We recommend reading this chapter on Varsity to learn more and understand the concepts in-depth.

Key takeaways from this chapter

1. Short straddle requires you to Sell the ATM Call and Put option simultaneously. The options should belong to the same underlying, same strike, and same expiry
2. By selling the CE and PE – the trader is placing the bet that the market won’t move and would essentially stay in a range
3. The maximum profit is equal to the net premium paid, and it occurs at the strike at which the long straddle has been initiated
4. The upper breakdown is ‘strike + net premium’. The lower breakdown is ‘strike – net premium.’
5. The deltas in a short straddle add up to zero
6. The volatility should be relatively high at the time of strategy execution
7. The volatility should decrease during the holding period of the strategy
8. Short straddles can be set around significant events, wherein before the event, the volatility would drive the premiums up, and just after the announcement, the volatility would cool off, and so would the premiums.

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We recommend reading this chapter on Varsity to learn more and understand the concepts in-depth.

Key takeaways from this chapter

1. A moderate move would mean you expect a movement in the stock/index, but the outlook is not too aggressive
2. One has to quantify ‘moderate’ by evaluating the volatility of the  stock/index
3. Bull Call spread is a basic spread that you can set up when the outlook is moderately bullish
4. Classic bull call spread involves buying ATM option and selling OTM option – all belonging to same expiry, same underlying, and equal quantity
5. The theta plays an essential role in strike selection
6. The risk-reward gets skewed based on the strikes you choose

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We recommend reading this chapter on Varsity to learn more and understand the concepts in-depth.

There are no key takeaways in this chapter

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We recommend reading this chapter on Varsity to learn more and understand the concepts in-depth.

Key takeaways from this chapter

1. Neither option buying nor selling entails mark to market; M2M is only for futures
2. Margins charged for option selling is a function of both price movement and volatility
3. As volatility increases, so does the option premium
4. Option positions closed before expiry can be generalized to the Difference between buying and selling price of premium multiplied by lot size
5. The option positions held to expiry are physically settled

The post Options M2M and P&L calculation appeared first on Varsity by Zerodha.

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We recommend reading this chapter on Varsity to learn more and understand the concepts in-depth.

Key takeaways from this chapter

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We recommend reading this chapter on Varsity to learn more and understand the concepts in-depth.

Key takeaways from this chapter

1. Option sellers are always compensated for the time risk
2. Premium = Intrinsic Value + Time Value
3. All else equal, options lose money on a daily basis owing to Theta
4. Time moves in a single direction hence Theta is a positive number
5. Theta is a friendly Greek to option sellers
6. When you short naked options at the start of the series you can pocket a large time value but the fall in premium owing to time is low
7. When you short option close to expiry the premium is low (thanks to time value) but the fall in premium is rapid

The post Theta appeared first on Varsity by Zerodha.

We recommend reading this chapter on Varsity to learn more and understand the concepts in-depth.

Key takeaways from this chapter

1. Financial derivatives are called Financial derivatives because of their dependence on calculus and differential equations (generally called Derivatives)
2. Delta of an option is a variable and changes for every change in the underlying and premium
3. Gamma captures the rate of change of delta, it helps us get an answer to a question such as “What is the expected value of delta for a given change in underlying”
4. Delta is the 1st order derivative of premium
5. Gamma is the 2nd order derivative of premium
6. Gamma measures the rate of change of delta.
7. Gamma is always a positive number for both Calls and Puts.
8. Large Gamma can translate to large gamma risk (directional risk)

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We recommend reading this chapter on Varsity to learn more and understand the concepts in-depth.

Key takeaways from this chapter

1. Option Greeks are forces that influence the premium of an option
2. Delta is an Option Greek that captures the effect of the direction of the market
3. Call option delta varies between 0 and 1; some traders prefer to use 0 to 100.
4. Put option delta varies between -1 and 0 (-100 to 0)
5. The negative delta value for a Put Option indicates that the option premium and underlying value move in the opposite direction
6. ATM options have a delta of 0.5
7. ITM option has a delta of close to 1
8. OTM options have a delta of close to 0.

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We recommend reading this chapter on Varsity to learn more and understand the concepts in-depth.

