Have you ever come across something in your life after knowing that the first thing on your mind was “why was I not aware of this before ? ” or “where were you all these years ? ”, well these were my feelings after knowing about the derivative market. The perspective about life changed after understanding markets and investments, but after understanding derivatives like futures and especially options the change was colossal.

Here is a quick recap of the history of the Indian derivative markets –

o June 12th, 2000 – Index futures were launched

o June 4th, 2001 –Index options were launched

o July 2nd, 2001 – Stock options were launched

o November 9th, 2001 – Single stock futures were launched.

What are derivatives? Derivatives are financial instruments whose value is derived from an underlying asset or a group of assets. The most common underlying assets can be stocks, bonds, currencies, commodities, and market indices. A simple example could be curd, curd is a derivative of milk because it is derived from milk. Take Reliance Industries as an example: Reliance call option strike premium will go up only when the price of Reliance stock goes up and reliance put option premium price will go up only when the stock price of Reliance goes down. The value of the underlying asset keeps on changing based on market conditions and the change in the price of derivatives fluctuates with the price change of underlying assets and various other features which are called the greeks which will be discussed further. The basic idea behind entering the derivative contract is to maximize profits by speculating the value of the underlying assets.

There are four major types of derivative contracts that are

- Forwards
- Futures
- Options
- Swaps

Our main focus here will be on options and let us understand the basics one by one. Forwards and futures are contracts where the buyer is obligated to buy a contract at a pre-agreed price at a specified future date. Forwards and futures are essentially the same but the main difference is that futures are traded in exchanges whereas forwards are customized contracts that are not traded anywhere. Let us understand with an example. A farmer who produces wheat expects to sell 4000 Kilograms of wheat at 4000 per quintal after four months but due to unpredictable weather, the farmer is a bit worried about the harvest and also because of the price fluctuations after 4 months. To avoid the risk, they approached a commodities broker and both of them agreed to a contract where the farmer agreed to sell 40 quintals of wheat @4000 per quintal after 4 months and the broker agreed to buy it. Now three cases are possible but let’s discuss two cases, the first case is due to oversupply. The price of 1 quintal can drop below 4000 and still the commodities broker will have to pay the farmer 4000 thereby making a loss. The second case is due to demand-supply mismatch say because of over-demand the prices of wheat can go above 4000 where the farmer will be the one making losses. This is a simple example of a forward contract.

Speaking of options, More than 80% of the derivatives are traded in options which accounts for a significant part of the derivative market. options provide the buyer of the contract the right but not the obligation to purchase or sell the underlying asset at a predetermined price. To buy any kind of option you have to pay a premium amount.

There are two kinds of options and a trader can be a buyer or seller of both of these.

A **Call option** gives the buyer the right but not the obligation to buy a given quantity of an underlying asset at a given price.

A **Put option** gives the buyer the right but not the obligation to sell a given quantity of an underlying asset at a given price.

Now **Swaps** are derivative contracts that allow the exchanges of cash flows between two parties. The most popular types of swaps are interest rate swaps, commodity swaps, and currency swaps.

What is Mark To market or MTM? It involves recording the price or value of a security to reflect the current market value rather than just the book value.

**Benefits of derivative trading**

- Hedging – since the value of the derivatives is linked to the asset’s value, the contracts are primarily used for hedging risks. Click here to read more about hedging.
- Spot prices are frequently used to determine the price of the underlying assets. i.e the spot prices of futures can serve as an approximation of a commodity price.
- Higher returns, derivative trading gives you more possibilities for higher returns

There are certain risks as well involved in derivative trading those are

- The high volatility of derivatives exposes them to potentially huge losses.
- Derivatives are widely regarded as the tool of speculation. Due to derivatives’ extremely risky nature and risky behavior, unreasonable speculation may lead to unimaginable losses.

**Now Let Us Dive Deep Into Options**

As discussed before there are two types of options – The call option and The put option and a trader can buy or sell these options according to his view about the direction of the market. All options contracts are cash-settled in India.

Let us think and understand The **call Option **with the help of The Nifty Giant Reliance.

