All About Options

5 Simple Tools to Research Options

Traders normally complain that they want to trade in options but they do not have the tools and the expertise to trade. An option is not very complicated. It is a right to buy or the right sell. The only thing you must be able to judge is whether this right will become more valuable or less valuable over time. Accordingly, you can take a call. Remember, Black & Scholes calculator is very easily available. Broadly, there are five basic tools that are easily available to everyone and here is how you can make the best of it.

  • Black and Scholes Intrinsic Value Calculator

The Black and Scholes formula allows you to calculate the intrinsic value of the option. We will look at how to actually use this tool, but let's see where to find it. The simplest thing to do is to use this Black & Scholes calculator on the NSE website or if you run a simple Google search, you can actually get an excel calculator, which will help you to play around with numbers. It is also available on the ITS exe platform of Tradeplusonline. Now, back to business.

How do you decide whether a call or put option is undervalued or overvalued?

Let us start off with some NSE data for Nifty options. The Nifty is currently at 14,881, we will first look at the calls and put prices for the 14,900 Nifty.

To the left are the call option details on 14,900 strike of Nifty and to the right are the put option details. The price of the call option is Rs.82.70 while the price of the put is Rs.103.90. (Let us assume volatility at 20%, risk free rate of interest at 5% and time to maturity at 8 days, which is the time left to 25 March expiry). How will intrinsic value of the option look?

Stock Price 14881.00
Strike Price 14900.00
Interest Rate 5%
Volatility (S.D.) 20%
Time 0.022222
Call 175.78
Put 178.23

 

Now the call is priced at Rs.82.70 and the put is priced at Rs.103.90. That means both the call and the put are very much under-priced compared to their intrinsic values. However, here the assumption is that our volatility estimates holds, but for an investor or trader, this is a very good method of ratifying if what they believe about call and put values are right or wrong. Let us now also look at the 15,000-strike call and put.

To the left are the call option details on 15,000 strike of Nifty and to the right are the put option details of 15,000 strike. The price of the call option is Rs.44.15 while the price of the put is Rs.164.00. (Here again we assume volatility at 20%, risk free rate of interest at 5% and time to maturity at 8 days, which is the time left to 25 March expiry). Here is how the intrinsic value of the option will look like?

Stock Price 14881.00
Strike Price 15000.00
Interest Rate 5%
Volatility (S.D.) 20%
Time 0.022222
Call 131.10
Put 233.44

 

Now the call is priced at Rs.44.15 and the put is priced at Rs.164.00. What do we see here? The call has an intrinsic value of Rs.131, which is almost 3 times the current options price. Clearly, the call option is grossly undervalued. Even the put option is undervalued because the put value is Rs.233.44 but the current market price of only Rs.164. However, the undervaluation is not to the same extent as the call.

I am sure you will agree with me that this very simple to understand and you just need to feed in some basic numbers to get the value of the option. Then just compare with the option price and decided whether the option should be bought or whether the option should be sold. You always buy under-priced options and sell overpriced options.

 

  • Black and Scholes Simulator

Undervaluation and overvaluation of options is what we saw in the first tool. That is important but we need to go one step further. We need to simulate. Now that looks like a very complex word, but actually it is not. Let me put in simple terms. Once you buy an option or sell an option, so many things are going to change. For example, the price could change, the volatility can change, the time to expiry will reduce with every passing day etc.

Let us take a hypothetical of Stock X priced at Rs.495 and there is a Rs.500 call and put option that you are considering. We assume volatility to be 20%, interest rate to be 5% and time to maturity of the option at 1 month or 1/12. Let us look at how the value of the option changes under different scenarios. Let us look at each of these 3 factors.

What happens when the stock price changes?

