Month: October 2020

Initial Margin

Initial Margin is also called SPAN Margin. NSCCL (Clearing Corporation of NSE) and ICCL (Clearing Corporation of BSE) collects initial margin up-front for all the open positions of a Clearing Member (CM) based on the margins computed by SPAN Software. A CM is in turn required to collect the initial margin from the Trading Member (TMs generally known as Stock Broker) and his respective clients. Similarly, a TM should collect upfront margins from his clients.

Initial margin requirements are based on 99% value at risk over a one day time horizon. However, in the case of futures contracts (on index or individual securities), where it may not be possible to collect mark to market settlement value, before the commencement of trading on the next day, the initial margin is computed over a two-day time horizon, applying the appropriate statistical formula. The methodology for computation of Value at Risk percentage is as per the recommendations of SEBI from time to time.

Initial margin requirement for a member:

1. For client positions: Is netted at the level of individual client and grossed across all clients, at the Trading/Clearing Member level, without any setoffs between clients.
2. For proprietary positions: Is netted at Trading/Clearing Member level without any setoffs between client and proprietary positions.

Premium Margin

In addition to Span Margin, Premium Margin is charged to members. The premium margin is the client wise premium amount payable by the buyer of the option and is levied till the completion of pay-in towards the premium settlement.

Assignment Margin

Assignment Margin is levied on a CM in addition to SPAN margin and Premium Margin. It is levied on assigned positions of CMs towards interim and final exercise settlement obligations for option contracts on index and individual securities till the pay-in towards exercise settlement is complete.

The Assignment Margin is the net exercise settlement value payable by a Clearing Member towards interim and final exercise settlement and is deducted from the effective deposits of the Clearing Member available towards margins.

Initial Margin requirement = Total SPAN Margin Requirement + Buy Premium + Assignment Margin

Exposure Margin

The exposure margins for options and futures contracts on index are as follows:

For Index options and Index futures contracts:

3% of the notional value of a futures contract. In case of options it is charged only on short positions and is 3% of the notional value of open positions.

For option contracts and Futures Contract on individual Securities:

The higher of 5% or 1.5 standard deviation of the notional value of gross open position in futures on individual securities and gross short open positions in options on individual securities in a particular underlying. The standard deviation of daily logarithmic returns of prices in the underlying stock in the cash market in the last six months is computed on a rolling and monthly basis at the end of each month.

Additional Exposure Margin

Effective from February 2018, immediately the day after the expiry of February 2018 contracts , levying additional exposure margin based on Market Wide Position Limit has been started. The change in exposure margin shall be applicable from next trading day and shall be applicable till the open interest in the security reduces to below 70% of MWPL at end of the day.

For this purpose notional value means:

• For a futures contract: The contract value at last traded price/closing price.
• For an options contract: The value of an equivalent number of shares as conveyed by the options contract, in the underlying market, based on the last available closing price.

In case of calendar spread positions in futures contract, exposure margins are levied on one third of the value of open position of the far month futures contract. The calendar spread position is granted calendar spread treatment till the expiry of the near month contract.

Initial Margin requirement = Total SPAN Margin Requirement + Buy Premium + Assignment Margin+ Exposure Margin + Additional Exposure Margin

Option strategies are the simultaneous, and often mixed, buying or selling of one or more options that differ in one or more of the options’ variables. Call options, simply known as calls, give the buyer a right to buy a particular stock at that option’s strike price. Conversely, put options, simply known as puts, give the buyer the right to sell a particular stock at the option’s strike price. This is often done to gain exposure to a specific type of opportunity or risk while eliminating other risks as part of a trading strategy. A very straightforward strategy might simply be the buying or selling of a single option; however, option strategies often refer to a combination of simultaneous buying and or selling of options.

Options strategies allow traders to profit from movements in the underlying assets based on market sentiment (i.e., bullish, bearish or neutral). In the case of neutral strategies, they can be further classified into those that are bullish on volatility, measured by the lowercase Greek letter sigma (σ), and those that are bearish on volatility. Traders can also profit off time decay, measured by the uppercase Greek letter theta (Θ), when the stock market has low volatility. The option positions used can be long and/or short positions in calls and puts.

