
Terminology: Moneyness
Call option
• At-the-money option: When strike price is equal to stock price
• In-the-money option: When strike price is less than to stock price
• Out-of-the-money option: When strike price is more than stock price
• Put option
• At-the-money option: When strike price is equal to stock price
• In-the-money option: When strike price is more than stock price
• Out-of-the-money option: When strike price is less than stock price
Intrinsic value of an option and Time value of option
Any option price (premium) can be splitted into two parts: Intrinsic value and time
value
• Intrinsic value of an option: it shows that is we exercise the option today, what would
be your payoff.
• Call option=Max(-X,0)
• Put option=Max(X- ,0)
• The time value of an option is the difference between its premium (option value) and
its intrinsic value.
• Since the intrinsic value of out-the-money option is zero at time t, however, the time
difference (T-t) provides an opportunity to the buyer that the option can be in the
money. It is called time value of option.
• Both calls and puts have time value. The longer the time to expiration, the greater is
an option’s time value, all else equal. At expiration, an option should have no time
value.
 Intrinsic value of an option and Time value of option

INSTRUMEN SYMBO OPTION STRIKE Call UNDERLYING

T TYPE L EXPIRY DATE TYPE PRICE value VALUE Intrinsic Time value of
value option
Index Options NIFTY 11-Feb-21 Call 15,000.00 117.8 14,924.25 0 117.8
Index Options NIFTY 11-Feb-21 Call 15,200.00 47.5 14,924.25 0 47.5
Index Options NIFTY 11-Feb-21 Call 15,100.00 77 14,924.25 0 77
Index Options NIFTY 11-Feb-21 Call 14,900.00 171 14,924.25 24.25 146.75
Index Options NIFTY 11-Feb-21 Call 15,500.00 10.4 14,924.25 0 10.4
Generation of strikes for Index options

NUMBER OF STRIKES
INDEX LEVEL STRIKE INTERVAL IN THE MONEY- AT THE MONEY-
OUT OF THE MONEY
≤ 2000 50 8-1-8
>2001 ≤ 3000 100 6-1-6
>3000 ≤ 4000 100 8-1-8
>4000 ≤ 6000 100 12-1-12
>6000 100 16-1-16
Dividends & Stock Splits impact on options

• No adjustments are made to the option terms for cash dividends

• When there is an n-for-m stock split,
• the strike price is reduced to m/n* strike price
• the number of shares covered by one contract is increased by n/m
Consider a put option to sell 100 shares of firm for Rs 30 per share (strike price).
Suppose the firm makes 2-for -1 stock split.
After stock split, the number of stocks covered by one contract is 200 with strike
price Rs 15 per share
• Stock dividends are handled in a manner like stock splits
Margin requirement for writing naked options
• A naked option is an option that is not combined with an offsetting position in the
underlaying stock. In order to reduce counterparty risk, Margin in equity and
index options trading is the amount of cash deposit needed in an options trading
broker account when writing options. Options margin is required as collateral to
ensure the options writer's ability to fulfill the obligations under the options
contracts sold.
• Generally, we close our position in option market by taking opposite position. For
instance, the buyer of the call option can close his or her position by writing a call
option. Similarly, the writer of a call option can close his or her position by buying
a call option.
• Writers of options are also exposed to unlimited risk and limited profit, which
means that the position can lose more and more money the more the underlying
stock goes against your expectation. In order to close such losing positions, you
would need to buy to close those options, that is why options trading brokers also
need to make sure you have enough cash in your account to be able to do that.
 Margin requirement for writing naked options
• There are two types of margins that are normally measured. At the time of taking position,
investors are required to deposit the Initial margin on the position estimated by Span
software (Standard Portfolio Analysis of Risk).
• Exposure margin
• For Index options and Index futures contract:
3% of the notional value of a futures contract.
• For option contracts and Futures Contract on individual Securities:
The higher of 5% or 1.5 standard deviation of stock returns over the last 6 months
period and is applied on the notional value of position. Therefore, while taking
position in volatile stocks, seller of the option must deposit more margin.
 Open Interest
• Open Interest indicates number of open contracts.
• If one contract is traded, neither investor is closing an existing position, the open
interest will increase by one contract.
• If one investor is closing an existing position, and other is not, the open interest
stays the same.
• If both investors are closing existing position, the open interest goes down by one
contract.
• Open interest can be a proxy of liquidity of options.
 Estimation of open interest

Open
Interest
1-Jan A buys 1 options B Sells 1 options 1
2-Jan C buys 5 options D sells 5 options 6
3-Jan A sells 1 options and E buys 1 options 6
4-Jan D buys 1 options and E sells 1 options 5
Open interest and price analysis

Open interest Price Interpretation Analysis

(Tentatively)
Increases Increases Investors are taking Positive sentiment
long position
Deceases Decreases Investors are closing Negative sentiment
long position
Increases Decreases Investors are taking Negative sentiment
short position
Decreases Increases Investors are closing Positive sentiment
short position
INSTRUMENT EXPIRY OPTION STRIKE LAST VOLUME OPEN UNDERLY
TYPE SYMBOL DATE TYPE PRICE PRICE CHNG %CHNG (Contracts INTEREST NG VALU
) VALUE
Stock Options RELIANCE 25-Feb-21Call 2,000.00 45.15 -6.05 -11.82 33493 421,258,207.50 14717 1,928.5
Stock Options RELIANCE 25-Feb-21Call 2,100.00 21.7 -4.25 -16.38 18461 116,535,062.50 10886 1,928.5
Stock Options RELIANCE 25-Feb-21Call 1,950.00 64 -6.2 -8.83 14024 245,455,060.00 4414 1,928.5

INDUSIND
Stock Options BK 25-Feb-21Call 1,100.00 44.5 26.7 150 13495 611,283,015.00 953 1,046.8
Stock Options RELIANCE 25-Feb-21Call 2,200.00 11.8 -2.9 -19.73 12333 42,733,845.00 8111 1,928.5
Stock Options PNB 25-Feb-21Call 40 2.7 1.25 86.21 10367 353,307,360.00 3147 38.5

BHARTIAR
Stock Options TL 25-Feb-21Call 620 27.9 6.1 27.98 9365 501,317,065.80 2276 611

TATAMOT
Stock Options ORS 25-Feb-21Call 360 14.7 8.75 147.06 8796 831,274,776.00 1315 331

BHARTIAR
Stock Options TL 25-Feb-21Call 700 7.45 2.4 47.52 7321 102,717,876.18 2202 611
Factors affecting option value

