Trading Strategies (Options) – 3

In my previous two posts about Trading Strategies, I discussed about COVERED POSITIONS. Today I am going to discuss about OPTIONS SPREADS.

What is an Option Spread?
It involves the simultaneous purchase and sale of options in the same class, ie, calls or puts on the same underlying.

There are different types of options spreads, Those are as below..

1. Vertical spread
Buying and selling calls/puts with different strikes, but the same expiry.
eg. buy Nov 1200 call and sell Nov 1300 call or
buy Dec 1000 put and sell Dec 1100 put

2. Horizontal (calendar) spread
Buying and selling options with same strike, but different expiry months.
eg. buy Nov 1200 call and sell Dec 1200 call or
buy Oct 1000 put and sell Nov 1000 put

3. Diagonal (diagonal calender) spread
Buying and selling options with different strikes and different expiry months.

In this post I am going to discuss the Vertical spread in detail.

These vertical spreads can be classified into two basic types: bull spreads and bear spreads

In a bull spread the investor buys the lower strike and sells the higher strike. Where as in a bear spread the investor sells the lower strike and buys the higher strike.

Basically the vertical spreads are used to profit from a directional movement in the underlying. However One must use these strategies when they are moderately bullish/bearish on the underlying.

Bull spreads can again be classified into Bull Call spread and Bull Put spread

Bull Call A strategy to be used when an investor is moderately bullish on the underlying, and it is constructed by buying a CALL option with lower strike, and selling a CALL option with higher strike.

Bull Put This is also a strategy to be used when an investor is moderately bullish on the underlying, and is constructed by buying a PUT option lower strike, and selling a PUT option with higher strike.

Below is the summary of the bull spreads..

	Bull Call	Bear Call	Bull Put	Bear Put
Motivation	Moderately Bullish	Moderately Bearish	Moderately Bullish	Moderately Bearish
Construction	Buy lower strike, sell higher strike.	Sell lower strike, buy higher strike.	Buy lower strike, sell higher strike.	Sell lower strike, buy higher strike.
Net permeum	Paid out.	Received.	Received.	Paid out.
Maximum risk	Net premium paid.	Difference in strikes less net premium received.	Difference in strikes less net premium received.	Net premium paid.
Maximum reward	Difference in strikes less net premium paid.	Net premium received.	Net premium received.	Difference in strikes less net premium paid.
Breakeven point	Lower strike + net premium paid.	Lower strike + net premium received.	Higher strike – net premium received.	Higher strike – net premium paid.

That’s it for now about Vertical spreads; I shall discuss Horizontal & Diagonal spreads in my next post.

Happy Trading!

Options Terminology – 2

Options Greeks
Option traders are often refer to the delta, gamma, vega and theta of their open option positions. Collectively, these terms are known as the “Greeks“. These greeks can not be simply looked at the daily option tables. They need to be calculated. The greeks represent the price sensitivity of any option with respect to the underlying parameters such as price of underlying, time to expiry and implied volatility.

Let’s now discuss the first greek.

1. Delta The Delta of an option is measure of the sensitivity of the option’s price to changes in the price of the underlying asset. That means it can be calculated by measuring the change in an option premium brought about by a small change in the price of the underlying. This would be calculated using option pricing models such as Black-Scholes.

The delta value will be between 0 and 1. For example if the change in the underlying price was 10, and perhaps the option increased by 6, this would give a delta 6/10 = 0.6.

• A delta 0 means the premium is totally insensitive to small change in the price of the underlying. This will be the case of far Out-Of-the Money options
• a delta 1 means the premium is fully sensitive to small change in the price of the underlying, that means the premium will change by exactly the same amount as the underlying. This will be the case for deep In-The-Money options

To know about out-of-the money and in-the-money options read my other post “Options Terminology“.

Call option deltas are positive because the premium will rise when the price of the underlying rises.

Put option deltas are negative because the premium will fall when the price of the underlying rises.

Lets have a look at the summary of deltas.

Instrument	Delta
Physical asset or future or deep ITM call	+1
ATM call	+0.5
Far OTM call or Far OTM put	0
ATM put	-0.5
Deep ITM put	-1

Delta value can also be calculated for portfolios (containing futures, and options) to measure the sensitivity of portfolio to the underlying price movements, and the calculated delta is known as “cumulative delta”.

Cumulative deltas help to gauge what is required to hedge a portfolio. A portfolio with cumulative delta or 0 is insensitive to price movements of the underlying and the portfolio is often referred as ‘delta neutral’ or ‘delta hedged’.

Lets now discuss the second greek.

