project 5.3 option market

8/6/2019 Project 5.3 Option Market

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Project:

Options (call & put)

Compiled by

Sr no Names Roll call

1 Kavita kohli 10

2 Shital

3 Sunita

4 Jinsha

5 Shifa

Submitted to department ofBanking & Insurance.

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WHAT IS AN OPTION?

We all know many opportunities exist in tradingtoday. Everywhere you turn, someone is waitingto inform you of the tremendous profits to berealized in the stock and futures markets.

However, many people are unaware of thederivative trading possibilities that are availablewithin and across several different markets.Option trading is just one of the many ways to

participate in these secondary markets. And

contrary to popular belief, this potential tradingarena is not limited strictly to the practice ofselling or writing options.

Options are an important element of investing inmarkets, serving a function of managing risk andgenerating income. Unlike most other types of

investments today, options provide a unique set ofbenefits. Not only does option trading provide acheap and effective means of hedging ones

portfolio against adverse and unexpected price fluctuations, but it also offers a tremendousspeculative dimension to trading.

One of the primary advantages of option trading

is that option contracts enable a trade to beleveraged, allowing the trader to control the fullvalue of an asset for a fraction of the actual cost.

And since an options price mirrors that of theunderlying asset at the very least, any favorablereturn in the asset will be met with a greater

percentage return in the option provides limited

risk and unlimited reward.

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With options, the buyer can only lose what waspaid for the option contract, which is a fraction ofwhat the actual cost of the asset would be.

However, the profit potential is unlimited becausethe option holder possesses a contract thatperforms in sync with the asset itself. If the outlookis positive for the security, so too will the outlookbe for that assets underlying options. Options also

provide their owners with numerous tradingalternatives. Options can be customized and

combined with other options and even otherinvestments to take advantage of any possibleprice dislocation within the market. They enablethe trader or investor to acquire a position that isappropriate for any type of market outlook that heor she may have, be it bullish, bearish, choppy, orsilent.

While there is no disputing that options offer manyinvestment benefits, option trading involves riskand is not for everyone. For the same reason thatones returns can be large, so too can the losses leverage. Also, while the potential for financialsuccess does exist in option trading, the means ofrealizing such opportunities are often difficult to

create and to identify. With dozens of variables,several pricing models, and hundreds of differentstrategies to choose from, it is no wonder thatoptions and option pricing have been a mystery tothe majority of the trading public.

Most often, a great deal of information must beprocessed before an informed trading decision can

be reached. Computers and sophisticated trading

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models are often relied upon to select tradingcandidates. However, as humans, we like things tobe as simple as possible. This often creates a

conflict when deciding what, when, and how totrade a particular investment. It is much easier tobuy or sell an asset outright than to contend withthe many extraneous factors of these derivativemarkets.* If an investor thinks an assets value willappreciate, he or she can simply buy the security;if an investor thinks an assets value will

depreciate, he or she can simply sell the security.In these scenarios, the only thing an investor mustworry about is the value of the investment relativeto the value of the prevailing market. If onlyoptions were that easy!

*A derivative security is any security, in whole orin part, the value of which is based upon the

performance of another (underlying) instrument,such as an option, a warrant, or any hybridsecurities.

Typically, option trading is more cumbersome andcomplicated than stock trading because tradersmust consider many variables aside from thedirection they believe the market will move. Theeffects of the passage of time, variables such asdelta, and the underlying market volatility on the

price of the option are just some of the many itemsthat traders need to gauge in order to makeinformed decisions. If one is not prudent in onesinvestment decisions, one could potentially lose alot of money trading options. Those who disregard

careful consideration and sound money

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management techniques often find out the hardway that these factors can quickly and easily erodethe value of their option portfolios.

Because of these risks and benefits, options offertremendous profit potential above and beyondtrading in any other instrument, including theunderlying security itself. This is the juncture atwhich option theoreticians enter the picture. Oncethe benefits have been defined, it is now a matterof determining how to best attain them. Up to now,

the vast majority of option techniques have beenelaborate mathematical models designed to helpidentify when option-writing or sellingopportunities exist. However, we hope to breaknew ground by introducing simple market-timingtechniques that will enable traders to buy optionswith greater confidence and with greater success.

Type of options

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Call Options

A call option gives the holder (buyer/ one who islong call), the right to buy specified quantity of theunderlying asset at the strike price on or beforeexpiration date.

The seller (one who is short call) however, has theobligation to sell the underlying asset if the buyerof the call option decides to exercise his option tobuy.

Example: An investor buys One European calloption on Infosys at the strike price of Rs. 3500 ata premium of Rs. 100. If the market price of

Infosys on the day of expiry is more than Rs. 3500,the option will be exercised.

The investor will earn profits once the share pricecrosses Rs. 3600 (Strike Price + Premium i.e.3500+100).