• The following six factors affect option value. That is, the price for the right to
trade.
1. The current stock price
2. The strike price.
3. The time to expiration
4. The volatility of the stock price
5. The risk-free interest rate
6. The dividend that are expected to be paid in the life of options
Current stock price, and strike price

Call option payoff: Max(0, S-X), S=stock price, and X=strike price
• Since the increase in stock price increases the payoff of call option, the value of call
option increases with an increased stock price.
• Since the increase in strike price decreases the payoff of call option, the value of call
option decreases with an increased strike price.
Put option payoff= Max(0, X-S)
• Since the increase in stock price decreases the payoff of put option, the value of put
option decreases with an increased stock price.
• Since the increase in strike increases the payoff of put option, the value of put option
increases with an increased strike price.
 Time to expiration

• Both call and put American option becomes more valuable as the time to expiration
increases, since the longer time increases the possibility that options may expire as in-the-
money option.
• However, European put and call option normally become more valuable as the time to
expiration increases, this is not always the case. Consider two European call options on a
stock: one with an expiration date 1 month, the other with an expiration date in 2 months.
Suppose that a very large dividend is expected in 6 weeks. The dividend will cause the
stock price to decline after ex-dividend date. Therefore, the short-life option could be
worth more than the long-life option.
Volatility

• Volatility of a stock price is a measure of how uncertain we are about future stock
price movement.
• As Volatility increases, the change that the stock will do very well or very poorly
increases.
• Since the payoff options (both call and put) are nonlinear (having limited
downside risk, but unlimited upside protentional), the greater volatility increases
the chance that options would expire as in-the-money options
 Volatility
300
Call
Stock option
200
Expecte Purchase price Profit Profit
d price /Stike price (Loss) (Loss) 100
50 300 -250 0

Profit
100 300 -200 0 0
150 300 -150 0 50 100 150 200 250 300 350 400 450 500 550
200 300 -100 0 -100
250 300 -50 0
300 300 0 0 -200
350 300 50 50
400 300 100 100 -300
450 300 150 150 Expected price
500 300 200 200
550 300 250 250
Spot market Call option
Risk-free rate

• The effect of risk-free rate on option value is not clear. On the one hand, an
increase in risk-free rate decreases the present value of any future cashflow (strike
price) received by the option holders. On the other hand, an increase in risk-free
rate increases the expected returns required by investors that leads to decrease in
stock prices. The combined effect would affect the option value.
Amount of future dividends

• Since dividends reduce stock price on the ex-dividend date. This is bad news for
call option, but good new for put option. Therefore, the value of call option goes
down, whereas the value of put option goes up.
The value of option
The price of option at the expiration day
• Value of option consists of intrinsic value, and time value. On the day of
expiration day, time value of option will be zero (close to zero), and therefore, the
value of option will be max(intrinsic value, 0), since the value option cannot be
negative. Moreover, at the expiration day, the value of out-the-money will be
worthless.
• If out-the-money option at the expiration day is trading at positive price, the
arbitrager can make risk-less profit by writing a call and collecting a premium
value.
• For instance, Suppose that a call with strike price of X=40 is selling for 3 at
expiration day, when the stock is selling for 39. To arbitrage, a trader can write a
call option and collect premium amount. Now, no rational person will prefer to
exercise out-of-the money option. Even if, irrational person does, a trader can buy
the stock from the market (at price 39) and deliver to the buyer of the option and
collect the strike price.
The price of option at the expiration day

• Suppose that a call with strike price of X=40 is selling for 3 at expiration day,
when the stock is selling for 44. To arbitrage, a trader can buy a call option and
collect stocks after paying Rs 40 per stock and sell the stock at Rs 44 per stock.
Total investment Rs 43 and profit Rs 1
The price of option before the expiration day.

• Assumption
• There are no transaction costs
• All trading profit are subject to the same tax rate.
• Borrowing and lending are possible at the risk-free rate.
The price of option before the expiration day: Upper
bounds
• Call value cannot be more than the stock price
call value <= S
If this is not true, an arbitrageur can make risk-less profit by writing a call option
and buying a stock.
Call value=Rs 100 and Stock price=Rs 80
• Put value cannot be more than the present value of strike price
put value <=
Example: Put value Rs 98, Strike price Rs 100, risk-free rate=10% T=6 months
Lower Bound for call option prices

• In-the-money option can trade less than its intrinsic value, and before the
maturity, the option would also have some time value. Therefore, the lower
bound of option should be more than its intrinsic value.
• For call, c (S0 –Xe –rT)
Example: call option

Intrinsic value=(20-13.67)=Rs 6.37

• Is there an arbitrage opportunity?
Lower Bound for call option prices

• Call option is underpriced and therefore, c<(S0 –Xe –rT), it can be written as c+ Xe –
rT <
S0
• Portfolio A: Call option, and zero-coupon bond that provides a payoff of X at
expiration date (T)
• Portfolio B: one share of the stock
• Now, we short Portfolio B (overvalued), and long call and zero-coupon bond
(undervalued).
• Cash inflow from shorting stock is Rs 20, buy a call option (outflow Rs 3),
remaining cashflow deposit in the bank (Rs 17).
• Bank amount after one year=Rs 18.7
Lower Bound for call option prices

• If the market price at the expiration day is more than strike price (assume Rs 24).
The trader will exercise its right after paying Rs 18 and buy a stock and will use
this stock to close his short-position. Thus, making profit of 0.7
• If the market price at the expiration day is less than strike price (assume Rs 16).
The trader will not exercise its right and buy the stock from spot market and close
his short position. Thus, making profit =18.7-16=Rs 2.7
Lower Bound for Call Option Prices
• Portfolio A: Call option, and zero-coupon bond that provides a payoff of X at
expiration date (T)
• Portfolio B: one share of the stock
>X <X
Portfolio A Call option 0
Zero Coupon bond X X
Total payoff X
Portfolio B Stock

• At time T portfolio A’s payoff is Max(,X), and portfolio B’s payoff is . Therefore,
the worth of portfolio A should be at least the worth of Portfolio B at time t.
Lower Bound for put Option Prices

• p (Xe –rT - S0 )

• Is there an arbitrage opportunity?

Lower Bound for put Option Prices; No Dividends

• Portfolio C: Put option and one share of the stock

• Portfolio D: Zero-coupon bond that provides a payoff of X at expiration date (T)

>X <X
Portfolio C Put option (X-
Stock
Total payoff X
Portfolio D Zero coupon bond

• At time T portfolio C’s payoff is Max(,X), and portfolio D’s payoff is X.

