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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.

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.

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

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.

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.

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-

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 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.

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.

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.

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.

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

hold the long option till expiry

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

formula during the series

the position well before the expiry

paid. However he enjoys an unlimited profit potential

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

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)

hold the position till expiry

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

Below the pay off diagrams for the four different option variants

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

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

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

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.

Pricing Model:

Black Option Pricing Model:

on 6 variables. These variables are:

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.

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.

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:

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.

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.

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.

the directional movement of the underlying

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-

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.

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.

-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

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

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.

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.

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.

Parameters Values

Underlying Nifty

Strike 8700

Spot value 8668

Premium 128

Delta -0.55

Expected Nifty Value (Case) 8630

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.

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

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?

assume Delta is 0.4

2. Assume Nifty spot moves from 8712 to 8800, what do you think is

the Delta value?

option

3. Further assume Nifty spot moves from 8800 to 8900, what do you

think is the Delta value?

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.

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)

GAMA

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.

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.

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?

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

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.

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.

Slightly OTM

= 170 points

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.

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.

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).

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

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

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

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

deductions

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

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

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.

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)

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

irrespective of how much the spot price falls ( going from OTM to deep

OTM) the options delta will remain at 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

6. When the spot moves along from the ATM towards ITM the delta

starts to move beyond the 0.5 mark

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.

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

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

Strike = 8600 CE

Status = OTM

Premium = 99.4

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

Strike = 190

Spot = 179.6

Premium = 30 Paisa

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 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

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?

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

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.

To better understand implied volatility and how it drives the price of

options, let's go over the basics of options pricing.

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.

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/

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

using relative values

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.

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.

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.

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.

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.

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.

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.

Supply for a Particular Option

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

following factors:

the amount of time remaining until expiration;

interest rates, where higher interest rates increase the call premium

but lower the put premium;

lowers a call premium but increases the put premium.

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.

strike price

interest rates

any dividend

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

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

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 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.

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.

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

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