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What is an “Option”?

Ans: An option is a contract between two parties to buy or sell a given amount of underlying assets at pre-specified price on or before a given date.

Let us understand options contract with the help of an insurance example. Mr A insures his car of Rs 5,00,000 by paying a premium of Rs 10,000. If the event occurs that he has a car accident, then he receives most of the value of his car, less the premium, assuming the car is destroyed. If the event occurs that the car does not get destroyed, then he loses his premium.

If any accident occurs, Mr A receives payment equal Rs 5, 00,000 — Rs 10,000(premium paid) = Rs 4, 90.000.

If the event of "no accident" occurs then Mr “A” only loses his premium of Rs 10,000.

Insurance Payoff is asymmetric where the upside and down side payoff are not the same just like the Options Contract.

 

What are the different types of Options?

There are two types of Option – Call option and Put Option.

Call Option is an option which gives the right but not the obligation to buy the underlying at a specific price on or before a specific date.

Put Option is an option which gives the right but not the obligation to sell the underlying at a specific price on or before specific date.

Buyer of an option by paying option premium buys the right but not the obligation to exercise his option on the seller/writer.

The writer of Call/Put option receives the option premium and thus it becomes obligatory for them to sell/buy the underlying if the buyer wishes to exercise his option.

 

Features of Option Trading: (what is premium ? what is strike price ? what is expiration date ?)

  • Buying of option requires premium to be paid and selling of option requires margin to be paid
  • The price which option buyer pays to option seller to acquire the right is called an option price or option premium
  • The pre-specified price is called as strike price and the date at which strike price is applicable is called expiry date
  • The asset which is bought or sold is called underlying assets (here commodities)

 

Style of Options:

American Options can be exercised any time on or before the expiration date. (Binomial option pricing methodology is mainly used to price American Option).

 

European Options can only be exercised on expiry date of contract. (Black and Sholes methodology is used to price European Options).

 

All index option and even commodity options are European trade options in India and they can’t be exercised in between but they can be sold anytime.

 

Option Value

Intrinsic Value of an option is the difference between the spot price and strike price of the underlying i.e.

Intrinsic Value of Call option = Spot Price - Strike Price.

Intrinsic Value of Put option = Strike Price – Spot Price.

Time Value of an option is the difference between its premium and its intrinsic value i.e. Premium – (Spot Price – Strike Price)

 

A Call ATM and OTM have only time value. Usually, the maximum time value exists when option is ATM.

 

In-the-Money Option: An ITM option is an option that would lead to positive cash flow to the holder, if it were exercised immediately. Call option is said to be in ITM when Spot price > Strike price (i.e. higher) whereas Put options is said to be ITM when Spot price < Strike price (i.e. lower/below)

At the money option: An ATM is an option that would lead to zero cash flow if it were exercised immediately i.e. Spot price = Strike price.

Out-of-the Money: An OTM is an option that would lead to a negative cash flow if it were exercised immediately. In case of Call option = Spot Price < Strike Price, then Put Option = Spot Price > Strike Price.

 

Determinants of Option Price:

Spot Price of the Underlying Asset, Strike Price, Annualized Volatility, Time to Expiration and Interest Rate are the determinants of Option Price.

 

Now that you have got to know about the basic of Option Trading, Let us go through a couple of basic option strategies.

 

Options trading strategies can be customized as per the requirement of the participants and can either be a simple “one legged” trades or exotic multi-legged complex strategies. However, irrespective of its complexity and function all option strategies have one thing in common and that is they’re based on only two fundamental option types: Calls and Puts.

 

1. The Long Call: In this strategy, you buy a call option or “go long”. This straightforward strategy is a bet that the underlying commodity will rise above the strike price by the date of expiry.

 

Example: Gold trades at INR 29000 per 10 grams, and a Call option at INR 29000 strike is available for INR 290 with an expiry date in three months. The contract is for 1 kilogram, which means this call option costs INR 29000 (Premium): INR 290 X 100. Here’s the payoff profile of the long call contact:-

 

Gold Price at Expiry date in INR/10 gms Long call’s profit in INR
33000 400000
32000 300000
31000 200000
30000 100000
29290 (Breakeven) 0
29000 -29000
28000 -29000
27000 -29000
26000 -29000

 

Potential upside/downside: If the call option entry is well-timed, the upside on a long call is theoretically infinite, until the expiry date, as long as gold moves higher. Even if gold moves the wrong way (in the above, case downside), traders often can salvage some of the premium by selling the call before expiry date. The maximum downside is a complete loss of the premium paid — INR 29,000 in this example.

