Monieness and Options

Relationship Calls Puts

A > S in-the-money out-of-the-money
A = S at-the-money at-the-money
A < S out-of-the- in-the-money
money
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‘A’ denotes the current price of the underlying asset
‘S’ denotes the strike price of the option
 Value of an Option

The two components are,

 Intrinsic Value: of call = Max [A-S,
0]
of put = Max [S-A, 0]
 Time value: It is the value in excess of
the intrinsic value and indicates option’s
potential to become more valuable
before it expires. It decays with passage
of time.
 How is Value of Options
Affected*?
Factor Call Value Put Value

Increase in asset value Increase Decrease

Increase in strike price Decrease Increase

Increase in variance of Increase Increase

underlying asset
Increase in time to Increase Increase
expiration
Increase in interest rate Increase Decrease
Increase in dividend paid Decrease Increase
*American Options
 Call Option
Pay-off Diagram:
Net payoff
on call

Strike
Price

Price of underlying
asset
 Put Option
Pay-off Diagram:
Net payoff
on put

Strike
Price

Price of underlying asset

 Options other than Calls and
Puts

 Convertible in bonds: purchaser buys a

straight bond and a call option
 Callable bonds: purchaser buys a
straight bond and sells a call option to
issuer
 An equity share can be viewed as a
call option on the assets of a company.
 Buying and Selling Stock:
Long Position

Profit

E
0 MP (T)
400

(-) 400
Loss
 Buying and Selling Stock:
Short Position

Profit
240

240
0 MP (T)
E

Loss
 Elementary Investment
Strategies

 Long Call
 Short Call
 Long Put
 Short Put
 Long Call
Profit
This refers to the purchase of a call

400 E
0 MP (T)
440
(-) 40

These are cash flows when a bullish

Loss
Investor buys a 3-month call on the
Stock with an exercise price of Rs.400
Per share by paying a premium of Rs.40
 Short Call
This involves writing a call without owning the
underlying asset
Profit

(+) 40
440
0 MP (T)
400 E

Loss These cash flows relate to writing a

3-month call on a stock at an exercise
price of Rs.400 per share
by receiving a premium of Rs.40.
 Long Put
This involves buying a put – the right to sell the
Underlying asset at a specified price
Profit
(+) 216

E 240
0 MP (T)
216
(-) 24

Loss These cash flows relate to a bearish investor

Buying 3-month put with a exercise price of
Rs.240 per share by paying a premium of Rs.24
 Short Put
This involves writing a put
Profit

E
0 MP (T)
216 240

(-) 216
Loss
These cash flows relate to a bullish investor
Writing a put at an exercise price of Rs.240
Per share receiving a premium of Rs.24.
 Complex Investment
Strategies
Covered Call Writing
Protective Put
Straddles
Strangles
Spreads
 Covered Call Writing
It involves buying the stock and writing call
on that.
Profit

(+)48

E
302 MP (T)
350

These are cash flows when we

(-)302
buy
100 shares @310 and write a
May 350 call for Rs.8 so that
initial
Investment is Rs.302
 Covered Call Writing:
CF0 = (Rs.302)

MP (T) At Time T NCF

Sell Stock Buy Call CF(T)
270 270 0 270 -32
290 290 0 290 -12
310 310 0 310 8
330 330 0 330 28
350 350 0 350 48
370 370 -20 350 48
Covered Call:
Why better than stock or only short calls?
 Reduces the risk of uncovered call writing.
 Downside risk is reduced by the premium amount.
 Loss of upward gains can be minimized by rolling up
the exercise price.
 When call ends up out-of-the-money, profits increase
by every dollar by which the stock price exceeds the
original price.
 Has a lower B.E.P. compared to only stock.
 Writing a covered call at lower exercise price is
conservative, it reduces the loss but also the upward
gains.
 Writing at higher exercise price is risky. Downside loss
is higher (less protective) and also gains are higher.
 A short holding period reduces the stock movement
possibility and is the best.
 Protective Put
It involves buying the stock and buying put on
that.
Profit

