Options and strategies to mitigate the risk
- 1. OPTIONS & STRATEGIES TO MITIGATE THE RISK FINANCIAL DERIVATIVES Priyank Srivastava
- 2. WHAT ARE OPTIONS? OPTIONS are type of derivative security. They are derivative because the price of an option in intrinsically linked to the price of something else. Specifically, the option are contracts that grant the right, but not the obligation to buy or sell an underlying asset at a set price on or before a certain date. The right to buy is called a Call option The right to sell is called a Put option. Priyank Srivastava
- 3. CALL OPTION A call option gives the buyer a right but not the obligation to buy a given quantity of the underlined asset at a given price on or before a certain date. Example: - Call Option Right to buy 100 Reliance shares at a strike price of 300/share after 3 months. Assuming that the current price of each Reliance share is 250/share and premium is 25 per share. The amount involved to buy this call option will be number of shares involved to buy in call option multiply premium per share i.e. 100 X 25 = 2500. Possibilities after 3 months Share price will rise Share price will fall Profit? Priyank Srivastava
- 4. Share price will rise Suppose after a month market price of each Reliance share is 400. Then the option will be exercised and shares will be bought up. Net flow in such scenario will be: - 400 X 100 – 300 X 100 – 2500 = 7500 7500 will be the profit. Share price will fall Suppose after a month market price of each Reliance share is 200. Then the option will not be exercised. Net flow in such scenario will be: - Net loss will be 2500 the premium amount. Priyank Srivastava
- 5. PUT OPTION A put option gives the buyer a right but not the obligation to sell a given quantity of the underlined asset at a given price on or before a certain date. Example: - Put Option Right to sell 100 Reliance shares at a strike price of 300/share after 3 months. Assuming that the current price of each Reliance share is 350/share and premium is 25 per share. The amount involved to buy this call option will be number of shares involved to buy in call option multiply premium per share i.e. 100 X 25 = 2500. Possibilities after 3 months Share price will rise Share price will fall Profit? Priyank Srivastava
- 6. Share price will rise Suppose after a month market price of each Reliance share is 400. Then the option will not be exercised. Net flow in such scenario will be: - net loss will be 2500 the premium amount Share price will fall Suppose after a month market price of each Reliance share is 200. Then the option will be exercised. Net flow in such scenario will be: - 300 X 100 – 200 X100 – 2500 = 7500 7500 will be the profit. Priyank Srivastava
- 7. Strategies to mitigate the risk 1. Option Spreads: - Spreads involved combining options on the same underline and of same type (call/put) but in different strikes and maturity. There is a situation of limited profit and limited loss. Spreads are of various types: - 1. Vertical Spreads: - They are created by using options having same expiry but different strike prices. These can be created either use call formation or put combination. These can be further classified as: - A. Bullish vertical spread (Using Call): - A bull spread is created when the underline view of market is positive, but the trader would also like to reduce its cost on position so he takes 1 long (buy) position with lower strike price and sells a call option at higher strike price. Priyank Srivastava
- 8. 5800 6000 6200 Long call SP @ 300 Short Call SP @ 145 Spot price Case 1: - Suppose market ends at 6800. The flow will be? Net flow will be – 6800 – 5800 - 300 = 700 6200 – 6800 + 145 = (455) 700 + (455) = 245 245 is the maximum profit. 6800 Market Ends +1000 Case 2: - Suppose market ends at 5200. The flow will be? Net flow will be – 300 (Long Premium paid) 145 (Short Premium received) (300) + 145 = (155) (155) will be the maximum loss. 5200 Market Ends Example: - A trader is bullish in the market so he decided to go long on 5800 strike price call option at a premium of 300. and he expect the market not to be above the 6200. so he spot the call option and receives a premium of 145. -600 LIMITED PROFIT LIMITED LOSSPriyank Srivastava
- 9. B. Bullish vertical spread (using put): - Here also the call on the market is bullish. Hence, the trader would like to spot a put option, if prices were trader would end up with a premium on sold puts. However in case, prices go down trader would face the loss. In order to put a flow in down size, he may buy a put option with a lower strike. 6000 6200 Short put SP @ 220 Spot price, Long put SP @ 170 Case 1: - Suppose market ends at 6800. The flow will be? Net flow will be – 220 (Short Premium received) 170 (Long Premium paid) 220 + (170) = 50 50 will be the maximum profit. 6800 Market Ends -1000 Case 2: - Suppose market ends at 5200. The flow will be? Net flow will be – 5200 – 6200 + 220 = (780) 6000 – 5200 – 170 = 630 (780) + 630 = (150) (150) Will be the maximum loss. 5200 Market Ends Example: - A trader goes short in a put option of strike 6200 and receives a premium of 220 and goes long in a put option of strike 6000 and pays a premium of 170. +800 LIMITED PROFIT LIMITED LOSSPriyank Srivastava
