Option Trading Guide

Option Trading Introduction

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The derivative market is started as a tool for hedging instrument, later used for arbitrating, speculation, and scalping.

Today we are used for purely for speculation. Speculation is trading. Assets are divided into real assets and financial assets. Real assets are land and building. Shares, bonds, and derivative markets are financial assets.

Financial assets have only paper value. Derivatives are financial instruments which derive its value from an underlying asset.

A derivative is a financial instrument whose value depends upon the value of an underlying asset. Derivative Instrument always has a dependent value; they don’t have independent value.

Underlying assets can be equity, commodity, currency and interest rate etc.  All these underlying assets we will have derivative instruments.

Derivative Instruments

Today Derivative instruments we don’t have just futures and options, we have swap options and leaps. In India, only two tradable instruments are futures and options. The derivative instrument is a risk management tool, as well. We can use Derivatives to mitigate our risk. Mitigating risk means to transfer risk.

In Derivative market, we have two different markets one is exchange Traded Market and OTC Market. OTC Market means there is no Exchange, the Buyer and Seller Meet Each Other without an Intermediary .They do the Trading. It does not exist in India. Underlying assets what we have can be index future. Nifty future is an index future. An index is a group of stocks. Also, we have index options. Index options can be nifty call option.

Futures Contracts:

In the Futures market, we have a buyer and a seller, if you feel underlying asset price will be going up you will be a buyer, and if you think underlying asset price will become down, you will be a seller.

Long means buy and short means sell. Whenever you’re Bullish, you always go long, and whenever you’re Bearish, you always go short.

Futures market gives you leverage. A futures contract is an agreement between two parties, one the buyer and the other seller of the future but it will happen at a certain time in the future date, and it will be had a certain price. So Future contracts are traded in exchange, and these contracts have standard lot size. Standard lot means you can buy multiples of lot size. Future contracts will expire at a standard time that standard time will be last Thursday of every month.

Futures are standardized forward contracts, forwards are an unstandardized futures contract. In forwarding market, the parties will decide when will be the expiry, in futures market exchange will decide. In the futures market, an exchange will decide the margin. The forward market has counterparty risk; the futures market doesn’t have counterparty risk.  Future market is always cash settled all open positions are marked to market. There won’t be a delivery of an underlying asset. The profit or loss is either debited or credited to your account.

Mark -to- Market (MTM)

Mark -to- Market (MTM) is on a daily basis exchange will run; it will arrive at something called a settlement price. Profit and loss will be credited or debited on a daily basis. Always in the futures market, you have to pay an initial margin. An exchange will ensure you will always maintain a minimum margin. At any point of time, Balance in your margin account cannot drop below the minimum margin. Balance drops below minimum margin exchange will give powers to the broker without asking you.

How to Value Futures pricing

Based on Cost of Carrying model Future price is determined based on three different variables, a 1st variable is the spot price

Future price=spot price*ert

e= exponential value
r= rate of interest
t=time

The difference between the spot price and the futures price is called  Premium.

Near month contract of nifty will be lower than the middle month or far month of the nifty.

According to the cost of carrying model future rice can never be a discount, why means t cannot be negative, r cannot be below zero. In reality, the future price can be a discount.

Expectation Model, it says it is not your interest rate and time, it is the demand and supply which the roots of price go to discount it means that market is bearish, it means a number of people going short than long.  Another reason is there can be any corporate announcements like dividend also there is a chance to future price can go into a discount.

Options Market

The options market is very similar to the insurance contract the two parties involved in options markets are holder and writer. Holder pays a premium; the writer receives a premium. Holder has right but doesn’t have an obligation.  The writer has no right but has an obligation. Holder profits are unlimited, and losses are limited to the extent of the premium paid. Whereas writer profits are limited to the extent of the premium received, but losses are unlimited. Becoming Holder or Writer will depend on Premium Value.

Call option and Put option

Two Types of Options are call option and put option.

Buy a Call option when you are in bullish, Sell a Call option when you are in Bearish.

Buy a put option when you are in Bearish, Sell a put when you are in Bullish Depends on Premium.

A Call Option gives the holder the right to buy, but no obligation to buy the underlying asset by a certain date for a certain agreed price called a straight price.

In futures, if you are a bullish buy future if you are bearish sell futures. Put Option gives the holder the right to sell but no obligation to sell. Buy call is Holder of the Call (Long Call), writer of a call is sell call (short call), Holder of a Put Called as Buy Put (Long Put), Writer of a Put also Called as Sell Put (Short put).

Straight price (Exercise price) means price decided today but for a transaction to take place on a future date.

Spot price means price decided today for a transaction to take place today.

Future spot price means spot price on a future date.

Option Premium or Option Price or Option Value:

Options are classified as In the Money Option, At the Money Option and Out of the Money Option.

Whenever the Straight Price of an Option is lesser than the Spot Price of an Option and if it is Call Option, then it is called In the Money. Whenever the Straight Price of an Option is equal to the Spot Price and if it is Call Option, then it is called At the Money. Whenever the Straight Price of an Option is greater Than the Spot Price of an Option and if it is Call Option then it is called Out of the Money.

Whenever the Straight Price of an Option is greater than the Spot Price of an Option and if it is Put Option, then it is called In the Money. Whenever the Straight Price of an Option is equal to the Spot Price and if it is Put Option, then it is called At the Money. Whenever the Straight Price of an Option is lesser than the Spot Price of an Option and if it is Put Option, then it is called Out of the Money.

Option Premium can be divided into intrinsic value and Time value. Intrinsic Value will come only for In the Money Option.

Intrinsic Value = Future Price – Straight Price

Time Value = Option Premium – Intrinsic Value

For all Out of the Money Options Intrinsic Value is zero.  Time Value = Option Premium

Deeply In the Money Options might have a chance of Premium below the intrinsic value because it is not traded.