Imagine like Reliance stock is trading at a price range of 2000 and its next month premium for the strike price of 2000 is 100 rupees i.e for the getting Reliance share at the current price of 2000 you are ready to pay a premium of 200 and Next month the reliance AGM is about to happen and you are pretty positive that the price of the share will skyrocket to 2500 rupees due to some major beneficial announcements.

Now three scenarios could happen on the day of AGM

**Scenario 1 – Price goes up to Rs.2500/- **

Since Reliance has announced its new business plans which were gonna bring multiple investments and showing the future growth potential the Market sentiments turned positive and the prices skyrocketed to 2500.

How much money you will make, well let’s check out the math

As you have bought a 2000 call option

**Buy price = 2000**

**Premium paid = 100**

**Total Expense = 2100**

**Current Price or Price on Expiry = 2500**

Hence the profit is 2500-2000-100= 400, So If you exercise this option you can say for the initial cash commitment of 2100 you made around 20 Percent Profit.

**Scenario 2 – Price goes down to Rs.1800/-**

Now imagine the AGM happened and there were no significant announcements that created many positive sentiments around investors. It didn’t add any value to showcase future business growth. So, due to all these reasons, the sentiments turned negative and the price of the share has gone down 200 rupees.

How much money you will make, well let’s check out the math

As you have bought a 2000 call option

**Buy price = 2000**

**Premium paid = 100**

**Total Expense = 2100**

**Current Price or Price on Expiry = 1800**

Hence the profit/loss is 1800-2000-100= -300, So If you exercise this option you can say for the initial cash commitment of 2100 you made around 300 losses.

So now it makes no sense to wait till the expiry as the stock is available for 1800 why would you think of buying it at 2000 now. Here in this case as a buyer you have to let go of the premium of 100 rupees paid as it won’t become zero before the day of expiry you will lose at least 70% of it. So the seller of the particular contract will gain 70% of the money lost by the buyer.

**Scenario 3 – Price stays at Rs.2000/- **

Since there were some good announcements but which were not so significant to make a move to the stock price and the price of reliance stayed flat, trading near the range of 2000. In this case, there is no point in buying the share price at 2000 by giving an extra premium of 100 and the buyer will not exercise the contract as he has the right and no obligation to exercise the contract. The second and third scenario is kind of similar but in the last scenario, you will only lose the premium paid. Here the seller will gain the entire premium from this contract.

So from these three scenarios what did you understand?? If the results are good the buyer of the contract will be in profit, If the results are average the seller will make a profit and if the results are bad the seller will make a profit. So 2 out of three scenarios the sellers are making a profit, hence the probability of the seller making more profit is higher compared with the buyer.

**Some Basic Option Jargons**

**Strike Price** – The price at which you bought/sold the option contract is called the strike price, from the above Reliance example scenarios 2000 is the strike price.

**Underlying** – The stock or any asset from which the derivative price is derived is called the underlying. From the above example, the Reliance share is underlying.

**Expiry** – The day on which the contract settlement is done in cash is called Expiry day. There are monthly expiry dates for stocks and weekly as well as monthly expiry for index options.

**Premium** – The price paid to get into the option contract is called the premium. For indexes and stocks, the price of premiums will change every second.

The buyer of the call option has the right, but not the obligation, to buy an agreed quantity of a particular commodity or financial instrument (the underlying) from the seller of the option at a certain time (the expiration date) for a certain price (the strike price). The seller (or “writer”) is obligated to sell the commodity or financial instrument should the buyer so decide. The buyer pays a fee (called a premium) for this right”.

The Above Image illustrates How an option chain looks like from the New NSE Website. The left-hand side of the option chain shows call option contracts and the right-hand side shows put option contracts.

**Buying And Selling **the** Call Option**

From the above Reliance examples, we understood the basics of a call option buying scenario. Let us generalize the call option to understand the different price movements and changes according to the underlying movement.

Some Observations from above regarding buying call options are that

- It makes sense to buy a call option only when you are expecting a significant upside move to the underlying price.
- When the Market stays flat for bearish the call option buyer will lose money.
- The Buyer of the call option will lose only the premium paid if his view goes wrong.

**Intrinsic Value of a call option on Expiry**

Let us consider Reliance from the options chain shown above, we can see the stock is trading at 2110. Let us choose to buy the 2100 call option. Let us understand the various cases where the price of the premium will change in accordance with the intrinsic value.

