Topic of Financial Derivative. Strategies of options to hedge the risk while trading. Different ways of hedging the risk in Call option and Put Option. Index Future market

1. OPTIONS & STRATEGIES
TO MITIGATE THE RISK
FINANCIAL DERIVATIVES
Priyank Srivastava

2. WHAT ARE OPTIONS?
OPTIONS are type of derivative security.
They are derivative because the price of an option in intrinsically linked
to the price of something else.
Specifically, the option are contracts that grant the right, but not the
obligation to buy or sell an underlying asset at a set price on or before a
certain date.
The right to buy is called a Call option
The right to sell is called a Put option.
Priyank Srivastava

3. CALL OPTION
A call option gives the buyer a right but not the obligation to buy a given
quantity of the underlined asset at a given price on or before a certain date.
Example: -
Call Option
Right to buy 100
Reliance shares
at a strike price
of 300/share
after 3 months.
Assuming that the current price of each Reliance share
is 250/share and premium is 25 per share.
The amount involved to buy this call option will be
number of shares involved to buy in call option multiply
premium per share i.e.
100 X 25 = 2500.
Possibilities after 3 months
Share price
will rise
Share price
will fall
Profit?
Priyank Srivastava

4. Share price will rise
 Suppose after a month market price of each Reliance share is 400. Then the
option will be exercised and shares will be bought up.
 Net flow in such scenario will be: -
400 X 100 – 300 X 100 – 2500 = 7500
7500 will be the profit.
Share price will fall
 Suppose after a month market price of each Reliance share is 200. Then the
option will not be exercised.
 Net flow in such scenario will be: -
Net loss will be 2500 the premium amount.
Priyank Srivastava

5. PUT OPTION
A put option gives the buyer a right but not the obligation to sell a given
quantity of the underlined asset at a given price on or before a certain date.
Example: -
Put Option
Right to sell 100
Reliance shares
at a strike price
of 300/share
after 3 months.
Assuming that the current price of each Reliance share
is 350/share and premium is 25 per share.
The amount involved to buy this call option will be
number of shares involved to buy in call option multiply
premium per share i.e.
100 X 25 = 2500.
Possibilities after 3 months
Share price
will rise
Share price
will fall
Profit?
Priyank Srivastava

6. Share price will rise
 Suppose after a month market price of each Reliance share is 400. Then the
option will not be exercised.
 Net flow in such scenario will be: -
net loss will be 2500 the premium amount
Share price will fall
 Suppose after a month market price of each Reliance share is 200. Then the
option will be exercised.
 Net flow in such scenario will be: -
300 X 100 – 200 X100 – 2500 = 7500
7500 will be the profit.
Priyank Srivastava

7. Strategies to mitigate the risk
1. Option Spreads: - Spreads involved combining options on the same
underline and of same type (call/put) but in different strikes and
maturity. There is a situation of limited profit and limited loss.
Spreads are of various types: -
1. Vertical Spreads: - They are created by using options having same expiry
but different strike prices. These can be created either use call formation
or put combination. These can be further classified as: -
A. Bullish vertical spread (Using Call): - A bull spread is created when the
underline view of market is positive, but the trader would also like to reduce
its cost on position so he takes 1 long (buy) position with lower strike price
and sells a call option at higher strike price.
Priyank Srivastava

8. 5800
6000
6200
Long call SP @ 300
Short Call SP @ 145
Spot price
Case 1: - Suppose market ends at
6800. The flow will be?
Net flow will be –
6800 – 5800 - 300 = 700
6200 – 6800 + 145 = (455)
700 + (455) = 245
245 is the maximum profit.
6800 Market Ends
+1000
Case 2: - Suppose market ends at
5200. The flow will be?
Net flow will be –
300 (Long Premium paid)
145 (Short Premium received)
(300) + 145 = (155)
(155) will be the maximum loss.
5200 Market Ends
Example: - A trader is bullish in the market so he decided to go long on 5800 strike price
call option at a premium of 300. and he expect the market not to be above the 6200. so he
spot the call option and receives a premium of 145.
-600
LIMITED PROFIT
LIMITED LOSSPriyank Srivastava

