Futures and Options (F&O)

There is a whole world of financial securities other than stocks and bonds. One of such securities
is Derivatives, which are financial instruments whose “value” are derived from the value of the
underlying. Hence, they are called “derivative” i.e. derive from something else. The underlying
on which derivative is based could be:
Asset: e.g. stocks, bonds, mortgages, real estate, commodities, real estate properties.
Index: e.g. stock market indices, Consumer Price Index, Foreign Currencies and interest rates
Other items: e.g. Weather (yes- you will derivatives written on rain!!)

For example – a derivative on a stock derive its value from the value of underlying stock! There
are three main types of derivatives: Forwards (similar to Futures), Options and Swaps. Futures
are very similar to Forwards except for the fact that Futures are traded on exchange while
Forwards are traded over the counter (OTC). In this article I am going to concentrate only on
Futures (F) and Options (O). So whenever you come across any article on F&O or any reference
to it, remember it means Futures & Options.

Why do we need derivatives?

Derivatives are used to either
1. Hedge the risk i.e. lessen the risk which may arise due to changes in the value of underlying –
This is known as “hedging”.
2. Increase the profit arising from the changes in the value of underlying in the direction they
expect or guess – This is known as “speculation”.

Hence, there should not be any misconception that derivatives or F&O are used only by
speculators to make money. These are extremely useful financial instruments which are used by
corporate or individuals to mitigate their risk. But unfortunately same instruments can be used by
speculators to make money. One simple example is nuclear energy. People can use it to generate
1000s of MW of energy for peaceful purpose whereas others can use the same nuclear energy to
make nuclear bombs for mass destruction. Is it fair to blame nuclear energy for this? We cannot.
So if you want to blame someone, blame speculators and not derivatives.

How hedging works?

Assuming that our readers are not speculators, I will focus on how futures or future contracts are
used for hedging. Suppose I am a petroleum distributor whose job is to sell petroleum products
such as Petrol and Diesel in the market while I am in the businessϑ you are an airline owner,
say Mr. Vijay Mallya of selling petroleum while you are a net buyer of petroleum products. I
will be concerned with drop in prices of petroleum because that would hurt my revenues and
profit margin. This is because I am selling petrol, right? While you, an airline owner, would be
concerned with any increase in prices of petroleum because it would increase your costs. Thus
we two have a common concern – uncertainty in the price of petroleum products.

To reduce our risk and buy a peace of mind, we will sit together and fix a price of petroleum to
be sold in the future. Thus, I have reduced the risk of prices going down while you have reduced
the risk of prices going up. This is called hedging.
F&O Market in the US and India
You would be surprised to know that the volume of F&O trade is much more than volume of
stocks trade in the world. This shows the sheer popularity of F&O instruments among investors.
In the US futures are traded primarily on CME (Chicago Mercantile Exchange), which is the
largest financial derivatives exchange in the United States and most diversified in the world.
CME’s currency market is the world’s largest regulated marketplace for foreign exchange (FX)
trading. In the US Options are traded on CBOE (Chicago Board Options Exchange).

In India Futures and Options are traded on both BSE and NSE. The market hasn’t developed to
its potential yet due to lot of political and regulatory issues. Hence, the size of derivatives market
is much smaller in India as compared to those in developed worlds.

Forward Contract vs. Futures Contract

While futures and forwards are both contracts to deliver an asset at a fixed (pre-arranged) price
on a future date, they are different in following respects:

Features Forward Contracts Future Contracts

Operational Mechanism
Contract Specifications
Counterparty Risk
Liquidation Profile
Price Discovery
Traded Over The Counter Traded on exchange
(OTC) and NOT on exchange
Extremely customized; differs Standardized contracts
from trade to trade
High because of default risk Less risky because only
margins are settled
Poor liquidity due to Very high because contracts
customized products are customized
Poor; as markets are Better because market is on a
fragmented common platform of an
exchange

Source: Derivatives India

Futures
Let us now focus only on Future contracts, which are an agreement between two parties to buy or
sell an asset (underlying) at a given point of time in the future. They are standardized contract i.e.
an agreement, traded on a futures exchange, to buy or sell a standardized quantity of a specified
commodity of standardized quality at a certain date in the future, at a price (the futures price)
determined by the parties involved. The future date is called the delivery date or final settlement
date. The official price of the futures contract at the end of a day\'s trading session on the
exchange is called the settlement price for that day of business on the exchange.
I have assumed that no cash settlement was done between the two parties. A futures contract
gives the holder the obligation to make or take delivery under the terms of the contract. Also
both parties of a futures contract must fulfill the contract on the settlement date – it is legally
binding. The seller delivers the underlying asset to the buyer, or, if it is a cash-settled futures
contract, then cash is transferred from the futures trader who sustained a loss to the one who
made a profit. Money lost and gained by each party on a futures contract are equal and opposite.
In other words, a future trading is a zero-sum game.

Future prices are not definitive statements of prices in the future. In fact they are not even
necessarily predictions of the future. But they are important pieces of information about the
current state of a market, and futures contracts are powerful tools for managing risks.

Terminology
I will discuss a few terms that are often associated with derivatives. They are following:

Underlying: It is the asset or index on which a derivative is written. For example a futures index
has the underlying as an index.

Delivery Date: This is the date at which the underlying will be delivered by the seller to the
buyer. It is also known as final settlement date.

Future Price: This is the agreed upon or prearranged price determined by the instantaneous
equilibrium between the forces of supply and demand among competing buy and sell orders on
the exchange at the time of the purchase or sale of the contract. Simply, the price prearranged
between the seller and the buyer.