Bullish strategies

Bullish options strategies are employed when the options trader expects the underlying stock price to move upwards. They can also use Theta (time decay) with a bullish/bearish combo called a Calendar Spread, when sideways movement is expected. The trader may also forecast how high the stock price may go and the time frame in which the rally may occur in order to select the optimum trading strategy for buying a bullish option.

The most bullish of options trading strategies, used by most options traders, is simply buying a call option.

The market is always moving. It’s up to the trader to figure out what strategy fits the markets for that time period. Moderately bullish options traders usually set a target price for the bull run and utilize bull spreads to reduce cost or eliminate risk altogether. There is limited risk trading options by using the appropriate strategy. While maximum profit is capped for some of these strategies, they usually cost less to employ for a given nominal amount of exposure. There are options that have unlimited potential to the up or down side with limited risk if done correctly. The bull call spread and the bull put spread are common examples of moderately bullish strategies.

Mildly bullish trading strategies are options that make money as long as the underlying asset price does not decrease to the strike price by the option’s expiration date. These strategies may provide downside protection as well. Writing out-of-the-money covered calls is a good example of such a strategy. The purchaser of the covered call is paying a premium for the option to purchase, at the strike price (rather than the market price), the assets you already own. This is how traders hedge a stock that they own when it has gone against them for a period of time.

Bearish strategies

Bearish options strategies are employed when the options trader expects the underlying stock price to move downwards. It is necessary to assess how low the stock price can go and the time frame in which the decline will happen in order to select the optimum trading strategy. Selling a Bearish option is also another type of strategy that gives the trader a “credit”. This does require a margin account.

The most bearish of options trading strategies is the simple put buying or selling strategy utilized by most options traders.

The market can make steep downward moves. Moderately bearish options traders usually set a target price for the expected decline and utilize bear spreads to reduce cost. This strategy has limited profit potential, but significantly reduces risk when done correctly. The bear call spread and the bear put spread are common examples of moderately bearish strategies.

Mildly bearish trading strategies are options strategies that make money as long as the underlying asset does not rise to the strike price by the options expiration date. However, you can add more options to the current position and move to a more advanced position that relies on Time Decay “Theta”. These strategies may provide a small upside protection as well. In general, bearish strategies yield profit with less risk of loss.

Neutral or non-directional strategies

Neutral strategies in options trading are employed when the options trader does not know whether the underlying asset’s price will rise or fall. Also known as non-directional strategies, they are so named because the potential to profit does not depend on whether the underlying price will increase or decrease. Rather, the correct neutral strategy to employ depends on the expected volatility of the underlying stock price.

Examples of neutral strategies are:

• Guts: Buy (long gut) or sell (short gut) a pair of ITM (in the money) put and call (compared to a strangle where OTM puts and calls are traded);
• Butterfly: A neutral option strategy combining bull and bear spreads. Long butterfly spreads use four option contracts with the same expiration but three different strike prices to create a range of prices the strategy can profit from.
• Straddle: An options strategy in which the investor holds a position in both a call and put with the same strike price and expiration date, paying both premiums (long straddle)
• Strangle: Where you buy a put below the stock and a call above the stock, with profit if the stock moves outside of either strike price (long strangle).
• Risk reverse: Simulates the motion of an underlying so sometimes these are referred as synthetic long or synthetic short positions depending on which position you are shorting;
• Collar: Buy the underlying and then simultaneous buying of a put option below current price (floor) and selling a call option above the current price (cap);
• Fence: Buy the underlying then simultaneous buying of options either side of the price to limit the range of possible returns;
• Iron butterfly: Sell two overlapping credit vertical spreads but one of the verticals is on the call side and one is on the put side;
• Iron condor: The simultaneous buying of a put spread and a call spread with the same expiration and four different strikes. An iron condor can be thought of as selling a strangle instead of buying and also limiting your risk on both the call side and put side by building a bull put vertical spread and a bear call vertical spread;
• Jade Lizard: A bull vertical spread created using call options, with the addition of a put option sold at a strike price lower than the strike prices of the call spread in the same expiration cycle;
• Calendar spread: The purchase of an option in one month and the simultaneous sale of an option at the same strike price (and underlying) in an earlier month, for a debit

Bullish on volatility

Neutral trading strategies that are bullish on volatility profit when the underlying stock price experiences big moves upwards or downwards. They include the long straddle, long strangle, long condor (Iron Condor), long butterfly, and long Calendar.