9. B. Bullish vertical spread (using put): - Here also the call on the market is bullish. Hence,
the trader would like to spot a put option, if prices were trader would end up with a
premium on sold puts. However in case, prices go down trader would face the loss. In
order to put a flow in down size, he may buy a put option with a lower strike.
6000
6200 Short put SP @ 220
Spot price, Long put SP @ 170
Case 1: - Suppose market ends at
6800. The flow will be?
Net flow will be –
220 (Short Premium received)
170 (Long Premium paid)
220 + (170) = 50
50 will be the maximum profit.
6800 Market Ends
-1000
Case 2: - Suppose market ends at 5200.
The flow will be?
Net flow will be –
5200 – 6200 + 220 = (780)
6000 – 5200 – 170 = 630
(780) + 630 = (150)
(150) Will be the maximum loss.
5200 Market Ends
Example: - A trader goes short in a put option of strike 6200 and receives a premium of 220 and goes long
in a put option of strike 6000 and pays a premium of 170.
+800
LIMITED PROFIT
LIMITED LOSSPriyank Srivastava

10. C. Bearish vertical spread (Using call): - Here the trader is bearer in the market so he shorts
a low strike price with high premium on call option. To prevent his unlimited loss he
long high strike call and pays a lesser premium.
6000
6200 Long call SP @ 145
Spot price
Case 1: - Suppose market ends at
6800. The flow will be?
Net flow will be –
6800 – 6200 - 145 = 455
5800 – 6800 + 300 = (700)
455 + (700) = (245)
(245) Will be the maximum loss.
6800 Market Ends
Case 2: - Suppose market ends at 5200.
The flow will be?
Net flow will be –
145 (Long Premium)
300 (Short Premium)
300 – 145 = 155
155 will be the maximum profit
5200 Market Ends
Example: - A trader goes long in a call option of strike 6200 and pays a premium of 145 and goes short in
a call option of lower strike 5800 and receives a premium of 300. Spot price is 6000.
5800 Short call SP @ 300
+600 -1000
LIMITED PROFIT
LIMITED LOSSPriyank Srivastava

11. C. Bearish vertical spread (Using put): - Here the trader is bearer in the market so he goes
long in one put option by paying a high premium. Further, to reduce its cost he shorts
another put option of lower strike and receives a low premium.
6000
6200 Long put SP @ 220
Spot price, Short put SP @ 170
Case 1: - Suppose market ends at
6800. The flow will be?
Net flow will be –
170 (Short Premium)
220 (Long Premium)
(220) + 170 = (50)
(50) Will be the maximum loss.
6800 Market Ends
Case 2: - Suppose market ends at 5200.
The flow will be?
Net flow will be –
6200 – 5200 – 220 = 780
5200 – 6000 + 170 = (630)
780 + (630) = 150
150 will be the maximum profit.
5200 Market Ends
Example: - A trader goes long in a put option of strike 6200 and pays a premium of 220 and goes short in a
put option of lower strike 6000 and receives a premium of 170. Spot price is 6000.
-600 +1000
LIMITED PROFIT
LIMITED LOSSPriyank Srivastava

12. 2. Horizontal Spread: - It involves same price, same type
but different expiry contract. This is also known as
time spread or calendar spread.
3. Diagonal Spread: - It involves combination of option
having same underlined asset but different expiry
with different strike prices.
Priyank Srivastava

