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Project Assignment on Financial

Derivatives & Market

SUBMITTED BY
Rohan Gholam
Roll No 222

MFM 2014-17

Option Derivative:
An option is a contract that gives the buyer the right, but not the
obligation, to buy or sell an underlying asset at a specific price on or
before a certain date. An option, just like a stock or bond, is a security. It
is also a binding contract with strictly defined terms and properties.

Still confused? The idea behind an option is present in many everyday


situations. Say, for example, that you discover a house that you'd love to
purchase. Unfortunately, you won't have the cash to buy it for another
three months. You talk to the owner and negotiate a deal that gives you
an option to buy the house in three months for a price of $200,000. The
owner agrees, but for this option, you pay a price of $3,000.

Now, consider two theoretical situations that might arise:

1. It's discovered that the house is actually the true birthplace of Elvis!
As a result, the market value of the house skyrockets to $1 million.
Because the owner sold you the option, he is obligated to sell you
the house for $200,000. In the end, you stand to make a profit of
$797,000 ($1 million - $200,000 - $3,000).

2. While touring the house, you discover not only that the walls are
chock-full of asbestos, but also that the ghost of Henry VII haunts
the master bedroom; furthermore, a family of super-intelligent rats
have built a fortress in the basement. Though you originally thought
you had found the house of your dreams, you now consider it
worthless. On the upside, because you bought an option, you are
under no obligation to go through with the sale. Of course, you still
lose the $3,000 price of the option.

This example demonstrates two very important points. First, when you
buy an option, you have a right but not an obligation to do something. You
can always let the expiration date go by, at which point the option
becomes worthless. If this happens, you lose 100% of your investment,
which is the money you used to pay for the option. Second, an option is
merely a contract that deals with an underlying asset. For this reason,
options are called derivatives, which means an option derives its value
from something else. In our example, the house is the underlying asset.
Most of the time, the underlying asset is a stock or an index.
Calls and Puts

The two types of options are calls and puts:

1. A call gives the holder the right to buy an asset at a certain price
within a specific period of time. Calls are similar to having a long
position on a stock. Buyers of calls hope that the stock will increase
substantially before the option expires.

2. A put gives the holder the right to sell an asset at a certain price
within a specific period of time. Puts are very similar to having
a short position on a stock. Buyers of puts hope that the price of the
stock will fall before the option expires.

Participants in the Options Market


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

1. Buyers of calls

2. Sellers of calls

3. Buyers of puts

4. Sellers of puts

People who buy options are called holders and those who sell options are
called writers; furthermore, buyers are said to have long positions, and
sellers are said to have short positions.

Here is the important distinction between buyers and sellers:

Call holders and put holders (buyers) are not obligated to buy or
sell. They have the choice to exercise their rights if they choose.

Call writers and put writers (sellers), however, are obligated to buy
or sell. This means that a seller may be required to make good on a
promise to buy or sell.

Don't worry if this seems confusing - it is. For this reason we are going to
look at options from the point of view of the buyer. Selling options is more
complicated and can be even riskier. At this point, it is sufficient to
understand that there are two sides of an options contract.
The Call Option
Let us now attempt to extrapolate the same example in the stock market
context with an intention to understand the Call Option. Do note, I will
deliberately skip the nitty-gritty of an option trade at this stage. The idea
is to understand the bare bone structure of the call option contract.
Assume a stock is trading at Rs.67/- today. You are given a right today to
buy the same one month later, at say Rs. 75/-, but only if the share price
on that day is more than Rs. 75, would you buy it?. Obviously you would,
as this means to say that after 1 month even if the share is trading at 85,
you can still get to buy it at Rs.75!
In order to get this right you are required to pay a small amount today,
say Rs.5.0/-. If the share price moves above Rs. 75, you can exercise your
right and buy the shares at Rs. 75/-. If the share price stays at or below
Rs. 75/- you do not exercise your right and you do not need to buy the
shares. All you lose is Rs. 5/- in this case. An arrangement of this sort is
called Option Contract, a Call Option to be precise.
After you get into this agreement, there are only three possibilities that
can occur. And they are-

1. The stock price can go up, say Rs.85/-

2. The stock price can go down, say Rs.65/-

3. The stock price can stay at Rs.75/-

Case 1 If the stock price goes up, then it would make sense in
exercising your right and buy the stock at Rs.75/-.
The P&L would look like this
Price at which stock is bought = Rs.75
Premium paid =Rs. 5
Expense incurred = Rs.80
Current Market Price = Rs.85
Profit = 85 80 = Rs.5/-
Case 2 If the stock price goes down to say Rs.65/- obviously it does not
makes sense to buy it at Rs.75/- as effectively you would spending Rs.80/-
(75+5) for a stock thats available at Rs.65/- in the open market.
Case 3 Likewise if the stock stays flat at Rs.75/- it simply means you are
spending Rs.80/- to buy a stock which is available at Rs.75/-, hence you
would not invoke your right to buy the stock at Rs.75/-.
At this stage what you really need to understand is this For reasons we
have discussed so far whenever you expect the price of a stock (or any
asset for that matter) to increase, it always makes sense to buy a call
option!
Now that we are through with the various concepts, let us understand
options and their associated terms,

Stock
Variabl Ajay Venu
Exampl Remark
e Transaction
e
Do note the concept of lot size is applicable in
Underlyin options. So just like in the land deal where the deal
1 acre land Stock
g was on 1 acre land, not more or not less, the option
contract will be the lot size
Expiry 6 months 1 month Like in futures there are 3 expiries available
Reference
Rs.500,000/- Rs.75/- This is also called the strike price
Price
Do note in the stock markets, the premium changes
Premium Rs.100,000/- Rs.5/- on a minute by minute basis. We will understand the
logic soon
None, based Stock All options are cash settled, no defaults have
Regulator
on good faith Exchange occurred until now.

Finally before I end this topic, here is a formal definition of a call options
contract
The buyer of the call option has the right, but not the
obligation to buy an agreed quantity of a particular commodity or
financial instrument (the underlying) from the seller of the option
at a certain time (the expiration date) for a certain price (the
strike price). The seller (or writer) is obligated to sell the
commodity or financial instrument should the buyer so decide.
The buyer pays a fee (called a premium) for this right.
What Are Put Options:
In any market, there cannot be a buyer without there being a seller.
Similarly, in the Options market, you cannot have call options without
having put options. Puts are options contracts that give you the right to
sell the underlying stock or index at a pre-determined price on or before a
specified expiry date in the future.

In this way, a put option is exactly opposite of a call option. However, they
still share some similar traits.

For example, just as in the case of a call option, the put options strike
price and expiry date are predetermined by the stock exchange.

WHEN DO YOU BUY A PUT OPTION:

There is a major difference between a call and a put option


when you buy the two options. The simple rule to maximize
profits is that you buy at lows and sell at highs. A put option
helps you fix the selling price. This indicates you are expecting a
possible decline in the price of the underlying assets. So, you
would rather protect yourself by paying a small premium than
make losses.

This is exactly the opposite for call options which are bought in
anticipation of a rise in stock markets. Thus, put options are used when
market conditions are bearish. They thus protect you against the
decline of the price of a stock below a specified price.

ILLUSTRATION OF A PUT STOCK OPTION:

Put options on stocks also work the same way as call options on
stocks. However, in this case, the option buyer is bearish about
the price of a stock and hopes to profit from a fall in its price.
Suppose you hold ABC shares, and you expect that its quarterly results
are likely to underperform analyst forecasts. This could lead to a fall in the
share prices from the current Rs 950 per share.

To make the most of a fall in the price, you could buy a put option on ABC
at the strike price of Rs 930 at a market-determined premium of say Rs 10
per share. Suppose the contract lot is 600 shares. This means, you have to
pay a premium of Rs 6,000 (600 shares x Rs 10 per share) to purchase
one put option on ABC.

Remember, stock options can be exercised before the expiry date. So you
need to monitor the stock movement carefully. It could happen that the
stock does fall, but gains back right before expiry. This would mean you
lost the opportunity to make profits.

Suppose the stock falls to Rs 930, you could think of exercising the put
option. However, this does not cover your premium of Rs 10/share. For
this reason, you could wait until the share price falls to at least Rs 920. If
there is an indication that the share could fall further to Rs 910 or 900
levels, wait until it does so. If not, jump at the opportunity and exercise
the option right away. You would thus earn a profit of Rs 10 per share once
you have deducted the premium costs.

However, if the stock price actually rises and not falls as you had
expected, you can ignore the option. You loss would be limited to Rs 10
per share or Rs 6,000.

ILLUSTRATION OF PUT STOCK OPTION


Thus, the maximum loss an investor faces is the premium amount. The
maximum profit is the share price minus the premium. This is because,
shares, like indexes, cannot have negative values. They can be value at 0
at worst.

What is a 'Put Option'

Formal contract between an option seller and an option buyer which


gives the optionee the right but not the obligation to sell a specific
contract, financial instrument, property, or security, at a specified price
(called exercise Price) on or before the option's expiration date.

