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Call option
It is a option contract
which gives the buyer the right but not the obligation to buy an asset from the seller at
a pre-fixed price (exercise price) and within a specified period or time by paying a fixed
amount upfront called premium. An option, which can be exercised at anytime during its
life is called an American option whereas those, which can be exercised only on the last
day of expiration, are called European options. Most of the options on individual stocks
are American while index options are mostly European. It is a near and safer alternative
to buying a stock without paying full amount for it and yet enjoying the unlimited (not
anymore) upside profits.
Put option
It
is an option contract which gives the buyer the right but not the obligation to sell the
underlying to the seller at a pre-fixed price (exercise price) and within a specified
period or time by paying a fixed sum upfront called premium. It is just a mirror image of
the call option and is a near and safer alternative to short selling and yet enjoying the
downside profits.
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BADLA VERSUS OPTIONS AND FUTURES
Though it would be
imprudent to compare options and futures with the now-dead badla system as it would be
like comparing apples and oranges, still we could attempt at some comparisons to pacify
those troubled souls who are feel cheated with the exit of badla. Under the century-old
badla system, an investor kept his position open by just paying some margin (around 20 per
cent) and paid or received some finance charges depending on whether he had a buy or sell
position. Under badla system, his position was purely naked without knowing which way the
price would go. Post badla, an investor with a long position in badla would buy a call on
the share and a put in case he was carrying a short position by paying some premium for
the downside protection for long and upside protection for the short.
Under
options you have an inherent element of insurance which limits your losses to the extent
of the premium paid. Here, atleast you can lock in your losses unlike under the
carryforward system, which promoted recklessness to the extent that the investor carried
on positions till he was trapped when the price turned against him (remember Ketan
Parekh). Here, the option buyer does not pay any upfront margin except for the premium.
Secondly, unlike badla rates, the cost of options are significantly influenced by
volatility (besides demand-supply) in the underlying asset. However, futures have a much
closer resemblance with badla since both require an upfront margin to be paid and a
marking-to-market feature (daily though). However, we have futures for the last one-year
but they are yet to attract investors interest due to the presence of badla.
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Enter index options…
Unlike
bonds, stocks have a larger proportion of unsystematic risk (stock specific risk) since
diversification works better with stocks unlike bonds. Exchange traded options started in
1973 but futures came in 1982 only. Index-based derivatives are more popular than
stock-based ones and index futures are ahead of index options. Theoretically, an index
option allows the buyer to buy the underlying index, though practically worldwide it is
settled in cash since the index is a bit difficult to be delivered (though not
impossible). However, after buying the option you can always cancel your position by
selling the option in the markets. Normally, the more you delay the lesser the premium you
get when you go to sell. As a buyer you would pay a premium to the option seller in cash
upfront.
Index
options enable investors to have exposure in a broad market with far lesser trades and
hence transaction costs and commissions are lower. To have the same level of
diversification using individual stocks or individual stock options, you have to take
numerous decisions and trades. In percentage terms, premiums on index options are usually
lower than those of individual stock options as the latter are more volatile than the
Index. However, if you find difficult to predict the markets, index options are riskier
than stock options. Index options appeal to all kinds of users whether conservative or
aggressive. For small investors options are better than futures since they have in-built
insurance and large investors find it better to manage portfolio risks better.
To
remind, volumes in S&P 500 futures alone are about 70% of the volumes on NYSE and
NASDAQ (cash markets) put together. Whereas volumes in S&P 500 options are about
one-third of that in S&P 500 futures. Retail investors find derivatives attractive,
and in Korea they account for about 40% of derivatives market though it took about two
years. However, the number of stock options traded on various exchanges in the US is less
than 10% of the volumes in the underlying cash markets.
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NSE Nifty Options
The multiplier
for Nifty options is 200 with a minimum price change of Rs 10 (200*0.05). To make it
simpler, for example you hold say, a one-stock portfolio of HLL valued at Rs.10 lakhs
(bought at Rs.290 each share). Beta is 1.13 so you need to buy puts worth 11,30,000
(10,00,000*1.13) for hedging. Nifty 1-month puts of strike price 1412 are trading for
premium of 11. To hedge, you bought 4 puts (200*4*1412 = 1130000 lakhs). The premium paid
by you is 8800(11*4*200). If at expiration, Nifty declines to 1329, and HLL falls to Rs.
