Options – 1

Think of options as the right to buy (call) or sell (put) a specified lot size of an underlying asset at a specific price (strike price), on or before an expiration date. -- They are called options as they offer choices as the price of the underlying changes.   -- Underlying assets can be stocks, ETFs, indexes, currencies, etc. We only talk stocks for now. -- Strike (or exercise) prices are trigger points, set by the exchange where the stock trades. (X) -- Expiration dates are set by the exchanges too, and are when the option dies. Choice of expirations vary widely. In some, both shorter (weekly) and longer exist. -- The lot size in US exchanges is typically set at a 100 shares will adjust if splits occur before expiration). In India, the lot size varies as a function of the stock price.  

What are your choices? If you originally did buy (sell) the option, you can later close the trade if you sell (buy) it and book profit or loss. Can hold onto the option until expiration. If call purchased, you can exercise the option and buy shares (if European), or anytime before expiration (if American). There are also Asian options (profits depend on the path taken, nor just at end) and Bermudan options (exercise on preset date rather than anytime like the American). Not in India though, d) Did I mention chooser options?

India specifics Futures and options segment has about 175 optionable stocks. For stocks, expirations are typically near-month, middle-month and a far-month. More (quarterly) expirations exist for index options. Strikes prices seem to be 5-10 each ITM and OTM, and one ATM. Why limit them? Lot sizes vary with the stock price, from 25 for Bosch (P = 22484) to 45000 for GMR (price = 14). Nifty is 75, Nifty mid-cap is 200. This is an attempt to “fix” the size of the bet. Expiration day is the last Thursday of the expiration month. Settlement is T+1. Margins are messy, there is a premium margin, a SPAN margin, a settlement margin, an assignment margin, depending on the type of transaction.

An example (Jan 25, 2019) HUL FEB-2019 expiration, Stock Price = 1755. (lot size 600) Strike Call Price Put Price 1740 59.75 31.25 1760 48.00 40.20 1780 38.75 50.45 For the 1760 strike call, you would pay 48 for the right to purchase one share on expiration (European).

Examine the call option. Lower strike calls are more expensive- right to buy lower. Likewise, longer expiration options are more expensive- more time. Suppose the 1740 call is priced at 10. There is an arbitrage, you buy call and exercise immediately (cost 1750), and sell the stock at 1755. So the min. price must be 15. With the stock at 1755, the 1740 (and lower strike) calls are said to be in-the-money, i.e there is a positive cash flow (not necc profit) if exercised. A 1755 calls would be at-the-money. The 1760 is near it! The 1780 calls (and higher strikes) are out-of-the-money. Notion of moneyness relates directly to the option’s value. For the 1740 call, 15 of the is intrinsic value, the remaining is time value. For the other two call options, all the premium is time value.

EXPIRATION DAY GRAPH (CALL) WRITE CALL Stock Price strike B/E BUY CALL Hockey stick shape only at expiration, non-linear otherwise. Exp pay to call holder is max (S(T) – X. X = strike, S = stock, T = exp.

Moneyness and delta. Options at different strikes respond differently to stock price moves. Think first derivative, dC/dS. A LOW LOW strike call is pretty much like owning the stock. A one point move in the stock moves the option by 1 point. Delta = 1. An at the money call typically has a delta around 0.5. The price of an out-of-the-money call will barely budge if the stock moves around at prices way below it. Delta close to zero. (tie to delta hedging). Puts have deltas of -1 to 0 (different direction) Call delta = 1 – Put delta.

BUYING AND WRITING CALLS-1 Buy calls on the expectation of upward price movement. Sell calls to collect premium on expectation of no upward price movement. Own stock and sell calls: Covered Calls. Popular strategy to generate revenue when a stock you own is not moving. Or to protect against downturn. Graphically, a covered call looks like a Written Put !!!

Buying and selling calls-2 SHORT STOCK AND BUY CALLS  The call purchase is like insurance, acts as a hedge against potential losses on a short position (if the stock price rises). In that case, gains on the call offset the loss on the short. Graphically, looks like a purchased put option. In many such combination strategies, the temptation to initiate or exit from the two trades at different times rather than simultaneously is often very strong. (fire-hydrant risk?)