Standardization
Futures contracts ensure their liquidity by being highly standardized, usually by specifying:
• The underlying asset or instrument. This could be anything from a barrel of crude oil to a short
term interest rate.
• The type of settlement, either cash settlement or physical settlement.
• The amount and units of the underlying asset per contract. This can be the notional (fictional)
amount of bonds, a fixed number of barrels of oil, units of foreign currency, the notional amount
of the deposit over which the short term interest rate is traded, etc.
• The currency in which the futures contract is quoted.
• The grade of the deliverable. In the case of bonds, this specifies which bonds can be delivered.
In the case of physical commodities, this specifies the quality of the underlying goods
• The delivery month
• The last trading date

Types of Futures Contracts

There are a large number of futures contracts trading on future exchanges around the world. I
have highlighted characteristics of each major group of contracts:

Agricultural Commodities
This category is the oldest group of futures contracts. It includes all widely used grains such as
wheat, soybeans, corn and rice. Additionally, futures are traded actively on Cocoa, coffee,
orange juice, sugar, cotton, wool, wood, and cattle.

Equities
Futures are actively traded on individual stocks as well as index. These are generally cash settled
i.e. no exchange of stocks happens between the contracted parties; only the party which loose
(prices of stocks move against them) gives money to the party which wins. Stock index futures
have been quite popular in the market. These contracts are generally indices of a combination of
stocks.

Natural Resources
Futures contracts are actively traded on metals and natural resources. Metals include gold, silver,
copper, aluminum etc while natural resources include crude.

Foreign Currencies
There is a very large market of futures contract traded on foreign currencies because a large
number of multinational companies are concerned about the volatility (changes) in the value of
currencies of different countries where they sell or buy their products. Most popular currencies
are Japanese Yen (¥), British Pound (£), Euro (€) and Swiss Franc (CHF).

Disadvantages of futures or derivatives

Remember, I gave you an example of Petroleum distributor (me) and airline owner (you). I will
be concerned with the drop in prices of petro products while you will be worried about a rise in
the prices. Let’s say the current price of petro is Rs. 50 per liter. I think the prices will fall further
from Rs. 50 to 40 while you think US might attack Iran and hence prices will go up from Rs. 50
to 60. So you want to fix a price little higher from today’s price (but less than what you expect it
to be in 3 months) which is favorable to both of us as per our own calculations and predictions.
Two of us decide to exchange 100 liters of petro 3 months later on March 24, 2009 at a price of
Rs. 55.

Now, imagine US didn’t attack Iran and global economy sink further. Hence, on May 24, 2009
price of petro products drop to Rs. 45. Here, I, the seller, will sell you petro at a price of Rs. 55
even though the market price is Rs. 45 per liter. Thus, I will make money while you lose it.

Hence, the biggest disadvantage of futures is that one of the parties involved will not be able to
take advantage of favorable movement in price i.e. if you have not entered into a futures contract
with me, you could have bought petro at Rs. 45 (market price) instead of Rs. 55.

Options
An option is a contract where the buyer has the “right” (depends on buyer to execute it), but not
the “obligation” (legally bonded) to buy or sell an underlying asset (a stock or index) at a
specific price on or before a certain date. An option is a security, just like a stock or bond, and
constitutes a binding legal contract with strictly defined terms and conditions.

Futures Vs Options
Remember from the previous article, Futures are contracts where both the buyer and the seller
have the obligation to honor the contract whereas option does not involve any obligation for both
the parties. A contract is a zero sum game i.e. one party will book loss while the other take home
the profit. If the contract is futures, the losing party will pay the winning party. However, in
options, the buyer will decide whether to execute the contract. You will understand this by the
following example.

Let say there is a contract between you and me which says that I will buy one kg of gold at Rs.
1,000 per gm from you on March 1st, 2009. I am the buyer of this contract and you are the seller.
So we will either go for cash settlement or you have to deliver the gold to me. Now suppose on
the date of settlement i.e. March 1st, 2009, price of gold is Rs. 500 per gram. Thus, the market
price of gold on March 1st, 2009 is lower than the contract price.

If the contract were Futures, I would have to buy the gold from you because I have the
“obligation” to do so. Hence, I will pay you Rs. 1,000 per gm and you will deliver me the gold.
Hence, you make profit while I book loss. Good for you, Bad for me!!

However, if the contract were an Option, I would not have executed it i.e. would not have bought
the gold from you. I would have let the contract expire (i.e. do nothing and wait till March 1st,
2009 passes by). How can I do so? I can do it because Options gives me (the buyer) the “right”
and not the “obligation” to buy it. Thus, an option would protect me from any adverse movement
in the price of underlying asset. In an option, seller has no right because he is compensated by
the buyer by paying option premium. Thus, the buyer of an option contract has the “right” but
the seller of option contract has the “obligation” to honor the option.

So you may now be wondering that why on earth somebody will ever buy a futures contract
when options contract are better. We must know that option has a “premium” attached to it
which is called “Options Premium”. This is the amount that a buyer of option contract has to pay
the seller of the option contract in exchange for higher flexibility and protection against adverse
price movement in the value of underlying. Thus, if I have to buy an option contract from you, I
will pay a premium to the seller i.e. You.

Options Vs Stocks
In order for you to better understand the benefits of trading options you must first understand
some of the similarities and differences between options and stocks.

Similarities:
• Listed Options are securities, just like stocks.
• Options trade like stocks, with buyers making bids and sellers making offers.
• Options are actively traded in a listed market, just like stocks. They can be bought and sold just
like any other security.

Differences:
• Options are derivatives, unlike stocks (i.e, options derive their value from something else, the
underlying security).
• Options have expiration dates, while stocks do not.
• There is not a fixed number of options, as there are with stocks available e.g. there could tens
or even hundreds of options written on the same stock
• Stockowners have a share of the company, with voting and dividend rights. Options convey no
such rights.

Remember these options are not issued or written by companies who stocks act as underlying
asset. These options are generally written by brokers or traders for investors.

Options Terminology

Options Premium
An option Premium is the price of the option that a buyer pays to purchase the contract from the
seller.

