Options are derivative products that are fundamentally different from forward and futures contracts. Prior to 1973, options of various kind were traded over the counter (OTC), but in 1973, the Chicago Board options Exchange (CBOE) began trading options on Individual Stocks. Since that time, the options market have experienced rapid growth with creation of new exchanges and many different kind of new option contracts. Options market are very diverse and they have their own particular jargon. Therefore, understanding options requires a grasp of the terminology employed in the market. Besides, a successful option trader must also understand the pricing relationship that prevails in the options market.
What is an Option?
An Option gives the right but not the obligation to the option owner, to buy or sell and underlying asset at a specific price within a specific time period in the future. There are two basic type of Options -Call Option and Put Option.
A call option is an option contract that gives the buyer/owner/holder of the option, the right but not the obligation to buy the underlying asset on or before a specific date and at a specific price.
A put option is an option contract that gives the option buyer/owner/holder the right but not the obligation to sell the underlying asset on or before a specific date and at a specific price.
As in any other financial transaction, there are two sides to every contract. For instance, whereas the buyer of a call option has the right to buy an asset the seller or grantor of the same option has the obligation to perform the other side of the transaction i.e.
The Seller / writer/ grantor / of an option has the obligation:
In case of a call option to sell the underlying asset to the buyer of that option if the latter so desires (exercise the right).
In case of a put option to buy the underlying asset if te buyer of that option exercises the right.
The Option seller is virtually selling Price Protection to the buyer who pays a certain amount called the premium to the option seller. In an option contract, the seller receives the premium for undertaking the obligation and the buyer pays the premium for acquiring the right under the relevant option contract. It is obvious that a buyer will exercise his right to buy or sell the underlying only if it is profitable to him or he derives some other benefits in doing so.
Terminology to remember:
Option Premium: Option premium is basically the price at which the option contract is traded i.e the amount which is paid by the buyer of the option to seller of the option.
Strike Price/ Exercise Price: The price at which the buyer of the option agrees to buy (in case of a call option ) or aggress to sell (in the case of a put option) the underlying asset is called the strike price or the exercise price.
Exercise Date: The last day on or before which the option can be exercised by the option buyer is called the exercise date or the expiration date of the option.
Assignment: Assignment takes place when the written option is exercised by the option holder. The options writer is said to be assigned the obligation to deliver the terms of the option contract. If a call option is assigned, the option writer will have to sell the obligated quantity of the underlying asset at the strike price. If a put option is assigned, the option writer will have to buy the quantity of the underlying asset at the strike price.
Expiration Date: The date on which an option contract becomes invalid and the right to exercise it no longer exists.
American option: An option in which the option buyer gets a right to exercise the option at any time between the date of purchase and the exercise date of that option is called an American option. Options traded on DGCX are American style.
European Option: An option in which the buyer can exercise his right only on the exercise date is called European option.
Examples 1 and 2 below will be used through out to explain the various terms associated with options trading.
Example 1 - Buying a call / Put
A buys one DGCX gold call/put option with following details: Strike Price : 640 Expiray Dtae : March 20th Premium : $10 Underlying : 1 gold futures contract 32 troy oz. Maturing on 5th April.
A pays Premium of $320/- i.e underlying quantity covered by the contract (32 troy oz) X Premium per oz ($10)
A has right but not the obligation to buy (in case of a call) / sell (in case of a put) 1 gold futures contract (underlying)
At a price of $640/troy oz (strike/exercise price)
A can exercise his right on or before March 20th (Expiration Date)
Example 2- Selling a Call / Put
X sells one DGCX gold call/put options with following details: Strike Price : 640 Expiry Date : March 20th
Premium : $ 10
Underlying : 1 gold future contract 32 troy oz. Maturing on 5th April.
X receives a premium of (32*10) i.e $320/-
If the buyers exercise his right, X is obligated to sell (in case of a call) / buy (in case of a put) 1 gold futures contract (underlying).
