Professional option traders use theoretical Option pricing models throughout the options industries. These models are rather complicated formulas that take six quantifiable factors and produce theoretical value for an option.
Six Quantifiable Factors
Theoretical Option Pricing Mode
Theoretical Option Value
Professional traders use the theoretical option values generated from these models as a trading guide. These models are often viewed as essential tools for maintaining large option positions .An option pricing model assists the trader in keeping the prices of Calls and Puts in proper numerical relationships with each other
The Six Factors are:
1) Stock Price
2) Volatility
3) Time Decay
4) Strike Price
5) Dividends
6) Interest Rate
A change in any one factor will result in a change to the options theoretical price
Black & Scholes is the first theoretical option-pricing model.
Pricing models are applied by some professional traders and not by all. Applying this do not guarantee and nor do the real time option price match to any particular model.
Options are low risk instruments in the markets as compared to futures and one should know the risk reward ratio before entering into any position in the market.
There are various factors which affect the real time option values and it is nearly next to impossible to predict the price and the direction of the option with certainty at any point of time .If Volatility, Dividends and Interest rates vary then the theoretical models are no longer true.
Option Contract
An equity option is a securities which conveys to its owner the right but not the obligation, to buy or sell a particular stock at a specified price on or before a given date. The seller of the option grants this right.
There are two types of options Call Option and Put Option
Call Option:
Before expiry of the option the owner of equity call option has the right to purchase and the writer has the obligation to sell.
Put Option:
Before expiry of the option the owner of a put option has the right to sell and the writer has the obligation to purchase.
When you are long on an equity option contract you are in control because the maximum risk is the amount, which you have paid for the option.
When you are short (i.e. you are a writer) of an equity option contract you are not in control because there are two reasons:
1) The writer can be assigned at any point of time before expiry.
2) Theoretically put or call sold means beyond a point of price the loss is unlimited.
In India, American Options are traded where the owner has the right to exercise the option contract on are at any point of time before expiry. The lot size on ach and every stock varies in quantity. The different between the strike prices are standardized by the exchanges and the expiry is the last Thursday of every month.
Premium:
The option premium is a non-refundable premium, which is on per share basis, and the buyer pays the premium and the writer keeps the premium.
The strike price are defined in three different terms In-the-Money, At-the–Money and Out-of-the- Money.
In the Money: When the strike price is less then the current stock price
For eg, ABC stock price is 2200 so 2100 strike price options would be considered as in- the-money. (ITM)
At-the-Money: When the strike price and the current stock price are same
For e.g., ABC stock price is 2200, so the 2200 strike price would be considered as At-the-Money (ATM).
A nominal amount is considered when the current stock price is near to the strike price it is also considered as ATM
Out-of-the-Money: When the strike price is greater than the current stock price
For eg, ABC stock price is 2200 so 2300 strike price would be considered as Out-of-the-Money.OTM
Options Calculation:
The 1st is Intrinsic Value for Call
: The Intrinsic value reflects the amount; if any by which the option is ITM .ATM may not have intrinsic values at all and OTM do not have intrinsic value.
Formula with e.g., Calls Intrinsic Value =ABC stock price-calls price
ABC stock price is 2200 so the 2150 intrinsic value would be 50.
The Puts Intrinsic value: Puts strike price –ABC stock price
For e.g., ABC stock price is 2200 so the 2250 puts value would be 2250-2200=50.
The 2nd is Time Value :It is whatever the premium the option has in addition to its intrinsic value .For ATM and OTM all premiums are considered time value.
Summary:
The time value of an options premium is greatest when the stock price and the option price are equal, so when ATM options are highest they do not have intrinsic values so the entire premium consists of time value.
Remember any option that expires unexercised becomes worthless.
There are some non- quantifiable factors that also affect the option price
1) Estimation of stocks future volatility
2) Fundamentally or technically estimation on future performance.
3) Supply and Demand both in options as well as futures and cash.
4) Volume and the quantity of options traded on one day
These factors make it impossible to predict the exact value of any option at any time.
