# Professional Trading through Option Theory

## 2.1 - The basics concept  of jargon

The basic structure of call options was explained in the previous chapter. The purpose of the previous chapter was capture some essential concepts about 'Call Option' such as -

1. If you anticipate the underlying price will rise, it makes sense to buy a call option.
2. The buyer of the call option is liable for any decrease or stagnation in the underlying price.
3. The amount of money that the buyer of the option call would lose is equal to the premium (agreement fee) paid by the buyer to the seller/writer.

The next chapter, i.e. We will be looking at the Call Option (Part 2) in greater detail. Before we move on, let's first decode some basic options jargons. These jargons will help us learn and make it easier to understand the next discussion about the options.

We will be looking at a few of these jargons.

1. Strike Price
2. Pricing Basis
3. Exercise of an option contract
4. Expiry of Option
6. Option Settlement

Remember, we only have looked at the structure of a call option. I encourage you to only understand the call option's jargons.

Strike price

The strike price is the price at which both the buyer and seller agree to enter into an option agreement. In the previous chapter, the anchor price for the "Ajay-Venu" example was Rs.500,000/–, which is also their 'Strike Price. We also examined a stock example in which the anchor price was Rs.75/–, which is also their strike price. The strike price is the price at which stock can be purchased on expiry for all 'Call" options.
for example- If A is willing to buy HCL's call option of Rs.370(being strike price)then it implies that A is ready to pay premium today to 'purchase the rights of (buying HCL at Rs.370 on expiry'.so he will buy HCL at Rs.370,only if HCL is trading above Rs 370.

Below a snapshot is given from NSE"s website where different strike prices and the associated premium is given-
(IMAGE 1)

The table you see is an "Option Chain", which lists all strike prices for a contract and the premium. The option chain also contains additional trading information like Open Interest, volume, bid/ask quantity, etc. For now, I suggest that you ignore the rest and focus only on the highlighted information.

1. The price of the spot's underlying is highlighted in maroon. We can see that ITC traded at Rs.336.9 per Share at the time we took this snapshot
2. Highlighted in blue are all available strike prices. We have strike prices that start at Rs.260 with Rs.10 intervals, and go all the way to Rs.480
3. Remember that each strike price can be used independently of the others. An option agreement can be entered into at a particular strike price, by paying the premium
4. One can, for example, enter into a 340 call option paying a premium in the amount of Rs.4.75/ (highlighted red).
1. The buyer can then buy ITC shares at Rs.340 at the expiry. You now know the circumstances under which it makes sense to purchase ITC shares at Rs.340 at expiry.

Basis Price

As one knows that from an underlying asset ,a derivative contract gets its value . The spot market price at which an underlying asset trades is called the underlying price. In the ITC case, ITC traded at Rs.336.90/= in the spot market. This is the underlying market price. To benefit from a call option, the price must rise for the buyer.

Exercise of an option contract

The act of exercising an option contract means that you claim your right to purchase the options contract after the expiry. When you hear the phrase "exercise an option contract" used in context of a Call Option, it means that one is claiming the right and price to purchase the stock. He or she would only do it if the stock trades above the strike. Important: You can only exercise your option on the expiry date and not before.

Assume that one has 15 days left to expire and buys the ITC 340 call option. ITC is currently trading at 330 on the spot market. Assume that the stock price rises to 360 the day after the option buyer buys the 340 call option. In such a scenario, an option buyer cannot request a settlement (he can't exercise) against the call options he has. Settlement will take place on expiry date, based upon the price of the asset in the spot market on that day.

Option Expiry

Options contracts also have expiry, just like futures contracts. Both equity futures contracts and option contracts expire the last Thursday in every month. Option contracts have the same concept as futures contracts. They can be categorized by current month, middle month, or far month. Take a look at this snapshot -

(image 2

Here's a quick snapshot of the option to purchase Ashok Leyland Ltd for a strike price Rs.70 at Rs.3.10/+. There are two expiry options available: 26 March 2015 and 30 April 2015. (mid-month), 28 th Mai 2015. (far month). The premium can change as the expiry date changes. We will discuss it in detail once we have the chance. Option Premium

We have already discussed premium in a couple of instances. I think you now know a few facts about the 'Option Premium. Premium is the amount that the option buyer must pay to the option seller/writer. The premium is paid by the option buyer to purchase the right to buy or sell the asset at strike price after expiry.

You have probably understood this part. Now we will look at 'Premiums from a different perspective. It is also important to mention that all of option theory rests on 'Option Premium. Option premiums are a crucial part of trading options. As we move through the module, you'll see that discussions will be heavily centered on the option premium.

Let's go back to the 'Ajay Venu' example that we discussed in the previous chapter. Take a look at the circumstances in which Venu accepted Rs.100,000.00 from Ajay.

1. News flow - News about the highway project was speculative. No one knew for certain if it would actually come up.
1. Consider this: We discussed 3 scenarios in the previous chapter, of which Venu was favorable to 2 others. Venu's natural statistical advantage and the fact that highway news is speculative increase his chances of benefiting from this agreement.
2. Time - It took 6 months to determine if the project would succeed or fail.
1. This is actually a benefit to Ajay. Ajay has a greater chance of winning the event because there is more time before it expires. Consider this: If you ran 10kms in 20 minutes, which time period would you prefer to complete it? Or 70 minutes? The probability of achieving it is higher the longer the run.

