Derivatives Insights & Option Trading Strategies

 What is “Option”?

An Option is a contract, which gives the buyer the right, but not the obligation
to buy or sell shares of the underlying security at a specific price on or before a
specific date.

 Index options: These options have index as the underlying

E.g. Nifty options, Mini Nifty options, etc.

 Stock options: Stock options are options on individual stocks. A stock

option contract gives the holder the right to buy or sell the underlying
shares at the specified price.
In India Stock Options have an American style settlement.
 European options: European options are options that can be exercised
only on the expiration date itself

In India Index options have European style settlement.

 Call option:

A call option gives the Buyer the right but not obligation to buy an asset by a
certain date at a certain price.

Calls are similar to having a long position in a stock.

 Put option:

A put option gives the Buyer the right but not obligation to sell an asset by a
certain date at a certain price.

Puts are very similar to having short position on a stock.

 Option price/premium:

Option Premium is the price which the buyer pays to the seller.

 Expiration date: The contract maturity date specified in the options

contract is known as the expiration date.
  Strike Price: The price agreed in the contract at which the transaction is
supposed to take place on or before expiry date is known as the Strike
Price.

Strike prices are established when a contract is first written.

For call options, the strike price is where the security can be bought.

For put options the strike price is the price at which shares can be sold.

 Exercise : Contract can be Exercised only by Buyer at the difference

between Strike Price and Settlement Price of underlying on exercise day.
 Square-off: Square-Off can be made by both BUYER and SELLER

Difference between PREMIUM amounts at the time of Square-off.

 Participants in the Options Market
 Buyer of an option: The buyer is the one who by paying the premium
buys the right (but is not obliged) to buy or sell a certain stock at a
specific price (Strike price) on or before a certain date (Expiry Date)
 Writer / seller of an option: The writer / seller of an option is the one
who receives the premium and is thereby obliged to sell/buy the assets
at a specific price, if the buyer exercises his rights on him.
 People who buy options are called holders and People who sell options
are called Writers.
 Buyers are said to have long positions and Sellers are said to have short
positions.
 Buyer: Get Rights, Pays Premium
 Seller: Has an OBLIGATION, Receives Premium
 BUYER of CALL / PUT options : Maximum loss : PREMIUM / Maximum
Gain : Unlimited
 Seller of CALL / PUT options

Maximum loss : UNLIMITED / Maximum Gain : PREMIUM

 Who can write options in Indian Derivatives market?

In the Indian Derivatives market, SEBI has not created any particular category
of options writers. Any market participant can write options. However, the
margin requirements are stringent for option writers.
Open Interest

• Open interest represents the total number of open contracts on a

security.

• It is total number of options/futures contracts that are not exercised or

expired or fulfilled by delivery.

• The open-interest position is reported each day representing the

increase or decrease in the number of contracts for that day

• Open interest can be used as an indicator to confirm trends and trend

reversals.

An increase in open interest along with an increase in price confirms an

upward trend.

An increase in open interest along with a decrease in price confirms a

downward trend.

An increase or decrease in prices while open interest remains flat or declining

may indicate or possible trend reversal.

Volumes
• Volume represents the total number of shares or contracts that have
changed hands in a one-day trading session.

• Greater the amount of trading during a market session, higher will be

the trading volume.

• Volume represents a measure of intensity or pressure behind a price

trend.

• Greater the volume, more we can expect the existing trend to continue
rather than reverse.

• Volumes precedes price, which means that the loss of either upside
price pressure in an uptrend or downside pressure in a downtrend will show in
the volume figures before presenting itself as a reversal in trend.
Significant Differences between Futures and Options
 Futures are agreements/contracts to buy or sell specified quantity of the
underlying assets at a price agreed upon by the buyer & seller, on or
before a specified time. Both the buyer and seller are obligated to
buy/sell the underlying asset.
 In case of options the buyer enjoys the right and not the obligation, to
buy or sell the underlying assets.
 Futures Contracts have symmetric risk profile for both the buyer as well
as the seller, whereas options have asymmetric risk profile. In case of
options, for a buyer (or holder of the option). The seller or writer of an
option, however the downside is unlimited while profits are limited to
the premium he has received from the buyer.
 The Futures contracts prices are affected mainly by the prices of the
underlying asset. The prices of options are however; affected by prices
of the underlying asset, time remaining for expiry of the contract,
interest rate & volatility of the underlying asset.
 What are different pricing models for options?
The two most popular option pricing models are:

 Black Scholes Model which assumes that percentage change in the price
of underlying follows a lognormal distribution
 Binomial Model which assumes that percentage change in price of the
underlying follows a binomial distribution.

Option Greeks?

