Options

Initial margin: The margin to be deposited when the trader takes position or initiates the
trade in futures
Maintenance margin: The minimum amount to be maintained in trader’s account all the
time during his holding position.
Variation margin: The amount to be brought in by the trader to bring his balance to the
initial level. In other words, the margin deposited with the broker as replenishment up to
initial margin i.e. marginal call.
Options:
Option means choice or right.
Call Option Put Option
Seller/Writer Buyer Seller/Writer
Buyer (Long)
(Short) (Long) (Short)
Right to buy or Obligation to sell Right to sell or not to sell Obligation to buy
not to buy if buyer wants to underlying asset on if buyer wants to
underlying asset buy maturity at a specified sell
on maturity at a price
specified price
Pays premium Receives premium Pays premium to Receives premium
to by selling right buy right by selling right
buy right
Exercised Spot price on Exercised Spot price on
maturity is more maturity is less
than strike price than strike price
Not exercised Spot price on Not exercised Spot price on
maturity is less maturity is more
than strike price than strike price

Style of options:
• European Style of options: Can be exercised only on maturity
• American Style of options: Can be exercises any time on or before maturity
Ex: (Call Option)
You bought a July call option on the stock of Infosys at strike price (exercise price) of
Rs. 800 and at a premium of Rs. 80 (call option price).
On last Thursday of July if price of Infosys stock is : 900 (ST)
You will exercise call option as spot price on maturity (ST) is more than strike price (K or X).
There is gain of Rs. 100, net gain after adjusting for premium of Rs.80 is Rs. 20
On last Thursday of July if price of Infosys stock is : 700 (ST)
You ll not exercise call option as spot price on maturity (ST) is less than strike price (K or X).
But, since you don’t exercise, loss is limited to premium of Rs. 80 paid initially.
Ex: (Put Option)
You bought a July put option on the stock of Infosys at strike price (exercise price) of Rs. 800
and at a premium of Rs. 80 (put option price).
On last Thursday of July if price of Infosys stock is : 900 (ST)
You will not exercise put option, as spot price on maturity (ST) is more than strike price (K).
Your loss is limited to premium amount of Rs. 80
On last Thursday of July if price of Infosys stock is : 700 (ST)

1
You will exercise put option, as spot price on maturity (ST) is less than strike price (K), gain
is Rs .100, net gain after adjusting for premium of Rs.80 is Rs. 20

1. Current market price of the stock of SBI is Rs 190. Call option on SBI stock at the strike
price (exercise price) of Rs 200 is currently trading at a premium (option price) of Rs 20 for
July 2020 expiry.
a. What is the pay-off of call option buyer (Long Call) if the market price of the
stock on 27 July (expiry day) is i. Rs 180 ii. Rs 190 iii. Rs 200 iv. Rs 210
v. Rs 220 vi. 230 vii. 240 viii.250. Show even pay-off diagram. Identify break-
even point, maximum gain, maximum loss for call option buyer. What is the
view point of call option buyer?
a. What is the pay-off of call option seller/writer (Short Call) if the market price
of the stock on 27 July (expiry day) is i. Rs 180 ii. Rs 190 iii. Rs 200 iv. Rs
210 v. Rs 220 vi. 230 vii. 240 viii.250. Show even pay-off diagram. Identify
break-even point, maximum gain, maximum loss for call option seller. What is
the view point of call option seller?

1. Ans: Call option at the strike price of Rs. 200 (K or X) and premium of Rs. 20 for July expiry

Long Call Position Short Call Position

(right to buy) (Obligation to sell if buyers says
‘Yes’)
Spot Exercised: Gross Pay-off: Net Pay-off Gross Pay-off: Net off (Gross
price on Yes/No Max (ST -K,0) (Gross payoff- Min(K-ST, 0) payoff +Call
Maturity Call premium) premium)
(ST)
0 No 0 -20 0 20
180 No 0 -20 0 20
190 No 0 -20 0 20
200 Ind 0 -20 0 20
210 Yes 10 -10 -10 10
220 Yes 20 0 -20 0
230 Yes 30 10 -30 -10
240 Yes 40 20 -40 -20
250 Yes 50 30 -50 -30

Long Call Position:

Maximum gain: Unlimited
Maximum loss: Limited to Premium
Break-even point: Strike price + Call premium
Viewpoint: Bullish
Payoff Equation: Max(ST – K, 0)
Payoff Diagram: Net Payoff

Spot Price on
Maturity (ST)
2
Short Call Position:
Maximum gain: Limited to Premium
Maximum loss: Unlimited
Break-even point: Strike price + Call premium
Viewpoint: Moderately Bearish
Net Pay off
Payoff Equation: Min (K – ST, 0)
Payoff Diagram:
Spot Price on
Maturity (ST)

2. Current market price of the stock of Infosys is Rs 980. Put option on Infosys stock at the
strike price (exercise price) of Rs 1000 is currently trading at a premium (option price) of Rs
50 for July 2020 expiry.
a. What is the pay-off of put option buyer if the market price of the stock on 27
July (expiry day) is i. Rs 0 ii. Rs 910 iii. Rs 930 iv. Rs 950 v. Rs 970 vi. 990
vii. 1000 viii.1020 viii.1040. Show even pay-off diagram. Identify break-even
point, maximum gain, maximum loss for put option buyer. What is the view
point of put option buyer?

b. What is the pay-off of the option buyer if the market price of the stock on 27
July (expiry day) is i. Rs 0 ii. Rs 910 iii. Rs 930 iv. Rs 950 v. Rs 970 vi. 990
vii. 1000 viii.1020 viii.1040. Show even pay-off diagram. Identify break-even
point, maximum gain, maximum loss for put option seller. What is the view
point of put option seller?