Key takeaways from this chapter

1. The intrinsic value is equivalent to the value of money the option buyer makes provided if he were to exercise the contract.
2. The intrinsic value cannot be negative; it is a non zero positive value.
3. The intrinsic value of call option = Spot Price – Strike Price
4. The intrinsic value of the put option = Strike Price – Spot Price.
5. Any option with an intrinsic value is classified as an ‘In the Money’ (ITM) option.
6. Any option that does not have an intrinsic value is classified as an ‘Out of the Money (OTM) option.
7. If the strike price is almost equal to the spot price, the option is considered the ‘At the money (ATM) option.
8. All strikes lower than ATM are ITM options (for call options)
9. All strikes higher than ATM are OTM options (for call options)
10. All strikes higher than ATM are ITM options (for Put options)
11. All strikes lower than ATM are OTM options (for Put options)
12. When the intrinsic value is very high, it is called the ‘Deep ITM’ option.
13. Likewise, it is called the ‘Deep OTM’ option when the intrinsic value is the least.
14. The premiums for ITM options are always higher than the premiums for OTM options.
15. The Option chain is a quick visualisation to understand which option strike is ITM, OTM, ATM (for both calls and puts), and other information relevant to options.

The post Moneyness of option appeared first on Varsity by Zerodha.

We recommend reading this chapter on Varsity to learn more and understand the concepts in-depth.

Key takeaways from this chapter

1. Buy a call option or sell a put option only when you expect the market to go up.
2. Buy a put option or sell a call option only when you expect the market to go down
3. The buyer of an option has unlimited profit potential and limited risk (to the extent of the premium paid)
4. The seller of an option has an unlimited risk potential and limited reward (to the extent of the premium received)
5. Majority of options traders prefer to trade options only to capture the variation in premiums
6. Option premiums tend to gyrate drastically – as an options trader, and you can expect this to happen quite frequently.
7. Premiums vary as a function of 4 forces called the Option Greeks
8. Black & Sholes option pricing formula employs four forces as inputs to give out a price for the premium
9. Markets control the Option Greeks and the Greek’s variation itself

The post Summarizing Call & Put Options appeared first on Varsity by Zerodha.

We recommend reading this chapter on Varsity to learn more and understand the concepts in-depth.

Key takeaways from this chapter

1. Buy a Put Option when you are bearish about the underlying prospects. In other words, a Put option buyer is profitable only when the underlying declines in value.
2. The intrinsic value calculation of a Put option is slightly different from the intrinsic value calculation of a call option.
3. IV (Put Option) = Strike Price – Spot Price
4. The P&L of a Put Option buyer can be calculated as P&L = [Max (0, Strike Price – Spot Price)] – Premium Paid
5. The breakeven point for the put option buyer is calculated as Strike – Premium Paid

The post Put Buy and Put Sell appeared first on Varsity by Zerodha.

We recommend reading this chapter on Varsity to learn more and understand the concepts in-depth.

Key takeaways from this chapter

1. It makes sense to be a buyer of a call option when you expect the underlying price to increase.
2. If the underlying price remains flat or goes down, then the call option buyer loses money.
3. The money the buyer of the call option would lose is equivalent to the premium (agreement fees) the buyer pays to the seller/writer of the call option.
4. The intrinsic value (IV) of a call option is a non-negative number
5. IV = Max[0, (spot price – strike price)]
6. The maximum loss the buyer of a call option experiences is to the extent of the premium paid. The loss is experienced as long as the spot price is below the strike price.
7. The call option buyer has the potential to make unlimited profits, provided the spot price moves higher than the strike price.
8. Though the call option is supposed to make a profit when the spot price moves above the strike price, the call option buyer first needs to recover the premium he has paid.
9. The point at which the call option buyer completely recovers the premium he has paid is called the breakeven point.
10. The call option buyer truly starts making a profit only beyond the breakeven point (which naturally is above the strike price)

The post Long Call Payoff and Short Call Trade appeared first on Varsity by Zerodha.

We recommend reading this chapter on Varsity to learn more and understand the concepts in-depth.

