What are options?

A: Before you begin options trading it is critical to have a clear idea of what you hope to accomplish. Only then will you be able to narrow down on an options trading strategy. Let us first understand the concept of options. An option is part of a class of securities called derivatives. The concept of options can be explained with this example. For instance, when you are planning to buy some property you might have placed a nonrefundable deposit to hold it for a short time while you evaluate other options. That is an example of a type of option. Similarly, you have probably heard about Bollywood buying an option on a novel. In 'optioning the novel,' the director has bought the right to make the novel into a movie before a specified date. In both cases, with the house and the script, somebody put down some money for the right to buy a product at a specific price before a specific date. Buying a stock option is quite similar. Options are contracts that give the holder the right to buy or sell a fixed amount of a certain stock at a specified price within a specified time. A put option gives the holder the right to sell the security, a call option gives the right to buy the security. However, this type of contract gives the holder the right, but not the obligation to trade stock at a specific price before a specific date. Several individual investors find options useful tools because they can be used either as: A) A type of leverage or B) A type of insurance. Trading in options lets you benefit from a change in the price of the share without having to pay the full price of the share. They provide you with limited control over the shares of a stock with substantially less capital than would be required to buy the shares outright. When used as insurance, options can partially protect you from the specific security's price fluctuations by granting you the right to buy or sell shares at a fixed price for a limited amount of time. Options are inherently risky investment vehicles and are suitable only for experienced and knowledgeable investors who are prepared to closely monitor market conditions and are financially prepared to assume potentially substantial losses. What are the different types of Options? How can Options be used as a strategic measure to make profits/reduce losses? A: Options may be classified into the following types:

a) Call Option b) Put Option As mentioned before, there are two types of options, calls and puts. A call option gives the holder the right to buy the underlying stock at the strike price anytime before the expiration date. Generally Call options increase in value as the value of the underlying instrument increases. By contrast, the put option gives the holder the right to sell shares of the underlying stock at the strike price on or before the expiry date. The put option gains in value as the value of the underlying instrument decreases. A put option is one where one can insure a stock against subsequent price fall. If the value of your stocks goes down, you can exercise your put option and sell it at the price level decided upon earlier. If in case the stock price moves higher, all you lose is just the premium amount that was paid. Note that in newspaper and online quotes you will see calls abbreviated as C and puts abbreviated as P. The examples stated below will explain the use of Put options clearly: Case 1: Rajesh purchases 1 lot of Infosys Technologies MAY 3000 Put and pays a premium of 250 This contract allows Rajesh to sell 100 shares of Infosys at Rs 3000 per share at any time between the current date and the end of May.Inorder to avail this privilege, all Rajesh has to do is pay a premium of Rs 25,000 (Rs 250 a share for 100 shares). The buyer of a put has purchased a right to sell. The owner of a put option has the right to sell. Case 2: If you are of the opinion that a particular stock say "Ray Technologies" is currently overpriced in the month of February and hence expect that there will be price corrections in the future. However you don't want to take a chance , just in case the prices rise. So here your best option would be to take a Put option on the stock. Lets assume the quotes for the stock are as under: Spot Rs 1040 May Put at 1050 Rs 10 May Put at 1070 Rs 30 So you purchase 1000 "Ray Technologies" Put at strike price 1070 and Put price of Rs 30/-. You pay Rs 30,000/- as Put premium.

Your position in two different scenarios have been discussed below: 1. May Spot price of Ray Technologies = 1020 2. May Spot price of Ray Technologies = 1080 In the first situation you have the right to sell 1000 "Ray Technologies" shares at Rs 1,070/- the price of which is Rs 1020/-. By exercising the option you earn Rs (10701020) = Rs 50 per Put, which amounts to Rs 50,000/-. Your net income in this case is Rs (50000-30000) = Rs 20,000. In the second price situation, the price is more in the spot market, so you will not sell at a lower price by exercising the Put. You will have to allow the Put option to expire unexercised. In the process you only lose the premium paid which is Rs 30,000. what is open interest? A: The total number of option contracts and/or futures contracts that are not closed or delivered on a particular day and hence remain to be exercised, expired or fulfilled through delivery is called open interest. What are Index Futures? A: As Stated above, Futures are derivatives where two parties agree to transact a set of financial instruments or physical commodities for future delivery at a particular price. Index futures are futures contracts where the underlying is a stock Index (Nifty or Sensex) and helps a trader to take a view on the market as a whole. What is meant by the terms Option Premium, strike price and spot price? A: The price that a person pays for a call option/Put Option is called the Option Premium. It secures the right to buy/sell that particular stock at a specified price called the strike price. In other words the strike price is the specified price at which the holder of a stock option may purchase the stock. If you decide not to use the option to buy the stock, and you are not obligated to, your only cost is the option premium. Premium of an option = Option's intrinsic value + Options time value The stated price per share for which underlying stock may be purchased (for a call) or sold (for a put) by the option holder upon exercise of the option contract is called the Strike price. Spot Price is the current price at which a particular commodity can be bought or sold at a specified time and place. What is meant by settlement price? A: The last price paid for a contract on any trading day. Settlement prices are used to determine open trade equity, margin calls and invoice prices for deliveries. How does one determine the price of an option? A: A variety of factors determine the price of an option.

