Category: Your Money

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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What can Modi do?

The following are excerpts from a recent JP Morgan special report titled “India: elections, markets & the tyranny of economic reality.”

The equity market exuberance, however, appears based on opinion polls increasingly pointing to a stable government post election, and the presumption of a dramatic economic pivot post election that jump starts a new capex cycle.

EM India Flow

The broad hope is that a positive cycle can be unleashed if projects get unclogged, increasing cash flow for infra companies (which account for 30% of stressed loans), enabling loan repayments, and healing bank balance sheets, which can allow a fresh lending cycle to start.

India stalled projects

But the problem is that the vast majority of projects are currently stuck because of issues that are under the purview of state governments, over which the central government has little jurisdiction.

India stalled projects reasons

And even if these problems were magically resolved, where is the money going to come from? Among the BSE-200 non-financials, 17% have operating incomes (before depreciation, interest and taxes) that are less than the perilous threshold of 1.5 times their debt service obligations. So a significant deleveraging would need to be undertaken before these infrastructure companies have the balance sheet strength to finance another investment cycle. This is a multi-quarter process.

India debt to equity

Banks are not in a position to lend. Public sector banks – which account for 70% of banking sector assets – are saddled with the overwhelming majority of impaired loans, and would need a significant quantum of capital injection by the government – far in excess of what has been budgeted – to finance any large pick-up in credit growth.

India bad loans

Given the economic reality on the ground, the translation from political stability to economic performance is likely to be far more lagged, incomplete and uncertain than the current market euphoria may be betraying.

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Forensics: NIFTY Options – Implied Volatility(IV)

Implied volatility(IV) is a measure of the market’s expectations for the underlying’s performance during the life span of the option.

The IV of an option is actually backed out of the price of the option. All the inputs of an options pricing model are known (time to expiration, strike, price, interest rates) except for the volatility that the option is pricing in. So that value can be backed out and allows you to understand the relative value of the option’s price.

This Khan Academy video does a good job of explaining what IV is:


 

  • When IV is high, options will be more expensive to purchase. And low IV will translate to more affordable option prices.
  • Heightened implied volatility correlates with bearish sentiment, while low IV suggests a bullish mood.
  • If you purchase an option with high IV, you need a much bigger move out of the underlying stock to profit from the trade.
  • IV will rise ahead of scheduled events, such as earnings reports and new product launches. Once the anticipated event occurs, IV will immediately drop.

IV in Action: March 2014 NIFTY Options Since Jan

First, lets look at the underlying:

NIFTY

To capture the full move of the NIFTY, you’ll have to look at, at least, a dozen strikes between 5950 and 6900.

IV of calls:
March 2014 NIFTY IV (CE)
IV of puts:
March 2014 NIFTY IV (PE)
 

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Forensics: NIFTY Options – Vega(κ)

Vega(κ) is the sensitivity of an option’s value to underlying volatility(σ). σ is one of the main drivers of change in an option’s value and so κ allows you to quantify this particular risk.

For example, a κ of 1178.50 when the model price is Rs.188.92 and σ is 0.185 implies that if σ rises by 1% to 0.195, then the price will increase to Rs.188.92 + 1178.50/100 = Rs.200.705

  • κ increases as volatility increases
  • κ for a long term option is higher than the κ for a shorter term option with the same strike
  • an at-the-money option will have a greater κ than either an in-the-money option or an out-of-the-money option
  • κ is the same value for calls and puts

Vega in action: March 2014 NIFTY Options since Jan

First, lets look at the underlying:

NIFTY

To capture the full move of the NIFTY, you’ll have to look at, at least, a dozen strikes between 5950 and 6900.

κ:

March 2014 NIFTY Vega

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Forensics: NIFTY Options – Gamma(γ)

The option’s gamma(γ) is a measure of the rate of change of its delta(δ). δ is dynamic: it changes not only as the underlying stock moves, but as expiration approaches. γ is the Greek that determines the amount of that movement.

  • γ is the amount a theoretical δ will change for a corresponding one-point change in the price of the underlying.
  • γ will be a number anywhere from 0 to 1.00 and is positive when buying options and negative when selling them.
  • Deep-in-the-money or far-out-of-the-money options have lower γ than at-the-money options.
  • As implied volatility decreases, γ of at-the-money calls and puts increases.
  • When implied volatility goes higher, the γ of both in-the-money and out-of-the-money calls and puts will be decreasing.
  • As the time to expiration draws nearer, the γ of at-the-money options increases while the γ of in-the-money and out-of-the-money options decreases.

Gamma in Action: March 2014 NIFTY Options Since Jan

First, lets look at the underlying:

NIFTY

To capture the full move of the NIFTY, you’ll have to look at, at least, a dozen strikes between 5950 and 6900.

γ:

March 2014 NIFTY Gamma

Note that the γ value is the same for calls as for puts. Some intuitions:

  1. The δ tells us how many underlying contracts we are long/short.
  2. The γ tells us how fast our “effective” underlying position will change.
  3. So γ shows how volatile an option is relative to movements in the underlying asset.
  4. γ will let you know how large your δ (position risk) changes.

Source:
Option Gamma
Gamma
 

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