Exchange Traded Currency Options — moneyness, pricing, the Greeks and payoffs

Where this chapter sits

Chapter 4 carries 20% of the paper — equal with futures, and together they are 40% of the exam.

Three things dominate: the four payoff positions with their break-even formulas, moneyness, and the Greeks table.

4.1 What an option is

Forward/futures contract is a commitment to buy/sell the underlying and has a linear pay off, which indicates unlimited losses and profits. Some market participants desire to ride the upside and limit their losses. Accordingly, options emerged as a financial instrument, which restrict the losses while allowing unlimited profits on buying or selling of the underlying asset.

An option is a contract that gives the option buyer the right, but not the obligation, to buy or sell the underlying asset on or before a specified date/day, at a pre-determined price. For acquiring this right, the option buyer must pay a certain price/premium to the option seller.

The land example

Mr. X is looking to buy 1 acre of land from Mr. Y. The land is valued at Rs.10,00,000. Mr. X has information about an infrastructure project which is expected to be started near the land within the next 3 months. He expects the value of land to increase as a result of this project. However, if the news turns out to be a rumour, then Mr. X would be stuck with a useless piece of land.

The arrangement:

Mr. X pays an upfront fee of Rs. 50,000/- today i.e. March 01, 2024, to Mr. Y. Consider this as a non-refundable fee. Against this fees, Mr. Y agrees to sell the land after 3 months to Mr. X The price of the land (which is expected 3 months later) is fixed today at Rs.10,00,000/- Mr. X has paid an upfront fee and hence only he can call off the deal at the end of 3 months. Mr. Y cannot back out of the contract. In the event Mr. X calls off the deal at the end of 3 months, Mr. Y gets to keep the upfront fee.

The asymmetry is the whole point: only one party can walk away, and he paid for that privilege.

The terminology it defines

The right to buy the asset is called a call option and the right to sell the asset is called a put option. Mr. X has received the right to buy the land, hence this is a call option transaction.

The pre-specified price at which the underlying asset may be purchased or sold by the option holder is called the strike price of the option — Rs.10,00,000 here.

The date at which the option contract will expire / or ceases to exist is called the expiration date of the contract — May 31, 2024.

The difference between the date of entering into the contract and the expiration date is called the time to maturity — 3 months.

The party which buys the rights but not the obligation and pays a premium for buying the right is called as the option buyer and the party which sells the right and receives a premium for assuming such obligation is called the option seller/writer.

The price that the option buyer pays to the option seller to acquire the right is called the option price or option premium — Rs. 50000/-.

The asset which is bought or sold is an underlying or the underlying asset.

In options trading, "to exercise" means to put into effect the right to buy or sell the underlying security that is specified in the options contract. If the price of land on May 31, 2024, is Rs. 15 lacs, Mr. X will exercise its option as he needs to pay only Rs. 10 lacs to buy the land.

And a put example everyone knows

When you get your car insured, you pay an insurance premium to the insurance company and the insurance company guarantees to compensate you for the damage to your car during the insurance period. In this example, you are buying a put option from the insurance company and paying it an option premium in the form of insurance premium.

If your car gets damaged during the insurance period, you can use your policy to claim the compensation and if all goes well and you do not need to claim the compensation, the insurance company keeps the premium in return for taking on the risk.

A customer paying additional charges for a warranty of certain parts is also an example of a put option, where the customer is the buyer of the put.

4.2 Futures versus options

The similarities:

Both the contracts have a buyer and a seller Both the contracts have a set price for the underlying asset Both the contracts have a set settlement date

And both have the same uses: just like futures, options can be used for hedging, or to generate returns by taking a view about the future direction of the market, or for arbitrage.

The difference, in the workbook's own words: in the case of futures both the parties have the right as well as obligation to buy or sell and therefore face similar risk. Whereas in options, the option buyer has only rights and no obligation and therefore faces only the risk of premium paid. On the other hand, the option seller is under obligation to buy or sell... and therefore faces unlimited risk.

