Option Pricing

Pricing of Options:

Either we have to pay or we receive a price (premium) for purchasing or selling option. There are two components of this price/ Premium of an Option. These are;

Intrinsic Value

Time Value

Intrinsic Value:

If the market value is more than the strike price, then a call option is In the Money. The difference between the two is called as Intrinsic Value.

In simple words, it is the value by which is already available in the market. If you are holding NIFTY 5000 Call (Bullish/Long) option and NIFTY is at 5050 level then you already have 50 Rs advantage even if the option expires today. These 50 Rs is the intrinsic value of option.

Conversely if you are holding Put option and NIFTY is below strike price then your option has some intrinsic value which is the difference between strike price and NIFTY value.

So,

Intrinsic Value = Current Stock Price – Strike Price (Call Option)

                        = Strike Price – Current Stock Price (Put Option)

Time Value:

Option premium is always more than intrinsic value. This extra money is for the risk which option writer/seller is undertaking. This is called as Time Value.

Time value is the amount option trader is paying for a contract above its intrinsic value, with the belief that prior to expiration the contract value will increase because of a favourable change in the price of the underlying. Obviously, longer the amount of time till expiry of contract, the greater is the time value.

So,

Time Value = Option Premium – Intrinsic Value

There are many factors which determine Option Premium. These factors affect the premium of the option with varying intensity. I will list some of these factors in next post. Really tired today to write a long post…

Lot Sizes

Lot sizes Table:

Every option contract is worth the price of underlying multiplied by the quantity of underlying in the contract. In our example it was 10 Tonnes of Sugar Cane at 2000 Rs price so the contract was worth 20000 Rs. Now we would have simply split it in to 10 different contracts worth 2000 Rs for 1 Tonne of sugar cane in each contract. Or it could have been one contract worth 100 Tonne as well.

Exchange on its part tries to maintain each contract value roughly between Rs 2-3 Lacs. The table below gives you the lot size in contracts of various indices as well as few popular stocks. Entire list of lot sizes of all indices (7) stocks (228) can be found here.

The table above gives the lot sizes for near, next and far month contracts for indices as well as many blue chips. Please note that S&P500 and DJIA contracts are recently introduced so you will not see their near month lot size. Even the stock list also keeps changing from time to time.

Contracts for NIFTY are not limited to these three option chain till far month. NIFTY contracts as far as few years down the line are also tradable however most of the online brokers do not activate them for retail traders like you and I.

I trade primarily NIFTY unless something very interesting is happening in a sector index or a particular stock. For our trade, NIFTY lot size is 50 and Mini-NIFTY lot size is 20 which was started with the intention of increasing participation of retails and small investors in Derivatives market.

Now before I start posting actual trades and strategies behind them, we will have small explanation of Options pricing. As per my plan, I should be able to post my first trade post by this weekend. As I said earlier, follow that at your own peril.

Definitions... continued

My apologies for this delay in posting. Got caught up in an unplanned wedding of a friend (it was fun). Will try my best not to let it happen again (no not the wedding... I am talking about delay in posting).

Okay, so far we have seen Call, Put, Strike Price, Lot Size, Expiry Date and Open Interest and so on… only couple more are needed for you to gain tradable understanding of Options.

At the Money (ATM), In the Money (ITM), Out of the Money (OTM):

Positive/Negative or In Profit/In Loss being such complex terms... were neglected by ancient Option Traders. In all their wisdom they chose At the Money, In the Money and Out of the Money to denote loss/profit position of your Option contract. So as the name suggests, At the Money is you are neither making loss nor profit (that raises the question, why are you trading?), In the Money denotes that you are making money on your position and no prizes for guessing what Out of the Money means.