Option Buyer in a nutshell

By now Im certain you would have a basic understanding of the call and
put option both from the buyers and sellers perspective.
Buying an option (call or put) makes sense only when we expect the
market to move strongly in a certain direction. If fact, for the option buyer
to be profitable the market should move away from the selected strike
price. Selecting the right strike price to trade is a major task; we will learn
this at a later stage. For now, here are a few key points that you should
remember

1. P&L (Long call) upon expiry is calculated as P&L = Max [0, (Spot
Price Strike Price)] Premium Paid

2. P&L (Long Put) upon expiry is calculated as P&L = [Max (0, Strike
Price Spot Price)] Premium Paid

3. The above formula is applicable only when the trader intends to


hold the long option till expiry

4. The intrinsic value calculation we have looked at in the previous


topic is only applicable on the expiry day. We CANNOT use the same
formula during the series

5. The P&L calculation changes when the trader intends to square of


the position well before the expiry

6. The buyer of an option has limited risk, to the extent of premium


paid. However he enjoys an unlimited profit potential

Option seller in a nutshell


The option sellers (call or put) are also called the option writers. The
buyers and sellers have exact opposite P&L experience. Selling an option
makes sense when you expect the market to remain flat or below the
strike price (in case of calls) or above strike price (in case of put option).
I want you to appreciate the fact that all else equal, markets are slightly
favourable to option sellers. This is because, for the option sellers to be
profitable the market has to be either flat or move in a certain direction
(based on the type of option). However for the option buyer to be
profitable, the market has to move in a certain direction. Clearly there are
two favourable market conditions for the option seller versus one
favourable condition for the option buyer. But of course this in itself should
not be a reason to sell options.
Here are few key points you need to remember when it comes to
selling options

1. P&L for a short call option upon expiry is calculated as P&L =


Premium Received Max [0, (Spot Price Strike Price)]
2. P&L for a short put option upon expiry is calculated as P&L =
Premium Received Max (0, Strike Price Spot Price)

3. Of course the P&L formula is applicable only if the trader intends to


hold the position till expiry

4. When you write options, margins are blocked in your trading


account

5. The seller of the option has unlimited risk but very limited profit
potential (to the extent of the premium received)

Perhaps this is the reason why Nassim Nicholas Taleb in his book Fooled
by Randomness says Option writers eat like a chicken but shit like an
elephant. This means to say that the option writers earn small and
steady returns by selling options, but when a disaster happens, they tend
to lose a fortune.
Well, with this I hope you have developed a strong foundation on how a
Call and Put option behaves. Just to give you a heads up, the focus going
forward in this module will be on moneyless of an option, premiums,
option pricing, option Greeks, and strike selection. Once we understand
these topics we will revisit the call and put option all over again. When we
do so, Im certain you will see the calls and puts in a new light and
perhaps develop a vision to trade options professionally.
Payoff :
There are two basic option types i.e. the Call Option and the Put
Option. Further there are four different variants originating from these 2
options

1. Buying a Call Option

2. Selling a Call Option

3. Buying a Put Option

4. Selling a Put Option

Below the pay off diagrams for the four different option variants

Payoff diagrams in the above fashion helps us understand a few things


better. Let me list them for you
1. We have stacked the pay off diagram of Call Option (buy) and Call
option (sell) one below the other, they both look like a mirror image. The
mirror image of the payoff emphasis the fact that the risk-reward
characteristics of an option buyer and seller are opposite. The maximum
loss of the call option buyer is the maximum profit of the call option seller.
Likewise the call option buyer has unlimited profit potential, mirroring this
the call option seller has maximum loss potential

2. We have placed the payoff of Call Option (buy) and Put Option (sell)
next to each other. This is to emphasize that both these option variants
make money only when the market is expected to go higher. In other
words, do not buy a call option or do not sell a put option when you sense
there is a chance for the markets to go down. You will not make money
doing so, or in other words you will certainly lose money in such
circumstances. Of course there is an angle of volatility here which we
have not discussed yet; we will discuss the same going forward. The
reason why Im talking about volatility is because volatility has an impact
on option premiums

3. Finally on the right, the payoff diagram of Put Option (sell) and the
Put Option (buy) are stacked one below the other. Clearly the payoff
diagrams looks like the mirror image of one another. The mirror image of
the payoff emphasizes the fact that the maximum loss of the put option
buyer is the maximum profit of the put option seller. Likewise the put
option buyer has unlimited profit potential, mirroring this the put option
seller has maximum loss potential

Further, here is a table where the option positions are summarized.

Your Market Position also Other Premiu


Option Type
View called Alternatives m
Call Option Buy Futures or Buy
Bullish Long Call Pay
(Buy) Spot
Put Option Buy Futures or Buy
Flat or Bullish Short Put Receive
(Sell) Spot
Call Option
Flat or Bearish Short Call Sell Futures Receive
(Sell)
Put Option
Bearish Long Put Sell Futures Pay
(Buy)

It is important for you to remember that when you buy an option, it is also
called a Long
Position. Going by that, buying a call option and buying a put option is
called Long Call and Long Put position respectively.
Likewise whenever you sell an option it is called a Short position. Going
by that, selling a call option and selling a put option is also called Short
Call and Short Put position respectively.
Now here is another important thing to note, you can buy an option under
2 circumstances

1. You buy with an intention of creating a fresh option position

2. You buy with an intention to close an existing short position

The position is called Long Option only if you are creating a fresh buy
position. If you are buying with and intention of closing an existing short
position then it is merely called a square off position.
Similarly you can sell an option under 2 circumstances

1. You sell with an intention of creating a fresh short position

2. You sell with an intention to close an existing long position

The position is called Short Option only if you are creating a fresh sell
(writing an option) position. If you are selling with and intention of closing
an existing long position then it is merely called a square off position.
Definition of the Option
Pricing Model:
The Option Pricing Model is a formula that is used to determine a fair price
for a call or put option based on factors such as underlying stock volatility,
days to expiration, and others. The calculation is generally accepted and
used on Wall Street and by option traders and has stood the test of time
since its publication in 1973. It was the first formula that became popular
and almost universally accepted by the option traders to determine what
the theoretical price of an option should be based on a handful of
variables.

Option traders generally rely on the Black Scholes formula to buy options
that are priced under the formula calculated value, and sell options that
are priced higher than the Black Schole calculated value. This type of
arbitrage trading quickly pushes option prices back towards the Model's
calculated value. The Model generally works, but there are a few key
instances where the model fails.

The Black Scholes Option


Pricing Model:
Black Option Pricing Model:

The Model or Formula calculates an theoretical value of an option based


on 6 variables. These variables are:

Whether the option is a call or a put

The current underlying stock price

The time left until the option's expiration date

The strike price of the option

The risk-free interest rate

The volatility of the stock

What you need to know about the Option Pricing For the beginning call
and put trader it is NOT necessary to memorize the formula, but it is
important to understand a few implications that the formula or equation
has for option pricing and, therefore, on your trading.

Here's what you need to


know about the formula:
The formula shows the time left until expiration has a direct positive
relationship to the value of a call or put option. In other words, the more
time that is left before expiration, the higher the expected price will be.
Options with 60 days left until expiration will have a higher price than
options that only has 30 days left. This is because the more time that is
left, the more of a chance the underlying stock price will move. But here is
what you really need to understand--every minute that goes by, the
cheaper the option price will become. Think of it this way. As time ticks by
and as the days tick by, all things being equal, an option with 60 days left
will lose about 1/60th of its value tomorrow when it only has 59 days left.
That may not seem like a lot, but when we get to expiration week and as
Monday changes to Tuesday, options lose 1/5 of their value. As Tuesday
slips into Wednesday of expiration week, options lose 1/4 of their value,
etc. so you must be careful! While nothing is certain in the stock market,
there is ALWAYS one thing that is certain--time ticks by and options lose
their value day by day. Please note: Don't take me literally here as the
formula for this "time decay" is more complicated than that. It actually
indicates that the "time decay" accelerates as you get closer to expiration,
but I hope you get the point.

The formula suggests the historical volatility of the stock also has a direct
correlation to the option's price. By volatility we mean the daily change in
a stock's price from one day to the next. The more a stock price fluctuates
within a day and from day to day, then the more volatile the stock. The
more volatile the stock price, the higher the Model will calculate the value
of its options. Think of stocks that are in industries like utilities that pay a
high dividend and have been long-term, consistent performers. Their
prices go up steadily as the market moves, and they move small
percentage points by week. But if you compare those utility stocks' price
movements with bio-tech stocks or technology stocks, whose prices swing
up and down a few dollars per day, you will know what volatility is.
Obviously a stock whose price swings up and down $5 a week has a
greater chance of going up $5 then a stocks whose price swings up and
down $1 per week. If you are buying options, both put and calls, you LOVE
volatility--you WANT volatility. This volatility can be calculated as the
variance of the the prices over the last 60 days, or 90 days, or 180 days.
This becomes one of the weaknesses of the model since past results don't
always predict future performance. Stocks are often volatile immediately
after an earnings release, or after a major press release.

Watch out for dividends! If a stock typically pays a $1 dividend, then the
day it goes ex-dividend the stock price should drop $1. If you have calls on
a stock that you KNOW will drop $1 then you are starting off in the hole
$1. Nothing is worse than identifying a stock you are confident will go up,
looking at the call prices and thinking "boy those are cheap", buying a few
contracts, and then finding the stock go ex-dividend and then you realize
why the options were so cheap.

Beware of Earnings Releases and Rumors--You can calculate an option


price all you want, but nothing can drive a stock price (and its call option
prices as well) up more than a positive rumor or a strong earnings release.
The Option Pricing Model simply cannot overcome the supply and demand
curve of option traders hungry for owing a call option on the day of a
strong earnings release or a positive press release.

BlackScholes in practice:
The BlackScholes model disagrees with reality in a number of ways, some
significant. It is widely employed as a useful approximation, but proper
application requires understanding its limitations blindly following the
model exposes the user to unexpected risk.Among the most significant
limitations are:

the underestimation of extreme moves, yielding tail risk, which can be


hedged with out-of-the-money options; the assumption of instant, cost-
less trading, yielding liquidity risk, which is difficult to hedge; the
assumption of a stationary process, yielding volatility risk, which can be
hedged with volatility hedging; the assumption of continuous time and
continuous trading, yielding gap risk, which can be hedged with Gamma
hedging.

The volatility smile


One of the attractive features of the BlackScholes model is that the
parameters in the model other than the volatility (the time to maturity,
the strike, the risk-free interest rate, and the current underlying price) are
unequivocally observable. All other things being equal, an option's
theoretical value is a monotonic increasing function of implied volatility.

