hedging using derivatives
...o buy the share any time up through October 28 at Rs.100 and the seller is obliged to do that. For this privilege the buyer pays the seller a premium of Rs.5. 8. Put Option: A put option is an option to sell an asset at a fixed price. For Example, a put option with an exercise price of Rs.100 and expiration date of October 28. If the stock currently has a price of Rs.95, it allows the put holder to sell the share at Rs.100 at any time up through October 28 and the seller is obliged to do that. For this privilege the buyer pays the seller a premium of Rs.5. A person can be in any one of the three below situations depending on the strike price: a) In the Money ? If the stock price exceeds the exercise price, it is said to be in-the-money. b) At the Money ? If the stock price equals the exercise price, the option is at-the-money. c) Out of the Money ? If the stock price is less than the exercise price, the call option is said to be out-of-the-money. Exiting an Option Position Once an option is owned, there are three methods that can be used to make a profit or avoid loss: exercise it, offset it with another option, or let it expire worthless. By exercising an option that has been purchased, one is choosing to take delivery of (call) or to sell (put) the underlying asset at the option's strike price. Only option buyers have the choice to exercise an option. Option sellers, on the other hand, may experience having an option assigned to an option holder and subsequently exercised. Offsetting is a method of reversing the original transaction to exit the trade. If a call was bought, one needs to sell the call with the same strike price and expiration. If a call is sold, one has to buy a call with the same strike price and expiration. If a put was bought, one has to sell a put with the same strike price and expiration. If a put is sold, one has to buy a put with the same strike price and expiration. If the person doesn?t offset his/her position, then he/she has not officially exited the trade. If an option has not been offset or exercised by expiration, the option expires worthless. Since an option seller wants an option to expire worthless, because he/she will be getting premium, the passage of time is an option seller's friend and an option buyer's enemy. The premium is nonrefundable even if one lets the option expire worthless. So, as an option gets closer to expiration, it decreases in value. Call Options Call options give the buyer the right, but not the obligation, to purchase an underlying asset. They are available in various strike prices depending on the current market price of the underlying instrument. Expiration dates can vary from one month out to more than a year (LEAPS options). Depending on the mood of the market, you may choose to buy (go long) or sell (go short) a call option. If you choose to buy or go long a call option, you are purchasing the right to buy the underlying instrument at whatever strike price you choose until the expiration date. The premium of a long call option shows up as a debit in your trading account. The premium amount represents the maximum risk a long call strategy can incur. Profit is made on a long call when the price of the underlying asset rises above the strike price of the call. You can then either exercise the call or offset it by selling a call with the same strike price and expiration date. By exercising a long call, you end up with 100 shares per option of the underlying stock at the call strike price. You can then turn around and sell the underlying asset at the current (higher) price to garner a profit on the difference between two (current price - strike price = profit). If you choose to offset the call option, the maximum profit is unlimited. The call's premium will increase in value depending on how high the underlying instrument rises in price beyond the strike price of the call. As the price of the underlying asset rises, the long call becomes more valuable because it gives you (or the person you sell it to) the right to buy the underlying stock at the lower strike price of the call. That's why you want to go long a call option in a rising or bull market. If you choose to sell or go short a call option, you are selling the right to buy the underlying instrument at a particular strike price to an option holder. Selling a call option prompts the deposit of a credit in your trading account in the amount of the call's premium-a limited profit. You get to keep this credit if the option expires worthless. Thus, to make money on a short call, the price of the underlying asset must stay below the call's strike price. If the price of the underlying asset rises above the short call strike price, it will be assigned to an option holder who may choose to exercise it. This gives the option holder the right to buy 100 shares (per option) of the underlying stock from the assigned option buyer at the strike price of the short call. This means that the option seller must buy the underlying asset at the current price and sell it at the call's lower strike price to the assigned option holder, thereby incurring a loss on the trade (current price - strike price = loss). The maximum loss is therefore unlimited to the upside, which is why selling "naked" or unprotected call options comes with such a high risk. However, experienced traders who do choose to short call options would be wise to do so in a stable or bear market. Call options give you the right to buy something at a specific price for a specific time period. However, if the current market price is more than the strike price, the call option is in-the-money (ITM). If the current market price is less than the strike price, the call option is out-of-the-money (OTM). If the current market price is the same as (or close to) the strike price, the call option is at-the-money (ATM). Example: A local newspaper advertises a sale on VCRs for only $129.95. The next day Jane goes down to the electronics store intending to purchase a VCR at the advertised price. Unfortunately, by the time she arrives, the VCR is already out of stock. The manager apologizes and gives her a rain check entitling Jane to buy the same VCR for the advertised price of $129.95 anytime within the next two months. Jane has just received