OPTIONS

Portfolio investments normally include mutual funds stocks and bonds. The type
of securities not end here, as ̳options ̳present a world of opportunity to sophisticated
investors, as another type of security with their veracity. Options can be as speculative
or as conservative as one wants. They are complex securities and can be extremely
risky. But at the same time ignorant of this type of investment places one in a weak
position. Without knowledge about options, one would not only forfeit having another
item in ones investing toolbox but also lose insight into the workings of some of the
world's largest corporations. Whether it is to hedge his risk of foreign-exchange
transactions or to give employees ownership in the form of stock options, most multi-
nationals today use options in some form or another.

Options-Meaning An option is a contract whereby one party (the holder or buyer) has
the right, but not the obligation, to exercise the contract (the option) on or before a future
date (the exercise date or expiry). The other party (the writer or seller) has the obligation
to honor the specified feature of the contract. Since the option gives the buyer a right and
the seller an obligation, the buyer has received something of value. The amount the buyer
pays the seller for the option is called the option premium

Because this is a security whose value is determined by an underlying asset, it

is classified as a derivative. The idea behind an option is present in everyday situations.
For example, you discover a house that you'd love to purchase. Unfortunately, you
won't have the cash to buy it for another three months. You talk to the owner and
negotiate a deal that gives you an option to buy the house in three months for a price
of Rs.200, 000. The owner agrees, but for this option, you pay a price of Rs.3, 000.
Now, consider two theoretical situations that might arise: 1.It's discovered that the
house is actually the true birthplace of a great man. As a result, the market value of
the house skyrockets to Rs.1 crore. Because the owner sold you the option, he is
obligated to sell you the house for Rs.200, 000. In the end, you stand to make a profit
ofRs.97, 97,000(Rs.1 Crore–Rs.200, 000 –Rs.3, 000). 2. While touring the house, you
discover not only that the walls are chock-full of asbestos, but also that a ghost haunts
the master bedroom; furthermore, a family of super-intelligent rats have built a fortress
in the basement. Though you originally thought you had found the house of your
dreams, you now consider it worthless. On the upside, because you bought an option,
you are under no obligation to go through with the sale. Of course, you still lose the
Rs.3, 000 price of the option. This example demonstrates two very important points.
First, when you buy an option, you have a right but notan obligation to do something.
You can always the expiration date go by, at which point the option becomes worthless.
If this happens, you lose 100% of your investment, which is the money you used to pay
for the option. Second, an option is merely a contract that deals with an underlying
asset. For this reason, options are called derivatives, which mean an option derives its
value from something else. In our example, the house is the underlying asset. Most of
the time, the underlying asset is a stock or an index.

Participants in the Options Market

There are four types of participants in options markets depending on the
position they take: They are:
1. Buyers of calls
2. Sellers of calls
3. Buyers of puts
4. Sellers of puts
People who buy options are called holders and those who sell options are called
writers: furthermore, buyers are said to have long positions, and sellers are said to
have short positions. -Call holders and put holders (buyers) are not obligated to buy or
sell. They have the choice to exercise their rights if they choose. -Call writers and put
writers (sellers), however, are obligated to buy or sell. This means that a seller may be
required to make good ona promise to buy or sell.
There are many different types of options that can be traded and these can be
categorized in a number of ways. In a very broad sense, there are two main types: calls
and puts. Calls give the buyer the right to buy the underlying asset, while puts give the
buyer the right to sell the underlying asset. Along with this clear distinction, options
are also usually classified based on whether they are American style or European style.
This has nothing to do with geographical location, but rather when the contracts can
be exercised. You can read more about the differences below.
Classification of options

Options can be further categorized based on the method in which they are traded, their
expiration cycle, and the underlying security they relate to. There are also other specific
types and a number of exotic options that exist. On this page we have published a
comprehensive list of the most common categories along with the different types that
fall into these categories. We have also provided further information on each type.

 Calls
 Option Type by Expiration
 Puts
 Option Type by Underlying Security
 American Style
 Employee Stock Options
 European Style
 Cash Settled Options
 Exchange Traded Options
 Exotic Options
 Over The Counter Options

Calls

Call options are contracts that give the owner the right to buy the underlying
asset in the future at an agreed price. You would buy a call if you believed that the
underlying asset was likely to increase in price over a given period of time. Calls have
an expiration date and, depending on the terms of the contract, the underlying asset
can be bought any time prior to the expiration date or on the expiration date.

Puts

Put options are essentially the opposite of calls. The owner of a put has the right
to sell the underlying asset in the future at a pre-determined price. Therefore, you
would buy a put if you were expecting the underlying asset to fall in value. As with
calls, there is an expiration date in the contact.

American Style

The term “American style” in relation to options has nothing to do with where
contracts are bought or sold, but rather to the terms of the contracts. Options
contracts come with an expiration date, at which point the owner has the right to buy
the underlying security (if a call) or sell it (if a put). With American style options, the
owner of the contract also has the right to exercise at any time prior to the expiration
date.

European Style

The owners of European style options contracts are not afforded the same
flexibility as with American style contracts. If you own a European style contract then
you have the right to buy or sell the underlying asset on which the contract is based
only on the expiration date and not before.

Exchange Traded Options

Also known as listed options, this is the most common form of options. The term
“Exchanged Traded” is used to describe any options contract that is listed on a public
trading exchange. They can be bought and sold by anyone by using the services of a
suitable broker.

Over The Counter Options

“Over The Counter” (OTC) options are only traded in the OTC markets, making
them less accessible to the general public. They tend to be customized contracts with
more complicated terms than most Exchange Traded contracts.

Option Type by Underlying Security

When people use the term options they are generally referring to stock options,
where the underlying asset is shares in a publically listed company. While these are
certainly very common, there are also a number of other types where the underlying
security is something else. We have listed the most common of these below with a brief
description.