275, then the diminution in your portfolio is 51,724 (290-275) but your gain on the puts
is Rs 66,400 (1412-1329)*4*200. So you gain more than what you lose because the Nifty
index fell down more than your portfolio.
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BSE Sensex options
These
would be European in nature (exercise at expiry though daily mark-to-market will be there)
and will expire on last Thursday of contract month. There would be call and put option
contracts with 1, 2 and 3-month maturity. At any point of time, there will be at least two
in-the-money, two out-of-the-money and one near-the-money contract. For example, at a
Sensex 3700, contracts with exercise prices of 3900, 3800, 3700, 3600 and 3500 will be
available for trading. As the Sensex crosses 3,800 or 3,600 level, the new contracts with
strike prices of 4000 and 3400 respectively will be introduced for trading. Settlement
will be done in cash on a T+1 basis and settlement prices will be based on expiration
price as may be decided by the exchange.
Contracts
will have a multiplier of 100. Suppose you buy one June Sensex options at 3600 for Rs 10
premium which is Rs 360,000 (3600*100) in value terms. If at expiration, Sensex closes at
3700 you gain Rs. 10000 (3700-3600*100) on one trade on an investment of just Rs. 1000
(10*100). When option holder exercises a randomly selected seller is assigned the
obligation to honor the underlying contract, and this process is termed as assignment.
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Trading
strategy for index options
As a call
buyer, you would normally prefer to buy longer maturity contracts whenever the Sensex
falls to bottom levels. But you will have to pay a higher premium for longer maturity
contracts since chances of gains are higher. Similarly, you will rush for buying a put at
higher levels fearing a crash. Options act as a hedging tool when you do not buy it with a
view on the markets - you buy a call or put blindfolded just to create an opposite
position to your existing position in cash market. But when you do not have any exposure
in cash market and you are betting on a scenario (like Sensex will shoot up to 5000 or a
war will break etc) the same instrument becomes speculative. Or you may use options to
have a normal position as you do in the cash market since your investment is small and the
position is similar as if you have a delivery based position. And when you are just eyeing
the price gaps in two instruments (intra-index, inter-index or inter market) you become an
arbitrageur. Still as a buyer in all these cases you stand to lose nothing more than the
premium paid - such is the beauty of options.
If you have a long
position in the cash market you will buy a put and lock in your losses so that if the
Sensex goes down, you gain on the put and if it goes up you gain in the cash market. Well,
nothing stops you from going long or short in both the markets simultaneously but then you
must be inviting bankruptcy or making fortunes by doing that. Individual investors might
want to profit from their views on the broad market or some sectors. Professionals find
index options as excellent tools for enhancing market timing decisions and manipulating
asset mix. For them, managing portfolio risk might mean using index options to either
reduce risk or increase market exposure based on the scenario.
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Options
premiums are not fixed by any trading exchanges but are rather decided by forces of
demand-supply and certain variables. It is important that investors understand whether the
premium charged by the broker is fair and what are the factors underlying while deciding
the premium. Option premiums factor the usual market forecasts about the underlying asset
but buyers will profit from any unpredictable movements, which is not factored at the time
of deciding the premium. A pricing model also assists traders in keeping the prices
of calls and puts in proper numerical relationship to each other and helps traders quote
bids and offers quickly. Mathematically, the premium is calculated by the Black-Scholes
model (values European and non-dividend paying only) or Binomial model (American only)
considering certain variables like, stock price, stock volatility, time to expiration,
risk free rate of interest, exercise price and dividends. The call premium varies directly
with first four and inversely with last two. All except volatility, time to expiration and
dividends have an inverse relationship with the put premium.