By computing the implied volatility for traded options with different strikes
and maturities, the BlackScholes model can be tested. If the Black
Scholes model held, then the implied volatility for a particular stock would
be the same for all strikes and maturities.

Despite the existence of the volatility smile (and the violation of all the
other assumptions of the BlackScholes model), the BlackScholes PDE
and BlackScholes formula are still used extensively in practice. A typical
approach is to regard the volatility surface as a fact about the market, and
use an implied volatility from it in a BlackScholes valuation model. This
has been described as using "the wrong number in the wrong formula to
get the right price. This approach also gives usable values for the hedge
ratios (the Greeks). Even when more advanced models are used, traders
prefer to think in terms of BlackScholes implied volatility as it allows
them to evaluate and compare options of different maturities, strikes, and
so on.

Criticism and comments:


EspenGaarderHaug and Nassim Nicholas Taleb argue that the Black
Scholes model merely recasts existing widely used models in terms of
practically impossible "dynamic hedging" rather than "risk", to make them
more compatible with mainstream neoclassical economic theory. They
also assert that Boness in 1964 had already published a formula that is
"actually identical" to the BlackScholes call option pricing
equation.Edward Thorp also claims to have guessed the BlackScholes
formula in 1967 but kept it to himself to make money for his investors.
Emanuel Derman and NassimTaleb have also criticized dynamic hedging
and state that a number of researchers had put forth similar models prior
to Black and Scholes. In response, Paul Wilmott has defended the model.
Living systems need to extract resources to compensate for continuous
diffusion. This can be modelled mathematically as lognormal processes.
The BlackScholes equation is a deterministic representation of lognormal
processes. The BlackScholes model can be extended to describe general
biological and social systems. British mathematician Ian Stewart published
a criticism in which he suggested that "the equation itself wasn't the real
problem" and he stated a possible role as "one ingredient in a rich stew of
financial irresponsibility, political ineptitude, perverse incentives and lax
regulation" due to its abuse in the financial industry.
The Option Greeks- Delta
Overview
There is a remarkable similarity between a Bollywood movie and an
options trade. Similar to a Bollywood movie, for an options trade to be
successful in the market there are several forces which need to work in
the option traders favour. These forces are collectively called The Option
Greeks. These forces influence an option contract in real time, affecting
the premium to either increase or decrease on a minute by minute basis.
To make matters complicated, these forces not only influence the
premiums directly but also influence each another.
Options Premiums, options Greeks, and the natural demand supply
situation of the markets influence each other. Though all these factors
work as independent agents, yet they are all intervened with one another.
The final outcome of this mixture can be assessed in the options
premium. For an options trader, assessing the variation in premium is
most important. He needs to develop a sense for how these factors play
out before setting up an option trade.

So without much ado, let me introduce the Greeks to you

1. Delta Measures the rate of change of options premium based on


the directional movement of the underlying

2. Gamma Rate of change of delta itself

3. Vega Rate of change of premium based on change in volatility

4. Theta Measures the impact on premium based on time left for


expiry

We will discuss these Greeks over the next few topics. The focus of this
topic is to understand the Delta.

Delta of an Option
Notice the following two snapshots here they belong to Niftys 8650 CE
option. The first snapshot was taken at 09:18 AM when Nifty spot was at
8692.
A little while later
Now notice the change in premium at 09:18 AM when Nifty was at
8692 the call option was trading at 183, however at 10:00 AM Nifty
moved to 8715 and the same call option was trading at 198.
In fact here is another snapshot at 10:55 AM Nifty declined to
8688 and so did the option premium (declined to 181).
From the above observations one thing stands out very clear as and
when the value of the spot changes, so does the option premium. More
precisely as we already know the call option premium increases with the
increase in the spot value and vice versa.
Keeping this in perspective, imagine this you have predicted that Nifty
will reach 8755 by 3:00 PM today. From the snapshots above we know that
the premium will certainly change but by how much? What is the likely
value of the 8650 CE premium if Nifty reaches 8755?
Well, this is exactly where the Delta of an Option comes handy. The Delta
measures how an options value changes with respect to the change in the
underlying. In simpler terms, the Delta of an option helps us answer
questions of this sort By how many points will the option premium
change for every 1 point change in the underlying?
Please see below 2 images which shows the change in Spot by 1 point
how much option premium changes.
With change in Spot by 1 point see below change in premium-

Premium changed to 159.99. Delta of 0.57385 added to premium when


nifty moved up by 1 point.
Therefore the Option Greeks Delta captures the effect of the directional
movement of the market on the Options premium.

The delta is a number which varies

1. Between 0 and 1 for a call option, some traders prefer to use the 0
to 100 scale. So the delta value of 0.55 on 0 to 1 scale is equivalent to 55
on the 0 to 100 scale.

2. Between -1 and 0 (-100 to 0) for a put option. So the delta value of


-0.4 on the -1 to 0 scale is equivalent to -40 on the -100 to 0 scale

3. We will soon understand why the put options delta has a negative
value associated with it

Delta for a Call Option


We know the delta is a number that ranges between 0 and 1. Assume a
call option has a delta of 0.3 or 30 what does this mean?
Well, as we know the delta measures the rate of change of premium for
every unit change in the underlying. So a delta of 0.3 indicates that for
every 1 point change in the underlying, the premium is likely change by
0.3 units, or for every 100 point change in the underlying the premium is
likely to change by 30 points.
The following example should help you understand this better
Nifty @ 10:55 AM is at 8688
Option Strike = 8850 Call Option
Premium = 133
Delta of the option = + 0.55
Nifty @ 3:15 PM is expected to reach 8710
What is the likely option premium value at 3:15 PM?
Well, this is fairly easy to calculate. We know the Delta of the option is
0.55, which means for every 1 point change in the underlying the
premium is expected to change by 0.55 points.
We are expecting the underlying to change by 22 points (8710 8688),
hence the premium is supposed to increase by
= 22*0.55
= 12.1
Therefore the new option premium is expected to trade
around 145.1 (133+12.1)
This is the sum of old premium + expected change in premium
As you can see from the above example, the delta helps us evaluate the
premium value based on the directional move in the underlying. This is
extremely useful information to have while trading options.
At this stage let me post a very important question Why is the delta
value for a call option bound by 0 and 1? Why cant the call options delta
go beyond 0 and 1?
To help understand this, let us look at 2 scenarios wherein I will purposely
keep the delta value above 1 and below 0.
Scenario 1: Delta greater than 1 for a call option

Nifty @ 10:55 AM at 8668


Option Strike = 8650 Call Option
Premium = 133
Delta of the option = 1.5 (purposely keeping it above 1)
Nifty @ 3:15 PM is expected to reach 8710
What is the likely premium value at 3:15 PM?
Change in Nifty = 42 points
Therefore the change in premium (considering the delta is 1.5)
= 1.5*42
= 63

Do you notice that? The answer suggests that for a 42 point change in the
underlying, the value of premium is increasing by 63 points! In other
words, the option is gaining more value than the underlying itself.
Remember the option is a derivative contract, it derives its value from its
respective underlying, hence it can never move faster than the
underlying.
If the delta is 1 (which is the maximum delta value) it signifies that the
option is moving in line with the underlying which is acceptable, but a
value higher than 1 does not make sense. For this reason the delta of an
option is fixed to a maximum value of 1 or 100.
Let us extend the same logic to figure out why the delta of a call option is
lower bound to 0.

Scenario 2: Delta lesser than 0 for a call option


Nifty @ 10:55 AM at 8688
Option Strike = 8700 Call Option
Premium = 9
Delta of the option = 0.2 (have purposely changed the value to below 0,
hence negative delta)
Nifty @ 3:15 PM is expected to reach 8200
What is the likely premium value at 3:15 PM?
Change in Nifty = 88 points (8688 -8600)
Therefore the change in premium (considering the delta is -0.2)
= -0.2*88
= -17.6
For a moment we will assume this is true, therefore new premium will be
= -17.6 + 9
= 8.6

As you can see in this case, when the delta of a call option goes below 0,
there is a possibility for the premium to go below 0, which is impossible.
At this point do recollect the premium irrespective of a call or put can
never be negative. Hence for this reason, the delta of a call option is lower
bound to zero.

Who decides the value of the Delta?


The value of the delta is one of the many outputs from the Black &
Scholes option pricing formula. the B&S formula takes in a bunch of inputs
and gives out a few key outputs. The output includes the options delta
value and other Greeks. After discussing all the Greeks, we will also go
through the B&S formula to strengthen our understanding on options.
However for now, you need to be aware that the delta and other Greeks
are market driven values and are computed by the B&S formula.
However here is a table which will help you identify the approximate delta
value for a given option

Option Type Approx Delta value (CE) Approx Delta value (PE)
Deep ITM Between + 0.8 to + 1 Between 0.8 to 1
Slightly ITM Between + 0.6 to + 1 Between 0.6 to 1
ATM Between + 0.45 to + 0.55 Between 0.45 to 0.55
Slightly OTM Between + 0.45 to + 0.3 Between 0.45 to -0.3
Deep OTM Between + 0.3 to + 0 Between 0.3 to 0

Of course you can always find out the exact delta of an option by using a
B&S option pricing calculator.

Delta for a Put Option

Parameters Values
Underlying Nifty
Strike 8700
Spot value 8668
Premium 128
Delta -0.55
Expected Nifty Value (Case) 8630

Do recollect the Delta of a Put Option ranges from -1 to 0. The negative


sign is just to illustrate the fact that when the underlying gains in value,
the value of premium goes down. Keeping this in mind, consider the
following details
Note 8668 is a slightly ITM option, hence the delta is around -0.55 (as
indicated from the table above).
The objective is to evaluate the new premium value considering the delta
value to be -0.55. Do pay attention to the calculations made below.
Case: Nifty is expected to move to 8630
Expected change = 8668 8630
= 38
Delta = 0.55
= -0.55*38
= -20.9
Current Premium = 128
New Premium = 128 + 20.9
= 148.9
Here Im adding the value of delta since I know that the value of a Put
option gains when the underlying value decreases.