2. Ans: Put option at the strike price of Rs. 1000 and premium of Rs. 50 July expiry

Long Put Position (right to sell) Short Put Position (Obligation

to buy if buyers says ‘Yes’)
Spot price Exercised: Gross Pay- Net Pay-off Gross Pay- Net off (Gross
on Yes/No off: (Gross payoff- off: Min (ST- payoff + put
Maturity Max(K-ST,0) put premium) K,0) premium)
(ST)
0 Yes 1000 950 -1000 -950
910 Yes 90 40 -90 -40
930 Yes 70 20 -70 -20
950 Yes 50 0 -50 0
970 Yes 30 -20 -30 20
990 Yes 10 -40 -10 40
1000 Ind 0 -50 0 50
1020 No 0 -50 0 50
1040 No 0 -50 0 50

3
Long Put Position:
Maximum gain: Unlimited
Maximum loss: Limited to Premium
Break-even point: Strike price - Put premium
Viewpoint: Bearish
Payoff Equation: Max(K – ST, 0)
Payoff Diagram:
Net payoff
Spot Price on
Maturity (ST)

Short Put Position:

Maximum gain: Limited to Premium
Maximum loss: Unlimited
Break-even point: Strike price - Put premium
Viewpoint: Moderately Bullish
Payoff Equation: Min (ST – K, 0) Net payoff
Payoff Diagram:
Spot Price on
Maturity (ST)

Long Call Short Call Long Put (buyer Short Put

(buyer of call (seller/writer of of put option) (seller of put
option) call option) option)
Right / Right to buy or not Obligation to Right to sell or not Obligation to
Obligation to buy a specified sell a specified to sell a specified buy a specified
underlying asset at underlying asset underlying asset at underlying
the strike price on at the strike the strike price on asset at the
maturity price on maturity strike price on
maturity maturity
Role Right to buy Obligation to Right to sell Obligation to
underlying asset sell underlying underlying asset buy underlying
asset asset
Premium Pays premium Receives Pays premium Receives
upfront as he bought premium upfront as he premium
call option upfront as he bought put option upfront as he
sold call option sold put option
Exercised Spot price on maturity (ST) is more than Spot price on maturity (ST) is less
strike price than strike price
Not Spot price on maturity (ST) is less than Spot price on maturity (ST) is more

4
exercised strike price than strike price
Payoff Max (ST – K, 0) Min (K-ST, 0) Max(K-ST,0) Min(ST – K,0)
(Gross)
Unlimited Limited to Unlimited Limited to
premium premium
Gain
Loss Limited to premium Unlimited Limited to Unlimited
premium
BEP Strike price + call Strike price + Strike price – put Strike price –
premium call premium premium put premium
Viewpoint Bullish Bearish Bearish Bullish
(Moderately) (Moderately)

Money-ness of the Options

Call Option Put Option
Spot price is much more than strike price Deep-In-the Money Deep-Out-of the Money
Spot price is more than strike price In-the- Money Out of the Money
Spot price is less than strike price Out of the Money In-the Money
Spot price is much less than strike price Deep-Out-of the Money Deep-In-the Money
Spot price is equal to strike price At-the Money At-the Money

Option Premium = Intrinsic Value + Time Value

Call Option Put Option
In-8the- Money Intrinsic Time Value Intrinsic Time Value= Put
Value = Call premium – Value = K- Premium – Intrinsic
= ST-K Intrinsic value ST Value
Out-the- Money 0 Call premium 0 Put Premium
At the Money 0 Call premium 0 Put Premium

Factors effecting call or put premium

Call Premium Put Premium
Spot Price Positive Negative
Strike Price Negative Positive
Time to expiry Positive Positive

3. Consider the following call option contracts available on NSE on 13th July 2020 on the
stock of Reliance for July expiry. Current market price of Reliance stock is Rs 1520. Fill in
the table. What is your observation?

S.No Call Strike Option Identify in the Intrinsic Time

option Price exercised money/out of the Value Value
price (Yes/No) money/at the
(premium) money
1 50 1480
2 35 1500
3 20 1520
4 15 1540
5 10 1560

5
Ans. Since CMP (spot price) is Rs 1520

S.No Call option Strike Option Identify in the Intrinsic Time

price Price exercised money/out of the Value Value
(premium) (Yes/No) money/at the
money
1 50 1480 Y In the Money 40 10
2 35 1500 Y In the Money 20 15
3 20 1520 I At the Money 0 20
4 15 1540 N Out of the Money 0 15
5 10 1560 N Out of the Money 0 10
Ans.

S.No Put option Strike Option Identify in the Intrinsic Time

price Price exercised money/out of the Value Value
(premium) (Yes/No) money/at the money
1 10 1480 N Out of the money 0 10
2 15 1500 N Out of the money 0 15
3 20 1520 I At the Money 0 20
4 30 1540 Y In the Money 20 10
5 55 1560 Y In the Money 40 15

Intrinsic value of in the money options is positive. It is zero for at the money and out of the
money options

5. Current market price of Infosys stock is Rs 1000. If call option on the stock for one month
expiry is currently trading at Rs 40 at the strike price of Rs 980, what would be the likely
price of call option under the different scenarios (assuming other factors remain constant) if
current market price is i. 900 ii. 1000 iii. 1200. What would be your answer if it is put option?
What is your understanding about the relationship between price of call and put options and
current market price of the stock?

