Of Futures, Options, and Greeks
A quick guide to the basics of the Indian derivative market
At Minance we believe that transparency is vital to the work that we do. We achieve this by giving our partners unfettered access to their accounts and updating them every time we make changes to their investments.
These ‘Investment Notes’ explain the basic strategy behind the position, the expected profit, and also, the greeks.
While we try our best to ensure that the reasoning and intuition behind our strategies is put across in the most efficient and simplified manner, we understand that trading and trading strategies are often a little difficult to understand.
This guide is meant to help our partners (and anyone else interested in derivatives) understand the basics of the market and terminologies.
The Basics: What are derivatives
Arbor, our core derivative product, invests primarily in futures and options. First things first, what exactly are derivatives? Derivatives are financial securities whose value depends on an underlying asset.
There are several types of derivatives, including forwards, swaps, futures and options. A NIFTY option for example, derives its value from the NIFTY index.
An important advantage of taking positions in derivative instruments as compared to taking positions in bond or stock markets is the fact that the capital required is generally a lot lower. Investors in derivative instruments therefore, can control large positions for a comparatively low outflow of funds.
What are options? The Calls and the Puts
The options market accounts for a significant portion of India’s derivative market. An option is an instrument or a tool that can be used for protecting a certain position and to reduce risk.
There are two types of options; Call options and Put options. These options can be bought or sold.
Here, it’s imperative to understand the concept of strike prices and spot prices. In the simplest of terms, spot price refers to the current market price of the underlying asset. The strike price, on the other hand, refers to the price at which you can buy or sell the underlying security when exercising a call option or a put option, respectively.
A natural question would then be what exactly differentiates the strike price and the spot price of an option, at any given point in time? It is this difference that determines an option’s value or “moneyness”.
The “moneyness” of a given option is determined by the relationship the strike price shares with the spot price.
For Calls, an option is said to be “in the money” when the spot price is greater than the strike price, and out of the money when the opposite holds true.
For Puts, an option is said to be “in the money” when the strike price is greater than the spot price and “out of the money” in the opposite scenario. When the strike price equals the spot price, for either Calls or Puts, the option is said to be “at the money”. How do these classifications determine the value of an option?
What do you mean in/at/out of the money?
When options are “in the money”, they possess intrinsic value. In simple words, if an “in the money” option is exercised right now, it would return money.
Total Option Value or Premium = Intrinsic Value + Extrinsic Value
Options that are “at the money” or “out of the money”, will not be profitable if exercised immediately.
They, therefore, do not possess any intrinsic value, but possess extrinsic value. Intuitively, investors will pay more than an options current exercise price if there is something to gain by holding the contract over time. The amount of time left till the expiry of the option and the volatility of the underlying security, among other factors, determine the premium of an option, this directly impacting the extrinsic value.
The factors that affect the price of an option contract are measured by Option Greeks.
When opposites attract — Contract buyers and sellers
Now that we’ve got an understanding of spot prices and strike prices, we can discuss the two different types of options in more detail.
It’s important to understand here that the view or outlook that the buyer of an option contract has, the seller of the contract will have to exact opposite view.
1. Call Option: A call is an option to purchase an underlying stock at a specified strike price, within a certain timeframe.
- Buyer: The buyer of a Call option has the right but not the obligation to buy stock at a specified strike price. The buyer would want markets to rise in order to make a profit.
- Seller/Writer: The writer of a Call option has the obligation to sell stock at a specified strike price. The writer would want markets to fall in order to make a profit.
Lets take an example
Let’s assume that a certain stock is trading at Rs. 50/- today, and that you are given the right to purchase that stock one month from now at Rs. 80 — this is the strike price, with the condition that the share price is more than Rs. 80.
What would you do? Naturally, it makes sense to buy it. Why? Because if after a month, even if the share is trading at Rs. 90, you still get to buy it at Rs. 80. The cost of having this right is a small amount that needs to be paid today, let’s say Rs. 5 — this is the premium.
If after a month, the share price is greater than Rs. 80, you can take advantage of the right you have to buy the shares at Rs. 80. If it stays below Rs. 80 or at Rs. 80, then you do not need to exercise your right (you have no obligation).
The maximum you can lose in this case then is the initial amount of Rs. 5 that you paid. This is the case for an individual who buys a call option. In order for a call buyer to be profitable, therefore, the share price should increase. In order for a call seller or writer to be profitable, the share price should fall.
2. Put Option: A put is an option to sell an underlying stock at a specific strike price, within a certain time frame.
- Buyer: The buyer of a Put option has the right but not the obligation to sell stock at a specified strike price. The buyer would want markets to fall in order to make a profit.
- Seller/Writer: The writer of a Put option has the obligation to buy stock at a specified strike price. The writer wants markets to rise in order to make a profit.
Lets take an example
The Put option buyer is betting on his view that the share price will fall. The buyer of the Put option buys the the right to sell the underlying the seller of the option at a predetermined rate — this is the strike price. Let us again take the help of an example.
Share X is currently trading at Rs. 600. The put option buyer buys the right to sell share X to the contract seller/writer at Rs. 600 upon expiry. As was the case with a call option contract, the buyer pays a small amount (premium) to receive this right.
The contract seller, when he receives this premium, agrees to buy share X at Rs. 600 at expiry, but only if the buyer wants to exercise his right. When will the buyer want to exercise his right?
Only if share X’s price at expiry is below Rs. 600, as in that case he can exercise his right and demand the writer buys share X from his at Rs. 600. Conversely, if upon expiry, share X’s price is above Rs. 600, the buyer will not exercise his right.