Strike Price
The Strike (or Exercise) Price is the price at which the underlying security (in this case, XYZ)
can be bought or sold as specified in the option contract from the seller. The strike price also
helps to identify whether an option is In-the-Money, At-the-Money, or Out-of-the-Money when
compared to the price of the underlying security.
Expiration Date
The Expiration Date is the day on which the option is no longer valid and ceases to exist.

Classes of Options
There are two classes of options – American Option and European Option. The key differences
are:

1. American option can be exercised before the expiration while an European option is exercised
only on the expiration date.
2. Dividends can be issued by the underlying stock in an American option while it is not the case
in European option

Types of Options
There are only two types of options: Call option and Put option. In this article we will discuss
only European options i.e. options which can not be executed before the agreed upon date.

Call Options
A Call Option is an option to “buy” a stock (underlying) at a specific price on a certain date. The
buyer of call option holds the rights while the seller has the obligation to honor the contract. The
buyer of a call option enters the contract assuming that the value of underlying will increase in
future and benefit him. The seller thinks otherwise i.e. the stock price will not go up and hence
the buyer will not execute the contract. So he (seller) will keep the option premium to himself –
that would be his profit. Hence, the buyer will execute the contract only when the market price of
underlying stock is higher than the strike price.

Example 1 – I bought a call option from you with the following feature: Underlying is an
Infosys Stock, Exercise price is Rs. 1100 and expiration period is Jan 24, 2009. Option premium
is Rs. 100 per underlying stock and the option is written on only 1 stock.

How call option helps me (the buyer) in realizing profits. Let us assume that the stock price on
Jan 24, 2009 is Rs. 1250. Thus, I will execute the call option and you will sell the stock to me for
Rs. 1100 and NOT at the current price. I will take that stock from you and sell it for Rs. 1250 in
the open market and book a profit of Rs. 1250 – Rs. 1100 – Rs. 100 (Option premium) = Rs. 50.
Now look at my return on investment and NOT on amount of investment. My return on
investment (ROI) is = (Profit * 100 / Total Cost or investment) %
= 50*100/100 = 50%

Compare this to someone who invested in Infosys stock and NOT in the option. If he bought the
stock at Rs. 1000 and sold for Rs. 1250 in the market, his profit would be
= (Profit * 100 / Total Cost or investment) %
= (250* 100 /1000) = 25%

Isn’t it great? One golden rule of investment – Don’t measure your profit or loss based on
“absolute value of profit or loss” but on return on investment (ROI).
Remember this – The buyer of a call option will execute the contract only when the market price
of the underlying stock will be higher than the strike price of the stock. This is because the buyer
will buy the stock from the seller at a lower cost and sell in the open market to book the
difference as profit. However, if the market price of underlying stock is less than that of the
exercise price, the buyer will let the option expire. In the above example, if the stock price of
Infosys on Jan 24, 2009 were Rs. 1090, I will not exercise the contract! Thus, my only loss
would be Rs. 100, the option premium that I paid to the seller (you).

Put Options
Put options are options to sell a stock at a specific price on a certain date. Put options mean
“right to sell”. It is just the opposite of a call option. The buyer of a put option holds the right to
sell while the seller has the obligation to buy. Here, the buyer assumes that the price of
underlying asset will go down in future and he will benefit from the put option. Hence, the buyer
of a put option will execute the contract only when the market price of underlying stock is lower
than the strike price.

Profit realization for the buyer - When do you make profit by selling something? Only when you
buy something for X amount and sell it for Y amount where Y>X. Or, you sell someone a
product at a price higher than the market price. Why will someone buy a product at a price
higher than the market price? He will do it only when he has signed a contract to do so. This is
put option which protects and benefits its buyer from any downward movement in the stock
price.

State of an option
In-the-Money option – This is when strike price is less than the market price for a call option or
the strike price is more than the market price for a put option.
At-the-money – This is when strike price is equal to the market price.
Out-of-the-money – This is when the strike price is more than the market price for the call option
while the strike price is less than the market price for the put option.

How to read an option traded listed on an exchange

If you read any business newspaper you may find quotations like this:

INFOSYSTCH Jan 29 CA 1,020.00 51.00 51.00 50.00 51.00

What does this mean? It simply means it is an option with

1. Underlying as Infosys stock
2. Jan 29 is the expiry date
3. to BUY (because it is a “call”) Infosys stock - CA is Call Option
4. 1020.00 is the Strike Price
5. The numbers (51.00, 51.00, 50.00, 51.00) shown after the strike are high price, low price,
previous close and Last price respectively.

INFOSYSTCH Feb 26 PA 1,020.00 35.00 35.00 52.00 35.00

It simply means it is an option to SELL (because it is a “put”) Infosys stock with similar details.
Table1: Representation of rights and obligations

CALL PUT
BUYER (Long) Right but not the obligation to Right but not the obligation to sell
buy
SELLER (Short) Obligation to sell Obligation to buy

Common terminology – people who buy options are also called \"holders\" or are considered to
be “Long” on option and, those who sell options are also called \"writers\" or are considered as
“Short” on option.

Remember this:
Long –> Buy
Short –> Sell (Selling the right to someone else is like buying obligation for oneself)

Call option –> Right to buy

Put option –> Right to sell (Selling the right to someone else is like buying obligation for
oneself)

Long call –> Buy the right to buy

Short call –> Sell the right to buy (Selling the right to someone else is like buying obligation for
oneself)

Long put –> Buy the right to sell

Short put –> Sell the right to sell (Selling the right to someone else is like buying obligation for
oneself)

Hence, if I buy a call option, I will say “I am Long Call” or “I am a Call Holder”. People who
buy options have a right to exercise.

When a Call is exercised, Call holders may buy stock at the strike price from the Call seller, who
is required to sell stock at the strike price to the Call holder. When a Put is exercised, Put holders
(buyers) may sell stock at the strike price to the Put seller, who is required to buy stock at the
strike price from the Put holder. Neither Call holders nor Put holders are obligated to buy or sell;
they simply have the rights to do so, and may choose to exercise or not to exercise based upon
their own judgment.

