Chapter 8 option strategies and payoffs
This classification helps the trader to decide which strike to trade, given a particular circumstance in the market. However before we get into the details, I guess it makes sense to look through the concept of intrinsic value again. The intrinsic value of an option is the money the option buyer makes from an options contract provided he has the right to exercise that option on the given day.
Intrinsic Value is always a positive value and can never go below 0. Consider this example —. Given this, assume you bought the CE and instead of waiting for 15 days to expiry you had the right to exercise the option today. Now my question to you is — How much money would you stand to make provided you exercised the contract today? Do remember when you exercise a long option, the money you make is chapter 8 option strategies and payoffs to the intrinsic value of an option minus the premium paid.
Hence to answer the above question we need to calculate the intrinsic value of an option, for which we need to pull up the call option intrinsic value formula from Chapter 3. So, if you were to exercise this option today, you are entitled to make 20 points ignoring the premium paid. Here is a table which calculates the intrinsic value for various options strike these are just random values that I have used to drive across the concept —.
With this, I hope you are clear about the intrinsic value calculation for a given option strike. Let me summarize a few important points —. Before we wrap up this discussion, here is a question for you — Chapter 8 option strategies and payoffs do you think the intrinsic value cannot be a negative value? To answer this, let us pick an example from the above table — Strike isspot isand option type is long call.
Let us assume the premium for the Call option is Rs. Hopefully this should give you some insights into why the intrinsic value of an option can never go negative.
With our discussions on the intrinsic value of an option, the concept of moneyness should be quite easy to comprehend. Moneyness of an option is a classification method which classifies each option strike based on how much money a trader is likely to make if he were to exercise his option contract today.
There are 3 broad classifications —. Understanding these option strike classification is very easy. All you need to do is figure out the intrinsic value. Let us take up an example to understand this well. As you chapter 8 option strategies and payoffs notice from the image above, the available strike prices trade starts from all the way upto From the definition of ATM option that we posted earlier we know, ATM option is that option strike which is closest to the spot price.
Considering the spot is atthe closest strike is probably If there was strike, then clearly would be the ATM option. But in the absence of strike the next closest strike becomes ATM. Hence we classify as, the ATM option. In order to do this we will pick few strikes and calculate the intrinsic value. Do remember the spot price iskeeping this in perspective the intrinsic value for the strikes above would be —. We know this is the ATM option as strike is closest to the spot price of Chapter 8 option strategies and payoffs we will not bother to calculate its intrinsic value.
Negative intrinsic value, therefore the intrinsic value is 0. You may have already sensed the generalizations for call options that exists here, however allow me to restate the same again.
Now let us chapter 8 option strategies and payoffs at 2 ITM options — and The intrinsic value works out to be and 60 respectively considering the spot is at Higher the intrinsic value, deeper the moneyness of the option. I would encourage you to observe the premiums for all these strike prices highlighted in green box. Do you sense a pattern here? Here is the snapshot of various strikes available for a Put option. The strike prices on the left are highlighted in a blue box.
As you can see there are many strike prices available right from to Since the spot is atthe nearest strike to spot should be the ATM option. As we can see from the snapshot above there is a strike at which is trading at Rs. This obviously becomes the ATM option. Let us go with the following strikes and evaluate their respective intrinsic value also called the moneyness —.
And as you can see from the snapshot, the premiums for ITM options are much higher than the premiums for the OTM options. I hope you have got a clear understanding of how option strikes are classified based on their moneyness.
However you may still be wondering about the need to classify options based on their moneyness. As you briefly know by now, Option Greeks are the market forces which act upon options strikes and therefore affect the premium associated with these strikes. So a certain market force will have a certain effect on ITM option while at the same time it will have a different effect on an OTM option.
Hence classifying the option strikes will help us in understanding the Option Greeks and their impact on the premiums better. The Option chain is a common feature on most of the exchanges and trading platforms. The option chain is a ready reckoner of sorts that helps you identify all the strikes that are available for a particular underlying and also classifies the strikes based on their moneyness.
Besides, the option chain also provides information such as the premium price Chapter 8 option strategies and payoffsbid —ask price, volumes, open interest etc for each of the option strikes. Here is the link to check the option chain for Nifty Options. Having understood the basics of the call and put options both from the buyers and sellers perspective and also having understood the concept of ITM, OTM, and ATM I suppose we are all set to dwell deeper into options.
The next couple of chapters will be dedicated to understand Option Greeks and the kind of impact they have on option premiums. Based on the Option Greeks impact on the premiums, we will figure out a way to select the best possible strike to trade for a given circumstance in the market.