Due to low liquidity in options the Bid-Ask price difference is also some times very big and at times it is possible that only the old economy stocks are the low value momentum stocks options are liquid.
Traders fear in two ways to trade in options that is lack of proper knowledge of the “pros and cons”, or short selling and they feel buying futures is more simple and not at all complicated as in options.
It is always observed that the open positions in the options market is always very small as compared to futures.
Factors, which affect the Option price:
Stock price up =call up and put down
Stock Price down=call down and put up
Volatility
All other factors if assumed remained constant
Volatility up =call up and put down
Volatility down=call down and put up.
Volatility does not imply a bias movement in one direction or the other. It is simply a measurement by which a stock is expected to fluctuate in a given period of time .The higher the volatility the probability of larger moves on either ways in stock price and the option prices are also higher.
Volatility is nowhere published in any form of media, so it is not directly observable.
Price fluctuation =Volatility
Each stock has its own unique volatility pattern
Standard Deviation =Volatility
Standard deviation is the square root of the variance calculated for the closing sample prices under revives.
Rules of thumb:
(+/-) 1st Std. Dev. covers approx 68% of all closing prices
(+/-) 2nd Std. Dev. covers approx 95% of all closing prices
(+/-) 3rd Std. Dev. covers approx 99% of all closing prices.
For e.g., ABC scrip price is 600. Its daily trading history for the last year is used to calculate on annualized volatility equal to 30%
So 1 std dev equals 180
1 std dev =ABC *Volatility
1 std dev =600*.30
1 std dev =180
So in one-year time one could expect ABC to be trading between
420 and 780 (600+/-180) approx 68 % of time
240 and 960 (600+/-360) approx 95% of time
60 and 1140(600+/-540) approx 99% of time
Volatility is the most sensitive variable used in determining option prices
There are three types of volatility
Historical Volatility
Implied Volatility
Forecast Volatility
Historical volatility is based on past performance and is expected or assumed to repeat itself.
Implied volatility is the volatility that gives the investor the current stock price for the option; by determining the implied volatility of ABC options the investor can monitor the markets current opinion about the volatility of ABC.
Time Value:
Since an option is usually worth its intrinsic value it is time value part of an option, which falls victim to “Father Time”.
If all the other things held constant
Days until expiration is up =call price up and put price up
Days until expiration down =call price down and put price down.
The amount of an option decays each day (known as “Theta”) begins to accelerate as expiration approaches.
Strike Price:
It is the option strike price related to the stock price, which determines whether or not an option is ITM or OTM.Intrinsic value can be thought of as the ITM portion of an option price .If all other things held constant
Strike Price up=call down and put up
Strike Price down=call up and put down
As the stock price falls or raises the intrinsic value of an ITM option will change as the price of the underlying stock changes. As ITM options are the only options having intrinsic value so they are the only options with any value on expiration day. An option, which was OTM, may become ITM or vice versa. An option, which had only intrinsic value because it was ITM, may become an OTM option with only time value
Dividends:
The stock price is adjusted downward by the amount of dividend. The larger the dividend pay out, the larger impact on stocks prices. Thus expected future decrease in the price of the underlying has an impact on its options .If all other things being held constant
Cash Dividends up =call down and put up
Cash Dividends down=call up and put down
Dividend dates; There are three types of distinct dates associated with companies dividend payment (i) The Ex dividend date: This is the date when a purchaser of the stock would not be entitled to receive the dividend, (ii)Record Rate: All recorded owners of a company’s stock on the record date are entitled to receive the current dividend payment.
(iii) Payment Date: This is the date when the company actual pays the dividend to share holders.
Interest Rates: If all other things held constant
Interest Rate up =Call up and put down
Interest Rates down =Call down and put up
Greeks:
Delta:
Options have a characteristic called “Delta”. The delta reflects options sensitivity to a change in stock price.” Delta” is not constant it changes as the input factor changes. All the calls and puts have its own unique delta.
Delta= change in option/ change in stock
For e.g. ABC in the morning is trading for 590.35 and the call is 55, Later that afternoon ABC is trading at 600.35 and the call is 60 rs. Using historical data and the equation above the options delta can be as follows
Delta=60-55/600.35-590.35=5/10=0.5=50% so delta is 50.