Let us discuss example 1 from the point of view of put option in the next example.

Example 2 – I bought a put option from you with the following feature: Underlying is an Infosys
Stock, Exercise price is Rs. 1100 and expiration period is Jan 24, 2009. Option premium is Rs.
100 per underlying stock and the option is written on only 1 stock. The current price of Infosys
stock is say, Rs. 1050.

How put option helps me (the buyer) in realizing profits and protecting my interests. Let us
assume that the stock price on Jan 24, 2009 is Rs. 950. Thus, I will execute the put option and
you will buy the stock from me at Rs. 1100 and NOT at the current price which is Rs. 900. Thus,
my profit is Rs. 1100 – Rs. 950 – Rs. 100 (Option premium) = Rs. 50. Now look at my return on
investment and NOT on amount of investment. My return on investment (ROI) is = (Profit * 100
/ Total Cost or investment) %
= 50*100/100 = 50%

Compare this to someone who invested in Infosys stock and NOT in the option. The value of
Infosys stocks has come down from Rs. 1050 to Rs. 950; hence, his profit would be
= (Profit * 100 / Total Cost or investment) %
= (-100* 100 /1000) = - 10% i.e. a loss of 5%.

Gain, Loss and Breakeven Table

Calls Puts
Long Short Long Short
Maximum gain Infinite Premium Limited
Maximum loss Premium Infinite
Breakeven Market price = Strike Price + Premium Market Price = Strike Price -
Premium

Potential Benefits of Options

• Greater return for smaller amount invested
• Less risk
• Less initial investment
• Diversify portfolio

These previous examples introduced how options can provide investors with more alternatives,
allowing them to specify, precisely, the amount of risk they are willing to take in their holdings.
If used on a 1-to-1 basis with the underlying shares, then options can be used to invest in stocks
with limited risk, to insure stock investments held, or to set levels of market exposure consistent
with one\'s investment strategy. Options can also be used as alternatives to stock investments
(one option for each 100 shares), giving investors the ability to profit from favorable market
moves just as if they held the underlying security, but with lower potential risk due to a lower
initial investment.

Final few words

I know you have to read a lot of things which might sound vague and confusing, which is totally
understandable. It took me few weeks to completely understand the concepts of F&O! I am not
kidding. However, they are wonderful concepts and knowing them only add to your investments
knowledge and profile. Go through both Part-1 and Part-2 regularly for sometime. To help you, I
have decided to introduce a section on Q&A to test what you learnt in this article. I will publish
the answers in the next article.

Test your skills

1. __________ option conveys the right to Buy.
A. Call
B. Put

2. ________ option conveys the right to Sell.

A. Call
B. Put

3. Long on an option means_____.

A. Buy
B. Sell

4. For a call option when the strike price is more than the market price, it is ____.
A. In-the-money
B. At-the-money
C. Out-of-the-money

5. For a put option when the strike price is less than the market price, it is ____.
A. In-the-money
B. At-the-money
C. Out-of-the-money

6. The buyer of a call option will exercise the option when ____.
A. Strike price is higher than the market price
B. Strike price is lower than the market price
C. Strike price is equal to the market price

Top 4 Questions from our readers – Part 1 of F&O

Q1. One thing I want to ask if I have both long n short positions in future for different share on
different scripts and the market moves in reverse direction how can I square off my position with
minimum loss. Reader: Binay Mohanty
Answer: You can square off by placing opposite orders on the same scripts i.e. if you are long
on XYZ, go short on XYZ and square off your position. Only loss here would be the transaction
cost. In case of options, loss will only be the option premium.

Q2. How equities futures are traded please explain with example actually I didn’t understood
how equity futures are actually settled? Reader: Nupur Suri
Answer: Futures are traded on exchange – just like stocks. There are ask-bids for them as well.
Across the world, equities futures are settled in two ways:
1. Cash settlement – Futures contracts are written on underlying asset. So the buyer and the seller
can agree not to take actual delivery of underlying asset. Instead they will do a cash settlement,
where the loser will pay difference of price as cash to the winner.
2. Physical delivery – In this case, the seller will make a physical delivery of underlying asset to
the buyer and accept cash from the buyer.

However, in India, there is only one way of settling derivatives – Cash Settlement.
Q3. I would also like to ask you about the OTC products and their use. Could you throw some
light in the OTC products, in simple language and full depth insight? Reader:
Dhritiman Das
Answer: There are thousands of OTC (Over The Counter) products in the market. They are NOT
traded on any exchange. Instead a broker writes or facilitates such agreement between the buyer
and the seller. These contracts are highly customized to suit the buyer and/or seller
specifications. Hence, the contract size, expiry date, settlement type and contract cycles are all
customized, which are not possible for exchange traded futures. You can find OTC on forex,
bonds, stocks, commodities (gold) etc.

Q4. I wanted to know y does a future contract in equities doesn’t have specified circuit levels
while it does in commodity? Reader: Sandeep Lodaya

Answer: I believe you meant circuit breakers. A circuit-breaker is a device that halts trading in a
stock if the price changes by a pre-determined percentage on a given day. The stock exchanges
currently have 2, 5, 10 and 20 per cent circuit breakers on stocks that are not part of the
derivatives segment.
There is not circuit breaker in derivatives because people think it is against free market trade.
Believers in free market say that such things will only make investors jittery and create panic.
There is circuit breaker in commodity because prices rise or fall in commodities are directly
linked to the economy. Hence, government has imposed a circuit breaker on commodity prices.

Options Strategies
Let us refresh our memory on Options which I covered in my previous article F&O Part 1 and
F&O Part 2. Options are financial instruments that give the buyer the right to buy (for a call
option) or sell (for a put option) the underlying security at some specific point of time in the
future (European Option), which is fixed in advance i.e. when the option is written. Call options
increase in value as the underlying stock increases in value. Likewise put options increase in
value as the underlying stock decreases in value.

