Glossary of Options

American style: Type of option contract which allows the holder to exercise at any time up to and including the Expiry Day.

Annualised return: The return or profit, expressed on an annual basis, the writer of the option contract receives for buying the shares and writing that particular option.
Assignment: The random allocation of an exercise obligation to a writer. This is carried out by the exchanges.
At-the-money: When the price of the underlying security equals the exercise price of the option.
Buy and write: The simultaneous purchase of shares and sale of an equivalent number of option contracts.
Call option: An option contract that entitles the taker (buyer) to buy a fixed number of the underlying shares at a stated price on or before a fixed Expiry Day.
Class of options: Option contracts of the same type – either calls or puts - covering the same underlying security.
Delta: The rate in change of option premium due to a change in price of the underlying securities.
Derivative: An instrument which derives its value from the value of an underlying instrument (such as shares, share price indices, fixed interest securities, commodities, currencies, etc.). Warrants and options are types of derivative.
European style: Type of option contract, which allows the holder to exercise only on the Expiry Day.
Exercise price: The amount of money which must be paid by the taker (in the case of a call option) or the writer (in the case of a put option) for the transfer of each of the underlying securities upon exercise of the option.
Expiry day: The date on which all unexercised options in a particular series expire.
Hedge: A transaction, which reduces or offsets the risk of a current holding. For example, a put option may act as a hedge for a current holding in the underlying instrument.
Implied volatility: A measure of volatility assigned to a series by the current market price.
In-the-money: An option with intrinsic value.
Intrinsic value: The difference between the market value of the underlying securities and the exercise price of the option. Usually it is not less than zero. It represents the advantage the taker has over the current market price if the option is exercised.
Long-term option: An option with a term to expiry of two or three years from the date the series was first listed. (This is not available in currently in India)
Multiplier: Is used when considering index options. The strike price and premium of an index option are usually expressed in points.
Open interest: The number of outstanding contracts in a particular class or series existing in the option market. Also called the "open position".
Out-of-the-money: A call option is out-of-the-money if the market price of the underlying securities is below the exercise price of the option; a put option is out-of-the-money if the market price of the underlying securities is above the exercise price of the options.
Premium: The amount payable by the taker to the writer for entering the option. It is determined through the trading process and represents current market value.
Put option: An option contract that entitles the taker (buyer) to sell a fixed number of underlying securities at a stated price on or before a fixed Expiry Day.
Random selection: The method by which an exercise of an option is allocated to a writer in that series of option.
Series of options: All contracts of the same class having the same Expiry Day and the same exercise price.
Time value: The amount investors are willing to pay for the possibility that they could make a profit from their option position. It is influenced by time to expiry, dividends, interest rates, volatility and market expectations.
Underlying securities: The shares or other securities subject to purchase or sale upon exercise of the option.
Volatility: A measure of the expected amount of fluctuation in the price of the particular securities.
Writer: The seller of an option contract.

Learnings from the stock market

With the introduction of index options, the derivatives market is all set to shift to a multi-product environment from a single-product market. Options like futures are leveraged products used by participants to manage the risk in the underlying market. Many people perceive options to be very risky. Debacles like the Barings episode are responsible for this misconception.