Ata price of $640/troy oz (strike/exercise price)
X can be assigned the obligation on or before March 20th (Expiration Date)
An important question is when does one make use of options instead of futures? Options vary from futures in several ways. The option buyer pays for the option in full at the time it is purchased. By doing this, he only has a upside as it is not possible for the option position to generate any further losses to him (other then the funds already paid for the option). This is different from futures, which doesn't require a premium but is likely to generate very large losses, the characteristic makes options attractive to many occasional market participants, who cannot put in the time to closely monitor their futures positions.
Buying put options is like buying Insurance. For example, to buy a put option on Gold futures is similar to buying an Insurance, which reimburses the full extent to which the gold futures drop below the strike price of the put option.
Moreover, options offer "nonlinear payoffs" By combining futures and option a wide variety of innovative and useful payoff structures can be created.
The following table shows the similarities and differences between the futures and options contract.
|Exchange traded, with novation||Same as futures|
|Exchange defines the product||Same as futures|
|Futures prices moves up and down||Price (premium) fluctuates but the strike price remains fixed|
|No premium is receivable or payable||Buyer pays premium to the seller|
|Linear payoff||Nonlinear payoff|
|Both long and short at risk||Only short at risk|
|Trading is based on future prices||Trading is based on options premium|
Options contracts can be traded either on an exchange or over the counter (OTC) markets.
Over the counter option, contracts are tailor made contracts matching the specific needs of the investor, and need not be standardized, Exchange -traded options (ETOs) on the other hand are standardized with respect to:
Standardized options can be traded, cleared and offset in the same way as future contracts. The purchase of an option limits the maximum loss at the same time allows buyer to take advantage of favorable price movements. Therefore price risk management using options could be advantageous when compared to using futures contract for hedging. This is because when a futures contract is used for hedging, it only enables the user to lock-in the price of the underlying assets and does not allow any advantage in respect of a favorable movement in the price of the underlying asset.
Options are often referred to as in -the-money, at-the-money and out -of-the money depending on the market price of the underlying and the strike price of the underlying and the strike price of the option. The money reference is not a statement about the profitability of the concerned option. Let us get familiar with the concept.
In the Money Option (ITM): An in-the-money option is an option that would lead to a positive cash flow to the holder if it was exercised immediately. A call option is said to be in the money if the price of the underlying future contract is above the strike price (i.e Current Price> Strike Price). If the current traded price of the underlying futures is much higher than the strike price, the call is said to be deep ITM. A put option is said to be in the money if the price of the underlying futures contract is below the strike price (i.e Current< Strike Price).
At-the -money options: An at-the-money (ATM) is an option that would lead to a Zero cash flow to the holder if it was exercised immediately. A call or put option will be at the money if the price of the underlying future contract is equal to the strike price (i.e Current price = Strike Price).
Out-of -the-money options: An out-of-the-money option (OTM) is an option that would lead to a negative cash flow to the holder if it was exercised immediately. A call option is said to be out of the money if the price of the underlying future contract is below the strike price (current price< Strike price).
A put option is said to be out of the money if the prices of the underlying future contract is above the strike price i.e (urrent price > strike price).
Let us understand the concept of moniness with the simple example given below where a call and a put option with the strike price of 620 has been bought:
|Moniness of Call concept||Price of the underlying future contract (u)||Strike price of the option (s||Moniness of put option|
|(U < S) OTM||600||620||ITM (S > U)|
|(U < S) OTM||610||620||ITM (S > U)|
|(U = S) ATM||620||620||ATM(S = U)|
|(U > S) ITM||625||620||OTM (S < U)|
|(U > S) ITM||630||620||OTM (S < U)|
The option premium is made up of two parts: 1- Intrinsic Value2- Time Value
The options premium at any given time is the sum of its intrinsic value and time value.
Premium = Intrinsic Value + Time Value
Let us understand both the components of the premium.
Intrinsic Value: The amount by which an option is in-the-money is called the intrinsic value of the option. Intrinsic value of the option. Intrinsic value is calculated by taking the difference between the strike price and the current price of the underlying.
Intrinsic value for a CALL OPTION is calculated as the current price of the underlying futures contract less then the Strike Price.
Example: Following are some of the details of a 20th July Gold call option as on 10th June:
Premium : $ 10/oz
Strike Price : $ 600
Current Price of gold future contract : $ 608
Here, intrinsic value of a call = current price of the underlying - strike price i.e 608-600 = 8
Intrinsic value for a PUT OPTION is calculated as the strike price less then current price of the underlying future contracts.