In this article we will discuss some most commonly used options strategies. These strategies
depend on whether investors are growth-oriented or conservative, or short-term aggressive
traders. Options are generally used to speculate on the movement of the price of underlying asset
or hedge an existing position or investment. An option strategy is implemented by combining
one or more option positions and possibly an underlying stock position. Options strategies can
favor movements in the underlying stock that are bullish, bearish, neutral, event driven and stock
combination. The option positions used can be long and/or short positions in calls and/or puts at
various strikes. Before we begin our discussion, I would like to explain few important terms used
extensively in options:

Options Premium
An option Premium is the price of the option that a buyer pays to purchase the contract from the
seller.
Strike Price
The Strike (or Exercise) Price is the price at which the underlying security (in this case, XYZ)
can be bought or sold as specified in the option contract from the seller. The strike price also
helps to identify whether an option is In-the-Money, At-the-Money, or Out-of-the-Money when
compared to the price of the underlying security.

Expiration Date
The Expiration Date is the day on which the option is no longer valid and ceases to exist.

In-the-Money option (ITM)

The option is said to be in-the-money option when the strike price (SP) is less than the market
price (MP) of the underlying asset for a call option or the strike price is more than the market
price for a put option.
i.e. SP < MP For Call option
SP > MP For Put option

At-the-money option (ATM)

The option is said to be at-the-money option when strike price is equal to the market price of the
underlying asset.
i.e. SP = MP For both Put and Call option

Out-of-the-money option (OTM)

This is when the strike price is more than the market price of the underlying asset for call option
while the strike price is less than the market price for the put option.
i.e. SP > MP For Call option
SP < MP For Put option

Time Decay
Generally, the longer the time remaining until an option’s expiration, the higher its premium will
be. This is because the longer an option’s lifetime, greater is the possibility that the underlying
share price might move so as to make the option in-the-money. All other factors affecting an
option’s price remaining the same, the time value portion of an option’s premium will decrease
(or decay) with the passage of time. Note: This time decay increases rapidly in the last several
weeks of an option’s life. When an option expires in in-the-money, it is generally worth only its
intrinsic value.

Intrinsic Value
For call options, this is the difference between the underlying stock's price and the strike price.
For put options, it is the difference between the strike price and the underlying stock's price. In
the case of both puts and calls, if the respective difference value is negative, the intrinsic value is
given as zero.

Volatility
Volatility is the tendency of the underlying security’s market price to fluctuate either up or down.
It reflects a price change’s magnitude; it does not imply a bias toward price movement in one
direction or the other. Thus, it is a major factor in determining an option’s premium. The higher
the volatility of the underlying stock, the higher the premium because there is a greater
possibility that the option will move in-the-money. Generally, as the volatility of an underlying
stock increases, the premiums of both calls and puts overlying that stock increase, and vice versa.

Leverage
Options can provide leverage. This means an option buyer can pay a relatively small premium
for market exposure in relation to the contract value (usually 100 shares of underlying stock). An
investor can see large percentage gains from comparatively small, favorable percentage moves in
the underlying equity. Leverage also has downside implications. If the underlying stock price
does not rise or fall as anticipated during the lifetime of the option, leverage can magnify the
investment’s percentage loss. Leverage is like a magnifying force – it magnifies both the upside
gain as well as downside loss.

Now, let’s begin our discussion on various options strategies.

Bullish Strategies
Bullish options strategies are employed when the options trader expects the underlying stock
price to move upwards. It is necessary to assess how high the stock price can go and the time
frame in which the rally will occur in order to select the optimum trading strategy.

Stocks seldom go up by leaps and bounds. Moderately bullish options traders usually set a target
price for the bull run and utilize bull spreads to reduce cost. (It does not reduce risk because the
options can still expire worthless.) While maximum profit is capped for these strategies, they
usually cost less to employ for a given nominal amount of exposure. The bull call spread and the
bull put spread are common examples of moderately bullish strategies.

Mildly bullish trading strategies are options strategies that make money as long as the underlying
stock price does not go down by the options expiration date. These strategies may provide a
small downside protection as well. Writing out-of-the-money covered calls is a good example of
such a strategy.

Long Call
This is the most common option trading among investors.

How to design: Buy 1 call.

Margins: No
Market Outlook: Bullish. Investors believe that the share price will rise well above the strike
price. The more bullish your view the further out of the money you can buy to create maximum
leverage.
Profit: The profit increases as the market rises. The break-even point (BEP) will be the options
strike price plus the premium (OP) paid for the option i.e.
BEP = Strike Price + OP.
Loss: The maximum loss is the premium paid for the option. Any point between the strike price
A, and the break-even point you will make a loss although not the maximum loss.
Volatility: The option value will increase as volatility increases (good) and will fall as volatility
falls (bad).
Time Decay: As each day passes the value of the option erodes.

Short Put
How to design: Sell 1 put.
Margins: Yes
Market Outlook: Bullish. The share price will not fall below the strike price. If it does you are
obligated to buy at the strike price, or buy the option back to close.
Profit: The maximum profit is the premium you sold the option for. The break-even point will
be the options strike price, minus the premium received for the option.
Loss: The maximum loss is the strike price less the premium received.
Volatility: The option value will increase as volatility increases (bad) and will decrease as
volatility decreases (good).
Time Decay: As each day passes the value of the option erodes (good).

Bull Call Spread

How to design: Buy an at-the-money call option while simultaneously Sell a higher striking out-
of-the-money call option of the same underlying security and the same expiration month.
Margins: No
Market Outlook: Bullish. The share price will expire above the higher strike price and not below
the lower strike price. The strategy provides protection if your view is wrong.
Profit: The maximum profit is limited to the difference between the strike price of two options
less the cost of the spread i.e. net premium paid.
Loss: The maximum loss is also limited to the cost of the spread (Calls). The bull call spread
strategy will result in a loss if the stock price declines at expiration. Maximum loss cannot be
more than the initial debit taken to enter the spread position.
Volatility: You are not affected by volatility.
Time Decay: It depends on the underlying share price, if it is below lower strike price, then time
decay works against you. If it is above higher strike price, then it works for you.