a long call option which gives her the right, but not the obligation, to purchase the VCR at the guaranteed strike price of $129.95 until the expiration date two months away. Scenario 1: A few weeks later, Jane return's to the store to exercise her rain check. The same VCR is now in stock, priced at $179.95. Jane approaches the store manager who agrees to honor the rain-check and sell her a VCR for the advertised price of $129.95. Jane has just saved $50. Her long call option was in-the-money. Scenario 2: A few weeks later, Jane returns to the store and finds the VCR on sale for $119.95? Her rain check is now worthless because she can simply purchase the VCR at the reduced price. In this case, Jane's call option expired worthless because it was out-of-the-money. Just because you own a long call option doesn't mean you are under any obligation to use it. Scenario 3: Jane's friend Jeff phones and mentions that his VCR has just broken. She tells him about her rain-check and agrees to sell it to Jeff for $5 (the option premium). The strike price is still $129.95 and the expiration date is 2 months out. However, Jeff is taking a risk. The VCR might be priced lower than the $129.95 strike price in which case the rain-check is worthless and Jeff loses $5. Put Options Put options give the buyer the right, but not the obligation, to sell an underlying asset at the strike price until market close on the 3rd Friday of the expiration month. Just like call options, put options come in various strike prices depending on the current market price of the underlying instrument with a variety of expiration dates. Expiration dates can vary from one month out to more than a year (LEAPS options). However, unlike call options, you might consider going long a put option if you expect market prices to fall (bearish). In contrast, if you are bullish (expect the market to rise), you might consider selling a put option. If you choose to buy or go long a put option, you are purchasing the right to sell the underlying instrument at whatever strike price you choose until the expiration date. The premium of the long put option will show up as a debit in your trading account. The cost of the premium is the maximum loss you risk by purchasing a put option. The maximum profit is limited to the downside as the underlying stock falls to zero. A profit can be made in one of two ways if the underlying market declines. By exercising a put option, you are short 100 shares of the underlying stock. If and when the underlying stock falls below the put strike price, you can exercise the put to short the shares at a higher price and then buy the underlying stock at a cheaper price to cover the short and exit the trade (strike price - current price = profit). The second technique for profiting on a put comes from offsetting it. If the price of the underlying stock falls, the corresponding put premium increases and can then be sold at a profit. If you go long a put option in a bull market, the value of the put will diminish. Then your only choices are to sell it at a loss or let it expire worthless. If you choose to sell or go short a put option, you are selling the right to sell the underlying stock at a particular strike price to an option holder. The premium of the short put will show up as a credit in your trading account. In most cases, you are anticipating that the short put option will simply expire worthless on the expiration date so that you can keep the premium received. The premium amount is the maximum profit you can receive by selling a put option. If the underlying stock falls below the put strike price, the put will most likely be assigned to an option holder who may choose to exercise the option. The option seller then has an obligation to buy 100 shares (per option) of the underlying stock at the put strike price from the option holder. You will then be long 100 shares of the underlying stock and your loss depends on how low the price of the underlying stock falls as you try to sell the shares to exit the position. Experienced traders who choose to go short put options do so in a stable or bull market because the put will not be exercised unless the market falls. Put options give you the right to sell something at a specific price for a fixed amount of time. A put option is in-the-money (ITM) when the strike price is higher than the market price of the underlying asset. A put option is at-the-money (ATM) when the price of the underlying is equal (or closes) to its strike price. A put option is out-of-the-money (OTM) when the price of the underlying security is greater than the strike price. Example: Jane opens a small travel business that specializes in island vacations. The manager of a a local business agrees to purchase 100 trips to Hawaii in January for $300 round-trip as perks for his employees. Jane's computed total cost of each trip is $200-a $100 profit on each trip which locks in a guaranteed profit of $10,000 for her initial period of operation. In effect, the guaranteed order is a put option. Scenario 1: As luck would have it, just as November rolls around, a competitor offers the same trip for only $250. If Jane didn't have a put option agreement, she would have to drop her price to meet the competition's price, and thereby lose a significant amount of profit. Luckily, she exercises her right to sell the trips to Hawaii for $300 each and enjoys a healthy profit in the new year. Jane's put option was in-the-money in comparison to the price of her competitor. Scenario 2: Jane gets a call from another client who needs to set up 100 trips in January to fulfill obligations to his management team and is willing to pay up to $400 per trip. Since Jane is under no obligation to sell the trips to her first customer, she agrees to sell them for the higher market price and makes a total profit of $20,000 on the deal Intrinsic Value and Time Value Intrinsic value and time value are two of the primary determinants of an option's price. Intrinsic value can be defined as the amount by which the strike price of an option is in-the-money. It is actually the portion of an option's price that is not lost due to the passage of time. The following equations will allow you to calculate the intrinsic value of call and put options: Call Options: Intri...