Stock Options: The underlying asset for these contracts is shares in a specific
publically listed company.

Index Options: These are very similar to stock options, but rather than the underlying
security being stocks in a specific company it is an index – such as the S&P 500.

Forex/Currency Options: Contracts of this type grant the owner the right to buy or
sell a specific currency at an agreed exchange rate.
Futures Options: The underlying security for this type is a specified futures contract.
A futures option essentially gives the owner the right to enter into that specified
futures contract.

Commodity Options: The underlying asset for a contract of this type can be either a
physical commodity or a commodity futures contract.

Basket Options: A basket contract is based on the underlying asset of a group of

securities which could be made up stocks, currencies, commodities or other financial
instruments

Option Type By Expiration

Contracts can be classified by their expiration cycle, which relates to the point to
which the owner must exercise their right to buy or sell the relevant asset under the
terms of the contract. Some contracts are only available with one specific type of
expiration cycle, while with some contracts you are able to choose. For most options
traders, this information is far from essential, but it can help to recognize the terms.
Below are some details on the different contract types based on their expiration cycle.

Regular Options: These are based on the standardized expiration cycles that
options contracts are listed under. When purchasing a contract of this type, you will
have the choice of at least four different expiration months to choose from. The reasons
for these expiration cycles existing in the way they do is due to restrictions put in place
when options were first introduced about when they could be traded. Expiration cycles
can get somewhat complicated, but all you really need to understand is that you will be
able to choose your preferred expiration date from a selection of at least four different
months.

Weekly Options: Also known as weeklies, these were introduced in 2005. They
are currently only available on a limited number of underlying securities,including
some of the major indices, but their popularity is increasing. The basic principle of
weeklies is the same as regular options, but they just have a much shorter expiration
period.

Quarterly Options: Also referred to as quarterlies, these are listed on the

exchanges with expirations for the nearest four quarters plus the final quarter of the
following year. Unlike regular contracts which expire on the third Friday of the
expiration month, quarterlies expire on the last day of the expiration month.

Long-Term Expiration Anticipation Securities: These longer term contracts are

generally known as LEAPS and are available on a fairly wide range of underlying
securities.

Employee Stock Options

These are a form of stock option where employees are granted contracts based
on the stock of the company they work for. They are generally used as a form of
remuneration, bonus, or incentive to join a company.

Cash Settled Options

Cash settled contracts do not involve the physical transfer of the underlying
asset when they are exercised or settled. Instead, whichever party to the contract has
made a profit is paid in cash by the other party. These types of contracts are typically
used when the underlying asset is difficult or expensive to transfer to the other party.

Exotic Options

Exotic option is a term that is used to apply to a contract that has been
customized with more complex provisions. They are also classified as Non-
Standardized options. There are a plethora of different exotic contracts, many of which
are only available from OTC markets. Some exotic contracts, however, are becoming
more popular with mainstream investors and getting listed on the public exchanges.
Below are some of the more common types.

Barrier Options: These contracts provide a pay-out to the holder if the

underlying security does (or does not, depending on the terms of the contract) reach a pre-
determined price.

Binary Options: When a contract of this type expires in profit for the owner, they
are awarded a fixed amount of money.

Chooser Options: These were named "Chooser," options because they allow the
owner of the contract to choose whether it's a call or a put when a specific date is
reached.
 Compound Options: These are options where the underlying security is another
options contract.

Look Back Options: This type of contract has no strike price, but instead allows
the owner to exercise at the best price the underlying security reached during the term
of the contract

Moneyness of the Options

Moneyness refers to the potential profit or loss from the exercise of an option. At
any time before the expiration, an option may be in-the-money, at-the-money, out-of-
the money.

1. In-the-money options:
An in-the-money (ITM) option is an option that would lead to a positive cashflow
to the holder if it were exercised immediately. A call option on the index is said to be in-
the-money when the current index stands at a level higher than the strike price (i.e.
spot price> strike price). If the index is much higher than the strike price, the call is
said to be deep ITM. In the case of a put, the put is ITM if the index is below the strike
price.
2. At-the-money option:
An at-the-money (ATM) option is an option that would lead to zero cashflow if it
were exercised immediately. An option on the index is at-the-money when the current
index equals the strike price (i.e. spot price = strike price).
3. Out-of-the-money option:
An out-of-the-money (OTM) option is an option that would lead to a negative
cashflow if it were exercised immediately. A call option on the index is out-of-the-
money when the current index stands at a level which is less than the strike price
(i.e. spot price < strike price). If the index is much lower than the strike price, the call
is said to be deep OTM. In the case of a put, the put is OTM if the index is above the
strike price. Intrinsic value and time value

To buy an option, an investor must pay an option premium. The option premium
can be thought as the sum of two different numbers that represent the value of the
option. The first is the current value of the option, known as the intrinsic value. The
second is the potential increase in value that the option could gain over time, known as
the time value.

Intrinsic Value of an Option

The intrinsic value of an option represents the current value of the option, or in
other words how much in the money it is. When an option is in the money, this means
that it has a positive payoff for the buyer. A $30 call option on a $40 stock would be
$10 in the money. If the buyer exercised the option at that point in time, he would be
able to buy the stock at $30 from the option and then subsequently sell the stock for
$40 on the market, capturing a $10 payoff. So the intrinsic value represents what the
buyer would receive if he decided to exercise the option right now. For in the money
options, intrinsic value is calculated as the difference of the current price of the
underlying asset and the strike price of the option.

For options that are out of the money or at the money, the intrinsic value is
always zero. This is because a buyer would never exercise an option that would result
in a loss. Instead, he would let the option expire and get no payoff. Since he receives no
payoff, the intrinsic value of the option is nothing to him.