At the same time, the option buyer has chances to capture unlimited upside while the option seller has limited upside equal to the premium received.

And the exercise rule: the call option buyer would exercise the option, only if the price of underlying asset is higher than the strike price. Similarly, the put option buyer would exercise the option, only if the price of the underlying asset is less than the strike price.

4.3 Style — European and American

European options can be exercised by the option buyer only on the expiration date. Hence, the option buyer enjoys less flexibility in how they handle option trading.

But that is not as restrictive as it sounds: in the case of exchange-traded options, participants can sell their option in the secondary market prior to the option expiration date to square-off their position.

American options can be exercised by the buyer any time on or before the expiration date. American options offer more flexibility to option buyer as they can be exercised on any trading day prior to their expiration.

And flexibility has a price: all other things remaining constant (underlying asset, strike price, expiry date etc.) the price of American options is always higher than or equal to European options.

In India, everything is European. Currently only European Options i.e. right to exercise option on specific date only, are allowed in the OTC market as well as in the ETCD segment.

4.4 Moneyness

Moneyness of an option indicates whether the contract would result in a positive cash flow, negative cash flow or zero cash flow for the option buyer at the time of exercising it.

In the money (ITM) option: An option is said to be in the money, if on exercising it, the option buyer gets a positive cash flow. Thus, a call option would be in the money, if underlying price is higher than the strike price and similarly a put option would be in the money, if underlying price is lower than the strike price.

Out of the money (OTM) option: An option is said to be out of the money, if on exercising it, the option buyer gets a negative cash flow. So a call option would be out of the money, if underlying price is lower than the strike price and similarly a put option would be out of the money, if underlying price is higher than the strike price.

At the money (ATM) option: An option is said to be at the money if the spot price is equal to the strike price. On exercise of ATM option buyer gets zero cash flows. Any movement in spot price of underlying from this stage would either make the option ITM or OTM.

One practical caution: in certain cases, transaction/regulatory charges are applicable at the time of exercise. If these costs are included, the decision of the option buyer would take into account these costs also.

4.5 Pricing

Intrinsic value and time value

The option value/option premium can be broken down into two parts.

Intrinsic value refers to the amount by which the option is in the money i.e. the amount an option buyer will realize, before adjusting for premium paid, if he exercises the option instantly.

Therefore, only in-the-money options have intrinsic value whereas at-the-money and out-of-the-money options have zero intrinsic value. The intrinsic value of an option can never be negative. This is because the option buyer would never choose to exercise the option if such exercise can result in a loss for him.

For a call: intrinsic value of a call option can be calculated as S-X, with minimum value possible as zero.

For a put: intrinsic value of a put option can be calculated as: X-S, with minimum value possible as zero.

Time value: The difference between the option premium and the intrinsic value is the time value of that Option. ATM and OTM options have only time value because the intrinsic value of such option is zero.

The time value is directly proportional to the length of time to expiration date of the option. The longer the time to expiration, higher is the time value. Therefore, everything else remaining the same, a call option with two months' maturity would be priced higher than the call option at the same strike price but with one month maturity.

Why: the time value reflects the probability that the option will gain intrinsic value or become profitable to exercise before its maturity. Therefore, the higher the time to expiration, higher is this probability and higher is the time value.

And at the end: at expiry the option value is its intrinsic value and time value will become zero.

The five factors

Prices are never fixed by stock exchanges or RBI or SEBI or anybody for that matter. In fact, price discovery is a very critical and basic component of markets. Stock exchanges only provide a platform where buyers and sellers meet, and SEBI's role is to ensure the smooth functioning of our markets.

Thus, there are five fundamental parameters on which the option price depends:

1) Spot price of the underlying asset 2) Strike price of the option 3) Volatility of the underlying asset's price 4) Time to expiration 5) Interest rates

Spot price — if the price of the underlying asset goes up, the value of the call option increases, while the value of the put option decreases. Similarly, if the price of the underlying asset falls, the value of the call option decreases, while the value of the put option increases.

