Financial Engineering & Risk Management

Unit –V
Types of Options- There are two types of options. One gives you the right to buy the asset and
the other gives you the right to sell it.

Call Option

The right to buy is called a Call Option or a call. A call option is "in the money" when the strike
price is below the underlying stock value. If you bought the option and sold the stock today,
you'd make money.

You buy call options when they believe the security will rise in value before the exercise date. If
that happens, you'll exercise the option. You'll buy the security at the strike price and then
immediately sell it at the higher market price. If you feel bullish, you might also wait to see if the
price goes even higher. Buyers of call options are called holders.

Your profit equals the security proceeds, minus the strike price, the premium for the call option,
and any transactional fees. That's called being in the money. The profit is called the option's
intrinsic value.

If the price doesn't rise above the strike price, you won't exercise the option. Your only loss is the
premium. That's true even if the stock plummets to zero.

Why wouldn't you just buy the security instead? Buying a call option gives you more leverage.

If the price rises, you can make a lot more money than if you bought the security instead. Even
better, you only lose a fixed amount if the price drops. As a result, you can gain a high return for
a low investment.

The other advantage is that you can sell the option itself if the price rises. You've made money
without ever having to pay for the security. 

You would sell a call option if you believe the asset price will drop. If it drops below the strike
price, you keep the premium. A seller of a call option is called the writer.

Put Option

With a Put Option, or simply a put, you purchase the right to sell your stock at the strike price
anytime until the expiration day. In other words, you have purchased the option to sell it. A put
option is "in the money" when the strike price is above the underlying stock value. So, if you
bought the option to sell, and bought the stock today, you'd make money because your purchase
price was lower than your sale price.
Uses of Options-
They have been a long time, but options are just now starting to get the attention
they deserve. Many investors have avoided options, believing them to be
sophisticated and, therefore, too difficult to understand. Many more have had bad
initial experiences with options because neither they nor their brokers were
properly trained in how to use them.

The use of option is done for the following reasons

 They may provide increased cost-efficiency

 They may be less risky than equities
 They have the potential to deliver higher percentage returns
 They offer a number of strategic alternatives

1. Cost-Efficiency

Options have great leveraging power. As such, an investor can obtain an option
position similar to a stock position, but at huge cost savings. For example, to
purchase 200 shares of an $80 stock, an investor must pay out $16,000. However,
if the investor were to purchase two $20 calls (with each contract representing 100
shares), the total outlay would be only $4,000 (2 contracts x 100 shares/contract x
$20 market price). The investor would then have an additional $12,000 to use at
his or her discretion.

2. Less Risk

There are situations in which buying options are riskier than owning equities, but
there are also times when options can be used to reduce risk. It really depends on
how you use them. Options can be less risky for investors because they require less
financial commitment than equities, and they can also be less risky due to their
relative imperviousness to the potentially catastrophic effects of gap openings.

Options are the most dependable form of hedge, and this also makes them safer
than stocks. When an investor purchases stocks, a stop-loss order is frequently
placed to protect the position. The stop order is designed to stop losses below a
predetermined price identified by the investor. The problem with these orders lies
in the nature of the order itself. A stop order is executed when the stock trades at or
below the limit as indicated in the order.

3. Higher Potential Returns

You don't need a calculator to figure out if you spend less money and make almost
the same profit, you'll have a higher percentage return. When they pay off, that's
what options typically offer to investors.

For example, using the scenario from above, we'll compare the percentage returns
of the stock (purchased for $50) and the option (purchased at $6). Let's say the
option has a delta of 80, meaning the option's price will change 80% of the stock's
price change. If the stock were to go up to $5, your stock position would provide a
10% return. Your option position would gain 80% of the stock movement (due to
its 80 delta), or $4. A $4 gain on a $6 investment amounts to a 67% return—much
better than the 10% return on the stock. Of course, when the trade doesn't go your
way, options can exact a heavy toll: there is the possibility you will lose 100% of
your investment.

4. More Strategic Alternatives

The final major advantage of options is they offer more investment alternatives.
Options are a very flexible tool. There are many ways to use options to recreate
other positions. We call these positions synthetics.

Synthetic positions present investors with multiple ways to attain the same
investment goals, which can be very useful. While synthetic positions are
considered an advanced option topic, options offer many other strategic
alternatives. For example, many investors use brokers who charge a margin when
an investor wants to short a stock. The cost of this margin requirement can be quite
prohibitive. Other investors use brokers who simply do not allow for the shorting
of stocks, period. The inability to play the downside when needed virtually
handcuffs investors and forces them into a black-and-white world while the market
trades in color. But no broker has any rule against investors purchasing puts to play
the downside, and this is a definite benefit of options trading.
Payoff through Options
Option payoff diagrams are profit and loss charts that show the risk/reward profile of an option
or combination of options. As option probability can be complex to understand, P&L graphs give
an instant view of the risk/reward for certain trading ideas you might have.

