DERIVATIVE RESEARCH

Mathematically, prediction is not a yes-or-no game; mathematics likes to express games as probabilities. The probability of winning a coin toss is 50% (that is, one in two); of winning a dice throw is 16.667% (that is, one in six); of picking a winning card is 1.923% (that is, one in 52); of winning Kerala's Akshay AK-518 lottery is 0.0000111% (that is, one in 19 lakhs), and so on. Unlike a coin, dice, or lottery, an option’s price prediction isn't completely random; it depends on a few other observable quantities. In this article, we will look into the factors that affect option prices. Understanding these factors can help you choose the right option for yourself. Option prices depend on the spot price, strike price, time to expiry, volatility, and interest rate. Let us understand these one by one.

1. Spot Price:

The very definition of a derivative is that the asset derives its value from an underlying. If the spot price is close to the option strike price, there is a higher probability that the option will expire "in the money" (i.e., the option will have some premium on expiry).

2. Strike Price:

The strike price is like a hurdle a trader aims to cross. Depending on how far above or below that hurdle the trader’s prediction goes, the position will be more profitable and command a premium equivalent to the difference between the spot price and strike price. The wider the difference between the spot and strike price, the higher the premium on the option.

3. Time to Expiry:

An option with a longer time to expiry will see more events happening to its underlying asset; therefore, the probability of change in option price also increases.

4. Volatility:

As volatility increases, the probability of significant movements in the price of the underlying asset increases, and therefore, the option's premium also increases.

5. Interest Rate:

Option premiums incorporate the cost of the capital traders put in while taking a position. This cost is in the form of an interest rate—the higher the interest, the higher the cost of capital.

Now that we know the different factors, let us look at Option Greeks. Option Greeks help us understand the risk associated with options contracts due to various factors. There are five primary Greeks: Delta, Gamma, Theta, Vega, and Rho.

1. Delta:

Delta measures changes in the option premium due to changes in the market price of the underlying asset. In other words, Delta represents how much an option premium will rise for every one-rupee change in the stock price. Calls have a positive Delta between 0 and 1. If a call has a Delta of 0.60 and the stock goes up by one rupee, in theory, the price of the call will go up by about ₹0.6. If the stock goes down by one rupee, the call price will decrease by about ₹0.6 (assuming other pricing variables remain constant). Puts have a negative Delta between 0 and -1. For example, if a put has a Delta of -0.50 and the stock goes up by one rupee, in theory, the price of the put will go down by ₹0.50. Conversely, if the stock goes down by one rupee, in theory, the put price will go up by ₹0.50 (assuming other pricing variables remain constant).

Call option Delta moves from 0 to +1 for the OTM to ITM options. For put options, Delta moves from 0 to -1 for the OTM to ITM options. For deep OTM call options, the option price does not change much with changes in the underlying price, as the Delta of the OTM call option is close to zero. When the call option is deep in the money (ITM), the option's price almost increases in the ratio of 1:1, as the Delta of ITM options is +1. The Delta of the ATM call option will typically be in the range of 0.4 to 0.6. For deep OTM put options, the option price does not change much with changes in the underlying price, as the Delta is close to zero. For deep ITM put options, a change in the option’s price is equivalent to a change in the underlying price, but in opposite directions, as deep ITM put options will have a Delta close to -1. The Delta of the ATM put option will typically stay between -0.4 to -0.6.

But what happens to Delta as options near expiry? For OTM call and put options, Delta moves closer to zero as the option reaches expiry. For ITM call options, Delta moves closer to 1, and for ITM put options, it moves closer to -1 as the options reach expiry.

2. Gamma:

Gamma calculates the extent to which Delta would change due to a change in the underlying price. Therefore, Gamma is considered a second-order derivative, as it defines how the Delta of an option changes. Let's understand this with an example: Suppose stock ABC is trading at ₹50. A ₹45 strike price call option trades at ₹6 and has a Delta of 0.80 and a Gamma of 0.04. If the stock price moves up by one rupee and reaches ₹51, the Delta of the stock will change to 0.80 + 0.04 = 0.84, as Gamma is responsible for a change in Delta value. In the above example, if the stock price falls to ₹49, the Delta of the option will also fall to 0.80 - 0.04 = 0.76. It means Delta will keep reducing as the underlying moves toward the strike price. But does Gamma remain the same? No, Gamma will increase as the underlying reaches near the strike price, which is ₹45 as per the example. Gamma will increase and let us say will reach 0.045, when underlying reach ₹49. So, when stocks fall to ₹48, its new delta will be 0.76 – 0.045 = 0.715. Gamma value is the maximum for ATM call and put options. In other words, we can say that Delta is very sensitive to the underlying price when options are ATM, because of which Gamma is also at a maximum for ATM options. Conversely, for deep ITM and OTM options, the Gamma value approaches zero, as Delta’s value does not change much with the underlying price change for these options.