Let us take a reverse e.g.
ABC is 590.35 and 600 call is 55 and has a theoretical delta of 56, the price which the call would be if the ABC moves by 10 would be 10*0.56=5.60
49.40 and 60.60 respectively on both the sides.
So change in stock*”Delta”=change in option
Call deltas are always positive
As time passes and expiration nears a call options delta will rise to 100 for deep ITM calls, stay near 50 for ATM calls and fall to 0 for OTM calls.
Puts deltas are always negative “nos”
As time passes and expiration nears a put option ‘s delta will rise to –100 for deep ITM puts, stay near –50 for ATM puts and fall to-0 for OTM puts
The delta of an underlying stock is always 1
For any put and call with same strike price and expiration month the sum of their absolute value of their deltas will total 100.
Gamma:
A rate of change in options delta, Gamma is not constant. Gamma is the largest when the option is ATM
Call and Put with the same strike price and expiration the gamma for both options is the same.
Theta
Theta of an option is the rate at which an option’s value erodes per unit of time. Theta measures are more commonly referred to as the options time decay.
Theta is not constant.
Vega:
An options Vega represents the sensitivity of an options theoretical value to a change in volatility. Vega is not constant .K Vega is not a Greek letter .It is commonly used as a substitute for” kappa” because of its ease of identification: Vega/Volatility.
Options investing like other forms of investing involves tax considerations, transaction costs and margin requirements, that can significantly affect the profit or loss results of buying and writing options. Neverthless it should be remembered that their impact may significantly reduce the opportunity for profit and the rate of return obtainable from particular options trading strategies; indeed their effect may in some instances turn an apparent profit into a loss.
Call Options :
Long calls: Select a stock that will advance in price
Select an expiration month that insures the expected advance will occur before the option expires Select a strike price so that the potential benefits of the advance are balanced with the possibility of losing the entire premium
When to use Long calls: Bullish
Simply thinking that ABC is a good company &that is sure to go up is not enough .A call purchase based on stock vague notions to cause frustration as losses mount when the advances fail to materialize.
Why Buying Calls?
(i)The bullish speculator wanting to take advantage of the leverage options can offer.
(ii)The investor buying a call as a substitute for buying the stock.
Long call offers the bullish investor unlimited profit potential and limited downward risk.
Break Even Point: At expiration the Breakeven point (B.E) is equal to the strike price of the call option plus the call options premium
Short Calls:
Select the stock that will decline in price, if it does not decline okay but it should not move up. Call writing can be viewed as neutral or bullish
3 reasons why call writing is done
(a)Unaware of less risky bearish strategies (b) Strongly hopes that ABC stock cannot go any higher (c) Time Decay.
Profits are limited and losses are unlimited
Break-even point: At expiration the breakeven point is equal to the strike price of the call plus the call options premium.
Put Options:
Long Put: Puts like buying is for the investor who thinks that the stock price will decline
Put buyer looks to protect a long position in the stock position for a period of time covered by the option
Stockowner who buys puts is able to:
(a) Retain stock ownership for further upside potential and any dividends. (b) Establish a guaranteed minimum selling price by having the right to sell ABC stock at the puts strike and (c) insure that most of the assets current value is protected.
OTM and ATM puts decay slower then OTM and ATM calls.
As the option becomes more and more ITM, ITM puts lose their time value faster than ITM calls.
Breakeven point-At expiration the breakeven is equal to the strike price of the put option minus the put options premium
Short Puts: A put writer is an investor who sells a put option minus the put options premium
Profits are limited and losses is unlimited
Investor write put for two major reasons (i) to receive the premium income and to acquire stock at a net cost below the current market price.
An option writer, if assigned is obligated to either sell ABC at the strike price (call writer) or buy ABC at the strike price (Put writer), so writing covered calls can be compared to owning a stock.
Breakeven point. At expiration the (B.E) is equal to the strike price of the put option minus the put options premium.
