Strategy - Buying a Call

Let us start with the simplest of Option trading… plain vanilla buying of Options.

So let us say that your analysis shows (not just you feel) that there is a good probability (not certainty… isn’t it?) of NIFTY increasing in value by the target expiry date. Since you do not want to bet on one of the 50 stocks of NIFTY, you simply buy NIFTY Call Option. Let us say you buy NIFTY 5000 Call at 100 Rs Premium (100 x 50 lot size = 5000 Rs) and then you forget it… you do not square it off or sell your position. You wait till the expiry date for exchange to auto settle your option. Graph below tells you what is your profit or loss from this transaction depending on various levels of NIFTY.

As you will see, if NIFTY is below 5000, you have lost your premium in total because Call option below strike price expires worthless. If NIFTY is between 5000 and 5100 then you recover some of your premium. Let’s say NIFTY is at 5070, so exchange gives you 3500 Rs (70 x 50 lot size) and your loss if 1500 Rs. In case, your analysis is correct and NIFTY increased much more than 5100 then your trade is in profit at expiry and your profits are directly proportional to NIFTY level above 5100. E.g. if NIFTY is at 5200, exchange will give 10000 Rs (200 x 50) and you would have made 5000 profit on 5000 premium. That is a whopping 100%.

This brings us to another important factor in Derivative trading; Leverage. If you were to invest 5000 in a stock and wait till it doubles it would probably take few years. In case of derivatives it can happen in a very quick time. There were times when I have made more than 200% profits on trades. Not to forget, it is not rosy picture all the time on this path. Downside of leverage is you can lose money equally fast. So instead of making 5000 Rs you can simply lose entire 5000 Rs if NIFTY is below your strike in this case. I have been through such situation too.

When you are buying option you cannot lose more than 100% of your Premium and hence you know the worst case scenario right away. But you are exposed to much higher risk when you sell the Options. That is why it is recommended to start with buying options as you experiment and learn the tricks of the trade.

Life is anyway short to make all the mistakes yourself and learn from them. It is worthwhile to learn from other's mistakes too. I have made many and observed many more. Let's shorten our learning curve.

Option Price Variation

Below is the table which shows variation in the premium of option over a period of time as I promised in the previous post.

This table shows variation of NIFTY 5000-CE-29-SEP (NIFTY Strike Price 5000, Call Option, Expiry on 29-Sept-2011) Option Premium with respect to time.

Traditional wisdom says that Time Value of this Option should drop as it approaches expiry however the same is not seen here. The explanation lies in the increased volatility. If you can recall, in the last couple of weeks we have had many 3%-5% drop/rise days due to unraveling of US and Europe crisis. I could have included Volatility Index (VIX) and also highest/lowest levels of NIFTY and many more factors but that would have only complicated the table.

As of now, the only takeaway from this table is normal things do not happen during abnormal times...;-)

Well, about next post,  initially, we will have to discuss strategies and trades that will involve only buying of options. I will have to make a post on margin calculation before we get to selling options. Yes, we will also talk about selling options... yes, yes selling options, you read it right. Yeah, I know every piece of information out there suggests that it is very risky and all that but with little bit of ingenuity the risk of it can be reduced to a manageable level if not altogether eliminated. We will see...

Option Pricing

There are many factors which determine Option Premium. These factors affect the premium of the option with varying intensity. Some of these factors are listed here;

Price of the Underlying: Any fluctuation in the price of the underlying (stock/index/commodity) obviously has the largest impact on premium of an option contract. An increase in the underlying price increases the premium of call option and decreases the premium of put option. Reverse is true when underlying price decreases.

Strike Price: How far is the strike price from spot also has an impact on option premium. Say, if NIFTY goes from 5000 to 5100 the premium of 5000/5100 strike will change a lot compared to a contract with strike of 5500 or 4700.

Time till Expiry: Lesser the time to expiry, option premium follows the intrinsic value more closely. On the expiry date Time Value approaches zero.

Volatility of Underlying: Underlying security is a constantly changing entity. The degree by which its price fluctuates can be termed as volatility. So a share which fluctuates 5% on either side on daily basis is said to have more volatility than let’s say a stable blue chip shares whose fluctuation is more benign at 2-3%. Volatility affects calls and puts alike. Higher volatility increases the option premium because of greater risk it brings to the seller.

Apart from above, other factors like bond yield (or interest rate) also affect the premium. This is due to the fact that the money invested by the seller can earn this risk free income if invested in bonds and hence while selling option; he has to earn more than this because of higher risk he is taking.

Sometimes dividend payment by an underlying is also factored in to the premium as it affects the cost of buying those shares directly rather than buying the option.

There are other factors too which I will touch upon as and when opportunity presents itself during our trading posts and strategies.

Fortunately for us we do not have to take all these factors and do some complex spreadsheet calculation for finding out premium. There are many models developed for options pricing one of which (and most popular) is Black & Scholes pricing model. The two professors, Fischer Black & Myron Scholes, won a Nobel Prize in Economics for its creation. Though its knowledge is not a precursor to options trading, a little bit extra knowledge has not killed anybody.  At least not anyone I know of. Read about it here and let me know if you felt any uneasiness after reading it.

I will post a table which shows variation in the premium of option over a period of time in next post.

Stay tuned and fasten your seat belt as the ride is gonna get bumpy here after...