Black Scholes model
assumes that the percentage change in the price of underlying asset follows a normal
distribution. This model also assumes that stock prices are lognormally distributed. A
random variable has a log normal distribution if the natural logarithm of the variable is
normally distributed. If stock prices were normally distributed, this would imply that it
is equally likely for a stock price to move up or down. But there are natural factors that
impede downward movements. Black Scholes model is good for pricing at-the-money options
especially when T is more than two months and no dividends occur. On the other hand,
Binomial model assumes a binomial distribution. There are other models like
Merton’s, Adesi Whaley as well.
An option premium is
the sum of intrinsic value and time value. The intrinsic value of the call is maximum of
{(S-E), 0} while that of put option is maximum of {(E-S), 0}. Intrinsic value can never be
negative and hence if it is zero, the option value equals the time value. Time value is
highest for at-the-money options whereas a deep out-of-money has little potential to gain
intrinsic value. An option with intrinsic value is said to be in-the-money while one
without it is called either at-the-money or out-of-money. Options that have higher
intrinsic value are called deep in-the-money and near-the-money if close to money.
Just like all other
assets, chances of mispricing in shorter maturity options are relatively higher. Also,
options on extremely low and extremely high volatility stocks are often mispriced. Market
prices do not always conform to theory, but most options trade somewhere near their
theoretical values. Prior to reaching parity, premiums tend to increase less than
point-for-point change in stock prices because point-to-point increase would reduce option
buyer’s leverage (which lowers demand). Point-to-point movement with stock price
happens only at parity. Declining stock prices too do not normally result in a
point-to-point decrease in call premium. And for the option on the same stock, the
premiums will vary for different maturities and those with longer maturities will attract
more premiums.
Any unforeseen
happenings due on the stock will definitely not get factored into the premium and exercise
price and it is here that the buyer can make a killing by having a view. Options premiums
must be sufficiently high enough to encourage writers to write rather than seek
alternative investments. Therefore, rising interest rates put upward pressure on premiums
and declining rates increase the option value. Increasing interest rate impacts longer
maturity options comparatively more than short maturity ones. There are other measures,
which are too complex to be understood and with not much utility given the nature of
products initially. More about it later.
Delta : Measures estimated change in option price for a
change in the price of the underlying.
Gamma : Measures estimated change in the Delta of option for a change in price of
underlying
Vega : Measures the estimated change in the option price for a
change in volatility of underlying.
Theta : Measures the estimated change in the option price for a change in the
time to option expiry.
Rho : Measures the estimated change
in the option price for a change in the risk free interest rates.
Remember that the value of
an option for a given stock does not depend on what the stock is expected to do. The value
of the option on a stock that is expected to go up has the same value as another option
whose stock is expected to go down. Option buyers are not entitled to vote and receive
bonus, rights and dividends unless they exercise.
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Before
we start, let us remember that before derivatives came into existence, we Indians had only
one normal market, which now will have to be called with a new name – the cash
market, since quite parallel to this, we now have the derivatives market. An investor can
create a hedge position or an entirely speculative position through various strategies
that reflect his risk tolerance level as underlined below.
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STAND ALONE STRATEGIES
Buy
a naked call
Buyer has opportunity
for unlimited profit potential on an upward move in the underlying stock while having very
little capital at risk (premium) compared to the amount needed to actually buy the stock
in the cash market. He is behaving like somebody who genuinely wants to buy but does not
have funds to take delivery. On the other hand, speculators may get a hot tip on a stock
but not have money to buy the stock, can also take a position in the stock by buying a
call.
Another reason is the
investor might be afraid that the stock might fall after he buys. So buying a call keeps
his upside open but limits his loss only to the amount of premium paid. While judicious
use of stop loss order might limit his loss in the cash market one is not sure whether the
order will be exercised at all. He can maintain a perpetual long position in the
underlying by rolling over options (based on his outlook) since initially the instruments
will have a maximum duration of 3 months only.
Buy
a covered call
Here the investor
might have sold his holdings because he had some immediate cash requirements or he might
have simply thought that the upside would take some time so why not make some extra income
in between. Or, he simply wants to participate in the upside with a lesser amount at
stake.
Sell
a naked call
Seller
runs the risk of losing heavily in case of drastic movements on the upper side. Writer
should be too confident about his forecast else be prepared to lose heavily. Naked writers
have to deposit higher upfront margins. If an investor feels that the stock will decline
but is not sure to what extent, he may write naked calls.