To summarize
Buying Options — Makes sense to buy options only when the markets are expected to move strongly in a certain direction.
Selling Options — It makes sense to sell options when the markets are expected to remain flat or below/above the strike price.
It is important to note here that option sellers or writers are at a natural advantage over option buyers. As you can see from the table above, option sellers need the market to either stay flat or move in a certain direction. Option buyers, on the other hand, benefit only when the market moves in a certain direction.
When reading an investment note, refer to this table to understand our outlook while executing trades.
At this point, judging by the strike price of the option and the spot price of the underlying, you can tell whether an option is at the money (ATM), in the money (ITM) or out of the money (OTM).
As a result, you can also determine whether or not a given option has intrinsic value or extrinsic value. Being able to understand these terms will help take us forward to the key indicators that Options Traders use to assess the potential profitability of their positions. These indicators are commonly known as Options Greeks.
Delta, Theta, and Vega — Understanding the Greeks
We know that an option is a derivative contract which derives its value from an underlying asset. Every contract has a price. This price is dependent on the demand and supply of the particular option on the exchange.
However, since the option derives all its value from the underlying, the price of the option is also sensitive to changes in the price of the underlying. This is where the Greeks come into play.
Options Greeks are statistical references that measure an individual options sensitivity to changes in any variable that could affect the price of an option. These variables include the price of the underlying, the strike price, the time to expiration, the volatility and interest rates.
For the purposes of simplicity, we will be tackling only three Greeks today. These are Delta, Theta and Vega.
Delta = Direction
Delta is defined as the rate of change in the price of an option, given a one rupee change in the price of the underlying.
Let us assume that we have a Call Option that is trading at 5 and a delta of 0.50. In a situation where the price of the underlying increases by 1, our Call Option should now be priced at:
( 5 + 0 .50 ) = 5.50.
Similarly, in a situation where the price of the underlying decreases by 1, our Call Option should now be priced at:
( 5–0.50 ) = 4.50
Now let us assume we have a Put Option that is also trading at 5 and has a delta of 1. In a situation where the price of the underlying increases by 1, our Put Option should now be priced at:
( 5–1 ) = 4
Similarly, in a situation where the price of the underlying decreases by 1, our Put Option should now be priced at:
( 5 + 1 ) = 6
In general, the Delta of an option or a strategy, indicates the directionality that you think the market will take towards expiry. Therefore, if your Delta is positive, it hints that you are Bullish. If your Delta is negative, it indicates that you are Bearish.
Most option traders create strategies involving multiple options across various strikes to get their Delta as close to 0 as possible. The more market neutral you want your strategy to be, the closer your Delta has to be to 0.
Theta = Time
Every option has an expiry date. As the option gets closer to the date of expiry, its price begins to decay. All other factors remaining constant, Theta is defined as the rate of decay of an options price as it gets closer to expiry.
When we say all other factors remaining constant, we are making two assumptions:
- There are no price movements in the options market.
- There are no changes in the volatility of the underlying.
Therefore, under these circumstances, if we see a certain theta value on one day, on the next day the price of the option should decrease by that specific value.
Let us assume that we purchase a Call Option for Rs. 200. On the next trading day, we see that the price of our option has now reduced to Rs. 199.50. All other factors remaining constant, we can infer that the Theta of our positions is:
(200–199.50) = 0.50
Theta is useful to option traders since it lets them capitalize on the time decay of a given position. For example, if you are the seller of an option, you would want your Theta to be higher.
This way you can sell the option at a high price, capitalize on the high theta which reduces the options value on a daily basis and then buy it back at a lower price for a significant profit.
Similarly, as a buyer of an option, you would want your theta to be lower. This is because a high decay, would prevent you some selling back the option at a profit.
Vega = Volatility
This one is a bit tricky. So before we move into the definition, let’s start with an analogy.
Think about election season in India. For months leading up to these elections, we are surrounded by mass campaigns, expert opinions, political commentary and even public outcry. As we get closer to the elections and the results, we think we have a clearer idea of the victor.
However, that is not entirely true. Our perception of the success of political campaigns are just that, our own perception. Regardless of the studies, the analytics or even the exit polls, we have no idea of who will emerge victorious till the final results are announced.
In other words, we know the candidates, we know every possible outcome, but we don’t know which particular outcome we will be dealing with. This is where the concept of volatility kicks in, both for the politicians as well as the options traders.
Vega is defined as the rate of change of an option price given a 1% change in volatility. Since options gain value with increase in volatility, the Vega of an option is mostly positive for both Calls and Puts.
Let us assume that we have a Call Option worth Rs.200. On the next trading day, after a 1% increase in volatility of our underlying, we see that the value of our option has increased to Rs. 200.20. Given this data, we can infer that our Vega is:
(200.20–200) = 0.20
During political elections, options traders expect large swings in the market depending on the potential winning candidate. However, since they don’t know who the winning candidate is going to be, they are unsure about the direction in which the market will go.
To hedge their own risk, traders begin to purchase both Calls as well as Puts. As a result, the premiums of both calls and puts increase exponentially. This causes a massive increase in market volatility.
This is because, if the market runs up, all the Puts lose massive amounts of money, and if the market crashes, all the Calls are rendered worthless. Tracking the Vega in these situations and using the other Greeks to create a well-balanced strategy helps options traders to better manage their risk.
Conclusion
And there you have it! You now have a basic understanding of the derivative market and the various terms used in the industry. We hope this guide serves as a useful little milestone in your investing journey. Let us know what we can improve on in the comments and remember to share this with your friends!
This article was written by Shyla Mathur and Ishan Chatterjee.
Minance is a private wealth management firm. To know how we can help with your investments, click here.