Here is an example;

Underlying: MSFT
Type: Call Option
Exercise Price: $25
Expiry Date: 25th May (30 days until expiration)

The market price of this call option $1.2. Buying the option means you pay this
price to the seller. As the option is a call option, exercising the option means you
will buy the shares at the exercise price of $25. You would only exercise if it is
profitable to do so. But the exercise price alone is not doesn't determine
probability.

You also need to consider that you paid something to have the right to exercise; the
option premium, in this case $1.20. Therefore, the shares have to be trading at
$26.20 for us to break even (Exercise Price of $25 plus the Option Premium of
$1.20). If the shares are trading anywhere above $26.20 then we can say the option
is profitable. Anywhere below $26.20 and we lose out by the premium - $1.20. So,
with a long call we have limited risk (the Option Premium) while at the same time
having uncapped profit potential.

Different type of options

Bull-Bear Option Strategy-

In a bull call spread strategy, an investor will simultaneously buy calls at a

specific strike price and sell the same number of calls at a higher strike price. Both
call options will have the same expiration and underlying asset. This type
of vertical spread strategy is often used when an investor is bullish on the
underlying and expects a moderate rise in the price of the asset. The investor limits
his/her upside on the trade, but reduces the net premium spent compared to buying
a naked call option outright.

The bear put spread strategy is another form of vertical spread. In this strategy,

the investor will simultaneously purchase put options at a specific strike price and
sell the same number of puts at a lower strike price. Both options would be for the
same underlying asset and have the same expiration date. This strategy is used
when the trader is bearish and expects the underlying asset's price to decline. It
offers both limited losses and limited gains.

Butterfly option Strategy

In a long butterfly spread using call options, an investor will combine both a bull

spread strategy and a bear spread strategy, and use three different strike prices. All
options are for the same underlying asset and expiration date.

For example, a long butterfly spread can be constructed by purchasing one in-the-
money call option at a lower strike price, while selling two at-the-money call
options, and buying one out-of-the-money call option. A balanced butterfly spread
will have the same wing widths. This example is called a “call fly” and results in a
net debit. An investor would enter into a long butterfly call spread when they think
the stock will not move much by expiration.
Calendar and Diagonal Spread

A diagonal spread is an options strategy established by simultaneously entering

into a long and short position in two options of the same type (two call options or
two put options) but with different strike prices and different expiration dates.
Typically these structures are on a 1 x 1 ratio.

This strategy can lean bullish or bearish, depending on the structure of the options.

This strategy is called a diagonal spread because it combines a horizontal spread,

also called a time spread or calendar spread, which represents the difference in
expiration dates, with a vertical spread, or price spread, which represents the
difference in strike prices.

The names horizontal, vertical and diagonal spreads refer to the positions of each
option on an options grid. Options are listed in a matrix of strike prices and
expiration dates. Therefore, options used in vertical spread strategies are all listed
in the same vertical column with the same expiration dates. Options in a horizontal
spread strategy use the same strike prices, but are of different expiration dates. The
options are therefore arranged horizontally on a calendar.

Because there are two factors for each option that are different, namely strike price
and expiration date, there are many different types of diagonal spreads. They can
be bullish or bearish, long or short and utilize puts or calls.

Most diagonal spreads refer to long spreads and the only requirement is that the
holder buys the option with the longer expiration date and sells the option with the
shorter expiration date. This is true for call strategies and put strategies alike.

Straddles-

A straddle is a neutral options strategy that involves simultaneously buying both a

put option and a call option for the underlying security with the same strike price
and the same expiration date.

A trader will profit from a long straddle when the price of the security rises or falls
from the strike price by an amount more than the total cost of the premium paid.
Profit potential is virtually unlimited, so long as the price of the underlying
security moves very sharply.
  A straddle is an options strategy involving the purchase of both a put and
call option for the same expiration date and strike price on the same
underlying.
 The strategy is profitable only when the stock either rises or falls from the
strike price by more than the total premium paid.
 A straddle implies what the expected volatility and trading range of a
security may be by the expiration date.

Strip and Straps-

A strip is an option strategy that involves the purchase of two put options and one
call option all with the same expiration date and strike price. It can also be
described as adding a put option to a straddle.