Examples : Following are some of the details of a 20th July Gold put option as on 10th June:
Premium : $10/oz
Strike Price : $ 610
Current price of gold future contracts : $ 602
Here, intrinsic value of a put = strike price - current price of the underlying i.e 610-602=8
Intrinsic value is never taken as a negative figure. It can be zero or higher. If the call or put option is OTM, its intrinsic value is zero.
Time Value: The amount by which an option's premium exceeds its intrinsic value is called the time value of the option. Time value is the amount an investor is willing to pay for an option above its intrinsic value in the hope that at some time before the expiration of the contract, the value of the underlying will generate positive cash flows. It is that part of the premium which the option buyer pays to the seller for the unexpired time period of the contract. Hence greater the time remaining for maturity, more will be the premium on account of time value. The time value decreases as the underlying futures contract approaches expiry. Both calls and puts have the time value. As the total premium for an option is the sum of Intrinsic value and time value, an OTM or ATM option (which does not have any intrinsic value) ha only time value. Usually, the maximum time value exists when the option is ATM. At expiration , an option should have no time value.
Finding time value from the equation
Examples: Following are some of the details of a 20th September Gold call option as on 16th August:
Premium : $10/oz
Strike Price : $600
Current Price of gold future contract : $ 608
Here, intrinsic value of a call = current price of the underlying - strike price i.e 608-600 = 8
Now substituting the value in the equation :
Premium = Intrinsic value + time value
i.e 10=8+? (Time value )
Time Value = 2
Examples ; Following are some of the details of a 20th September Gold put option as on 16th August:
Strike Price: $610
Current price of gold future contract : $620
Here intrinsic value of a put = strike price - current price of the underlying i.e 610-620=0 (intrinsic value is always taken the maximum of 0 or actual. As the figure is negative it has been taken as 0)
Premium = Intrinsic Value + Time Value
i.e 2.50 = 0 + ? (Time value)
Time Value = 2.50
In this example as the option does not have any intrinsic value, the entire premium represents time value only.
How are DGCX Gold Option Traded ?
Some of the important details in respect of Gold option on DGCX as follows:
The Symbol: The symbol for gold option is DGO
The Underlying: The underlying asset for each option is one standard
DGCX traded gold future contract.
Calls and Put are two different contracts: The calloptions contract and the put option options contract are two different products. Buying or selling a call does not in any way involve a put and vice-versa. These are separate contracts and not the opposite sides of the same transaction.
Price Quotation: Options are quoted in US Dollar terms and the price quoted represents the premium per unit quantity of the underlying contract. For example if A DGCX Gold call is quoted at $5, it actually means that the quote is per troy ounce and not for the entire contract. The total cost in case the call is purchased will be $160 ($15 X 32 troy oz.)
Trading months: Three options series based on nearest existing futures contract months for gold i.e February, April, June, August, October and December will be listed fro trading. In all, there will be three traded contract months at all time. For example: During first week of April, options on June, August and October gold futures will be available for trading.
Strike Prices: For each option contracts, the strike price are at increments of $10. On the first day of trading for any options contract month, there will be a minimum of 7 strike prices each spaced $10 apart for call and puts. Of these three strikes would be in the money. One strike near or at the money and three strike prices shall be out of the money.
For example if, on the first day of a contract month, the price of a future contact was at $ 620/troy oz, option with the following strikes would be listed for trading:
Calls : (ITM) 590-600-610-620-630-640-650(OTM)
Puts : (OTM) 590-600-610-620-630-640-650(ITM)
In the event the price of the gold futures contract falls below the lowest strike price or moves above the highest strike price, options with new strike price based on the settlement price are introduced for trading.
Reading option prices
To locate an option from within the large population of quotes usually available or to understand the critical features of quoted options, one must know how to read them. There are usually five distinct parts of an option quote as shown below.
|Option Symbol||Expiration Date||Strike Price||Option type|
The first field relates to the unique symbol allotted to the option class by the exchange while the second and the third field relate to the expiration date and its strike price. The fourth relates to the basic type of option -whether a call or a put - usually represented by C (call) or P (put) and the last one represents the style of option i.e whether it is an American (A) or European (E) style.