Ans.
CMP Call Premium Put Premium
900 < 40 >40
1000 >40 <40
1200 >40 <40

Option Trading Strategies

6. Union election result is shortly going to be out. You are not sure about the direction of
the market. If the result is favourable to the market, there will be significant uptrend.
Otherwise, it significantly comes down. Thus, you are sure that there will be huge
volatility in either direction. Current price of Nifty 50 is 9880. Its call and put option
prices on NSE for one month expiry are as follows:

6
 Call Option Put Option
Strike Price Premium Strike Price Premium
9900 60 9900 90
Based on the above information, construct suitable option strategy and show pay off
profile, pay of diagram, maximum gain, maximum loss, break-even- points of the
strategy, if Nifty 50 on maturity trades at 9500, 9600, 9700, 9750, 9800, 9900, 10000,
10050, 10100, 10200, 10300.

What would be your strategy if you expect that the market would be stable and no
volatility is expected (range bound)? Based on the above information, show pay off
profile, pay of diagram, maximum gain, maximum loss, break-even- points of the
strategy.

Long straddle: It involves buying a call option and buying a put option at the same strike price for the
same maturity. It is suitable when huge volatility is expected in the market but no clarity
about the direction of movement. This is also a market neutral strategy.
Cost of strategy:
Long call + Long put = 60+90 = 150 at the strike price of 9900.
Cost of strategy 150
9900 60 90 150
Call Put
Max (ST - Max (K- Total Gross Net
K,0) ST,0) Payoff Payoff
9500 0 400 400 250
9600 0 300 300 150
9700 0 200 200 50
9750 0 150 150 0
9800 0 100 100 -50
9900 0 0 0 -150
10000 100 0 100 -50
10050 150 0 150 0
10100 200 0 200 50
10200 300 0 300 150
10300 400 0 400 250
Maximum gain: Unlimited
Maximum loss: Limited to cost of the strategy
Lower BEP = Strike price- Cost i.e. (9900-150=9750)
Upper BEP = Strike price+ Cost i.e.(9900+150=10050)
Viewpoint: Huge volatility is expected in either side but no clarity in the direction of
movement

Net Payoff
Spot price on maturity

7
 Short straddle: It involves selling a call option and selling a put option at the same strike
price for the same maturity. It is suitable when market is expected to be range bound and
relatively stable. This is also a market neutral strategy.
Income from the strategy:
Short call + Short put = 60+90 = 150 at the strike price of 9900.
Call Put
Min (K- Min (ST
ST,0) -K,0) Total Gross Payoff Net Payoff
9500 0 -400 -400 -250
9600 0 -300 -300 -150
9700 0 -200 -200 -50
9750 0 -150 -150 0
9800 0 -100 -100 50
9900 0 0 0 150
10000 -100 0 -100 50
10050 -150 0 -150 0
10100 -200 0 -200 -50
10200 -300 0 -300 -150
10300 -400 0 -400 -250
Maximum gain: Limited to income from the strategy
Maximum loss: Unlimited
Lower BEP = Strike price- Cost i.e. 9750 (9900-150=9750)
Upper BEP = Strike price+ Cost i.e.10050 (9900+150=10050)
Viewpoint: Market is range bound and relatively stable.

Net payoff
Spot price on maturity

7. You are expecting huge volatility but not sure about the direction of the market. At
the same time, you want to reduce initial cost of buying the strategy. Current price of
Nifty 50 is 9900. Its call and put option prices on NSE for one month expiry are as
follows:

Call Option Put Option

Strike Price Premium Strike Price Premium
9950 40 9850 70
Based on the above information, construct suitable option strategy and show pay off
profile, pay of diagram, maximum gain, maximum loss, break-even- points of the
strategy, if Nifty 50 on maturity trades at 9500, 9600, 9700, 9740, 9800, 9900, 9950,
10000, 10060, 10100, 10200, 10300.
What would be your strategy if you expect that the market would be stable and you
want to improve the profitability of your trade? Show pay off profile, pay of diagram,
maximum gain, maximum loss, break-even- points of the strategy.

8
Long Strangle : It involves buying slightly out of the money call and buying slightly out of the
money put for the same maturity to reduce the cost. In other words, buying a call option at K1
and buying a put option at K2, where K1>K2. However, despite this strategy is less
expensive, it requires greater changes in prices to break-even. This is also a market neutral
strategy.
Cost of the strategy: Long call + Long put = 40+ 70 = 110
Call (9950) Put (9850)
Max (ST - Max (K-
K,0) ST,0) Total Gross Payoff Net Payoff
9500 0 350 350 240
9600 0 250 250 140
9700 0 150 150 40
9740 0 110 110 0
9800 0 50 50 -60
9850 0 0 0 -110
9900 0 0 0 -110
9950 0 0 0 -110
10000 50 0 50 -60
10060 110 0 110 0
10100 150 0 150 40
10200 250 0 250 140
10300 350 0 350 240
Maximum gain: Unlimited
Maximum loss: Limited to the cost of the strategy
Lower BEP = Lower strike price- Cost i.e. (9850-110=9740)
Upper BEP = Higher strike price+ Cost i.e. (9950+110=10060)
Viewpoint: Huge volatility is expected in either side but no clarity in the direction of
movement and aims at reducing initial cost.