Example: Suppose ABC stock is trading at Rs. 420 in June. An options trader executes a bull
call strategy by buying a JUL 400 call (it means call put option has the strike price of Rs. 400
and will expire in the last week of July) for Rs. 3,000 (option premium) and selling a JUL 450
call for Rs. 1,000. The net debit (or investments) to trader (i.e. he paid to enter this strategy) to
enter the trade is Rs. 2,000.

If ABC stock goes up and trades at Rs. 460 on expiration in July, both the call options expire in-
the-money (because market price is more than the strike price). However, the trader will earn
profit on JUL 400 call (because he is the buyer) but he will loose money in JUL 450 (because he
is the seller of that call)
Intrinsic value of JUL 400 call= (Market price - Strike price) * No. of underlying stocks
= (Rs. 460- Rs. 400)* 100 = Rs. 6,000
Intrinsic value of JUL 450 call= (Market price - Strike price) * No. of underlying stocks
= (Rs. 460- Rs. 450)* 100 = Rs. 1,000
Hence, the trader’s net profit to the trader is equal to Rs. 6,000-1,000 = Rs. 5,000
Subtracting the initial debit of Rs. 2,000, the options trader's net profit comes to Rs. 5,000-2,000
= Rs. 3,000.

If the price of stock ABC goes down to Rs. 380 on expiration, both the options expire worthless.
The trader will loose his investment of Rs. 2,000, which is also his maximum possible loss.

Bearish Strategies
Bearish options strategies are the mirror image of bullish strategies. They are employed when the
options trader expects the underlying stock price to move downwards. It is necessary to assess
how low the stock price can go and the time frame in which the decline will happen in order to
select the optimum trading strategy.

Stock prices only occasionally make steep downward moves. Moderately bearish options traders
usually set a target price for the expected decline and utilize bear spreads to reduce cost. While
maximum profit is capped for these strategies, they usually cost less to employ. The bear call
spread and the bear put spread are common examples of moderately bearish strategies.

Mildly bearish trading strategies are options strategies that make money as long as the
underlying stock price does not go up by the options expiration date. These strategies may
provide a small upside protection as well. .

Long Put
How to design: Buy 1 ATM put.
Margins: No
Market Outlook: Bearish. Investors believe the share price will expire well below the strike
price. It is used to profit from an expected fall in a share. This strategy is commonly used to
provide protection to stocks held in your portfolio. If the share price falls, the profit from the Put
will offset the loss on the Share.
Profit: The maximum profit is limited to the strike price less the cost of the option (Option
Premium), as the share can only fall as low as zero.
Loss: The maximum loss is equal to the amount of premium paid for the option.
Volatility: The option value will increase as volatility increases (good) and will fall as volatility
falls (bad).
Time Decay: As each day passes the value of the option erodes (bad).

Short Call
How to design: Sell 1 call.
Margins: Yes
Market Outlook: Bearish. The share price will expire below the strike price A. If it does you
will get to keep the option premium.
Profit: The maximum profit is the premium you sold the option. The break-even point will be
the options strike price A, plus the premium received for the option.
Loss: The maximum loss for this trade is unlimited.
Volatility: The option value will increase as volatility increases (bad) and will decrease as
volatility decreases (good).
Time Decay: As each day passes the value of the option erodes (good).

Bear Call Spread

A bear call spread is a limited profit, limited risk options trading strategy that can be used when
the options trader is moderately bearish on the underlying security.
How to design: Buy 1 OTM Call (higher strike price) and Sell 1 ITM Call option (lower strike
price) on the same underlying security expiring in the same month.
Margins: Yes
Market Outlook: Bearish. The options trader thinks that the price of the underlying asset will go
down moderately in the near term.
Profit: The maximum profit is limited to the difference net premium received i.e. the premium
received for the short call minus the premium paid for the long call.
Loss: The maximum loss is also limited to the difference in the strike price of two options -Net
Premium. If the stock price rise above the strike price of the higher strike call at the expiration
date, then the bear call spread strategy suffers a maximum loss equals to the difference in strike
price between the two options minus the original credit taken in when entering the position.
Volatility: You are not affected by volatility.
Time Decay: It depends on the underlying share price, if it is below A, then time decay works
for you. If it is above B, then it works against you.

Example: Suppose ABC stock is trading at Rs. 380 in June. An options trader executes a bear
call spread by buying a JUL 400 call (it means call put option has the strike price of Rs. 400 and
will expire in the last week of July) for Rs. 1,000 (option premium) and selling a JUL 350 call
for Rs. 3,000. The net credit to trader (i.e. he receives Rs. 2000 to enter this strategy) taken to
enter the trade is Rs. 2,000.

If ABC stock goes up and trades at Rs. 420 on expiration in July, both the call options expire in-
the-money (because market price is more than the strike price). However, the trader will earn
profit on JUL 400 call (because he is the buyer) but he will loose money in JUL 350 (because he
is the seller of that call and has to pay the buyer).
Intrinsic value of JUL 400 call= (Market price - Strike price) * No. of underlying stocks
= (Rs. 420- Rs. 400)* 100 = Rs. 2,000
Intrinsic value of JUL 350 call= (Market price - Strike price) * No. of underlying stocks
= (Rs. 420- Rs. 350)* 100 = Rs. 7,000

Hence, the trader’s net loss is equal to Rs. 7,000-2,000 = Rs. 5,000
Subtracting the initial credit of Rs. 2,000, the options trader's net loss comes to Rs. 5,000-2,000 =
Rs. 3,000.