E
MP (T)
270 312
(-)42
These are cash flows when
buy
100 shares @ Rs.310 and buy
Loss a
Jun 270 put for Rs.2 so that
initial
Investment is Rs.312
 Protective Put
 Guards against fall and also participate in gains. Put
ensures min. selling price for stock.
 Gain on upside movement is restricted by the premium.
 Smaller downside risk and smaller upward gains and
higher BEP.
 Higher strike price costs maximum but also provides
maximum protection. Reduces the profits maximum.
 Lower strike price costs less, less protective and
reduces profits less.
 Long holding period has chances of recovery of time
value due to more chances of price movements.
 Synthetic Put and Call

A synthetic put involves long calls

and short sale of an equal number of
shares of stock.
 Synthetic call involves buying stock
and an equal number of puts and is
nothing but protective put.
 Long Straddle
Involves buying a put and a call, each with same
exercise price
and same time to expiration.
Profit
247

E1 E2 MP (T)
247 373

(-)63
310

Buying a Jun 310 call for Rs.21

Loss
And Jun 310 put for Rs.42 per
Share. Initial investment Rs63.
 Short Straddle
Involves selling a put and a call, each with same
exercise price
and same time to expiration.
Profit

(63)

E1 E2
MP (T)
247 310 373

Loss
(-)24
7
 Straddle Variants
Straps:
A bullish variation of straddle, involves two
calls and one put. Investors are more bullish
than bearish and therefore increase calls.
Strips:
It is a slightly bearish variation of straddle,
has long position in two puts and one call
and involves one’s bet that the market will
go down.
 Long Strangle
Involves buying a call and a put on the same
underlying asset
for same expiration period at different exercise prices
Profit
247

E1 270 310 E2 MP (T)

247 333
-23

Buy Jun 310 call for Rs.21 and Jun 270

Put for Rs. 2. Initial investment Rs.23.
Loss Usually one in-the-money and another
Out-of-the-money. Initial investment
Can be less than straddle
 Spreads
 Involve buying of one option and selling of
another.
 Offer potential for small profit and limit the
risk.
 Vertical Spreads also called Strike or
Money spreads. Could be written as say, July
120/125 Spread.
 Horizontal Spreads also called as Time or
Calendar Spreads. Could be written as
June/July 120 Spread.
 Spreads

For Vertical Spreads:

 A July 120/125 call spread is a net long
position and is called Buying the
Spread, sometimes referred to as Debit
Spread.
 A July 120/125 put spread is a net short
position and is called Selling the Spread,
sometimes referred to as Credit Spread.
 Spreads

For Horizontal Spreads:

 A June/July 120 call spread is a net short
position and is called Selling the Spread,
sometimes referred to as Credit Spread.
 A July/June 120 call spread is a net long
position and is called Buying the
Spread, sometimes referred to as Debit
Spread.
 Vertical Spread
(Across Strike Prices)
Involves buying an option and selling another option of the
same type and time to expiration but with different exercise
price
Profit

+ 30
E
MP (T)
270 320 350

- 50

Bullish vertical spread using calls wherein we

Buy Mar 270 calls for Rs.58 and sell Mar 350
Loss Calls for Rs.8 i.e. buy lower strike price and
Sell higher strike price calls.
 Vertical Spread
Involves buying an option and selling another option of the
same type and time to expiration but with different exercise
price
Profit

+ 68

E
MP (T)
270 282 350
- 12

Bullish vertical spread using puts wherein

We buy Mar270 put for Rs.2 and sell
Loss Mar 350 put for Rs.70.
 Vertical Spread
.

Profit

+59

E
MP (T)
270 329 350

-21

Bearish vertical spread wherein Sell

Jun 270 call for Rs.71 and buy
Loss Jun 350 call for Rs.12.
 Vertical Spread
.