I hope you are as excited to learn chapter 8 option strategies and payoffs all these topics as we are to write about the same. So please stay tuned. Hi kartik, Thanks for new chapter. You have magical writing power which makes the learning so interesting and easy. I completely understood the concept of this chapter and very excited for next chapter.
Thanks for the kind words and we are really glad you were able to understand the chapter: Will put up chapter 8 option strategies and payoffs next chapter as soon as we can. Are you facing any problems with this? Hi kartik If I place an order to buy niftyCE at premium of with a trailing stop loss of points. After sometime premium iscan I modify my trailing stop loss to 80 points or 60 points or can I square off my chapter 8 option strategies and payoffs at current price. Hi Karthik, Varsity is the great effort of you and Zerodha.
I do not have words to appreciate, thanks a lot…. We will try our best Keshav. In fact that is our aim as well. But nevertheless we will do our best. Hi kartik, I have rs in my trading account. So for every 1 point up or down move chapter 8 option strategies and payoffs can make or lose Rs. For trading options please look into the charts of the spot market and not really the chart of chapter 8 option strategies and payoffs Options. You should look at the spot charts.
The index is made up of these 50 stocks, check this http: The volume of Nifty spot is cumulative volumes of all the 50 stocks. Check this — http: For intraday it may not be possible Narsimha.
I will get back to you on this soon, meanwhile you can chapter 8 option strategies and payoffs use the Nifty futures chart. Hi Karthik, the bid-ask spread for the Nifty is quite close; and when I square off an order at market price, there are no major surprises. So while trading larger volumes, is it safer to trade Nifty? The spread is tight when liquidity is abundant. In simpler words — when there are more people trading a particular contract liquidity improves and therefore the spreads get better it gets tighter.
Tighter spreads imply lesser damage when you place market orders lesser surprise. Karthik, I was asking about the spread in absolute terms not percentage. With Bank Nifty options, I see a difference of over 10 rupees between chapter 8 option strategies and payoffs bid price and the ask price onscreen.
Yes in absolute terms the difference is kind of bigger on Bank Nifty. It makes sense to trade Nifty especially when you know that you will use market orders. Thanks a lot for this information. The lot of 25 is fixed for both futures and options.
I think came about because one of the comments posted earlier. Also, it may not be safe to assume point daily moment in Nifty. The change in premium based on the change is underlying is captured by delta…which is the focus in chapter 9. Hi Jose, request you not to use caps lock.
Further we looked at four different variants originating from these 2 options —. Think of it this way — if you give a good artist a color palette and canvas he can create some really interesting paintings, similarly a good trader can use these four option variants to create some really good trades. Imagination and intellect is the only requirement for creating these option trades. Hence before we get deeper into options, it is important to have a strong foundation on these four variants of options.
For this reason, we will quickly summarize what we have learnt so far in this module. Arranging the Payoff diagrams in the above fashion helps us understand a few things better.
Let me list them for you —. Going by that, buying a call option and buying a put option is called Long Call and Long Put position respectively. Going by that, selling a call option and selling chapter 8 option strategies and payoffs put option is also called Short Call and Short Put position respectively.
However I think it is best to reiterate a few key points before we make further progress in this module. Buying an option call or put makes sense only when we expect the market to move strongly in a certain direction.
If fact, for the option buyer to be profitable the market should move away from the selected strike price. Selecting the right strike price to trade is a major task; we will learn this at a later stage. For now, here are a few key points that you should remember —. The option sellers call or put are also called the option writers. Selling an option makes sense when you expect the market to remain flat or below the strike price in case of calls or above strike price in case of put option.
I want you to appreciate the fact that all else equal, markets are slightly favorable to option sellers. This is because, for the option sellers to be profitable the market has to be either flat or move in a certain direction based on the type of option.
However for the option buyer to be profitable, the market has to move in a certain chapter 8 option strategies and payoffs. Clearly there are two favorable market conditions for the option seller versus one favorable condition for the option buyer.
But of course this in itself should not be a reason to sell options. This means to say that the option writers earn small and chapter 8 option strategies and payoffs returns by selling options, but when a disaster happens, they tend to lose a fortune.
Well, with this I hope you have developed a strong foundation on how a Call and Put option behaves. Just to give you a chapter 8 option strategies and payoffs up, the focus going forward in this module will be on moneyness of an option, premiums, option pricing, option Greeks, and chapter 8 option strategies and payoffs selection.
Once we understand these topics we will revisit the call and put option all over again. This information is highlighted in the red box. Below the red box, I have highlighted the price information of the premium. If you notice, the premium of the CE opened at Rs.
Moves like this should not surprise you. These are fairly common to expect in the options world. Assume in this massive swing you managed to capture just 2 points while trading this particular option intraday. This chapter 8 option strategies and payoffs to a sweet Rs. In fact this is exactly what happens in the real world.