On expiration in July, if ABC stock drops to Rs. 340, both the JUL 350 call and the JUL 400 call
expires worthless and the bear call spread trader pockets his profit which is equal to the initial
credit of Rs. 2,000

Neutral Strategies
Neutral strategies in options trading are employed when the options trader does not know
whether the underlying stock price will rise or fall. Also known as non-directional strategies,
they are so named because the potential to profit does not depend on whether the underlying
stock price will go upwards or downwards. Rather, the correct neutral strategy to employ
depends on the expected volatility of the underlying stock price.
Examples of neutral strategies are:

Short Straddle
How to design: Sell 1 at-the-money Call and Sell 1 at-the-money Put of the same underlying
stock, striking price and expiration date simultaneously.
Margins: Yes
Market Outlook: Neutral. The share price will expire around the strike price. If it does you will
get to keep the option premium from both sold options. This strategy is also used if your view is
that volatility will decrease.
Profit: The maximum profit is the combined total premium you received for the sale of the
options. One break-even point (Upper BEP) will be the strike price plus the combined options
premium received. The other break-even point (Lower BEP) will be the strike price minus the
combined options premium received.
Loss: The maximum loss for this trade is unlimited on the upside and limited on the downside to
the strike price, as the share can’t fall below zero.
Volatility: The option value will decrease as volatility decreases which is good for both options.
Alternatively an increase in volatility will be bad for both options.
Time Decay: As each day passes the value of the option erodes (good).

Example: Suppose ABC stock is trading at Rs. 400 in June. An options trader executes a short
straddle by selling a JUL 400 put (it means put option has the strike price of Rs. 400 and will
expire in the last week of July) for Rs. 2,000 (option premium) and a JUL 450 call for Rs. 2,000.
The net credit to enter the trade is Rs. 4,000, which is also his maximum possible profit (because
the trader is selling these options and getting premium).

If ABC stock goes up and trades at Rs. 500 on expiration in July, the JUL 400 put will expire
worthless (because market price is more than the strike price) but the JUL 400 call expires in-
the-money (because market price is greater than the strike price) and has an intrinsic value of :
Rs. 10,000 (Intrinsic value of call = (Market price - Strike price) * No. of underlying stocks).
= (Rs. 500- Rs. 400)* 100 = Rs. 10,000
Subtracting the initial credit of Rs. 4,000, the options trader's loss comes to Rs. 10,000-4,000 =
Rs. 6,000 (because trader has to pay Rs. 10,000 to the buyer of call option).

On expiration in July, if ABC stock is still trading at Rs. 400, both the JUL 350 put and the JUL
450 call expire worthless and the options trader gets to keep the entire initial credit of Rs. 4,000
taken to enter the trade as profit.

Short Strangle
How to design: Sell 1 out-of-the-money Call and Sell 1 out-of-the-money Put of same expiration
date and same underlying stock but different strike price.
Margins: Yes
Market Outlook: Neutral. The share price will expire between the strike prices A and B. If it
does you will get to keep the option premium from both sold options. This strategy is also used if
your view is that volatility will decrease.
Profit: The maximum profit is the combined total premium you received for the sale of the
options. One break-even point (Lower BEP) will be the strike price of short put minus the net
options premium received. The other break-even point (Upper BEP) will be the strike price of
short call plus the net options premium received.
Loss: The maximum loss for this trade is unlimited on the upside and limited on the downside to
the strike price, as the share can’t fall below zero.
Volatility: The option value will decrease as volatility decreases which is good for both options.
Alternatively an increase in volatility will be bad for both options.
Time Decay: As each day passes the value of the option erodes (good).

Example: Suppose ABC stock is trading at Rs. 400 in June. An options trader executes a short
strangle by selling a JUL 350 put (it means put option has the strike price of Rs. 350 and will
expire in the last week of July) for Rs. 1000 (option premium) and a JUL 450 call for Rs. 1000.
The net credit to enter the trade is Rs. 2000, which is also his maximum possible profit (because
the trader is selling these options and getting premium).

If ABC stock goes up and trades at Rs. 500 on expiration in July, the JUL 350 put will expire
worthless (because market price is more than the strike price) but the JUL 450 call expires in-
the-money (because market price is greater than the strike price) and has an intrinsic value of :
Rs. 5000 (Intrinsic value of call = (Market price - Strike price) * No. of underlying stocks).
= (Rs. 500- Rs. 450)* 100 = Rs. 5000
Subtracting the initial credit of Rs. 2000, the options trader's loss comes to Rs. 5000-2000 = Rs.
3000 (because trader has to pay Rs. 5000 to the buyer of call option).

On expiration in July, if ABC stock is still trading at Rs. 400, both the JUL 350 put and the JUL
450 call expire worthless and the options trader gets to keep the entire initial credit of Rs. 2000
taken to enter the trade as profit.

Long Put Butterfly

A long butterfly is similar to Short Straddle except the fact that loss is limited.
How to design: Buying 1 in-the-money Put and 1 out-of-the-money Put + Selling 2 at-the-
money Puts
All these options must have same underlying stock and expiration dates. The strike price differs
for these three puts (1 for ATM, 1 for OTM and 1 for ITM).
Margins: Yes
Market Outlook: Neutral. Investor thinks that the underlying stock will not rise or fall much by
expiration (i.e. when the investor is bearish on volatility.
Profit: The maximum gain for the long put butterfly is attained when the underlying stock price
remains unchanged at expiration. At this price, only the highest striking put expires in the
money.
The maximum profit for this trade is limited to the strike price of (ATM - ITM) - Net premium
paid for the spread.
There are 2 break-even points for the long put butterfly position. The breakeven points can be
calculated using the following formulae.
Upper Breakeven Point = Strike Price of Highest Strike Long Put - Net Premium Paid
Lower Breakeven Point = Strike Price of Lowest Strike Long Put + Net Premium Paid
Loss: The maximum loss is = Net Premium Paid + Commissions Paid
Volatility: The option value will decrease as volatility decreases which is generally good for the
strategy. Alternatively an increase in volatility will be generally bad for the strategy.
Time Decay: As each day passes the value of the option erodes (good). Most of the decay will
occur in the final month before expiry.