Sell a covered call
Writer
is holding underlying asset and writes to gain some additional income to enhance his yield
or return on his portfolio. He does not have any drastic view and rather believes that
markets would show feeble uppish movements but not strong enough so as to lead to
exercise. The risk of diminution in underlying value and premium may not be adequate to
cover his notional losses. On exercise, seller faces risk of opportunity loss since had he
not written he could have sold the stock at higher levels. He has to remain content with
the dividends and the premium. Short calls can be covered with a long position in cash
market.
Buy
a put
Buyer hopes to make a
killing with his bearish view on the markets. At lower levels, puts will be selling for
cheap. For instance the premium on Sensex options when the index is quoting at 3400 will
be lesser compared to that when it is at 3800. The beauty of buying a put is that if the
stock rises instead of falling your loss is merely the premium paid unlike the
theoretically infinite loss possibility in selling stocks short. Bears will discover that
buying puts are a better way of hammering a stock since as the price falls, he will first
make money by exercising the put and selling at higher exercise price and simultaneously
accumulating the shares at lower levels.
This
is alternative to short selling but he invests less cash than the margin and is not
responsible for the dividend which he has to pass on to the buyer. Suppose one buys a put
DSQ at Rs 90/5 and the stock goes down to 70. The profit of the put buyer is 300 per cent
which he could have never made even if the stock had come down to 30-40 levels. Plus he
had to deposit upfront margins for going short or would have to borrow shares. As a
measure of interpretation, since ESOPs have lock-in-periods employees can buy puts to
insulate against declining markets.
An
investor can lock-in his portfolio value irrespective of whatever happens to the price of
the underlying asset. This is essentially similar to buying an insurance product for your
portfolio and you are just trying to minimize your loss rather than trying to make any
profits. However, based on your risk disposition, you can alter the hedge ratio for making
some profits. For instance, if you have a Rs 10 lakh long position in cash market, you may
buy a put for Rs 7 lakh only because you think that markets may not fall that much.
Sell
a put
Here,
the writer is overly confident of the markets not dropping down and rather thinks that the
cash market may be on the upper side. Selling puts can be a nice strategy to accumulate
stocks since buyers will sell it at lower prices. Ideal for those with a takeover motive?
Writing a put can also act as an alternative to buying a stock at a price lower than the
market price by writing at a lower E and further reducing the cost of purchase by the
premium amount.
We
must understand that writing a put is almost similar to writing a covered call writer. The
only difference is that the covered call writer has a large sum invested whereas the put
writer keeps his cash alongwith the interest earned on it with the hope of buying the
stock back in case of a decline. Thus the economic opportunity and risk of writing are
same both for covered call writing and a naked put. Other things being equal, selling a
put is less risky than selling a call since a stock cannot be 0. As a corollary to the
above, short puts can be covered with short position in cash market.
Straddle
This
involves buying a call and a put with the same exercise price and T. The buyer expects a
lot of volatility in the markets and wants to profit out of it but is not sure which way
the markets will move. However, he wants to participate in the profits. To ensure that he
gains in either case, he buys both a call and a put by paying premiums on both the options
knowing fully well that only either of the call or put will be exercised and the premium
on one option will definitely get wasted. The very fact that he is paying double premium
proves that he is ignorant about which way the markets will go. But, he expects a drastic
movement on either side so as to gain from exercising either of the two options. For a
limited movement, he ends up with a net loss because the double premium he paid may not be
setoff against the small profit on exercise of any one option.
The writer hopes that
there will be a narrow movement so that he can coolly keep the premium without losing much
on the exercise. Natural strategy for a company subject to a takeover bid? Naked writing
may prove too riskier in case of drastic movements on either side since either of the
options will definitely be exercised. The (in)famous derivatives trader, Nick Leeson
earned bankruptcy (and of course a jail term) as he kept on writing naked straddles even
after being caught in the Kobe-earthquake-triggered collapse of the Nikkei. However, funds
sitting on huge chunks of stocks can maximize their returns by writing and buying a
combination of straddles intelligently.