Time Value of an Option

The time value of an option is an additional amount an investor is willing to pay

over the current intrinsic value. Investors are willing to pay this because an option
could increase in value before its expiration date. This means that if an option is
months away from its expiration date, we can expect a higher time value on it because
there is more opportunity for the option to increase or decrease in value over the next
few months. If an option is expiring today, we can expect its time value to be very little
or nothing because there is little or no opportunity for the option to increase or
decrease in value.

Time value is calculated by taking the difference between the option’s premium and
the intrinsic value, and this means that an option’s premium is the sum of the intrinsic
value and time value:

 Time Value = Option Premium - Intrinsic Value

  Option Premium = Intrinsic Value + Time Value

Difference between futures and options

Basis for
Futures Options
Comparison
Options are the contract in which the
Futures contract is a binding
investor gets the right to buy or sell
agreement, for buying and selling
the financial instrument at a set
Meaning of a financial instrument at a
price, on or before a certain date,
predetermined price at a future
however the investor is not obligated
specified date.
to do so.
Obligation of
Yes, to execute the contract. No, there is no obligation.
buyer
Execution of Anytime before the expiry of the
On the agreed date.
contract agreed date.
Risk High Limited
Advance
No advance payment Paid in the form of premiums.
payment
Degree of
Unlimited Unlimited profit and limited loss.
profit/loss

Difference between Forwards and Options

Forwards Options
1. Both buyer and seller have 1. Only the seller has an obligation
obligations 2. Standardized contract
2. Customized contract 3. Trade in stock exchanges
3. Not traded in stock exchange 4. The buyer pays premium to the
4. There is no premium and margin seller, while the seller deposits
5. Expiry date depends upon the margin initially with subsequent
 transactions deposits made depending on the
market

Positions in the option contract

There are four types of option positions. They are briefly explained as below.
1. Long position in a call option
A person who buys a call option is said to have a long position in a call option. He
purchases the right, but not the obligation to buy underlying asset at the stated exer
cise price at any time before the option expires. In short, long means buy.
2. Long position in a put option
A person who buys put option is said to have a long position in a put option. He
buys the right, but not the obligation, to sell the underlying asset at the stated exercise
price at any time before the option expires.
3. Short position in a call option
A person who sells a call option is said to have a short position in a call option. He
sells the right to buy the asset.
4. Short position in a put option

A person who sells a put option is said to have a short position in a put option. He
sells the right to sell the asset at a fixed price. He has the obligation to buy the
underlying asset at the stated exercise price.

Pay-off for options

The optionality characteristic of options results in a non-linear payoff for options. In

simple words, it means that the losses for the buyer of an option are limited, however
the profits are potentially unlimited. The writer of an option gets paid the premium.
The payoff from the option writer is exactly opposite to that of the option buyer. His
profits are limited to the option premium, however his losses are potentially unlimited.
These non-linear payoffs are fascinating as they lend themselves to be used for
generating various complex payoffs using combinations of options and the underlying
asset. We look here at the four basic payoffs.
 1. Payoff for buyer of call options:

Long call A call option gives the buyer the right to buy the underlying asset at the
strike price specified in the option. The profit/loss that the buyer makes on the option
depends on the spot price of the underlying. If upon expiration, the spot price exceeds
the strike price, he makes a profit. Higher the spot price, more is the profit he makes. If
the spot price of the underlying is less than the strike price, he lets his option expire un-
exercised. His loss in this case is the premium he paid for buying the option. Figure
1.1 gives the payoff for the buyer of a three month call option on gold (often referred to
as long call) with a strike of Rs. 7000 per 10 gms, bought at a premium of Rs. 500.

The figure shows the profits/losses for the buyer of a three-month call option on
gold at a strike of Rs. 7000 per 10 gms. As can be seen, as the prices of gold rise in the
spot market, the call option becomes in-the-money. If upon expiration, gold trades
above the strike of Rs. 7000, the buyer would exercise his option and profit to the
extent of the difference between the spot gold-close and the strike price. The profits
possible on this option are potentially unlimited. However if the price of gold falls
below the strike of Rs. 7000, he lets the option expire. His losses are limited to the
extent of the premium he paid for buying the option.
 2. Payoff for writer or call options: short call

A call option gives the buyer the right to buy the underlying asset at the strike price
specified in the option. For selling the option, the writer of the option charges a
premium. The profit/loss that the buyer makes on the option depends on the spot price
of the underlying. Whatever is the buyer’s profit is the seller’s loss. If upon expiration,
the spot price exceeds the strike price, the buyer will exercise the option on the writer.
Hence as the spot price increases the writer of the option starts making losses. Higher
the spot price, more is the loss he makes. If upon expiration the spot price of the
underlying is less than the strike price, the buyer lets his option expire un-exercised
and the writer gets to keep the premium. Figure 6.2 gives the payoff for the writer of a
three month call option on gold (often referred to as short call) with a strike of Rs. 7000
per 10 gms, sold at a premium of Rs. 500.

3. Payoff for buyer of put options:

Long put 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 option
depends on the spot price of the underlying. If upon expiration, the spot price is below
the strike price, he makes a profit. Lower the spot price, more is the profit he makes. If
the spot price of the underlying is higher than the strike price, he lets his option expire
un-exercised. His loss in this case is the premium he paid for buying the option.
PAYOOF FOR BUYER OF A PUT: LONG PUT

PAYOFF FOR WRITER OF A PUT: SHORT PUT

4. Payoff profile for writer of put options: Short put

A put option gives the buyer the right to sell the underlying asset at the strike price
specified in the option. For selling the option, the writer of the option charges a
premium. The profit/loss that the buyer makes on the option depends on the spot price
of the underlying. Whatever is the buyer’s profit is the seller’s loss. If upon expiration,
the spot price happens to the below the strike price, the buyer will exercise the option
on the writer. If upon expiration the spot price of the underlying is more than the strike
price, the buyer lets his option expire un-exercised and the writer gets to keep the
premium. Figure 6.4 gives the payoff for the writer of a three month put option (often
referred to as short put) with a strike of 2250 sold at a premium of 61.70.
Trading strategies involving stock options (uses of options)

Options open up a lot of possibilities. This means that different strategies can be
formulated by using options. Each of these strategies has a different risk/reward
profiles. Some are comparatively high risk, like purchasing call and put options. Others
are meant to earn profit if specific expectations are met.