Net payoff

Spot price on maturity

Short Strangle : It involves selling slightly out of the money call and buying slightly out of
the money put for the same maturity to reduce cost. In other words, selling a call option at K1
and selling a put option at K2, where K1>K2. Income from the strategy is less than that of
short straddle, but it requires greater market movements to get into loss zone. This is also a
market neutral strategy.

Income from the strategy: Short call + Short put = 40+ 70 = 110

Call (9950) Put (9850)

Min (K- Min (ST -
ST,0) K,0) Total Gross Payoff Net Payoff
9500 0 -350 -350 -240

9
 9600 0 -250 -250 -140
9700 0 -150 -150 -40
9740 0 -110 -110 0
9800 0 -50 -50 60
9850 0 0 0 110
9900 0 0 0 110
9950 0 0 0 110
10000 -50 0 -50 60
10060 -110 0 -110 0
10100 -150 0 -150 -40
10200 -250 0 -250 -140
10300 -350 0 -350 -240

Maximum gain: Limited to income from the strategy

Maximum loss: Unlimited
Lower BEP = K- Cost i.e. (9850-110=9740)
Upper BEP = K+ Cost i.e. (9950+110=10060)
Viewpoint: Range bound market (relatively stable market) and improve the profitability of the
trade.

Net payoff

Spot price on maturity

8. You are expecting huge volatility in the price of SBI stock in either direction. You are
also expecting that the probability of price rise is more than that of price fall. Current
market price of SBI stock is Rs 288. The following one month options on SBI stock
are available on NSE.
Call Option Put Option
Strike Price Premium Strike Price Premium
290 5 290 6
What would be the suitable strategy and show pay off profile, pay of diagram,
maximum gain, maximum loss, break-even- points of the strategy, if spot price of SBI
on maturity takes any of the values: 250, 260, 270, 274, 280, 290, 298, 300, 310, 320,
330?
Straps: It involves buying 2 call options and one put option at the same strike price and same
maturity. This strategy is suitable, when huge volatility is expected in either direction, but
price rise is more likely than price fall.

2 Long Calls + One Long Put = 2×5+6 = Rs.16 (Cost of the strategy)

10
 Calls (2) Put (1)
Max (ST - Max (K- Gross Net
K,0) ×2 ST,0) Payoff Payoff
250 0 40 40 24
260 0 30 30 14
270 0 20 20 4
274 0 16 16 0
280 0 10 10 -6
290 0 0 0 -16
298 16 0 16 0
300 20 0 20 4
310 40 0 40 24
320 60 0 60 44
330 80 0 80 64
Maximum gain: Unlimited
Maximum loss: Limited to the cost of the strategy
Lower BEP = Strike price- Cost i.e. 274
Upper BEP = Strike price + Cost/2 i.e.298
Upper BEP is half the distance from strike price of the lower BEP. It indicates that BEP can
be reached sooner when the prices rise compared to price fall.
Viewpoint: Huge volatility is expected in either side and probability of price rise is more
likely than probability of price fall

Net payoff

Spot price on maturity

9. You are expecting huge volatility in the price of SBI stock in either direction. You are
also expecting the probability for price fall is more than that of price rise. Based on
the information in question 8, what would be the suitable strategy and show pay off
profile, pay of diagram, maximum gain, maximum loss, break-even- points of the
strategy, if spot price of SBI on maturity takes any of the values: 250, 260, 270, 274,
281.5, 290, 300, 307, 320, 330.
Strips: It involves buying 1 call option and 2 put options at the same strike price and same maturity.
This strategy is suitable, when huge volatility is expected in either direction, but price fall is
more likely than price rise.

One Long Call + Two Long Puts = 5+6×2 = Rs 17 (Cost of strategy)

Puts (2)
Call (1) Max
Max (ST (K- Gross Net
-K,0) ST,0)×2 Payoff Payoff
250 0 80 80 63
260 0 60 60 43

11
 270 0 40 40 23
274 0 32 32 15
281.5 0 17 17 0
290 0 0 0 -17
300 10 0 10 -7
307 17 0 17 0
320 30 0 30 13
330 40 0 40 23
Maximum gain: Unlimited
Maximum loss: Limited to cost of the strategy
Lower BEP = Strike price- Cost /2 i.e. 281.5 (290-17/2 = 281.5)
Upper BEP = Strike price + Cost i.e.307 (290+17 = 307)
Lower BEP is half the distance from strike price of the higher BEP. It indicates that BEP can
be reached sooner when the prices fall compared to price rise.
Viewpoint: Huge volatility is expected in either side and probability of price fall is more
likely than probability of price rise

Net payoff

Spot price on maturity

10. Your viewpoint is that the stock of Bharti Airtel is moderately bullish. Based on the
following information, what would be the suitable strategy and show pay off profile,
pay of diagram, maximum gain, maximum loss, break-even- points of the strategy, if
spot price of Bharti Airtel on maturity takes any of the values: 360, 370, 380, 390,
400, 406, 410, 420, 430, 440, 450 and 460.
Call Option Call Option
Strike Price Premium Strike Price Premium
400 14 410 8
Bull spread using calls (Bull call spread): It consists of buying a call option at lower strike price
(ITM call) and selling a call option at higher strike price (OTM call) on the same underlying
asset for the same maturity. This is suitable when there is a moderately bullish view point.