Key takeaways from this chapter

1. It makes sense to buy a call option only when one anticipates an increase in the price of an asset
2. The strike price is the anchor price at which both the option buyer and option writer enter into an agreement
3. The underlying price is simply the spot price of the asset
4. Exercising an option contract is the act of claiming your right to buy the options contract at the end of the expiry
5. Similar to futures contracts, options contracts also have an expiry. Options contracts expire on the last Thursday of every month
6. Options contracts have different expiries – the current month, mid-month, and far month contracts
7. Premiums are not fixed, in fact, they vary based on several factors that act upon it
8. Options are cash-settled in India.

The post Option Jargons appeared first on Varsity by Zerodha.

We recommend reading this chapter on Varsity to learn more and understand the concepts in-depth.

Key takeaways from this chapter

1. Options are traded in the Indian markets for over 15 years, but the real liquidity was available only since 2006
2. An Option is a tool for protecting your position and reducing risk
3. A buyer of the call option has the right, and the seller must make delivery
4. The Optionhttps://zerodha.com/varsity/chapter/call-option-basics/ is only given to one party in the transaction (the buyer of a vote)
5. The option seller is also called the option writer
6. At the time of the agreement, the option buyer pays a certain amount to the option seller; this is called the ‘Premium’ amount
7. The deal happens at a pre-specified price, often called the ‘Strike Price.’
8. The option buyer benefits only if the asset’s cost increases higher than the strike price.
9. If the asset price stays at or below the strike, the buyer does not benefit; for this reason, it always makes sense to buy options when you expect the price to increase.
10. Statistically, the option seller has a higher odds of winning in a typical option contract.
11. The directional view must pan out before the expiry date; otherwise, the Option will expire worthlessly.

The post Introduction to Options appeared first on Varsity by Zerodha.

After many years, I’m updating this module with a new chapter, and it still feels as if I wrote this module on options just yesterday.

Thousands of queries have poured in for this module, and one question that has come up repeatedly is – ‘I’ve sold (written) an option, and after which, the option premium has gone up. What is my loss?’

The question comes up because people expect options to have a mark to market (M2M) for options just like the futures contract.

In this chapter, I’ll try and explain why that’s not the case.

Let’s shift focus back to Futures for a moment.

If I decide to trade Reliance Futures, I need to ensure I have the required margins in my account. As of today, the margin for Reliance is Rs.1,40,133.

The lot size is 250 shares, and the contract value is –

250 * 2504.7

= Rs.6,26,175.

The margin is similar even if I want to short Reliance futures.

Margin blocked has two components, i.e. the SPAN and Exposure. If you wish to know the rough breakup, you can always visit Zerodha’s margin calculator to figure the split between SPAN and Exposure.

Now that apart, I want you to think about why futures trading attracts margins. To understand, you need to think about the core premise of a futures contract. Rather,  the core premise of a forwards contract. Remember, futures are essentially an improvisation over a forwards contract.

The underlying premise in the futures contract is that buyers and sellers agree to get into a contract TODAY at a pre-decided price and quantity. The actual exchange of goods (stocks) happens at a date set in the future.

For example, suppose I press that buy button and buy Reliance Futures today, then it implies I get the delivery of Reliance shares from the Reliance futures seller on contract expiry in December. Of course, assuming I hold the contract till expiry.

Now, for a moment, assume on the contract expiry day, instead of taking delivery of Reliance, I walk away from my obligation. What happens next?

Walking away from the obligation implies that the person who sold the futures to me, i.e. my counterparty, is left with an open-ended contract. The purpose of a futures contract is lost, and the exchanges cannot afford to let this happen.

The exchange overcomes the default or the counterparty risk by charging a margin and running a P&L mark to market (M2M).

25.2 – Margin and M2M

The structure of a futures contract is such that there is no counterparty/default risk. Of course, there is a price risk, but that’s another thing altogether. Exchanges prevent default in two ways – they block a margin when buyers and sellers enter a futures trade, and the exchange also runs a daily mark to market process.

Margins ensure there is skin in the game, and the mark to market process ensures that daily profits and losses are credited and debited to the relevant parties.

I’ve explained the technicalities of margins and mark to market in the futures module. At this stage, please keep this thought of margins and mark to market and shift gears back to options.