3. Theta:

The concept behind Theta is relatively simple. As an options contract approaches expiry, it loses its value; this phenomenon is known as time decay. For example, if the Theta value of an option is -10, you can expect the option premium to fall by ₹10 each passing day if all other factors remain the same. Theta (or time decay) is not linear. The decay rate tends to increase as the contract nears expiry. At expiry, the time value becomes zero, and options trade only at intrinsic value.

4. Vega:

Vega is the estimated change in an option premium with a 1% change in implied volatility. Implied volatility is the likely movement in the price of a security as forecasted by the market. Implied volatility will increase with the uncertainty in the market. The higher the volatility, the higher the price of both call and put options, so Vega is positive for both call and put options. For example, if a contract has a Vega of 0.2 on the option chain, it means the option premium may rise by ₹0.2 if IV increases by 1%. Options with a longer expiry period are more affected by volatility and have a higher Vega. Similarly, contracts near the strike price (ATM options) have higher Vega, which falls when options move away from the strike price. Note that Vega and implied volatility can change without any change in the underlying stock price. Therefore, it is best not to look at Vega in isolation, as volatility also impacts Delta and Gamma. With an increase in volatility, Delta and Gamma also tend to move. Thus, we need to consider the combined impact of Greeks on option pricing.

5. Rho:

Rho calculates the extent to which the option premium would change due to a change in the risk-free rate. But why do interest rates impact option pricing? We assume that a trader doesn’t have their own money and needs to borrow money to purchase an option. Similarly, if they sell the option, they will use the money to earn interest income by investing in a risk-free instrument. Changes in interest rates impact long-term options more than near-expiry options. The call option Rho is positive, and the value of call options increases as the risk-free rate increases. The Rho of a put option is negative, and the value decreases as risk-free rates increase. For example, assume the current risk-free rate is 5%. If a call option has a Rho of 0.5 and the interest rate suddenly goes up to 6%, the option premium would rise by ₹0.5. Conversely, if a put option has a Rho of -0.5, the put premium would decline by ₹0.5.

You can easily find option Greeks from your stock broker's website or trading app. If you like this blog and find it valuable, please do share it with your friends!

When you look back at your college days, which is the one time that stands out for being both exciting and stressful? You’re right—it’s the time when companies come to your institution for campus placements. There is so much to be done, from ensuring you know all the technical aspects of the job to improving your responses to questions like, "Where do you see yourself five years from now?" Campus placement is a time when everyone in college is driven to a frenzy. And then, lo and behold, you receive your first offer letter! However, do you stop there and start partying? Not really. You start exploring how you can be better prepared for the job so that you will have all the relevant information beforehand at the time of joining. But your learning is usually linear—you start as a trainee at your workplace, learn the ropes, and then move up the ladder. After all, even a lion does not hunt as a newborn; it takes months or a few years of observation and training before it can go on the prowl. Similarly, before executing any options trades, you need to understand options terminology first, which is what we will be doing in this article. So here are some of the terms you need to know before beginning your options trading journey.

1. Lot size:

The term lot size indicates the same thing in both options and futures contracts—it is the minimum quantity that you can trade in or in multiples of that. For example, if you look at the TCS options contract, you will see that the lot size is 175 shares. The term refers to the total number of units in a single contract.

2. Expiry date:

Options contracts expire on the last Thursday of the month. If you’re keen on weekly expiry contracts, these are also available in the market and expire on Thursday every week.

3. Number of available contracts:

In options, you have the following contracts available to you. For index weekly options, seven weekly expiry contracts (excluding the expiry week of the monthly contract) are available for trading. Three monthly contracts are also available for index options. For stocks, three monthly expiry contracts are available. Long-term index options of Nifty are also available with three quarterly expiries (March, June, September, and December cycles) and the next eight half-yearly expiries (June and December cycles).