Strike price — if all the other factors remain constant but the strike price of a call option increases, the intrinsic value of the call will decrease and hence the price of the call will also decrease. On the other hand... an increase in the strike price of a put option increases its intrinsic value, which in turn increases the price of the put.

Volatility — it is the magnitude of movement in the underlying asset's price, either up or down. It affects both call and put options in the same way. The higher the volatility of the underlying stock, the higher would be the option premium because there is a greater possibility that the option will move in-the-money during the life of the contract.

Higher volatility = Higher premium, Lower volatility = Lower premium (for both call and put options).

Time to expiration — generally, the longer the maturity of the option, the greater is the uncertainty and hence the premiums would be higher. If all other factors affecting an option's price remain the same, the time value portion of an option's premium will decrease with the passage of time. This is also known as time decay. Options are known as 'wasting assets', due to this property where the time value gradually falls to zero.

And a consequence worth pausing on: of the two components of option pricing (time value and intrinsic value), one component, i.e. the time value, is inherently biased towards reducing in value. So, if all things remain constant throughout the contract period, the option price will always fall by its expiry date. Thus, option sellers are at a fundamental advantage as compared to option buyers as there is an inherent tendency for the option price to decline over its life.

Interest rates — the "interest rate" referred to in relation to the prices of options is what is known as the "Risk Free Interest Rate". Interest rates are slightly complicated because they affect different options, differently. In a simpler way high interest rates will result in an increase in the value of a call option and a decrease in the value of a put option.

The full table:

Volatility and time move both premiums the same way. Spot, strike and interest rates move them in opposite directions. That single sentence covers the whole table.

4.5.3 The Greeks

"Greeks" is a term used in the options market to describe the different dimensions of risk involved in taking an options position. There are five primary Greek risk measures represented by Delta, Gamma, Theta, Vega and Rho.

Delta

The most important of the 'Greeks' is the option's "Delta". This measures the sensitivity of the option value to a given small change in the price of the underlying asset. It may also be seen as the speed with which an option moves with respect to change in the price of the underlying asset.

Delta = Change in option premium / Unit change in price of the underlying asset.

Delta of a long call option (and/or short put) is always positive and ranges between 0 and 1 and for a long put (and/or short call) is always negative and ranges between 0 and -1.

The worked example:

Price of USDINR @ 9:30 AM is at Rs. 82.80 · Option Strike = 82.50 Call Option · Premium = Rs. 0.45 · Delta of the option = + 0.55

Scenario 1 — USDINR expected to reach Rs. 83.00. We are expecting the underlying to change by 0.20 paise (83.00-82.80), hence the premium is supposed to increase by = 0.20*0.55 = 0.11. Therefore, the new option premium is expected to trade around 0.56 (0.45+0.11).

Scenario 2 — USDINR expected to reach Rs. 82.60. The premium is supposed to change by = -0.20*0.55 = -0.11. Therefore, the new option premium is expected to trade around 0.34 (0.45-0.11).

Gamma

It measures the potential change in option delta with respect to a very small change in the price of the underlying asset. This is the second derivative of the option price with respect to a change in the underlying price.

Gamma = Change in the option delta / Unit change in price of underlying asset

Gamma works as an acceleration of the delta, i.e. it signifies the speed with which an option will go either in-the-money or out-of-the-money due to a change in price of the underlying asset.

The worked case: the delta and Gamma of an ATM Put option is -0.50 and 0.004 respectively. Remember Put options have a negative Delta. Gamma as you notice is a positive number i.e., +0.004.

