Introduction To Option Contracts And Hedging Using Options

Introduction to Option Contracts and
Hedging using Options

Table of Contents

Options ................................................................................................................................ 3
Call Options..................................................................................................................... 3
Speculating using Call options ........................................................................................ 4
Put Options ...................................................................................................................... 5
How to read the options table.............................................................................................. 5
Additional information on Option Contracts ...................................................................... 6
Hedging in the Market......................................................................................................... 6
Common Hedging Strategies .......................................................................................... 7
References ........................................................................................................................... 7

Copyright © Prashant Ram All rights reserved
This document may not be reproduced or distributed in part or whole without written consent
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Options
Options are financial derivates, in that their price and value is dependent on the
underlying stock. There are two categories of options. Call Options are bought in case the
we think the price of the underlying stock is going higher. Put Options are bought in case
we think the price of the underlying stock is going lower.

Call Options
You will be a Buyer of a call option on a stock, if you think the price of the stock is
going to go up in the future. An option has a strike price, expiration date and cost (price
of purchasing the option). An option contract gives the buyer of the option the right to
‘call’ (i.e buy the stock) at the strike price, on or before the expiration date.

Example:
Lets assume that MSFT currently trades at $30. The call option on MSFT with strike
price of $35 (expiring in next 3 months) may sell at $0.25 (i.e. If you are buy the call
option on MSFT today you will spend only $0.25 per option contract). If the stock price
of MSFT goes up to $40 you can exercise your call option and ‘call’(i.e. buy the MSFT
stock) at the strike price of $35, and sell the stock for current price of $40. Thus you have
made a profit of $5 per option.

Note:
• Note, If you ‘call’ the option, the person who SOLD you the option is obligated to
sell you the stock at the strike price(i.e. $35), even if the current market price of the
stock is higher ($40). You make your profit by buying the stock cheap from him
(Seller) and then sell the stock in the market for profit.
• The strike price for an option is constant and doesn’t change.

At any given time you may have several option contracts with different strike prices
trading on the single stock. Eg. At any given time MSFT may have several options
contracts with different strike prices trading on it. Some of them may be in the money
some out of the money. As an example MSFT is trading at $30, may have several options
contracts available

Options contract 1: Expiration Dec, Strike price $27

Clearly, the option contract 1, will be most expensive since this call option is ‘in the
money’.

Lets assume that MSFT currently trades at $30 and there is a set of call options on MSFT
which have strike price of $35. The call options, whose strike price is greater that the
current stock price is called ‘out of the money’ option. If there is another set of call

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option contracts with strike price of $27, it is ‘in the money’ option. The cost of
purchasing an ‘in the money’ options will be much higher than purchasing ‘out of the
money’ options.

Summarizing, for call option
If strike price > current stock price, out of money options
If strike price = current stock price, on the money options
If strike price < current stock price, in the money options

Speculating using Call options
Speculation is a practice where the trader ‘speculates’ if the stock price is going to go
higher or lower. The speculator may not ‘hedge’ his speculations against market taking a
downturn.

Lets assume that MSFT trades at $3, if we speculate the price of MSFT is going to go up
to $38, within the next 6 months, there are 2 way we can invest money. Say we had
$1000 to invest.

1. We could buy MSFT @ $30, today i.e. 33 stocks @ 990 (i.e. 33 stocks = $1000 / $30)
If the stock price went up to $38 in the next 6 months, we would have a profit of $38 -
$30 = $8, per stock. The total profit would be $8 * 33 = $264

2. Alternatively we could buy call options on MSFT with strike price of (say) $32. (note
that currently the price of MSFT is $30 and the strike price of our options is $32 (out of
money) so the option will be relatively cheaper. Lets assume that each option contract
costs $0.50. At this price we can purchase $1000 / $0.50 = 2000 option contracts with
strike price of $32.

If the stock price went up to $38, we can ‘call’ the stock at strike price of $32 and sell it
in the market for $38. In this case we would make a profit of $38 – 32 = $6, minus the
cost of each option i.e $6 – 0.50 = $5.50, per option contract. In all we had bought 2000
option contracts with our $1000, so the total profit is $5.50 * 2000 = $11,000

This is significantly higher than if we had just purchased the stock in which case the
profit was a paltry $264.

Note:
Using of options instead of stocks significantly leveraged our profit. Typically on
speculation traders buy some percentage of stock and some percentage of the underlying
‘out of money’ call options to spread the risk. Note that only once the stock price crosses
the strike price of $32 will the trader actually make profits. If the stock price went up
only to $31 the trader would not be able to exercise the option and lose all the money
spent in purchasing the options.