At this juncture, when options are being introduced in the Indian capital market, it would be prudent to understand what happened in the Barings case to prevent similar incidents from occurring here.
The episode
The man behind the widely-reported debacle, Nicholas Leeson, had an established track record of being a savvy operator in the derivatives market and was the darling of the top management at the Barings headquarters in London.
As head of derivatives trading, Leeson was responsible for both the trading and clearing functions of Barings Futures Singapore (BFS), a subsidiary of London-based Barings Plc.
Leeson engaged himself in proprietary trading on the Japanese stock exchange index Nikkei 225. He operated simultaneously on the Singapore Exchange – Derivatives Trading Ltd., (SGX – DT) (erstwhile Singapore International Monetary Exchange, SIMEX), Singapore and Osaka Securities Exchange (OSE), Japan in Nikkei 225 futures and options.
A major part of Leeson's trading strategy involved the sale of options on the Nikkei 225 index futures contracts. He sold a large number of option straddles (a strategy that involves simultaneous sale of both call and put options) on Nikkei 225 index futures.
Without going into the intricacies, it may be understood that straddle results in a loss, if the market moves in either direction (up or down) drastically. His strategy amounted to a bet that the Japanese stock market would neither fall nor rise substantially.
But events took an unexpected and dramatic turn. The news of a killer earthquake in Kobe sent the Japanese stock markets tumbling. The futures on the Nikkei 225 started declining and Leeson's straddle position started incurring losses.
Desperate to make some profit from his straddles, he started supporting the index by building up extraordinarily huge long positions in Nikkei 225 futures on both exchanges - SGX – DT and OSE.
However, the Barings management was made to understand that Leeson was trying to arbitrage between the SGX-DT and OSE with the Nikkei 225 index futures.
When OSE authorities warned Leeson about his huge long positions on the exchange in Nikkei 225 futures, the trader claimed that he had built up exactly the opposite positions in the Nikkei 225 on SGX - DT. He wanted to suggest that if his positions in the Nikkei 225 at the OSE suffered losses, they would be made up by the profits by his position in the SGX - DT.
A similar impression was given to SGX - DT authorities, when they inquired about Leeson's positions. While Leeson misled both exchanges with wrong information, neither exchanges bothered to cross-check the trader's positions on the other exchanges because they were competing for the same business.
Both exchanges were more concerned about protecting their financial integrity and in doing so, allowed the continuation of the exceptionally-large positions of Leeson after securing adequate margins.
We all know the consequences. A single operator couldn't take the market in the desired direction and the market crashed drastically.
Consequently, Barings registered losses on Leeson's futures and straddle positions. But, we must note that the flames of the Leeson disaster did not singe the financial integrity of either market. This was because the markets were protected with proper margins.
The lessons
A single operator can't move the market: Leeson was trying to drive up prices by buying index futures on the Nikkei 225 but could not succeed as the market was gripped by pessimism emanating from the devastating Kobe earthquake.
The point is that, a single operator cannot change the direction of the market and it is always prudent to live with the market movement strategically. In this instance, a better strategy for Leeson would have been the dynamic management of his portfolio.
For example, with the falling value of the index, his put leg of the straddle started incurring losses (call was to expire worthless), and he had the choice to square his put options off at the pre-determined level (cut-off loss strategy).
But Leeson, instead of squaring off his short put option position, chose to support the index price by buying futures on the Nikkei 225 and failed.
Traders should have clearly defined and well-communicated position limits: Position limits mean the limits set by top management for each trader in the trading organisation. These limits are defined in various forms with regard to product, market or trader's total market exposure etc.
Any laxity on this front may result in unbearable consequences to the trading organisation. These limits should be clearly defined and well communicated to all traders in the organisation.
Meticulous monitoring of position limits is a must: We may note that Leeson, too, had position limits set by top management, but, he exceeded all of them.
This attempt at crossing limits did not come to the notice of the top brass at Barings as Leeson himself was in charge of supervising back office operations at BFS.
It is understood that he had sent fictitious reports about his trading activities to the Barings' headquarters in London. Had the top management been aware of the real situation, the disaster could probably have been avoided.
Therefore, scrupulous monitoring of the position limits is as important as setting them. The top management's job of monitoring the positions of each dealer in the dealing room may be facilitated by bifurcating the front and back office operations.
Different people should be in charge of front and back-office operations so that any exposure by dealers, over and above the limits set, can be detected immediately. It means having proper checks and balances at various levels to ensure that everyone in the organisation has the disciplinary approach and works within set limits.
In fact, trading systems should be capable enough to automatically disallow traders any increase in exposures as soon as they touch pre-determined limits.
Exchanges should compete professionally: Both the competing exchanges, SGX – DT and OSE, were unconcerned about checking Barings' position at the other exchange.
While both the exchanges were safeguarded through margins, people must appreciate the fact that the effect of a big failure like Barings goes much beyond the financial integrity of a system.
The point to be noted is that exchanges can compete, but at the same time, must co-operate and share information. It could also help in deterring efforts at price manipulation.
Big institutions are as prone to risk as individuals: One broad issue from an overall market perspective is that big institutions are as prone to incurring losses in the derivatives market as is any other individual.
Therefore, irrespective of the entity, margins should be collected by the clearing corporation/ house and/ or exchange on time. Only timely collection of margins can protect the financial integrity of the market as we have seen in the Barings case.
The above-mentioned points are relevant to trading organisations in derivatives market. They have to intelligently work in-house to avoid any mishaps like the Barings episode at any point in time.
SEBI has done a good job in the Indian derivatives market by making margins universally applicable to all categories of participants including institutions. This provision will go a long way in creating a financially-safe derivatives market in India.
Conclusion
Clearly, the failure of Barings was not a 'derivatives' failure' but a failure of management. After the investigations were through in the Barings case, the Board of Banking Supervision's report also placed responsibility on poor operational controls at Barings rather than the use of derivatives.
An important lesson from the entire episode is that we all need a disciplinary and self-regulatory approach. The moment we go against this fundamental rule, this leveraged market is capable of threatening our very existence