Base Case When Price rises to Rs.525 When Price falls to Rs.475
Stock Price 495.00
Strike Price 500.00
Interest Rate 5%
Volatility (S.D.) 20%
Time 0.08333
Call 10.03
Put 12.95
Stock Price 525.00
Strike Price 500.00
Interest Rate 5%
Volatility (S.D.) 20%
Time 0.08333
Call 29.95
Put 2.87
Stock Price 475.00
Strike Price 500.00
Interest Rate 5%
Volatility (S.D.) 20%
Time 0.08333
Call 3.28
Put 26.20

 

When the price goes up from Rs.495 to Rs.525, the value of the call option shoots up from Rs.10.03 to Rs.29.95. That is a simple case. A call option is a right to buy. In this case, you have the right to buy the stock at Rs.500. When the stock price has gone from Rs.495 to Rs.525, this right to buy the stock at Rs.500 becomes a lot more valuable because you have the right to buy the stock Rs.25 below the current market price. That makes your right valuable.

Why is the situation different for the put option? When the price goes up from Rs.495 to Rs.525, the value of the put option falls sharply from Rs.12.95 to Rs.2.87. I am sure you have understood the reason by now. Let me tell you anyways.  A put option is a right to sell. In this case, you have the right to sell the stock at Rs.500. When the stock price has gone from Rs.495 to Rs.525, this right to sell the stock at Rs.500 becomes a lot less valuable because you have the right to sell the stock Rs.25 below the current market price. That makes your right worthless as you can sell at a higher price in the market.

What happens if the price goes down from Rs.495 to Rs.475?

Let us look at the call option first when the price goes down from Rs.495 to Rs.475, the value of the call option falls down from Rs.10.03 to Rs.3.28. Now, I am sure you can answer this? A call option is a right to buy. In this case, you have the right to buy the stock at Rs.500. When the stock price has gone down to Rs.475, this right to buy the stock at Rs.500 becomes worthless because you rather buy the stock in the market at Rs.475.

What about the put option then? When the price goes down from Rs.495 to Rs.475, the value of the put option rises sharply from Rs.12.95 to Rs.26.20. Let me tell you why.  A put option is a right to sell. In this case, you have the right to sell the stock at Rs.500. When the stock price has gone from Rs.495 to Rs.475, this right to sell the stock at Rs.500 becomes very valuable because you now have the right to sell the stock Rs.25 above the current market price. That is why put values are going up. With a simple excel, you can just put your price forecasts and see how the option values will change and then take a decision.

What happens when the volatility of the stock goes up?

Base Case Volatility rises to Rs.27% Volatility falls to Rs.12%
Stock Price 495.00
Strike Price 500.00
Interest Rate 5%
Volatility (S.D.) 20%
Time 0.08333
Call 10.03
Put 12.95
Stock Price 495.00
Strike Price 500.00
Interest Rate 5%
Volatility (S.D.) 27%
Time 0.08333
Call 14.02
Put 16.94
Stock Price 495.00
Strike Price 500.00
Interest Rate 5%
Volatility (S.D.) 12%
Time 0.08333
Call 5.50
Put 8.42

 

Firstly, what do we mean by volatility going up. Have you seen the Nifty moving up and down by 400-500 points on a regular basis? That is volatility in very simple terms. It shows fluctuations in price, but also mean risk. Let us see how the call and put prices are impacted by the changes in volatility.

What happens when the volatility increases from 20% to 27% with all the other factors remaining the same? The value of the call option goes up from 10.03 to 14.02 while the value of the put option goes up from 12.95 to 16.94. Hey, is there something wrong here. How come both call options and put options are going in the same direction. After all, one is a right to buy and one is a right to sell. This is most important aspect of options.

When you are holding a call option and volatility increase, it means that price could go much higher or much lower. Now if the price goes lower, you don’t worry as you only lose the premium. However, if the price goes up, you make a lot of money on the call option. Since you know risk is limited to option premium, your call option becomes more valuable.

If you are holding a put option and the volatility increases, it means that price could go much higher or much lower. Now if the price goes higher, you don’t worry as you only lose the option premium. However, if the price goes down, you make a lot of money on the put option. Since risk is limited to option premium, your put option becomes more valuable.

What happens when the volatility goes down from 20% to 12%? You will observe that the value of the call and the put is going down. When the volatility is going down, chances of getting good value on your right reduce. Remember this always, volatility is one of the most important determinants of the value of your option. Higher the better; for calls and puts.

What happens when the time to maturity of the stock goes down?