2. Gamma It is the measure of how delta changes with respect to the change in the underlying price. It is small when the option is deep-in-the money or far-out-of-the money. It is at its greatest when the option is at-the-money, especially when the option is close to expiry.

Short-dated ATM options are more volatile than longer-dated ones, and these differences may represent an opportunity for trading profits.

3. Vega It is a measure of how a 1% change in the implied volatility affects an option’s price. It is always positive for long option positions – both calls and puts. It is greatest for at-the-money. The further option goes in- or out-of-the money, the vega will get smaller.

4. Theta It is the measure of the rate of decline of an option’s value due to the passage of time. That means theta represents ‘time decay‘ on the value of an option. If all other factors are held constant then the option will lose its value as time moves closer to its expiry. Theta represents the fair value of an option per day.

All these greeks are used in combination to derive various trading strategies.

Folks, thats all about Greeks!!!

Trading Strategies (Options) – 2

As promised in earlier post (Trading Strategies (Options) – 1), today I am writing about COVERED SHORT PUT strategy.

What is Covered Short Put?
A covered short put position is constructed by selling a put but, at the same time, holding sufficient funds to buy the asset if necessary or already having a short position, such as being short the futures contract then writing/selling a put on the futures contract.

Example
XYZ plc share price is 207. An investor leaves the funds (2070) on deposit and sells the 200 put for 20 per share.

Let us now analyze the outcome at expiry.
1) If the share is price is unchanged at expiry, the option is abandoned by the long and the investor keeps the premium. This increases the return on his funds by the premium retained.

2) If the share price rises, although the investor is enhancing the return on this funds by the premium received, he has forgone the opportunity to make a profit on the shares he could have purchased. There is an opportunity cost for the investor.

3) If the share price falls below 200, the option will be exercised against the investor. He will have to buy the shares at 200. The investor has effectively reduced the cost price of the shares to 200, less the amount of the premium. That is 180 (200 – 20).

The investor makes maximum profit when the share price is unchanged (that is at 200). The investor will make 20 on the premium, plus interest on the funds, and be able to buy the shares at 200 rather than 207.

Summary
The motivation of this strategy is to enhance the return on funds in a stagnant market and to partially hedge a short underlying position. It is also an attractive method of taking profit on a short position.

Rish/Reward Summary

• Loss : Unlimited once the underlying asset (stock or futures contract) price falls below the break-even-point.
• Maximum Profit : Limited to premium received (if the option expired unexercised).

In my next post I shall discuss Options spreads

Options Terminology

Premium
Premium is the price of the option, the price paid. The premium is determined by buyers and sellers trading in the market and is the cost of the option. Option buyers must pay the agreed premium to the option sellers. It is non-returnable.

There are many factors that determine the level of the premium. A change in one of the factors will result in change in the option’s premium. The main two factors are strike (exercise) price and time to expiry. That means, different strikes and expiries have different premium levels reflecting the risks involved in holding/selling these options.

The longer-dated expiries are more expensive than the near months.
Call options with lower strike price have higher premiums, and conversely Put options with higher strike price have higher premiums.

Premium for any option is calculated by using the following formula.
Premium (PM) = Intrinsic value (IV) + Time Value (TV)

What is Intrinsic value?
It is the difference between the strike price and the underlying asset’s price (spot price). Call Options have IV when the strike is lower than the underlying asset price. Put Options have IV when the strike is greater than the underlying asset price.IV can never be negative, it is either positive or zero. An option with zero intrinsic value is not worth exercising at the expiry. An option either has or does not have intrinsic value.

In-The-Money (ITM) options – An option with intrinsic value. If the option is significantly in-the-money then it is described as ‘deep’ in-the-money option
Out-of-The-Money (OTM) options – An option with no (zero) intrinsic value. If an option is significantly out-of-the-money then it is described as ‘far’ out-of-the-money option.
At-The-Money (ATM) options – An option with an exercise price that equals, or is close to, the underlying asset price.

	CALL Option	PUT Option
In-the-money	Market Price > Exercise Price	Market Price < Exercise Price
At-the-money	Market Price = Exercise Price	Market Price = Exercise Price
Out-of-the-money	Market Price < Exercise Price	Market Price > Exercise Price

What is Time value?
It is simply the difference between the premium and intrinsic value of the option. That means it can be calculated by using the formula

Time Value (TV) = Premium (PM) – Intrinsic Value (IV)

A longer-dated option will have more time value than a near-dated one with the same strike. The price of the underlying can move over a greater range in one year than in one week. This means that there is more uncertainty associated with an option with one year to expiry, so the time value will be greater. On expiry, there is no uncertainty left. At that stage time-value will be ’0′.

Look at the below table for the factors that determines the options premium, and their impact on option price.

