Tuesday, February 26, 2013

Excellent Trading School - 28 - Frequently Asked Questions about Options Contracts - Part 4

Question: How does the margin system work in option trading?
Answer: Since the risk of the buyer of an option is limited to the premium paid, there is no margin required from the buyer of the option. The buyer’s cost is limited to the premium paid. The risk of the option seller is unlimited and therefore he needs to pay the margin as prescribed by the exchange at the time of entering into an option contract. To reduce the default risk, the option position of the seller is marked to market every day.

Question: If I have two opposite positions in futures and options, then do I have to pay margin on both the positions?
Answer: You have to pay margin on your positions but the net margin required is lower than the margin on two separate positions. Suppose you have sold one futures contract on ACC at Rs152 and simultaneously bought an ACC call option with a strike price of Rs160 at Rs5. In this portfolio one position is bullish and the other bearish, so in case ACC’S price goes up, one position would gain and the other would lose. Similarly if ACC’S price goes down, one position would gain while the other would lose. These are hedging positions. Hence the margin is less.

Question: How are options different from futures?
Answer: In case of futures, both the buyer and the seller are under obligation to fulfill the contract. They have unlimited potential to gain if the price of the underlying moves in their favour. On the contrary, they are subject to unlimited risk of losing if the price of the underlying moves against their views.
In case of options, however, the buyer of the option has the right and not the obligation. Thus he enjoys an asymmetric risk profile. He has unlimited potential to profit if the price of the underlying moves in his favour. But a limited potential to lose, to the extent of the premium paid, in case the price of the underlying moves against the view taken.

Similarly the seller of the option is under obligation. He has limited potential to profit, to the extent of the premium received, in case the price of the underlying moves in his favour. But an unlimited risk of losing in case the price of the underlying moves against the view taken.

Question: How are options different from futures in terms of price behaviour?
Answer: Trading in futures is one-dimensional as the price of futures depends upon the price of the underlying only. Trading in option is two-dimensional as the price of an option depends upon both the price and the volatility of the underlying.

Question: I want to know all about the behaviour of the price of an option?
Answer: You need to understand and appreciate various option Greeks like delta, gamma, theta, vega and rho to completely comprehend the behaviour of option prices.

Question: What is delta of an option and what is its significance?
Answer: For a given price of underlying, risk-free interest rate, strike price, time to maturity and volatility, the delta of an option is a theoretical number. If any of the above factors changes, the value of delta also changes.

The delta of an option tells you by how much the premium of the option would increase or decrease for a unit change in the price of the underlying. For example, for an option with delta of 0.5, the premium of the option would change by 50 paise for a Rs1 change in the price of the underlying. Delta is about 0.5 for near/at the money options. As the option becomes in the money, the value of delta increases.

Conversely as the option becomes out of the money, the value of delta decreases. In other words, delta measures the sensitivity of options with respect to change in the price of the underlying. Deep out-of-the-money options are less sensitive in comparison to at-the-money and deep in-the-money options.

Delta is positive for a bullish position (long call and short put) as the value of the position increases with rise in the price of the underlying. Delta is negative for a bearish position (short call and long put) as the value of the position decreases with rise in the price of the underlying.

Delta varies from 0 to 1 for call options and from –1 to 0 for put options. Some people refer to delta as 0 to 100 numbers.

The Delta is an important piece of information for a option Buyer because it can tell him much of an option & buyer he can expect for short-term moves by the underlying stock. This can help the Buyer of an option which call / Put option should be bought. The factors which can change the Delta of an option are Stock Price, Volitility & No. of Days.

Question: What is theta of an option and its significance?
Answer: The theta of an option is an extremely significant theoretical number for an option trader. Like the other Greek terms you can calculate theta using option calculator.

Theta tells you how much value the option would lose after one day, with all the other parameters remaining the same.

Suppose the theta of Infosys 30-day call option with a strike price of Rs3,900 is 4.5 when Infosys is quoting at Rs3,900, volatility is 50% and the risk-free interest rate is 8%. This means that if the price of Infosys and the other parameters like volatility remain the same and one day passes, the value of this option would reduce by Rs4.5.

Theta is always negative for the buyer of an option, as the value of the option goes down each day if his view is not realised. Conversely theta is always positive for the seller of an option, as the value of the position of the seller increases as the value of the option goes down with time.

Consider options as depreciating assets because of time decay and appreciating due to favourable price movements. If the rate of appreciation is more than that of depreciation hold the option, else sell it off. Further, time decay of option premium is very steep near expiry of the option. The following graph would make it clearer.

Question: What is vega of an option and its significance?
Answer: Vega is also a theoretical number that can be calculated using an option calculator for a given set of values of underlying price, time to expiry, strike price, volatility and interest rate etc. Vega indicates how much the option premium would change for a unit change in annual volatility of the underlying.

Suppose the vega of an option is 0.6 and its premium is Rs15 when volatility of the underlying is 35%. As the volatility increases to 36%, the premium of the option would change upward to Rs15.6.

Vega is positive for a long position (long call and long put) and negative for a short position (short call and short put).

Simply put, for the buyer it is advantageous if the volatility increases after he has bought the option. On the other hand, for the seller any increase in volatility is dangerous as the probability of his option getting in the money increases with any rise in volatility.

Sometimes you might have observed that though seven to ten days have passed after you bought an option, the underlying price is almost in the same range while the premium of the option has increased. This clearly indicates that volatility of the underlying might have increased.

Question: What is gamma of an option and its significance?
Answer: Gamma is a sophisticated concept. You need patience to understand it as it is important too. Like delta, the gamma of an option is a theoretical number. Feeding the price of underlying, risk-free interest rate, strike price, time to maturity and volatility, you can compute value of gamma using the option calculator. The gamma of an option tells you how much the delta of an option would increase or decrease for a unit change in the price of the underlying.

For example, assume the gamma of an option is 0.04 and its delta is 0.5. For a unit change in the price of the underlying, the delta of the option would change to 0.5 + 0.04 = 0.54. The new delta of the option at changed underlying price is 0.54; so the rate of change in the premium has increased.

If I were to explain in very simple terms: if delta is velocity, then gamma is acceleration. Delta tells you how much the premium would change; gamma changes delta and tells you how much the next premium change would be for a unit price change in the price of the underlying.

Gamma is positive for long positions (long call and long put) and negative for short positions (short call and short put). Gamma does not matter much for options with long maturity. However for options with short maturity, gamma is high and the value of the options changes very fast with swings in the underlying prices.

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