An options strategy where the investor holds a position in both a call and put with different strike prices but with the same maturity and underlying asset. This option strategy is profitable only if there are large movements in the price of the underlying asset.
This is a good strategy if you think there will be a large price movement in the near future but are unsure of which way that price movement will be.
The strategy involves buying an out-of-the-money call and an out-of-the-money put option. A strangle is generally less expensive than a straddle as the contracts are purchased out of the money.
For example, imagine a stock currently trading at $50 a share. To employ the strangle option strategy a trader enters into two option positions, one call and one put. Say the call is for $55 and costs $300 ($3.00 per option x 100 shares) and the put is for $45 and costs $285 ($2.85 per option x 100 shares). If the price of the stock stays between $45 and $55 over the life of the option the loss to the trader will be $585 (total cost of the two option contracts). The trader will make money if the price of the stock starts to move outside of the range. Say that the price of the stock ends up at $35. The call option will expire worthless and the loss will be $300 to the trader. The put option however has gained considerable value, it is worth $715 ($1,000 less the initial option value of $285). So the total gain the trader has made is $415.
Thursday, August 16, 2007
Call & Put Options
To opt or not to opt...
Anup Menon
FROM July, options trading is likely to start in the capital market.
Starting this week, there will be a series of articles on options, aimed at increasing the awareness on the product.
An option gives you the right to buy or sell an asset at a future date. This can be done at the price specified in the option contract.
But you need to use it only if the option contract price is favourable to you. If the price trend is unfavourable, you need not exercise the option.
Instead you can go and buy or sell the asset in the market at a price better than the option contract price. This means an option holder has a right but not the obligation to exercise the contract. But this facility comes with a price; options help you benefit from the contract price if there are unfavourable movements asset prices in the market.
Options are classified into two types:
* Call option: A call option gives the holder the right but not the obligation to buy the underlying asset at a specified exercise price. Since the initial cash flow to buy the option is comparatively small, investors bullish on the asset (can be a stock or any other asset for that matter) can use call options to maximise their returns by buying into the product. Further, even in the case of the asset moving the other way, the maximum loss for the investor is only the premium he has paid.
* Put option: A put option is the reverse of the call option. It gives the holder the right to sell an asset at a predetermined price. Investors bearish on the future trends of the asset price can use a put option. It confers the same benefits as in a call option.
The players in an option market are holders (buyers) and writers (sellers):
* Option holders: Option holders are actually the buyers of the contract -- be they puts or calls. They have the `right' but not the obligation to do something at expiry. For instance, if the option holder has a call option and the asset price does not move in the expected direction, he will not exercise his option. From this perspective, his risk is limited.
* Option writers: Option writers are those who sell options. In other words, for a fee, they promise the holders delivery of an asset at a fixed price-tag. For instance, if an investor decides to exercise a call option, then the option holder will have to provide delivery of the underlying asset at that price. From this perspective, the risk is much greater for option writers.
Next week, we shall look at some more basic terminologies of the options market.
Option Basics - II
Anup Menon
LAST week we defined what an option is and talked about the two basic types of options namely calls and puts. We also saw the difference between an option writer and a buyer. This week we shall discuss some more key terms in options.
European Options: In India all options that are being introduced are of the European type. We can have a European put, call or any other advanced option variants. The question is what is the European Option. We know that an option holder has the right to exercise his option but not the obligation. The question is when can he exercise his right. Should it be on the maturity date or can he exercise it at any time after he has entered the contract. If the option can be exercised on the maturity date only, then the option is a European option.
American Options: The other type of option is known as the American Options. Most option contracts traded in developed markets are of the American type. The biggest advantage with the American Option is that it can be exercised by the holder at any point of time after entering the contract. However the question remains whether early exercise is optimal. Since the discussion of that topic is fairly academic, we shall deal with it on a later date.
Now that we have seen some of the basic types of options, let us look at some of the key valuation parameters that we should look for. The most important valuation parameter is volatility.
Measurement of volatility has been a subject for financial research, both academic and applied. This is all the more important in options since most positions tend to be leveraged and a wrong call on volatility can cost the trader a packet. The simplest and most widely used measure of volatility is the standard deviation. The standard deviation measures the deviation or changes in the return series from an average value. The higher the standard deviation, the more volatile the series.
However there have been many revised versions of volatility. For instance computation of the standard deviation assumes that the mean is unconditional. Modern volatility measurement techniques such as ARCH and its variants have been frequently referred to.
Next week we shall look into some of the other major valuation parameters such as exercise price and follow it up with a brief discussion on pricing models.
Option Basics - III
Anup Menon
Last week we saw what is meant by American and European options. We also discussed volatility, which is one of the key factors in valuation of options. This week we shall see some more key terms in options.