4. Strike price:

The next term you must know is the strike price, which refers to the rate at which a trader has entered into the options contract. So, this is the rate at which you want to trade, and this can be both lower or higher than the spot price of the stock or index.

5. Options premium:

This is the price that the option buyer or holder pays to acquire the right (but not the obligation) to either buy or sell the underlying asset. So, if you’re a call option buyer, you are purchasing a right to buy an underlying asset. Therefore, you do not have to face any risk except the premium paid. However, since the seller is taking the risk, you have to pay them a premium to offset possible losses. The amount of the option premium depends on factors like the strike price, price of the underlying asset, volatility of prices, and time to expiry.

6. The concept of margins in options:

As an options buyer, you don’t have to pay any margin amount because you are exposed to limited risk, which is already compensated for with the premium paid. On the other hand, the option seller is exposed to unlimited risk; therefore, the seller needs to deposit a margin with the broker, and that is equivalent to a future margin, which is usually in the range of 10 to 30 percent of the lot value.

7. Intrinsic value:

Now let us look at the term intrinsic value. Option premium equals intrinsic value plus time value. You can calculate the intrinsic value of a call option by subtracting the strike price from the current market price. Therefore, the term refers to the amount you receive if you end up exercising the option. In the case of a put option, intrinsic value equals the subtraction of the spot price from the strike price. You should note here that the intrinsic value of a call or put option can never be below zero, because the option buyer will not exercise the option unless it results in positive cash flow. Let me give you an example to make this concept simpler. Suppose there’s a company named ABC Limited. The call option of ABC Limited with a strike price of ₹1000 is available at ₹50. If the current market price of ABC is ₹1020, its intrinsic value can be calculated as the spot price minus the strike price—that is, 1020 minus 1000, which is ₹20.

8. Time value:

The term time value refers to the falling value of an options contract over a period of time. At its expiry, the time value of the contract will become zero, since it has no time left. The time value can be calculated by deducting the intrinsic value from the premium. So, the greater the volatility and time of the option, the higher its time value would be. Therefore, if you’re looking at two options, one with a week’s expiry and the other expiring next month, then the second option has a greater time value. In the previous example, the time value of an option would be premium minus intrinsic value—that is, 50 minus 20 equals ₹30.

Metal stocks set to boost your portfolio next year! Have you seen this headline recently and wondered about adding steel stocks to your portfolio? Did you just go to your investment app and search for the stock of Tata Steel? If yes, you must have seen a long list of items with names such as December call, December put, and other months’ options. If you have tried your luck at investing in the stock market, you would have heard of a variety of terms such as stocks, derivatives, options, futures, etc.

For many of us, just hearing these words can lead to confusion, but that need not be the case. While you probably already know that stocks or equities refer to the shares of companies which you can buy and trade for a profit, do you know what derivatives are? If you have a basic idea about these concepts, or even if you know nothing at all, we are here to help you clear your doubts. So let us get started by demystifying these concepts in the simplest way possible. Let us first talk about derivatives. As a financial product, which, just like its name suggests, derives or gets its value from another asset. Derivatives can be an exciting investment option.

Let us take a very simple example to start with. When your car's tank runs empty, what do you do? You drive to the nearest petrol pump for a refill. Here, you look at the electronic fuel meter, which displays the volume of petrol being filled along with the amount you need to pay. You know that the price of petrol changes from time to time. Have you ever wondered how they arrive at that price? The price you pay for petrol depends on the current price of crude oil, so one could say that petrol’s value is derived from the prevailing rates of crude oil. The concept of derivatives is quite similar. It is a financial instrument that has no value of its own; a derivative gets its worth or value from that of the underlying asset, which could be stocks, bonds, commodities, currencies, indices, or interest rates. Now that you know what a derivative means, let us look at some of its important features. Each time you refuel your car, there is a transaction between you, the buyer, and the petrol pump, the seller. The petrol pump sells you petrol for a specific price, and you agree to buy it at that price. A derivative contract also involves a transaction between a buyer and a seller.