Long ITM Call + Short OTM Call = 14-8 = 6 (Cost of strategy)

ITM OTM
Call at Call at
400 410
Max
(ST- Min (K- Gross Net
K,0) ST, 0) Payoff Payoff
360 0 0 0 -6
370 0 0 0 -6
380 0 0 0 -6

12
 390 0 0 0 -6
400 0 0 0 -6
406 6 0 6 0
410 10 0 10 4
420 20 -10 10 4
430 30 -20 10 4
440 40 -30 10 4
450 50 -40 10 4
460 60 -50 10 4
Maximum gain: Limited to higher strike price – Cost of Strategy
Maximum loss: Limited to cost of the strategy
BEP = Lower strike price + Cost
View point: Moderately bullish and limited los

Net payoff
Spot price on maturity

11. Your viewpoint is that the stock of Axis Bank is moderately bearish. Based on the
following information, what would be the suitable strategy and show pay off profile,
pay of diagram, maximum gain, maximum loss, break-even- points of the strategy, if
spot price of Axis Bank on maturity takes any of the values: 470, 480, 490, 500, 510,
515, 520, 530, 540, 550.
Put Option Put Option
Strike Price Premium Strike Price Premium
510 11 520 16

Bear spread using puts (Bear put spread): It consists of buying a put option at higher strike price
and selling a put option at lower strike price on the same underlying asset for the same
maturity. This is suitable when there is a moderately bearish view point.
Long ITM Put + Short OTM Put = 14-8 = 6 (Cost of strategy)

ITM OTM
Put at Put at
520 510
Max Min
(K- (ST-
ST,0) K,0) Gross Net
470 50 -40 10 5
480 40 -30 10 5
490 30 -20 10 5
500 20 -10 10 5
510 10 0 10 5
515 5 0 5 0
520 0 0 0 -5

13
 530 0 0 0 -5
540 0 0 0 -5
550 0 0 0 -5

Maximum gain: Higher strike price –Lower strike price – Cost of Strategy
Maximum loss: Limited to cost of the strategy
BEP = Lower strike price + Cost
View point: Moderately bearish and limited loss

Net payoff
Spot price on maturity

12. You are expecting that the price of Axis Bank stock would be stable. Based on the
following information, what would be the suitable strategy and show pay off profile,
pay of diagram, maximum gain, maximum loss, break-even- points of the strategy, if
spot price of Axis Bank on maturity takes any of the values: 495, 498, 500, 502, 505,
510, 515, 518, 520 and 522.

Call Option
Strike Price Premium
500 19
510 13
520 9
Butterfly spread strategy: It involves buying a call at lower strike (K1), buying a call option at (K3)
and selling two call options at intermediary strike price (K2). When the market is range bound
and relatively stable, this strategy is suitable.

One Long call at 500 + Two Short Calls at 510 + One Long Call at 520

= 19 -13×2+9 = 2 (Cost of strategy)

Two
Long Short Long
Call at Calls at Call at
500 510 520 Gross Net
Max Min
(ST- (ST- Max (ST-
K,0) K,0) ×2 K,0)
495 0 0 0 0 -2
498 0 0 0 0 -2
500 0 0 0 0 -2
502 2 0 0 2 0
505 5 0 0 5 3
510 10 0 0 10 8

14
 515 15 -10 0 5 3
518 18 -16 0 2 0
520 20 -20 0 0 -2
522 22 -24 2 0 -2
Maximum gain: Middle strike price – Cost of Strategy
Maximum loss: Cost of the strategy
Lower BEP = Lower strike price + Cost
Higher BEP = Higher strike price - Cost
Viewpoint: Market is range bound (relatively stable) and limited losses (unlike short straddle
with has unlimited losses)

Net payoff
Spot price on maturity

13. Based on the following information, construct a box spread strategy. Show pay off
profile, pay of diagram, maximum gain, maximum loss, break-even points of the
strategy, if spot price of Bharti Airtel on maturity takes any of the values: 360, 370,
380, 390, 400, 406, 410, 420, 430, 440, 450, 460 and 470? What is your observation?

Call Option Put Option

Strike Price Premium Strike Price Premium
400 14 400 6
410 8 410 10
Box spread: A combination of a bull call spread and bear put spread. The gross pay-off from box
spread is always the difference between two strike prices. It is a arbitrage strategy.

Long ITM Call + Short OTM Call + Long ITM Put + Short OTM Put
= 13-8+9-6 = 8 (cost of the strategy)

Long Short Long Short

Call at Call at Put at Put at
400 410 410 400
Max Max Min
(ST- Min (K- (K- (ST-
K,0) ST,0) ST,0) K,0) Gross Net
360 0 0 50 -40 10 2
370 0 0 40 -30 10 2
380 0 0 30 -20 10 2
390 0 0 20 -10 10 2
400 0 0 10 0 10 2
406 6 0 4 0 10 2

15
 410 10 0 0 0 10 2
420 20 -10 0 0 10 2
430 30 -20 0 0 10 2
440 40 -30 0 0 10 2
450 50 -40 0 0 10 2
460 60 -50 0 0 10 2

Net payoff
Spot price on maturity

14. Construct a condor spread strategy using the following information, assuming spot
price on maturity may take any value between Rs 360 and Rs 460 in multiples of
Rs 10. Show pay off profile, pay of diagram, maximum gain, maximum loss, break-
even points of the strategy.