Expiration Date: Options quoted in exchange include the date and the month on which the option can be exercised. This is called the expiration date. In the case of the European option, the investor can exercise his right on the specified `expiration date' only. In the case of an American Option, investors can exercise the option on or before the `expiration date'.
Strike Price: The `strike price' is the price at which an option can be exercised. For instance, assume that you hold an European Option on XYZ company for one share. The strike price is fixed at Rs 5,000 and the expiration date is 15th June 2001. If the prevailing market price is say Rs 5,500, then you can exercise your option on the 15th and buy one share of XYZ for Rs 5,000.
In-the-money options: Those options which are trading in positive territory are called in-the-money options. This means that in the event of exercising the option, it leads to a gain for the investor. For instance, in the example given above, if the stock was trading at Rs 5,400 on 13th June, then the option is in-the-money from the point of view of the holder.
Out-of-the-money options: Those options which give a negative cash flow to the investors are classified as out-of-the-money options. For instance, in the above example, if the price of XYZ on 13th June was Rs 4,500, then it would have generated a negative cash flow if exercised. Hence the option is classified as out-of-the-money.
At-the-money options: Those options which do not result in any cash flow, in other words, which result in zero cash flow for the investors are called At-the-money options. For instance, in the same example as described above is the price of XYZ was Rs 5,000 on 13th June, then the option is at-the-money.
Next week we shall look into some of the properties of the factors affecting valuation of options.
Option Basics -- IV
Anup Menon
This week we shall look at an option strategy known as collars.
Assume you are an investor and want to own the stock of ABC company. You also know that the stock is not likely to move up at a rapid pace and you want to limit your downside. Under these conditions, an investor can consider using a collar strategy. A collar strategy involves three distinct transactions, namely the purchase of the asset in the spot market. purchase of an out-of-the-money put option and sale of an out-of-the-money call option. The potential risk and reward from using this strategy is limited.
Normally investors using this strategy try to even out the cash outflow on buying the put with the cash inflow from selling the call. In other words the premium paid for the buying the put and selling the call will be equal. This effectively means that the cost incurred by the investor is the equal to that of buying the stock in the spot market. An example would make the operation clearer.
Assume that the stock of ABC is selling at Rs 100. The investor purchases 10 shares of ABC, which means a net outflow of Rs 1,000 (for the purchase in spot market). At the same time the investor also purchases 1 put option (10 shares) with strike price at Rs 95. The investor also sells 1 call option (10 shares) with a strike of Rs 110. Since the premium paid for the put option is the same as the premium received for the call option, the net cost for the investor is Rs 1,000 only.
Assume that the stock price moves down to Rs 90. In that case three events happen. Firstly the call option is worthless. The investor will exercise his put option and thereby receives a cash inflow of Rs 50. The spot position incurs a loss of Rs 100. Therefore, the maximum loss that an investor will suffer is Rs 50. The same condition holds true for any combination of the spot price. If the asset price falls below the put strike, then the maximum loss that the investor can suffer is the difference between the put strike and initial spot price.
Similarly assume that the price of the asset rises to Rs 120. Then the put option is worthless. The investor will have to provides the shares at Rs 110. This means that he will lose Rs 100 (10*10) in the process. However the spot position will gain by around Rs 200. Therefore the net gain will always be Rs 100, that is the difference between the call strike and the original asset price.
Hence we can see that while the risks are contained, the rewards are also constrained.
Option Basics -- V
Anup Menon
ASSUME you are an investor and want to own the stock of ABC company.
However, at present, you are not sure as to the direction in which the stock will move. Is it possible to devise a strategy with limited risk but unlimited gains. Yes, the investor can consider using the (long) straddle strategy. A straddle involves two distinct transactions. For the (long) straddle involves the purchase of a call and put option with the same exercise and terms and conditions. The (short) straddle involves selling of a put and a call option with the same exercise and terms and conditions.
Normally, investors using this strategy are unable to gauge the direction of the stock. Therefore, the more volatile the stock, the better the payoffs from a (long) straddle and vice versa. Investors have to be careful when using this strategy. Why? Options tend to lose value quickly. In the case of a straddle, the erosion is twice that of holding a call or a put option. This apart the transaction costs would also be higher as the investor has to buy twice the number of options. An example would make the strategy more clear.
First let us look at an example of the (long) straddle strategy. Assume that the stock of ABC is selling at Rs 100. The investors purchases one call option at a strike price of Rs 105 and one put option with the same strike price. All other terms and conditions are similar for both options. Further assume that the investor pays a total premium (inclusive of call and put) of Rs 10. Therefore the cost for the investor is Rs 10. This effectively means that if the stock price moves beyond Rs 110, the call option will make money and if it falls below Rs 95, the put option will make money. In the event of the stock price remaining rangebound between Rs 95 and Rs 110, the maximum loss suffered by the investor is Rs 10.