 

Why use it: : If you’re not concerned about losing the entire premium, a long call is a way to bet on a commodities rising price and to earn much more profit than if you owned the commodity directly. It can also be a way to limit the risk of owning the commodity directly. For example, some traders might use a long call rather than owning a comparable amount of gold stock (in this case 1 kilograms of gold) because it gives them upside while limiting their downside to just the call’s cost (Premium which is INR 29,000) — versus the much higher expense of owning the 1 kilograms gold stock and paying additional storage cost and security.

Advantage: Loss is limited only up to the premium paid while profit is unlimited.

 

2. The Short Put: The short put is the opposite of the long put, with the commodity trader selling a put, or “going short.” This strategy bets that the commodity will stay flat or rise until the expiry date, with the put expiring worthless and the put seller walking away with the whole premium. Like the long call, the short put can be a bet on a commodity price rising, but with significant differences. s

 

Example: Gold trades at INR 29000 per 10 grams, and a Put option at INR 29000 strike can be sold for INR 290 with an expiry date in three months. The contract is for 1 kilogram, which means this put option is sold for INR 29000: INR 290 X 100. The payoff profile of one short put is exactly the opposite of the long put.

 

Gold Price at Expiry date in INR/10 gms Long Put’s profit in INR
33000 -29000
32000 -29000
31000 -29000
30000 -29000
29000 -29000
28710 (Breakeven) 0
28000 100000
27000 200000
26000 300000

 

Potential upside/downside: The long put is worth the most when the price of gold is INR 0, so its maximal value is the strike price x 100 x the number of contracts. In this example, that’s INR 29,00,000. Even if gold price rises, traders can still sell the put and often save some of the premium, as long as there’s some time to expiry date. The maximum downside is a complete loss of the premium, or INR 29,000 here.

 

 

Why use it: A long put is a way to bet on a commodities price decline, if you can digest/bear the potential loss of the whole premium. If the commodity price declines significantly, traders will earn much more by owning puts than they would by short-selling the commodities in the futures market. Some traders might use a long put to limit their potential losses, compared with short-selling, where the risk is uncapped because theoretically a commodities price could continue rising indefinitely and a commodity has no expiry date.

 

Advantage: Traders and Jewellers can use the long put to hedge their gold price risk.

3. The Short Put: The short put is the opposite of the long put, with the commodity trader selling a put, or “going short.” This strategy bets that the commodity will stay flat or rise until the expiry date, with the put expiring worthless and the put seller walking away with the whole premium. Like the long call, the short put can be a bet on a commodity price rising, but with significant differences.

Example: Gold trades at INR 29000 per 10 grams, and a Put option at INR 29000 strike can be sold for INR 290 with an expiry date in three months. The contract is for 1 kilogram, which means this put option is sold for INR 29000: INR 290 X 100. The payoff profile of one short put is exactly the opposite of the long put.

 

Gold Price at Expiry date in INR/10 gms Short Put’s profit in INR
33000 29000
32000 29000
31000 29000
30000 29000
29000 29000
28710 (Breakeven) 0
28000 -100000
27000 -200000
26000 -300000

 

Potential upside/downside: Whereas a long call bets on a significant increase in gold price, a short put is a more modest bet and pays off more modestly. While the long call can return multiples of the original investment, the maximum return for a short put is the premium, or INR 29000 in this case, which the seller receives upfront.

 

If the commodity price stays at or rises above the strike price, the seller takes the whole premium. If the commodity sits below the strike price at expiry date, the put seller is forced to buy the commodity at the strike, realizing a loss. The maximum downside occurs if the commodity falls to INR 0. In that case, the short put would lose the strike price x 100 x the number of contracts, or INR 29,00,000.

 

Why use it: Commodity participants often use short puts to generate income, selling the premium to other traders who are betting that the commodity price will fall. Like someone selling insurance, put sellers aim to sell the premium and not get stuck having to pay out. However, traders should sell puts sparingly, because they’re on the hook to buy the commodity in this case gold if gold falls below the strike at expiry date. A falling commodity can quickly eat up any of the premiums received from selling puts.

 

Commodity market participants can use a short put to bet on a commodity’s appreciation, especially since the trade requires no immediate outlay. But the strategy’s upside is capped, unlike a long call, and it retains more substantial downside if the commodity falls.

 

Advantage: Commodity participants can also use short puts to achieve a better buy price on a too-expensive commodity, selling puts at a much lower strike price, where they’d like to buy the commodity. For example, with gold at INR 29000, an investor could sell a put with INR 28000 strike price for INR 200, then for 1 kg gold contract:

  • If gold dips below the strike at expiry date, the put seller is assigned the stock, with the premium offsetting the purchase price. The investor pays a net INR 80,000 for 1 kg gold, or the INR 28000 strike price minus the INR 20000 premium already received.
  • If gold price remains above the strike at expiry date, the put seller keeps the cash and can try the strategy again.