Strangle
It
is a straddle in which the two legs do not have common exercise price and are also out of
money. Here the stock price has to move much farther away from the exercise price compared
to that in the straddle for the investor to make a profit. Buying is called a bottom
vertical combination whereas selling is called a top vertical combination. Other things
being equal strangles sell for lesser premium than straddles. This suits a seller who bets
that the chances of his being assigned to buy or sell are less than had he wrote a
straddle. The buyer sees it as a better instrument than the straddle provided the markets
are expected to be volatile enough to give him enough profits since he is paying a lesser
premium than the straddle. Actually, it suits conservative buyers and sellers but is
relatively biased in favor of the seller than straddle.
Strip
Involves
buying two puts and one call with same exercise price and T. Buyer is betting that there
will be a big price movement and considers a decline more likely than an increase. But he
is not a fool - at the same time he is a bit skeptical about his view and hence he has
bought a call also. For all this he is paying a fat premium - on all three options. Seller
thinks that the premiums on three instruments will more than offset the downside risk and
hopes that the market will trade in a narrow range. Obviously, a strip buyer is a deep
pocket investor who wants a sureshot profit even at the cost of paying exorbitant
premiums.
Strap
Involves buying two
calls and one put with same exercise price and T. Investor is betting that there will be a
big stock price move and considers an increase more likely but is apprehensive about any
surprise downside therefore he has bought a put also. However, he expects an increase more
likely than a decrease. Seller thinks that premium on three instruments will still leave
him with something to take home and hence prays for a flattish movement.
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SPREAD STRATEGIES
Vertical spread
The exercise prices appear vertically
in the quotation tables for traded options, therefore a spread strategy using different
exercise prices are called as vertical spreads. This involves simultaneous purchase and
sale of options of the same class and time to expiration but different exercise price. The
below given payoffs are from the point of view of the buyer.
Bullish call
spread
This
involves buying a call with lower exercise price and selling the one with a higher
exercise price. In a bullish spread you are buying a call which has a lower exercise price
(higher premium) than an another call which you are selling (lower premium). At the
upfront itself, you have an outflow. Say suppose, you are buying a September call on Tisco
by paying a premium of Rs 10 which has an exercise price of 140 and are also selling a
call with an exercise price of 160 and receiving a premium of Rs 8. If your view is
correct and Tisco moved up to 180, your profit is (180-140) – (8-10) = 38. And mind
you this is almost riskless since your maximum loss is Rs. 2 (8-10) if none of them are
exercised. And your breakeven point is Rs. 142 (140+2).
At any point of
time your payoffs would be:
Maximum Profit =
(Higher E – Lower E) – Net premium
Maximum Loss =
Net premium
Break even =
Lower E + Net premium
Bearish call
spread
In a bearish spread, you buy a call
that has a higher E (lower premium) and sell a call, which has a lower E (higher premium).
At the upfront itself you have a net inflow. You can work out an example yourself.
Maximum Profit = Net premium
Maximum Loss = (Difference in E) - Net
premium
Break even = Higher E - Net premium
Bullish put spread
Buy a put with a lower exercise price
and sell a put with a higher exercise price.
Maximum Profit = Net premium
Maximum Loss = (Higher E – lower
strike) - Net premium
Break even = Higher E – Net
premium
Bearish put
spread
Buy a put with a higher exercise price
and sell a put with lower exercise price.
Maximum Profit = (Difference in E)
– Net premium
Maximum Loss = Net premium
Break even = Higher E - Net premium
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Horizontal/Calendar spread
The time maturity for
traded options in quotation tables appear horizontally, hence a spread strategy using
different maturities are called as horizontal spread. This is created by simultaneously
buying and selling different maturity options but with same exercise price, based on
whether you are bullish or bearish. Thus as long as cash price remains stable or does not
move significantly against you, you can profit from ‘riding down’ the time value
of the near term option, since the loss on longer term one will be less than the profit on
the near term one. In neutral calendar spread, the exercise price close to the current
stock price is chosen.
In a bullish calendar
spread you buy a call with higher maturity and sell another call with a lower maturity.