Here are the key components of a derivative contract: lot size or contract size stands for the minimum number of units being exchanged; for example, a crude oil derivative may have a lot size of 100 barrels. The expiry date is when the derivative transaction must take place—you cannot trade the contract once the expiration date has passed. Price is the pre-agreed rate at which you will settle the contract. So how do you then trade derivatives?

Derivative contracts are mainly of two kinds:

1. Over-the-counter (OTC) derivatives:

These derivatives are traded directly over the counter between the buyer and the seller; there is no intermediary, so you and the other party are free to customize the contract terms.

2. Exchange-traded derivatives:

They are bought and sold through an intermediary known as the exchange, which links the buyers and sellers of derivatives. Here, the contracts are most standardized, so you have no scope for personalization.

Now that you're aware of derivatives, let us understand what options are:

An option contract is an example of an exchange-traded derivative instrument. Now let us look at what this concept means. Suppose you're planning on booking a hotel room for your vacation a month from today during the festive season. You know that the prices will go up in the next month, so you want to book in advance. However, what if the hotel does not receive any bookings and reduces its price in the meantime? You would be facing a loss since you have entered a contract to pay more. What could be a solution here? Options could be the solution to this problem. Options are a derivative instrument that gives rights to the buyer of an option, and the option seller has an obligation to honour the contract. Options contracts are different from futures contracts because one party has the right to buy or sell an underlying, while another party has an obligation; while in futures, both parties have an obligation.

• Call and put options:

  The right to buy is a call option, while the right to sell is a put option. Options contracts provide the buyer with the option to exercise their right to buy or sell, as the case may be. The buyer may choose to exercise their right only if it is favourable. If a transaction is not in the buyer's favour, they're not required to go through with it. On the other hand, the seller doesn't have any right but has an obligation. If a buyer wants to exercise their right, the seller must compulsorily oblige and honour the contract. The buyer of an option is also known as the holder; the seller of an option is also known as the writer. So, in a hotel example, you can buy a call option with the hotel to stay at your booked rate despite an increase in prices. However, if the price falls, you are not liable to check in at your booked price. Similarly, if you expect a fall in price and want to sell at your earlier agreed price, you can buy a put option.

• Premium:

  To enjoy this right of buy or sell, you would have to pay a premium, as the party with the right has to compensate the party with the obligation. So, when a buyer purchases their right, they need to pay the cost of that right, known as a premium, upfront to the seller. This means that the buyer needs to make an upfront compensation to the seller for taking on risk. Since the hotel is taking on a risk by agreeing to your price, you need to compensate them with a premium, because you may choose to cancel your stay if the hotel price falls at the time of the trip, which will lead to a loss for the hotel. That's why options are always a zero-sum game; that is, profit for one party is equivalent to the loss for the counterparty.

Let us look at examples of market-based call and put options to understand the concept better. Assume you are bullish on ABC Limited stock and have purchased the ABC Limited ₹1000 call option with an expiry of January 29th at ₹100. This means that you have purchased the right to buy ABC stock at ₹1000 on expiry. You don't need to exercise or use your right compulsorily; you can exercise your right only if it is favourable to you. For instance, if you find that the ABC Limited’s market price is more than ₹1000, you can choose to exercise your call option. The amount you paid to purchase the right is known as premium—that is, ₹100 in this example. The rate at which you enter the contract is known as the strike price or the exercise price—that is, ₹1000 in this example. If you don't exercise your right, you will lose the premium to the seller, who will earn it. However, if your expectation turns into reality and ABC Limited stock touches ₹1300, then you have the right to buy the stock at ₹1000 and earn a profit after deducting the premium paid. The level at which you start earning profits is known as your break-even point.

Let us understand the put option now. Assume that you have purchased the ABC Limited’s ₹1000 put option with an expiry of January 29th at ₹80. This means you have purchased the right to sell ABC Limited at ₹1000 on expiry. You don't need to exercise your right if it is not in your favour; you may exercise your right only if you find that ABC Limited’s market price is less than ₹1000. In this case, if you don't exercise your right, you will lose the premium to the seller, who will earn it. But suppose ABC Limited does fall below ₹1000, as you expected. Then you can earn a profit from exercising your right to sell the stock at ₹1000. Now that you have a fair idea of what derivatives and options mean, do you think this is a call you want to take?