 

Similarly, various multi legged strategies like the covered call and Married Put can be easily executed through the call and put options.

4. The Covered Call: The covered call starts to get fancy because it has two parts. The trader must first own the underlying commodity and then sell a call on the commodity. In exchange for a premium payment, the trader gives away all appreciation above the strike price. This strategy bets that the commodity will stay flat or go just slightly down until expiry date, allowing the call seller to pocket the premium and keep the commodity.

 

If the commodity sits below the strike price at expiry date, the call seller keeps the commodity and can write a new covered call. If the commodity rises above the strike, the trader must deliver the commodity to the call buyer, selling them at the strike price.

One critical point: For each 1 kilogram of gold, the gold trader/jeweler sells at most one call; otherwise, the trader would be short “naked” calls, with exposure to potentially uncapped losses if gold prices gains. Nevertheless, covered calls transform an unattractive options strategy — naked calls — into a safer and still potentially effective one, and it’s a favorite among commodity traders looking for income.

 

Example: Gold trades at INR 29000 per 10 grams and a Call option at INR 29000 strike is available for INR 290 with expiry date in three months. In total, the call is sold for INR 29,000. The trader buys or already owns 1 kilograms of gold

 

Gold Price at Expiry date in INR/10 gms Short Call’s profit in INR Profit from 1 kg Physical gold stock in INR, bought at INR 29000/10 gms Total Profit in INR
33000 -400000 400000 29000
32000 -300000 300000 29000
31000 -200000 200000 29000
30000 -100000 100000 29000
29290 0 29000 29000
29000 29000 0 29000
28000 29000 -100000 -71000
27000 29000 -200000 -171000
26000 29000 -300000 -271000

Potential upside/downside: The maximum upside of the covered call is the premium, or INR 29,000, if gold remains at or just below the strike price at expiry date. As the gold price rises above the strike price, the call option becomes more costly, offsetting most of the gains of holding the physical stock and capping upside. Because upside is capped, call sellers might lose a profit that they otherwise would have made by not setting up a covered call, but they don’t lose any new capital. Meantime, the potential downside is a total loss of the gold’s value, less the INR 29,000 premium, or INR 28,71,000.

 

Why use it: The covered call is a favorite of traders looking to generate income with limited risk while expecting the gold price to remain flat or slightly down until the option’s expiry date.

Advantage: Traders can also use a covered call to receive a better sell price for the gold, selling calls at an attractive higher strike price, at which they’d be happy to sell the physical gold. For example, with gold at INR 29000 per 10 grams, a trader could sell a call with INR 33000 strike price for INR 200, then:

  • If the gold price rises above the strike at expiry date, the call seller must sell the gold at the strike price, with the premium as a bonus. The trader receives a net INR 33,00,000 per 1 kg for the gold, or the INR 33000 strike price plus the INR 200 premium already received
  • If the gold price remains below the strike at expiry date, the call seller keeps the cash and can try the strategy again

5. The Married Put: Like the covered call, the married put is a little more sophisticated than a basic options trade. It combines a long put with owning the underlying stock, “marrying” the two. For each 100 shares of stock, the investor buys one put. This strategy allows an investor to continue owning a stock for potential appreciation while hedging the position if the stock falls. It works similarly to buying insurance, with an owner paying a premium for protection against a decline in the asset.

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Example: Gold trades at INR 29000 per 10 grams and a Put option at INR 29000 strike is available for INR 290 with expiry date in three months. In total, the put costs INR 29,000. The trader already owns 1 kilograms of gold

 

Gold Price at Expiry date in INR/10 gms Long Put’s profit in INR Profit from 1 kg Physical gold stock in INR, bought at INR 29000/10 gms Total Profit in INR
33000 -29000 400000 371000
32000 -29000 300000 271000
31000 -29000 200000 171000
30000 -29000 100000 71000
29000 -29000 0 -29000
28710 0 -29000 -29000
28000 100000 -100000 -29000
27000 200000 -200000 -29000
26000 300000 -300000 -29000

Potential upside/downside: The upside depends on whether gold goes up or not. If the married put allowed the trader to continue owning the gold that rose, the maximum gain is potentially infinite, minus the premium of the long put. The put pays off if the gold price falls, generally matching any declines and offsetting the loss on the gold minus the premium, capping downside at INR 29000. The trader hedges losses and can continue holding the gold for potential appreciation after expiry date.

Advantage: The above option strategy is a hedge. Traders use a married put if they’re looking for continued appreciation in the price of gold or are trying to protect gains they’ve already made while waiting for more.

If the commodity prices continue to fall/decline, this strategy will allow a physical player to limit his losses only up to the premium and hence it acts as a hedge.

 
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