13. 2. Straddle: - This strategy involves both options of same strike price with same maturity
period. A long straddle position is created by buying a call and a put option of same
strike with same expiry; whereas a short straddle is created by shorting a call and a put
option of same strike and same expiry.
6000 Spot price, call @ 257, put @ 136
Case 1: - Suppose market ends at
6700. The flow will be?
Net flow will be –
6700 – 6000 – 257 = 443
443 – 136 (put premium) = 307
As stock price increase the profit also
increase.
6700 Market Ends
Case 2: - Suppose market ends at 5300.
The flow will be?
Net flow will be –
6000 – 5300 – 136 = 564
564 – 257 (call premium) = 307
As the stock price decreases the profit
will be increase.
5300 Market Ends
Long Example: - Let us say a stock is trading at 6000 and premium for At the Money (ATM) call and put
options are 257 and 136 respectively.
+700
+700
NOTE: - Here the maximum loss is 393,
the both premium amount 257 + 136.
UNLIMITED PROFIT
LIMITED LOSS
Priyank Srivastava

14. 6000 Spot price, put@136, call@257
Case 1: - Suppose market ends at
6700. The flow will be?
Net flow will be –
6000 – 6700 + 257 = (443)
(443) + 136 (put premium) = (307)
As stock price increase the loss also
increase.
6700 Market Ends
Case 2: - Suppose market ends at 5300.
The flow will be?
Net flow will be –
5300 – 6000 + 136 = (564)
(564) + 257 (call premium) = (307)
As the stock price decreases the loss
will be increase.
5300 Market Ends
Short Example: - Let us say a stock is trading at 6000 and short a call option at 6100 and short a put
option at 5900 and receive a premium of 257 and 136 respectively.
-700
-700
NOTE: - Here the maximum profit is 393,
the both premium amount 257 + 136.
UNLIMITED LOSS
LIMITED PROFITPriyank Srivastava

15. 3. Strangle: -
 Long – In long straddle we have same strike price, but in long strangle the strike price of both
options are different, and both the options are Out of the Money (OTM) which means premium
is low.
Example: - Suppose cash market is 6100, option call strike price is 6200 @ 145 and option put
strike price is 6000 @ 140.
6100
6200 Call SP @ 145
Spot price
6800 Market Ends
5400 Market Ends
+600
+600
UNLIMITED PROFIT
LIMITED LOSS
6000 Put SP @ 140
Case 1: - Suppose market ends at
6800. The flow will be?
Net flow will be –
6800 – 6200 – 145 = 445
140 (Put premium)
445 + (140) = 315
As stock price increase the profit also
increase.
Case 2: - Suppose market ends at 5200.
The flow will be?
Net flow will be –
6000 – 5400 – 140 = 460
145 (Call Premium)
460 + (145) = 315
As the stock price decreases the profit
will be increase.
NOTE: - Here the maximum loss is 285,
the both premium amount 145 + 140.
Priyank Srivastava

16. 3. Strangle: -
 Short – Short strangle is exactly opposite to the long strangle with two Out of the money (OTM)
option shortened. The market will remain stable over the period of the option.
Example: - Suppose cash market is 6100, option call strike price is 6200 @ 145 and option put
strike price is 6000 @ 140.
6100
6200 Call SP @ 145
Spot price
6800 Market Ends
5400 Market Ends
+600
+600
LIMITED PROFIT
UNLIMITED LOSS
6000 Put SP @ 140
Case 1: - Suppose market ends at
6800. The flow will be?
Net flow will be –
6200 – 6800 + 145 = (445)
140 (Put premium)
(445) + 140 = (315)
As stock price increase the loss also
increase.
Case 2: - Suppose market ends at 5200.
The flow will be?
Net flow will be –
5400 – 6000 + 140 = (460)
145 (Call Premium)
(460) + 145 = (315)
As the stock price decreases the loss
will be increase.
NOTE: - Here the maximum profit is 285,
the both premium amount 145 + 140.
Priyank Srivastava

17. 4. Covered Call: - This strategy is used to generate extra income from existing holding
from cash market. If an investor had bought shares and intend them to hold for some
time, then he would like to earn some extra income on that asset without selling it.
There by reducing the cost of acquisition. This is called covered call.
1590
1600 Short Call @ 10
Spot price
1640 Market end
+ 50
Example: - A trader buy a shares
when market is 1590.
To earn extra income and hedge the
risk he short the call at 1600 @ 10.
Suppose market rise up to 1640.
Then the flow will be –
1640 – 1590 = 50; (profit from share holding)
1640 – 1600 = (40); (loss from option)
(40) + 10(premium)= (30);
50 + (30) = 20 (All over profit)
- 40
1520
- 70
Market end
Suppose market falls down to 1520.
Then there will be a loss –
1520 – 1590 = (70); (loss from share holding)
10 (received premium)
(70) + 10(premium)= (60);
(60) It is not a actual loss, when the shares
will be sold then there will be a loss.
Priyank Srivastava