I hope with the above Illustrations you are now clear on how to use the Put
Options delta value to evaluate the new premium value. Also, I will take
the liberty to skip explaining why the Put Options delta is bound between
-1 and 0.

Delta versus spot price


We looked at the significance of Delta and also understood how one can
use delta to evaluate the expected change in premium. Before we proceed
any further, here is a quick recap from the previous topic

1. Call options has a +ve delta. A Call option with a delta of 0.4
indicates that for every 1 point gain/loss in the underlying the call option
premium gains/losses 0.4 points

2. Put options has a ve delta. A Put option with a delta of -0.4


Indicates that for every 1 point loss/gain in the underlying the put option
premium gains/losses 0.4 points

3. OTM options have a delta value between 0 and 0.5, ATM option has
a delta of 0.5, and ITM option has a delta between 0.5 and 1.

Let me take cues from the 3rd point here and make some deductions.
Assume Nifty Spot is at 8712, strike under consideration is 8800, and
option type is CE (Call option, European).

1. What is the approximate Delta value for the 8800 CE when the spot
is 8712?

a. Delta should be between 0 and 0.5 as 8800 CE is OTM. Let us


assume Delta is 0.4
2. Assume Nifty spot moves from 8712 to 8800, what do you think is
the Delta value?

a. Delta should be around 0.5 as the 8800 CE is now an ATM


option

3. Further assume Nifty spot moves from 8800 to 8900, what do you
think is the Delta value?

a. Delta should be closer to 1 as the 8800 CE is now an ITM


option. Let us say 0.8.

4. Finally assume Nifty Spot cracks heavily and drops back to 8700
from 8900, what happens to delta?

a. With the fall in spot, the option has again become an OTM
from ITM, hence the value of delta also falls from 0.8 to let us say 0.35.

5. What can you deduce from the above 4 points?

a. Clearly as and when the spot value changes, the moneyness


of an option changes, and therefore the delta also changes.

Now this is a very important point here the delta changes with
changes in the value of spot. Hence delta is a variable and not really a
fixed entity. Therefore if an option has a delta of 0.4, the value is likely to
change with the change in the value of the underlying.
Have a look at the chart below it captures the movement of delta versus
the spot price. The chart is a generic one and not specific to any particular
option or strike as such. As you can see there are two lines

1. The blue line captures the behavior of the Call options delta (varies
from 0 to 1)

2. The red line captures the behavior of the Put options delta (varies
from -1 to 0)

Let us understand this better


GAMA

Gamma is one of the more obscure


Greeks. Delta, Vega and Theta generally get most of the attention,
but Gamma has important implications for risk in options strategies that
can easily be demonstrated.
Gamma measures the rate of change of Delta. Delta tells us how much an
option price will change given a one-point move of the underlying. But
since Delta is not fixed and will increase or decrease at different rates, it
needs its own measure, which is Gamma.

Delta, recall, is a measure of directional risk faced by any option strategy.


When you incorporate a Gamma risk analysis into your trading, however,
you learn that two Deltas of equal size may not be equal in outcome.
The Delta with the higher Gamma will have a higher risk (and potential
reward, of course) because given an unfavorable move of the underlying;
theDelta with the higher Gamma will exhibit a larger adverse change.
Figure 9 reveals that the highest Gammas are always found on at-the-
money options, with the January 110 call showing a Gamma of 5.58, the
highest in the entire matrix. The same can be seen for the 110 puts. The
risk/reward resulting from changes in Delta are highest at this point.

Delta as we know represents the change in premium for the given


change in the underlying price.

For example if the Nifty spot value is 8600, then we know the 8800 CE
option is OTM, hence its delta could be a value between 0 and 0.5. Let us
fix this to 0.2 for the sake of this discussion.Assume Nifty spot jumps 300
points in a single day, this means the 8800 CE is no longer an OTM option,
rather it becomes slightly ITM option and therefore by virtue of this jump
in spot value, the delta of 8800 CE will no longer be 0.2, it would be
somewhere between 0.5 and 1.0, let us assume 0.8.

With this change in underlying, one thing is very clear the delta itself
changes. Meaning delta is a variable, whose value changes based on the
changes in the underlying and the premium! If you notice, Delta is very
similar to velocity whose value changes with change in time and the
distance travelled.

The Gamma of an option measures this change in delta for the given
change in the underlying. In other words Gamma of an option helps us
answer this question For a given change in the underlying, what will be
the corresponding change in the delta of the option?

1st order Derivative

Change in distance travelled (position) with respect to change in time is


captured by velocity, and velocity is called the 1st order derivative of
position. Change in premium with respect to change in underlying is
captured by delta, and hence delta is called the 1st order derivative of the
premium

2nd order Derivative

Change in velocity with respect to change in time is captured by


acceleration, and acceleration is called the 2nd order derivative of
position. Change in delta is with respect to change in the underlying value
is captured by Gamma, hence Gamma is called the 2nd order derivative of
the premium

Calculating the values of Delta and Gamma (and in fact all other Option
Greeks) involves number crunching and heavy use of calculus (differential
equations and stochastic calculus). Derivatives are called derivatives
because the derivative contract derives its value based on the value of its
respective underlying.

The Gamma (2nd order derivative of premium) also referred to as the


curvature of the option gives the rate at which the options delta changes
as the underlying changes. The gamma is usually expressed in deltas
gained or lost per one point change in the underlying with the delta
increasing by the amount of the gamma when the underlying rises and
falling by the amount of the gamma when the underlying falls.

For example consider this

Nifty Spot=8726, Strike = 8800, Option type = CE, Moneyness of Option =


Slightly OTM

Premium = Rs.122/- , Delta = 0.4848, Gamma = 0.00121, Change in Spot


= 170 points

New Spot price = 8726 + 170 = 8896


New Moneyness = ATM
When Nifty moves from 8726 to 8896, the 8800 CE premium changed
from Rs.122 to Rs.221, and along with this the Delta changed from 0.45 to
0.70.

Notice with the change of 170 points, the option transitions from slightly
OTM to ITM option. Which means the options delta has to change from
0.45 to somewhere close to 0.70. This is exactly whats happening here.

In reality the Gamma also changes with the change in the underlying. This
change in Gamma due to changes in underlying is captured by
3rd derivative of underlying called Speed or Gamma of Gamma or
DgammaDspot. For all practical purposes, it is not necessary to get into
the discussion of Speed, unless you are mathematically inclined or you
work for an Investment Bank where the trading book risk can run into
several $ Millions.

Unlike the delta, the Gamma is always a positive number for both Call and
Put Option. Therefore when a trader is long options (both Calls and Puts)
the trader is considered Long Gamma and when he is short options (both
calls and puts) he is considered Short Gamma.

For example consider The Gamma of an ATM Put option is 0.004, if the
underlying moves 10 points, what do you think the new delta is?

With 1 point change in spot how much Delta will change is totally depends
on the Gamma.

Gamma added to the Delta.

Please see below chart of change in spot by 1 point how delta changes in
respect to Gamma-
Delta is at 0.57385 and Gamma is 0.00118. Premium is at 161.25.

If you notice Delta changed to 0.57503. Gamma of 0.00118 added to


Delta value which was at the time of Nifty Spot was at 8800.

Gamma movement
Gamma changes with respect to change in the underlying. This change in
Gamma is captured by the 3rd order derivative called Speed. Have a look
at the chart below,

The chart above has 3 different CE strike prices 80, 100, and 120 and
their respective Gamma movement. For example the blue line represents
the Gamma of the 80 CE strike price. I would suggest you look at each
graph individually to avoid confusion. In fact for sake of simplicity I will
only talk about the 80 CE strike option, represented by the blue line.

Let us assume the spot price is at 80, thus making the 80 strike ATM.
Keeping this in perspective we can observe the following from the above
chart

Since the strike under consideration is 80 CE, the option attains ATM
status when the spot price equals 80. Strike values below 80 (65, 70, 75
etc) are ITM and values above 80 (85, 90, 95 etx) are OTM options.

Notice the gamma value is low for OTM Options (80 and above). This
explains why the premium for OTM options dont change much in terms of
absolute point terms, however in % terms the change is higher. For
example the premium of an OTM option can change from Rs.2 to Rs.2.5,
while absolute change in is just 50 paisa, the % change is 25%.

The gamma peaks when the option hits ATM status. This implies that the
rate of change of delta is highest when the option is ATM. In other words,
ATM options are most sensitive to the changes in the underlying

Also, since ATM options have highest Gamma avoid shorting ATM options
The gamma value is also low for ITM options (80 and below). Hence for a
certain change in the underlying, the rate of change of delta for an ITM
option is much lesser compared to ATM option. However do remember the
ITM option inherently has a high delta. So while ITM delta reacts slowly to
the change in underlying (due to low gamma) the change in premium is
high (due to high base value of delta).