In the Money scenarios:

When you have bought Call (Long/Bullish) contract and now the market value is more than the Strike Price (+ expenses)

When you have bought Put (Short/Bearish) contract and the market value is less than Strike Price (+ expenses)

When you have sold Call (Long/Bullish) Option and market value is lesser than Strike Price (+ expenses)

When you have sold Put (Short/Bearish) contract and market value is more than Strike Price (+ expenses)

Out of the Money scenarios:

When you have bought Call (Long/Bullish) contract and now the market value is lesser than the Strike Price (+ expenses)

When you have bought Put (Short/Bearish) contract and the market value is more than Strike Price (+ expenses)

When you have sold Call (Long/Bullish) Option and market value is more than Strike Price (+ expenses)

When you have sold Put (Short/Bearish) contract and market value is less than Strike Price (+ expenses)

American / European Options:

No, it is not NRIs dealing in Indian Options.

In our example of sugar cane contract if the buyer has the liberty to exercise the contract any time before the validity of option then it is called as American Option. So essentially the buyer could ask the farmer to deliver sugar cane anytime after contract is done and till two months which is expiry date of that contract. (Please note that in this scenario, it may not be possible for farmer to deliver what is yet to be produced but actual settlement of Option Contracts is slightly different.)

However, if the contract says that I cannot exercise the Option before expiry date then it is a European type of Option. Please note that in India, all the Options are European type so you cannot exercise them before expiry date.

Option Settlement:

We would like to think that on expiry date, the farmer will deliver the sugar cane and buyer will pay the money. This is called as actual physical delivery settlement. However on Nifty, all the Options are cash settled. So if you have a call Option on Reliance at 1000 Strike Price and on expiry date, Reliance share price is 1050 then you get 50 Rs per Reliance Share in the contract. You don’t actually pay 1000 Rs per share and get the delivery of Shares. So the difference in market value and Strike Price is paid to you in cash.

The no of shares (or underlying) in one contract is called Lot Size. I will write on that in the next post. Then the last pre-trade post will be on Pricing of Options at a basic level. That’s the plan as of now. Let us hope that my other friends do not get inspired by the wedding last weekend and decide to rope me in again as a witness.

Some more definitions...

Few more options terms which are very relevant for understanding once we start talking about strategies:

As if Long and Short was not confusing enough or Bullish/Bearish was not sexy enough, Option traders created their own words for conveying essentially the same thing. So if you want to go long or bullish on some script then you are interested in Call Option. Obviously when you want to go short or bearish about something, you will look for Put Option.

Please note that it is the simplest explanation that I can give you at this moment. Funny thing about Options is you can trade both Call/Put Options in either of Bullish/Bearish case but let us not jump the gun. We will have another day and another time for that.

Lot Size:

One option is usually called as contract and it can contain multiple quantity of underlying. In our example, one contract meant one Tonne of sugar cane for which the premium was 100 Rs. However, had it been apple, it could have been 100 Rs for every 1000 apples. One NIFTY option contract has 50 Nifty in it.

Open Interest:

Unlike shares where we know exactly how many are issued in the market and how many are traded on any given day, Options do not have any fixed number. Someone creates one option which acquires some meaning only if someone buys it. Open Interest essentially mean one completed leg of such creating and buying one contract of Option. So someone creates 10 contracts and finds a buyer for them then 10 contracts are added to Open Interest. However if the seller in this transaction sells his contracts to someone else and closes his position then nothing is added to Open Interest. This is simply because the same option is traded here. It was not created new... it just changed hands. You can read a short note on Open Interest to know more.

A common misconception is that open interest is the same thing as no of option contracts traded. The difference is explained with a short scenario here:

Hope this example will help clear your concept of Open Interest. High OI suggests lot of interest in the contract and sometimes a useful indicator. We will discuss that later.

Put/Call Ratio:

As the name suggests, it is a ratio of the trading volume (not Open Interest) of put (short) options to call (long) options. It is used to gauge market expectations. For example, a high volume of puts compared to calls indicates a bearish sentiment expecting market to weaken. This is also an useful indicator while trading options.

There is at least one more post needed on basic definitions related to Options before we get to trading them. Even in between the trades I will keep posting on some high fandu terminologies and definitions which are used by professional traders.

Then the turn will come for strategies. Simple, sweet, successful, superb, s-effective, s-easy strategies. Probably wrote that on s-unday. Did I get it across?

Please read

Hey people, since you are reading this blog, I would like to clarify couple of things here.