Bearish on volatility

Neutral trading strategies that are bearish on volatility profit when the underlying stock price experiences little or no movement. Such strategies include the short straddle, short strangle, ratio spreads, short condor, short butterfly, and short calendar.

Option strategy profit / loss chart

A typical option strategy involves the purchase / selling of at least 2-3 different options (with different strikes and / or time to expiry), and the value of such portfolio may change in a very complex way.

One very useful way to analyze and understand the behavior of a certain option strategy is by drawing its Profit / Loss graph.

An option strategy profit / loss graph shows the dependence of the profit / loss on an option strategy at different base asset price levels and at different moments in time.

Option Strategies

1. Orientation

Setting the context Before we start this module on Option Strategy.

2. Bull Call Spread

Background The spread strategies are some of the simplest option strategies that a trader can implement. Spreads are multi leg strategies involving 2 or more options.

3. Bull Put Spread

Why Bull Put Spread? Similar to the Bull Call Spread, the Bull Put Spread is a two leg option strategy invoked when the view on the market is ‘moderately bullish’.

4. Call Ratio Back Spread

Background The Call Ratio Back Spread is an interesting options strategy. I call this interesting keeping in mind the simplicity of implementation and the kind of pay off it offers the trader.

5. Bear Call Ladder

Background The ‘Bear’ in the “Bear Call Ladder” should not deceive you to believe that this is a bearish strategy. The Bear Call Ladder is an improvisation over the Call ratio back spr.

6. Synthetic Long & Arbitrage

Background Imagine a situation where you would be required to simultaneously establish a long and short position on Nifty Futures, expiring in the same series.

7. Bear Put Spread

Spreads versus naked positions Over the last five chapters we’ve discussed various multi leg bullish strategies. These strategies ranged to suit an assortment of market outlook – from.

8. Bear Call Spread

Choosing Calls over Puts Similar to the Bear Put Spread, the Bear Call Spread is a two-leg option strategy invoked when the view on the market is ‘moderately bearish’. The Bear Call Spread.

9. Put Ratio Back spread

Background We discussed the “Call Ratio Back spread” strategy extensively in chapter 4 of this module. The Put ratio back spread is similar except that the trader invokes this when he is b ..

10. The Long Straddle

The directional dilemma How many times have you been in a situation wherein you take a trade after much conviction, either long or short and right after you initiate the trade the market move.

11. The Short Straddle

Context In the previous chapter we understood that for the long straddle to be profitable, we need a set of things to work in our favor, reposting the same for your quick reference – The vo ..

12. The Long & Short Strangle

Background If you have understood the straddle, then understanding the ‘Strangle’ is quite straightforward. For all practical purposes, the thought process behind the straddle and strangl ..

13. Max Pain & PCR Ratio

My experience with Option Pain theory in the never ending list of controversial market theories, the theory of ‘Option Pain’ certainly finds a spot. Option Pain, or sometimes referred to.

14. Iron Condor

New margin framework These are fascinating times we are living in, especially if you are an options trader in India Starting 1st June 2020, NSE’s new margin framework is live.

In finance, the binomial options pricing model (BOPM) provides a generalizable numerical method for the valuation of options. Essentially, the model uses a “discrete-time” (lattice based) model of the varying price over time of the underlying financial instrument, addressing cases where the closed-form Black–Scholes formula is wanting.

The binomial model was first proposed by William Sharpe in the 1978 edition of Investments (ISBN 013504605X), and formalized by Cox, Ross and Rubinstein in 1979 and by Rendleman and Bartter in that same year.

For binomial trees as applied to fixed income and interest rate derivatives see Lattice model (finance) #Interest rate derivatives.

Method

The binomial pricing model traces the evolution of the option’s key underlying variables in discrete-time. This is done by means of a binomial lattice (tree), for a number of time steps between the valuation and expiration dates. Each node in the lattice represents a possible price of the underlying at a given point in time.

Valuation is performed iteratively, starting at each of the final nodes (those that may be reached at the time of expiration), and then working backwards through the tree towards the first node (valuation date). The value computed at each stage is the value of the option at that point in time.

Option valuation using this method is, as described, a three-step process:

• Price tree generation,
• Calculation of option value at each final node,
• Sequential calculation of the option value at each preceding node.