All trading strategies involving options may be broadly classified into the following four.

1. Hedging

Hedging involves an attempt to control or manage risk by combining the purchase

or sale of an option with some position in the asset.

2. Speculation

Speculation involves the purchase or sale of an option without any position in

the underlying asset.

3. Spreading

Spreading is a case when hedging is done within the option market ie, by
simultaneous purchase and sale of option of same type.

4. Combinations

Combinations of call options and put options in various ways can also be used
to design option strategies. Different types of options strategies can be framed with
different perceptions on ris reward combinations.

Alternatively, the option strategies can be classified into bullish strategies,

bearish strategies and neutral strategies
Option trading strategies

Bullish strategies bearish strategies neutral strategy

1. Long call 1. Short call 1. Long straddle

2. Short put 2. Long put 2. Short straddle
3. Call bull spread 3. Call bear spread 3. Butterfly spread:
4. Put bull spread 4. Put bear spread long call butterfly
5. Call back spread 5. Put back spread short call butterfly
6. Covered call long put butterfly
7. Protective call short put butterfly
4. time spread:
Call time spread
Put time spread
5. condor
Long condor
Short condor
Hedging with options

Unique feature of hedging with options is that when combined with position in
the asset is protects the losses from the adverse movement while retaining the potential
gain from the favourable movement of price. The returns from the favourable side are
reduced only marginally by the amount of the premium paid.

We consider hedging with options for long and short position in an asset which
need protection against fall and rise in the prices respectively.

1. Hedging long position in stock (the protective put)

The protective put, or put hedge, is a hedging strategy where the holder of a security
buys a put to guard against a drop in the stock price of that security. A protective put
strategy is usually employed when the options trader is still bullish on a stock he
already owns but wary of uncertainties in the near term. It is used as a means to
protect unrealized gains on shares from a previous purchase.
Protective Put Construction

Long 100 Shares

Buy 1 ATM Put

The formula for calculating profit is given below:

 Maximum Profit = Unlimited

 Profit Achieved When Price of Underlying > Purchase Price of Underlying +
Premium Paid
 Profit = Price of Underlying - Purchase Price of Underlying - Premium Paid

2. Hedging short position in stock with call option

Now consider an opposite position with no asset in possession. Many of s would

wonder what protection one needs on an asset that is not owned yet. Of course, one
has nothing to lose because he does not own. Yet protection is needed if he is intending
to own the asset in near future. Possibly one does not have funds to acquire the asset
now. Such a position is considered as short position on asset. For short position, the
price fall in favourable. But price rise is unfavorable.
 3. Income generation through the strategy of writing covered call

Both the strategies discussed above aim at limiting the is of an underlying position
in an equity stock option. Both of them may be used for generating returns from the
positions in stock. To earn the premium an investor may choose to write a call option
expecting that the price will not exceed the exercise price.

4. Income generation through the strategy of writing put

The strategy of writing a covered call is used when no upside movement in price is
forecast. Similarly, when one is short on stock and no downside movement is foreseen,
an investor can decide to write a put option to increase returns in the short turn.

5. Speculations with single option

This is another trading strategy involving option. Speculative strategy with options
are rather simple. When one is bullish he will buy a call option. This call option
provides a gain if the market price exceeds the strike price. Similarly under bearish
conditions, the investor will buy put option.

Other option trading strategies (combination of options)

Options are very versatile in nature. there are a large number of trading strategies
that can be created by combination of options. These strategies are used for trading as
well as for hedging purposes. If options are combined with the objective of risk
containment it will be called hedging.

1. Straddle

A straddle consists of buying a put option and a call option with the same exercise
price and date of expiration. Straddle is an appropriate strategy for an investor who
expects a large move in the price but does not now in which direction the move will be.
Straddles may be long or short.

Long straddle

A long straddle is an options strategy where the trader purchases both a long
call and a long put on the same underlying asset with the same expiration date and
strike price. The strike price is at-the-money or as close to it as possible. Since calls
benefit from an upward move, and puts benefit from a downward move in the
underlying security, both of these components cancel out small moves in either
direction, Therefore the goal of a straddle is to profit from a very strong move, usually
triggered by a newsworthy event, in either direction by the underlying asset.

Short Straddle

A short straddle is simultaneous sale of a call and a put on the same stock, at
same expiration date and strike price.

Breakeven stock price at expiration

There are two potential break-even points:

1. Strike price plus total premium:

In this example: 100.00 + 6.50 = 106.50
2. Strike price minus total premium:
In this example: 100.00 – 6.50 = 93.50

Profit/Loss diagram and table: short straddle

Short 1 100 call at 3.30

Short 1 100 put at 3.20

Total credit = 6.50

 2. Strangle

A strangle is a combination of one call option and one put option with different
exercise prices but with same expiration date. Strangle may be long or short.

Long strangle

The long strangle, also known as buy strangle or simply "strangle", is a neutral
strategy in options trading that involve the simultaneous buying of a slightly out-of-
the-money put and a slightly out-of-the-money call of the same underlying stock and
expiration date.

