Author: shyam

Long Call Spread

Introduction

Suppose you are moderately bullish about a stock/index and you feel that it has room to run but its not going to be gangbusters. Then you could buy a call outright but that could be expensive. What you could do is buy the call and then sell a call at a higher strike to mitigate the cost of your (moderately) bullish outlook.

A long call spread (or a bull spread) contains two calls with the same expiration but different strikes. The strike of the short call is higher than the strike of the long call. The short call’s main purpose is to help pay for the long call’s upfront cost.

Example

long call spread

The Max loss is the net premium paid: Rs.1825.00
For the trade to break even, the NIFTY should end above 6786.50 at expiration (April 24).
The Max profit at expiration is Rs.3175.00

The greeks

The long call is more sensitive to changes in the underlying than the short call due to its ATM-ness.
All the greeks, δ, θ, κ, and λ are higher for the long call than for the short call.
The long-call will lose money faster to time decay than the short call.

By freezing all other inputs, you can observe θs across different strikes of the bull spread at different values of the NIFTY as expiry approaches:

Bull Spread Theta

Time decay is helpful to this position when it is profitable and harmful when it is loss-making.

Similarly, observe how δs of the bull spread at different values of the NIFTY as expiry approaches:

Bull Spread Delta

Exiting the trade

If the trade is profitable, allow time-decay to work for you. You could even hold this to expiration. If the position is moving against you, it is best to cut your losses.

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Introducing The Facebook National Bank

We had pointed out back in February as to how startups are disintermediating banking and that given the amount of data that both banks and Facebook have on us, it is only a matter of time that we saw a “Facebook National Bank.” Turns out that it is now a reality:

Facebook is readying itself to provide financial services in the form of remittances and electronic money. The social network is only weeks away from obtaining regulatory approval in Ireland for a service that would allow its users to store money on Facebook and use it to pay and exchange money with others. “Facebook wants to become a utility in the developing world, and remittances are a gateway drug to financial inclusion.”

Source: Facebook targets financial services

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Trading Options, Know your Greeks

The first rule of trading options is that options are not stocks. Just because the underlying stock moves doesn’t mean that the option moves in the same direction. You need to think of options as a separate asset class.

For example, if you are in a ship at sea, you know that the tides are linked to the phases of the moon. But the tides are only a small part of what is involved in sailing, isn’t it? You should also know about ocean currents, developing weather patterns, presence of icebergs, reefs, etc… Similarly, the option premium is only lightly tethered to the value of the underlying.

The key thing to remember is that the option premium is a function of intrinsic value, time value and volatility.

Lets say you buy a April NIFTY 6750 Call @ Rs. 59.70 when the NIFTY was trading at 6733.10. Say, the NIFTY rallies by 1% to 6800.431 the next minute. Would your call option also increase by 1%? Nope. It will probably tick up by 0.5% Why? because the delta(δ) of that option is 0.49

Read: Forensics: NIFTY Options – Delta(δ)

But what if the NIFTY rallies tomorrow by 2%. Will your call option premium now increase by 1%? Nope. There are two opposing forces that are now acting on the option.

The first, and the strongest force, is time decay. It is known to crush the best laid plans of both men and mice.

Read: Forensics: NIFTY Options – Theta(θ) Decay

The second, is volatility. As a buyer of an option, you want volatility to go up, and NIFTY rallying by 2% in a day is just that.

Read: Forensics: NIFTY Options – Vega(κ)

It is not only important to mind your greeks at the time of putting on the trade, but you need to monitor it constantly. Greeks change not only as the underlying moves, but also as expiration approaches.

Read: Forensics: NIFTY Options – Gamma(γ)

Remember your Greeks:

Vega(κ) Theta(θ) Delta(δ) Gamma(γ)
Measures the impact of change in volatility (σ) Measures the impact of change in time remaining Measures the impact of change in underlying price Measures the rate of change of delta(δ)
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Study reveals why economists suck at making predictions

The ability of forecasters to predict turning points is limited. Forecasts from the official sector, either from national sources or international agencies, are no better at predicting turning points.

So the explanation for why recessions are not forecasted ahead of time lies in three other classes of theories, which are not mutually exclusive.

  • One class says that forecasters do not have enough information to reliably call a recession. Economic models are not reliable enough to predict recessions, or recessions occur because of shocks (e.g. political crises) that are difficult to anticipate.
  • A second class of theories says that forecasters do not have the incentive to predict a recession, which – though not a tail – event are still relatively rare. Included in this class are explanations that rely on asymmetric loss functions: there may be greater loss – reputational and other kinds – for incorrectly calling a recession than benefits from correctly calling one.
  • The third class stresses behavioural reasons for why forecasters hold on to their priors and only revise them slowly and insufficiently in response to incoming information.

A more than a healthy dose of skepticism is always warranted when dealing with these so called “expert forecasts.”

Source: “There will be growth in the spring”: How well do economists predict turning points?

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Trading Options

A brief history

The first options were used in ancient Greece to speculate on the olive harvest. It was mid-winter, and the owner of the olive presses was happy to sell the right to use the olive presses during the harvest season. It generated income for the olive press owner during the off season.

The man purchasing the rights ensured that he would have use of the presses during the busy season. If the olive harvest was really good, the purchaser might be able to even resell his right to use the olive presses for a profit.

The stock options of today appear to have made their debut in what were described as “bucket shops”. It wasn’t until 1973 that the modern financial options market came into existence. The Chicago Board of Trade (CBOT) opened the Chicago Board Options Exchange (CBOE).

Option pricing

The option premium is a function of intrinsic value, time value and volatility.

Intrinsic value: The intrinsic value of an option is the difference between the actual price of the underlying security and the strike price of the option. The intrinsic value of an option reflects the effective financial advantage which would result from the immediate exercise of that option.

Time value: It is determined by the remaining lifespan of the option and the cost of refinancing the underlying asset (interest rates).

Volatility: Higher volatility implies higher premiums as the probability that the option will expire in-the-money increases with volatility.

Some heuristics used to come up with a price for an option:

  1. make sure put-call parity is respected
  2. a call of a certain strike K cannot trade at a lower price than a call K+ΔK (avoidance of negative call and put spreads)
  3. a call struck at K and a call struck at K+2ΔK cannot be more expensive than twice the price of a call struck at K+ΔK (negative butterflies)

There are theoretical option-pricing models, the most popular being Black-Scholes-Merton (BS), that can be used to price options. However, the primary use of BS in the real world is to trade the greeks.

This Khan Academy video does a good job of explaining the BS model:

Put-Call Parity

The put-call parity states that a portfolio of a long call option and a short put option is equivalent to (and hence has the same value as) a single forward contract at this strike price and expiry.

put call parity

The intuition behind this is: Call + Cash = Put + Underlying Asset

The put-call parity provides a simple test of option pricing models. Any pricing model that produces option prices which violate the put-call parity is considered flawed.

Options on StockViz

The BS Model greeks for “on the run” strikes (strikes closest to the underlying) are available for all listed options on StockViz. These values are updated on the fly using the latest market information.

NIFTY options screen

You can place (dummy) trades by clicking on the green button. This will allow you to track your options P&L over the life of the trade.

Source:
Option Traders Use (very) Sophisticated Heuristics, Never the Black–Scholes–Merton Formula
A Short History of Options
Put–call parity
Relationship between put and call

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