Like straddles, strips attempt to capitalize on large price movements of an

underlying stock. However, for whatever reason, investors pursuing a strip strategy
believe that the stock price is more likely to decrease than increase. Consequently,
they purchase two puts to double their potential profits from any decreases in the
stock's value.

A strap is an option strategy that involves the purchase of two call options and one
put option all with the same expiration date and strike price. It can also be
described as adding a call option to a straddle.

Like strips and straddles, straps try to profit from large deviations of a stock's value
from the strike price. However, opposite of strips, investors pursuing a strap
strategy believe that the stock price will more likely increase rather than decrease.
For this reason, straps involve two call options that will double the profits from any
increases in the stock's value.

Options Valuations and Pricing-

Option pricing theory uses variables (stock price, exercise price, volatility, interest
rate, time to expiration) to theoretically value an option. Essentially, it provides an
estimation of an option's fair value which traders incorporate into their strategies to
maximize profits. Some commonly used models to value options are Black-
Scholes, binomial option pricing, and Monte-Carlo simulation. These theories have
wide margins for error due to deriving their values from other assets, usually the
price of a company's common stock.
The primary goal of option pricing theory is to calculate the probability that an
option will be exercised, or be in-the-money (ITM), at expiration. Underlying asset
price (stock price), exercise price, volatility, interest rate, and time to expiration,
which is the number of days between the calculation date and the option's exercise
date, are commonly used variables that are input into mathematical models to
derive an option's theoretical fair value.

Aside from a company's stock and strike prices, time, volatility, and interest rates
are also quite integral in accurately pricing an option. The longer that an investor
has to exercise the option, the greater the likelihood that it will be ITM at
expiration. Similarly, the more volatile the underlying asset, the greater the odds
that it will expire ITM. Higher interest rates should translate into higher option
prices.

Factors Determining Option Price

1. Underlying Price & Strike Price

The value of calls and puts are affected by changes in the underlying stock price in
a relatively straightforward manner. When the stock price goes up, calls should
gain in value because you are able to buy the underlying asset at a lower price than
where the market is, and puts should decrease. Likewise, put options should
increase in value and calls should drop as the stock price falls, as the put holder
gives the right to sell stock at prices above the falling market price.

2. Time to Expiration

The effect of time is easy to conceptualize but takes experience before

understanding its impact due to the expiration date. Time works in the stock
trader's favor because good companies tend to rise over long periods of time. But
time is the enemy of the buyer of the option because, if days pass without
a significant change in the price of the underlying, the value of the option will
decline. In addition, the value of an option will decline more rapidly as
it approaches the expiration date. Conversely, that is good news for the option
seller, who tries to benefit from time decay, especially during the final month when
it occurs most rapidly.
3. Interest Rates

Like most other financial assets, options prices are influenced by prevailing
interest rates, and are impacted by interest rate changes. Call option and put option
premiums are impacted inversely as interest rates change: calls benefit from rising
rates while puts lose value. The opposite is true when interest rates fall.

4. Volatility

The effect of volatility on an option's price is the hardest concept for beginners to
understand. It relies on a measure called statistical (sometimes called historical)
volatility, or SV for short, looking at past price movements of the stock over a
given period of time.

Option pricing models require the trader to enter future volatility during the life of
the option. Naturally, option traders don't really know what it will be and have
to guess by working the pricing model "backwards". After all, the trader already
knows the price at which the option is trading and can examine other
variables including interest rates, dividends, and time left with a bit of research. As
a result, the only missing number will be future volatility, which can
be estimated from other input.

Black Scholes Models

The Black Scholes model, also known as the Black-Scholes-Merton (BSM) model,
is a mathematical model for pricing an options contract. In particular, the model
estimates the variation over time of financial instruments. It assumes these
instruments (such as stocks or futures) will have a lognormal distribution of prices.
Using this assumption and factoring in other important variables, the equation
derives the price of a call option.

The model assumes the price of heavily traded assets follows a geometric
Brownian motion with constant drift and volatility. When applied to a stock option,
the model incorporates the constant price variation of the stock, the time value of
money, the option's strike price, and the time to the option's expiry.

Also called Black-Scholes-Merton, it was the first widely used model for option
pricing. It's used to calculate the theoretical value of options using current stock
prices, expected dividends, the option's strike price, expected interest rates, time to
expiration and expected volatility. 

The formula, developed by three economists—Fischer Black, Myron Scholes and

Robert Merton—is perhaps the world's most well-known options pricing model. It
was introduced in their 1973 paper, "The Pricing of Options and Corporate
Liabilities," published in the Journal of Political Economy. Black passed away two
years before Scholes and Merton were awarded the 1997 Nobel Prize in
Economics for their work in finding a new method to determine the value of
derivatives (the Nobel Prize is not given posthumously; however, the Nobel
committee acknowledged Black's role in the Black-Scholes model). 