Spread
A spread is a position consisting of at least two pieces, each of which alone would profit from opposite directional price moves in the ABC
There are two types of basic spreads: Time spreads & Vertical spreads
Time spread: A time spread is an option strategy, which involves options with the same strike price but the different expiration months.
Vertical spreads: A vertical spread is an option strategy, which involves options within the same expiration month but with different strike price.
Time Spreads: Bullish, Bearish and Neutral strategies can be formed depending upon the relation ship of strike price.
A Calendar or Horizontal Spread involves buying a call or a put with one expiration and writing the same strike call (put) with an earlier expiration
For e.g. Short 1 ABC Aug 2000 call @50, Long 1 ABC sept 2000 call @70
When the investor is confident that the price of ABC will be at or near the strike price as the near term option expires.
If the strike price is selected than current strike price has a bullish bias and if close to, a neutral bias.
Break even points: The spread has two break even points one some distance above and other some distance below the spreads strike price .If ABC moves significantly from the strike price Losses will be incurred.
ITM and OTM time spreads gain very little from time decay since there is little time value to erode in the short option
Increase/decrease in volatility benefits and hurts the spreads respectively
Spreads maximum loss is limited
Vertical Spreads: Bullish or Bearish strategies can be formed depending on which option is purchased or written.
A Bull Spread or a Bear Spread depending upon the options selected involves buying a call option or a put option and simultaneously writing another call with the same expiration but with a different strike price.
For e.g.
Long 1 ABC 2000 Aug call @50
Short 1 ABC 2100 ague call @15
Bull Spread =Long call strike <Short call strike
= Long put strike < short put strike
For Bull Call spreads Conservative spread=Long call=ITM
For Bull Put Spreads ITM=2 strike price, he more aggressive is the spread
Bear Spread = Long call strike >short call strike
=Long put strike>short put strike
For Bear call spread the more short call ITM, the more aggressive the spread
For Bear put spread the more OTM =2 strike price, the more aggressive the spread
This is done by investors who hedges his positions
This is a limited risk limited reward strategy.
B.E points: Call (Vertical Spread) Lower strike price+spread price
Put (Vertical Spread) higher strike price –spread price
Bullish Strategies
1)Buying naked call option
2)Synthetic long call (Married Put): For e.g. Long 1 put of Aug ABC 1700 put @50
Long (Lot sized shares) ABC @1700
As long as the put is owned the strategy risk reward ratio profile is equivalent to Long Call
3)Short Naked Put
4)Covered Write: For e.g. Short 1 call of Aug 2000 strike price of ABC @50
Long (Lot sized shares) ABC @2000
This strategy’s risk reward is equivalent to a written put.
5)Covered Straddle: For e.g..
Short 1 Aug ABC 2000 call @50
Short 1 Aug ABC 2000 put @40
Long (Lot sized shares) ABC @2000
Covered straddle is a combination of Covered call write plus writing puts
This is used mostly when the stock is expected to move sideways, so if the stock price remains the same at the expiry the investor would collect both the premiums.
If the ABC stock declines than the Put will be assigned and the stock position will be doubled. Profits are limited but more than a covered call. Losses are unlimited
B.E point: stock price +straddle premium/2
If volatility increases both the options increase in price and vice versa.
With the written options the investor must watch ABC for possible assignment on whichever option is then currently ITM
The put is one that should concern, because the stock position doubles and if ABC declines the value of the holding stock too declines so one should re examine his original bullish opinion.
6) Synthetic Long stock:(Collar)
For e.g. Short 1 ABC Aug 1700 put @40
Long 1 ABC Aug 1750 call @25
Unlimited risk and unlimited rewards.
This is used when the stock is at a mid point between two-strike prices, first the spread is often established for little or no debit and secondly it provides a little room for ABC to decline before the Put becomes ITM
B.E point: If debit spread, call strike price +spread debit
If credit spread Put strike price –spread credit
If ABC is near long call strike price, time decay is negative,
If ABC is near short put strike price, time decay is positive.
Volatility increase or decrease do not affect and stays as it affects on both the sides.