Now let us look at the (short) straddle. This is an extremely risky strategy. For instance, as in our above example, the investor will write a call and a put option with a strike price of Rs 105. He receives a total premium of Rs 10 for his troubles. Therefore his maximum profit from the transaction is Rs 10 only. However of the stock fluctuates beyond the range stated above, the loss for the investor is unlimited. This is an extremely risky strategy and advised only for players with substantial financial backing and experience in trading options.
Next week we shall look at another strategy known as strangles.
Anup Menon
FROM July, options trading is likely to start in the capital market.
Starting this week, there will be a series of articles on options, aimed at increasing the awareness on the product.
An option gives you the right to buy or sell an asset at a future date. This can be done at the price specified in the option contract.
But you need to use it only if the option contract price is favourable to you. If the price trend is unfavourable, you need not exercise the option.
Instead you can go and buy or sell the asset in the market at a price better than the option contract price. This means an option holder has a right but not the obligation to exercise the contract. But this facility comes with a price; options help you benefit from the contract price if there are unfavourable movements asset prices in the market.
Options are classified into two types:
* Call option: A call option gives the holder the right but not the obligation to buy the underlying asset at a specified exercise price. Since the initial cash flow to buy the option is comparatively small, investors bullish on the asset (can be a stock or any other asset for that matter) can use call options to maximise their returns by buying into the product. Further, even in the case of the asset moving the other way, the maximum loss for the investor is only the premium he has paid.
* Put option: A put option is the reverse of the call option. It gives the holder the right to sell an asset at a predetermined price. Investors bearish on the future trends of the asset price can use a put option. It confers the same benefits as in a call option.
The players in an option market are holders (buyers) and writers (sellers):
* Option holders: Option holders are actually the buyers of the contract -- be they puts or calls. They have the `right' but not the obligation to do something at expiry. For instance, if the option holder has a call option and the asset price does not move in the expected direction, he will not exercise his option. From this perspective, his risk is limited.
* Option writers: Option writers are those who sell options. In other words, for a fee, they promise the holders delivery of an asset at a fixed price-tag. For instance, if an investor decides to exercise a call option, then the option holder will have to provide delivery of the underlying asset at that price. From this perspective, the risk is much greater for option writers.
Next week, we shall look at some more basic terminologies of the options market.
Option Basics - II
Anup Menon
LAST week we defined what an option is and talked about the two basic types of options namely calls and puts. We also saw the difference between an option writer and a buyer. This week we shall discuss some more key terms in options.
European Options: In India all options that are being introduced are of the European type. We can have a European put, call or any other advanced option variants. The question is what is the European Option. We know that an option holder has the right to exercise his option but not the obligation. The question is when can he exercise his right. Should it be on the maturity date or can he exercise it at any time after he has entered the contract. If the option can be exercised on the maturity date only, then the option is a European option.
American Options: The other type of option is known as the American Options. Most option contracts traded in developed markets are of the American type. The biggest advantage with the American Option is that it can be exercised by the holder at any point of time after entering the contract. However the question remains whether early exercise is optimal. Since the discussion of that topic is fairly academic, we shall deal with it on a later date.
Now that we have seen some of the basic types of options, let us look at some of the key valuation parameters that we should look for. The most important valuation parameter is volatility.
Measurement of volatility has been a subject for financial research, both academic and applied. This is all the more important in options since most positions tend to be leveraged and a wrong call on volatility can cost the trader a packet. The simplest and most widely used measure of volatility is the standard deviation. The standard deviation measures the deviation or changes in the return series from an average value. The higher the standard deviation, the more volatile the series.
However there have been many revised versions of volatility. For instance computation of the standard deviation assumes that the mean is unconditional. Modern volatility measurement techniques such as ARCH and its variants have been frequently referred to.
Next week we shall look into some of the other major valuation parameters such as exercise price and follow it up with a brief discussion on pricing models.
Option Basics - III
Anup Menon
Last week we saw what is meant by American and European options. We also discussed volatility, which is one of the key factors in valuation of options. This week we shall see some more key terms in options.
Expiration Date: Options quoted in exchange include the date and the month on which the option can be exercised. This is called the expiration date. In the case of the European option, the investor can exercise his right on the specified `expiration date' only. In the case of an American Option, investors can exercise the option on or before the `expiration date'.
Strike Price: The `strike price' is the price at which an option can be exercised. For instance, assume that you hold an European Option on XYZ company for one share. The strike price is fixed at Rs 5,000 and the expiration date is 15th June 2001. If the prevailing market price is say Rs 5,500, then you can exercise your option on the 15th and buy one share of XYZ for Rs 5,000.