30 days to expiry 15 days to expiry
Stock Price 495.00
Strike Price 500.00
Interest Rate 5%
Volatility (S.D.) 20%
Time 0.08333
Call 10.03
Put 12.95
Stock Price 495.00
Strike Price 500.00
Interest Rate 5%
Volatility (S.D.) 27%
Time 0.04167
Call 6.27
Put 10.23

 

Another very important determinant of options prices is the time to maturity. In the above illustration, the time to maturity of the option is reduced from 30 days to 15 days. You will find that the value of the call goes down from 10.03 to 6.27 while the value of the put goes down from 12.95 to 10.23. Both calls and puts are moving in the same direction; i.e., their values are reducing as the time to maturity reduces.

Why does this happen. As the time reduces, the chances of volatility reduces and so the chances of prices fluctuating also reduces. Whether you are holding a call option or a put option, your chances of getting the price of your choice is more likely when there is more time to option expiry than when there is less time to option expiry.

This is one of the most important factors in understanding options. Options lose money as time elapses. So, if you are an options buyer, every passing day works against. However, if you are the seller of the option, then each passing day works in your favour.

 

  • Option pay-off analysis

An Option payoff analyser is a simple excel sheet that helps you to evaluate your likely profits or losses at different price levels. This pay off sheet differs from strategy. Let us look at a basic pay-off where you have bought Reliance 2100 call and 2100 put. Let us assume that the call premium is Rs.22 and the put premium is 31. How will the pay-off analysis look like if you buy one call and one put option at the 2100 strike?

Stock Price Call Strike Put Strike Cal Premium Put Premium Call Profit Put Profit Overall Profit
1800 2100 2100 -22 -31 0 300 247
1840 2100 2100 -22 -31 0 260 207
1880 2100 2100 -22 -31 0 220 167
1920 2100 2100 -22 -31 0 180 127
1960 2100 2100 -22 -31 0 140 87
2000 2100 2100 -22 -31 0 100 47
2040 2100 2100 -22 -31 0 60 7
2080 2100 2100 -22 -31 0 20 -33
2100 2100 2100 -22 -31 0 0 -53
2120 2100 2100 -22 -31 20 0 -33
2160 2100 2100 -22 -31 60 0 7
2200 2100 2100 -22 -31 100 0 47
2240 2100 2100 -22 -31 140 0 87
2280 2100 2100 -22 -31 180 0 127
2320 2100 2100 -22 -31 220 0 167
2360 2100 2100 -22 -31 260 0 207

 

This is a simple simulator you can prepare on the excel or even download. You need to make one for each strategy, but it tells you some important stuff. You know from this pay off chart that your maximum loss of buying the call and put can never be more than Rs.53 in total. There will be two break even levels. On the upside your break-even level is 2153 and on the downside it is 2047. As long as the stock price is within this range you will make a loss.

However, once the price either goes below 2047 or above 2153, then from that point you can earn unlimited profits. The pay-off diagram helps you understand the profits and losses under various scenarios. Also, the break-even point tells you at what price can sell and what will be the ROI at different levels.

 

  • Open Interest / Implied Volatility shift analyser

Did you know that open interest (OI) and implied volatility (IV) can give some interesting signals? You must be a little more comfortable with basic F&O trading to start using these but I will give you a quick picture. OI is the open positions in the market i.e., call and put positions and futures that are opened but not closed out.

Normally, when OI is compared with the price movement it tells us whether the OI trend is hinting at fresh long positions, fresh short positions, profit booking or short covering. This gives you an indication of whether the rally will be sustained or whether you must use dips to buy more of the stock. It basically shows accumulation trends in stocks and indices.

IV or implied volatility is a measure of risk that is implied in options. Normally, if IVs go up, it is a signal that the traders expect the market to become riskier. The reverse is also true.

 

  • Net Profit / loss simulator

This is a straight forward extension of the pay off diagram. But this goes a step further and you must always use this before taking a position. Apart from telling you the profit  or loss at various prices, this simulator will also tell you the net profit after considering brokerage and statutory costs. This gives you an idea of whether you will make profits after meeting all costs or not. This should always be your starting point before taking positions.

Some of the more advanced simulators also assign illiquidity cost to options that are not liquid and hence have spread costs. That will give you a still better picture. The moral of the story there are enough tools for you to effectively use and be a better options trader.

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