Source: Bombay Stock Exchange.

Advantages of option trading

Risk management: Put options allow investors holding shares to hedge against a possible fall in their value. This can be considered similar to taking out insurance against a fall in the share price.
Time to decide: By taking a call option the purchase price for the shares is locked in. This gives the call option holder until the Expiry Day to decide whether or not to exercise the option and buy the shares. Likewise the taker of a put option has time to decide whether or not to sell the shares.
Speculation: The ease of trading in and out of an option position makes it possible to trade options with no intention of ever exercising them. If an investor expects the market to rise, they may decide to buy call options. If expecting a fall, they may decide to buy put options. Either way the holder can sell the option prior to expiry to take a profit or limit a loss. Trading options has a lower cost than shares, as there is no stamp duty payable unless and until options are exercised.
Leverage: Leverage provides the potential to make a higher return from a smaller initial outlay than investing directly. However, leverage usually involves more risks than a direct investment in the underlying shares. Trading in options can allow investors to benefit from a change in the price of the share without having to pay the full price of the share.
We can see below how one can leverage ones position by just paying the premium.


                                                           Option Premium                                         Stock

Bought on Oct 15                                  Rs 380                                                   Rs 4000

Sold on Dec 15                                     Rs 670                                                   Rs 4500

Profit                                                        Rs 290                                                   Rs 500

ROI (Not annualised)                            76.3%                                                    12.5%

Income generation: Shareholders can earn extra income over and above dividends by writing call options against their shares. By writing an option they receive the option premium upfront. While they get to keep the option premium, there is a possibility that they could be exercised against and have to deliver their shares to the taker at the exercise price.
Strategies: By combining different options, investors can create a wide range of potential profit scenarios. To find out more about options strategies read the module on trading strategies.

Key Regulations in Derivatives

In India we have two premier exchanges The National Stock Exchange of India (NSE) and The Bombay Stock Exchange (BSE) which offer options trading on stock indices as well as individual securities.

Options on stock indices are European in kind and settled only on the last of expiration of the underlying. NSE offers index options trading on the NSE Fifty index called the Nifty. While BSE offers index options on the country’s widely used index Sensex, which consists of 30 stocks.
Options on individual securities are American. The number of stock options contracts to be traded on the exchanges will be based on the list of securities as specified by Securities and Exchange Board of India (SEBI). Additions/deletions in the list of securities eligible on which options contracts shall be made available shall be notified from time to time.
Underlying: Underlying for the options on individual securities contracts shall be the underlying security available for trading in the capital market segment of the exchange.
Security descriptor: The security descriptor for the options on individual securities shall be:

• Market type - N
• Instrument type - OPTSTK
• Underlying - Underlying security
• Expiry date - Date of contract expiry
• Option type - CA/PA
• Exercise style - American Premium Settlement method: Premium Settled; CA - Call American
• PA - Put American.