Traders just trade premiums. Hardly any traders hold option contracts until expiry. Most of the traders are interested in initiating a trade now and squaring it off in chapter 8 option strategies and payoffs short while intraday or maybe for a few days and capturing the chapter 8 option strategies and payoffs in the premium.
They do not really wait for the options to expire. These details are marked in the blue box. Below this we can notice the OHLC data, which quite obviously is very interesting.
The CE premium opened the day at Rs. However assume you were a seller of the call option intraday and you managed to capture just 2 points again, considering the lot size isthe 2 point capture on the premium translates to Rs. However by no means I am suggesting that you need not hold until expiry, in fact I do hold options till expiry in certain cases. Generally speaking option sellers tend to hold contracts till expiry rather than option buyers.
This is because if you have written an option for Rs. So having said that the traders prefer to trade just the premiums, you may have a few fundamental questions cropping up in your mind. Why do premiums vary? What is the basis for the change in premium? How can I predict the change in premiums? Who decides what should be the premium price of a particular option?
Well, these questions and therefore the answers to these form the crux of option trading. To give you a heads up — the answers to all these questions lies in understanding the 4 forces that simultaneously exerts its influence on options premiums, as a result of which the premiums vary.
Think of this as a ship sailing in the sea. The speed at which the ship sails assume its equivalent to the option premium chapter 8 option strategies and payoffs on various forces such as wind speed, sea water density, sea pressure, and the power of the ship.
Some forces tend to increase the speed of the ship, while some tend to decrease the speed chapter 8 option strategies and payoffs the ship. The ship battles these forces and finally arrives at an optimal sailing speed. Crudely put, some Option Greeks tends to increase the premium, while some try to reduce the premium. Try and imagine this — the Option Greeks influence the option premium however the Option Greeks itself are controlled by the markets.
As the markets change on a minute by minute basis, therefore the Option Greeks change and therefore the option premiums!
Going forward in this module, we will understand each of these forces and its characteristics. We will understand how the force gets influenced by the markets and how the Option Greeks further influences the premium. We will do the same in the next chapter. A quick note here — the topics going forward will get a little complex, although we will try our best to simplify it.
While we do that, we would request you to please be thorough with all the concepts we have learnt so far. Thanks a lot for sharing learning material, it is really helpful for beginners like me to understand the concept and strategy of share market.
We are trying out best to complete the modules as fast as we can. European option means the settlement is on expiry day. However, you can just speculate on option premiums…and by virtue of which, you can hold the position for few mins or days.
Also we have potential of unlimited profit in long call or long put and even we can trail stoploss of premiums. Thank you so much for your articles sir. Cause sitting in front of computer is not possible.
Even if we r there we may miss the trade id doing some thing else at the time we are suppose to trade or squareoff the tyrade. Till now it has been very clear and crisp.
Thanks for that and hope that further chapters will also come the same way. We will be discussing SL based on Volatility very soon. Request you to kindly stay tuned till then. We certainly hope to keep the future chapters as easy and lucid as the previous ones have been. Hi Really nice initiative sir. Hello Sir, if I buy a lot ofcall option of strike price at a premium of Rs 2 with a spot price of Now if the price moves to and premium is now at 3 so would be my profit??
Firstly, if the spot moves from tothe premium of the Call option will certainly be more than Rs. Your profits would be —. Hello Sir, I am still confused with the way the profit is calculated. Might be, I am not able to get what u explained and I am really sorry for asking it again.
In some of your replies, you mentioned that the profit is chapter 8 option strategies and payoffs as per the difference of spot price chapter 8 option strategies and payoffs strike price and in some replies u mentioned that it is as per the difference of premium.
In case of 1 lot of shares the profit would be. So which of the above options are correct??? Is there a difference if I am closing my position before expiry or excersize it at expiry? For all practical purposes I would suggest you use the 2nd way of calculating profits…i.
Do remember the premium paid for this option is Rs 6. Irrespective of how the spot value changes, the fact that I have paid Rs. This is the cost chapter 8 option strategies and payoffs I have incurred in order to buy the Call Option. Please note — the negative sign before the premium paid represents a cash out flow from my trading account.
This lead to my confusion. Got your point, see if you are holding the option till expiry you will end up getting the amount equivalent to the intrensic value of the option. I have explained more on this in the recent chapter on Theta…but I would suggest you read up sequentially and not really jump directly to Theta.
The calculation provided by karthik in chapter 3 is for expiry calculation on expirt date. Hope this clears your doubt. The minimum value for this option should be STT stands for Security Transaction Tax, which is levied by the Government whenever a person does any transaction on the exchange.