7.1 - Graphs to consider

In the last few chapters we've looked at two types of basic options: The 'Call Option and the Put Option'. We also looked at four variants that could be derived from these two options.

1. Buy a Call Option
2. Selling a call option
3. Buy a put option
4. Selling a put option

These 4 options allow traders to create many different combinations and explore some very efficient strategies. They are commonly called 'Option Strategies'. You can think of it like this: If you give an artist a palette and canvas, he can create amazing paintings. A good trader can also use these four variants to make some exceptional trades. These option trades can only be created by imagination and intelligence. Before we dive into options, it is crucial to have a solid foundation in these four options. This module will summarize the information we have learned so far.

Below are the payoff diagrams for each of the four option options (image 1)
 

The above arrangement of the Payoff diagrams helps us to understand a few things. Let me give you an overview.

1. Let's start at the left. You will notice that we have placed the Call Option (buy), and Call option (sell), one below the next. Both the payoff diagrams look almost identical if you carefully examine them. The payoff mirror image emphasizes the fact that sellers and buyers have opposite risk-reward ratios. The maximum loss for the buyer of a call option is equal to the seller's maximum profit. The call option buyer can make unlimited profits, and the call seller can lose maximum profit.
2. The payoffs of Put Option (sell), and Call Option (buy), are shown next to one another. This is because both option options make money when the market is expected higher. If you feel the market is likely to fall, don't buy or sell a call option. This will result in you losing money, not making any money. There is a side of volatility that we haven't yet discussed. We will continue to discuss this. Volatility has an effect on option premiums.This is the reason I am referring it.
3. On the right is the payoff diagram for Put Option (sell), and Put Option (buy). They are stacked one above the other. The payoff diagrams look almost identical. Mirror images of the payoff show that the maximum loss for the buyer is the maximum profit for seller. The buyer of put options can make  profits that too unlimited and the seller has the potential of same profit .  

Here is a table that summarizes the options positions.
(CHART)
 

You should also remember that an option you purchase is also known as a "Long" position. This means that buying a call option or a put option are called Long Call and Long Place, respectively.

The same applies to selling options. It is called a "Short" position. Selling a call option or a put option are also known as a Short Call or Short Put position.

Here's another thing you should know: You can purchase an option in 2 circumstances.

1. To create a new option position, you buy.
2. The intention is to close an existing short position.

Only if you're creating a new buy position, the position is called 'Long Options'. If you intend to close an existing short position and buy with the intention of closing it, then it's simply called a "square off" position.

You can also sell an option in 2 situations.

1. The intention is to sell in order to open a new short position.
2. The intention is to sell in order to close an existing long position.

Only if you're creating a new sell (writing an option), the position is called "Short Option". If you intend to close an existing long position and sell it with the intention of doing so, it's simply called a "square off" position.
 

7.2 - Explaination to The Option Buyer 

You should now have an understanding of both the seller's and buyer's perspectives on the call and put options. Before we move on to the next module, it's best to review a few important points.

If the market is expected to move strongly in one direction, buying an option (call/put) makes sense. The market should move away the strike price in order for an option buyer to make a profit. It is difficult to choose the right strike price for trading. We will get more information at a later stage.Below some keypoints given-

7.2 - Explaination to The option seller 

Option sellers (call and put) are also known as option writers. Both buyers and sellers have a completely different P&L experience. If you expect the market will remain flat, below or above the strike price in the case of calls or above the strike price for a put option, selling an option is logical.

You should be able to see that markets can be slightly favorable to option sellers, even if all other factors are equal. The reason this is so, depending on which option you choose, the market must be either flat or moving in a specific direction for option sellers to be financially successful. The market must move in a specific direction for an option buyer to make a profit. There are clearly two market conditions favorable to the option seller and one favorable for the buyer. This should not be considered a reason to stop selling options.

These are some key points to keep in mind when selling options.

This may be why Nassim Nicholas Taleb, in his book "Fooled By Randomness", says that option writers eat like chickens but spit like elephants. This is to say that option writers make small, steady returns selling options but lose money when something bad happens.

This should give you a solid foundation for understanding how a Call and Put option works. This module will focus on moneyness, premiums and option pricing. It will also cover option Greeks and strike selection. After we have mastered these topics, we'll revisit the call/put option. You will be able to see calls and puts differently and maybe even have a better understanding of how to trade professionally.