The two assets, which the valuation depends upon, are the call option and the underlying stock. There is an agreement among participants that the underlying stock price can move from the current $100 to either $110 or $90 in one year and there are no other price moves possible.

In an arbitrage-free world, if you have to create a portfolio comprised of these two assets, call option and underlying stock, such that regardless of where the underlying price goes – $110 or $90 – the net return on the portfolio always remains the same. Suppose you buy “d” shares of underlying and short one call options to create this portfolio.

If the price goes to $110, your shares will be worth $110*d, and you’ll lose $10 on the short call payoff. The net value of your portfolio will be (110d – 10).

If the price goes down to $90, your shares will be worth $90*d, and the option will expire worthlessly. The net value of your portfolio will be (90d).

If you want your portfolio’s value to remain the same regardless of where the underlying stock price goes, then your portfolio value should remain the same in either case:

h(d)−m=l(d)

where:

h = Highest potential underlying price

d = Number of underlying shares

m = Money lost on short call payoff

l = Lowest potential underlying price

Use of the model

The Binomial options pricing model approach has been widely used since it is able to handle a variety of conditions for which other models cannot easily be applied. This is largely because the BOPM is based on the description of an underlying instrument over a period of time rather than a single point. As a consequence, it is used to value American options that are exercisable at any time in a given interval as well as Bermudan options that are exercisable at specific instances of time. Being relatively simple, the model is readily implementable in computer software (including a spreadsheet).

Although computationally slower than the Black–Scholes formula, it is more accurate, particularly for longer-dated options on securities with dividend payments. For these reasons, various versions of the binomial model are widely used by practitioners in the options markets.

For options with several sources of uncertainty (e.g., real options) and for options with complicated features (e.g., Asian options), binomial methods are less practical due to several difficulties, and Monte Carlo option models are commonly used instead. When simulating a small number of time steps Monte Carlo simulation will be more computationally time-consuming than BOPM (cf. Monte Carlo methods in finance). However, the worst-case runtime of BOPM will be O(2n), where n is the number of time steps in the simulation. Monte Carlo simulations will generally have a polynomial time complexity, and will be faster for large numbers of simulation steps. Monte Carlo simulations are also less susceptible to sampling errors, since binomial techniques use discrete time units. This becomes more true the smaller the discrete units become.

Call Option

Call options are financial contracts that give the option buyer the right, but not the obligation, to buy a stock, bond, commodity or other asset or instrument at a specified price within a specific time period. The stock, bond, or commodity is called the underlying asset. A call buyer profits when the underlying asset increases in price.

A call option may be contrasted with a put, which gives the holder the right to sell the underlying asset at a specified price on or before expiration.

For options on stocks, call options give the holder the right to buy 100 shares of a company at a specific price, known as the strike price, up until a specified date, known as the expiration date.

For example, a single call option contract may give a holder the right to buy 100 shares of Apple stock at $100 up until the expiry date in three months. There are many expiration dates and strike prices for traders to choose from. As the value of Apple stock goes up, the price of the option contract goes up, and vice versa. The call option buyer may hold the contract until the expiration date, at which point they can take delivery of the 100 shares of stock or sell the options contract at any point before the expiration date at the market price of the contract at that time.

The market price of the call option is called the premium. It is the price paid for the rights that the call option provides. If at expiry the underlying asset is below the strike price, the call buyer loses the premium paid. This is the maximum loss.

If the underlying’s price is above the strike price at expiry, the profit is the current stock price, minus the strike price and the premium. This is then multiplied by how many shares the option buyer controls.

• A call is an option contract giving the owner the right, but not the obligation, to buy a specified amount of an underlying security at a specified price within a specified time.
• The specified price is known as the strike price and the specified time during which a sale is made is its expiration or time to maturity.
• Call options may be purchased for speculation, or sold for income purposes. They may also be combined for use in spread or combination strategies.

Put Option

A put option is a contract giving the owner the right, but not the obligation, to sell–or sell short–a specified amount of an underlying security at a pre-determined price within a specified time frame. This pre-determined price that buyer of the put option can sell at is called the strike price.

Put options are traded on various underlying assets, including stocks, currencies, bonds, commodities, futures, and indexes. A put option can be contrasted with a call option, which gives the holder the right to buy the underlying at a specified price, either on or before the expiration date of the options contract.