Vega Volatility Types


The last few topics have laid a foundation of sorts to help us understand
Volatility better. We now know what it means, how to calculate the same,
and use the volatility information for building trading strategies. It is now
time to steer back to the main topic Option Greek and in particular the
4th Option Greek Vega.
The different types of volatility that exist Historical Volatility, Forecasted
Volatility, and Implied Volatility. So lets get going.
Historical Volatility is similar to us judging the box office success of The
Hateful Eight based on Tarantinos past directorial ventures. In the stock
market world, we take the past closing prices of the stock/index and
calculate the historical volatility. Do recall, we discussed the technique of
calculating the historical volatility in topic. Historical volatility is very easy
to calculate and helps us with most of the day to day requirements for
instance historical volatility can somewhat be used in the options
calculator to get a quick and dirty option price.
Forecasted Volatility is similar to the movie analyst attempting to
forecast the fate of The Hateful Eight. In the stock market world, analysts
forecast the volatility. Forecasting the volatility refers to the act of
predicting the volatility over the desired time frame.
However, why would you need to predict the volatility? Well, there are
many option strategies, the profitability of which solely depends on your
expectation of volatility. If you have a view of volatility for example you
expect volatility to increase by 12.34% over the next 7 trading sessions,
then you can set up option strategies which can profit this view, provided
the view is right.
Also, at this stage you should realize to make money in the stock
markets it is NOT necessary to have a view on the direction on the
markets. The view can be on volatility as well. Most of the professional
options traders trade based on volatility and not really the market
direction. I have to mention this many traders find forecasting volatility
is far more efficient than forecasting market direction.
Now clearly having a mathematical/statistical model to predict volatility is
much better than arbitrarily declaring I think the volatility is going to
shoot up. There are a few good statistical models such as Generalized
AutoRegressive Conditional Heteroskedasticity (GARCH) Process. I know it
sounds spooky, but thats what its called. There are several GARCH
processes to forecast volatility, if you are venturing into this arena, I can
straightaway tell you that GARCH (1,1) or GARCH (1,2) are better suited
processes for forecasting volatility.
Implied Volatility (IV) is like the peoples perception on social media. It
does not matter what the historical data suggests or what the movie
analyst is forecasting about The Hateful Eight. People seem to be excited
about the movie, and that is an indicator of how the movie is likely to fare.
Likewise the implied volatility represents the market participants
expectation on volatility. So on one hand we have the historical and
forecasted volatility, both of which are sort of manufactured while on the
other hand we have implied volatility which is in a sense consensual.
Implied volatility can be thought of as consensus volatility arrived
amongst all the market participants with respect to the expected amount
of underlying price fluctuation over the remaining life of an option. Implied
volatility is reflected in the price of the premium.
For this reason amongst the three different types of volatility, the IV is
usually more valued.
You may have heard or noticed India VIX on NSE website, India VIX is the
official Implied Volatility index that one can track. India VIX is computed
based on a mathematical formula, here is a whitepaper which explains
how India VIX is calculated
If you find the computation a bit overwhelming, then here is a quick wrap
on what you need to know about India VIX (I have reproduced some of
these points from the NSEs whitepaper)

1. NSE computes India VIX based on the order book of Nifty Options

2. The best bid-ask rates for near month and next-month Nifty options
contracts are used for computation of India VIX

3. India VIX indicates the investors perception of the markets


volatility in the near term (next 30 calendar days)

4. Higher the India VIX values, higher the expected volatility and vice-
versa
5. When the markets are highly volatile, market tends to move steeply
and during such time the volatility index tends to rise

6. Volatility index declines when the markets become less volatile.


Volatility indices such as India VIX are sometimes also referred to as the
Fear Index, because as the volatility index rises, one should become
careful, as the markets can move steeply into any direction. Investors use
volatility indices to gauge the market volatility and make their investment
decisions

7. Volatility Index is different from a market index like NIFTY. NIFTY


measures the direction of the market and is computed using the price
movement of the underlying stocks whereas India VIX measures the
expected volatility and is computed using the order book of the underlying
NIFTY options. While Nifty is a number, India VIX is denoted as an
annualized percentage

Further, NSE publishes the implied volatility for various strike prices for all
the options that get traded. You can track these implied volatilities by
checking the option chain. For example here is the option chain of Cipla,
with all the IVs marked out.
The Implied Volatilities can be calculated using a standard options
calculator. We will discuss more about calculating IV, and using IV for
setting up trades in the subsequent topic. For now we will now move over
to understand Vega.
Realized Volatility is pretty much similar to the eventual outcome of the
movie, which we would get to know only after the movie is released.
Likewise the realized volatility is looking back in time and figuring out the
actual volatility that occurred during the expiry series. Realized volatility
matters especially if you want to compare todays implied volatility with
respect to the historical implied volatility. We will explore this angle in
detail when we take up Option Trading Strategies.

Vega
Have you noticed this whenever there are heavy winds and
thunderstorms, the electrical voltage in your house starts fluctuating
violently, and with the increase in voltage fluctuations, there is a chance
of a voltage surge and therefore the electronic equipments at house may
get damaged.
Similarly, when volatility increases, the stock/index price starts swinging
heavily. To put this in perspective, imagine a stock is trading at Rs.100,
with increase in volatility; the stock can start moving anywhere between
90 and 110. So when the stock hits 90, all PUT option writers start
sweating as the Put options now stand a good chance of expiring in the
money. Similarly, when the stock hits 110, all CALL option writers would
start panicking as all the Call options now stand a good chance of expiring
in the money.
Therefore irrespective of Calls or Puts when volatility increases, the option
premiums have a higher chance to expire in the money. Now, think about
this imagine you want to write 500 CE options when the spot is trading
at 475 and 10 days to expire. Clearly there is no intrinsic value but there
is some time value. Hence assume the option is trading at Rs.20. Would
you mind writing the option? You may write the options and pocket the
premium of Rs.20/- I suppose. However, what if the volatility over the 10
day period is likely to increase maybe election results or corporate
results are scheduled at the same time. Will you still go ahead and write
the option for Rs.20? Maybe not, as you know with the increase in
volatility, the option can easily expire in the money hence you may lose
all the premium money you have collected. If all option writers start
fearing the volatility, then what would compel them to write options?
Clearly, a higher premium amount would. Therefore instead of Rs.20, if
the premium was 30 or 40, you may just think about writing the option I
suppose.
In fact this is exactly what goes on when volatility increases (or is
expected to increase) option writers start fearing that they could be
caught writing options that can potentially transition to in the money.
But nonetheless, fear too can be overcome for a price, hence option
writers expect higher premiums for writing options, and therefore the
premiums of call and put options go up when volatility is expected to
increase.
The graphs below emphasizes the same point
X axis represents Volatility (in %) and Y axis represents the premium value
in Rupees. Clearly, as we can see, when the volatility increases, the
premiums also increase. This holds true for both call and put options. The
graphs here go a bit further, it shows you the behavior of option premium
with respect to change in volatility and the number of days to expiry.
Have a look at the first chart (CE), the blue line represents the change in
premium with respect to change in volatility when there is 30 days left for
expiry, likewise the green and red line represents the change in premium
with respect to change in volatility when there is 15 days left and 5 days
left for expiry respectively.
Keeping this in perspective, here are a few observations (observations are
common for both Call and Put options)

1. Referring to the Blue line when there are 30 days left for expiry
(start of the series) and the volatility increases from 15% to 30%, the
premium increases from 97 to 190, representing about 95.5% change in
premium

2. Referring to the Green line when there are 15 days left for expiry
(mid series) and the volatility increases from 15% to 30%, the premium
increases from 67 to 100, representing about 50% change in premium

3. Referring to the Red line when there are 5 days left for expiry
(towards the end of series) and the volatility increases from 15% to 30%,
the premium increases from 38 to 56, representing about 47% change in
premium

Keeping the above observations in perspective, we can make few


deductions

1. The graphs above considers a 100% increase of volatility from 15%


to 30% and its effect on the premiums. The idea is to capture and
understand the behavior of increase in volatility with respect to premium
and time. Please be aware that observations hold true even if the volatility
moves by smaller amounts like maybe 20% or 30%, its just that the
respective move in the premium will be proportional

2. The effect of Increase in volatility is maximum when there are more


days to expiry this means if you are at the start of series, and the
volatility is high then you know premiums are plum. Maybe a good idea to
write these options and collect the premiums invariably when volatility
cools off, the premiums also cool off and you could pocket the differential
in premium

3. When there are few days to expiry and the volatility shoots up the
premiums also goes up, but not as much as it would when there are more
days left for expiry. So if you are a wondering why your long options are
not working favorably in a highly volatile environment, make sure you look
at the time to expiry

So at this point one thing is clear with increase in volatility, the


premiums increase, but the question is by how much?. This is exactly
what the Vega tells us.
The Vega of an option measures the rate of change of options value
(premium) with every percentage change in volatility. Since options gain
value with increase in volatility, the vega is a positive number, for both
calls and puts. For example if the option has a vega of 0.15, then for
each % change in volatility, the option will gain or lose 0.15 in its
theoretical value.

Taking things forward

It is now perhaps time to revisit the path this module on Option Trading
has taken and will take going forward (over the next topic).
We started with the basic understanding of the options structure and then
proceeded to understand the Call and Put options from both the buyer and
sellers perspective. We then moved forward to understand the moneyness
of options and few basic technicalities with respect to options.
We further understood option Greeks such as the Delta, Gamma, Theta,
and Vega along with a mini series of Normal Distribution and Volatility.
At this stage, our understanding on Greeks is one dimensional. For
example we know that as and when the market moves the option
premiums move owing to delta. But in reality, there are several factors
that works simultaneously on one hand we can have the markets moving
heavily, at the same time volatility could be going crazy, liquidity of the
options getting sucked in and out, and all of this while the clock keeps
ticking. In fact this is exactly what happens on an everyday basis in
markets. This can be a bit overwhelming for newbie traders. It can be so
overwhelming that they quickly rebrand the markets as Casino. So the
next time you hear someone say such a thing about the markets, make
sure you point them to Varsity.
Anyway, the point that I wanted to make is that all these Greeks manifest
itself on the premiums and therefore the premiums vary on a second by
second basis. So it becomes extremely important for the trader to fully
understand these inter Greek interactions of sorts. This is exactly what
we will do in the next topic. We will also have a basic understanding of the
Black & Scholes options pricing formula and how to use the same.
This is a very interesting chart, and to begin with I would suggest you look
at only the blue line and ignore the red line completely. The blue line
represents the delta of a call option. The graph above captures few
interesting characteristics of the delta; let me list them for you
(meanwhile keep this point in the back of your mind as and when the
spot price changes, the moneyness of the option also changes)

1. Look at the X axis starting from left the moneyness increases as


the spot price traverses from OTM to ATM to ITM

2. Look at the delta line (blue line) as and when the spot price
increases so does the delta

3. Notice at OTM the delta is flattish near 0 this also means


irrespective of how much the spot price falls ( going from OTM to deep
OTM) the options delta will remain at 0

a. Remember the call options delta is lower bound by 0


4. When the spot moves from OTM to ATM the delta also starts to pick
up (remember the options moneyness also increases)

a. Notice how the delta of option lies within 0 to 0.5 range for
options that are less than ATM

5. At ATM, the delta hits a value of 0.5

6. When the spot moves along from the ATM towards ITM the delta
starts to move beyond the 0.5 mark

7. Notice the delta starts to fatten out when it hits a value of 1

a. This also implies that as and when the delta moves beyond
ITM to say deep ITM the delta value does not change. It stays at its
maximum value of 1.