DGO - 20th September 200X-620-C A
Will be read as; DGCX GOLD option contract - expiring on 20th September 200X- strike price of $620 -call option - American Style.
The buyer of an option contract on DGCX has to pay the full premium.
The Premium amount is settled on T+1 basis. The position does not entail payment of any margin. On the contrary, the seller of an option on DGCX will receive the premium on T+1 basis. He will attract margin on his short position based on SPAN margining system followed by the exchange.
Mechanics of Exercise
DGCX option contracts are traded in much the same manner as their underlying future contracts. All buying and selling occurs by competitive bids and offers (for premium) made through the exchanges electronic order system.
The options are American style and therefore the buyer of an option has the right to exercise it any time before its Expiration.All-in-the money options get automatically exercised on the expiration date even if the buyer of the options has not exercised the same. The exercise price in such cases will be the settlement price. Out-of-the-money options that are held till expirations date expire worthless and cannot be exercised.
Where an option is in the money , the buyer has the following alternatives:
He can offset his position and book his profit. His profit in this case will be excess premium received by him over and above the premium that was paid by him to enter into the initial position.
If an option is cash settled, he may leave it for an automatic exercise by the exchange on the expiration date. In this case, he shall get the difference between the strike price of his option and the settlement price of the underlying future contract. DGCX GOLD options, however are not cash settled.
He may exercise his right and get the option assigned to the seller. Depending on whether he had bought a call or a put, the exercise will result into a buy (call) or sell (put) position in the underlying gold future contract at the strike price. It is pertinent to note here that once an option position is exercised by the buyer and converted into a buy or sell position in the underlying future contract, all applicable margins related to the relivant futures contracts are payable by him.
In case a buyer choose not to exercise on ITM option, he has to inform the exchange (through the concerned member broker of the exchange) by 2345 hrs (15 minutes after the trading ceases).
Last Trading day : Expiration and the last trading day for DGCX gold futures options will occur on the tenth business day prior to start date of the tender period of the underlying Gold futures contract. If the designated day is a Friday or a day immediately preceding an Exchange holiday, the expiration and last trading day in that case will be the previous business day.
Factors influencing Option Premium
The Premium is the only part of the option contract that is negotiated by trading. All other terms and condition remain fixed and are predetermined.
For an option buyer the premium paid remains his maximum risk amount. Is contrast for a seller of the option the premium receives defines his maximum gain. Putting in simple terms the premium also called the price of the option moves up and down depending on the basic forces of demand and supply. However there are six factors, which influences the price of an option. A brief description of each factor hag been given below.
a- Changes in the price of the underlying future contract.
Changes in the price of the underlying futures contract can increase or decrease the value of an option. The price changes have opposite effects on calls and put. For instance, as the value of the underlying futures contract rises, the value of the call option will increase and the value of a put option will decrease. In contrast, a decrease in the price of the underlying futures contract will decrease the value of a call option and increase the value of a put option.
The strike price determines whether or not an option has any intrinsic value. An option's premium (intrinsic value plus time value ) generally increases as the option moves further in-the-money, and decreases as the option moves more and more out-of -the money.
c- Time till expiration.
Time till expiration affects the time value component of an option's premium. It is sometimes also referred to as extrinsic value. Generally, as expiration approaches, the level of an option's time value for both puts and call decreases. For example suppose on August 1, a DGCX September expiration gold call option with a strike price of $680 is quoted at a premium of $6. The price of the underlying gold futures contract at that time is $ 675.
Suppose if all other factors like future prices and volatility remain the same, on September 10, the same option will be quoted at much lower premium say $ 2. Even though the price of the underlying gold futures contracts remains at the same level ($675), the premium shrinks with the elapse of time. This effect is more pronounced with at the money options. For this reasons options are also called wasting or decaying asset. On expiration of an option, the time value component becomes nil and the residual premium pertains only to the intrinsic value of an option on expiration, the option is said to expire worthless. Therefore the length of time remaining until expiration is an important is an important determinant of the time value and consequently the premium.There is another important characteristic of time value - its decay is not linear. The time value decays at a faster rate as the time nears expiration. This is shown in the graph below.