First, though this blog primarily is related to Options on Nifty India it does not mean that you cannot learn ‘options’ here if you are not dealing in Indian Markets. ‘Options’ or ‘Derivatives’ are a generic concept and do not differ much with respect to Markets. They are some subtle differences which can be learned in no time if your basics are clear.

Primarily these differences are of the category as in India you have right hand drive while in US you have left hand drive. That does not mean that you learn driving right from the scratch if you change countries... isn’t it? I will be glad to answer any queries which you may have regarding these subtle differences. Do write to me.

Second, I am not professionally trained stock market analyst or Guru. Heck, I am not even a professional trader. I do this solely to get an extra income stream and just for the kick of it. Hence it is imperative that you may find my writing style little raw and unpolished.

Whatever I am writing on this blog is my own opinion and I do not claim any scientific, professional or technical accuracy of it. My writing here is simply a way of structuring my own thoughts at one place. In the future also, whenever I write about the actual trades, please note that they will not mean to be serving as an investment advice in any way.

You are welcome on this blog for reading it, you can follow this blog for understanding derivatives in a simple and non-technical language but I do not guarantee accuracy of my posts. Though I will try my best to be correct, but still, you are forewarned to check accuracy of what you read here with a trusted source before making any investment or any other kind of decision.

Keeping in mind the importance of this post, I will repeat this post every 10 odd posts. Do bear with me.

Definitions

Some more fancy and not so fancy terminologies related to Options (or Derivatives in general) in this post:

Underlying: It is the item to be traded (in our example – the sugar cane). It could be anything under the Sun like Nifty or any other index, Individual stocks, house (estate agents do it all the time) or sugar cane literally

Strike Price:  Agreed price of the item to be traded (in our example – 2000 Rs). It can vary in a very wide range. For Nifty at 5000 the available options can be from 2500 to 7000 and more. While the most traded options are close to value of Nifty, such wide options serve some purpose which we will address in a separate post

Expiry Date: This is the time limit within which the option is valid (in our example – 2 months). This also covers a very wide range from few months to many years. Again the most popular and most traded option is the one which is valid for next one month or less. To keep matters simple, NSE keeps the common expiry date of monthly options as the last Thursday of every month. We will be talking mostly about the near month (options expiring on coming expiry Thursday) or next month (options expiring on next expiry Thursday)

This calls for an example…

Let’s day today is 17^th September 2011. The last Thursday of this month is on 29^th and hence the option of this month will expire on 29^th. New series will start from 30^th which will expire on October 27^th which is the last Thursday of October. However you can trade the October series even today. In fact you can trade November series as well. On NSE you can trade present series and next two series. We will simply call the present series as Near Month, next series as Next Month and series expiring after two months as Far Month series for simplification.

This is more than enough for one post… anything more and it will only cause confusion. I will have only couple more go as I try to confuse you… err, I mean, only couple more post for definitions.

It will have meaning of call, put, open interest, call/put ratio, volatility, intrinsic value, extrinsic value, time value, value decay, black-scholes model, alpha, beta, delta, theta, Indica Xeta and most important of all Duckworth-Lewis method.

Hey, I am just kidding… do come back for next post.

What are Options... continued

Continuing with the example in the previous post, before we understand what makes this whole transaction resemble to 'Option' let us try our hands at ethics (I am an ethical trader, don't forget) and see if any one party is being short-handed here.

The farmer, by agreeing to price of Rs 2000 after two months has the thinking that though the rate may be higher after two months, they could be lower as well. Expecting higher prices, lot of farmers may grow sugar cane and supply may increase bringing down the prices. He has ensured his peace of mind by securing a price which he thinks is reasonable for him.

Similarly for you, you are of the thinking that you can sell it at a higher price and hence you are entering in this transaction. There is risk for you but hey aren't you a trader...

So that settles it. It is totally ethical and hence I can get in to it (I can be such a jerk at times).

Now what exactly is ‘Option’ in this?