Strike Price Premium

380 30
400 13
420 4
440 1
Condor Spread: It involves buying deep in the money call, selling in the money call option,
selling out of the money call and buying even deep out of the money call.

Long Deep ITM Call + Short ITM Call + Short OTM Call + Long Deep OTM Call

Cost of strategy= 30-13-4+1= 14

Long Short Short Long

call at call at call at call at
380 400 420 440
Max Min Max
(ST- (K- Min (K- (K-
K,0) ST,0) ST,0) ST,0) Gross Net
360 0 0 0 0 0 -14
370 0 0 0 0 0 -14
380 0 0 0 0 0 -14
390 10 0 0 0 10 -4
394 14 0 0 0 14 0
400 20 0 0 0 20 6
410 30 -10 0 0 20 6
420 40 -20 0 0 20 6
426 46 -26 -6 0 14 0

16
 430 50 -30 -10 0 10 -4
440 60 -40 -20 0 0 -14
450 70 -50 -30 10 0 -14
460 80 -60 -40 20 0 -14
Maximum gain: Higher strike price –Lower strike price – Cost of Strategy
Maximum loss: Cost of the strategy
Lower BEP = Lower strike price + Cost
Higher BEP = Higher strike price – Cost
Viewpoint: Range bound and stable market with limited losses (unlike short strangle which
has unlimited losses)

Net payoff
Spot price on maturity

15. One month SBI CE 290 is trading at Rs 6. You have bearish viewpoint on the stock
which is currently trading at Rs 286. Hence you decided to write a call option on the
stock. At the same time, you want to cover your position by buying the stock. What
would be the suitable strategy and show pay off profile, pay of diagram, maximum
gain, maximum loss, break-even points of the strategy, if spot price of SBI on
maturity takes any of the values: 260, 270, 280, 290, 300, 310, 320, 330, 340, 350 and
360?
Covered Call: It involves holding a long position in a stock and then selling (writing) call options on
that same asset, representing the same size as the underlying long position. A covered call is a
popular options strategy used to generate income from investors who think stock prices are
unlikely to rise much further in the near-term. A covered call will limit the investor's potential
upside profit, and will also not offer much protection if the price of the stock drops.
Long underlying + Short call = 286 – 6 = 280

Underlying Gross Pay Net Pay

value Short Call off off
260 260 0 260 -20
270 270 0 270 -10
280 280 0 280 0
285 285 0 285 5
290 290 0 290 10
300 300 -10 290 10
310 310 -20 290 10
320 320 -30 290 10
330 330 -40 290 10
340 340 -50 290 10
350 350 -60 290 10
360 360 -70 290 10

17
 370 370 -80 290 10
380 380 -90 290 10
Max gain: Limited to Strike price – Cost of the strategy
Max loss: Unlimited
BEP: Cost of the strategy
Viewpoint: Moderately bullish (Payoff is similar to short put)

Net payoff

Spot price on maturity

16. You bought a stock of HDFC at Rs 1650. You are worried that the price comes down
in the near future. You want to protect its value by buying put option. If HDFC 1640
PE for July expiry is trading at 30, show pay off profile, pay of diagram, maximum
gain, maximum loss, break-even points of the strategy, if spot price of SBI on
maturity takes any of the values: 1630, 1640, 1650, 1655, 1660, 1670, 1680, 1690,
1700 and 1710?
Protective put (Married put or synthetic long call): It involves buying underlying stock and buying
a put option. It is a portfolio insurance strategy. In other words, it helps in protecting the
value of the underlying stock from the fall in prices. Hence, it is a hedging strategy used to
protect the value of the underlying.

Long underlying + Long put = 1650 +30 = 1680

If underlying stock sold If underlying stock not sold

Underlying Long Net
value Put payoff
=Max
(K-ST, Gross Net Underlying Gross
0) Payoff payoff Value payoff
1610 1610 30 1640 -40 1610 1640 1610
1620 1620 20 1640 -40 1620 1640 1610
1630 1630 10 1640 -40 1630 1640 1610
1640 1640 0 1640 -40 1640 1640 1610
1650 1650 0 1650 -30 1650 1650 1620
1660 1660 0 1660 -20 1660 1660 1630
1670 1670 0 1670 -10 1670 1670 1640
1680 1680 0 1680 0 1680 1680 1650
1690 1690 0 1690 10 1690 1690 1660
1700 1700 0 1700 20 1700 1700 1670
1710 1710 0 1710 30 1710 1710 1680
1720 1720 0 1720 40 1720 1720 1690
1730 1730 0 1730 50 1730 1730 1700

18
 Max gain: Unlimited
Max loss: Limited to cost of the strategy
BEP: Cost of the strategy
Viewpoint: Bearish (aims at protecting the value of the underlying, preferably adopted
by fund managers etc.) Payoff is similar to long call hence, it is called synthetic call.

Net payoff

Spot price on maturity

Factors effecting Option Prices Call Premium Put Premium

Spot Price Positive Negative
Strike Price Negative Positive
Time to Maturity Positive Positive
Interest Rate Positive Negative
Dividend Yield Negative Positive
Volatility of Underlying Asset Positive Positive

17. The following is the information extracted from NSE website on call option prices of
ICICI Bank on July 17 2017.
Spot Strike August September October
303 290 15 20 24
303 300 12 14 13
303 310 10 5 6
Identify violation of pricing relationship if any.