Example: Suppose ABC stock is trading at Rs. 400 in June. An options trader executes a long
put butterfly by selling a JUL 300 put (it means put option has the strike price of Rs. 300 and
will expire in the last week of July) for Rs. 1,000 (option premium), writing 2 July 400 puts for
Rs. 2,000 and a JUL 500 call for Rs. 5,000. The net debt taken to enter the trade is Rs. 4,000,
which is also his maximum possible profit (because the trader is selling these options and getting
premium).

If ABC stock is still trading at Rs. 400 on expiration in July, the JUL 400 and JUL 300 put will
expire worthless (because market price is more than the strike price) but the JUL 500 pull has
intrinsic value of Rs. 5000:
Intrinsic value of put = (Strike price - Market price) * No. of underlying stocks
= (Rs. 500- Rs. 400)* 100 = Rs. 10,000

Subtracting the initial credit of Rs. 4,000, the options trader's profit comes to Rs. 10,000-4,000 =
Rs. 6,000 (because trader is selling stocks at a higher rate than the market price).

Maximum loss results when the stock is trading below Rs. 300 or above Rs. 500. At Rs. 500, all
the options expire worthless. Below Rs. 300, any "profit" from the two long puts will be
neutralized by the "loss" from the two short puts. In both situations, the long put butterfly trader
suffers maximum loss which is equal to the initial debit taken to enter the trade.

Event Driven
Event driven strategies in options trading are employed when the options trader is expecting
some events which will influence the prices of underlying asset. In general, they benefit from the
volatility in the price of stocks.

Long Straddle
How to design: Buy 1 ATM Call and Buy 1 ATM Put simultaneously at the same underlying
stock, striking price and expiration date.
Market Outlook: An investor may take a long straddle position if he thinks the market is highly
volatile, but does not know in which direction it is going to move. If volatility increase, both
bought options will increase in value.
Profit: The maximum profit for this trade is unlimited on the upside and limited on the downside
to the strike price, as the share can’t fall below zero.
Loss: The maximum loss for this trade is the premium paid to buy both options.
Volatility: The option value will increase as volatility increases which is good for both options.
Alternatively a decrease in volatility will be bad for both options.
Time Decay: As each day passes the value of the option erodes (bad).
Example: Suppose ABC stock is trading at Rs. 400 in June. An options trader executes a long
straddle by buying a JUL 400 put (it means put option has the strike price of Rs. 400 and will
expire in the last week of July) for Rs. 2,000 (option premium) and buying a JUL 400 call for Rs.
2,000. The net debt taken to enter the trade is Rs. 4,000, which is also his maximum possible loss
(because the trader is investing money to buy these options from the seller).

If ABC stock is still trading at Rs. 500 on expiration in July, the JUL 400 put will expire
worthless but JUL 400 call expires in the money (because market price is more than the strike
price which is good for buyer of a call option).
Intrinsic value of call= (Market price - Strike price) * No. of underlying stocks
= (Rs. 500- Rs. 400)* 100 = Rs. 10,000

Subtracting the initial credit of Rs. 4,000, the options trader's profit comes to Rs. 10,000-4,000 =
Rs. 6,000 (because trader is buying stocks at a lower rate than the market price).

On expiration in July, if ABC stock is still trading at Rs. 400, both the JUL 400 put and the JUL
400 call expires worthless and the long straddle trader suffers a maximum loss which is equal to
the initial debit of Rs. 4,000

Long Strangle
How to design: Buy 1 OTM Call and Buy 1 OTM Put of different strike price but the same
underlying stock and expiration date.
Market Outlook: The owner of a long strangle makes a profit if the underlying price moves far
enough way from the current price, either above or below. Thus, an investor may take a long
strangle position if he thinks the underlying security is highly volatile, but does not know which
direction it is going to move.
Profit: The maximum profit for this trade is unlimited on the upside and limited on the downside
to the strike price A, as the shares can’t fall below zero. A large gain for the long strangle option
strategy is possible when the underlying stock price makes a very strong move either upwards or
downwards at expiration.
Loss: The maximum loss for this trade is the premium paid to buy both options.
Volatility: The option value will increase as volatility increases which is good for both options.
Alternatively a decrease in volatility will be bad for both options.
Time Decay: As each day passes the value of the option erodes (bad).

Example: Suppose ABC stock is trading at Rs. 400 in June. An options trader executes a long
strangle by buying a JUL 350 put (it means put option has the strike price of Rs. 350 and will
expire in the last week of July) for Rs. 1,000 (option premium) and buying a JUL 450 call for Rs.
1,000. The net debt taken to enter the trade is Rs. 2,000, which is also his maximum possible loss
(because the trader is investing money to buy these options from the seller).

If ABC stock goes up and trades at Rs. 500 on expiration in July, the JUL 350 put will expire
worthless but JUL 450 call expires in-the-money (because market price is more than the strike
price which is good for buyer of a call option).
Intrinsic value of call= (Market price - Strike price) * No. of underlying stocks
= (Rs. 500- Rs. 450)* 100 = Rs. 5,000
Subtracting the initial credit of Rs. 2,000, the options trader's profit comes to Rs. 5,000-2,000 =
Rs. 3,000 (because trader is buying stocks at a lower rate than the market price).

On expiration in July, if ABC stock is still trading at Rs. 400, both the JUL 350 put and the JUL
450 call expires worthless and the long strangle trader suffers a maximum loss which is equal to
the initial debit of Rs. 2,000

Conclusion
There is around hundreds of different options strategies. However, my idea was to cover only
selected few simple options to educate you. The rest of options strategies are based on a
combination of these options. The successful use of options requires a willingness to learn what
they are, how they work, and what risks are associated with particular options strategies.
Individuals seeking expanded investment opportunities in today’s markets will find options
trading challenging, often fast moving, and potentially rewarding.