A put option becomes more valuable as the price of the underlying stock decreases. Conversely, a put option loses its value as the underlying stock increases. When they are exercised, put options provide a short position in the underlying asset. Because of this, they are typically used for hedging purposes or to speculate on downside price action.

Investors often use put options in a risk-management strategy known as a protective put. This strategy is used as a form of investment insurance; this strategy is used to ensure that losses in the underlying asset do not exceed a certain amount (the strike price.)

In general, the value of a put option decreases as its time to expiration approaches because of the impact of time decay. Time decay accelerates as an option’s time to expiration draws closer since there’s less time to realize a profit from the trade. When an option loses its time value, the intrinsic value is left over. An option’s intrinsic value is equivalent to the difference between the strike price and the underlying stock price. If an option has intrinsic value, it is referred to as in the money (ITM).

Out of the money (OTM) and at the money (ATM) put options have no intrinsic value because there is no benefit in exercising the option. Investors have the option of short selling the stock at the current higher market price, rather than exercising an out of the money put option at an undesirable strike price. However, outside of a bear market, short selling is typically riskier than buying options.

Time value, or extrinsic value, is reflected in the premium of the option. If the strike price of a put option is $20, and the underlying is stock is currently trading at $19, there is $1 of intrinsic value in the option. But the put option may trade for $1.35. The extra $0.35 is time value, since the underlying stock price could change before the option expires. Different put options on the same underlying asset may be combined to form put spreads.

There are several factors to keep in mind when it comes to selling put options. It’s important to understand an option contract’s value and profitability when considering a trade, or else you risk the stock falling past the point of profitability.

• Put options give holders of the option the right, but not the obligation, to sell a specified amount of an underlying security at a specified price within a specified time frame.
• Put options are available on a wide range of assets, including stocks, indexes, commodities, and currencies.
• Put option prices are impacted by changes in the price of the underlying asset, the option strike price, time decay, interest rates, and volatility.
• Put options increase in value as the underlying asset falls in price, as volatility of the underlying asset price increases, and as interest rates decline.
• They lose value as the underlying asset increases in price, as volatility of the underlying asset price decreases, as interest rates rise, and as the time to expiration nears.

Futures and options are tools used by investors when trading in the stock market. As financial contracts between the buyer and the seller of an asset, they offer the potential to earn huge profits. However, there are some key differences between futures and options. Click here if you want to know how to buy and sell Futures Contracts.

Obligation:

A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. Here, the buyer is obliged to buy the asset on the specified future date.

An options contract gives the buyer the right to buy the asset at a fixed price. However, there is no obligation on the part of the buyer to go through with the purchase. Nevertheless, should the buyer choose to buy the asset, the seller is obliged to sell it.

Risk:

The futures contract holder is bound to buy on the future date even if the security moves against them. Suppose the market value of the asset falls below the price specified in the contract. The buyer will still have to buy it at the price agreed upon earlier and incur losses.

The buyer in an options contract has an advantage here. If the asset value falls below the agreed-upon price, the buyer can opt out of buying it. This limits the loss incurred by the buyer.

In other words, a futures contract could bring unlimited profit or loss. Meanwhile, an options contract can bring unlimited profit, but it reduces the potential loss.

Advance payment:

There is no upfront cost when entering into a futures contract. But the buyer is bound to pay the agreed-upon price for the asset eventually.

The buyer in an options contract has to pay a premium. The payment of this premium grants the options buyer the privilege to not buy the asset on a future date if it becomes less attractive. Should the options contract holder choose not to buy the asset, the premium paid is the amount he stands to lose.

Contract execution:

A futures contract is executed on the date agreed upon in the contract. On this date, the buyer purchases the underlying asset.

Meanwhile, the buyer in an options contract can execute the contract anytime before the date of expiry. So, you are free to buy the asset whenever you feel the conditions are right.

1. Contract details:

At the time of drawing up a futures or options contract, four key details will be mentioned:

• The asset that is up for trade
• The quantity of the asset that is available for buying or selling
• The price at which it will be traded
• The date on which (futures contract) or by which (options contract) it must be traded

The futures contract will also mention the method of settlement.

2. Trade venue:

The trade in futures takes place on the stock exchange. The options trade takes place both on and off the exchanges.

3. Types of assets covered:

Futures and options contracts can cover stocks, bonds, commodities, and even currencies.

4. Requirements:

You would need a margin account to trade in futures and options.