The Black-Scholes model makes certain assumptions:

 The option is European and can only be exercised at expiration.

 No dividends are paid out during the life of the option.
 Markets are efficient (i.e., market movements cannot be predicted).
 There are no transaction costs in buying the option.
 The risk-free rate and volatility of the underlying are known and constant.
 The returns on the underlying are normally distributed.

Concept of Delta, Theta, Gamma Vega-

What is Delta?

Beginning option traders sometimes assume that when a stock moves $1, the price
of options based on that stock will move more than $1. That’s a little silly when
you really think about it. The option costs much less than the stock. Why should
you be able to reap even more benefit than if you owned the stock?

It’s important to have realistic expectations about the price behavior of the options
you trade. So the real question is, how much will the price of an option move if the
stock moves $1? That’s where “delta” comes in.

Delta is the amount an option price is expected to move based on a $1 change

in the underlying stock.

Calls have positive delta, between 0 and 1. That means if the stock price goes up
and no other pricing variables change, the price for the call will go up. Here’s an
example. If a call has a delta of .50 and the stock goes up $1, in theory, the price of
the call will go up about $.50. If the stock goes down $1, in theory, the price of the
call will go down about $.50.

Puts have a negative delta, between 0 and -1. That means if the stock goes up and
no other pricing variables change, the price of the option will go down. For
example, if a put has a delta of -.50 and the stock goes up $1, in theory, the price of
the put will go down $.50. If the stock goes down $1, in theory, the price of the put
will go up $.50.

GAMMA

Gamma is the rate that delta will change based on a $1 change in the stock price.
So if delta is the “speed” at which option prices change, you can think of
gamma as the “acceleration.” Options with the highest gamma are the most
responsive to changes in the price of the underlying stock.

As we’ve mentioned, delta is a dynamic number that changes as the stock price
changes. But delta doesn’t change at the same rate for every option based on a
given stock. Let’s take another look at our call option on stock XYZ, with a strike
price of $50, to see how gamma reflects the change in delta with respect to changes
in stock price and time until expiration.
Note how delta and gamma change as the stock price moves up or down from $50
and the option moves in- or out-of-the-money. As you can see, the price of at-the-
money options will change more significantly than the price of in- or out-of-the-
money options with the same expiration. Also, the price of near-term at-the-money
options will change more significantly than the price of longer-term at-the-money
options.

Theta

Time decay, or theta, is enemy number one for the option buyer. On the other
hand, it’s usually the option seller’s best friend. Theta is the amount the price of
calls and puts will decrease (at least in theory) for a one-day change in the time to
expiration.

This graph shows how an at-the-money option’s value will decay over the last
three months until expiration. Notice how time value melts away at an accelerated
rate as expiration approaches.

In the options market, the passage of time is similar to the effect of the hot summer
sun on a block of ice. Each moment that passes causes some of the option’s
time value to “melt away.” Furthermore, not only does the time value melt away,
it does so at an accelerated rate as expiration approaches
Vega

Vega is the amount call and put prices will change, in theory, for a
corresponding one-point change in implied volatility. Vega does not have any
effect on the intrinsic value of options; it only affects the “time value” of an
option’s price.

Typically, as implied volatility increases, the value of options will increase. That’s
because an increase in implied volatility suggests an increased range of potential
movement for the stock.

Let’s examine a 30-day option on stock XYZ with a $50 strike price and the stock
exactly at $50. Vega for this option might be .03. In other words, the value of the
option might go up $.03 if implied volatility increases one point, and the value of
the option might go down $.03 if implied volatility decreases one point.

Exchange Traded Option-

The most common way to trade options is via standardized options contracts that
are listed by various futures and options exchanges. [12] Listings and prices are
tracked and can be looked up by ticker symbol. By publishing continuous, live
markets for option prices, an exchange enables independent parties to engage in
price discovery and execute transactions. As an intermediary to both sides of the
transaction, the benefits the exchange provides to the transaction include:

 Fulfillment of the contract is backed by the credit of the exchange, which

typically has the highest rating (AAA),
 Counterparties remain anonymous,
 Enforcement of market regulation to ensure fairness and transparency, and
 Maintenance of orderly markets, especially during fast trading conditions.

Over-the-counter options

Over-the-counter options (OTC options, also called "dealer options") are traded
between two private parties, and are not listed on an exchange. The terms of an
OTC option are unrestricted and may be individually tailored to meet any business
need. In general, the option writer is a well-capitalized institution (in order to
prevent the credit risk). Option types commonly traded over the counter include:
  Interest rate options
 Currency cross rate options, and
 Options on swaps or swaptions.