Long Strangle Construction

Buy 1 OTM Call

Buy 1 OTM Put

The formula for calculating profit is given below:

 Maximum Profit = Unlimited

 Profit Achieved When Price of Underlying > Strike Price of Long Call + Net
Premium Paid OR Price of Underlying < Strike Price of Long Put - Net Premium
Paid
  Profit = Price of Underlying - Strike Price of Long Call - Net Premium Paid OR
Strike Price of Long Put - Price of Underlying - Net Premium Paid

Short strangle

The short strangle, also known as sell strangle, is a neutral strategy in options
trading that involve the simultaneous selling of a slightly out-of-the-money put and a
slightly out-of-the-money call of the same underlying stock and expiration date.

Short Strangle Construction

Sell 1 OTM Call

Sell 1 OTM Put

The short strangle option strategy is a limited profit, unlimited risk options
trading strategy that is taken when the options trader thinks that the underlying stock
will experience little volatility in the near term. Short strangles are credit spreads as a
net credit is taken to enter the trade.

The formula for calculating maximum profit is given below:

 Max Profit = Net Premium Received - Commissions Paid

 Max Profit Achieved When Price of Underlying is in between the Strike Price of
the Short Call and the Strike Price of the Short Put
 3. Strap

Strap is the reverse of strip. In this strategy, the trader buys two call options and
one put option at the same strike price and maturity. This strategy is used when the
chances of price going up are more than the chances of going it down. Thus, strap is
similar to long straddle. The only difference is the quantity traded. When the prices
increase, strap strategy will make more profit compared to long straddle because he
has bought two calls.

Strap construction

Buy 2 ATM calls

Buy 1 ATM put

Profit or loss

Maximum loss: maximum loss is limited to net premium paid. It occurs when the price
of underlying is equal to strike price of calls/puts

Maximum profit; profit is unlimited. the gains from upside movement would double
when two calls become in the money. The gains from upside movement will be larger
than straddle and remain same for downside movement

Breakeven point

There are 2 breakeven points for the strap position. These are calculated as follows.

 Upper breakeven point =strike price of calls/puts+(net premium paid/2)

 Lower breakeven point= strike price of call/puts-Net premium paid)

Strip

A strip is an option strategy that involves the purchase of two put options and
one call option all with the same expiration date and strike price. It can also be
described as adding a put option to a straddle.
Strip construction

Buy 1 ATM call

Buy 2 ATM puts

Profit or loss

Maximum loss: maximum is limited. Maximum loss =net premium paid +commission
paid

Maximum profit: profit is unlimited

Breakeven points

There are 2 break even points for the strip position. The breakeven points can be
calculated using the following formula

 Upper breakeven point= strike price of calls/puts+ net premium paid

 Lower breakeven point = strike price of calls/puts –(net premium paid /2)

Example

Suppose cash price of stock X Rs. 100. A trader buys one call and two put
options at a strike price of Rs. 100 on payment of a premium of Rs. 5 each. His total
outflow at the time of buying the strip is Rs. 15(premium). Trader will lose money
between the levels of 92.5 and 115 (breakeven points). He will suffer a maximum loss of
Rs. 15, if stock price closes at Rs. 100 on expiry. In the case of downward move in price
of the underlying stock the two put options generate values for the trader. But in the of
an upward move, only one call option generates profit.

The pay of position of s trip buyer is sown in the following diagram.

profit No profit zone

Breakeven point

price at expiration

92.5 115 stock

Max loss-15
100
 loss

when price goes down, two puts become in the money. When prices go up only one call
become in the money, making gains unequal for same rise than fall in the price.

The strip seller will earn the maximum profit if price of the stock happens to e
the strike price of the options, ie, Rs. 100 at expiry of the options. The maximum profit
will be equivalent to the total premium received ie, Rs. 15.The pay off profile of the strip
seller is shown in the following graph.
5. Option spreads strategy

Combinations, as discussed above are created by using to different types of

options on the same asset and same expiration dates, spreads are created with
positions on the same type of options on the same asset but with different strike prices.
Thus, an option spread trading strategy involves taking a position in two or more
options of the same type simultaneously on same asset but with different strike prices.

Option spread may be classified under three categories

1. Vertical spreads
2. Horizontal spread
3. Diagonal spread

Spread strategies can be evolved for bearish conditions and bullish conditions.
Accordingly, spread can be classified into bull spreads and bear spreads.

a. Bull spreads

Bull Spread is a strategy that option traders use when they try to make profit
from an expected rise in the price of the underlying asset. It can be created by using
both puts and calls at different strike prices. Usually, an option at a lower strike price
is bought and one at a higher price but with the same expiry date is sold in this
strategy.

Description: In the graphic example shown below, the user has bought a long call at
strike price 60 and shorted (sold) a long call at strike price of 65.

Bull put spread

A bull put spread is an options strategy that is used when the investor expects
a moderate rise in the price of the underlying asset. The strategy uses two put options
to form a range consisting of a high strike price and a low strike price. The investor
receives a net credit from the difference between the two premiums from the options.

Bull put spreads can be implemented by selling a higher striking in-the-money

put option and buying a lower striking out-of-the-money put option on the same
underlying stock with the same expiration date.

If the stock price closes above the higher strike price on expiration date, both
options expire worthless and the bull put spread option strategy earns the maximum
profit which is equal to the credit taken in when entering the position.
The formula for calculating maximum profit is given below:

 Max Profit = Net Premium Received - Commissions Paid

 Max Profit Achieved When Price of Underlying >= Strike Price of Short Put

b. Bear spread

A trader purchases a contract with a higher strike price and sells a contract
with a lower strike price. This strategy is used to maximize profit of a decline in price
while still limiting any loss that could occur from a steep decrease in price.

Bear call spread

A bear call spread is a type of vertical spread. It contains two calls with the
same expiration but different strikes. The strike price of the short call is below the
strike of the long call, which means this strategy will always generate a net cash inflow
(net credit) at the outset.