Therefore, the worth of portfolio C should be at least the worth of Portfolio D
Lower Bound for Option Prices

• For, in-the-money option at least intrinsic value,

• For, out-the-money option (should be more than 0, because of time value)
• Lower bound for call =Max(S0 –Xe –rT ,0)
• Lower bound for put=Max(Xe –rT - S0 ,0)
Put-call parity
Call and put option with same strike price and maturity.
• Portfolio A: Call option, and zero-coupon bond that provides a payoff of X at
expiration date (T)
• Portfolio C: Put option and one share of the stock
>X <X
Portfolio C Put option (X-
Stock
Total payoff X
Portfolio A Call option 0
Zero Coupon bond X X
Total payoff X
• Since the payoff both portfolios are same, they can not trade at different price. It is
call put-call parity
The Put-Call Parity Result

• Both are worth max(ST , X ) at the maturity of the options

• They must therefore be worth the same today. This means that
c + Xe -rT = p + S0
Arbitrage Opportunities

• Suppose that

• What are the arbitrage possibilities when

p = 2.25 ?
p=1?
 Arbitrage Opportunities

• Portfolio C: P+S=2.25 +31=Rs 33.25

• Portfolio A: C+
• Overvalued Portfolio C, and Undervalued portfolio A. Therefore, short portfolio C
and go long on Portfolio A
Go short: Writing a put option + shorting a stock (Portfolio C)
Cash inflow =2.25 +31 =Rs 33.25
Go long on call option
Cash outflow=Rs 3
Net cash inflow =33.25-3=30.25, now deposit this amount for next 6 months at
risk-free rate 10%.
Arbitrage Opportunities

• Case 1: When stock is more than Rs 30 at time T (Assuming Rs 35)

• The trader will exercise call option and close short position. The put option
will be expired.
• Net profit = =Rs 31.02 (from riskless investment) – 30 (amount paid to buy a
stock by using call option)=Rs 1.02
• Case 2: When stock is less than Rs 30 at time T (Assuming Rs 25)
• Buyer of put will exercise put option and after buying stock from him we can
close short position. The call option will be expired.
• Net profit = =Rs 31.02 (from riskless investment) – 30 (amount paid to buy a
stock by using put option)=Rs 1.02
 Arbitrage Opportunities

• Portfolio C: P+S=1 +31=Rs 32

• Portfolio A: C+
• Overvalued Portfolio A, and Undervalued portfolio C. Therefore, short portfolio A
and go long on Portfolio C
Go short: Writing a call option
Cash inflow =Rs 3
Go long on put option and stock
Cash outflow=Rs 1+31=Rs 32
Net cash outflow (borrowing)=32 -3=29, now borrow this amount for next 6 months
at risk-free rate 10%.
Arbitrage Opportunities

• Case 1: When stock is more than Rs 30 at time T (Assuming Rs 35)

• Buyer of call option will exercise call option. The put option will be expired.
• Net profit = =Rs 0.26
• Case 2: When stock is less than Rs 30 at time T (Assuming Rs 25)
• We will exercise put option and sell the stock at Rs 30. The call option will be
expired.
• Net profit = =Rs 0.26
Trading strategies using
options
Numbers
• Call or Put price =Rs 5
• X=Rs 30
• S=Rs 30
Writing a covered call

• Short on call option and long on stock (you are bullish about the market)
Stock price Long Short- Total 40
(T) Stock call Payoff
10 -20 5 -15 30

15 -15 5 -10 20
20 -10 5 -5
25 -5 5 0 10

Profit
30 0 5 5
0
35 5 0 5 10 15 20 25 30 35 40 45 50 55 60
40 10 -5 5 -10
45 15 -10 5
50 20 -15 5 -20

55 25 -20 5 -30
60 30 -25 5
Stock price

Long poistion Short-call Total Payoff

Reverse of Writing a covered call

• Long on call option and short on stock (you are bearish about the market)
Stock 30
price (T) Short stock Long call Total Payoff
10 20 -5 15 20
15 15 -5 10 10
20 10 -5 5
25 5 -5 0 0

Profit
10 15 20 25 30 35 40 45 50 55 60
30 0 -5 -5
-10
35 -5 0 -5
40 -10 5 -5 -20
45 -15 10 -5
50 -20 15 -5 -30
55 -25 20 -5 -40
60 -30 25 -5
Stock Price

Short poistion Long-call Total Payoff

Protective put

• Long on put option and long on stock (you are bullish about the market)
Stock 40
price Long Stock Long Put Total Payoff
10 -20 15 -5 30
15 -15 10 -5
20 -10 5 -5 20
25 -5 0 -5
10
30 0 -5 -5
35 5 -5 0 0
40 10 -5 5 10 15 20 25 30 35 40 45 50 55 60
45 15 -5 10 -10
50 20 -5 15
55 25 -5 20 -20
60 30 -5 25
-30

Long Stock Long Put Total Payoff

Bull spread

• If the trader is not bullish enough to buy a call outright but expects the share price
to rise moderately, the bull spread is a lower cost way to gain espouse to such a
market movement. This strategy consists of the simultaneous purchase call option
and sale a call option with a higher strike price, but with the same expiration date.
Call value
Long call X1 C1
Short call X2, where X2 is C2, where C1 is more than C2.
more than X1 Therefore, net cashflow is required.
X1=> X1=>
Long call -X1) -X1) 0
Short call -X2) 0 0
Total payoff (X2-X1) -X1) 0
 Profit
net of
Stock Short Total cash
price (t) Long call call payoff outflows
Bull spread 20
22
0
0
0
0
0
0
-3
-3
Strike price call value 24 0 0 0 -3
X1 30 18 Long Call 26 0 0 0 -3
X2 40 15 Short call 28 0 0 0 -3
30 0 0 0 -3
Net cash outflow 3 32 2 0 2 -1
34 4 0 4 1
30
36 6 0 6 3
38 8 0 8 5
25
40 10 0 10 7
20 42 12 -2 10 7
15 44 14 -4 10 7
10 46 16 -6 10 7
48 18 -8 10 7
5
50 20 -10 10 7
0 51 21 -11 10 7
20 22 24 26 28 30 32 34 36 38 40 42 44 46 48 50 51 52 53 54 55
-5 52 22 -12 10 7
-10 53 23 -13 10 7
-15
54 24 -14 10 7
55 25 -15 10 7
-20
Long call Short call Total payoff
 Bull spread