18. 5. Protective Put: - Any investor, long in the cash market, always runs the risk of a fall in
prices and thereby reduction in portfolio value. To hedge the risk we buy a put option
which will make profits on long put, which will be useful to negate the losses in the
cash market portfolio.
1600 Spot price, Long put @ 20
1660 Market end
+ 60
Example: - A trader buy a shares when
market is 1600 and same time buy a put
option with strike of 1600 by paying
premium of Rs 20.
Suppose market rise up to 1660.
Then the flow will be –
1660 – 1600 = 60; (profit from share holding)
20 (Put premium)
60 + (20) = 40
40 (All over profit)
1520
-80, cash
Market end
Suppose market falls down to 1520.
Then there will be a loss –
1520 – 1600 = (80); (loss from share holding)
1600 – 1520 – 20 = 60
(80) + 60 = (20)
(20) Will be the loss due to profit from put,
otherwise it could be (80).
+80, put
Priyank Srivastava

19. 6. Collar: - A collar strategy is an extension of covered call strategy. In covered
call downside risk remains for falling prices, that is if the stock price moves
down losses keep increasing. To hedge this risk we long a put option which
essentially negates the down side of the underlined asset.
1590
1600 Short Call @ 10
Spot price
1640 Market end
+ 50 Suppose market rise up to 1640.
Then the profit will be –
1640 – 1590 = 50; (profit from share holding)
1600 – 1640 + 10 = (30); (loss from call option)
7 (put premium)
50 + (30) – 7 = 13
13 Will be the maximum profit.
In the covered call, the profit would be 20.
- 40
1520
- 70
Market end
Suppose market falls down to 1520.
Then the profit will be –
1590 – 1520 = (70); (loss from share holding)
1580 – 1520 – 7 = 53; (profit from put option)
10 (call premium)
(70) + 53 - 10 = (7)
(7) Will be the maximum loss.
In the covered call, the loss would be (60)
Example: - A trader buy a shares when
market is 1590.
To earn extra income and hedge the risk he
short the call at 1600 @ 10.
1580 Long Put @ 7
+ 60
Priyank Srivastava

20. 7. Butterfly Spread: - As collar is an extension of covered call, similarly the butterfly spread is an extension of
short straddle. In short straddle the loss is unlimited if market moves significantly in either direction. To put
a limit on this downside, along with short straddle, trader buys one OTM call and one OTM put. As a result,
a position is created with pictorial pay-off which looks like a butterfly, so this strategy is called “Butterfly
Spread”. It can be created with only calls, only puts and combinations of both calls and puts.
Case 1: - Suppose market ends at 6800. The
flow will be?
Net flow will be –
6000 – 6800 + 140 + 145 = (515)
6800 – 6100 – 145 - 140 = 415
415 + (515) = (100)
(100) will be the total loss.
In the short straddle the flow is (315) a loss.
Case 2: - Suppose market ends at 5200. The
flow will be?
Net flow will be –
5200 – 6000 + 145 + 140 = (515)
5900 – 5200 – 140 – 145 = 415
415 + (515) = (100)
(100) will be the total loss.
In the short straddle the flow is (515) a loss.
Example: - Suppose cash market is 6000, same time short the call at 6200 @ 145 and long the call at
6100 @ 145, on the other side short a put at 5800 @ 140 and long a put at 5900 @ 140.
6000 Spot, short, call@145, put@140
6800 Market Ends
5200 Market Ends
+700
+700
5900 Long Put @ 140
6100 Long Call @ 145
-800
-800
Priyank Srivastava