Breakeven stock price at expiration

Strike price of short call (lower strike) plus net premium received.

In this example: 100.00 + 1.80 = 101.80

Profit/Loss diagram and table: bear call spread

Sell 1 XYZ 100 call at 3.30

Buy 1 XYZ 105 call at (1.50)

Net credit = 1.80

Put bear spread

A bear put spread is a type of options strategy where an investor or trader

expects a moderate decline in the price of a security or asset. A bear put spread is
achieved by purchasing put options while also selling the same number of puts on the
same asset with the same expiration date at a lower strike price. The maximum profit
using this strategy is equal to the difference between the two strike prices, minus the
net cost of the options.

Bear Put Spread Construction

Buy 1 ITM Put

Sell 1 OTM Put

By shorting the out-of-the-money put, the options trader reduces the cost of
establishing the bearish position but forgoes the chance of making a large profit in the
event that the underlying asset price plummets. The bear put spread options strategy
is also known as the bear put debit spread as a debit is taken upon entering the trade.

c. Butterfly spreads

A butterfly spread is an options strategy combining bull and bear spreads,

with a fixed risk and capped profit. These spreads, involving either four calls or four
puts are intended as a market-neutral strategy and pay off the most if the underlying
does not move prior to option expiration.

Long call butterfly

A long butterfly spread with calls is a three-part strategy that is created by

buying one call at a lower strike price, selling two calls with a higher strike price and
buying one call with an even higher strike price. All calls have the same expiration
date, and the strike prices are equidistant.

Short call butterfly

A short butterfly spread with calls is a three-part strategy that is created by

selling one call at a lower strike price, buying two calls with a higher strike price and
selling one call with an even higher strike price. All calls have the same expiration date,
and the strike prices are equidistant.
Long put butterfly

The long put butterfly spread is a limited profit, limited risk options trading
strategy that is taken when the options trader thinks that the underlying security will
not rise or fall much by expiration.

Short put butterfly

The short put butterfly is a neutral strategy like the long put butterfly but
bullish on volatility. It is a limited profit, limited risk options strategy. There are 3
striking prices involved in a short put butterfly and it can be constructed by writing
one lower striking out-of-the-money put, buying two at-the-money puts and writing
another higher striking in-the-money put, giving the options trader a net credit to put
on the trade.

d. Condor spreads

A condor spread is a non-directional options strategy that limits both gains

and losses while seeking to profit from either low or high volatility. There are two types
of condor spreads. A long condor seeks to profit from low volatility and little to no
movement in the underlying asset. A short condor seeks to profit from high volatility
and a sizable move in the underlying asset in either direction.

Long condor

A long condor spread with calls is a four-part strategy that is created by

buying one call at a lower strike price, selling one call with a higher strike price, selling
another call with an even higher strike price and buying one more call with an even
higher strike price. All calls have the same expiration date, and the strike prices are
equidistant.

Short condor

The short condor is a neutral strategy similar to the short butterfly. It is a

limited risk, limited profit trading strategy that is structured to earn a profit when the
underlying stock is perceived to be making a sharp move in either direction.
 e. Calendar spread

A calendar spread is an options or futures spread established by

simultaneously entering a long and short position on the same underlying asset at the
same strike price but with different delivery months. It is sometimes referred to as an
inter-delivery, intra-market, time, or horizontal spread.

f. Box spreads

A box spread, also known as a long box, is an option strategy that combines
buying a bull call spread with a bear put spread, with both vertical spreads having the
same strike prices and expiration dates. The long box is used when the spreads are
underpriced in relation to their expiration values. By reading this article, an investor
will gain a basic understanding of this complex option trading strategy.

g. Ratio Spreads

The ratio spread is a neutral strategy in options trading that involves buying a
number of options and selling more options of the same underlying stock and
expiration date at a different strike price. It is a limited profit, unlimited risk options
trading strategy that is taken when the options trader thinks that the underlying stock
will experience little volatility in the near term.

Settlement of option contracts

1. By exercising
2. By letting option expire
3. By offsetting

Exotic options (non generic options)

Exotic options are the classes of option contracts with structures and features
that are different from plain-vanilla options (e.g., American or European options).
Exotic options are different from regular options in their expiration dates, exercise
prices, payoffs, and underlying assets. All the features make the valuation of exotic
options more sophisticated relative to the valuation of plain-vanilla options. Below is a
list of various Exotic Options.
Types of Exotic Options

The most common types of exotic options include the following:

1. Asian options

The Asian option is one of the most commonly encountered types of exotic
options. They are option contracts whose payoffs are determined by the average price of
the underlying security over several predetermined periods of time.

2. Barrier options

The main feature of barrier exotic options is that the contracts become
activated only if the price of the underlying asset reaches a predetermined level.

3. Basket options

Basket options are based on several underlying assets. The payoff of a basket
option is essentially the weighted average of all underlying assets. Note that the
weights of the underlying assets are not always equal.

4. Bermuda options

These are a combination of American and European options. Similar to

European options, Bermuda options can be exercised at the date of their expiration. At
the same time, these exotic options are also exercisable at predetermined dates
between the purchase and expiration dates.

5. Binary options

Binary options are also known as digital options. The options guarantee the
payoff based on the occurrence of a certain event. If the event has occurred, the payoff
is a fixed amount or a predetermined asset. Conversely, if the event has not occurred,
the payoff is nothing. In other words, binary options provide only all-or-nothing
payoffs.

6. Chooser options

Chooser exotic options provide the holder with the right to decide whether the
purchased options are calls or puts. Note that the decision can be made only at a fixed
date prior to the expiration of the contracts.
7. Compound options

Compound options (also known as split-fee options) are

essentially an option on an option. The final payoff of this option
depends on the payoff of another option. Due to this reason, compound
options have two expiration dates and two strike prices.

