MBA Sem – 4

Unit 3 – Options
1. Meaning of Options
• An Option is a type of derivative contract that gives the buyer the
right, but not the obligation, to buy or sell an underlying asset at a
predetermined strike price on or before a specific date.
• The seller (writer) of the option has the obligation to fulfill the contract
if the buyer exercises the option.
• Underlying assets can include stocks, indices, commodities, or
currencies.

2. Need and Importance of Options

A. Hedging Tool

• Options protect against adverse price movements.

• E.g., an investor can hedge a stock position using a put option to
minimize losses.

B. Speculation

• Traders use options to speculate on the direction of price movement

with limited risk and high reward potential.

C. Leverage

• Small premium enables exposure to a large value of underlying assets.

• Increases return potential but also magnifies risk for sellers.

D. Income Generation

• Writing options can generate regular income through premiums.

E. Risk Management

• Customizable strategies to mitigate different types of financial risks.

3. Options and Futures: Comparison

 Feature Options Futures
Buyer has the right, not Both buyer and seller have
Obligation
obligation obligations
No premium, but margin
Premium Paid by buyer to seller
required
Risk (Buyer) Limited to premium Unlimited
Potentially unlimited (in
Risk (Seller) Unlimited
calls/puts)
Profit
Unlimited for buyer Depends on market movement
Potential
Settlement Mostly cash settled Can be cash or physical
Usage Hedging, speculation, income Hedging, speculation

4. Fundamental Option Strategies

A. Basic Strategies

1. Long Call: Buy a call option – Used when expecting a price rise.
2. Long Put: Buy a put option – Used when expecting a price drop.
3. Short Call: Sell a call – Used when expecting price to remain flat or
fall.
4. Short Put: Sell a put – Used when expecting price to rise or remain
stable.

B. Combined Strategies

1. Covered Call:

Buy stock + sell call – Earn premium with limited upside.

A Covered Call is an options trading strategy used by investors to generate

additional income from a stock they already own.

A Covered Call involves:

• Buying (or already owning) a stock, and

• Selling a call option on the same stock.

Because the investor already owns the stock, the call is “covered” (i.e., if the
buyer exercises the call, the seller can deliver the stock).

Working of the Strategy

Suppose you own 100 shares of TCS, currently trading at ₹3,500 per share.
You sell 1 call option with a strike price of ₹3,600, expiring in 1 month, and
receive a premium of ₹50 per share.
Scenarios at Expiry:

1. Stock stays below ₹3,600

o The option expires worthless.
o You keep the ₹50 premium as profit.
o You still own the TCS shares.
2. Stock rises above ₹3,600
o The option is exercised.
o You must sell your shares at ₹3,600, even if market price is
higher.
o Your effective selling price = ₹3,600 + ₹50 (premium) = ₹3,650.

When to Use:

• You are neutral to slightly bullish on the stock.

• You want to generate income from a stock you plan to hold.

Payoff Summary:

Stock Price at Expiry Net Outcome

Below ₹3,600 Keep premium ₹50
₹3,600 - ₹3,650 Gain from stock + premium
Above ₹3,650 Max profit ₹150 per share

Pros:

• Earns extra income through option premium.

• Reduces cost basis of the stock.

Cons:

• Upside is capped at strike price + premium.

• Still exposed to downside risk in the stock.

2. Protective Put:

Buy stock + buy put – Downside protection.

A Protective Put is an options strategy designed to protect against downside

risk in a stock you own. It works like an insurance policy.
A Protective Put involves:

• Buying a stock (or already owning it), and

• Buying a put option on the same stock.

This put gives you the right to sell the stock at a specified strike price,
protecting you from a sharp fall in the stock’s value.

Working of Strategy

Suppose you own 100 shares of Infosys, currently trading at ₹1,400.

You buy a put option with a strike price of ₹1,350, paying a premium of ₹30
per share.

Scenarios at Expiry:

1. Stock stays above ₹1,350

o The put expires worthless.
o Your loss = ₹30 premium.
o You keep your Infosys shares.
2. Stock falls below ₹1,350
o You exercise the put and sell at ₹1,350.
o You’re protected from further downside.
o Loss = (Stock price drop) + Premium paid.

When to Use:

• You are bullish on the stock but want downside protection.

• During volatile or uncertain markets.

Payoff Summary:

Stock Price at Expiry Net Outcome

Above ₹1,350 Loss = Premium ₹30
At ₹1,350 Loss = Premium ₹30
Below ₹1,350 Max loss capped (₹50 + ₹30)

Pros:

• Downside protection: Your losses are limited.

• Unlimited upside: You still benefit if the stock rises.

Cons:

• Premium cost reduces overall return.

• If stock rises, the put expires worthless (but you still benefit from the
rise).
 3. Straddle:

Buy ATM call + put – Profits from high volatility.

A Straddle is a popular options trading strategy used when a trader expects

high volatility in the price of a stock or index, but is unsure about the
direction (up or down).

A Long Straddle involves:

• Buying a Call Option, and

• Buying a Put Option
on the same underlying asset, with the same strike price and same
expiration date.

Working of the Strategy

Suppose a stock is trading at ₹1,000. You:

• Buy a call option (strike ₹1,000) by paying ₹40.

• Buy a put option (strike ₹1,000) by paying ₹35.