• Points need to be considered

• Three ways we can create bull spread.
• Both calls are initially out-the-money
• Short call is out-the-money and long call is in-the-money
• Both calls are initially in-the-money
• Unlike Call option, the bull spread has limited risk and limited reward, but it is a
cheaper strategy than simply buying a call option.
• The trader must be satisfied that the cost of spread is worth the potential reward.
Commission costs on entering and existing will be greater for this strategy than buying
a call outright.
• Consider bull spread when expecting a limited rise in the price of the stock.
• Can we create bull spread by put option.
Bear Spread
• If the trader is not bearish enough to buy a put outright but expects the share price
to decline moderately, the bear spread is a lower cost way to gain espouse to such
a market movement. This strategy consists of the simultaneous purchase put
option with higher strike price and sale a put option with a lower strike price, but
with the same expiration date.
Put value
Short put X1 P1
Long Put X2, where X2 is P2, where P1 is less than P2.
more than X1 Therefore, net cashflow is required.
X2=> X2<
Long put ) ) 0
Short Put ) 0 0
Total payoff (X2-X1) ) 0
 Profit
net of
Short Total cash
Stock price (t) Long Put put payoff outflows
Bear Spread 20 20 -10 10 7
Put value 22 18 -8 10 7
X1 30 18 Short Put 24 16 -6 10 7
X2 40 15 Long Put 26 14 -4 10 7
Net cash outflow 3 28 12 -2 10 7
30 10 0 10 7
32 8 0 8 5
25
34 6 0 6 3
20 36 4 0 4 1
15 38 2 0 2 -1
40 0 0 0 -3
10
42 0 0 0 -3
Payoff

5 44 0 0 0 -3
0 46 0 0 0 -3
20 22 24 26 28 30 32 34 36 38 40 42 44 46 48 50 51 52 53 54 55
48 0 0 0 -3
-5
50 0 0 0 -3
-10 51 0 0 0 -3
-15 52 0 0 0 -3
Stock price 53 0 0 0 -3
54 0 0 0 -3
Long Put Short put Total payoff 55 0 0 0 -3
Box spreads

• The trader prefers to use box spread when he is neutral view about the market
movement. Box spreads consist of bull spread and bear spread, but with the same
strike price.
• Bull Spread
• Long on call (X1) and short on call (X2), where the strike price is more for
short position
• Bear Spread
• Long put (X2) and short put (X1) where the strike price is lower for short
position
 Box spread
X2> =>X2
Bull spread
Long call (X1) -X1) -X1)
Short call (X2) -X2)
Bull spread payoff 0 -X1) (X2-X1)
Bear spread
Long put (X2) ) ) 0
Short Put (X1) ) 0 0
Bear spread payoff (X2-X1) ) 0
Total Payoff (X2-X1) (X2-X1) (X2-X1)

Since, the payoff of bull spread is (X2-X1), the value of box spread is present value of (X2-X1)
 Stock Total
price (t) Long call Short call Long put Short put payoff
Box spreads 20
22
0
0
0
0
20
18
-10
-8
10
10
24 0 0 16 -6 10
Bull spread Call value 26 0 0 14 -4 10
28 0 0 12 -2 10
X1 30 18 Long Call 30 0 0 10 0 10
X2 40 15 Short call 32 2 0 8 0 10
Net cash 34 4 0 6 0 10
outflow 3 36 6 0 4 0 10
38 8 0 2 0 10
40 10 0 0 0 10
Bear Spread 42 12 -2 0 0 10
X1 30 15 Short Put 44 14 -4 0 0 10
X2 40 18 Long put 46 16 -6 0 0 10
Net cash 48 18 -8 0 0 10
outflow 3 50 20 -10 0 0 10
51 21 -11 0 0 10
52 22 -12 0 0 10
53 23 -13 0 0 10
54 24 -14 0 0 10
55 25 -15 0 0 10
Butterfly Spreads

• Butterfly spreads can be used to generate extra income when the trader believes
the market is stagnating but does not want to be exposed to an unexpected rise or
fall. The strategy consists of buying one in-the-money call option and buying one
out-the-money option and selling two at-the-money options.
 Butterfly Spreads Stock price Long call Long Call Short
(T) (40) (20) call (30) Payoff
Strike price
Long Call 40 10 0 0 0 0
Long Call 20 15 0 0 0 0
Stock price 30
Short call 30 20 0 0 0 0
25 0 5 0 5
60
30 0 10 0 10
40
35 0 15 -10 5
20 40 0 20 -20 0
45 5 25 -30 0
Total Payoff

0
10 15 20 25 30 35 40 45 50 55 60 65
50 10 30 -40 0
-20

55 15 35 -50 0
-40
60 20 40 -60 0
-60
65 25 45 -70 0
-80

Stock price
Long call (40) Long Call (20) Short call (20) Payoff
Butterfly Spreads

• Butterfly Spread yields the maximum profit when stock price is near
to at the money strike price, but a small loss if there is a significant
price move in either direction. Therefore, this works when the trader
does not expect much market movement.
Straddle

• Straddle involves buying a call and a put option with the same strike price and
expiration date.
• Straddle strategy works when traders anticipate that there will be huge price
movement, but do not know its direction.
• The maximum loss to the trader is the amount invested in entering the strategy
when stock price is very close to strike price. However, if there is a sufficiently
large movement either direction, a significant profit will result.
 Straddle
Stock Total
Long call premium Rs. 4 price(T) Long call Long put Profit
Long put premium Rs. 3 55 -4 12 8
stock price (t) Rs. 69
Strike price Rs. 70 60 -4 7 3
65 -4 2 -2
35 70 -4 -3 -7
30 75 1 -3 -2
25
20 80 6 -3 3
15 85 11 -3 8
Profit

10
90 16 -3 13
5
0 95 21 -3 18
55 60 65 70 75 80 85 90 95 100 105
-5 100 26 -3 23
-10
105 31 -3 28
Stock price

Long call Long put Profit

How to make money from trading Straddles

• Suppose that a big move is expected a firm’s stock price because there is a
takeover bid for the firm or the outcome of a major lawsuit.
• In the above case, the huge price movement is expected. However, if your views
of firm’s situation is much the same as that of other market participants, this view
will be reflected in the prices of options. Therefore, options on the stock will be
significantly expensive. The V-shape profit pattern from the straddle will have
moved downward, so that a bigger move in the stock price is necessary for you to
a make a profit.
• For a straddle to be effective strategy, you must believe that there are likely to be
big movements in the stock price and these beliefs must be different than those
most investors.
Strips and Straps

• Strips involves long on one call and two put option with same strike price and
expiration date. The trader bets on a significant price movement, but the
probability of downward stock price is greater than upward stock price.
• Straps involves long on two call and one put option with same strike price and
expiration date. The trader bets on a significant price movement, but the
probability of upward stock price is greater than downward stock price.
 Straps
Strike 2 long call Long Total
price (T) profit put profit Long two call premium 8
40 -8 27 19 Long put premium 3
45 -8 22 14 Strike price 70
50 -8 17 9
70
55 -8 12 4
60
60 -8 7 -1
50
65 -8 2 -6
70 -8 -3 -11 40