25.3 – Options buyer

Place yourself in the shoes of the buyer of an option. To buy options, you pay a premium. Premium times the lot size times the number of lots is the total cash required to purchase an option.

For example, if I want to buy one lot of Reliance 2500 Call option –

The call option is trading at 76, lot size is 250, therefore –

1 *250*76

=Rs.19,000/-

As long as I have 19K in my account, I can buy the RIL 2500 CE. In a sense, this is a cash and carry deal, which makes two things very clear –

• • The amount required to buy an option and get into an options agreement – 19K in this case
  • The maximum risk for the buyer – again 19K

Unlike buying futures, the risk is not open-ended when you buy an option regardless of call or put. The risk is predetermined, and since it’s a cash and carry deal, there is no question of default.

Given that the risk of default is zero for an option buyer, do you think it makes sense to block margins for an option buyer? It does not make sense in doing so for obvious reasons.

But is there a need to mark to market the daily profits and losses to the option buyer? We will answer that in a bit.

Shift gears and think about the option seller.

For an option seller, we know the risk is significantly higher compared to an option buyer, and it is similar to a futures trader’s risk.

The risk of option selling is open-ended, and that introduces the risk of default as well.

Since the risk profile of an option seller is similar to the futures seller, the exchange levies a margin (SPAN + Exposure) to option sellers to counter the default risk.

For example, if I were to sell the RIL 2500 CE, the margin I need to bring to the table is Rs.1,36,530/-.

However, unlike in the futures contract, there is no mark to market in options. Think about it – in a futures trade, both the buyer and the seller have to put in a margin to enter the trade. But in options, only the seller puts in a margin. The buyer pays the premium in full.

If there was a mark to market in options, it implies that the notional profits or losses should be credited or debited to the option buyer. However, the option buyer has not placed any margins on the exchange.

Hence there is no concept of mark to market (M2M) in options.

The fact that there is no mark to market triggers another common question – how are profits and loss settled in options?

25.4 – Options P&L for the buyer

Option P&L is pretty straightforward, and the lack of mark to market makes it easier to understand compared to understanding the future’s P&L.

The complication in understanding the options P&L stems from the multiple market scenarios for the position you have. Here is what I mean by that –

A trader can go long on a call option or short on the call, post which the trader can decide to hold the position up until the expiry or close the position before expiry. The P&L in each case varies.

The same goes with the put option –

As an options trader, you need to get comfortable with P&L calculation in each of these cases.

But the good thing is that we can generalize the P&L for both long and short trades for instances where the trader closes the position before expiry.

For trades held to expiry, physical settlement kicks in, making it slightly tricky to understand.

Call and Put option Long, close before the expiry

If the trader decides to close the position before expiry, we can generalize the P&L for a long option trader (both call and put).

P&L = [Difference between buying and selling price of premium] * Lot size * Number of lots.

For example, if I buy two lots of Reliance 2500 CE at 76 and decide to sell the same after a few hours at 79, then my P&L is –

= [ 79 – 76] * 250 * 2

= 3 * 250 * 2

= 1500

Of course, 1500 minus all the applicable charges.

The P&L calculation is the same for long put options, squared off before expiry.

Call and Put option short, close before the expiry

As you know, when a trader shorts an option (regardless of call or put), margins are blocked to the extent of SPAN + Exposure.

Margin charged is a function of premium price and the volatility of the underlying. Generally, margin increases if –

• • The price of the option (premium) moves against your position
  • Volatility increase

Both don’t need to happen; margins can increase even if one of them occurs.

For example, assume you wrote/sold the Reliance 2500 put option at 80; the lot size is 250. If you write the put option, volatility stays the same, but the premium increases to 130, i.e. an increase of 50 Rupees, then the margin also increases by approximately Rs.12,500 (50*250).

Or let us say after you write the option, volatility shoots up, and the price remains the same; then again, the margins increase. Having said that, as you know, when volatility rises, option premium increases; we have discussed that extensively in the volatility chapter.

Have a look at this again –

To short or write Reliance 2500 CE at 76 per lot, I need a margin of Rs.1,36,530. Now, after I write this option, imagine the price increases to 126, the margin for this option increases approximately  –

50 * 250

= 12,500.