7.3 - A short note for Premiums

Take a look at this snapshot -
(image 3)
 

Here is a snapshot of how the premium behaved intraday (30 thApril 2015) for BHEL. The European Call Option (CE) is the option type and the strike being considered is 230. This information is highlighted below the red box. Below the red box I have highlighted the premium's price information. You will notice that the premium for the 230 CE opened at only Rs.2.25, jumped to a peak of Rs.8/–, and closed the day at Rs.4.05/–.

It's amazing to think about how the premium has increased by 350% per day! I.e. It closed at 180%, with Rs.2.25/– to Rs.8/–, From Rs.2.25/– to Rs.4.05/– These moves should not be surprising. These moves are quite common in the world of options.

Consider that you only managed to capture 2 points during this huge swing while trading this option intraday. This is a great profit of Rs.2000/- considering that the lot size was 1000 (highlighted with green arrow). In real life this is something that happens. Traders trade premiums. Traders rarely hold option contracts beyond expiry. Many traders want to initiate a trade right away and have it settled in a matter of hours or days. They don't wait for the options expire.

You might be surprised to learn that trading options can yield a return of around 100%. Don't get too excited about what I have just said. To enjoy consistent returns, you must be able to gain a thorough understanding of options.

Take a look at the following snapshot.
(image 4)
 

This is an option contract from IDEA Cellular Limited. The strike price is 190 and expires on 30 April 2015. The option type is European Call Option. These details are indicated in the blue box. The OHLC data can be found below, which is quite obvious and very interesting.

The 190CE premium started the day at Rs.8.25/– and dropped to Rs.0.30/–. Because it is ridiculous for intraday, I won't bother with the % calculation. Let's say you sell the 190 call option intraday. If you capture 2 points again, that is Rs.4000/day in profits. That's enough to get you a nice dinner at Marriot with J.

My point is that traders (mostly) only trade options to capture variations in premium. They don't bother to wait for expiry. In some cases, I hold options until expiry. However, I don't think you should. Option sellers are more likely to keep contracts until expiry than option buyers. Because if you have an option worth Rs.8/-, you will receive the entire premium. Only on expiry, Rs.8/-

Even though the traders would prefer to trade only premiums, there are still some fundamental questions that you might have. Why do premiums vary? What are the reasons for premium changes? How can I predict changes in premiums? Who decides the premium price for a particular option's option?

These questions, and the answers to them, are the core of option trading. These aspects can be mastered and you will soon be able to trade options professionally.

Let me give you a heads-up: Understanding the 4 forces that simultaneously influence options premiums is the key to understanding why premiums can vary. This is like a ship sailing through the ocean. The speed at which a ship sails (or its equivalent to an option premium) is dependent on many factors such as wind speed and sea water density. Sea pressure, sea pressure, and even the ship's power. Certain forces increase or decrease the speed of a ship. These forces are defeated and the ship finally reaches an optimal sailing speed.

The premium for an option is also affected by certain forces known as the "Option Greeks". Simply put, some Option Greeks increase the premium while others try to decrease it. These forces are used to create the 'Black & Scholes Option Pricing Formula', which converts them into a number that is the premium for the option.

Imagine this: The Option Greeks have an influence on the option premium, but the markets control the Option Greeks. The Option Greeks and option premiums are affected by market changes minute-by-minute.

We will be able to understand the characteristics of each of these forces in the future module. We will learn how the market influences the force and how the Option Greeks influence the premium.

The ultimate goal would then be -

Before we can learn how to become option Greeks, it is important to understand the "Moneyness" of an option. In the next chapter, we will continue the discussion.

We will do our best to simplify the future topics, but we need to make a quick note. We ask that you review all concepts so far, while we do this.

Keypoints

1. 1. Only buy a call option, or sell a option if you anticipate the market going up
   2. Only buy a put option and sell a call option if you anticipate the market going down
   3. Option buyers have unlimited potential for profit and minimal risk (up to the amount of premium paid).
   4. Option sellers have unlimited risk potential, but limited reward (up to the amount of the premium they receive).
   5. Most options traders prefer trading options to capture variation in premiums.
   6. Options premiums can gyrate dramatically - this is something you can expect as an options trader.
   7. Premiums can vary depending on 4 factors called the Option Greeks
   8. Black & Sholes pricing formula uses four forces to determine a premium price
   9. The Option Greeks and their variation are controlled by the markets