75 2 -3 -1 30

Profit
80 12 -3 9 20

85 22 -3 19 10

90 32 -3 29 0
40 45 50 55 60 65 70 75 80 85 90 95 100 105

95 42 -3 39 -10

100 52 -3 49 -20
Stock priceput
105 62 -3 59 2 long call profit Long Total profit
 Strike price 2 long put Total

Strips (T)
40
profit
52
Long call profit
-3 49
Long two put premium 8 45 42 -3 39
Long call premium 3 50 32 -3 29
Strike price 70
55 22 -3 19
60
60 12 -3 9
50

40
65 2 -3 -1
30
70 -8 -3 -11
20
75 -8 2 -6
10 80 -8 7 -1
0 85 -8 12 4
40 45 50 55 60 65 70 75 80 85 90 95 100 105
-10 90 -8 17 9
-20 95 -8 22 14
2 long put profit Long call Total profit 100 -8 27 19
105 -8 32 24
Valuation of Options
Binominal trees

• Binominal tree is a popular technique for pricing an option involves representing

different possible paths through a diagram.
• The underlying assumption is that the stock price follows a random walk.
• In each time step, it has a certain probabilities of moving up by a certain
percentage amount and a certain probabilities of moving down by a percentage
amount.
The Basic idea of binominal model

• A stock price is currently $20, and a call option is trading at strike price of
Rs 21. It is also possible to borrow (lend) at 4% per annum
• In 3 months, it will be either $22 or $18

Stock Price = $22

Stock price = $20
Stock Price = $18
A Call Option

A 3-month call option on the stock has a strike price of 21.

Stock Price = $22

Option Payoff = $1
Stock price = $20
Option Price=?
Stock Price = $18
Option Payoff = $0
Setting Up a Riskless Portfolio

• We now set up a portfolio using stock and option in such a way that there is no
uncertainly about the value of portfolio at the end of the 3 months. Since portfolio
does not have any risk, the returns it earns must equal the risk-free rate.
• Consider a portfolio consisting of a long position in Δ shares of the stock and
short position in call option to hedge its position to make risk-less profit.
• The value of portfolio will be
22D – 1

18D
 Setting Up a Riskless Portfolio
Making portfolio riskless
• when 22D – 1 = 18D or D = 0.25 (this shows that 0.25 stock is required to hedge a short
position in one option.)
D=
The riskless portfolio is:
long 0.25 shares
short 1 call option
• The value of the portfolio at the end of life of option
22 ×0.25 – 1 =Rs 4.50 (if stock price moves up)
18*0.25=Rs. 4.5 (if stock price moves down)
Since, the portfolio is riskless, the expected returns cannot be more than risk-free rate.
Present value of portfolio (the cost of portfolio) if risk-free rate is 4% per annum
4.5e–0.4×0.25 = Rs. 4.455
 Valuing call option
• Value of option at today
• 20 ×0.25 – value of call option = 4.455
• Value of call option at today is 0.545
• Let us assume that the option price is the market is Rs 1, therefore, Option is overvalued. Now, we can
make riskless profit by writing an option, and buy 0.25 stock to cover call option

Present date Stock price (T)=18 Stock price (T)=22

Call price +1 0 (22-21)=-1
Buying 0.25 stock -5 +4.5 +5.5
Borrowing +4 -4.04 -4.04
Total Profit 0 0.45 0.45
Valuing call option

• Let us assume that the option price is the market is Rs 0.2, therefore, Option is
undervalued. Now, we can make riskless profit by buying a call option and
shorting 0.25 stock to cover call option.
Present date Stock price (T)=18 Stock price (T)=22
Call price -0.25 0 (22-21)=1
Shorting 0.25 stock +5 -4.5 -5.5
Net investment in 4.75 +4.79 +4.79
risk-free rate
Total Profit 0 0.29 0.29
Valuation of put option

• We now set up a portfolio using stock and option in such a way that there is no
uncertainly about the value of portfolio at the end of the 3 months. Since portfolio
does not have any risk, the returns it earns must equal the risk-free rate.
• Consider a portfolio consisting of a long position in Δ shares of the stock and
short position in call option to hedge its position to make risk-less profit.
• The value of portfolio will be
22D

18D-3
 Setting Up a Riskless Portfolio
Making portfolio riskless
• when 22D = 18D-3 or D = -0.75 (this shows that 0.75 stock is required to short to hedge a
short position in one put option.)
D=
The riskless portfolio is:
short 0.75 shares
short 1 put option
• The value of the portfolio at the end of life of option
22 ×-0.75 =Rs -16.5 (if stock price moves up)
18*-0.75-3=Rs. -16.5 (if stock price moves down)
Since, the portfolio is riskless, the expected returns cannot be more than risk-free rate.
Present value of portfolio (the cost of portfolio) if risk-free rate is 4% per annum
-16.5e–0.4×0.25 = Rs. -16.33
Valuing put option

• Value of option at today

• 20 ×-0.75 – value of put option = -16.33
• Value of put option at today is 1.33
 The binominal option formula
S0u = 22
p call value = 1 call value=Max(S0u -X,0)
S0=20
ƒ
(1 – S0d = 18
p)
call value = 0

• P is the risk-adjusted probability that stock price will go up and (1-p) probability that stock price goes
down
U=1.1 and d=0.9 (Assuming 10% change in either direction)
(1-u) is percentage up in stock price, and (1-d) percentage down in stock price

e rT  d e0.040.25  0.9
p  0.5543
u d 1.1  0.9
79
The binominal option formula

• The value of call at (t=0)=(Probability of stock price up *value of call at

expiration +(1- Probability of stock price up) value of call at expiration )* e–rt
Valuing the Option

S0u = 22
43
0.55 Call value = 1
S0=20 Put value=0
ƒ
The value of call option is 0.44 S0d = 18
97
e–0.04×0.25 (0.5543 ×1 + 0.4497×0) Call value = 0
Put value=3
= 0.545
The value of put option is
e–0.04×0.25 (0.5543 ×0 + 0.4497×3)
= 1.34

81
A Two-Step Example

24.2
22

20 19.8

• K=21, r = 4% 18
• Each time step is 3 months 16.2

82
Valuing a Call Option
24.2
3.2
22
B
20 1.7433 19.8
0.9497 A 0.0
18

0.0 16.2
Value at node B 0.0
= e–0.04×0.25(0.5503×3.2 + 0.4497×0) = 1.7433
Value at node A
= e–0.04×0.25(0.5503×1.7433 + 0.4497×0) = 0.9497
Choosing u and d

In practice, when constructing a binominal tree to represent the movements in a

stock, we choose the parameters u and d to match volatility of real words.

u e  t

d 1 u e   t

where s is the volatility and Δt is the length of the time step.