Simple, by paying 100 Rs, you have ‘bought’ a ‘right’ to purchase the sugar cane crop at an agreed price in the future. This ‘right’ is called as an ‘option’. The ‘fee’ of 100 Rs is called as ‘premium’

Good to note that, you are a (option) buyer here (thank God they kept the terminology simple here). However the seller, the farmer, is not called a seller… he is bestowed with a fancy name of ‘Option Writer’.

Before I close, the last thing worth mentioning is, you as a buyer, have the ‘right’ to purchase sugar cane. In case after two month, you don’t want to, you will simply walk away losing 100 Rs (premium or fee that you paid). However, the farmer cannot walk away in this case. He (seller or writer) has to honor his side if buyer is asking for it. This ‘asking’… buyer asking for completing the transaction is called ‘exercising’ the option. So much for the fancy names… But this is one fancy name I like.

After all, ‘exercising’ is one thing; you should do every day, particularly a sofa potato like me. Off I go to get some ‘exercise’.

What are Options...

There are many Options... Option A, Option B but I always like to take Option C.
Hehehe, couldn't resist that one.

Okay, the Options I am interested in are very simple to understand and an award needs to be given to many pages on the internet for making it sound so awfully complicated. It took some time to sink in but once I understood, I was searching for creators of those pages with a whip in my hands... couldn't find them.

Let us start the simplification process. Lets say, you think that the sugarcane crop this year will be in demand and you want to buy it from farmer and sell it to a juice maker or sugar factory making some money (that's the objective, isn't it?) in the whole business.

However, there is still some time for the crop to be ready and you are afraid that when it is ready you may not be able to find a source, so what do you do? Simple, you go to a farmer who is cultivating sugar cane crop and tell him that you will be interested in buying his crop when it is ready after two months for Rs 2000 per tonne. You will pay him advance of Rs 100 per tonne for this. Now that farmer, depending on his reading of anticipated market scene after two months may or may not agree.

Lets say the farmer agrees to your offer and you pay him Rs 100 per tonne for this transaction which will be completed in future and voila... we are already financial genius. We have managed to create a option out of pure nothing... Hudini will be ashamed.

Hold your horses as I explain how this magic trick was performed in the next post.

Why Options...

Well the obvious question is if I want to be active trader, why options? or why derivatives at all?

Why not stick with old school stocks and do some intra-day trading and make merry. Internet is full of stories telling you how risky derivatives can be (its not for nothing that they are called financial WMDs).

Well, to be honest, tracking individual stock, its sector, peers (fundamentally) or its chart, indicators and trend (technically) everyday is not my peg of vodka. I would rather like to take a call as where Nifty or Sensex will move in next one month. That, to me, comes a lot easily and more often than not, I have found it to be fairly in sync with my expectations.

Now, I would have loved to trade some stock like Nifty whose value is defined by 50 stocks it comprises of. Mathematically speaking too, it is a lot easier to understand masses and their reactions rather than predicting behavior of individual (though I am no mathematician, I can vouch for this).

So basically, I feel comfortable in predicting trend for Nifty and can follow one chart technically. So I basically have two options... ;-))), one option is 'Options' and second option is 'Futures' to take a call on Nifty. Out of the two, with the initial reading I found Options easier to grasp and needing less money to start.

So Options it is and they got a head start.

Off to that peg of vodka I mentioned earlier...

About Myself...

I am a typical investor who is not satisfied with copy book 9 to 6 job and want to dabble with being an active trader. My lust for investment does not stop at Mutual Funds or Shares as in other 90% cases and I graduated (read: want to graduate) to a derivative trader.

This blog is my diary as I learnt trading options (I am not talking about futures here in this blog) and made mistakes. In the future if I want to do all these mistakes over again, this blog will serve as an instrument to remind me of how short memory moron (Gajini) I am...

I will be writing in simple language as I understood options basics, advanced and trading and strategies. I will also write the actual trades that I will do and I will be honest in writing how much money I loose and how much dejected I feel and how much I want to beat myself up... At times, I will also write about the money I made (touch-wood) and how I plan to spend it.

Surprisingly enough, but since you are anyway on this page, wish me luck.