Theta
Time is money
Remember the adage Time is money, it seems like this adage about
time is highly relevant when it comes to options trading. Assume you have
enrolled for a competitive exam, you are inherently a bright candidate and
have the capability to clear the exam, however if you do not give it
sufficient time and brush up the concepts, you are likely to flunk the exam
so given this what is the likelihood that you will pass this exam? Well, it
depends on how much time you spend to prepare for the exam right?
Lets keep this in perspective and figure out the likelihood of passing the
exam against the time spent preparing for the exam.

Number of days for preparation Likelihood of passing


30 days Very high
20 days High
15 days Moderate
10 days Low
5 days Very low
1 day Ultra low

Quite obviously higher the number of days for preparation, the higher is
the likelihood of passing the exam. Keeping the same logic in mind, think
about the following situation.
Is there anything that we can infer from the above? Clearly, the more time
for expiry the likelihood for the option to expire In the Money (ITM) is
higher. Now keep this point in the back of your mind as we now shift our
focus on the Option Seller. We know an option seller sells/writes an
option and receives the premium for it. When he sells an option he is very
well aware that he carries an unlimited risk and limited reward potential.
The reward is limited to the extent of the premium he receives. He gets to
keep his reward (premium) fully only if the option expires worthless. Now,
think about this if he is selling an option early in the month he very
clearly knows the following
1. He knows he carries unlimited risk and limited reward potential

2. He also knows that by virtue of time, there is a chance for the option
he is selling to transition into ITM option, which means he will not get to
retain his reward (premium received)

In fact at any given point, thanks to time, there is always a chance for
the option to expiry in the money (although this chance gets lower and
lower as time progresses towards the expiry date). Given this, an option
seller would not want to sell options at all right? After all why would you
want to sell options when you very well know that simply because of time
there is scope for the option you are selling to expire in the money. Clearly
time in the option sellers context acts as a risk. Now, what if the option
buyer in order to entice the option seller to sell options offers to
compensate for the time risk that he (option seller) assumes? In such a
case it probably makes sense to evaluate the time risk versus the
compensation and take a call right? In fact this is what happens in real
world options trading. Whenever you pay a premium for options, you are
indeed paying towards

1. Time Risk

2. Intrinsic value of options.

So given that we know how to calculate the intrinsic value of an option, let
us attempt to decompose the premium and extract the time value and
intrinsic value. Have a look at the following snapshot
Details to note are as follows

Spot Value = 8531

Strike = 8600 CE

Status = OTM

Premium = 99.4

Todays date = 6th July 2015

Expiry = 30th July 2015

Intrinsic value of a call option Spot Price Strike Price i.e. 8531 8600 =
0 (since its a negative value) we know Premium = Time value + Intrinsic
value 99.4 = Time Value positive 0 this implies Time value = 99.4! Do you
see that? The market is willing to pay a premium of Rs.99.4/- for an option
that has zero intrinsic value but ample time value! Recall time is
money. Here is snapshot of the same contract that I took the next day i.e.
7th July

Movement of time
Time as we know moves in one direction. Keep the expiry date as the
target time and think about the movement of time. Quite obviously as
time progresses, the number of days for expiry gets lesser and lesser.
Given this let me ask you this question With roughly 18 trading days to
expiry, traders are willing to pay as much as Rs.100/- towards time value,
will they do the same if time to expiry was just 5 days? Obviously they
would not right? With lesser time to expiry, traders will pay a much lesser
value towards time. In fact here is a snap shot that I took from the earlier
months

Date = 29th April

Expiry Date = 30th April

Time to expiry = 1 day

Strike = 190

Spot = 179.6

Premium = 30 Paisa

Intrinsic Value = 179.6 190 = 0 since its a negative value

Hence time value should be 30 paisa which equals the premium

With 1 day to expiry, traders are willing to pay a time value of just 30
paisa. However, if the time to expiry was 20 days or more the time value
would probably be Rs.5 or Rs.8/-. The point that Im trying to make here is
this with every passing day, as we get closer to the expiry day, the time
to expiry becomes lesser and lesser. This means the option buyers will pay
lesser and lesser towards time value. So if the option buyer pays Rs.10 as
the time value today, tomorrow he would probably pay Rs.9.5/- as the
time value. This leads us to a very important conclusion All other things
being equal, an option is a depreciating asset. The options premium
erodes daily and this is attributable to the passage of time. Now the next
logical question is by how much would the premium decrease on a daily
basis owing to the passage of time? Well, Theta the 3 rd Option Greek helps
us answer this question.

Theta
All options both Calls and Puts lose value as the expiration approaches.
The Theta or time decay factor is the rate at which an option loses value
as time passes. Theta is expressed in points lost per day when all other
conditions remain the same. Time runs in one direction, hence theta is
always a positive number, however to remind traders its a loss in options
value it is sometimes written as a negative number. A Theta of -0.5
indicates that the option premium will lose -0.5 points for every day that
passes by. For example, if an option is trading at Rs.2.75/- with theta of
-0.05 then it will trade at Rs.2.70/- the following day (provided other
things are kept constant). A long option (option buyer) will always have a
negative theta meaning all else equal, the option buyer will lose money on
a day by day basis. A short option (option seller) will have a positive theta.
Theta is a friendly Greek to the option seller. Remember the objective of
the option seller is to retain the premium. Given that options loses value
on a daily basis, the option seller can benefit by retaining the premium to
the extent it loses value owing to time. For example if an option writer has
sold options at Rs.54, with theta of 0.75, all else equal, the same option is
likely to trade at =0.75 * 3 = 2.25 = 54 2.25 = 51.75 Hence the seller
can choose to close the option position on T+ 3 day by buying it back at
Rs.51.75/- and profiting Rs.2.25
See below chart how change in 1 day keeping other things constant
premium changes.

Nifty trading at 8800 date is 4th October, 2016 and Theta is -4.1636,
Premium is 161.25
Now next day all things remains the same and premium changes to
157.05 Theta reduced from premium.
See the below chart for reference-

Have a look at the graph below How premium erodes as expiry comes
near-

This is the graph of how premium erodes as time to expiry approaches.


This is also called the Time Decay graph. We can observe the following
from the graph
1. At the start of the series when there are many days for expiry the
option does not lose much value. For example when there were 120 days
to expiry the option was trading at 350, however when there was 100
days to expiry, the option was trading at 300. Hence the effect of theta
is low

2. As we approach the expiry of the series the effect of theta is high.


Notice when there was 20 days to expiry the option was trading around
150, but when we approach towards expiry the drop in premium seems to
accelerate (option value drops below 50).

Implication of implied
volatility and influence of lV
on options Greek
What is volatility?

Volatility is the up down movement of the stock market. If you have a


similar opinion on volatility, then it is about time we fixed that .

What Is Implied Volatility?

It is not uncommon for investors to be reluctant about using options


because there are several variables that influence an option's premium.
Don't let yourself become one of these people. As interest in options
continues to grow and the market becomes increasingly volatile, this will
dramatically affect the pricing of options and, in turn, affect the
possibilities and pitfalls that can occur when trading them.

Implied volatility is an essential ingredient to the option pricing equation.


To better understand implied volatility and how it drives the price of
options, let's go over the basics of options pricing.

How Implied Volatility Affects Options

The success of an options trade can be significantly enhanced by being on


the right side of implied volatility changes. For example, if you own
options when implied volatility increases, the price of these options climbs
higher. A change in implied volatility for the worse can create losses,
however, even when you are right about the stock's direction!
Each listed option has a unique sensitivity to implied volatility changes.
For example, short-dated options will be less sensitive to implied volatility,
while long-dated options will be more sensitive. This is based on the fact
that long-dated options have more time value priced into them, while
short-dated options have less.

How to Use Implied Volatility to Your Advantage

One effective way to analyze implied volatility is to examine a chart. Many


charting platforms provide ways to chart an underlying option's average
implied volatility, in which multiple implied volatility values are tallied up
and averaged together. For example, the volatility index (VIX) is calculated
in a similar fashion. Implied volatility values of near-dated, near-the-
money S&P 500 Index options are averaged to determine the VIX's value.
The same can be accomplished on any stock that offers options.

Source: http://www.prophet.net/

Figure 1: Implied volatility using INTC


options

Figure 1 shows that implied volatility fluctuates the same way prices do.
Implied volatility is expressed in percentage terms and is relative to the
underlying stock and how volatile it is. For example, General Electric stock
will have lower volatility values than Apple Computer because Apple's
stock is much more volatile than General Electric's. Apple's volatility range
will be much higher than GE's. What might be considered a low
percentage value for AAPL might be considered relatively high for GE.

Because each stock has a unique implied volatility range, these values
should not be compared to another stock's volatility range. Implied
volatility should be analyzed on a relative basis. In other words, after you
have determined the implied volatility range for the option you are
trading, you will not want to compare it against another. What is
considered a relatively high value for one company might be considered
low for another.