Therefore, the new margin required is –

= 136530 +12500

= 149030

At, this point the broker will notify to bring in the additional margins (margin call) because the percentage margin utilization is –

Current margin / Margin at the time of writing the option

= 149030 / 136530

=109%

If you fail to bring in the additional margins, the broker can square off the short position because of the penalties imposed by the peak margin policy. Usually, the tolerance is about 120% margin utilization, beyond which the broker squares off the position immediately.

Anyway, continuing with our example, when the premium hits 126, and you no longer wish to hold the position (by adding additional margins to your account) and decide to square off.

The P&L is –

[Difference between the buy price and sell price of premium] * lot size * number of lots

= 50 * 250 * 1

=12,500

When you square off the position, margins are unblocked after adjusting for the profit or loss; settlement of P&L happens on a T+1 basis if you wish to withdraw the funds.

Now let’s shift focus to options trades held to expiry.

Call option, Long, held to expiry

In the money (ITM), options held to expiry get physically settled. If the option is OTM, then the buyer loses the premium paid, and the seller gets to retain the entire premium received at the time of writing the option.

We have discussed the physical settlement in detail in this chapter. However, for the sake of completeness, let’s quickly discuss only the P&L part.

Calculating the P&L if you hold a long call position to expiry is a little tricky since the stock options as physically settled.

Continuing with the above example, assume the settlement price of Reliance is 2650 upon expiry. The 2500 option is In the money (ITM); hence physically settled. Since it’s a call option, the option buyer has the right to buy Reliance at the strike price, i.e. 2500.  Premium paid is 76.

The effective price at which you get the shares is strike price + premium paid. In this case,

2500 + 76

= 2576

Assuming the stock price on Monday is 2650, the profit you’ll make here is –

2650 – 2576

= 74

As you know, the expiry of derivatives is on the last Thursday of the month; the delivery of shares happen on a T+2 basis. Hence the shares are delivered on the following Monday.

Call option short, held to expiry

The call option seller sells the 2500 CE at 76. Here the option seller has to give delivery of shares. The price at which the seller gives delivery is 2500, but since the seller receives a premium of 76, the effective price is –

2500 + 76

= 2576.

The stock is trading at 2650, but the seller sells the same at 2576. The loss for the option writer is –

2650 – 2576

= 74.

The shares will be debited from the seller’s Demat account and credited to the buyer’s Demat account.

Put option, Long, held to expiry

Let us change the example from Reliance to TCS, to break the monotony

Here are the trade details –

Underlying = TCS

Strike = 3520

Premium = 55

Option type = Put

Position = long

Settlement price = 3390

Since the settlement price is 3390, 3520 is an ‘In the Money’ (ITM) option, hence physically settled. The buyer of a put option has the right to sell the put option or give delivery of shares.

The put option buyer will give the delivery of shares at 3520, but since the put buyer has paid a premium, the effective price for delivery is –

Strike – Premium

= 3520 – 55

= 3465

The put seller gets to sell the stock at 3465 when the same stock is trading at 3390. The gain here is –

3465 – 3390

= 75.

Put option short, held to expiry

Continuing the same example, the put option seller has to take delivery of shares. The delivery price is the settlement price, i.e. 3390, but the seller has received the premium. Adjusting for that, the effective ‘take delivery’ price is –

Strike – premium

= 3520 – 55

= 3465

The put option seller has to take delivery of shares at an effective price of 3465 when the same underlying is available at 3390 in the market. Hence the loss here is 75.

Of course, physical settlement of options is net off if you have two opposite ITM positions. For example, if you have a spread position in which the ‘give delivery’ obligation arising out of one option offsets another option position, that has to take delivery obligation. I’d suggest you read this chapter to learn about position offsets.

Key takeaways from this chapter

• • Neither option buying nor selling entails mark to market; M2M is only for futures
  • Margins charged for option selling is a function of both price movement and volatility
  • As volatility increases, so does the option premium
  • Option positions closed before expiry can be generalized to the Difference between buying and selling price of premium multiplied by lot size
  • The option positions held to expiry are physically settled

The post Options M2M and P&L calculation appeared first on Varsity by Zerodha.