The intrinsic value (IV) of the option upon expiry (**specifically a call option for now**) is defined as the **non – negative value to **which the option buyer is entitled if he were to exercise the call option. In simple words ask yourself (assuming you are the buyer of a call option) how much money you would receive upon expiry if the call option you hold is profitable. Mathematically it is defined as –**IV = Spot Price – Strike Price **

Generalized Profit and Loss for Call Option Buyer

Loss Occurs for the call option buyer when the spot price moves below the strike price. However, the loss to the call option buyer is **restricted **to the extent of the premium he has paid

The call option becomes profitable as and when the spot price moves over and above the strike price. The higher the spot price goes from the strike price, the higher the profit.

So it’s fair for us to say that the call option buyer has limited risk and the potential to make an unlimited profit.

As you notice from the table above, the buyer suffers a maximum loss (Rs. 47.05 in this case) till the spot price is equal to the strike price. However, when the spot price starts to move above the strike price, the loss starts to **minimize. **The losses keep getting minimized till the point where the trade neither results in a profit or a loss. This is called the **breakeven point**.

The formula to identify the breakeven point for any call option is –

**B.E = Strike Price + Premium Paid **

**Here its 2100+47.05 = 2147.05**

The buyer of a call option will be in profit only when the spot price goes above the breakeven.

**Selling/Writing A Call option.**

From the above examples, we understood that there are some statistical and probability advantages for the option sellers. There are more advantages like Time Decay which we will learn in the second part.

In other words, 2 out of the 3 scenarios benefit the option seller. This is just **one **of the incentives for the option writer to sell options. Besides this natural statistical edge, if the option seller also has a good market insight then the chances of the option seller being profitable are quite high.

Let us understand how an option seller makes a profit/loss. Selling a call option is also called ‘Shorting a call option’ or simply ‘**Short Call**’. Sell a call option (also called option writing) only when you believe that upon expiry, the underlying asset will not increase beyond the strike price. If your view is correct on the day of expiry you will receive the premium amount at the time of selling. The profit of an option seller is restricted to the premium he receives, however, his loss is potentially unlimited but keeping stop loss can help you to save your capital. Since the short option position carries unlimited risk, he is required to deposit the margin. For selling one call option in Nifty, the option seller requires a margin of nearly 1.5 lakhs.

The call option writer experiences a maximum profit to the extent of the premium received as long as the spot price remains at or below the strike price (for a call option).

Let us Take the same Example of reliance and understand the generalized Profit and Loss for Call Option sellers. Imagine my view about the market has turned bearish and I have decided to short Reliance 2100 CE

The positive sign in the ‘premium received’ column indicates a cash inflow (credit) to the option writer. The call option writer starts to lose money as and when the spot price moves over and above the strike price. The higher the spot price moves away from the strike price, the larger the loss. We can put these generalizations in a formula to estimate the P&L of a Call option seller –

**P&L = Premium – Max [0, (Spot Price – Strike Price)] **

Even when the spot price moves higher than the strike, the option writer still makes money, he continues to make money till the spot price increases more than the strike + premium received. At this point, he starts to lose money, hence calling this the ‘breakdown point’ seems appropriate.

**Breakdown point for the call option seller = Strike Price + Premium Received **

The call option seller’s P&L payoff looks like a mirror image of the call option buyer’s P & L payoff. Let us Think about the risk taken by the call option buyer and call option seller. The call option buyer bears no risk. He just has to pay the required premium amount to the call option seller, against which he would buy the right to buy the underlying at a later point.

See the margin required to Buy our Reliance One lot Call options as of today.

Now see the Margin required to sell One lot of Reliance call options

The price required to sell one lot of Call Option is almost more than 10 times the Margin required to buy one lot of the same.

**So Concluding the Call Options**** **** **

*For option buying*

- You buy a call option only when you are bullish about the underlying asset. Upon expiry, the call option will be profitable only if the underlying has moved over and above the strike price
- Buying a call option is also referred to as ‘Long on a Call Option’ or simply ‘
**Long Call**’ - To buy a call option you need to pay a premium to the option writer
- The call option buyer has a limited risk (to the extent of the premium paid) and the potential to make an unlimited profit
- The breakeven point is the point at which the call option buyer neither makes money nor experiences a loss.