84
Valuing option

• Consider again the call option where stock price is Rs 50 the strike price is Rs 52,
the risk-free rate is 5%. The life of option is 2 years , and there are two-time steps.
Suppose annual volatility of stock is 30%. In this case

Probability of up-side movements=

Probability of down-side movements=1- =0.490

Valuing option
67.45*1.349=91.04

50*1.349=67.45
B

50
A 37.04*1.349=50

50*0.74=37.04

37.04*0.74=27.44
 Valuing call option
91.04
Call value=91.04-52=39.04
(0.509*39.04+(1-0.509)*0)*
67.45
Call value=19.89
B
(0.509*19.89+(1-0.509)*0)*
50
Call value=9.17 A 50
37.04 Call value=0
Call value=0

27.44
Call value=0
Delta (Hedging ratio)

The delta (Δ) of a stock option is the ratio of the change in the price of the stock
option to change in the price underlying stock. It is the number of units of the stock
we should hold for each option shorted in order to create riskless portfolio. This
construction of a riskless portfolio is called delta hedging. The delta is positive for a
call option and negative for put option.
• Second node (upside) delta=
• Second node (downside) delta=
• First node=
• This example shows that delta changes over time. Thus, in order to maintain a
riskless hedge using option and underlying stock, we need to adjust our holdings
in the stock periodically.
Valuing put option

• Consider again the put option where stock price is Rs 50 the strike price is Rs 52,
the risk-free rate is 5%. The life of option is 2 years , and there are two-time steps.
Suppose annual volatility of stock is 30%. In this case

Probability of up-side movements=

Probability of down-side movements=1- =0.490

Valuing put option

91.10594
0
67.49294
0.932698
50 50
6.245708 2.00
37.04091
12.42302
27.44058
24.55942
The Volatility

• The volatility is the standard deviation of the continuously compounded

rate of return in 1 year
• The standard deviation of the return in a short time period time Δt is
approximately  t
• If a stock price is $50 and its volatility is 25% per year what is the
standard deviation of the price change in one day?

91
 Estimating Volatility from Historical Data

1. Take observations S0, S1, . . . , Sn at intervals of t years (e.g. for

weekly data t = 1/52)
2. Calculate the continuously compounded return in each interval
as:
 Si 
ui  ln 
 Si  1 

3. Calculate the standard deviation, s , of the

s ui´s
ˆ 
4. The historical volatility estimate is: 

92
Nature of Volatility

• Volatility is usually much greater when the market is open (i.e., the asset is
trading) than when it is closed
• For this reason, time is usually measured in “trading days” not calendar days
when options are valued. Thus, the market participants ignore days when the
exchange is closed when estimating volatility from historical data and when life of
an option.
Volatility per annum =
• It is assumed that there are 252 trading days in one year for most assets.
• Suppose it is April 1 and an option lasts to April 30 so that the number of days
remaining is 30 calendar days or 22 trading days
• The time to maturity would be assumed to be 22/252 = 0.0873 years
93
 The Black-Scholes-Merton intuition
• BS model is based on the intuition that in any short period of time, the price of the
options is perfectly correlated with underlying assets. When an appropriate portfolio
of the stock and the option is established, the gain or loss from the stock position
always offsets the gain or loss from the option position so that the overall value of
the portfolio at the end of the short period of time is known with certainty.
• Let us assume the delta of option is 0.4 (Δ call value =0.4ΔStock price).
Long position consists of 0.4 shares and short position in one call option. Assume the
stock price has increased by Rs. 10, and therefore option price will increase by Rs 4.
Now, the loss on call value (Rs 4) will be offset by the profit on long position in
share.
• There is one difference between binominal model and BS model is that in BS model
the portfolio is riskless for a very short period. To remain riskless, it must be adjusted
or rebalanced, frequently
The Black-Scholes-Merton Formulas for Options

c S 0 N ( d1 )  K e  rT N ( d 2 )
p  K e  rT N (  d 2 )  S 0 N (  d1 )
ln( S 0 / K )  ( r   2 / 2)T
where d1 
 T
2
ln( S 0 / K )  ( r   / 2)T
d2   d1   T
 T

95
Decoding BS model

• N(d1) and N(d2) are probability, and d1 and d2 follow standard normal
distribution with mean 0 and standard deviation 1.
• In the risk neutral world (short-period of time), the expected returns of investors is
equal to risk-free rate. Therefore, future expected stock price after T period
(expiration day)=and * N(d1) gives expected future price. If we estimate the
present value of * N(d1), then ( N(d1)) As a result, we have ( N(d1)). It is the first
term of the BS model.
• N(d2) shows the risk-adjusted probability that the option will expire in-the-money.
Therefore, K* N(d2) gives present value of cashflow if the option exercises.
d1

• Since the BS model assumes that stock price follows lognormal

distribution. We use standard normal distribution formula to calculate
d1.
• d1= X=ln(S/X) , u=(r- and Std=,
• = or
 Daily Mean log returns 0.3%
Daily standard deviation 1.4%
Annulized std deviation 22.37%
Risk-free rate (91 days) 3.32%
Valuing
Nifty 50 Expiration date 29-Apr-21
option Strike price 16,000.00
Stock price 15,222.05
Trading days 1/12/2021
Days to expiration 107
Trading days 252
Time to expiration (in years) 0.424603
Valuing Nifty 50 option

ln(S0/K) -0.050
(r+σ2/2)t 0.02
σ√t 0.1457
d1 -0.1724
d2 -0.3181
N(d1) 0.432
N(d2) 0.375 0.375 probability that the call option will be expired in-the-money
e-rt 0.9860
call value 650.25
 The Standard Normal Distribution
The standard normal distribution is a normal distribution with a mean of 0 and a
standard deviation of 1.

d1=0-0.1724

d2=0-0.3181
The horizontal scale
corresponds to z-scores.

z
3 2 1 0 1 2 3

Value - Mean x-μ

z= = .
Standard deviation σ
Properties of Black-Scholes Formula

• As S0 becomes very large c tends to S0 – Ke-rT and p tends to zero

• As S0 becomes very small c tends to zero and p tends to Ke-rT – S0
• What happens as volatility becomes very large?
• What happens as T becomes very large?