Source: www.prophet.net

Figure 2 : An implied volatility range


using relative values

Figure 2 is an example of how to determine a relative implied volatility


range. Look at the peaks to determine when implied volatility is relatively
high, and examine the troughs to conclude when implied volatility is
relatively low. By doing this, you determine when the underlying options
are relatively cheap or expensive. If you can see where the relative highs
are (highlighted in red), you might forecast a future drop in implied
volatility, or at least a reversion to the mean. Conversely, if you determine
where implied volatility is relatively low, you might forecast a possible rise
in implied volatility or a reversion to its mean.

Implied volatility, like everything else, moves in cycles. High volatility


periods are followed by low volatility periods, and vice versa. Using
relative implied volatility ranges, combined with forecasting techniques,
helps investors select the best possible trade. When determining a
suitable strategy, these concepts are critical in finding a high probability
of success, helping you maximize returns and minimize risk.

Using Implied Volatility to Determine Strategy

You've probably heard that you should buy undervalued options and
sell overvalued options. While this process is not as easy as it sounds, it is
a great methodology to follow when selecting an appropriate option
strategy. Your ability to properly evaluate and forecast implied volatility
will make the process of buying cheap options and selling expensive
options that much easier.

When forecasting implied volatility, there are four things to consider:


1. Make sure you can determine whether implied volatility is high or low
and whether it is rising or falling. Remember, as implied volatility
increases, option premiums become more expensive. As implied volatility
decreases, options become less expensive. As implied volatility reaches
extreme highs or lows, it is likely to revert back to its mean.

2. If you come across options that yield expensive premiums due to high
implied volatility, understand that there is a reason for this. Check the
news to see what caused such high company expectations and high
demand for the options. It is not uncommon to see implied volatility
plateau ahead of earnings announcements, merger and
acquisition rumors, product approvals and other news events. Because
this is when a lot of price movement takes place, the demand to
participate in such events will drive option prices price higher. Keep in
mind that after the market-anticipated event occurs, implied volatility will
collapse and revert back to its mean.

3. When you see options trading with high implied volatility levels,
consider selling strategies. As option premiums become relatively
expensive, they are less attractive to purchase and more desirable to sell.
Such strategies include covered calls, naked puts, short
straddles and credit spreads. By contrast, there will be times when you
discover relatively cheap options, such as when implied volatility is
trading at or near relative to historical lows. Many option investors use
this opportunity to purchase long-dated options and look to hold them
through a forecasted volatility increase.

4. When you discover options that are trading with low implied volatility
levels, consider buying strategies. With relatively cheap time premiums,
options are more attractive to purchase and less desirable to sell. Such
strategies include buying calls, puts, long straddles and debit spreads.

The Bottom Line

In the process of selecting strategies, expiration months or strike price,


you should gauge the impact that implied volatility has on these trading
decisions to make better choices. You should also make use of a few
simple volatility forecasting concepts. This knowledge can help you avoid
buying overpriced options and avoid selling underpriced ones.
Volatility and Implied
Volatility - Explanation
Volatility, as applied to options, is a statistical measurement of the rate of
price changes in the underlying asset: the greater the changes in a given
time period, the higher the volatility. The volatility of an asset will
influence the prices of options based on that asset, with higher volatility
leading to higher option premiums. Option premiums depend, in part, on
volatility because an option based on a volatile asset is more likely to go
into the money before expiration. On the other hand, a low volatile asset
will tend to remain within tight limits in its price variation, which means
that an option based on that asset will only have a significant probability
of going into the money if the underlying price is already close to the
strike price. Thus, volatility is a measure of the uncertainty in the
expected future price of an asset.

An option premium consists of time value, and it may also consist of


intrinsic value if it is in the money. Volatility only affects the time value of
the option premium. How much volatility will affect option prices will
depend on how much time there is left until expiration: the shorter the
time, the less influence volatility will have on the option premium, since
there is less time for the price of the underlying to change significantly
before expiration.

Higher volatility increases the delta for out-of-the-money options while


decreasing delta for in-the-money options; lower volatility has the
opposite effect. This relationship holds because volatility has an effect on
the probability that the option will finish in the money by expiration:
higher volatility will increase the probability that an out-of-the-money
option will go into the money by expiration, whereas an in-the-money
option could easily go out-of-the-money by expiration. In either case,
higher volatility increases the time value of the option so that intrinsic
value, if any, is a smaller component of the option premium.

Implied Volatility is Not Volatility It Measures the Demand Over


Supply for a Particular Option

Because volatility obviously has an influence on option prices, theBlack-


Scholes model of option pricing includes volatility as a component plus the
following factors:

strike price in relation to the underlying asset price;


the amount of time remaining until expiration;

interest rates, where higher interest rates increase the call premium
but lower the put premium;

dividends, where a higher dividend paid by the underlying asset


lowers a call premium but increases the put premium.

The Black-Scholes formula calculates only a theoretical price for a call


premium; the theoretical price for a put premium can be calculated
through the put-call parity relationship. However, the actual value the
market price of an option premium will be determined by the
instantaneous supply and demand for the option.

When the market is active, the following factors are known:

the actual option premium

strike price

time until expiration

interest rates

any dividend

Therefore, volatility can be calculated with the Black-Scholes equation or


from another option-pricing model by plugging in the known factors into
the equation and solving for the volatility that would be required to yield
the market price of the call premium. This is what is known as implied
volatility. Implied volatility does not have to be calculated by the trader,
since most option trading platforms provide it for each option listed.
Implied volatility makes no predictions about future price swings of the
underlying stock, since the relationship is tenuous at best. Implied
volatility can change very quickly, even without any change in the
volatility of the underlying asset. Although implied volatility is measured
the same as volatility, as a standard deviation percentage, it does not
actually reflect the volatility either of the underlying asset or even of the
option itself. It is simply the demand over supply for that particular option,
and nothing more.

Generally, in a rising market, calls will generally have a higher implied


volatility while puts will have a lower implied volatility; in a declining
market, puts will have a higher implied volatility over calls. This reflects
the increased demand for calls in a rising market and a rising demand for
puts in a declining market.

A rise in the implied volatility of a call will decrease the delta for an in-the-
money option, because it has a greater chance of going out-of-the-money,
whereas for an out-of-the-money option, a higher implied volatility will
increase the delta, since it will have a greater probability of finishing in the
money.

Implied volatility is not present volatility nor future volatility. It is simply


the volatility calculated from the market price of the option premium.
There is an indirect connection between historical volatility and implied
volatility, in that historical volatility will have a large effect on the market
price of the option premium, but the connection is only indirect; implied
volatility is directly affected by the market price of the option premium,
which, in turn, is influenced by historical volatility. Implied volatility is the
volatility that is implied by the current market price of the option
premium. That implied volatility does not represent the actual volatility of
the underlying asset can be seen more clearly by considering the
following scenario: a trader wants to either buy or sell a large number of
options on a particular underlying asset. A trader may want to sell
because he needs the money; perhaps, it is a pension fund that needs to
make payments on its pension obligations. Now, a large order will have a
direct influence on the pricing of the option, but it would have no effect on
the price of the underlying. It is clear to see that the price change in the
option premium is not effected by any changes in the volatility of the
underlying asset, because the buy or sell orders are for the option itself,
not for the underlying asset. As a further illustration, the implied volatility
for puts and calls and for option contracts with different strike prices or
expiration dates that are all based on the same underlying asset will have
different implied volatilities, because the different options will each have a
different supply-demand equilibrium. This is what causes the volatility
skew and volatility smile. Thus, implied volatility is not a direct measure of
the volatility of the underlying asset.

Implied volatility varies with the change in the supply-demand


equilibrium, which is why it measures the supply and demand for a
particular option rather than the volatility of the underlying asset. For
instance, if a stock is expected to increase in price, then the demand for
calls will be greater than the demand for puts, so the calls will have a
higher implied volatility, even though both the calls and the puts are
based on the same underlying asset. Likewise, puts on indexes, such as
the S&P 500, may have a higher implied volatility, since there is a greater
demand by fund managers who wish to protect their position in the
underlying stocks. At the same time, the same fund managers generally
sell calls on the indexes to finance the purchase of puts on the same
index; such a spread is referred to as a collar. This lowers the implied
volatility on the calls while increasing the implied volatility for the puts.

Because implied volatility is a measure of the instantaneous demand-


supply equilibrium, it can indicate that an option is either over- or under-
priced relative to the other factors that determine the option premium,
but only if implied volatility is not higher because of major news or
because of an impending event, such as FDA approval for a drug or the
results of an important court case. Likewise, implied volatility may be low
because the option is unlikely to go into the money by expiration. If
implied volatility is high because of an impending event, then it will
decline after the event, since the uncertainty of the event is removed; this
rapid deflation of implied volatility is sometimes referred to as a volatility
crush.

However, implied volatility that is merely due to the normal statistical


fluctuation of supply and demand for a particular option may be used to
increase profits or decrease losses, especially for an option spread. If an
option has high implied volatility, then it may contract later on, reducing
the time value of the option premium in relation to the other price
determinants; likewise, low implied volatility may have resulted from a
temporary decline in demand or a temporary increase in supply that may
revert to the average later. So high implied volatility will tend to decline,
while low implied volatility will tend to increase over the lifetime of the
option. Thus, implied volatility may be an important consideration when
setting up option spreads, where maximum profits and losses are
determined by how much was paid for long options and how much was
received for short options. When selecting long options for a spread, some
consideration should be given to selecting strike prices that have lower
implied volatilities, while strike prices for short options should have higher
implied volatilities. This lowers the debit when paying for long spreads
while increasing the credit received for selling short spreads.

