Options Basics
Derivatives - These are securities that derive their value from the price of other assets (called
underlying).
Options are optional, it gives the right but no obligation to buy the asset. You can exercise the
option but its fine if you don’t buy it. There are traded on Organized Exchange & OTC.
Options are powerful tool for Hedging & Speculation.
Call Options - When you believe the price of the underlying asset will go up from the
Current Market Price and hit the strike price you buy Call Options or Sell Put Options.
Give its holder right but not the obligation to buy an asset. Only exercised if its in the favor of
the holder.
Put Options - When you believe the price of the underlying asset will go down from the
Current market price you short it and you do this by buying put options or selling call
options.
Give its holder right but not the obligation to sell an asset. Only exercised if its in the favor of
the holder.
Eg - Reliance CMP is 2000 you believe it will go 2500 till next expiry (Thursday) you buy
call options close to that range as the premium on those options will increase and lets assume
you bought an option of 2500 and the stock goes till 2800 you have the right to buy the stock
& you'll get the stock for 2500 & that 300 would be your profit, or you could sell Put options
close to that range and then later buy at a lower price.
Option Premium - Purchase price of the option
Strike Price - Price at which you buy or sell the security
In the Money Option - If the CMP is 2000 of Stock and you believe the stock will go up
from there and you buy call option of 1970, its called in the money. Premium would be
higher.
At the Money Option - If CMP & Strike/Exercise price are same.
Out of the money option - From the same example above you buy call option of 3500 that is
called out of the money option. Beware of the option decay.
Expiration Date - At this date the price of your option would go to Zero, your broker would
sell buy itself if not renewed. Last date on which the option can be exercised.
European option can only be exercised on expiration date.
American Option can be any time before expiration/maturity.
From the buyer's or long's side it is a right to not an obligation to exercise the option but from
seller's or short's side it is a potential obligation if the holder exercise the option.
, Options Payoff At Expiration
Derivatives Markets : Allow Market participants to trade/reallocate different types of risk in
the economy.
Hedging (Insurance) - A strategy used by Asset Managers, lets say they hold a particular
stock and they feel in the near future the price will fall from CMP, they will not sell all the
stocks rather they will buy Put Options or Short Call options and if the stock manages to go
down they'll make profit from the option trading. (Protective Put)
Speculation (Betting) - It is the practice of making high-risk financial transactions with the
hope of achieving substantial profit from short-term price movements. If you know how to
read charts and can find out any mispricing in the market, option strategy could be used.
3 Key differences -
1. Intent - The primary purpose of hedging is to reduce/mitigate risk. Speculation aims
for profit maximization.
2. Risk Profile - Hedging is a conservative approach to risk whereas speculation is
inherently riskier.
3. Investment Horizon - Hedging strategies are long term investment whereas
speculation are short trades
Straddle - A strategy used by traders when you buy a call option & put options with same
strike price & expiration date. The only catch is that the stock should move either way, if it
does not one might get caught up in option decay and may end up losing money. But if it
explodes one of the way then it could make huge potential profit on anyone option and the
other may go to zero. The options are typically at the money.
Strangle - Similar to straddle but call & put options have different strike prices. The call has
higher strike price. These are mostly out of the money option. Trader set up this strategy
when he believe he will witness a significant high volatility. The idea is that it should move
in any one direction at least.
Put - Call Parity
Put-Call Parity is the equation that establishes a relationship between the price of the
put & the price of the call.
Law of One Price - In efficient market, identical securities (same PV of cash flows) must
sell for same price no matter how they are created. The principle is based on the premise of
arbitrage, the practice of taking advantage of a price difference between two or more markets.
Synthetic Replication - Synthetic replication is a strategy used in finance to create a
portfolio that mimics the performance of an index or asset by using derivatives, such as
futures, options, and swaps, instead of holding the actual securities or assets in the index.
This approach allows for the replication of returns without owning the underlying
components directly.