101
Implied Volatility
• The implied volatility of an option is the volatility for which the Black-Scholes-
Merton price equals the market price.
• There is a one-to-one correspondence between prices and implied volatilities
• Implied volatility represents a one standard deviation change in the stock prices.
• Higher implied volatility implies that the market expects higher stock price’s
movement.
• Given call price on Nifty 50 Rs. 127, the implied volatility is 8.38% per annum. If
time to expiration period is 0.42, then implied volatility of this period is =5.4%.
• It suggests that the market expects the price of Nifty 50 index will move close 50
5.4% over 0.42 year. Given the spot price of Nifty is 15222, the expected range of
Nifty over time is 16048.69 (15222*(1+5.4%)) and Rs 14395 *(15222*(1+5.4%))
with 68% confidence interval.
Implied Volatility

• Implied volatility is greater for option (both call and put option ) is greater for
deep out-the-money compared to deep in-the-money.
• If implied volatility is high relative to your expectation and therefore, you believe
that option is overvalued, take a short position in options.
• If implied volatility is low relative to your expectation and therefore, you believe
that option is undervalued, the take a long position in options.
India VIX

• India VIX is a volatility index based on the index option prices of NIFTY. India
VIX is computed using the best bid and ask quotes of the out-of-the-money near
and mid-month NIFTY option contracts which are traded on the F&O segment of
NSE.
• VIX indicates the investor’s perception of the market’s volatility in the near term.
The index depicts the expected market volatility over the next 30 calendar days.
i.e., higher the India VIX values, higher the expected volatility and vice-versa.
India VIX computation methodology

• Time to expiry: The time to expiry is computed in minutes instead of days in

order to arrive at a level of precision expected by professional traders.
• Interest Rate: The relevant tenure NSE MIBOR rate (i.e 30 days or 90 days) is
being considered as risk-free interest rate for the respective expiry months of the
NIFTY option contracts
• The forward index level: India VIX is computed using out-of-the-money option
contracts. Out-of-the-money option contracts are identified using forward index
level
 Indian VIX
90

80

70

60

50

40
VIX

30

20

10

0
0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 1 1 1 1 1
-2 - 2 - 2 - 2 - 2 -2 -2 -2 - 2 - 2 - 2 - 2 -2 - 2 - 2 - 2 - 2 - 2 - 2 - 2 - 2 - 2 - 2 - 2 -2 -2 -2 - 2 -2 -2 -2 - 2 - 2 - 2 - 2 - 2 - 2 - 2 - 2 -2 - 2 - 2 - 2 - 2
ar ar ar ar Apr Apr Apr Apr ay ay ay ay Jun Jun Jun Jun -Jul -Jul -Jul Aug Aug Aug Aug Sep Sep Sep Sep Oct Oct Oct Oct Nov Nov Nov Nov Dec Dec Dec Dec Jan Jan Jan Feb Feb
M M M M - - - - M M M M - - - - - - - - - - - - - - - - -
2- 10- 18- 26- 3 11 19 27 5- 13- 21- 29- 6 14 22 30 8 16 24 1- 9- 17- 25- 2 10 18 26 4 12 20 28 5- 13- 21- 29- 7- 15- 23- 31- 8 16 24 1 9

Time
Hedging
Example
• A bank has sold for $300,000 a European call option on 100,000 shares of a
non-dividend paying stock
• S0 = 49, K = 50, r = 5%, s = 20%,
T = 20 weeks, m = 13%
• The Black-Scholes-Merton value of the option is $240,000
• How does the bank hedge its risk to lock in a $60,000 profit?
The perfect hedging involves that the cost of hedging should not be more than
the value of option, then the bank will make risk-less profit.
 Naked & Covered Positions

• Naked position
• Take no action. This works well if the option expiries with out-the-money.
However, if option expiries in-the-money , the bank would have significant losses.
• Covered position
• Buy 100,000 shares today: This works well if the option expiries with in-the-
money. However, if option expiries out-the-money , the bank would have
significant losses.
Stop-Loss Strategy

• This involves:
• Buying 100,000 shares as soon as price reaches $50
• Selling 100,000 shares as soon as price falls below $50
• The objective of this strategy is buying the stock if the call option is in-
the-money and selling the stock if the option is out-the-money. This
strategy ensures that the writer of call option owns the stock if the option
expires in-the-money and does not own stock if the option expires out-
the-money.
Stop-Loss Strategy
Stop-Loss Strategy

• The success of stop-loss strategy depends on trade that is executed close to strike
price. However, most of times, the trader fails to do that. Therefore, the cost of
stop-loss strategy can be more than the value of call option.
Delta hedging

• Delta (D) is the rate of change of the option price with respect to the
underlying asset price. It is a slope of the curve that relates the option price to
the underlying asset price. It suggest that if stock price changes by a small
amount, the call value changes by 60% of that amount.
Call option
price

Slope = D = 0.6
B

A Stock price
 Delta Hedging
• Trader would be hedged with the position:
• short 1000 options (call option (assuming lot size is 1 share)
• Delta is 0.6, therefore, to hedge call option risk, the trader must buy 600 stocks
If the stock price goes up by Rs 1 (producing a gain of Rs 600 on share purchased),
the option price tends to decrease by Rs 600).
• Delta of short call option position =1000*-0.6=-600, it means the trader will have loss
of Rs 600 on call option if stock price goes up by Rs 1.
• Delta of long position in stock is always 1. Therefore, for 600 shares long position, the
delta is 600.
• The delta of portfolio is (-600 (call position) + 600 (long position)=0. It is called delta
neutral hedging.
 Delta Hedging
Short position Long position
Call option Delta -N(d1) N(d1)

To hedge, the position in N(d1) (long position) -N(d1) (short position)

stock
Portfolio delta 0 0
Long position short position
Put option Delta N(d1)-1 -(N(d1)-1)

To hedge, the position in Long position short position

stock
Portfolio delta 0 0
Delta Hedging (Nifty 50 S=15222, X=16000, Volatility=22.37%,
T=0.42 Risk-free rate=3.32%
12

10

8
Delta

0
5000 7000 9000 11000 13000 15000 17000
Asset Price
 Delta Hedging (put option)
12

10

8
Delta

0
5000 7000 9000 11000 13000 15000 17000

Asset Price
Delta Hedging
Delta and volatility

• For out-the-money, the delta increases with volatility, whereas the-in-the money
delta decreases.
Dynamic delta hedging

• Since delta is function of stock price, delta changes with stock price. As a result,
the trader’s position can be delta neutral for a relatively short-period of time. The
hedge must be adjusted periodically. This is called dynamic delta hedging.
• Let as assume that stock price moved by Rs 110 in a single day, and therefore
delta moved by 0.65 from 0.60. Now, the trader must buy 0.05 more stocks (for
each short call option) to have delta neutral position.
Delta hedging