- 10. C. Bearish vertical spread (Using call): - Here the trader is bearer in the market so he shorts a low strike price with high premium on call option. To prevent his unlimited loss he long high strike call and pays a lesser premium. 6000 6200 Long call SP @ 145 Spot price Case 1: - Suppose market ends at 6800. The flow will be? Net flow will be – 6800 – 6200 - 145 = 455 5800 – 6800 + 300 = (700) 455 + (700) = (245) (245) Will be the maximum loss. 6800 Market Ends Case 2: - Suppose market ends at 5200. The flow will be? Net flow will be – 145 (Long Premium) 300 (Short Premium) 300 – 145 = 155 155 will be the maximum profit 5200 Market Ends Example: - A trader goes long in a call option of strike 6200 and pays a premium of 145 and goes short in a call option of lower strike 5800 and receives a premium of 300. Spot price is 6000. 5800 Short call SP @ 300 +600 -1000 LIMITED PROFIT LIMITED LOSSPriyank Srivastava
- 11. C. Bearish vertical spread (Using put): - Here the trader is bearer in the market so he goes long in one put option by paying a high premium. Further, to reduce its cost he shorts another put option of lower strike and receives a low premium. 6000 6200 Long put SP @ 220 Spot price, Short put SP @ 170 Case 1: - Suppose market ends at 6800. The flow will be? Net flow will be – 170 (Short Premium) 220 (Long Premium) (220) + 170 = (50) (50) Will be the maximum loss. 6800 Market Ends Case 2: - Suppose market ends at 5200. The flow will be? Net flow will be – 6200 – 5200 – 220 = 780 5200 – 6000 + 170 = (630) 780 + (630) = 150 150 will be the maximum profit. 5200 Market Ends Example: - A trader goes long in a put option of strike 6200 and pays a premium of 220 and goes short in a put option of lower strike 6000 and receives a premium of 170. Spot price is 6000. -600 +1000 LIMITED PROFIT LIMITED LOSSPriyank Srivastava
- 12. 2. Horizontal Spread: - It involves same price, same type but different expiry contract. This is also known as time spread or calendar spread. 3. Diagonal Spread: - It involves combination of option having same underlined asset but different expiry with different strike prices. Priyank Srivastava
- 13. 2. Straddle: - This strategy involves both options of same strike price with same maturity period. A long straddle position is created by buying a call and a put option of same strike with same expiry; whereas a short straddle is created by shorting a call and a put option of same strike and same expiry. 6000 Spot price, call @ 257, put @ 136 Case 1: - Suppose market ends at 6700. The flow will be? Net flow will be – 6700 – 6000 – 257 = 443 443 – 136 (put premium) = 307 As stock price increase the profit also increase. 6700 Market Ends Case 2: - Suppose market ends at 5300. The flow will be? Net flow will be – 6000 – 5300 – 136 = 564 564 – 257 (call premium) = 307 As the stock price decreases the profit will be increase. 5300 Market Ends Long Example: - Let us say a stock is trading at 6000 and premium for At the Money (ATM) call and put options are 257 and 136 respectively. +700 +700 NOTE: - Here the maximum loss is 393, the both premium amount 257 + 136. UNLIMITED PROFIT LIMITED LOSS Priyank Srivastava
- 14. 6000 Spot price, put@136, call@257 Case 1: - Suppose market ends at 6700. The flow will be? Net flow will be – 6000 – 6700 + 257 = (443) (443) + 136 (put premium) = (307) As stock price increase the loss also increase. 6700 Market Ends Case 2: - Suppose market ends at 5300. The flow will be? Net flow will be – 5300 – 6000 + 136 = (564) (564) + 257 (call premium) = (307) As the stock price decreases the loss will be increase. 5300 Market Ends Short Example: - Let us say a stock is trading at 6000 and short a call option at 6100 and short a put option at 5900 and receive a premium of 257 and 136 respectively. -700 -700 NOTE: - Here the maximum profit is 393, the both premium amount 257 + 136. UNLIMITED LOSS LIMITED PROFITPriyank Srivastava
- 15. 3. Strangle: - Long – In long straddle we have same strike price, but in long strangle the strike price of both options are different, and both the options are Out of the Money (OTM) which means premium is low. Example: - Suppose cash market is 6100, option call strike price is 6200 @ 145 and option put strike price is 6000 @ 140. 6100 6200 Call SP @ 145 Spot price 6800 Market Ends 5400 Market Ends +600 +600 UNLIMITED PROFIT LIMITED LOSS 6000 Put SP @ 140 Case 1: - Suppose market ends at 6800. The flow will be? Net flow will be – 6800 – 6200 – 145 = 445 140 (Put premium) 445 + (140) = 315 As stock price increase the profit also increase. Case 2: - Suppose market ends at 5200. The flow will be? Net flow will be – 6000 – 5400 – 140 = 460 145 (Call Premium) 460 + (145) = 315 As the stock price decreases the profit will be increase. NOTE: - Here the maximum loss is 285, the both premium amount 145 + 140. Priyank Srivastava
