Options are derivative products which, if you buy, give you certain rights.
What kind of rights do Options give?
Call Options give one a right to buy a share (at a certain specific price), while Put Options give a right to sell (again at a predefined price).
What does one pay for obtaining such rights?
The cost one pays for obtaining such rights is the premium (also called price or option value).
when should one buy a Call?
One should buy a Call when one is bullish.
What are the components of Option Value?
The value of an Option is made up of two components, viz. Intrinsic Value and Time Value.
What is Intrinsic Value?
The value that you will realize (as a buyer of an Option) on expiry or on exercise is the Intrinsic Value.
What is Time Value?
Time Value is the Total Option Value minus Intrinsic Value.
How does Intrinsic Value correlate with Share Price?
In the case of Call Options, higher the Share Price, higher the Intrinsic Value. In the case of Puts, the correlation is absolutely negative.
How does Time Value correlate with Share Price?
Time Value does not correlate with Share Price. It correlates with other factors, the principal ones being - Time left for Expiry and Volatility. If Time left for Expiry is high, the Time Value will be higher and vice versa. Time left to expiry affects both Calls and Puts equally. Thus, long term Calls and Puts are priced more than short term Calls and Puts. Volatility is a very interesting determining factor of Option Value. Higher the Volatility of the share, higher will be the values of both Calls and Puts. This is because, the probability of a highly volatile share moving up or down is much higher than that of a low volatile share. Option values are based on how much movement is possible or expected in the underlying share and higher this possible movement, higher the value of the Option.
Are American style Options more useful / flexible?
Yes, but only partly. The advantage of anytime exercise is useful for Option buyers. However, in practice, exercise is rare. You will find that it is more profitable to sell an Option (having bought it earlier) rather than exercise.
What are Index Puts?
One would use Index Puts when one is bearish about the market as a whole.
What is writing options all about?
A seller of Options is generally called as a Writer - in the initial days of Option Trading before the advent of computers, Option sellers wrote out a Contract and gave it to the Option buyers. Thus, the term Writers was coined and has stayed. The writer of Options earns a limited profit (the premium), but can incur unlimited losses.
What view does the Option writer have?
The writer of the Call Option is generally bearish while the writer of the Put Option is generally bullish.
A summary of the factors that determine Option Values?
Are there other factors determining Option Values?
Two other factors which affect Option Values are Interest rates in the economy and Dividends on stocks. These do not affect Option Values significantly. It is expected that higher Interest rates will result in higher Call Option Values and lower Put Option Values. Dividends have the impact of decreasing share prices. Accordingly, Call Option Values will decrease and Put Option Values will increase when Dividends are declared.
How does one know whether a particular Option is correctly priced in the market or not?
There is a popular Black Scholes Model which provides the theoretical price of Options. Black Scholes Option Calculators are available on various websites. You need to key in the basic parameters which are the following:
• Current Share Price
• Option Strike Price
• Time left for Expiry
• Volatility
• Interest Rate
Given this data, the calculator will provide you with the price. You can then compare this price with the actual price prevailing in the market and find out whether the Option is being overpriced or underpriced.
What is Volatility?
Volatility is the fluctuation in the price of the underlying.
Why is Volatility significant for Options?
The value of an Option, apart from other factors, depends upon the Volatility of the underlying. Higher the Volatility of the underlying, higher the Option Premium.
How isVolatility measured?
Volatility is the standard deviation of the daily returns on any underlying.
What is Daily Return?
The percentage of change in the value of the particular stock for that day is called the "Daily Return".
What is Standard Deviation?
Standard deviation is a measure of dispersion and comes from statistics. Dispersion indicates how widely a set of data is 'dispersed'.
How is Standard Deviation calculated?
- Identify the basic data (in our case the percentage daily returns)
- Work out the average
- Work out the deviations of each observation from the average (these deviations might be positive or negative)
- Take a square of these deviations
- Sum up these squares
- Divide the sum by the number of observations
- Work out the square root of this number
What are Bull Spreads?
Simple option positions carry unlimited profits, limited losses for buyers and limited profits, unlimited losses for sellers (writers). Spreads create a limited profit, limited loss profile for users. By limiting losses, you are limiting your risks and by limiting profits, you are reducing your costs.
Those spreads which will generate gains in a bullish market are bull spreads.
What are Strategies?
Strategies are specific game plans created by you based on your idea of how the market will move. Strategies are generally combinations of various products – futures, calls and puts and enable you to realize unlimited profits, limited profits, unlimited losses or limited losses depending on your profit appetite and risk appetite.
How are Strategies formulated?
The simplest starting point of a Strategy could be having a clear view about the market or a scrip. There could be strategies of an advanced nature that are independent of views, but it would be correct to say that most investors create strategies based on views.
What views could be handled through Strategies?
There could be four simple views: bullish view, bearish view, volatile view and neutral view. Bullish and bearish views are simple enough to comprehend. Volatile view is where One believe that the market or scrip could move rapidly, but One is not clear of the direction (whether up or down). One is however sure that the movement will be significant in one direction or the other. Neutral view is the reverse of the Volatile view where One believes that the market or scrip in question will not move much in any direction.
What strategies are possible if I have a bullish view?
The following strategies are possible:
• Buy a Future
• Buy a Call Option
• Sell a Put Option
• Create a Bull Spread using Calls
• Create a Bull Spread using Puts
What are Bull Spreads?
First of all, Spreads are strategies which combine two or more Calls (or alternatively two or more Puts). Another series of Strategies goes by the name Combinations where Calls and Puts are combined.
Bull Spreads are those class of strategies that enable One benefit from a bullish phase on the index or scrip in question. Bull spreads allow One to create a limited profit limited loss model of payoff, which One might be very comfortable with.
How many types of Bull Spreads can be created?
Bull spreads can be created using Calls or using Puts. One needs to buy one Call with a lower strike price and sell another Call with a higher strike price and a spread position is created. Interestingly, One can also buy a Put with a lower strike price and sell another with a higher strike price to achieve a similar payoff profile.
What are the various bearish strategies possible?
The following major choices are available:
• Sell Scrip Futures
• Sell Index Futures
• Buy Put Option
• Sell Call Option
• Bear Spreads
• Combinations of Options and Futures