• A bank has sold for $300,000 a European call option on 100,000

shares of a non-dividend paying stock
• S0 = 49, X = 50, r = 5%, s = 20%,
T = 20 weeks, m = 13%
• The Black-Scholes-Merton value of the option is $240,000
• How does the bank hedge its risk to lock in a $60,000 profit?
The perfect hedging involves that the cost of hedging should not be
more than the value of option, then the bank will make risk-less profit.
 Delta hedging
Stock Stock Required for delta Stock purchased Cost of puchased Total borrowing(including interest) at
Week Price Delta hedging (sold) (sold) shares the end of each week Interest
0 49 0.522 52200 52200 2557800 2557800 2461
1 48.12 0.458 45800 (6400) (307968) 2252293 2167
2 47.37 0.4 40000 (5800) (274746) 1979713 1904
3 50.25 0.596 59600 19600 984900 2966518 2854
4 51.75 0.693 69300 9700 501975 3471347 3339
5 53.12 0.774 77400 8100 430272 3904958 3757
6 53 0.771 77100 (300) (15900) 3892815 3745
7 51.87 0.706 70600 (6500) (337155) 3559404 3424
8 51.38 0.674 67400 (3200) (164416) 3398413 3269
9 53 0.787 78700 11300 598900 4000582 3849
10 49.88 0.55 55000 (23700) (1182156) 2822274 2715
11 48.5 0.413 41300 (13700) (664450) 2160540 2078
12 49.88 0.542 54200 12900 643452 2806070 2699
13 50.37 0.591 59100 4900 246813 3055582 2939
14 52.13 0.768 76800 17700 922701 3981223 3830
15 51.88 0.759 75900 (900) (46692) 3938361 3789
16 52.87 0.865 86500 10600 560422 4502572 4331
17 54.87 0.978 97800 11300 620031 5126934 4932
18 54.62 0.99 99000 1200 65544 5197410 5000
19 55.87 1 100000 1000 55870 5258280 5058
20 57.25 1 100000 0 0 5263338
 Delta hedging
• Total interest costs( cost of hedging )=Rs. 72591
• Cash received by selling stock to the option buyers=100000*50=Rs 50,00,000
• Option price received =Rs 300,000
• Total cash inflows= Rs 50,00,000 +300,000=Rs 53,00,000
• Total borrowing including interest after 52 weeks=Rs 52,63,338
• Cost of writing call option and hedging is Rs 2,63,338
Present value of cost of writing call option and hedging= 2,63,338*=Rs 258322.67
Delta hedging

• In the case of perfect hedging, the present value of cost of hedging should be
equal to BS model price. The reason for variation in the cost of hedging is that the
hedge is rebalanced only once in a week. As rebalancing takes place more
frequently the variation in the cost of hedging is reduced, assuming that volatility
of stock is constant and transaction cost is zero.
Delta hedging
Stock Stock Required for delta Stock purchased Cost of puchased (sold) Total borrowing at the end of
Week Price Delta hedging (sold) shares each week Interest
0 49 0.522 52200 52200 2557800 2557800 2461
1 49.75 0.568 56800 4600 228850 2789111 2683
2 52 0.705 70500 13700 712400 3504194 3371
3 50 0.579 57900 (12600) (630000) 2877565 2768
4 48.38 0.459 45900 (12000) (580560) 2299773 2212
5 48.25 0.443 44300 (1600) (77200) 2224785 2140
6 48.75 0.475 47500 3200 156000 2382926 2292
7 49.63 0.54 54000 6500 322595 2707813 2605
8 48.25 0.42 42000 (12000) (579000) 2131418 2050
9 48.25 0.41 41000 (1000) (48250) 2085218 2006
10 51.12 0.658 65800 24800 1267776 3355000 3228
11 51.5 0.692 69200 3400 175100 3533328 3399
12 49.88 0.542 54200 (15000) (748200) 2788527 2683
13 49.88 0.538 53800 (400) (19952) 2771257 2666
14 48.75 0.4 40000 (13800) (672750) 2101173 2021
15 47.5 0.236 23600 (16400) (779000) 1324195 1274
16 48 0.261 26100 2500 120000 1445469 1391
17 46.25 0.062 6200 (19900) (920375) 526484 506
18 48.13 0.183 18300 12100 582373 1109364 1067
19 46.63 0.007 700 (17600) (820688) 289743 279
20 48.12 0 0 (700) (33684) 256338
 Delta hedging
• Cash received by selling stock to the option buyers=0
• Total borrowing including interest after 52 weeks=Rs 256338
• Cost of writing call option and hedging is Rs 2,56,338
Present value of cost of writing call option and hedging= 2,56338*=Rs 251455
Delta of portfolio

• Delta of portfolio=
= is investment in assets i and
The following is the portfolio of the trader
1. A long position in 100,000 call options with delta 0.533
2. A short position in 2,00,000 call options with delta of each option is 0.468
3. A short position in 50,000 put option with delta of each option is -0.508
Portfolio delta=100,000*0.533 - 200,000*0.468 -50,000*(-508)= -14,900
Since the delta of option portfolio is negative, the portfolio can be made delta
neutral by buying 14,900 shares.
Theta

 Theta (Q) of option is the rate of change in option value with respect to the
passage of time with all else remaining the same
 The theta of a call or put is usually negative. This means that, if time passes
with the price of the underlying asset and its volatility remaining the same, the
value of a long call or put option declines. This is because time value of option
reduces with time.
 Long position in options carries negative theta, while short position in options
carries positive theta.
 Theta is not same type of hedge parameter as delta. There is uncertainty about
the future stock price, but no uncertainty about the passage of time. It makes
sense to hedge against changes in the price of the underlying asset, but it does
not make any sense to hedge against the passage of time.
Theta for Call Option (K=50, s = 25%, r = 0, T = 2,

0 20 40 60 80 100 120 140

0
Stock Price

-0.5

-1

-1.5

-2

-2.5

129
Theta and volatility

• Higher the volatility, more the time value of option. Therefore, the theta increases
with volatility.
Variation of Theta with Time to Maturity

131
 Gamma

• Gamma (G) is the rate of change of delta (D) with respect to the price
of the underlying asset
• Gamma is greatest for options that are close to the money

132
Gamma Addresses Delta Hedging Errors
Caused By Curvature

Call
price

C''
C'

C
Stock price
S S'
133
Gamma
• If gamma is small, delta changes slowly, and the adjustment to keep a portfolio
delta neutral need to be made only relatively infrequently. However, if gamma is
highly negative or highly positive, delta is very sensitive to the price of underlying
asset. Therefore, it is quite risky to leave a delta neutral portfolio unchanged for
any length of time.
Gamma