Bearish Strategies;
1)Buy Naked Put
2)Synthetic Long Put: for e.g. Long 1 ABC 1700 Aug call @50
Short (Lot sized shares) ABC @1700
As long as the call is owned the strategy’s risk/reward ratio is equivalent to a long put.
Profit is limited, only by the assumption that value cannot decline below zero and as long as the call option is owned losses are limited
B.E point: Selling price of ABC stock –premium paid for call
Volatility increase and decrease has a positive as well
3)Short call: Losses are unlimited and profits are limited.
4)Synthetic short stock (Collar)
For E.g.. Long 1 ABC Aug 1700 put @25
Short 1 ABC Aug 1750 call @12
This strategy is used using two different strike prices.
Unlimited risk and unlimited reward
This is used when ABC is near the mid point between two split strike prices. Firstly the spread is often established for little or no debit. And secondly it provides a little room for ABC to rally before the short call becomes ITM.
B.E point If debit spread =Put strike price –spread debit.
If credit spread =call strike price –spread credit
If ABC is near long put strike price time decay is negative
If ABC is near short call strike price time decay is positive.
Volatility does not make a difference if increased or decreased
One should watch ABC for possible assignment if ABC rallies above the calls strike price.
5)Ratio Put Spread : For e.g. Short 2 Aug ABC 2200 puts @25
Long 1 Aug ABC 2250 put @50
Bear put spread and short put are two strategies involved in this strategy. Most attractive when ABC is between 2 strike prices e.g. 2200 and 2250
This strategy has a limited upside risk downside risk can be large fib has a large decline before expiration.
Maximum profit =Strike price differential *no. Of long puts-net total debit (or plus net total credit)
B.E. points for debit spread –upside breakeven point = the strike price of long put-the positions net debit.
Downside B.E. point =to the lower strike price –(maximum profit potential/# of naked puts.) If ABC is near the strike price of 2 written puts. Profits from decay accelerate almost rapidly over time. If near strike price of long put, impact of time decay is negative.
Volatility increase would be negative for the spread
ABC assignment can be possible if ABC is below lower strike price as expiration approaches.
Neutral Strategies
Short Straddle : For e.g. Short 1 ABC Aug call of 1700 strike price @ 50
Short 1 ABC Aug put of 1700-strike price @45
A combination of writing calls and puts
When the stock is expected to stay in a narrow range then this strategy is used. The risk would be substantial if a large move on either side occurs.
The maximum profit is at the strike price 1700 at expiration
Because stock ownership is possible due to written put, the downside risk can be large if ABC has a large decline before expiration.
If the stock moves upside the risk can be large because the written call option becomes similar to a short stock position beyond the B.E. point.
B.E. Upside: Strike + premium received
Downside: Strike – premium received
An increase in volatility is negative for this spread it is imp. To look that the implied volatilities of ABC are near historic highs before considering of writing a straddle.
The risk of possible assignment of ABC is either if it is significantly above or below the strike price as expiration approaches.
One alternative is to purchase the 1800 call. This caps the upside exposure leaving a position equivalent to a long stock position should ABC decline.
2) Long Butter Fly
For e.g. Long 1 ABC Oct 2000 put @40
Short 1 ABC Oct 2050 call @75
Short 1 ABC Oct 2050 put @70
Long 1 ABC Oct 2100 call @45
A long butter fly is a short straddle with a conservative twist, By purchasing 2 OTM options 91 put and 1 call) the investors maximum risk exposure becomes definable.
The long butterfly is used who wants to profit from narrow trading for ABC but does not want to make unlimited loss by the sale of a straddle.
This strategy has limited risk and the max profit is at strike price at expiration =to spreads initial credit
B.E. points: Upside strike price of straddle + net premium received
Down side strike price of straddle – net premium received
An increase in volatility is negative for this spread
If ABC moves significantly above or below the strike price as expiration approaches than there is a possibility of assignment.
3)Short Combination: For e.g. Short 1 ABC aug 2000 put @40
Short 1 ABC ague 2100 call @60
A short combination is same as short straddle with one difference. Instead of using options of same strike price the investor uses two OTM options in the hope of limited loss.