Let's now consider each of these points separately and see what impact they would have on our option premium.

News The news about the deal between Ajay & Venu was only speculation. Venu was therefore happy to pay Rs.100,000. Let's just assume that the news was not speculative, and that there was bias. Perhaps a local politician suggested in the recent press conference they might consider building a highway in this area. This information makes it clear that the news is not a rumor. There is now a chance that the highway will indeed be built, although there is still some speculation.

You can use this for considering a bigger picture. Do you think Venu would accept Rs.100,000.00 as a premium? He may not be able to accept the premium because he knows that there is a good chance of the highway coming up, and therefore land prices will rise. He may still be open to taking the chance, provided that the premium is more appealing. He might consider an agreement more attractive if the premium was Rs.175,000/= instead of Rs.100,000.

Let's now put this in stockmarket perspective. Let's say Infosys trades at Rs.2200/day today. The 2300 call option has a one month expiry and is priced at Rs.20/. As Venu (option writer), would you accept Rs.20 per share as a premium to enter into an agreement?

As a seller/writer, you give the buyer the option to buy Infosys option for Rs. Two months down the road, you will be 2300.

Let's say that Infosys shares are expected to rise by 0% for the next month. You might consider accepting the premium of Rs.20/.

What if a corporate event, such as quarterly results, causes the stock price to rise? Is the option seller willing to accept Rs.20/ as the premium? It may not be worthwhile to take on the risk of Rs.20/-.

What if, despite the corporate event, someone offers Rs.75/- premium instead of Rs.20/? It may be worth the risk at Rs.75/-

We will keep this discussion in our minds. Let's now focus on the 2 and points. Time

Ajay clearly knew that 6 months was enough time to allow the dust to settle and for the truth to be revealed about the highway project. What if there were only 10 days? The time is now shorter and there is not enough time to make the event happen. Ajay is not likely to be happy to pay Rs.100,000./- premium to Venu in such circumstances. Ajay is not motivated to pay such a premium to Venu, so I don't believe so. He might offer a lower premium, like Rs.20,000/-.

However, I am trying to emphasize the fact that premium is not a fixed rate. It can be affected by many factors. There are a few factors that can increase or decrease the premium. In real markets, all of these factors affect the premium simultaneously. The premium is affected by 5 factors, similar to news and times. These are the "Option Greeks". Although we are not ready to fully grasp Greeks yet, we will in the next stage of this module.

Let me now remind you of and appreciate these points in relation to option premium.

1. Option Theory is based on the concept of premium.
2. Premium is not a fixed rate. It is dependent on many factors (influencing).
3. Real market premiums can vary minute to minute.

These points are important and I can assure you that you are on the right track if you have understood them.

Settlement
Take a look at this Call option agreement -
(image 3

This is a call option to purchase JP Associates at Rs.25/–, as highlighted in green. The expiry date is 26 th February 2015. The premium is Rs.1.35/– (highlighted in red) and the market lot, 8000 shares.

= 8000 * 1.35

Now that Trader B has the Premium form Trader, he is bound to sell Trader 8000 shares of JP Associates to Trader A on 26 thMarch 2015, if Trader A chooses to exercise his agreement. This does not mean that Trader A should have 8000 shares of JP Associates with him on 26 th March. Options are cash settled India. This means that Trader A can exercise his right to have 8000 shares with him on 26 March. Trader B must pay only the cash differential to Trader.

This is why 26 th February JP Associates is currently trading at Rs.32/. This means that the option buyer (Trader B) will be able to purchase 8000 shares of JP Associates at 25/\$. This means that he will be able to purchase JP Associates at 25/\$, even though the shares are trading at Rs.32/\$ in the open market.

This is the normal cash flow.

• The transaction price is predetermined at Rs.25 (strike cost).
•    At rs.25 Trader B releases 8000 sharews to Trader A,against the payment.
• Trader A sells the shares almost immediately on the open market for Rs.32 per share, and receives Rs.256,000/.
• This transaction nets Trader A a profit Rs.56,000/(256000 - 200000).

You can also look at it this way: The option buyer makes a profit of Rs.7/share (32-25 per share). The option buyer receives 8000 shares but the cash equivalent. This means that Trader A would get the cash equivalent of what he would make.

= 7*8000

The option buyer initially spent Rs.10 800/- to purchase this right. His real profits would therefore be -

= 56,000-10,800

= Rs.45,000./-

This is a staggering return of 41.99% if you consider it in percentage terms (without annualizing).

Options are a highly attractive trading instrument because they offer a large asymmetric return. Options are hugely popular among traders because of this.

## Keypoints

1. If one expects an increase in price for an asset, it makes sense to purchase a call option
2. The strike price is the price at which the option buyer or writer agrees to a contract.
3. Simply the underlying price is nothing but the spot price of the asset.
4. The act of exercising an option contract means that you can claim your right to purchase the options contract at expiry.
5. Options contracts have an expiry, just like futures contracts. Option contracts expire every Thursday.
6. Options contracts can have different expiry dates - current month, midmonth, and far month.
7. Premiums do not have a fixed value .Variety of factors can lead to vary them.
8. Options can be settled in cash in India.