Total premium paid = ₹40 + ₹35 = ₹75

Scenarios at Expiry:

1. Stock rises sharply (e.g., ₹1,100):

o Call is in-the-money.
o Put expires worthless.
o Profit = ₹100 (intrinsic) – ₹75 (premium) = ₹25
2. Stock falls sharply (e.g., ₹900):
o Put is in-the-money.
o Call expires worthless.
o Profit = ₹100 – ₹75 = ₹25
3. Stock stays near ₹1,000:
o Both options expire worthless or have little intrinsic value.
o You lose the premium (₹75).

When to Use:

• Before events like earnings announcements, elections, or central bank

decisions.
• When you expect a large price movement but don’t know the direction.

Payoff Summary:
 Stock Price at Expiry Net Outcome
Far below ₹1,000 Big profit from put
Far above ₹1,000 Big profit from call
Near ₹1,000 Loss = ₹75 premium (max loss)

Payoff Formula:

• Max Loss = Total Premium Paid

• Max Gain = Unlimited (if move is big enough)

Pros:

• Profits from volatility regardless of direction.

• Unlimited upside potential.

Cons:

• High premium cost.

• Loss if the market remains stable.

4. Strangle:

Buy OTM call + put – Similar to straddle, cheaper but needs more
movement.

A Strangle is an options strategy similar to a Straddle, used when you

expect significant price movement in a stock or index, but want to reduce
the upfront cost compared to a straddle.

A Long Strangle involves:

• Buying a Call Option with a higher strike price, and

• Buying a Put Option with a lower strike price,
on the same underlying asset, with the same expiry date.

The options are out-of-the-money (OTM), making them cheaper than a

straddle.

Assume a stock is trading at ₹1,000.

You:

• Buy a call option at strike ₹1,050 for ₹20.

• Buy a put option at strike ₹950 for ₹25.
Total premium paid = ₹45

Scenarios at Expiry:

1. Stock rises above ₹1,095

o Call option is in-the-money.
o Profit = (Spot – 1,050) – ₹45
2. Stock falls below ₹905
o Put option is in-the-money.
o Profit = (950 – Spot) – ₹45
3. Stock stays between ₹950 and ₹1,050
o Both options expire worthless.
o Max loss = ₹45

Working of the Strategy

• When expecting a big move in price, but want to keep cost lower than
a straddle.
• Events with uncertain direction and medium-high volatility.

Payoff Summary:

Stock Price at Expiry Outcome

Far below ₹950 Big profit from put
Far above ₹1,050 Big profit from call
Between ₹950–₹1,050 Both options may expire worthless
Near ₹1,000 Max loss = ₹45 (premium paid)

Payoff Formula:

• Max Loss = Total Premium Paid

• Break-even Points:
o Lower BEP = Put strike – Total premium
o Upper BEP = Call strike + Total premium

Pros:

• Cheaper than a straddle.

• Profits from large price movements in either direction.

Cons:

• Requires larger move to become profitable (because strikes are wider

apart).
• Still loses full premium if market is flat.
5. Types of Options: Call & Put
A. Call Option

• Gives the right to buy the underlying asset.

• Used when anticipating a rise in asset price.
• Buyer expects profit if price > strike price + premium.

B. Put Option

• Gives the right to sell the underlying asset.

• Used when anticipating a decline in asset price.
• Buyer profits if price < strike price – premium.

C. Based on Style

1. European Options: Exercised only at expiry. Most Indian index

options are European style.
2. American Options: Exercised anytime before expiry. Some stock
options globally are American.

6. Payoffs from Options Trading

Call Option Payoff

• Buyer:
o Profit = Spot Price – Strike Price – Premium
o Loss limited to premium
• Seller (Writer):
o Profit limited to premium
o Loss = Unlimited if price rises significantly

Put Option Payoff

• Buyer:
o Profit = Strike Price – Spot Price – Premium
o Loss limited to premium
• Seller (Writer):
o Profit limited to premium
o Loss = Substantial if price falls significantly
7. Strategies of Risk Instruments Using Options
A. Hedging

• Investors hedge portfolio risk using protective puts or index options.

B. Arbitrage

• Exploit price differences in underlying and options using spreads or

combinations.

C. Speculation

• Use calls and puts based on expected price movement.

D. Insurance

• Buy puts to insure against downward market movement.

E. Income Strategies

• Sell covered calls or cash-secured puts to generate income from stable

positions.

8. Positions in Options
Position Market View Risk Profile
Long Call Bullish Unlimited profit, limited loss
Limited profit (premium), unlimited
Short Call Bearish/Neutral
loss
Long Put Bearish High profit potential, limited loss
Limited profit, significant downside
Short Put Bullish/Neutral
risk
Covered Call Mildly bullish Limited gain, limited downside
Protective Bullish with Gain from upside, insured against
Put protection loss

9. Stock Indices Options in the Indian Stock

Market
A. Key Index Options in India
 1. Nifty 50 Options – Most actively traded.
2. Bank Nifty Options – Popular among traders due to high volatility.
3. Nifty Financial Services Options – Emerging liquidity.
4. Sensex Options – Traded on BSE.

B. Features of Index Options in India

• Traded on: NSE (National Stock Exchange)

• Style: European (exercisable only at expiry)
• Settlement: Cash settled (no delivery of actual index)
• Expiry Cycle: Weekly and Monthly expiry
• Lot Size: Defined by exchange (e.g., 50 for Nifty 50)

C. Market Participants

• Retail Traders: Short-term strategies, speculation.

• Institutions: Hedging large portfolios.
• Arbitrageurs: Exploit mispricing between futures, options, and spot
markets.

D. Regulatory Framework

• Governed by SEBI (Securities and Exchange Board of India).

• Exchange surveillance to ensure fair trading practices.