When we look at the effects of time to maturity, assuming other factors remaining constant,
1. As there is a positive relation between call premium and time to expiry,
i. At the spot price of Rs.303 and strike price of Rs.290, all contracts
with expiry of August, September and October seem to be correctly
priced.
ii. At the spot price of Rs.303 and strike price of Rs.300, violation of
pricing relationship seem be evident in October month contracts
iii. At the spot price of Rs.303 and strike price of Rs.310, violation of
pricing relationship seem be evident in September and October month
contracts
2. As, there is a negative relationship between strike price and call premium,
when spot price is Rs.303 and violation of pricing relationship seem be there
in contracts at the strike prices of Rs.290, Rs.300 and Rs.310 for all months

19
18. Fill in the blanks based on the information on the stock of ACC for July expiry:
Strike Price Premium Option Type Strike Price Premium Option Type
1720 50 Call 1720 30 Put
1740 40 Call 1740 40 Put
1760 30 Call 1760 50 Put
Spot Price Premium Option Type Spot Price Premium Option Type
1720 50 Put 1720 30 Call
1740 40 Put 1740 40 Call
1760 30 Put 1760 50 Call

19. Currently CE-Jul-1740 on the stock of Kotak Bank is currently trading at Rs

43 and PE-Jul-1740 at Rs 35.
a. If RBI announces policy rate hike, what would happen to the prices of call and
put options?
As there is positive relation between interest rates and call premium, call
premium increases above Rs. 43 when RBI announces policy rate hike. As
there is negative relation between interest rates and put premium, put premium
goes below Rs.35 when RBI announces policy rate hike

b. If Kotak Bank announces dividend payment, what would happen to the prices
of call and put options?
As there is negative relation between dividend yield and call premium, call
premium decreases below Rs. 43 when Kotak bank announces dividend
payout. As there is positive relation between dividend yield and put premium,
put premium goes above Rs.35 when Kotak bank announces dividend payout.

20. If you observe the following prices in the market, what would you do, assuming the
American Style of Options?

Scenario S K C P
1 110 100 4
2 110 100 120
Ans. In Scenario 1, there is a scope for arbitrage opportunity. In this case, arbitrager

• Buys a call at 4 (-)

• As spot is more than strike price, exercises call by paying Rs. 100 (-) and
receive stock
• Sell the stock at 110 (+)
• Net gain is Rs.6, which is risk free arbitrage
In an efficient market, there should not be risk free profit. To prevent the arbitrage
profit of Rs. 6, minimum price of call option should be Rs. 10 i.e. (S0-K).
Hence, lower boundary for call option is (S0-K).

If call price is below (S0-K), call is said to be underpriced. Hence, there is a scope for
arbitrage as described above.

20
 Similarly, call option price can never be more than spot price (S0), as call option is derivative
of spot. If call price is more than S0, there is a scope for arbitrage. Hence, upper boundary
for call option is (S0).

In Scenario 2, there is a scope for arbitrage opportunity. In this case, arbitrager

• Buy a put at 4 (-)

• Buy stock at 100(-)
• As spot is less than strike price, exercise put by selling stock at Rs.110 (+) and
receive the cash
• Net gain is Rs.6, which is risk free arbitrage profit

In an efficient market, there should not be risk free profit. To prevent the arbitrage
profit of Rs. 6, minimum price of put option should be Rs. 10 i.e. (K-S0).
Hence, lower boundary for put option is (K-S0).

If put price is below (K-S0), put is said to be underpriced. Hence, there is a scope for
arbitrage as described above.

Similarly, put option price can never be more than strike price (K), as put option allows buyer
to sell at strike price. If put price is more than K, there is a scope for arbitrage. Hence, upper
boundary for put option is (K).

American Call American Put

Lower boundary S-K K-S

Upper boundary S K
Price Range (S-K)<C<S (K-S)<P<S
European Call European put
Lower boundary S-Ke-rT Ke-rT-S
Upper boundary S Ke-rT
Price Range (S-Ke-rT)<c<S (Ke-rT-S)<p< Ke-rT

In case of European options, since option is exercised on maturity, the amount

equivalent to strike price (which is fixed) is paid on maturity. Hence, to determine
today’s option price, K is replaced with present value of K in case of European style
of options.

21. If S0 = Rs 20, K = Rs 18, r =10%, what would you do if one year European call price
is Rs.3. What is your pay-off if stock price on maturity is S-I: Rs 16 and S-II: Rs 20.
What is your inference from this?
Ans. Price of European call option = 𝑆0 − 𝐾𝑒 −𝑟𝑇 = 20−18e−0.1×1 = Rs 3.71
Since European call option is underpriced, there is a scope for arbitrage as follows:
Today After a Year
1.Buy call -3 3. Receive 18.79 3. Receive 18.79
option at investment proceeds investment
strike with interest (17 e0.1) proceeds with
price of 18 interest (17 e0.1)

21
 2.Short 20 If spot price is 16 (S<K) If spot price is 20 (S>K)
Sell stock
3.Invest 17 1. Let the call option 1.Exercise the -18
Net lapse call option at 18
Proceeds 2. Buy the stock at and take the
at 10% 16 in the market and delivery of the
close the short -16 stock
position in the stock 2. Close the
short position in
the stock
Net 0 Net arbitrage profit 2.79 0.79
investment

