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on Derivatives
OPEN INTEREST
This indicates the outstanding position of
contracts on a particular asset
An investor who purchased an option can close
the position by selling the same
A writer of option can close the position by buying
the same option
When an option contract is traded and if neither
investor close the position, open interest
increases by one contract
If one investor is closing existing position and
other do not, the open interest remains same
Contd.
If both investors close existing position, the open
interest goes down
It indicates expected market trend either bullish or
bearish
Higher price but decline in trade volume and open
interest indicates bullish trend
Decline in Price together with rise in trading
volume and open interest, market may go bearish
Decline in price and declining in trading volume
and open interest, maeket is likely to reverse.
Topics
Introduction
Strategies for a single option and a stock
Covered call
Combinations
Long Straddle
Strangle
Short Straddle
Other strategies
Box spread
Calendar spread
Diagonal spread
Butterfly spread
Conclusion
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Introduction
Factors affecting the option price
S0
(Positive)
Strike price
K ( Inverse)
Time to expiration
T (positive)
Volatility of the stock
(positive)
Risk-free interest rate
r (Positive)
Dividend expected before the option expiration (Inverse)
Options can be combined to create a range of payoffs looking at holding a portfolio vs. a single stock or option
For simplicity, we will ignore the time value of money thus
the profit for any strategy will be the final payoff initial cost
Including transaction costs will not change the strategy being
discussed. It is not included in the examples shown.
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Stock price
Strike price
Time to expiration
Call premium
S0 = 63
K = 67
T = 3 mo (Sep 15)
c = 1 (currently out-of-the money)
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73 100 -50 50
Long Stock
Investor owns 100 share at Rs.63. So for any
change in price above Rs.63 there is a profit
and for any change in price below Rs.63 there
is a loss incurred
Short Call (investor has sold a call option)
Investor has received the premium of Rs.1 per
share for 100 shares
The option will be exercised by the holder only if
the ST is above K or else it will expire unused
When exercised the investor will lose the
difference in the ST and K but will always have
the initial premium collected
If ST = 70 then investor has to sell the shares at
67 and incur a loss: (67-70)*100 + 100 = -200
Portfolio
Sum of the two positions
Strike price
Call premium (K=67)
Strike price
Call premium (K=70)
Time to expiration
S0 = 63
K = 67
c = 1 (currently out-ofthe money)
K = 70
c = 0.75(out-of-the money and lower premium)
T = 3 mo (Sep 15)
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Combinations
Combination involves taking a position in both a call
and put on the underlying stock at the same time.
Traders and investors are betting on the volatility of
the stock price
Long Straddle: Buy a call and put option with the
same strike price and expiration date. Close to atthe-money options work best. The premium on these
options could be high.
Strangle: Buy an out-of the-money call and put option
with different strike prices to reduce the cost. This is
a low cost trade needing a high volatility to be
profitable
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Combinations
Short Straddle: Short a call and a put on the same
stock with the same strike price and expiration date.
Investors and traders are expecting volatility and the
stock to trade in a range. Unexpectedly if the stock
declines rapidly, the risk is high. Barings Bank fiasco.
Consider the following example of ABC Company
Stock price
Strike price
Call premium (K=67)
Put premium (K=67)
Time to expiration
S0 = 63
K = 67
c = 1 (currently out-ofthe money)
p = 4 (currently in-the money)
T = 3 mo (Sep 15)
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Combinations Strangle
The idea in a Strangle is to profit on the volatility of the stock
movement but also reduce the cost. As such the volatility has
to be significant to realize a profit.
Consider the following example of ABC Company
Stock price
S0 = 63
Strike price (call)
Kc = 67
Call premium (K=67) c = 1 (currently out-of-money)
Strike price (put)
Kp = 61
Put premium (K=61)
p = 0.25 (currently out-of-money)
Time to expiration
T = 3 mo (Sep 15)
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Combinations Strangle
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Combinations Strangle
Long Call
The call option will be exercised only if the ST is
> K (67). However a premium of Rs.100 has
been paid for the option
At ST = 68 investor make no profit or loss
Long Put
The put option will be exercised if the stock
price ST is < K (61). A premium of Rs.25 has
been paid for the out-of-the money put
When exercised the investor will gain the
difference in the ST and K but reduced by the
premium paid
For ST > 61 the entire premium is lost
Portfolio
Sum of the two positions
Note that the cost of this strategy was lesser than
the Straddle since the premiums were lower20
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Other Strategies
Theoretically if European options with expiration at
time T exist for every single strike price then it is
possible to construct any payoff with a combination of
these
Box Spread: This is a combination of a bull call
spread with strike price K1 and K2 and a bear put
spread at the same two strike prices. When K 2 > K1,
buy a call option at K1 and sell a call option at K2 &
buy a put option at K2 and sell a put option at K1
This combination does not work with American
options
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Other Strategies
Calendar spread or Horizontal spread: The
combination is developed using options with different
expiration dates but with the same strike price
Diagonal spread: The strike price and the expiration
dates of the options are different
Butterfly spread: involves options with three different
strike prices and same expiration date. Either all
puts or all calls can be used for this strategy. The
idea is to buy a call (long) with at strike price K 1 and
another at strike price K2 and short two calls with a
strike price K3 midway between K1 and K2. Usually
potential gain and loss is limited
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S0 = 75.28
K1 = 72
c1 = 6.10 (in-the-money)
K2 = 78
c2 = 2.60 (currently out-of-money)
K3 = 75
c3 = 4.10 (almost at-the money)
T = 3 mo (Sep 15)
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Conclusions
Any payoff strategy can be developed using a combination
of options very exciting and challenging!
Many strategies are risky and have a significant downside
potential
Prudent financial risk management is critical to success in
trading
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Thank You!
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