EXAMINE THE PUT OPTIONS S = 860, the 850 put at 4.95, the 860 put costs 8.65, dies today. Lower strike puts cost less, the right to sell at 850 should be cheaper than the right to sell at 860. Can be a bet on the downside (connect to short-sales). Think in terms of a deductible on an insurance policy. The lower strike put is like a higher deductible. If you own the stock, more comes out of your pocket (loss of value till 850,which you bear), before the insurance kicks in.

CONNECT WITH SHORT SELLING   Buying puts limits downside loss- if stock price appreciates, the max you can lose is the premium. The max you gain is the strike price. With short selling, downside is unlimited (as stock goes up), but gains come earlier (no premium). Exp Payoff to put holder is max [ X-S(T) ]

Protective Puts OWN STOCK AND BUY A PUT   Stock appreciates, put expires worthless, lose cost of the put.  Stock declines, put profits to offset the decline in the stock (like an insurance policy, hence the use of the word “premium”). Graphically, a protective put looks like a purchased call. Q: CHOOSE STRIKE PRICE FOR THE PROTECTIVE PUT ? In the above example, the profits from the put purchase accrue to you only after the stock falls below strike. The loss in value from the current price until the strike price is borne by you (in the sense that the put does not protect you from that loss). This is the deductible feature. If you select a lower strike put, then losses in stock value until that strike are borne by you (higher deductible) and after that the puts pays you back.

WHY BUY PUTS Buying puts is like buying insurance to protect against losses on a position you own. As with homes/cars/life/stocks, we have an “insurable” interest -- when underlying asset falls in value, the put seller helps to makes you (or beneficiaries) whole.   By picking the level of insurance coverage (and the deductible) you choose the amount of protection you desire. This is essentially like choosing a strike price at which the put option can be exercised. Buying puts without owning the underlying asset is like buying insurance on someone’s house (or life?). It is then a bet that the underlying asset will fall in value at which time you can buy it cheap (own it later) and exercise to receive strike value. Or you can trade the puts directly without exercise, profiting from increases in its underlying value as the value of the underlying asset drops. Going away from stocks, the CDS market, was an unregulated environment where default risk (death) of individual companies/mortgage pools/countries was traded in this manner.

WHO SELLS PUTS-1 Insurance companies. The bet is that they will take in more as premiums than they have to pay out if assets lose their value. Regulations require them to set aside enough capital to ensure that such payments can actually be made if necessary. Concerns that they will not be able is a kind of counterparty risk. This is what happened to many insurance firms during GFC. These capital requirements can be just a good faith deposit for a portion of it (collateral). For some “special” insurers, deals can be cut. With the Dow at 13000 in Fall 2007, Berkshire Hathaway sold 20 year puts on broad indexes (without collateral) and closed out most of it last year (I think). Alternatively, these firms can “reinsure” against risks of catastrophes. This is Berkshire’s core business.  

WHO SELLS PUTS-2 Since stocks seem to trend upwards, selling puts to generate income during bull markets is appealing- you keep the premium. Often done with index options. Beware! Collateral! Margin! For years, Microsoft had a strategy of writing puts around the time of a stock buyback. Why? The buyback keeps the stock from falling and MSFT uses the premium received to fund a portion of the buyback! Think in terms of exercise. The put writer who is assigned has to purchase stock at the strike price from the put buyer. Exercise is likely as the stock drops below strike price. Of course the value of the put is increasing too, and the put writer would lose money if he/she has to close out the position at this time (by buying back the put at higher prices than where they had sold it).   A version of this can be used in falling markets where you don’t know how low the price will settle. Here the intent is to actually hope the option is exercised, so you get to buy the stock (from the put buyer) at the strike price (which is what you wanted in the first place).

MOTIVATING STRATEGIES Q: GET MORE CREATIVE. ARRANGE FINANCING?   Also write a call in addition to the protective put. Effectively, the put protects you against declines in the stock price, while the written call implies that you surrender some of the upside potential !(COLLAR) Q: WHAT IF YOU COULD DO THIS AT ZERO-COST? I.E Pick strike prices on the call and the put so that the price paid for the purchased put is equal to (or close to) the price received from the written call ! Who would do this? Think Bill Gates or Michael Dell. Q. Go one better ? Now that the stock value is locked up within a tight range, why not borrow against it !!(prepaid forward).