Options - My way of looking at it

[pratapvb]

Just wanted to jot down a simple way of looking at options, what it is, what to use when, some greeks (only elementary math rule of thumb type) and the like

The idea is to understand different kind of options like ATM (at-the money), OTM (outof-the-money) and ITM (in-the-money) and what to use where

for e.g. using OTM to trade a trend will not give good results while it can be used as low risk entry for news play, etc

Please bear with me as I would be adding to this thread over the next few days slowly but surely

 

[DataRam]

Please bear with me as I would be adding to this thread over the next few days slowly but surely

Don't say so Pratap Ji . We are enjoying trading with your inputs. Every Post of your's has its importance. We welcome this thread of yours' .

:clapping: :clapping:

 

[XRAY27]

@pratap sir,

Thanks for the new thread on options...it will add great boon to traders on options like me
welcome .....never use the word "please bear with me... "you are the asset in TJ"

 

[pratapvb]

I will be starting from scratch so this thread can stand on it's own

Options are derivatives (price changes as underlying stock/index changes

Two type of Options
1. Calls - its price increases as underlying increases
2. Puts - its price increases as unlerlying decreases

Buyer of options - has a right to purchase the undelrying at a future date (expiry date)

Seller of option - has an obligation to pay the buyer at a future date, if the buyer exercises the options

European / American options - dynamics of how exercising can be done is different and is beyond the scope of this thread

 

[pratapvb]

Options are available at different strikes

all my examples will be using Nifty options and NF spot as the underlying

at nseindia.com the option chain is availble which gives the different strike call / put prices and OI etc

http://nseindia.com/live_market/dyn...t=OPTIDX&date=-&segmentLink=17&segmentLink=17

so a buyer can buy options of dfferent strike and a seller can sell options of different strike

so what does it mean if I say that I have bought a Call option of strike 6300

it means that at expiry (in India all exercising is at expiry; trading buy and sell can be done at any time) I have a right to get the underlying at 6300 independent of where the mkt is.....obviously I will exercise it only if mkt is above 6300....In India in equity all settlements are in cash....

and what of the seller of 6300 strike....he is obligated to pay out if the mkt is above 6300 at expiry

 

[pratapvb]

ATM, ITM, OTM

when talking about options these terms will be often used...the option is in-the-money (ITM), at-the-money (ATM) and outof-the-money (OTM) so it is important to be aware of it

the closest strike to where the mkt is is called ATM
for e.g. if NF is at 6310 then 6300 option is ATM and if NF at 6340 then 6350 option is ATM

ITM
ITM means that the option has an intrinsic value.

simplest way to understand intrinsic value is, if say expiry is this instant will you get anything for your option and if so how much and that value is the intrinsic value

so mkt at 6333,
for a Call of strike 6300 the intrinsic value will be 33 and
for a Put of strike 6300 the intrinsic value will be 0 (technically/ mathematically -ve but remember we are say what we will get which will be 0)

mkt at 6275
for a Call of strike 6300 the intrinsic value will be 0 and
for a Put of strike 6300 the intrinsic value will be 25

so ITM options has a +ve intrinsic value

and OTM values are out of money, with no intrinsic value

 

[pratapvb]

Now to the Greeks which will increase our understanding of option prices and who they change with the underlying and other factors

1. Theta - Time decay

2. Delta - the amount by which the option price changes for a change in the underlying

3. Gamma - the rate of change of delta to the underlying

4. Vega - change in price of otpion with change in volatilty (uncertainity / fear factor)

5. Rho - change in price of option to changes in Rate of interest...the cost of money....not a big factor for us

will get to each shortly

 

[pratapvb]

Theta - Time Decay

the non-intrinsic part of option is called the premium

for a given strike the premium will keep reducing as we move closer to expiry...this is called time decay...that is the price of option decays without any change in underlying also

a rule-of-thumb is that 1/3rd of the premium will decay in 1/2 the time left for expiry

currently NF 6300 call has a price of 133 with spot at 6370 (intrinsic 70)

so premium is 133-70 = 63

there are 21 days left to expiry

so 10 days from now the premium would have decayed 1/3 of 63 = 21

so after 10 days on 16th March price of 6300 call assuming NF is still at 6370 will be around 70 (intrinsic) + (63-21) = 112

P.S. yes, 16th march is a sunday......but above calculation is for illustration purpose, so that we can do these calculation using mental math, no complex calculation is required

OTM 6400 call price is 71....but that is all premum...so on 10days from now it would be round 71-24 = 47 if mkt is at same price of 6370 10 days from now

 

[pratapvb]

Delta - the amount by which the option price changes for a change in the underlying....


so if the delta is 0.7 it will mean that option price will increase or decrease by 7 for an increase/decrease in underlying by 10

and if delta is 0.2 it will mean that it wil change by 2 for a change in underlying of 10

the delta of ATM option is 0.5 and more ITM it is closer it is to 1 and more OTM it is closer it is to 0

(now you know why your OTM NF options don't seem to be changing with significant change in NF )

but how to get delta without getting much in black-scholes etc...back to rule of thumb

ATM we know is 0.5

I use this for ITM options.....

6300 call priced at 133 with NF at 6370....intrinsic 70

intrinsic : total is 70 / 133 = 0.526.... so 1- 0.52 = 0.48 ....1/2 of which is 0.24....so delta = 1 - 0.24 = 0.76

ATM 100% is premium so intrisic / total = 0 .....1 - 0 = 1 ....1/2 of wich is 0.5 so delta = 1-0.5 = 0.5

 

[pratapvb]

Delta and OTM options

I usually don't do this calculation so will have to check...but I think a similar calculation should work once we take into account the -ve intrinsic value to get total

6400 call with mkt at 6370 is 71.....premium = 71 ; -ve intrinsic value = 30

so -intrinsic / total = 30/101 ~ 0.3...so 1-0.3 = 0.7 ...1/2 of which is 0.35....so delta is approx 0.35

far out of money option say 6600 call is 15 with NF at 6395.....-ve intrinsic = 205

so -intrinsic / total = 205/230 ~ 0.89...so 1-0.89 = 0.11 ...1/2 of which is 0.055....so delta is aprox 0.055


this way we get a rough idea of what delta is without getting too much into option calculator and black-scholes....which should do for most of our trading purposes and understanding