Another factor that impacts the time value of an option is the volatility of the underlying futures. As a general rule, higher the volatility of the underlying higher will be the time value content of the premium for that option.
d- Volatility of the Underlying Future Contract.
The Volatility in the price of the underlying asset can have a significant impact on the time value portion of an option's premium. Volatility is simply a measure of risk (uncertainty), or variability in the price of the underlying futures contract. Higher volatility estimates reflect greater expected fluctuations (in either direction) in the price levels of the underlying. This expectation generally results in higher option premium for puts and call alike, and is most noticeable with at the money options.
e- Interest rates
Yet another factor that influences the premium of an option is the interest rate. Even though the effect of this factor is minimal, it is important to note that with a rise in interest rate (all other pricing factors remaining constant), generally , call prices increase and the put prices decreases. In the case of a decrease in the Interest rates, the call prices decline and the put prices rise.
Another factor that influences options premium is sensitive is the dividend paid on stocks. This is applicable to options on equity shares and is not applicable and is not applicable in case of commodity futures.
As stated above, Option premium is sensitive to several factors. These individual measurements of options price sensitivities are labeled with names based on Greek alphabets like Delta, Gamma, Theta, and Vega etc. The value of Greeks can be calculated using mathematical options pricing models.
Delta describes the sensitivity of the option price to changes in the price of the underlying asset. Since option premiums do not generally move as much as the underlying asset (future) price, delta is less than 1 absolute value, although it may be positive (in case of a call option) or negative (in the case of a put option). Delta is sometimes expressed in percentages terms and ranges from 0% (for deep out of the money options) to 100% (for deep in the money options). Delta for at the money options is usually about 50% or .05 =, It is also called the hedge ratio. An option delta value helps in predicting a theoretical percentage change in an option's price given a small change in the price of the underlying futures. Deltas do not remain constant and may change with each change in the price of the underlying futures.
As said earlier, theoretical deltas for calls and puts are not constant. As the price of the underlying futures changes, an option delta will change as well. The change in the value of the delta corresponding to a change in the underlying future prices is called gamma. For example: if the delta of a call option is 0.4 and the gamma is +. 05, and if the price of the underlying moves up by $1, the delta will move up to .45 i.e. 0.4 +. 05, it is also called the curvature of the option. The gamma of an option position gives and indication of how difficult the option position is to hedge in the underlying asset market.
Theta is the measure of the changes in the option premium corresponding to one-day change in its time to expiration. It is also called the time decay. It predicts and quantifies the theoretical rate of time decay of a call or put s time value. It is expressed in dollar/cents amount and conveniently as a negative number. As explained earlier, the rate of time decay is not a linear process because it increases as expiration nears.
Vega is a measure of the sensitivity of options prices to market volatility. It is the change in options premium corresponding to a 1% change in volatility in the futures price of the underlying. Long positions have positive Vegas whereas short position has negative Vegas. Vega is also a function of time - more the time to remaining to expiration, higher the vega and conversely lesser the time to expiration , lower will be the vega.
The Rho of an option is a measure of the option price sensitivity to a percentage change in the risk - free interest rate. In other words it measures the sensitivity of the portfolio to interest rate changes. Calls have positive rhos whereas as puts have negative rhos. Greater the time to expiration, more is the value of rho.
Options pricing through mathematical models
Various mathematical pricing models are used to find out the theoretical price of the options based on specific values of each of the six factors that influence the option price. Some of the popular mathematical options pricing modules used by the options industry participants are, the Black -Scholes (1973) was Binomial model and the Whaley model. The Black Scholes was originally formulated to price European style options, and does not account for dividend payments and early exercise. The Cox- Ross- Rubenstein Binomial model (1979) is a variation of the original Black- Scholes. The Barone- Adessi & Whaley model (1987), accounts for early exercise of call options due to dividend payment and is widely used among individual investors fro pricing American-style options.
The accuracy of any theoretical value generated with these mathematical pricing models has its limitations. The core fact remains that prices are basically determined by the demand and supply factors governing the option market.
Exiting an Option Position
There are three different ways of exiting an option position.