In-the-money options: Those options which are trading in positive territory are called in-the-money options. This means that in the event of exercising the option, it leads to a gain for the investor. For instance, in the example given above, if the stock was trading at Rs 5,400 on 13th June, then the option is in-the-money from the point of view of the holder.
Out-of-the-money options: Those options which give a negative cash flow to the investors are classified as out-of-the-money options. For instance, in the above example, if the price of XYZ on 13th June was Rs 4,500, then it would have generated a negative cash flow if exercised. Hence the option is classified as out-of-the-money.
At-the-money options: Those options which do not result in any cash flow, in other words, which result in zero cash flow for the investors are called At-the-money options. For instance, in the same example as described above is the price of XYZ was Rs 5,000 on 13th June, then the option is at-the-money.
Next week we shall look into some of the properties of the factors affecting valuation of options.
Option Basics -- IV
Anup Menon
This week we shall look at an option strategy known as collars.
Assume you are an investor and want to own the stock of ABC company. You also know that the stock is not likely to move up at a rapid pace and you want to limit your downside. Under these conditions, an investor can consider using a collar strategy. A collar strategy involves three distinct transactions, namely the purchase of the asset in the spot market. purchase of an out-of-the-money put option and sale of an out-of-the-money call option. The potential risk and reward from using this strategy is limited.
Normally investors using this strategy try to even out the cash outflow on buying the put with the cash inflow from selling the call. In other words the premium paid for the buying the put and selling the call will be equal. This effectively means that the cost incurred by the investor is the equal to that of buying the stock in the spot market. An example would make the operation clearer.
Assume that the stock of ABC is selling at Rs 100. The investor purchases 10 shares of ABC, which means a net outflow of Rs 1,000 (for the purchase in spot market). At the same time the investor also purchases 1 put option (10 shares) with strike price at Rs 95. The investor also sells 1 call option (10 shares) with a strike of Rs 110. Since the premium paid for the put option is the same as the premium received for the call option, the net cost for the investor is Rs 1,000 only.
Assume that the stock price moves down to Rs 90. In that case three events happen. Firstly the call option is worthless. The investor will exercise his put option and thereby receives a cash inflow of Rs 50. The spot position incurs a loss of Rs 100. Therefore, the maximum loss that an investor will suffer is Rs 50. The same condition holds true for any combination of the spot price. If the asset price falls below the put strike, then the maximum loss that the investor can suffer is the difference between the put strike and initial spot price.
Similarly assume that the price of the asset rises to Rs 120. Then the put option is worthless. The investor will have to provides the shares at Rs 110. This means that he will lose Rs 100 (10*10) in the process. However the spot position will gain by around Rs 200. Therefore the net gain will always be Rs 100, that is the difference between the call strike and the original asset price.
Hence we can see that while the risks are contained, the rewards are also constrained.
Option Basics -- V
Anup Menon
ASSUME you are an investor and want to own the stock of ABC company.
However, at present, you are not sure as to the direction in which the stock will move. Is it possible to devise a strategy with limited risk but unlimited gains. Yes, the investor can consider using the (long) straddle strategy. A straddle involves two distinct transactions. For the (long) straddle involves the purchase of a call and put option with the same exercise and terms and conditions. The (short) straddle involves selling of a put and a call option with the same exercise and terms and conditions.
Normally, investors using this strategy are unable to gauge the direction of the stock. Therefore, the more volatile the stock, the better the payoffs from a (long) straddle and vice versa. Investors have to be careful when using this strategy. Why? Options tend to lose value quickly. In the case of a straddle, the erosion is twice that of holding a call or a put option. This apart the transaction costs would also be higher as the investor has to buy twice the number of options. An example would make the strategy more clear.
First let us look at an example of the (long) straddle strategy. Assume that the stock of ABC is selling at Rs 100. The investors purchases one call option at a strike price of Rs 105 and one put option with the same strike price. All other terms and conditions are similar for both options. Further assume that the investor pays a total premium (inclusive of call and put) of Rs 10. Therefore the cost for the investor is Rs 10. This effectively means that if the stock price moves beyond Rs 110, the call option will make money and if it falls below Rs 95, the put option will make money. In the event of the stock price remaining rangebound between Rs 95 and Rs 110, the maximum loss suffered by the investor is Rs 10.
Now let us look at the (short) straddle. This is an extremely risky strategy. For instance, as in our above example, the investor will write a call and a put option with a strike price of Rs 105. He receives a total premium of Rs 10 for his troubles. Therefore his maximum profit from the transaction is Rs 10 only. However of the stock fluctuates beyond the range stated above, the loss for the investor is unlimited. This is an extremely risky strategy and advised only for players with substantial financial backing and experience in trading options.
Next week we shall look at another strategy known as strangles.
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