8. Extendible options

Extendible option contracts provide the right to postpone their

expiration dates. For example, the holder-extendible options allow a
purchaser extending their options by a predetermined amount of time if
the options are out-of-money. Conversely, the writer-extendible options
provide similar rights to a writer (issuer) of options.

9. Lookback options

Unlike other types of options, lookback options initially do not

have a specified exercise price. However, on the maturity date, the
holder of lookback options has the right to select the most favorable
strike price among the prices that have occurred during the lifetime of
the options.

10. Spread options

The payoff of a spread option depends on the difference between

the prices of two underlying assets.

11. Range options

Range options are also distinguished by their final payoff. The

final payoff of range exotic options is determined as the spread between
maximum and minimum prices of the underlying asset during the
lifetime of the options.

SWAPS
Swap refers to an exchange of one financial instrument for another
between the parties concerned. This exchange takes place at a
predetermined time, as specified in the contract. A swap in simple terms
can be explained as a transaction to exchange one thing for another or
‘barter’. In financial markets the two parties to a swap transaction contract
to exchange cash flows. A swap is a custom tailored bilateral agreement
in which cash flows are determined by applying a prearranged formula on a
notional principal. Swap is an instrument used for the exchange of stream
of cash flows to reduce risk.

The advantages of swaps are as follows:

1) Swap is generally cheaper. There is no upfront premium and it
reduces transactions costs.
2) Swap can be used to hedge risk, and long time period hedge is possible.
3) It provides flexible and maintains informational advantages.
4) It has longer term than futures or options. Swaps will run for years,
whereas forwards and futures are for the relatively short term.
5) Using swaps can give companies a better match between their
liabilities and revenues.

The disadvantages of swaps are:

1) Early termination of swap before maturity may incur a breakage cost.
2) Lack of liquidity.
3) It is subject to default risk.
Different Types of Swaps

1. Currency Swaps

Cross currency swaps are agreements between counter-parties to

exchange interest and principal payments in different currencies. Like
a forward, a cross

currency swap consists of the exchange of principal amounts (based on

today’s spot rate) and interest payments between counter-parties. It is
considered to be a foreign exchange transaction and is not required by
law to be shown on the balance sheet.

In a currency swap, these streams of cash flows consist of a stream

of interest and principal payments in one currency exchanged for a
stream, of interest and principal payments of the same maturity in
another currency. Because of the exchange and re-exchange of notional
principal amounts, the currency swap generates a larger credit exposure
than the interest rate swap.

Cross-currency swaps can be used to transform the currency

denomination of assets and liabilities. They are effective tools for
managing foreign currency risk. They can create currency match within
its portfolio and minimize exposures. Firms can use them to hedge
foreign currency debts and foreign net investments.

Currency swaps give companies extra flexibility to exploit their

comparative advantage in their respective borrowing markets. Currency
swaps allow companies to exploit advantages across a matrix of currencies
and maturities. Currency swaps were originally done to get around
exchange controls and hedge the risk on currency rate movements. It also
helps in Reducing costs and risks associated with currency exchange.

They are often combined with interest rate swaps. For example, one
company would seek to swap a cash flow for their fixed rate debt
denominated in US dollars for a floating-rate debt denominated in Euro.
This is especially common in Europe where companies shop for the
cheapest debt regardless of its denomination and then seek to exchange it
for the debt in desired currency.

2. Credit Default Swap

Credit Default Swap is a financial instrument for swapping the risk of

debt default. Credit default swaps may be used for emerging market
bonds, mortgage backed securities, corporate bonds and local
government bond.

 The buyer of a credit default swap pays a premium for effectively

insuring against a debt default. He receives a lump sum payment
if the debt instrument is defaulted.

 The seller of a credit default swap receives monthly payments

from the buyer. If the debt instrument defaults they have to pay
the agreed amount to the buyer of the credit default swap.

The first credit default swap was introduced in 1995 by JP Morgan.

By 2007, their total value has increased to an estimated $45 trillion to
$62 trillion. Although since only 0.2% of Investment Company’s default,
the cash flow is much lower than this actual amount. Therefore, this
shows that credit default swaps are being used for speculation and not
insuring against actual bonds.

As Warren Buffett calls them “financial weapons of mass

destruction”. The credit default swaps are being blamed for much of the
current market meltdown.

Example of Credit Default Swap;

 An investment trust owns £1 million corporation bond issued by a

private housing firm.
 If there is a risk the private housing firm may default on
repayments, the investment trust may buy a CDS from a hedge
fund. The CDS is worth £1 million.
 The investment trust will pay an interest on this credit default swap
of say 3%. This could involve payments of £30,000 a year for the
duration of the contract.
 If the private housing firm doesn’t default. The hedge fund gains
the interest from the investment bank and pays nothing out. It is
simple profit.
 If the private housing firm does default, then the hedge fund has to
pay compensation to the investment bank of £1 million – the value
of the credit default swap.
 Therefore the hedge fund takes on a larger risk and could end
up paying
£1million

3. Commodity Swap

A commodity swap is an agreement whereby a floating (or market

or spot) price is exchanged for a fixed price over a specified period. The
vast majority of commodity swaps involve oil. A swap where exchanged
cash flows are dependent on the price of an underlying commodity. This
swap usually used to hedge against the price of a commodity.
Commodities are physical assets such as precious metals, base
metals,

energy stores (such as natural gas or crude oil) and food (including wheat,
pork bellies, cattle, etc.).

In this swap, the user of a commodity would secure a maximum

price and agree to pay a financial institution this fixed price. Then in
return, the user would get payments based on the market price for the
commodity involved.