Suppose stock price is Rs. 3800, the option will beexercised and the investor will buy 1 share of

Infosys from the seller of the option at Rs 3500 andsell it in the market at Rs 3800 making a profit of

Rs. 200 {(Spot price Strike price) Premium}.

In another scenario, if at the time of expiry stockprice falls below Rs. 3500 say suppose it touchesRs. 3000, the buyer of the call option will choosenot to exercise his option. In this case the investorloses the premium (Rs 100), paid which should be

the profit earned by the seller of the call option.

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Put Options

A Put option gives the holder (buyer/ one who islong Put), the right to sell specified quantity of theunderlying asset at the strike price on or before anexpiry date.

The seller of the put option (one who is short Put)however, has the obligation to buy the underlyingasset at the strike price if the buyer decides toexercise his option to sell.

Example: An investor buys one European Putoption on Reliance at the strike price of Rs. 300/- ,at a premium of Rs. 25/-. If the market price of

Reliance, on the day of expiry is less than Rs. 300,the option can be exercised as it is in the money.

The investors Break-even point is Rs. 275/ (Strike Price premium paid) i.e., investor will earnprofits if the market falls below 275.

Suppose stock price is Rs. 260, the buyer of the Putoption immediately buys Reliance share in themarket @ Rs. 260/- & exercises his option selling

the Reliance share at Rs 300 to the option writerthus making a net profit of Rs. 15 {(Strike price

Spot Price) Premium paid}.

In another scenario, if at the time of expiry,market price of Reliance is Rs 320/ -, the buyer ofthe Put option will choose not to exercise his optionto sell as he can sell in the market at a higher rate.

In this case the investor loses the premium paid

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(i.e. Rs 25/-), which shall be the profit earned bythe seller of the Put option. (Please see table)

Options are different from Futures

There are significant differences in Futures andOptions.

Futures are agreements/contracts to buy or sellspecified quantity of the underlying assets at a

price agreed upon by the buyer and seller, on orbefore a specified time. Both the buyer and sellerare obligated to buy/sell the underlying asset.

Futures Contracts have symmetric risk profile forboth buyers as well as sellers, whereas optionshave asymmetric risk profile.

In options the buyer enjoys the right and not theobligation, to buy or sell the underlying asset. Incase of Options, for a buyer (or holder of theoption), the downside is limited to the premium(option price) he has paid while the profits may beunlimited. For a seller or writer of an option,however, the downside is unlimited while profitsare limited to the premium he has received from

the buyer.

The futures contracts prices are affected mainly bythe prices of the underlying asset. Prices of optionsare however, affected by prices of the underlyingasset, time remaining for expiry of the contractand volatility of the underlying asset.

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It costs nothing to enter into a futures contractwhereas there is a cost of entering into an optionscontract, termed as Premium.

Call Option Put Option

Option

buyer or

option

holder

Buys the right to

buy the

underlying asset

at the specifiedprice

Buys the right to

sell the underlying

asset at the

specified price

Option

seller or

option

writer

Has the

obligation to sell

the underlying

asset (to the

option holder) at

the specifiedprice

Has the obligation

to buy the

underlying asset

(from the option

holder) at thespecified price

Rules for Buying Calls and Puts

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Rule No. 1: Buy calls when the overall market isdown; buy puts when the overall market is up. Byand large, when the stock market rallies, most

stocks rally, and when the stock market declines,most stocks perform likewise. The extent of thismovement can easily be measured by observingstock indices. We recommend using theadvance/decline index as a proxy for the overallmarket. However, if this is unavailable, one couldalso use the net price change of a comprehensive

market average, such as the BSE SENSEX andNSE NIFTY. For the overall market to rally, themajority of individual stocks must rally, too. Surethere are days in which the market is rallying eventhough the number of advancing issues is less thanthe declining issues but this cannot last long if thestock market is to mount a sustainable advance.

Similarly, on the downside, the market cannot

undergo an extended decline unless the numbers ofdeclining stocks outnumber the advancing stocks.

When the overall market trades lower, call option premiums typically decrease. Therefore, byrequiring the market index to be down for the dayat the time a call is purchased, the prospects for a

decline in a calls premium are enhanced.Similarly, when the overall market trades higher, put option premiums typically decrease.Therefore, by requiring the advance/declinemarket index to be up for the day at the time a putis purchased, the prospects for a decline in a puts

premium are enhanced similarly. Since moststocks rise and fall with the general market withthe possible exception of gold stocks this provides

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a measure of much-needed discipline and helpsprevent emotional, uncontrolled option buying.

Rule No. 2: Buy calls when the industry group isdown; buy puts when the industry group is up.