Derivatives - These are securities that derive their value from the price of other assets (called
underlying).
Options are optional, it gives the right but no obligation to buy the asset. You can exercise the
option but its fine if you don’t buy it. There are traded on Organized Exchange & OTC.
Options are powerful tool for Hedging & Speculation.
Call Options - When you believe the price of the underlying asset will go up from the
Current Market Price and hit the strike price you buy Call Options or Sell Put Options.
Give its holder right but not the obligation to buy an asset. Only exercised if its in the favor of
the holder.
Put Options - When you believe the price of the underlying asset will go down from the
Current market price you short it and you do this by buying put options or selling call
options.
Give its holder right but not the obligation to sell an asset. Only exercised if its in the favor of
the holder.
Eg - Reliance CMP is 2000 you believe it will go 2500 till next expiry (Thursday) you buy
call options close to that range as the premium on those options will increase and lets assume
you bought an option of 2500 and the stock goes till 2800 you have the right to buy the stock
& you'll get the stock for 2500 & that 300 would be your profit, or you could sell Put options
close to that range and then later buy at a lower price.
Option Premium - Purchase price of the option
Strike Price - Price at which you buy or sell the security
In the Money Option - If the CMP is 2000 of Stock and you believe the stock will go up
from there and you buy call option of 1970, its called in the money. Premium would be
higher.
At the Money Option - If CMP & Strike/Exercise price are same.
Out of the money option - From the same example above you buy call option of 3500 that is
called out of the money option. Beware of the option decay.
Expiration Date - At this date the price of your option would go to Zero, your broker would
sell buy itself if not renewed. Last date on which the option can be exercised.
European option can only be exercised on expiration date.
American Option can be any time before expiration/maturity.
From the buyer's or long's side it is a right to not an obligation to exercise the option but from
seller's or short's side it is a potential obligation if the holder exercise the option.
, Options Payoff At Expiration
Derivatives Markets : Allow Market participants to trade/reallocate different types of risk in
the economy.
Hedging (Insurance) - A strategy used by Asset Managers, lets say they hold a particular
stock and they feel in the near future the price will fall from CMP, they will not sell all the
stocks rather they will buy Put Options or Short Call options and if the stock manages to go
down they'll make profit from the option trading. (Protective Put)
Speculation (Betting) - It is the practice of making high-risk financial transactions with the
hope of achieving substantial profit from short-term price movements. If you know how to
read charts and can find out any mispricing in the market, option strategy could be used.
3 Key differences -
1. Intent - The primary purpose of hedging is to reduce/mitigate risk. Speculation aims
for profit maximization.
2. Risk Profile - Hedging is a conservative approach to risk whereas speculation is
inherently riskier.
3. Investment Horizon - Hedging strategies are long term investment whereas
speculation are short trades
Straddle - A strategy used by traders when you buy a call option & put options with same
strike price & expiration date. The only catch is that the stock should move either way, if it
does not one might get caught up in option decay and may end up losing money. But if it
explodes one of the way then it could make huge potential profit on anyone option and the
other may go to zero. The options are typically at the money.
Strangle - Similar to straddle but call & put options have different strike prices. The call has
higher strike price. These are mostly out of the money option. Trader set up this strategy
when he believe he will witness a significant high volatility. The idea is that it should move
in any one direction at least.
Put - Call Parity
Put-Call Parity is the equation that establishes a relationship between the price of the
put & the price of the call.
Law of One Price - In efficient market, identical securities (same PV of cash flows) must
sell for same price no matter how they are created. The principle is based on the premise of
arbitrage, the practice of taking advantage of a price difference between two or more markets.
Synthetic Replication - Synthetic replication is a strategy used in finance to create a
portfolio that mimics the performance of an index or asset by using derivatives, such as
futures, options, and swaps, instead of holding the actual securities or assets in the index.
This approach allows for the replication of returns without owning the underlying
components directly.