The most common method of exit is by offset.
Options that have value are usually offset before expiration. This can be done by purchasing a put or call identical to the put or call one originally sold or by selling a put or call identical to the put or call one originally bought.
For example, a trader X holds a bullish view on gold prices. At the time, December gold futures are trading at $ 655 a troy oz and the $650 strike November gold call on DGCX is trading at a premium of $8. x buys the November Gold call. Thereafter, December gold futures moves up to $665/troy oz and the November gold call option is now trading for a premium of $17 X exits his position by selling back (offsetting) the $ 650 - strike call for its current premium of $17. The difference between the option purchase price and sale price is is $9 ($17 premium received on sale -$8 premium originally paid to enter the position). His profit from the transaction (without considering brokerage or other transaction costs) would be $288/- ($9 x 32 oz )
Offsetting an option before expiration is the only way one can recover any remaining time value. Offsetting also prevents the risk of being assigned a futures position (exercised against) if one has originally sold an option.
The net profit or loss is the difference between the premium paid to buy (or received to sell) the option and the premium one receives (or pays) when one offsets the option. Market participants may face a risk if there is not an active market at the time by choose to offset, especially if the expiration date is near.
2- Exercising option
Only the option buyer can exercise an option and can do so at any time during the life of the option, regardless of whether it is a put or call. When an option position is exercised, both the buyer and seller of the option are assigned a futures position. Typically, an option buyer would exercise only if an option is in the money. Otherwise he would experience a market loss. If an option buyer exercises the option when it is in the money, the opposite future position acquired (by the option seller) will have a built loss. But this does not necessarily mean the option seller receives for writing the option may be greater than the loss in the futures position acquired through exercise.
For example A had bought a DGCX gold call option, which B had sold. The details are as follows:
Strike price of the call : $610
Options expirations Date: November 20
(Underlying: December Maturity gold futures)
Date of Transaction: October 1
Premium paid by A : $5 (*total premium paid =$160 i.e 32 X 5)
DGCX Gold future prices on October, 1 : 603/troy oz.
Premium received by B (seller) : $ 5 (*total premium received = $160 i.e 32 X 5)
*premium is quoted per unit of the underlying future contract. Each DGCX gold future contract id for 32 troy oz of gold.
On October 25, gold futures were quoting at $625/troy oz and the premium on November 610 call was at $17. A decides to exercise the call.
As a result of exercise, A`s option position will get converted into a long position in a DGCX gold future contract maturing in December at a price of $610/troy oz (at the strike price of the call option he had purchased). A may now either choose to offset his log futures position or hold the contract till delivery.
The seller of the cal, B faced assignment and his short-call position gets converted into a short position at $ 610/troy oz (strike price) in one DGCX gold future contract maturing in December. B may choose to offset his short position by buying a future contract and book his loss. Suppose he decides to offset his position at the existing futures prices of $625/troy oz. His gross loss of $15/troyoz (625-610) will stand reduced by $5/troy oz - the gross loss of $15/ troy oz (625-610) will stand reduced by $5/troy oz -the premium he had received. The net loss to B therefore will be $10/troy oz (15-5). Alternatively, he may hold the contract till expiration and deliver the underlying gold as per the futures contract specification.
3- Letting an Option Expire
The third option to exit from an option open position is to let the option expire anticipating the option will have no value at expiration (expire worthless). In fact, the right to hold the option up until the final day for exercising is one of the features that make options attractive to many. If the change in price an investor is anticipating doesn't occur or if the price move initially in the opposite direction then the investor has the assurance that the maximum amount he can lose is the premium he had for the option. On the other hand, option seller have the advantage of keeping the entire premium they earned provided the option doesn't move in the money until the expiration.
Taking the same example discussed above, if prices of gold future fall to $600/troy oz, it will not make any sense for A to exercise the $610 call as he can buy the same future contract at &600/troy oz from the future market. He will therefore allow the option to expire as it has become worthless for him. His loss will be limited to the premium he had paid. B, on the other hand, on expiry of the options will end up with gains in terms of the premium received.