Quite contrary, in a bearish calendar spread you buy a lower maturity call and sell a
higher maturity call. For bearish calendar spread using puts, you buy the long-term
maturity one and sell the shorter maturity one but both have same exercise price. Your
strategy would be opposite if you are bearish. For an example on bullish calendar spread
using calls, you buy a Reliance September call for 400/15 and sell Reliance July 400/5
call. If Reliance moves up to 430 your profit is (430 - 400)–(15-5) = 10. Your
breakeven would be (400+10) = 410. Your maximum loss will be Rs. 10 if none of them are
exercised. You can work out the payoffs for rest of the positions in a table for different
stock prices say in the Rs. 300-500 range with an interval of 10.
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Diagonal spread
Bull,
bear and calendar spreads can all be created from a long position in one call and short in
another call. In case of bull and bear spreads, calls have different E but same T. In case
of calendar spreads, calls have same E but different T. A diagonal spread has different E
and T in both the legs. You can workout the payoffs yourself in a table using a
hypothetical case.
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Box spread
Four different
options with two different E but same T. It is a spread of spreads - compound spread.
Involves buying a bull call spread and selling a bull put spread or vice versa. Outlook is
neutral and hence results in riskless profits. One has the chance to borrow money for at 0
per cent by selling the box spread.
Initial cost =
(Low Exercise-High Exercise) – (Low premium – High premium)
Maximum Profit =
0
Maximum Loss = 0
Break even at
every S.
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Butterfly spread
This involves buying 4
options with same asset (all calls or all puts) and T. The two middle ones are bought and
the two at either ends are sold or vice versa. If two middle ones are bought, it is called
reverse butterfly or sandwich spread. Profit potential is limited since it is a price
spread.
Break even of
buyer = Sell E + (Net premium)
Break even of
seller = Buy E + (Net premium)
For significant
price change, a buy is profitable while for a moderate change selling is profitable.
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Hedging strategies
If you feel that
markets should go up by Ganesh Chaturthi you better do either of these – buy a call,
sell a put, buy a bullish spread, buy a strap. Similarly, if you have a bearish outlook on
the markets, you can do either of these - buy a put, sell a call, buy a bearish spread or
buy a strip.
Options can also be
combined with futures to create a hedge.
Covered call sale =
Short call + Long Futures
Covered put sale =
Short Put + Short Futures
Synthetic futures and options
Synthetic
futures position are created by combining two option positions such that the resulting
payoff diagram is same as that of an outright futures position.
Synthetic
long futures = Long call + Short put
Synthetic
short futures = Long put + Short call
Synthetic
long call option = Long put + Long futures
Synthetic
long put option = Long call + Short futures
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PUT CALL PARITY
This
is central to the relationship between call and put options. It says that buying a stock
is equal to buying a call and selling a put. However, this parity does not hold good for
American options. It also says that the European call must be worth atleast its intrinsic
value as long as no cash payment will occur on underlying asset before expiration date.
While a European put may sell for less than its intrinsic value under certain conditions.
The put call parity is:
+ S = +C + (-P) Owns
upside potential but has the risk of ownership through short put
The
below given combinations are just rearrangements of the put call parity
+
P = +C + (-S) If an investor is short stock, he has downside potential but his loss is
limited to P
+
C = +S + (+P) Has upside potential but loss is limited to premium paid
-
C = -S + (-P) Profit is premium but loss upside is unlimited
-
P = +S + (-C) Profit limited to premium but has incurred ownership risk
-
S = +P + (-C) Profit from a decline but loss from rise
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Buying
or selling options in a stock for speculative gain may turn risky if you cannot cover
later due to poor liquidity. Any form of uncertainty in the cash market will render
hedging of the option more difficult, resulting in a higher premium.
If there are
imperfections in the cash market the same can infiltrate into the derivatives markets.
Buyer loses entire
premium since options are a wasting asset if remains out-of-money till expiration.
The seller faces
the risk of being assigned exercise randomly by the stock exchange.
Covered call
writer too faces risk of opportunity loss on the upper side.
The put writer
faces risk of buying at higher exercise price.
Transaction costs
in combination or spread trading is high.