*For option selling*

- You sell a call option (also called option writing) only when you believe that upon expiry, the underlying asset will not increase beyond the strike price
- Selling a call option is also called ‘Shorting a call option’ or simply ‘
**Short Call**’ - When you sell a call option you receive the premium amount
- The profit of an option seller is restricted to the premium he receives, however his loss is potentially unlimited
- The breakdown point is the point at which the call option seller gives up all the premium he has made, which means he is neither making money nor is losing money
- Since the short option position carries unlimited risk, he is required to deposit the margin.

**Buying and Selling Put Options**

I’ve given the title in red because as an option seller I’m afraid of selling puts as I’ve lost lot of money doing the same. Now that we have understood the call option from the buyers as well as sellers perspectives, it will be easier to understand how a put option works. The Opposite view of call options defines the put option contracts. As a call option buyer the view of us should be that the market should be extremely bullish but as a put option buyer our view of markets should be Bearish.

The Put option buyer bets on the fact that the markets are Going down and agrees into getting the contract with that view. The Put option buyer has the right to Sell the stock at a strike price irrespective of where it is trading.

As the seller of the option, let it be call option or put option the seller always anticipates exact opposite of what the buyer is anticipating. Here the put option seller is selling the right to the put option buyer to sell the stock at a strike price irrespective of the spot.

The buyer of the put option is bearish about the underlying asset, while the seller of the put option is neutral or bullish on the same underlying

o The buyer of the put option has the right to sell the underlying asset upon expiry at the strike price

o The seller of the put option is obligated (since he receives an upfront premium) to buy the underlying asset at the strike price from the put option buyer if the buyer wishes to exercise his right.

Let us get a clear picture of the put option buyer by understanding the math. The formula to calculate the intrinsic value of an option given below is applicable **only on the day of the expiry**.

The intrinsic value of a Put option is –

**IV (Put Option) = Strike Price – Spot Price **

Let us understand the Profit and loss behavior with the help of our same reliance put option.

The 2100 put option here is trading at a premium of 29.20 rupees. As a put option buyer, let’s create a P&L table and understand the behavior of a put option.

As you can see, the put option buyer benefits as the spot price falls and at the spot of 1980 he’s getting a maximum profit of 90.8 rupees.

Buyers of Put Options are profitable as and when the spot price goes below the strike price. In other words, buy a put option only when you are bearish about the underlying. A put option buyer experiences a loss when the spot price goes higher than the strike price. However, the maximum loss is **restricted **to the extent of the premium the put option buyer has paid.

Here is a general formula using which you can calculate the P&L from a Put Option position. Do bear in mind this formula applies to positions held till expiry.

**P&L = [Max (0, Strike Price – Spot Price)] – Premium Paid **

**Please find the put option buyers payoff graph below**

As the price of the stock decreases, the profit Increases.

**The Put Option selling **** **

The objective behind selling a put option is to collect the premiums and benefit from the bullish outlook on the market. Sellers of the Put Options are profitable as long as the spot price remains at or higher than the strike price. In other words, sell a put option only when you are bullish about the underlying or when you believe that the underlying will no longer continue to fall. A put option seller can potentially experience an unlimited loss as and when the spot price goes lower than the strike price.

Let us see the **P&L behavior for the put option seller **

Further, the breakdown point for a Put Option seller can be defined as a point where the Put Option seller starts making a loss after giving away all the premium he has collected –

**Breakdown point = Strike Price – Premium Received **

The Put option seller experiences a loss only when the spot price goes below the strike price (18400 and lower). The loss is theoretically unlimited (therefore the risk). The Put Option seller will experience a profit (to the extent of premium received) as and when the spot price trades above the strike price. The gains are restricted to the extent of the premium received. At the breakdown point (18085) the put option seller neither makes money nor loses money. However, at this stage he gives up the entire premium he has received.

So after reading all these In a Nutshell, what all options do we have? Don’t Worry We have many options.

Happy Trading:)

## Leave a Reply