The price of an Option depends on certain factors like price and volatility of the
underlying, time to expiry, etc. The Option Greeks are the tools that measure
the sensitivity of the option price to the above mentioned factors. They are
often used by professional traders for trading and managing the risk of large
positions in options and stocks. These option Greeks are:

 Delta : is the option Greek that measures the estimated change in option
premium/price for a change in the price of the underlying.
 Gamma: measures the estimated change in the Delta of an option for a
change in the price of the underlying
 Vega: measures the estimated change in the option price for a change in
the volatility of the underlying
 Theta: measures the estimated change in the option price for a change
in the time to option expiry.
 Rho: measure the estimated change in the option price for a change in
the risk free interest rates.
 Volatility: A measure of stock price fluctuation. Mathematically, volatility
is the annualized standard deviation of a stock’s daily price changes.

Premium is the price of an option and is equal to its intrinsic values plus time
value.

Theoretical value: The estimated value of an option derived from a

mathematical model.
 Option Premium components
 Intrinsic values of an option:

Only ITM Call or Put options will have intrinsic value

Intrinsic value of ITM call = Spot Price – Strike Price

Intrinsic value of ITM put = Strike Price – Spot Price

ATM and OTM will have zero intrinsic value.

 Time values of an option:

The time value of an option is the difference between its premium and its
intrinsic value.

An option that is OTM and ATM has only time value.

The longer the time to expiration, the greater is an option’s time value, all else
equal.

At expiration, an option should have no time value.

Option Price
 In-the-money option: A call option on the index is said to be in-the-
money when the current index stands at a level higher than the strike
price.

i.e. spot price > strike price

If the index is much higher than the strike price, the call is said to be deep ITM.

In the case of a put, the put is ITM if the index is below the strike price.

 At-the-money option: An option on the index is at-the-money when the

current index equals the strike price i.e. spot price = strike price
 Out-of-the-money option: A call option on the index is out-of-the-money
when the current index stands at a level which is less than the strike
price.
i.e. spot price < strike price

If the index is much lower than the strike price, the call is said to be deep OTM.

In the case of a put, the put is OTM if index is above the strike price.

CALL OPTIONS PUT OPTIONS

In-the-money Strike Price < Spot Price Strike Price > Spot Price
At-the-money Strike Price = Spot Price Strike Price = Spot Price
Out-of-the-money Strike Price > Spot Price Strike Price < Spot Price

Factors affecting the value of an option premium

Quantifiable factors:

 Underlying assets i.e. stock price

 Strike price of the option
 Volatility of the underlying stock
 Time to expiration
 Risk free interest rate

The theoretical option pricing models are used by option traders for calculating
the fair values of an option on the basis of the above mentioned influencing
factors.
 Open Interest Dashboard
General Rules for Price, Open Interest and Volume

S. No. Price Open Interest Volume Market

Direction
1 Up Up Up Bullish
2 Up Down Down Bearish
3 Down Up Up Bearish
4 Down Down Down Near to
Bullish
Reversal
5 Sideways Up Up Significant
movement in
any direction
6 Sideways Down Down Sideways
movement to
continue.

 Rising market and increasing open interest – Bullish

It implies the entry of new players into the market, who are creating fresh long
positions and suggests the flow of extra money into the market.

 Rising money and decreasing open interest – Precursor to a trend

reversal.

The lack of additions top open interest shows that the markets are rising on
the back of short-sellers covering their existing positions. This also implies that
money is flowing out of the market, given that open interest is decreasing.

 Falling market and increasing open interest – Bearish

Through a rise in open interest means that new trading positions are being
created and fresh money is getting routed into the market, the new money is
probably being used for creating fresh short positions, which will lead to a
further downtrend.

 Falling market and decreasing open interest – Strengthening

market/Bullish
If open interest decreases in a falling market, it can be attributed to the forced
squaring-off of long positions by traders.

It , thus, represents a trend reversal, since the downtrend in the market is

likely to reverse after the long positions have been squared off.

 Sideways market and increasing open interest – Expect significant

movement

However, the direction of the move cannot be predicted.

 Sideways market and a decreasing open interest – Continuation of flat

trend

Sideways movement will continue for some more time.

A decrease in open interest only represents the squaring-off of old positions

and lack of any new positions might result in a sideways or weak trends in the
market.
 Must learn for serious traders and investors
Golden Rules: Strategies
There is no “genius” in these rules. They are common sense and nothing else. But as Voltaire
said, “Common sense is uncommon.” Trading is a common-sense business.

 Don’t trade until the Technical and the Fundamentals both agree.
 In bull markets, one is supposed to be long or on the sidelines.
 Buy that which is showing strength – sell that which is showing weakness.
 On minor corrections against the major trend, add to trades.
 Be patient. If a trade is put on, allow it time to develop and give it time to create the
profits you expected.
 Taking small profits never allow to develop enormous profits.
 Once a trade is put on, give it time to work; give it time to insulate itself from
random noise.
 Be impatient. As always, small losses and quick losses are the best losses.
 Never, ever under any condition, add to a losing trade, or “average” into a position.
 Do more of what is working for you, and less of what’s not.
 When sharp losses in equity are experienced, take time off.
 Earn profits by fighting alongside the winning forces.
 Markets form their tops in violence; markets form their lows in quiet conditions.