Increased risk if
one leg is liquidated and other one is still outstanding.
Timing of cash
flow, spreads, dividends and margins can bring distortions in payoffs.
Operators can move
the cash market on the day the contract expires and then gain in the derivatives market
though higher liquidity would resist this to an extent. Manipulations can be done in the
cash market to influence the options market.
EXOTIC OPTIONS
The
below mentioned types will not be introduced in the Indian markets as most of them are
traded in commodity or fixed income markets.
Leaps
Long-term Equity
Anticipation Securities (LEAPS) are long-dated put and call options on common stocks or
ADRs. These long-term options provide the holder the right to purchase, in case of a call,
or sell, in case of a put, a specified number of shares at a pre-determined price up to
the expiration date of the option, which can be upto three years in the US.
Barrier Options
Here
the payoff depends on whether the price of underlying asset reaches a certain level during
a certain period of time. CAPS traded on CBOE (Chicago Board of Options Exchange) are
examples of barrier options where the payout is capped so that it cannot exceed a certain
amount. A Call CAP is automatically exercised on a day when the index closes more than a
certain amount above the strike price. A put CAP is automatically exercised on a day when
the index closes more than a certain amount below the cap level. Another type is a
knockout option - when price reaches a certain barrier the option ceases to exist. In case
of a call knockout, the barrier is generally below E. The option is sometimes referred to
as a down and out option. In case of a put knockout, it is referred as ‘up and
out’ option. A ‘down and in’ and ‘up and in’ options come to
exist only when the barrier is breached.
Binary Options
Options with
discontinuous payoffs. A simple example would be an option, which pays off if say price of
a Infosys ends above exercise price of say, Rs. 4000 and pays off nothing if it ends below
it. ‘Cash or nothing call’ - pays off nothing if stock price ends up below E and
pays a fixed amount if it ends up above E. ‘Asset or nothing call’ pays off
nothing if stock price ends up below E and pays off an amount equal to S if it ends up
above S.
OTC options
Options
dealt directly between counter-parties and are completely flexible & customized. There
is some standardization for ease of trading in the busiest markets, but the precise
details of each transaction are freely negotiable between buyer and seller.
Look back options
Gives the buyer the right to enjoy the
best rate that has occurred during a preceding period but at a higher premium.
As you like it option
Gives the buyer
the right to decide whether an option is a call or a put after passage of a
predetermination period. Obviously, the buyer pays a higher premium for this.
Range forward
options
In
a range forward purchase, two prices P1 and P2 are agreed upon at the time of inception of
the contract. At the maturity of the contract, the buyer is entitled to buy the asset at
F1 if the then cash price is less than F1, at P2 if the then cash price is more than P2
and at the cash price if it is in between P1 and P2. The values of P1 and P2 are set such
that no upfront payments are involved from the buyer to the seller. It is easy to see that
the purchase of a range forward is equivalent to a portfolio of options consisting of a
long position in a call with exercise price P2 and a short position in a put with exercise
price of P2. Range forwards are also called zero cost collar, flexible forward, cylinder
option, option fence, min-max and forward band.
Participation forward
Agreement is designed so that the
buyer can reap part of the benefit of the depreciation and seller can reap part of the
benefit of the appreciation with no upfront fee. The contract thus guarantees a floor
price to the seller, a ceiling price to the buyer and an opportunity of doing better than
these.
Compound option
A
option to buy another option and an option on the maximum of the two assets
Contingent
option
The exercise is
contingent upon occurrence of a particular event.
Forward
reversing option
Option premium is
paid in future and that too only if the price of the underlying is below a specified
level.
Bermuda options
Exercise is restricted to certain
dates during the life of the option. E.g. American options that can be exercised only on
certain reset dates. Warrants issued by companies too have a similar feature.
Forward start
options
Premium paid at beginning but contract
will start at some time in the future. Sometimes used in employee incentive schemes. The
terms are so chosen that it will be at the money at the starting time.