- 16. 3. Strangle: - Short – Short strangle is exactly opposite to the long strangle with two Out of the money (OTM) option shortened. The market will remain stable over the period of the option. Example: - Suppose cash market is 6100, option call strike price is 6200 @ 145 and option put strike price is 6000 @ 140. 6100 6200 Call SP @ 145 Spot price 6800 Market Ends 5400 Market Ends +600 +600 LIMITED PROFIT UNLIMITED LOSS 6000 Put SP @ 140 Case 1: - Suppose market ends at 6800. The flow will be? Net flow will be – 6200 – 6800 + 145 = (445) 140 (Put premium) (445) + 140 = (315) As stock price increase the loss also increase. Case 2: - Suppose market ends at 5200. The flow will be? Net flow will be – 5400 – 6000 + 140 = (460) 145 (Call Premium) (460) + 145 = (315) As the stock price decreases the loss will be increase. NOTE: - Here the maximum profit is 285, the both premium amount 145 + 140. Priyank Srivastava
- 17. 4. Covered Call: - This strategy is used to generate extra income from existing holding from cash market. If an investor had bought shares and intend them to hold for some time, then he would like to earn some extra income on that asset without selling it. There by reducing the cost of acquisition. This is called covered call. 1590 1600 Short Call @ 10 Spot price 1640 Market end + 50 Example: - A trader buy a shares when market is 1590. To earn extra income and hedge the risk he short the call at 1600 @ 10. Suppose market rise up to 1640. Then the flow will be – 1640 – 1590 = 50; (profit from share holding) 1640 – 1600 = (40); (loss from option) (40) + 10(premium)= (30); 50 + (30) = 20 (All over profit) - 40 1520 - 70 Market end Suppose market falls down to 1520. Then there will be a loss – 1520 – 1590 = (70); (loss from share holding) 10 (received premium) (70) + 10(premium)= (60); (60) It is not a actual loss, when the shares will be sold then there will be a loss. Priyank Srivastava
- 18. 5. Protective Put: - Any investor, long in the cash market, always runs the risk of a fall in prices and thereby reduction in portfolio value. To hedge the risk we buy a put option which will make profits on long put, which will be useful to negate the losses in the cash market portfolio. 1600 Spot price, Long put @ 20 1660 Market end + 60 Example: - A trader buy a shares when market is 1600 and same time buy a put option with strike of 1600 by paying premium of Rs 20. Suppose market rise up to 1660. Then the flow will be – 1660 – 1600 = 60; (profit from share holding) 20 (Put premium) 60 + (20) = 40 40 (All over profit) 1520 -80, cash Market end Suppose market falls down to 1520. Then there will be a loss – 1520 – 1600 = (80); (loss from share holding) 1600 – 1520 – 20 = 60 (80) + 60 = (20) (20) Will be the loss due to profit from put, otherwise it could be (80). +80, put Priyank Srivastava
- 19. 6. Collar: - A collar strategy is an extension of covered call strategy. In covered call downside risk remains for falling prices, that is if the stock price moves down losses keep increasing. To hedge this risk we long a put option which essentially negates the down side of the underlined asset. 1590 1600 Short Call @ 10 Spot price 1640 Market end + 50 Suppose market rise up to 1640. Then the profit will be – 1640 – 1590 = 50; (profit from share holding) 1600 – 1640 + 10 = (30); (loss from call option) 7 (put premium) 50 + (30) – 7 = 13 13 Will be the maximum profit. In the covered call, the profit would be 20. - 40 1520 - 70 Market end Suppose market falls down to 1520. Then the profit will be – 1590 – 1520 = (70); (loss from share holding) 1580 – 1520 – 7 = 53; (profit from put option) 10 (call premium) (70) + 53 - 10 = (7) (7) Will be the maximum loss. In the covered call, the loss would be (60) Example: - A trader buy a shares when market is 1590. To earn extra income and hedge the risk he short the call at 1600 @ 10. 1580 Long Put @ 7 + 60 Priyank Srivastava
- 20. 7. Butterfly Spread: - As collar is an extension of covered call, similarly the butterfly spread is an extension of short straddle. In short straddle the loss is unlimited if market moves significantly in either direction. To put a limit on this downside, along with short straddle, trader buys one OTM call and one OTM put. As a result, a position is created with pictorial pay-off which looks like a butterfly, so this strategy is called “Butterfly Spread”. It can be created with only calls, only puts and combinations of both calls and puts. Case 1: - Suppose market ends at 6800. The flow will be? Net flow will be – 6000 – 6800 + 140 + 145 = (515) 6800 – 6100 – 145 - 140 = 415 415 + (515) = (100) (100) will be the total loss. In the short straddle the flow is (315) a loss. Case 2: - Suppose market ends at 5200. The flow will be? Net flow will be – 5200 – 6000 + 145 + 140 = (515) 5900 – 5200 – 140 – 145 = 415 415 + (515) = (100) (100) will be the total loss. In the short straddle the flow is (515) a loss. Example: - Suppose cash market is 6000, same time short the call at 6200 @ 145 and long the call at 6100 @ 145, on the other side short a put at 5800 @ 140 and long a put at 5900 @ 140. 6000 Spot, short, call@145, put@140 6800 Market Ends 5200 Market Ends +700 +700 5900 Long Put @ 140 6100 Long Call @ 145 -800 -800 Priyank Srivastava