Factor	Call Premium	Put Premium
Price of underlying rises	Rise	Fall
Time to expiry rises	Rise	Rise
Volatility rises	Rise	Rise
Exercise price rises	Fall	Rise

Note: A change in interest rates generally will not affect the option prices.

Trading Strategies (Options) – 1

In this series I am going to discuss various trading (investment) strategies using Options. In this first post of this series, I would like to discuss about the COVERED OPTIONS POSITIONS.

1. Covered Short Call
This sometimes referred to as a buy/write strategy. It is constructed by combining a long underlying position with a short call position.

Example
An investor is long 1000 XYZ Plc shares. Current share price is 207. He sells an ABC Plc 225 call for a premium of 11 (each contract is for 1000 shares).

Let us now analyze the outcome at expiry.
1) If the share price is unchanged at expiry, the option is abandoned. The investor keeps the premium, thereby creating a position return on investment.

2) If the share price falls, the premium helps to cushion the drop. The investor is hedged to the extent of the premium. If the drop is less than the premium, he is still better off. If the drop in the price is greater than the premium, the investor losses the excess above the premium.

Summary
The motivation of this strategy is to enhance returns in a stagnant market and, at the same time, to partially hedge a long underlying position (stock or futures contract). If the market remains static, an investor will enhance the return on the asset, since he has received the option’s premium and it will expire unexercised.

In a falling market, the premium reduce the loss, but will not provide a true hedge. In a raising market, overall gains will be limited, since the call will be exercised and any further gains above the strike price will not be realized, since he no longer owns the asset (underlying).

Risk/Reward Summary

• Loss : Unlimited once the underlying asset (stock or futures contract) price falls below the break-even-point.
• Profit : Limited to premium received (if the option expired unexercised).
• Maximum Profit : Premium received + (Strike Price – Cost of acquisition)

Trading Tip
Anybody holding a stock for a long period of time can generate a consistent income (options premium) every month by writing (short) Out-Of-The money (OTM) calls.

In the next post we shall discuss another covered options position i.e., Covered Short Put

General Introduction to Derivatives

People think ‘derivatives’ as complex and dangerous instruments. They can be dangerous, after all it was mainly trading in derivatives that collapsed many banks and organizations. (Collapse of Barings Bank). However, these instruments are mainly designed to be used to reduce the risk faced by organizations and individuals.
Derivatives are not as complex as people think. The below illustration can help you to understand the underlying simplicity of the derivatives.

Imagine you wanted to purchase a couch from a furniture showroom. You make your choice of couch and see that it will cost £1000. On enquiry, you discover from the sales person that the couch is currently out of stock. However, you can sign a contract to accept delivery of the couch in a months’ time (when the stock will be replenished) and at that point of time the store will charge the £1000 to your credit card. If you sign, you have agreed to defer delivery for a month – and you have entered into a derivative (it is derived from something else, here, a couch). This is very similar to a ‘futures contract’. You have contracted to buy an underlying asset (in this case couch) and pay a pre-agreed sum of money (£1000) in a months time (the ‘future’ date). As far as the furniture showroom is concerned, they have contracted to sell the underlying (couch) in exchange for £1000 in a months time.

So, this is an example of a futures-type contract that we could refer to as a ‘couch future’. In the jargon of the derivative markets, you are ‘long’ a couch future because of you have agreed to buy at a future date. The furniture showroom is ‘short’ a couch future because they have agreed to sell at a future date.

Futures are not the only type of derivatives – there are also ‘options’. To illustrate how these instruments differ from futures, we can use the same above example of a couch in a furniture store. This time the sales person tells you the couch you want is not in the stock at present, but there is a small batch of ten couches due for delivery in a months’ time. Of these ten couches, nine have been pre-sold. You cannot make up your mind whether to go ahead and commit to buy the tenth couch or to try a few other stores to see if anything else catches your eye. Noticing this, the sales person makes you an offer. If you pay £25 now he will give you the right to reserve the tenth couch. It will become yours on the payment of £1000 in a months’ time and, in the intervening period, the sales person cannot sell it to anyone else.

Again, this is a derivative transaction (derived from something else – the couch). if you agree to it you will be paying a non-returnable sum of money (£25) that gives you the right to buy the couch for £1000 in a months’ time. This is a ‘couch option’ and, using derivatives jargon, you are ‘long’ the option because you have the right to do something (here, the right to buy the couch for £1000). However, you are not obliged to buy the couch, but if you decide not to buy then you will lose the £25 you paid over the outset. As far as the furniture store is concerned, they are ‘short’ the option because they have granted the right to do something (by giving you the right to buy the sofa for £1000) in return for the receipt of an agreed sum (here £25).

Thats it for now!!