Bearish vertical spread using

Profit Puts wherein Buy Mar 350 put
for Rs.70 and sell Mar 270 put
for Rs.2
+12

E
MP (T)
270 282 350

-68

Loss
 Horizontal Spreads (Across Expiration
Months)

 Involve buying an option and selling

another of same type with same exercise
price but with different expiration time.
 In a horizontal bull spread, we buy back
month and sell the front month. In a
horizontal bear spread, we buy front month
and sell back month.
 Horizontal bull spread has similar pay-off as
that of a short straddle and horizontal bear
spread has similar payoff as that of a long
straddle.
 Diagonal Spreads

They are vertical and horizontal

at the same time i.e. the are
across both strike price and
expiration month.
 Butterfly Spread
 Involves four options, all calls or all
puts.
 All have same expiration month and
same underlying asset.
 One option has high strike price, one
has low strike price and two have same
strike price which is between those of
high strike and low strike.
 Two middle strike price are sold and
the two end options are purchased.
 Reverse Butterfly or Sandwich
Spreads

 This is strategy reverse of the

butterfly spread.
 The two middle strike price
options are purchase and the
two end strike price options are
sold.
 Evaluation of the
Strategies
 Transaction costs have not been
considered and should be kept in mind.
 Bid-ask spreads may affect payoffs.
 They are not dividend protected.
 Margin requirements are applicable to
option writing.
 Possibility of early exercise may pose new
risks.
 Timing of cash flows can make a
difference.
 Futures vs. Options:
Performance
 Option purchasers do not post margins
since they have no obligations
 An option clearing house serves the similar
functions as those of clearing associations
in futures trading
 Option writers have to post margins to
clearing houses
 Options are also OTC and dealers may
require margins or guarantees.
 Illustration 1
Consider the price of the stock at
$165.125. Buy 100 shares of stock and
write one August 170 call contract at a
premium of $3.25. Hold the position
until expiration. Determine the profits
and graph the results. Identify the
breakeven stock price at expiration, the
maximum profits, and the maximum
loss.
 Illustration 2
Consider the price of the stock at the same
level as in the previous illustration i.e.
$165.125. Now assume that you buy 100
shares of stock and buy one August 165
put contract at a premium of $4.75. Hold
the position till expiration. Determine the
profits and graph the results. Identify the
breakeven stock price at expiration, the
maximum profits, and the maximum loss.
 Illustration 3
A call option with a strike price of
$50 costs $2. A put option with a
strike price of $45 costs $3. Explain
how a strangle can be created from
these two options. What is the
pattern of profits from the strangle?
 Illustration 4
A call with a strike price of $50
costs $6. A put with the same strike
price and expiration date costs $4.
Construct a table that shows the
profits from a straddle. For what
range of stock prices would the
straddle lead to a loss?
 Illustration 5

1. Discuss the main objectives of

covered call and protective put vis-
à-vis simple call and put strategies.
2. What is synthetic puts and
synthetic calls?
 A Transaction on an Option
Exchange
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1a 2 1b
Options 2
Buyer
6a Buyer’s a Buyer’s Broker’s Exchange Seller’s Broker’s
b
Seller’s 6b
Seller
5a Floor Broker Floor Broker 5b
7a Broker 3 Broker 7b

8a 4 8b

9a Options 9b
Buyer’s Broker’s Clearing Buyer’s Broker’s
Clearing Firm Clearing Firm
House

1a 1b Buyer and seller instruct their respective brokers to conduct an option transaction.
2a 2b Buyer’s and seller’s brokers request their firm’s floor brokers execute the transaction. Note: Either
3 buyer or seller
Both floor brokers meet in the pit on the floor of the options exchange and agree on a price.
4 Information on the trade is reported to the clearinghouse. (or both) could
5a 5b Both floor brokers report the price obtained to the buyer’s and seller’s brokers. be a floor trader,
6a 6b Buyer’s and seller’s brokers report the price obtained to the buyer and seller.
eliminating the
7a 7b Buyer deposits premium with buyer’s broker. Seller deposits margin with seller’s broker.
8a 8b Buyer’s and seller’s brokers deposit premium and margin with their clearing firms. broker and floor
9a 9b Buyer’s and seller’s brokers’ clearing firms deposit premium and margin with clearinghouse.broker.