Intrinsic Value is only for In the Money Option That is the way as we go Out of the Money Premium Becomes Smaller.

How do you decide to buy an option, sell option based on three factors, view of an underlying asset, time left for expiry and volatility?

Option Pricing

The option price is nothing but option premium or option value.

Option Price Depends upon 6 Factors.

Stock Price or underlying asset price.
Strike Price.
Time left for expiring
Volatility
Interest Price.

Stock Price or Underlying asset Price: – Whenever underlying asset price goes up call premium goes up and put premium comes down. Similarly, whenever underlying asset price comes down, call premium comes down and put premium goes up.

Strike Price or Exercise Price:- Whenever Strike price increases, call premium decreases and put premium increases. Similarly, whenever strike price decreases, call premium increases and put premium decreases.

Time left for expiring: – Whenever time left for expiry says an increase in the time left for expiry will result in an increase in call premium increase as well as an increase input premium. Whenever time left for expiry is lower call premium is lower as well as put premium is lower. The longer the time to expiration, the more valuable will be the option. The option expiring three months from now will be more valuable than one month if more time left for expiration, that is the better chance for the stock to move in the money and stay there by expiration.

Volatility: – Whenever volatility is more Call premium will be more put premium will also be more. More the volatility more costly will be the option. Any increase in volatility will result in an increase in call premium as well as an increase input premium.

Dividend: – whenever the company place Dividend stock price will come down. Call premiums will come down, and put premiums will go up.
Interest Rate: – Whenever the interest rate in the market goes up. Call premium goes up and put premium also goes up.

Single leg Option Strategies:

Long Call or Buy Call: whenever you’re holder you want your volatility to be lower where you expect it to go up. The call premium will go up, put premium will go up and give more time for expiry. Whenever you’re the writer, you want your volatility to be higher where you expect it to come down and give lesser time for expiry.

Whenever you’re in Aggressively Bullish on Market, you can go for Long Call or Buy Call, and Implied Volatility should below. Implied Volatility is the Expected Volatility so that you purchase a cheaper Option and allow enough time for the stock to move higher so that the effect of time decay is reduced.

Short Call or Sell Call: Whenever you’re a writer, time left for expiry should less and expect volatility to come down. You can sell a call when you’re in Bearish or when you expect the market to goes up but below the strike price by maturity.

Long Put or Buy Put: whenever you’re holder you want your volatility to be less and give more time for expiry. When you’re in aggressively bearish, you can go for long put or buy put, and Implied Volatility should below. Implied Volatility is the Expected Volatility. So that you purchase a cheaper Option and allow enough time for the stock to go lower so that the effect of time decay is reduced. Maximum gain is substantial.

Short Put or Sell Put: whenever you’re a writer, time left for expiry should less and expect volatility come down. You can sell a call when you’re in Bullish or when you expect the market to goes up but above the strike price and Implied Volatility should be higher to sell an expensive put and always use the lesser time for expiration so that the advantage time decay comes to the writer. Maximum gain is Premium received.

Break Even Point= Strike Price – Premium.

Open Low Open High method:

Whenever the market opening and creating low at the same point. Check whether the open low is trading greater than the previous day’s value area high, and it should be greater than the last day’s close. If the market is satisfied above conditions, it is entirely in bullish.

Whenever the market opening and creating high at the same point. Check whether the open high is trading below the previous day’s value area low, and it should be below the last day’s close. If the market is satisfied above conditions, it is entirely in bearish.

Initial balance method:

The first hour of trade is called an initial balance. The market will create an initial balance low and initial balance high. If the market is not trending then wait for initial balance high to break and if it breaks initial balance high and sustains, then it is the bullish indication. If it breaks initial balance low, then it is bearish. This method to be used only on days whether you won’t find the trending day. Buy when the current market price is above initial balance high and keep this stop loss as initial balance low and sell when the current market price is below the initial balance of that day keep this initial balance high as to stop loss.

Value area method:

This method can be used for the positional trader.  If the market is trading above a previous day value area high is buy. If the market is trading above a previous day value area high is Sell. Here there is no target stop loss.

Moving average cross over method:

Use a 5days moving average and 20 days moving average. Use it on 15 minutes or 30 minutes chart. Whenever 5days moving average crosses 20days moving average from below go for the buy. Whenever it crosses from above go for sale. If you’re a positional trader, use it on a daily chart instead of 30 minutes chart.

Sideways market:

When open generally happens near the point of control of the previous day expect a high chance of sideways market. Point of control means it is the weighted average price of the previous day. When open happens within the previous day value area also, we expect the market to be sideways and the day next to big move day which may either be a trend day or a double distribution day being a previous day chance of sideways market is very high.

Advanced Option Strategies

Two leg strategies:

Spread: both the position will be a call or put.

Bull call spread:

A bull call spread is a position where you buy a call which is generally In the Money, and you sell a call which is usually Out of the Money. Buy a call as lower strike price and sell a call as the higher strike price.

Maximum loss is limited to the initial premium paid – net amount.

Maximum gain is the difference between strike prices – initial premium.

Break-Even point = long call strike price + premium paid

Bear Put Spread:

Bear put spread is the position where you buy a put which is generally Out of the Money, and you sell a put which is usually In the Money. Buy a put as higher strike price and sell a put at the lower strike price.

Maximum loss is limited to the initial premium paid – net amount.

Maximum gain is the difference between strike prices – initial premium.

Break-Even point = long put strike price – premium paid

Bull call ladder:

Bull call ladder means bull call spread only, but instead of doing buy one lot and sell one lot we do the buy one lot and sell two lots.

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