Although the implied volatility varies widely among different assets,


including different stocks, different indexes, different futures contracts,
and so on, the volatility of an index will usually be less than the volatility
of individual assets, since an index is a measure of the price changes of all
of the individual components of the index, where assets with greater
volatility will be offset by other assets with lower volatility.

Diagram showing the difference in the expected price distribution about


the mean for a volatile and a non-volatile stock.
Implied volatility, like volatility, is calculated as an annual standard
deviation, expressed as a percentage, that can be used to compare
implied volatility of different options that are not only based on the same
asset, but also on different assets, including stocks, indexes, or futures.
Moreover, the other factors of the option-pricing model, such as interest
and dividends, are also usually expressed as an annual percentage. Most
trading platforms calculate the implied volatility for the different options.

The standard deviation is a statistical measure of the variability and,


therefore, of volatility of an underlying asset and can be useful in
predicting the probability that the asset will be within a particular price
range. In a normal distribution, which characterizes the price variation
of most assets, 68.3% of price changes of the underlying asset over a 1-
year period will be within 1 standard deviation of the mean, 95.4% will be
within 2 standard deviations, and 99.7% will be within 3 standard
deviations. Volatility determines how wide the standard deviation is. If
there is little variability, then the normal distribution will be much
narrower, whereas for a highly variable asset, the normal distribution
would be much flatter, where 1 standard deviation would encompass a
wider variability in pricing over a unit of time. So if a stock has a mean
price of $100, and has a volatility percentage of 15%, then during the
course of the year, the price of the stock will stay within $15 for 68.3%
of the time.

Vega and Other Measures of Volatility

Vega measures a change in the theoretical option price caused by a 1-


point change in implied volatility. For instance, an option with a vega of .
01 will increase by $10 per contract (which consists of 100 shares) for
each point increase in volatility and will lose $10 per contract for each 1%
decline in volatility. For the short position, vega would have the exact
opposite effect, where a 1-point increase in volatility would decrease the
value of the short option by $10.

Most options have both intrinsic value and time value. Intrinsic value is a
measure of how much the option is in the money; the time value is equal
to the option premium minus the intrinsic value. Thus, time value depends
on the probability that the option will go into the money or stay into the
money by expiration. Volatility only affects the time value of an option.
Therefore, vega, as a measure of volatility, is greatest when the time
value of the option is greatest and least when it is least. Because time
value is greatest when the option is at the money, that is also when
volatility will have the greatest effect on the option price. And just as time
value diminishes as an option moves further out of the money or into the
money, so goes vega.

There are general measures of volatility that represent volatility of entire


markets. The Chicago Board Option Exchange (CBOE) Volatility Index (VIX)
measures the implied volatility on the options based on the S&P 500
index. This is not the same as implied volatility of the underlying stocks
that compose the S&P 500 index, but as a measure of the implied
volatility of the options on those stocks. VIX is also known as a fear
index, because it presumably measures the amount of fear in the market;
in actuality, it probably causes fear rather than reflecting fear, because
higher fluctuations in the supply and demand for the options creates more
uncertainty. Other measures of general volatility include the NASDAQ 100
Volatility Index (VXN), which measures the volatility of the NASDAQ 100,
which includes many high-tech companies. The Russell 2000 Volatility
Index (RVX) measures the volatility of the index composed of the 2000
stocks in the Russell 2000 Index.

Volatility Skew

Volatility skew is a result of different implied volatilities for different


strike prices and for whether the option is a call or put. Volatility skew
further illustrates that implied volatility depends only on the option
premium, not on the volatility of the underlying asset, since that does not
change with either different strike prices or option type.

How the volatility skew changes with different strike prices depends on
the type of skew, which is influenced by the supply and demand for the
different options. A forward skew is exhibited by higher implied
volatilities for higher strike prices. A reverse skew is one with lower
implied volatilities for higher strike prices. A smiling skew is exhibited by
an implied volatility distribution that increases for strike prices that are
either lower or higher than the price of the underlying. A flat skew means
that there is no skew: implied volatility is the same for all strike prices. The
options of most underlying assets exhibit a reverse skew, reflecting the
fact that slightly out-of-the-money options have a greater demand than
those that are in the money. Furthermore, out-of-the-money options have
a higher time value, so volatility will have a greater effect for options that
only have time value. Thus, a call and a put at the same strike price will
have different implied volatilities, since the strike price will likely differ
from the price of the underlying, demonstrating yet again that implied
volatility is not the result of the volatility of the underlying asset.

Options with the same strike prices but with different expiration months
also exhibit a skew, with the near months generally showing a higher
implied volatility than the far months, reflecting a greater demand for
near-term options over those with later expirations.

Put Call Parity Option:


Put/call parity is an options pricing concept first identified by economist
Hans Stoll in his 1969 paper "The Relation between Put and Call Prices." It
defines the relationship that must exist between European put and call
options with the same expiration and strike price (it does not apply to
American style options because they can be exercised any time up to
expiration). The principal states that the value of a call option, at one
strike price, implies a fair value for the corresponding put and vice versa.
The relationship arises from the fact that combinations of options can
create positions that are identical to holding the underlying itself (a stock,
for example). The option and stock positions must have the same return
or an arbitrage opportunity would arise. Arbitrageurs would be able to
make profitable trades, free of risk, until put/call parity returned.

Put-call parity is one of the simplest and best known no-arbitrage


relations. It requires neither assumptions about the probability distribution
of the future price of the underlying asset, nor continuous trading, nor a
host of other complications often associated with option pricing models.
Investigations into apparent violations of put-call parity for the most part
find that the violations do not represent tradable arbitrage opportunities
once one accounts for market features such as dividend payments, the
early exercise value of American options, short-sales restrictions,
simultaneity problems in trading calls, puts, stocks and bonds at once,
transaction costs, lending rates that do not equal borrowing rates, margin
requirements, and taxes, to name a few.

Prices are not fully efficient in the model and option prices deviate from
put-call parity in the direction of the informed investors private
information. Over time, of course, deviations are expected to be
arbitraged away, but this is not instantaneous given that there is private
information. In practice one would also expect any tradable violations of
put-call parity to be quickly arbitraged away. However, options on
individual stocks are American and can be exercised before expiration,
therefore put-call parity is an inequality rather than a strict equality; in
addition, market imperfections and transactions costs only widen the
range within which call and put prices are required to fall so as not to
violate arbitrage restrictions.
Lets investigate whether the relative position of call and put prices within
this range matters, using the difference in implied volatility, or volatility
spread, between call and put options on the same underlying equity, and
with the same strike price and the same expiration date, to measure
deviations from put-call parity. Our main results are easily summarized.

First, we find that deviations from put-call parity contain information about
subsequent stock prices. The evidence of predictability that we report is
significant, both economically and statistically. For example, between
January 1996 and December 2005, a portfolio that is long stocks with
relatively expensive calls (stocks with high volatility spreads) and short
stocks with relatively expensive puts (stocks with low volatility spreads)
earns a value-weighted, four-factor adjusted abnormal return of 50 basis
points per week (t-statistic 8.01) in the week that follows portfolio
formation. Consistent with the view that deviations from put-call parity are
not driven solely by short sales constraints, the long side of this portfolio
earns abnormal returns that are as large as the returns on the short side:
29 basis points with a t-statistic of 6.3 for the long side versus -21 basis
points (t-statistic -4.47) for the short side. In addition, we present direct
evidence that our results are not driven by short sales constraints by
using a shorter sample for which we have data on rebate rates, a proxy for
the difficulty of short selling from the stock lending market.

Also, we find even stronger results when we form portfolios based on both
changes and levels of volatility spreads: a portfolio that buys stocks with
high and increasing volatility spreads and sells stocks with low and
decreasing volatility spreads earns a value-weighted and four-factor
adjusted return of 107 basis points per week (t-statistic 7.69) including the
first overnight period, and 45 basis points (t-statistic 3.53) excluding it.
Again, the long side of this portfolio earns abnormal returns that are as
large as the returns on the short side. The four-weekly return on the hedge
portfolio, excluding the overnight period, is 85 basis points (t-statistic
2.48). Thus we present strong evidence that option prices contain
information not yet incorporated in stock prices that it takes several days
until this information is fully incorporated, and that the predictability is not
due to short sales constraints. This constitutes our first main result.

Put-Call Parity and Arbitrage Opportunity

An important principle in options pricing is called a put-call parity. It says


that the value of a call option, at one strike price, implies a certain fair
value for the corresponding put, and vice versa. The argument, for this
pricing relationship, relies on the arbitrage opportunity that results if there
is divergence between the value of calls and puts with the same strike
price and expiration date. Arbitrageurs would step in to make profitable,
risk-free trades until the departure from put-call parity is eliminated.
Knowing how these trades work can give you a better feel for how put
options, call options and the underlying stocks are all interrelated.

Put options, call options and the underlying stock are related in that the
combination of any two yields the same profit/loss profile as the remaining
component. For example, to replicate the gain/loss features of a long
stock position, an investor could simultaneously hold a long call and a
short put (the call and put would have the same strike price and same
expiration). Similarly, a short stock position could be replicated with a
short call plus a long put and so on. If put/call parity did not exist,
investors would be able to take advantage of arbitrage opportunities.

Options traders use put/call parity as a simple test for their European style
options pricing models. If a pricing model results in put and call prices that
do not satisfy put/call parity, it implies that an arbitrage opportunity exists
and, in general, should be rejected as an unsound strategy.

There are several formulas to express put/call parity for European options.
The following formula provides an example of a formula that can be used
for non-dividend paying securities:

c= S + p Xe r(T-t)
p = c S + Xe r(T-t)
Where
c = call value
S = current stock price
p = put price
X = exercise price
e = Euler\'s constant (exponential
function on a financial calculator equal
to approximately 2.71828
r = continuously compounded risk free
rate of interest
T = Expiration date
t = Current value date