Trading cycle: The contract cycle and availability of strike prices for options contracts on individual securities shall be as follows:
Options on individual securities contracts will have a maximum of three-month trading cycle. New contracts will be introduced on the trading day following the expiry of the near month contract.
On expiry of the near month contract, new contract shall be introduced at new strike prices for both call and put options, on the trading day following the expiry of the near month contract. (See Index futures learning centre for further reading)
Strike price intervals: The exchange shall provide a minimum of five strike prices for every option type (i.e call & put) during the trading month. There shall be two contracts in-the-money (ITM), two contracts out-of-the-money (OTM) and one contract at-the-money (ATM). The strike price interval for options on individual securities is given in the accompanying table.
New contracts with new strike prices for existing expiration date will be introduced for trading on the next working day based on the previous day's underlying close values and as and when required. In order to fix on the at-the-money strike price for options on individual securities contracts the closing underlying value shall be rounded off to the nearest multiplier of the strike price interval. The in-the-money strike price and the out-of-the-money strike price shall be based on the at-the-money strike price interval.
Expiry day: Options contracts on individual securities as well as index options shall expire on the last Thursday of the expiry month. If the last Thursday is a trading holiday, the contracts shall expire on the previous trading day.
Order type: Regular lot order, stop loss order, immediate or cancel, good till day, good till cancelled, good till date and spread order. Good till cancelled (GTC) orders shall be cancelled at the end of the period of 7 calendar days from the date of entering an order.
Permitted lot size: The value of the option contracts on individual securities shall not be less than Rs 2 lakh at the time of its introduction. The permitted lot size for the options contracts on individual securities shall be in multiples of 100 and fractions if any, shall be rounded off to the next higher multiple of 100.
Price steps: The price steps in respect of all options contracts admitted to dealings on the exchange shall be Re 0.05.
Quantity freeze: Orders which may come to the exchange as a quantity freeze shall be the lesser of the following: 1 per cent of the marketwide position limit stipulated of options on individual securities as given in (h) below or Notional value of the contract of around Rs 5 crore. In respect of such orders, which have come under quantity freeze, the member shall be required to confirm to the exchange that there is no inadvertent error in the order entry and that the order is genuine. On such confirmation, the exchange at its discretion may approve such order subject to availability of turnover/exposure limits, etc.
Base price: Base price of the options contracts on introduction of new contracts shall be the theoretical value of the options contract arrived at based on Black-Scholes model of calculation of options premiums. The base price of the contracts on subsequent trading days will be the daily close price of the options contracts. However in such of those contracts where orders could not be placed because of application of price ranges, the bases prices may be modified at the discretion of the exchange and intimated to the members.
Price ranges: There will be no day minimum/maximum price ranges applicable for the options contract. The operating ranges and day minimum/maximum ranges for options contract shall be kept at 99 per cent of the base price. In view of this the members will not be able to place orders at prices which are beyond 99 per cent of the base price. The base prices for option contracts may be modified, at the discretion of the exchange, based on the request received from trading members as mentioned above.
Exposure limits: Gross open positions of a member at any point of time shall not exceed the exposure limit as detailed hereunder:

• Index Options: Exposure Limit shall be 33.33 times the liquid networth.

• Option contracts on individual Securities: Exposure Limit shall be 20 times the liquid networth.

Memberwise position limit: When the open position of a Clearing Member, Trading Member or Custodial Participant exceeds 15 per cent of the total open interest of the market or Rs 100 crore, whichever is higher, in all the option contracts on the same underlying, at any time, including during trading hours.
For option contracts on individual securities, open interest shall be equivalent to the open positions multiplied by the notional value. Notional Value shall be the previous day's closing price of the underlying security or such other price as may be specified from time to time.
Market wide position limits: Market wide position limits for option contracts on individual securities shall be lower of:
*20 times the average number of shares traded daily, during the previous calendar month, in the relevant underlying security in the underlying segment of the relevant exchange or, 10 per cent of the number of shares held by non-promoters in the relevant underlying security i.e. 10 per cent of the free float in terms of the number of shares of a company.
The relevant authority shall specify the market wide position limits once every month, on the expiration day of the near month contract, which shall be applicable till the expiry of the subsequent month contract.
Exercise settlement: Exercise type shall be American and final settlement in respect of options on individual securities contracts shall be cash settled for an initial period of 6 months and as per the provisions of National Securities Clearing Corporation Ltd (NSCCL) as may be stipulated from time to time.