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Put Options
You will be a Buyer of a put option on a stock or financial instrument if you think the
price of the stock (or financial instrument) is going to go down in the future.

Put option work opposite to the Call Options.

Lets assume VMW is trading at 120, If we speculate that the price is going to go down
we may buy a PUT options with a strike price of $115. If the price of VMW falls to $100
then we can put (short sell the stock) at the strike price of $115, and cover our shorts by
buying it at $100. This way per contract we make a profit of $100 - $115 = $15.

Note: The Seller of the Put is obligated to Buy the stock from us at the strike price (i.e.
$115) even though the actual price of the stock is less ($100).

Just like call options there may be several put option contracts trading on a stock at
different strike price.


Also, just like Call options Put options may be ‘in the money’, or our ‘out of the money’
depending on the current price of the stock. Since Puts work reverse to Calls, we may
summarize the following for puts,

If strike price < current stock price, out of money options
If strike price = current stock price, on the money options
If strike price > current stock price, in the money options

How to read the options table

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Column 1: Strike Price - This is the stated price per share for which an underlying stock
may be purchased (for a call) or sold (for a put) upon the exercise of the option contract.
Option strike prices typically move by increments of $2.50 or $5 (even though in the
above example it moves in $2 increments).

Column 2: Expiry Date - This shows the termination date of an option contract.
Remember that U.S.-listed options expire on the third Friday of the expiry month.

Column 3: Call or Put - This column refers to whether the option is a call (C) or put (P).

Column 4: Volume - This indicates the total number of options contracts traded for the
day. The total volume of all contracts is listed at the bottom of each table.

Column 5: Bid - This indicates the price someone is willing to pay for the options
contract.

Column 6: Ask - This indicates the price at which someone is willing to sell an options
contract.

Column 7: Open Interest - Open interest is the number of options contracts that are
open; these are contracts that have neither expired nor been exercised.

Additional information on Option Contracts
Some additional information on Options.
• Options usually expire on the Friday of the third week on the month.
• Option may be used in speculation or hedging.
• Options are sold in lots of 1000.

Hedging in the Market
Hedging means reducing risk exposure in the market. A hedge is an investment that is
taken out specifically to reduce or cancel out the risk in another investment. Hedging is a
strategy designed to minimize exposure to an unwanted business risk, while still allowing
the business to profit from an investment activity. In effect it is similar to purchasing an
insurance policy on your financial security.

Buying or selling options, along with the buying and selling of the underlying security is
a common way to hedge.

Example Hedge

Lets us assume that MSFT is trading at $30 and you want to go long MSFT. As an
investor you will buy (say) 1000 shares of MSFT @ $30. In order to ‘hedge’ your
investment you may also buy 1000 PUT options on MSFT with a strike price of (say) $27

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(since these put options are currently ‘out of the money’ you will get it cheap (say) $0.50
per options contract. So for 1000 put contracts on MSFT you will pay $0.50 * 1000 =
$500). Your investment is now ‘hedged’ or insured against losses below $27. The extra
$500 spent in purchasing the PUTs is the ‘cost of hedge’ or ‘cost of insurance’. Thus
your $30,000 investment in MSFT you are buying an insurance at $500.

Now, if the price of MSFT went up to $35, you will have a profit of $35 - $30 - $0.50 =
$4.50 per share. (Of course the profit would be higher had you not ‘hedged’ your
investment).

However, if the price of MSFT went down to $25, since you have ‘hedged’ your
investment at $27, your losses will be limited. If you had not purchased the hedge your
losses would be $25 - $30 = $5 per share. Since you have ‘hedged’ your losses are now
limited to $30 - $27 - $0.50 = $3.50.

So a $500 insurance (hedge) has protected your losses. Instead of loosing $5 * 1000 =
$5000, your losses are limited to $3.50 * 1000 = $3500.

Hedging is mainly used to insure against the downturn in the market.

Common Hedging Strategies
Hedges are created by selling the ‘other’ side of the trade. You may use options, futures
contracts or any other financial instrument to create hedging strategies. Some common
ways to create hedges are.

Trade: Buying a stock (going long)
Hedging strategy 1: Buy PUTs along with the stock (this is shown in example above)
Hedging strategy 2: Sell CALLs along with the stock

Trade: Selling Short on a stock
Hedging strategy 1:Buy CALLs along with shorting the stock
Hedging strategy 2: Selling PUTs along with shorting the stock.

Trade: Purchase of Commodity at a future date
Hedging Strategy: Buy a Futures Contract on the commodity

References
1. http://www.investopedia.com/university/options/
2. http://en.wikipedia.org/wiki/Hedge_%28finance%29

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Introduction To Option Contracts And Hedging Using Options

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