Basics option strategies
A call option gives the buyer the right to buy the underlying asset at the strike price specified in the option. A call is usually purchased when the trader has a bullish outlook on the prices of the underlying and also expects the prices to be volatile. The profit/loss that the buyer makes on the option depends the price of the underlying future contract. If upon expiration, the prices of the future exceeds the strike price he makes a profit. Higher the future price more is the profit he makes. Conversely, if the price of the underlying is less than the strike price, he lets his option expire unexercised. His loss in this case is the premium he had paid for buying the option. The diagram given below shows the payoff for the buyer of a three month call option in gold (long call) with a strike price of $650 bought at a premium of $ 6.60
The seller of a call option has the obligation to sell the underlying asset to the buyer at the strike price if the latter exercises his right on or before the expiration date. For taking the risk of future obligation. the seller receives a premium which remains his maximum possible profit. On the other hand , the loss potential of the writer is theoretically unlimited as the price of the underlying could rise to any level. A short call strategy is considered as a purely speculative "high risk low-reward strategy" if the writer does not own the underlying asset. This is often referred to as naked call selling. Whatever is the buyers profit is the seller's loss. If upon expiration the price of the underlying future exceeds the strike price, the buyer will exercise the option on the writer. Hence as the price of the underlying increases beyond the strike price plus the premium received, the writer of options starts making losses. Higher the price of the underlying, greater is the loss he makes. Conversely, if upon expiration the price of the underlying is less than the strike price . the buyer lets his option expire un-exercised and the writer profits by keeping the premium. A short call strategy is usually taken when in the view of the seller, price of the underlying is likely to decline or move sideways with volatility remaining low. A much safer strategy often advocated by expert is to short a call against ownership of the underlying. The following diagram gives the payoff for the writer of a three month call option in gold (short call) with a strike of $650 sold a at a premium of $6.60.
A long Put strategy is usually adopted by a trader when his view on the market is bearish. He expects the price to fall and volatility to remain on the higher side. A put option gives the buyer the right to sell the underlying asset at the strike price specified in the option. The profit/loss that the buyer makes on the options depends on the price of the underlying. If upon expiration, if price of the underlying is below the strike price less then the premium paid, he makes a profit. Lower the price fall: greater is the profit he makes. If the price of the underlying futures is higher than the strike price, he lets the option expire unexercised. His loss in the case is the premium he paid for buying the option. The diagram given below shows the pay off for the buyer of a three month put option in gold (long put) with a strike of $ 640 boughta ta apremium of $5
Shorting a put is a higher risk- low reward strategy. The seller of the put has a moderately bullish view on the market and expects the volatility to remain low. A seller of the put receives premium for obligation himself to buy the underlying from the put holder at the strike price in case the price of the underlying falls. The writer's profit is limited to the premium received and this happens only if the price of the underlying remains above the strike price. But his losses could be very high as theoretically the price of the underlying may fall to even zero. If upon expiration, the underlying price happens to be below the strike price, the buyer will exercise the option on the write. I f upon expiration the price of the underlying is more than the strike price, the buyer lets his option expire unexercised and the writer profits from the premium he had received initially. The following diagram gives the payoff for the writer of a three months put option in gold (short put) with a strike of $640 sold at premium of $5
Why Use Options?
Options are unique trading instruments. They can be used for a multitude of purposes, as because these are tremendously versatile instruments. Some of the areas where options can be effectively used are:
Price Risk Management- One of the most important applications of options is their use as a price risk management vehicle. Usefulness of options stems from their special price performance characteristics. A future position exposes a trader to the risk of unlimited losses theoretically. On the other hand it also provides an opportunity for unlimited gains. But this is not true for the buyer of a futures option. For example, X possesses the ownership of 1 kilo gold @ $635/troy oz in the spot market. Even though the current price of gold future is $645, he maintains a bullish view on gold prices and would like to hold on to his physical position. On the other hand he also has concerns about unpredictable downside market risks. To mitigate such risks, he buys as a protection, a DGCX gold put option with a strike price of $640 trading at a premium of $5. Now if the price of gold futures fall below $640, X can exercise his option and sell a futures contract at $640/- (strike price). He can therefore protect himself against any downside in the price of gold. His breakeven for the transaction will be strike price of the put minus the premium paid i.e. $635/troy oz ($640-$5). Thus X is protected from any losses below a price of $635. The primary objective of the investor is to protect the long position in the underlying asset from a decrease in the market price. The main benefit of buying a put along with a long position in spot gold is that an investor can continue to enjoy the upward price benefit of holding a long position in the underlying asset based on his bullish views and at the same time enjoy a protection against losses owing to an adverse movement in price of the underlying. It is just like taking an insurance against downside price risk. The premium paid for the put option is equivalent to the premium paid for an insurance policy. No matter how much the underlying asset's price decreases in value during the options lifetime, the investor has a guaranteed selling price for that underlying and that is the put's strike price.