Long Butterfly Call Spread Strategy

The long butterfly call spread is a combination of a bull spread and a bear spread, utilizing calls and three different exercise prices. A long butterfly call spread involves:

·         Buying a call with a low exercise price,

·         Writing two calls with a mid-range exercise price,

·         Buying a call with a high exercise price.

To put on the September 40-45-50 long butterfly, you: buy the 40 and 50 strike and sell two 45 strikes.
This spread is put on by purchasing one each of the outside strikes and selling two of the inside strike. To put on a short butterfly, you do just the opposite.
The investor's profit potential is limited.
Maximum profit is attained when the market price of the underlying interest equals the mid-range exercise price (if the exercise prices are symmetrical).

The investor's potential loss is: limited.
The maximum loss is limited to the net premium paid and is realized when the market price of the underlying asset is higher than the high exercise price or lower than the low exercise price.
The breakeven points occur when the market price at expiration equals ... the high exercise price minus the premium and the low exercise price plus the premium. The strategy is profitable when the market price is between the low exercise price plus the net premium and the high exercise price minus the net premium.

Strangles in a Stable Market Outlook

A strangle is similar to a straddle, except that the call and the put have different exercise prices. Usually, both the call and the put are out-of-the-money.
To "buy a strangle" is to purchase a call and a put with the same expiration date, but different exercise prices. Usually the call strike price is higher than the put strike price.
To "sell a strangle" is to write a call and a put with the same expiration date, but different exercise prices.
A trader, viewing a market as stable, should: write strangles.
A "strangle sale" allows the trader to profit from a stable market.
The investor's profit potential is: unlimited.
If the market remains stable, investors having out-of-the-money long put or long call positions will let their options expire worthless.
The investor's potential loss is: unlimited.
If the price of the underlying interest rises or falls instead of remaining stable as the trader anticipated, he will have to deliver on the call or the put.
The breakeven points occur when market price at expiration equals...the high exercise price plus the premium and the low exercise price minus the premium.
The trader is short two positions and thus, two breakeven points. One for the call (high exercise price plus the premiums paid), and one for the put (low exercise price minus the premiums paid).

Why would a trader choose to sell a strangle rather than a straddle?
The risk is lower with a strangle. Although the seller gives up a substantial amount of potential profit by selling a strangle rather than a straddle, he also holds less risk. Notice that the strangle requires more of a price move in both directions before it begins to lose money.

Straddles in a Stable Market Outlook

Volatile market trading strategies are appropriate when the trader believes the market will move but does not have an opinion on the direction of movement of the market. As long as there is significant movement upwards or downwards, these strategies offer profit opportunities. A trader need not be bullish or bearish. He must simply be of the opinion that the market is volatile. This market outlook is also referred to as "neutral volatility."

·         A straddle is the simultaneous purchase (or sale) of two identical options, one a call and the other a put.

·         To "buy a straddle" is to purchase a call and a put with the same exercise price and expiration date.

·         To "sell a straddle" is the opposite: the trader sells a call and a put with the same exercise price and expiration date.

A trader, viewing a market as stable, should: write option straddles. A "straddle sale" allows the trader to profit from writing calls and puts in a stable market environment.

The investor's profit potential is limited. If the market remains stable, traders long out-of-the-money calls or puts will let their options expire worthless. Writers of these options will not have be called to deliver and will profit from the sum of the premiums received.
The investor's potential loss is unlimited. Should the price of the underlying rise or fall, the writer of a call or put would have to deliver, exposing himself to unlimited loss if he has to deliver on the call and practically unlimited loss if on the put.
The breakeven points occur when the market price at expiration equals the exercise price
plus the premium and minus the premium. The trader is short two positions and thus, two breakeven points; One for the call (common exercise price plus the premiums paid), and one for the put (common exercise price minus the premiums paid).