They are used for hedging against Fluctuations in commodity

prices or Fluctuations in spreads between final product and raw
material prices.

A company that uses commodities as input may find its profits

becoming very volatile if the commodity prices become volatile. This is
particularly so when the output prices may not change as frequently as
the commodity prices change. In such cases, the company would enter
into a swap whereby it receives payment linked to commodity prices and
pays a fixed rate in exchange. There are two kinds of agents
participating in the commodity markets: end-users (hedgers) and
investors (speculators).

4. Equity Swap

The outstanding performance of equity markets in the 1980s and

the 1990s, have brought in some technological innovations that have
made widespread participation in the equity market more feasible and
more marketable and the demographic imperative of baby-boomer saving
has generated significant interest in equity derivatives. In addition to the
listed equity options on individual stocks and individual indices, a
burgeoning over-the-counter (OTC) market has evolved in the distribution
and utilization of equity swaps.

An equity swap is a special type of total return swap, where the

underlying asset is a stock, a basket of stocks, or a stock index. An
exchange of the potential appreciation of equity’s value and dividends
for a guaranteed return plus any decrease in the value of the equity. An
equity swap permits an equity holder a guaranteed return but demands
the holder give up all rights to appreciation and dividend income.
Compared to actually owning the stock, in this case you do not have
to pay anything up front, but you do not have any voting or other rights
that stock holders do have.

Equity swaps make the index trading strategy even easier.

Besides diversification and tax benefits, equity swaps also allow large
institutions to hedge specific assets or positions in their portfolios

5. Interest Rate Swap

An interest rate swap, or simply a rate swap, is an agreement

between two parties to exchange a sequence of interest payments without
exchanging the underlying debt. In a typical fixed/floating rate swap, the
first party promises to pay to the second at designated intervals a
stipulated amount of interest calculated at a fixed rate on the “notional
principal”; the second party promises to pay to the first at the same
intervals a floating amount of interest on the notional principle calculated
according to a floating-rate index.

The interest rate swap is essentially a strip of forward contracts

exchanging interest payments. Thus, interest rate swaps, like interest
rate futures or interest rate forward contracts, offer a mechanism for
restructuring cash flows and, if properly used, provide a financial
instrument for hedging against interest rate risk.

The reason for the exchange of the interest obligation is to take

benefit from comparative advantage. Some companies may have
comparative advantage in fixed rate markets while other companies have a
comparative advantage in floating rate markets. When companies want to
borrow they look for cheap borrowing i.e. from the market where they
have comparative advantage. However this may lead to a company
borrowing fixed when it wants floating or borrowing floating when it wants
fixed. This is where a swap comes in. A swap has the effect of transforming a
fixed rate loan into a floating rate loan or vice versa. In an interest rate
swap they consist of streams of interest payments of one type (fixed or
floating) exchanged for streams of interest payments of the other-type in
the same currency.

Interest rate swaps are voluntary market transactions by two

parties. In an interest swap, as in all economic transactions, it is
presumed that both parties obtain economic benefits. The economic
benefits in an interest rate swap are a result of the principle of
comparative advantage. Further, in the absence of national and
international money and capital market imperfections and in the
absence of comparative advantages among different borrowers in these
markets, there would be no economic incentive for any firm to engage in
an interest rate swap.

Difference between currency swaps and interest swap

 Interest rate swap Currency swap

1. Cash flows exchanged are in the 1. Cash flows exchanged are in two
same currency. different currencies.
2. There is only one notional principal 2. There are two notional principal
amount. amounts
3. Notional principal amount is not 3. Notional principal amounts are
exchanged. exchanged
4. No counter party risk is involved 4. Counter party risk is involved
5. Benchmark rate is MIBOR for all 5. Benchmark rate is LIBOR
domestic swaps

Difference Between Swap and Future

• Swaps and futures are both derivatives, which are special types of
financial instruments that derive their value from a number of
underlying assets.

• A swap is a contract made between two parties that agree to swap cash
flows on a date set in the future.

• A futures contract obligates a buyer to buy and a seller to sell a

specific asset, at a specific price to be delivered on a predetermined date.

• Futures contract are exchange traded and are, therefore, standardized

contracts, whereas swaps generally are over the counter (OTC); they can
be tailor made according to specific requirements.

• Futures require a margin to be maintained, with the possibility of the

trader being exposed to margin calls in the event that the margin falls
below requirement, whereas there are no margin calls in swaps.

Swap derivative

When swaps are combined with options and forwards, we shall

derive some other derivatives, for example, when swap is combined with
forward, we get a new derivative called forward swap. It combines the
features of swaps and forwards.

Similarly, when swap is combined with option, we get an innovative

derivative called swaption. This combines the features of swap and
option. Thus forward swaps and swaptions are swap derivative. They
are derived from swaps.

Non generic or exotic swaps

A number of new generation swaps have been emerged in recent

years, they have unusual features, their structure are very complex. They
are non standard swaps. Their coupon, notional, accrual and calendar used
for coupon determination and payments are tailor made to serve client
perspectives and needs in terms of risk management, accounting hedging,
asset repackaging, credit diversification etc, such swaps are called
nongeneric or exotic swaps.

Some of the very popular first generation non generic swaps may be
briefly discussed as follows.

1. Forward staring swap

2. Roller coaster swap
3. Amortising swap
4. Accreting swap
5. Constant maturity swap.
6. In arrear swap
7. Quanto swap
8. Leveraged swap
9. Power swap
10. Overnight index swap

The first generations of non generic swaps have been widely used
for asset and liability management as well as simple trading
strategies. Some of the second generation non generic swaps may be
outlined as below.

1. index amortising swap 5. bermudan swaps.

2. Range accrual swaps 6. Asian swaps
3. Digital swap 7. Barrier swap
4. Chooser swap 8. Corridor swap