Portfolio diversification- options can be valuable tools within any portfolio. They can be used to reduce portfolio risk, to artificially diversify portfolio holdings, to hedge against various types of risks and to improve returns from a portfolio. An investor who holds an equity portfolio can easily diversify his portfolio by investing a part of his funds into precious metals. Instead of buying physical gold or silver, he can buy a call option which will give him a right to own the quantity of gold or silver underlying the option contract. For a relatively small cost incurred by him in terms of premium, he gets the right but not the obligation to own the underlying asset at a future date. Options are very flexible instruments that provide investors with the ability to use innovative investment strategies to reduce their overall portfolio risk. They can act as insurance policies against a drop in the underlying asset's prices or generate profit through strategies that limit the maximum loss to which an investor is exposed.
Leverage- When an investor trades in options market, he enjoys a distinct advantage as compared to trading in the physical market in terms of leverage. This means that with a small amount of capital, he can control a large volume of assets. The investor can obtain an option position at a much lower cost that will mimic a position in the spot market almost identically. Let's understand this with the help of an example. X bought 1 kilo of gold in the physical market @610/troy oz in January. His total cash outlay would amount to ($610*32troy oz= $19,520). He also bears the cost of interest, storage and insurance for holding the commodity up to the period of sale. In contrast to the above let's assume that the investor bought a Gold- July expiration -615 strike- call option contract on DGCX at $5 premium. His total cash outlay for purchasing the option amounts to ($5*32 troy oz= $160) which means x is only required to pay a premium of $160 for text-align: justify;obtaining the right to own 1 kilogram of gold in contrast to $19,520 required to buy spot gold. Moreover he does not incur interest, storage and insurance cost in respect of option position. Besides, the investor can put to use additional funds ($19520-$160= $19360) at his discretion thereby enjoying the advantage of leverage. Let's compare the percentage returns in both the situations assuming that the position were liquidated when the price for spot gold (purchased @ $ 610/ troy oz) rose to $630 and the call option was liquidated at a premium of $ 18.
Additional income on idle assets- Options benefit investors by enabling them to earn additional income on assets which are lying idle with them. For example, X possesses the ownership in 1 kilo of physical gold bought at a price of $650/troy oz. X can earn premium by writing appropriate out-of-the-money options depending upon his view on the market. Say, for example, X is of the view that the price of gold will move sideways and the volatility will remain low. He can, therefore, write an out-of-the-money(670 strike) DGCX gold call option say at a premium of $5. If gold price move as per his expectations, the call option sold by him will expire worthless. This will enable X to earn and keep the premium money of $160($5*32oz) received from the call's sale. The additional income/cash flow so generated helps in reducing the holding cost of the asset. Gold traders who carry large stocks of physical gold can use options to generate income against their inventory holdings.
Suitable for all market conditions- A major benefit of trading options is that they are suitable for all market conditions. The flexible nature of options allows one to build an appropriate strategy irrespective of the fact whether the market is trending or moving sideways. Depending on the specific need of the option trader which may be based upon his view on the market, a combination of any one or more of the basic strategies (long call, long put, short call and short put) can be used to create other interesting strategies like straddle, strangle, butterfly spread etc.
Flexibility- Yet another advantage of options is that they offer more strategic investment alternatives. Options provide a very flexible tool. There are many ways to use options to recreate or mimic other positions. These positions are better known as synthetics. Options allow the investor to trade not only the underlying asset's movements, but also the passage of movements in volatility. Only options offer the strategic alternatives necessary to profit in every type of market. ...