By avoiding an exchange, users of OTC options can narrowly tailor the terms of
the option contract to suit individual business requirements. In addition, OTC
option transactions generally do not need to be advertised to the market and face
little or no regulatory requirements. However, OTC counterparties must establish
credit lines with each other, and conform to each other's clearing and settlement
procedures.

With few exceptions, there are no secondary markets for employee stock options.
These must either be exercised by the original grantee or allowed to expire.

Foreign Currency Option

A currency option (also known as a forex option) is a contract that gives the buyer
the right, but not the obligation, to buy or sell a certain currency at a specified
exchange rate on or before a specified date. For this right, a premium is paid to the
seller.

Currency options are one of the most common ways for corporations, individuals
or financial institutions to hedge against adverse movements in exchange rates.

Investors can hedge against foreign currency risk by purchasing a currency put or
call. Currency options are derivatives based on underlying currency pairs. Trading
currency options involves a wide variety of strategies available for use in forex
markets. The strategy a trader may employ depends largely on the kind of option
they choose and the broker or platform through which it is offered. The
characteristics of options in decentralized forex markets vary much more widely
than options in the more centralized exchanges of stock and futures markets.

 Currency options give investors the right, but not the obligation, to buy or sell a
particular currency at a pre-specific exchange rate before the option expires.
 Currency options allow traders to hedge currency risk or to speculate on
currency moves.

 Currency options come in two main varieties, so-called vanilla options and
over-the-counter SPOT options
Exchange Option

An exchange-traded option is a standardized contract to either buy (using a call

option), or sell (using a put option) a set quantity of a specific financial product,
on, or before, a pre-determined date for a pre-determined price (the strike price).

Exchange-traded options contracts are listed on exchanges such as the Chicago

Board Options Exchange (CBOE). The exchanges are overseen by regulators –
including the Securities and Exchange Commission (SEC) and the Commodity
Futures Trading Commission (CFTC) – and are guaranteed by clearinghouses such
as the Options Clearing Corporation (OCC).

Exchange-traded options, also known as 'listed options', provide many benefits that

distinguish them from over-the-counter (OTC) options. Because exchange-traded
options have standardized strike prices, expiration dates, and deliverables (the
number of shares/contracts of the underlying asset), they attract, and accommodate,
larger numbers of traders. OTC options usually tend to have customized
provisions.

This increased volume benefits traders by providing improved liquidity and a

reduction in costs. The more traders there are for a specific options contract, the
easier it is for interested buyers to identify willing sellers, and the narrower the bid-
ask spread becomes.

Index Options

All the options that have an index as underlying are known as Index Options. The
two most basic and popular index options are Call Option and Put Option. Further,
they may be American Options or European Options.

A Call Option gives the buyer a right to buy a specified quantity of an underlying
index at a pre-decided price. For this privilege, the buyer of the Call Option pays
an upfront premium to the seller or writer. A Put Option gives the buyer the right
to sell a specified quantity of an underlying index at a pre-decided price; for this
privilege the buyer of the Put Option pays an upfront premium to the Put Option
seller or writer.

An American Option may be exercised anytime before the expiry of the contract
whereas a European Option can be exercised only on the day of expiry.
Put Call Parity-

Put-call parity is a principle that defines the relationship between the price of
European put options and European call options of the same class, that is, with the
same underlying asset, strike price, and expiration date.

Put-call parity states that simultaneously holding a short European put and long
European call of the same class will deliver the same return as holding one forward
contract on the same underlying asset, with the same expiration, and a forward
price equal to the option's strike price. If the prices of the put and call options
diverge so that this relationship does not hold, an arbitrage opportunity exists,
meaning that sophisticated traders can theoretically earn a risk-free profit. Such
opportunities are uncommon and short-lived in liquid markets.

Put-call parity applies only to European options, which can only be exercised on
the expiration date, and not American options, which can be exercised before. 

Say that you purchase a European call option for TCKR stock. The expiration date
is one year from now, the strike price is $15, and purchasing the call costs you $5.
This contract gives you the right—but not the obligation—to purchase TCKR stock
on the expiration date for $15, whatever the market price might be. If one year
from now, TCKR is trading at $10, you will not exercise the option. If, on the other
hand, TCKR is trading at $20 per share, you will exercise the option, buy TCKR at
$15 and break even, since you paid $5 for the option initially. Any amount TCKR
goes above $20 is pure profit, assuming zero transaction fees.