Just as most stocks move in phase with the market,most industry group components move in syncwith their counterparts within their specificindustry as well. Therefore, when one stock within

an industry group is down, chances are the othersare down as well. Its the exception when onecomponent of an industry advances while all theother members decline, or vice versa, especiallyover an extended period of time. For example, situations can arise where a buyoutoccurs and the accumulation of one companysstock causes it to outperform the others within theindustry group. However, announcements such asthese typically cause the other stocks within thesame industry group to participate in themovement since the markets perception is that allcompanies within the group are likely acquisitioncandidates and their stocks are in play, so tospeak.

Rule No. 3:Buy calls when the underlyingsecurity is down; buy puts when the underlyingsecurity is up. In order to time the purchase ofcalls, we look for the price of the underlyingsecurity to be down relative to the previous

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trading days close. If the stocks current market price is less than the previous days close, mosttraders extrapolate that the downtrend will

continue. It is also possible to relate the stockscurrent price with its opening price level to makethis rule more stringent. Either relationship, thatis, current price versus yesterdays close or current

price versus the current days open, can be appliedor a combination of the two can be used to insurethat the composite outlook for the market is

perceived bearish by most traders.In order to time the purchase of puts, we look forthe price of the underlying security to be uprelative to the previous trading days close. If thestocks current market price is greater than the

previous days close, most traders extrapolate thatthe up trend will continue. It is also possible to

relate the stocks current price with its openingprice level to make this rule more stringent. Eitherrelationship, that is, current price versusyesterdays close or current price versus thecurrent days open, can be applied or acombination of the two can be used to insure thatthe composite outlook for the market is perceived

bullish by most traders.

Rule No. 4: Buy calls when the option is down;buy puts when the option is down. Just as the

previous series of rules required that specific

relationships be fulfilled, so too must this

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prerequisite be met. In fact, of all rules listed, thisrequirement is singularly the most important. Theoptions price, be it a call or a put, must be less

than the previous days close. As an additionalrequirement, it may also be less than the currentdays opening price level as well. Obviously, if anoptions price is inevitably going to rally, it issmarter to buy as low as possible. Further, if thecall or the put unexpectedly continues to decline to

zero, then the loss incurred is nevertheless less

than if one had chased the price upside andpurchased the option when it was trading abovethe previous days close.

The combination of the preceding rules serves toremove a degree of emotionalism from operatingin the options markets and instills a level ofdiscipline in the trading process. We cant tell you

how long it took to acquire and apply theseimportant rules to our trading regimen.Obviously, the risk always exists that despite the

fact that all the previously described rules may bemet, option prices may continue to decline, and asa result purchasing the call options or the putoptions will translate into a losing proposition.

Thats a concern that can only be diminished byintroducing a series of sentiment measures orvarious market-timing indicators to confirmoption buying at a particular point in time. Theintegration of these together with marketsentiment information comparing put and callvolume and the information regarding variousindicators presented in the other chapters withinthis book enhance the timing and selection results

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further by concentrating upon ideal candidateswhich are low-risk opportunities based upon all

four requirements.

Benefits of Options Trading

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Besides offering flexibility to the buyer in form ofright to buy or sell, the major advantage of optionsis their versatility. They can be as conservative or

as speculative as ones investment strategydictates.

Some of the benefits of Options are as under:

High leverage as by investing small amount ofcapital (in form of premium), one can takeexposure in the underlying asset of much greater

value.

Pre-known maximum risk for an option buyer

Large profit potential and limited risk for optionbuyer

One can protect his equity portfolio from a decline

in the market by way of buying a protective putwherein one buys puts against an existing stockposition.

This option position can supply the insuranceneeded to overcome the uncertainty of themarketplace. Hence, by paying a relatively small

premium (compared to the market value of the

stock), an investor knows that no matter how farthe stock drops, it can be sold at the strike price ofthe Put anytime until the Put expires.

E.g. An investor holding 1 share of Infosys at amarket price of Rs 3800/-thinks that the stock isover-valued and decides to buy a Put option at a

strike price of Rs. 3800/- by paying a premium ofRs 200/-

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If the market price of Infosys comes down to Rs 3000/-, he can still sell it at Rs 3800/- byexercising his put option. Thus, by paying

premium of Rs 200,his position is insured in theunderlying stock.

How can you use options for short-term trading?

If you anticipate a certain directional movement inthe price of a stock, the right to buy or sell thatstock at a predetermined price, for a specific

duration of time can offer an attractive investmentopportunity. The decision as to what type of optionto buy is dependent on whether your outlook forthe respective security is positive (bullish) ornegative (bearish).

If your outlook is positive, buying a call optioncreates the opportunity to share in the upside

potential of a stock without having to risk morethan a fraction of its market value (premium

paid). Conversely, if you anticipate downwardmovement, buying a put option will enable you to

protect against downside risk without limitingprofit potential.

Purchasing options offer you the ability to positionyourself accordingly with your marketexpectations in a manner such that you can both

profit and protect with limited risk.