The behavior of the underlying stock considerably affects the value of an option. Investors have different opinions about how a particular stock will behave in the future and hence may disagree about the value of any given option. In addition, the value of an option decreases as its expiration date approaches. Thus, its value is also highly dependent on the amount of time left before the option expires. Intrinsic & Time Value An options price is composed of its intrinsic value and time value. What a particular option contract is worth to a buyer or seller is measured by how likely it is to meet their expectations. In the language of options, that's determined by whether or not the option is, or is likely to be, in the money or out-of-the-money at expiration. Intrinsic value is how far an option is 'in-the-money.' Thus, the phrase is an adjective used to describe an option with an intrinsic value. A call option is in- the-money if the spot price is above the strike price. A put option is in the money if the spot price is below the strike price. It is calculated by subtracting the options strike price from the spot price. An out-of-themoney option has an intrinsic value of zero. For example if XYZ is trading at Rs 58 and the June 55 call is trading at Rs 4, to calculate the intrinsic value subtract Rs 55 from 58, leaving you with Rs 3 of intrinsic value. The remaining Rs 1 is known as extrinsic or time value. Time value is the amount over intrinsic value that a buyer pays for the option. While buying time value, an options purchaser assumes that the option will increase in value before it expires. As the option nears expiration, its time value starts decreasing toward zero. Theoretical Value Theoretical value is the objective value of an option. It shows how much time-value is left in an option. The most commonly used formula to calculate the theoretical value of an option is known as the Black-Scholes model. This model considers the price of the stock, the options strike price, the time remaining before expiration, the volatility of the underlying stock, the stock's dividends and the current interest rate while arriving at the theoretical value of the option. Although an option may trade for more or less than its theoretical value, the market views the theoretical value as the objective standard of an option's value. This makes the price of all options tilt toward their theoretical value over time. The Components of Theoretical Value

Volatility The volatility of the underlying stock is one of the key factors in determining the value of an option. Often, the options price increases as the volatility of the stock increases. The difficulty in predicting the behavior of a volatile stock permits the option seller to command a higher price for the additional risk. There are two types of volatility, historical and implied. As the term suggests, historical volatility is a measurement of the stocks movement based on its past behavior. By contrast, implied volatility is calculated using option prices. It is a measurement of the stocks movement as implied by how the market is currently valuing options. Dividends As an owner of a call option you can always exercise your right to the stock and receive any dividend it might pay. Interest Rate If you buy an option rather than a stock, you invest less money upfront. Days Until Expiration An option, being a wasted asset; wastes a little as each day lapses. Thus its value is calculated in accordance to the amount of days left in its life. What are swaptions? A: A swaption is an option on an interest rate swap. Swaptions are options contracts, which give you the right to enter into a swap agreement at the option expiration, in return for a one-off premium payment. What is meant by Covered Call, Covered Put, In the Money, Out Of the Money, At the Money? A: In-the-money A call option is in the money if the strike price is less than the market price of the underlying security. A put option is in-the-money if the strike price is greater than the market price of the underlying security. Out of the money A call option is out-of-the-money if the price of the underlying instrument is lower than the exercise/strike price. A put option is out-of-the-money if the price of the underlying instrument is above the exercise/strike price.

 At-the-money At the money is a condition in which the strike price of an option is equal to (or nearly equal to) the market price of the underlying security. Covered Call You can take a covered call if you take a long position in an asset combined with a short position in a call option on the same underlying asset. Covered Put The selling of a put option while being short for an equivalent amount in the underlying security.