Futures options
Gives the buyer the right
to buy or sell a futures contract on an underlying asset. Options on futures limits the
losses to the amount of premium paid which normal futures do not provide. Also normal
futures require daily settlement of margin whereas this painful impediment does not affect
option on futures. The maturity of the option corresponds to the delivery month of futures
contract. Exercising actually increases the leverage and the attended downside risk
potential by converting the option position into a futures position. All futures options
in US are American. On exercise of futures option, buyer acquires a long/ short position
where the purchase price of futures is equal to the exercise price of the option.
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Sebi
has set out five parameters for options on individual stocks. Stocks must be among top 200
in terms of market cap and trading volume and must be traded in at least 90 per cent of
the trading days. Plus, non-promoter holding must be minimum 30 per cent while market cap
of free-float should be Rs 750 crore. The six-month average trading volume in the stock in
the underlying cash market should be a minimum Rs 5 crore. Additionally, the ratio of
daily volatility of the stock vis-a-vis the daily volatility of the index should not be
more than 4 times at any time during previous six months. This would depend upon the time
frame and the criteria used for measuring volatility. Based on these criteria, Sebi has
released a list of 31 stocks for stock-based option trading from July onwards. The 31
stocks are ACC, Bajaj Auto, BPCL, BHEL, BSES, Cipla, Digital, Dr Reddys, Grasim Gujarat
Ambuja, HLL, Hindalco, HDFC, ICICI, Infosys, ITC, L&T, M&M, MTNL, Ranbaxy, RPL,
RIL, Satyam, SBI, Sterlite Optical, Telco, Tata Power, Tisco, Tata Tea and VSNL. Contracts
will have minimum size of Rs 2 lakh initially. It has also decided to have a cash
settlement in options contracts for the first six months and after that stock exchanges
could move over to a physical settlement.
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Margining
Margins include
initial margin, daily variable margin, and additional margin based on marking to market.
Initial margins will be decided on a worst case loss covering 99 per cent value at risk
(VAR) in one day. This worst case loss will be calculated by valuing the portfolio under
different scenarios of changes in prices and volatility. The price range for generating
the scenarios will be 3.5 standard deviations. Simply put, this is just a mathematical way
of calculating the potential loss that a stock can suffer given its past volatility. The
volatility range for generating scenarios for stock options would be taken at 10% for an
initial period of six months, after which it shall be reviewed.
Standard deviation for
stocks would be calculated on periodic basis to classify them into various groups with
different volatility multiples. This will translate into a scripwise VAR, which will give
rise to a multiplier. This would be set at a minimum of 1.5 and can go upto 3. This
scripwise multiplier would be multiplied with the index-based VAR calculated above. This
will be the margin applicable to the particular stock.
For option sellers,
the margin will be equal to 7.5 per cent of the notional net option value based on
the closing price of the stock on the previous day or sum of the worst scenario loss,
whichever is higher. Buyers are not required to pay any margins but they will have to pay
the premium in advance (in cash) which will be handed over to sellers. Exchanges can set
limits on exercise price. The extent of margining automatically changes with any change in
the market conditions and there would be no need for the regulator to intervene.
Premium will be
deducted from broker’s net worth on a real time basis. The initial margin would be
netted at client level and will be grossed at the trading/clearing member level. The net
option value (number of options into price) will be added to the networth and the
mark-to-market gains and losses will get adjusted against it. The notional value of gross
short open position will not exceed 20 times of brokers’ networth. Exchanges will
ensure that 5 percent of notional value of gross short open position is collected or
adjusted from the networth. Apart from existing member-wise position limits, the
market-wide limit of open positions will be 20 times of daily average volume in last month
in cash market or 10% of free float, whichever is lower. Exchanges will double the price
and volatility range when the total open interest in a contract touches 80 per cent of
market-wide limit in that contract.
Brokers can use
Specific Portfolio Analysis of Risk SPAN, a portfolio based margining model which takes an
integrated view of client-wise risk. It determines the largest loss that a portfolio might
suffer within the period specified by the exchange. Members can also calculate
clients’ margin requirements using PC SPAN. Each business day the exchange will
generate risk parameter files (parameters set by the exchange) which can be downloaded by
members. The position file consisting of members' trades (own + clients) and the risk
parameter file is fed into the PC-SPAN which gives the margins.
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