22. If S0 = Rs 37, K = Rs 40, r =5%, what would you do if 6 month European put price is
Rs.1. What is your pay-off if stock price on maturity is S-I: Rs 38 and S-II: Rs 42.
What is your inference from this?
Price of European put option = 𝐾𝑒 −𝑟𝑇 − 𝑆0 = 40e−0.05×0.5 − 37 = Rs 2.01
Since European put option is underpriced, there is a scope for arbitrage

Today After six months

1. Buy put -1 If spot price is 38 (S<K) If spot price is 42 (S>K)
option at
strike of
40
2. Buy -37 1&2. Exercise the 40 1. Let the put
stock put option and sell option expire
the stock at 40 by 2. Sell the stock in
closing long position the market at 42 42
in the stock and close the long
position in the
stock
3. Borrow +38 3. Repay borrowings 38.96 3. Repay 38.96
at 5% for with interest borrowings with
6 months 38 e 05×0.5 interest
38 e 05×0.5
Net 0 Net arbitrage profit 1.04 Net arbitrage profit 3.04
investment

Put Call Parity

Portfolio 1: c + Ke-rT
Portfolio 2: p + S
Portfolio 1: Today if you buy call at c, you am also required to have the cash equivalent to
Ke-rT, as I may have to buy stock at K on maturity
If S>K on maturity, c loses its value and becomes zero on maturity; Ke-rT becomes K,
using the cash equivalent to K, you exercise call by receiving S and paying K
If S<K on maturity, c loses its value and becomes zero on maturity; Ke-rT becomes K,
call cannot be exercised, what is there in your hand? K

22
Portfolio 2: Today if you buy put at p, you are also required to have underlying asset S, as you
may have to sell the stock at on maturity
If S>K on maturity, p loses its value and becomes zero on maturity; as put option
cannot be exercised, what is left out in your hand? S
If S<K on maturity, p loses its value and becomes zero on maturity; exercise put
option, sell stock by giving delivering of S and receive cash equivalent to K
On maturity (Payoff)
S>K S<K
Portfolio 1 S K
Portfolio 2 S K

Since payoffs are equal,

Portfolio 1= Portfolio 2
c + Ke-rT =p+S (which is put call parity)

As per put call parity,

Price of European call (c) = p+S - Ke-rT
Price of European put (p) = c + Ke-rT -S
If there is a violation to this relationship, there is a scope for arbitrage.

23. Stock price is Rs 31, strike price is Rs 30, risk free interest rate is 10% p.a., price of a
3 month European call option is Rs 3 and price of a 3 month European put option is
Rs 2.25. Observe if put-call parity holds good. If it does not hold good, what would
you do, if spot price on maturity is S-I: Rs 28 and S-II: Rs 32.
What is your answer if 3 month European put option price is Rs 1?
Ans.
c + Ke−rT = 3 + 30e−0.1×3/12 = 32.26 (Underpriced, buy portfolio 1)
p + S0 = 2.25+31 = 33.25 (Overpriced, sell portfolio 2)
Since put call parity is not holding good,
An arbitrager can buy the securities in portfolio 1 and short the securities in portfolio
2. It involves buying the call and shorting both the put and the stock, generating a
positive cash flow of

Three month put price = 2.25

Today:
1.Buy call (right to buy) -3
2.Short put to realize (obligation to 2.25
buy)
3. Short sell the stock to realize 31
4.Invest at 10% for 3 months -30.25
After 3 months if S= 28 (S<K) After 3 months if S = 32 (S>K)
4. Receive investment proceeds 31.02 4. Receive investment proceeds 31.02
30.25e0.1×3/12 30.25e0.1×3/12
1. Let the call expire 1. Exercise call by buying stock at -30
Rs. 30 and receive stock

23
2. Fulfil you obligation to buy stock -30 3. Deliver the stock received under
under short put and receive the stock long call position to fulfil
obligation under short sale of stock
3. Deliver the stock received under 2. Since buyer does not exercise, let
short put position to fulfil obligation the put expire
under short sale of stock
Net arbitrage profit 1.02 Net arbitrage profit 1.02

If put price is Re.1 instead of Rs. 2.24

c + Ke−rT = 3 + 30e−0.1×3/12 = 32.26 (Overpriced, sell portfolio 1)

p + S0 = 1+31 = 32 (Underpriced, buy portfolio 2)
Since put call parity is not holding good,
An arbitrager can buy the securities in portfolio 2 and short the securities in portfolio 1.
It involves buying put & underlying stock and selling call and borrowing

Today
1.Short call (Obligation to sell) 3
2.Long put (Right to sell) -1
3.Long the stock -31
4.Borrow Rs 29 for 3 months at 29
10%
Net investment 0
After three months
If S= 28, S<K If S= 32, S>K
1. Since call buyer does not 1&3. Fulfil 30
exercise, let the call expire obligation to sell
the stock at Rs 30
under short call
and deliver the
stock
2&3. Exercise put by selling stock 30 2. Let the put
at Rs.30 and give delivery of stock expire
4. Repay loan with interest -29.73 4. Repay loan -29.73
29e0.1×0.25 with interest
29e0.1×0.25
Net arbitrage profit 0.27 Net arbitrage 0.27
profit

24