Option Trading Guide

Option Trading Introduction

 

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 has 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. And 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 feel 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 future 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 3 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 future 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.

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