Risks of an options buyer

The risk/ loss of an option buyer is limited to the

premium that he has paid.

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Risks for an Option writer

The risk of an Options Writer is unlimited wherehis gains are limited to the Premiums earned.When a physical delivery uncovered call isexercised upon, the writer will have to purchasethe underlying asset and his loss will be the excessof the purchase price over the exercise price of thecall reduced by the premium received for writingthe call.

The writer of a put option bears a risk of loss if thevalue of the underlying asset declines below theexercise price. The writer of a put bears the risk ofa decline in the price of the underlying asset

potentially to zero.

Option writing is a specialized job which issuitable only for the knowledgeable investor whounderstands the risks, has the financial capacityand has sufficient liquid assets to meet applicablemargin requirements. The risk of being an optionwriter may be reduced by the purchase of otheroptions on the same underlying asset therebyassuming a spread position or by acquiring othertypes of hedging positions in the options/ futures

and other correlated markets. In the Indian Derivatives market, SEBI has not created anyparticular category of options writers. Any marketparticipant can write options. However, marginrequirements are stringent for options writers.

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Participants in the Options Market

There are four types of participants in optionsmarkets depending on the position they take:

1. Buyers of calls2. Sellers of calls3. Buyers of puts4. Sellers of puts

People who buy options are called holders andthose who sell options are calledwriters;

furthermore, buyers are said to have longpositions, and sellers are said to have shortpositions.

Here is the important distinction between buyers

and sellers:-Call holders and put holders (buyers) are notobligated to buy or sell. They have the choice toexercise their rights if they choose.-Callwriters and put writers (sellers), however,are obligated to buy or sell. This means that aseller may be required to make good on a promise

to buy or sell.

Don't worry if this seems confusing - it is. For thisreason we are going to look at options from the

point of view of the buyer. Selling options is morecomplicated and can be even riskier. At this point,it is sufficient to understand that there are twosides of an options contract.

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Options Trading Strategies in India

Stock options provide strategies that ordinary

stock transactions cannot offer.

Stock options are financial contracts that trade in

the public markets. They trade on many stocks and

also on most exchange-traded funds (ETFs). Forinvestors outside of India, an ETF option strategy

allows you to profit from different scenarios in the

Indian stock market. Since most investors don't

have direct access to specific Indian stocks, an

options trading strategy on an India ETF is a

particularly convenient technique.

BULLISH STRATEGY

If you're "bullish" and believe the overall Indian

stock market will rise in the short term, you can

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significantly profit by purchasing "call" options on

an Indian ETF. The ETF with the ticker symbol

"INP" is one of the largest ETFs that tracks the

Indian stock market; buying "call" options on thisETF will provide significant returns if the market

does indeed rise. A "call" stock option is one of the

two main types of options. The value of a "call"

contract rises at a fast pace when its underlying

entity, the ETF, rises. However, since all options

have expiration dates, it's risky to trade the optionif it expires soon. Choose an option that expires at

least two months down the road so that you have

ample time to make sure the ETF does indeed move

up.

BEARISH STRATEGY

If you're "bearish" and think the Indian stock

market will likely decline in value in the short

term, purchase a "put" stock option on the ETF

"INP." A put is the other main type of stock option,and is the complement to a "call." A "put" option

rises in value when its underlying entity falls in

price. If you successfully hold a "put" while the

Indian stock market declines, you'll profit from

this scenario. As with all option strategies, always

be cognizant of the option expiration date. Alloptions are worthless after their expiration date.

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For this reason, you should minimize risks by

purchasing a "put" with an expiration date of at

least two months in the future. When you become

more experienced with predicting short-term stockmarket activity, you may consider more risky

positions with options that expire more quickly.

STRADDLES

Options offer unique investment strategies beyondbullish or bearish market conditions. Unlike a

stock purchase, you can make money by predicting

a major price move in the Indian stock market

without predicting the direction of the move. A

"straddle" is an option strategy where you

purchase an equal amount of both "calls" and"puts." Buying these on the "INP" ETF creates an

option position that profits from a major

movement in the Indian stock market either up or

down. One of the two option types will

significantly rise in price if the market moves,

while the other will significantly decline. However,

the gains of one option can overwhelm the losses of

the other, leading to profit regardless of the

market direction Option Selling or "Writing"

Many traders opt to buy options in an effort to

maximize gains and limit losses to the purchase

price of the option. On the surface this seems ideal,except for one major flaw: time decay. The

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Chicago Mercantile Exchange estimates that over

80% of all options expire worthless. Those who sell

these options to the buyers are known as option

writers or sellers. Their objective is to collect thepremium paid by the option buyer. Option writing

can also be used for hedging purposes and

reducing risk.. In appropriate situations you

should consider selling out-of-the-money options

instead of buying them.

Thank you

project 5.3 option market

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