Basics of Options (Derivatives) - Types of Options Options come in 2 different types, namely: 1) American Options American Options can be exercised at any time between the date of acquiring the options till the expiry date, upon which the Options become worthless (if not exercised). The example of Cocoa Corp. we used in the Basics of Options (Derivatives) - How

Options Work tutorial is an example of an American Option where the option was exercised at many intervals before the expiry date. 2) European Options European Options can only be exercised upon the end of their lives (upon their expiry dates). Note: The names European and American Options have nothing to do with their geographic locations. Long Term Options The American and European Options we talked about above are both short-term Options where the expiry date is within 1 year. However, Long Term Options are available for long term investors where the expiry date expands to multiple years, even 2-3 years sometimes. These Options are also known as Long Term Equity Anticipation Securities (LEAPS). Exotic Options Options that have Calls and Puts are known as Exotic Options.

The Basic Types of Derivatives Explained

Many investors are familiar with mutual funds, stocks and bonds to a certain extent. I think a less well understood category of investments are derivatives which get their name because they are derived from other underlying investments or because the value of the specific derivative investment fluctuates in value based on changes in value of something else (investment values, interest rates, exchange rates, etc). There are actually only two main types of derivatives: option-based and forwardbased. Either type can be traded on a recognized exchange or OTC (Over The Counter). The exchanges are public and provide for standardized, liquid contracts whereas the OTC market is private and allows for much more customization of the individual contracts between parties. Option Based Derivatives Option-based derivatives represent the right, but not the obligation, to engage in a transaction within a set period of time. In other words, an option is exactly that: an option. Just because you own an option does not mean you have to make a transaction rather it is the ability to make a certain transaction if you so desire. Options normally have an upfront cost associated with them known as the premium for the contract. They are known as options whether they are traded on an exchange or Over-TheCounter. An example would be a Call or Put option a Call option represents the right (but not the obligation) to buy a stock for a set price for a certain period of time. A Put option represents the right (but not the obligation) to sell a security at a certain price for a given period of time. Forward-Based Derivatives Forwards represent the obligation to make a transaction at a set point in time in the future. Once you enter into a forward-based contract, you are obligated to make the transaction (unless both parties agree to cancel or otherwise modify the agreement which is rare). Unlike an option, there is no up-front cost to entering into a forwardbased derivative contract. When a forward contract is traded on a recognized exchange, it is referred to as a futures contract or futures for short. Examples of futures include commodities, interest rates, currencies, and stock market indices. When a forward based derivative is traded OTC (Over-The-Counter) it can be referred to as a forward agreement or a forward. Two specific types of OTC forwards are forwards based on exchange rates, known as foreign exchange agreements and forwards based on interest rates, known as forward rate agreements. Another example of a special OTC forward-agreement is the swap. Specifically, a swap allows for the swapping of regular cash-flows based on a pre-determined formula. It can be viewed as a number of periodic forward agreements packaged into one agreement as well. A specific type of swap used can be between a bond fund manager and an equity fund manager. They can swap the performance with each other and in effect the equity manager could say that he is running a tax-efficient bond mandate for his investors (as is the case in a capital yield class or managed yield fund where the

investor receives fixed-income type risk and returns with the distributions treated as capital gains). A specific example would be the Mackenzie Sentinel Canadian Managed Yield Class click here to see the fund profile and then scroll down to the Major Holdings to see that it owns stocks and yet provides fixed-income like returns. (Note the profile explains they use options which is not correct, they use swaps which are a type of forward-based derivative.) A Third Main Type of Derivative CFDs CFDs or Contracts For Differences are a little different from the above mentioned derivatives. The main difference is that a CFD has no expiration date. CFDs are OTC products and you normally buy and sell them through a CFD provider and are cashsettled as opposed to physically-settled which means you never have to own the underlying investment which can be a commodity, stock market index, individual stocks, currencies, etc. They are normally offered with significant leverage built in to the tune of 100:1 with some CFD providers. 100:1 means that your returns are magnified 100 fold, not 100% you really need to think twice about playing the CFD markets. So there you have a very basic primer on the basic types of derivatives out there. One thing in common is that all derivative products basically can magnify risk and returns TREMENDOUSLY. There are however, many different strategies for the application of derivatives some of which are very conservative strategies and others are if I get this wrong Im going to commit suicide risky. Make sure to seek the counsel of a qualified financial advisor before engaging in derivative investments. Over time, I will write in more detail on some of these specific derivatives and some derivative strategies