Case 1 – Underlying price moves up by 10 points: Change in Delta = Gamma * Change in underlying = 0.004 * 10 = 0.04. New Delta = -0.5 + 0.04 = – 0.46. (The Put option's delta declines when the underlying price increases)

Case 2 – Underlying price goes down by 10 points: *Change in Delta = 0.004 ( – 10) = – 0.04. New Delta = – 0.5 + (-0.04) = – 0.54. (The Put option gains delta when underlying price declines)

Theta

It is a measure of an option's sensitivity to time decay. Theta is the change in option price given a one-day decrease in time to expiration.

Theta = Change in the option premium / Change in time to expiry

Other things being equal, options tend to lose time value each day throughout their life. This is due to the fact that the uncertainty element in the price decreases.

Theta is expressed in points lost per day when all other conditions remain the same. Time runs in only one direction; hence theta is always a positive number, however as it is a loss in the options value, it is sometimes written as a negative number.

A Theta of -0.5 indicates that the option premium will lose -0.5 points for every day that passes by. For example, if an option is trading at Rs.2.75 with theta of -0.05 then it will trade at Rs.2.70 the following day.

And who it favours: a long option position (option buyer) always has a negative theta meaning that all else being equal, the option buyer will lose money on a daily basis. A short option (option seller) has a positive theta. Theta is friendly to the option seller.

Vega

This is a measure of the sensitivity of an option price to changes in market volatility.

Vega = Change in an option premium / Change in volatility

Vega is positive for a long call and a long put. An increase in the assumed volatility of the underlying increases the expected pay-out from a long option, whether it is a call or a put.

Since options gain value with increase in volatility, the vega is a positive number, for both calls and puts.

And timing matters: the effect of volatility is highest when there are more days left for expiry.

The worked case: USDINR spot is trading at Rs. 83 in May and a June expiry 83.30 call is trading for Rs.0.10. Let's assume that the vega of the option is 0.02 and that the underlying volatility is 10%. If the underlying volatility increased by 1% to 11%, then the price of the option should rise to 0.10 + (1 x 0.02) = 0.12. However, if the volatility had gone down by 2% to 8% instead, then the option price should drop to 0.10 - (2 x 0.02) = Rs.0.06.

Rho

Rho is the change in option price given a one percentage point change in the risk-free interest rate. Rho measures the change in an option's price per unit increase in the cost of funding the underlying.

Rho = Change in an option premium / Change in cost of funding of the underlying

Call options generally rise in price as interest rates increase and put options generally decrease in price as interest rates increase. Thus, call options have positive rho, while put options have negative rho.

The worked case: assume that a put option is priced at Rs. 0.50 and has a rho of -0.05. If interest rates were to decrease from 5 per cent to 4 per cent, then the price of this put option would increase from Rs.0.50 to Rs.0.55. In this same scenario, assuming the call option mentioned above with price 0.25, its price would decrease from Rs 0.25 to Rs. 0.20.

Summary of signs:

4.5.4 Put-call parity

Put-call parity shows the relationship that has to exist between European put and call options that have the same underlying asset, expiration, and strike prices. Put-Call parity holds only for a European option.

It shows that value of European call with a certain exercise price and exercise date can be deduced from the value of a European put with the same exercise price and exercise date and vice versa.

C + PV(x) = P + S

Where C stands for the price of the call option · PV(x) is the present value of x (the strike price), as subtracted from the value it has on the date of expiration, as considered at a risk-free rate · P is the price of the put · S is the spot price (current market value) the underlying asset.

4.6 Pricing models

The Binomial Pricing Model

The binomial option pricing model was developed by William Sharpe in 1978. It has proved over time to be the most flexible, intuitive and popular approach to option pricing. It can be used for pricing European as well as American options.

The binomial model represents the price evolution of the option's underlying asset as a binomial tree of all possible prices at equally spaced time steps from today. The model assumes that at each step, the price can only move up and down at fixed rates and with respective simulated probabilities.

This is a very accurate model as it is iterative, but also running it is very time consuming.

The Black-Scholes Model

The Black-Scholes model was published in 1973 by Fisher Black and Myron Scholes. It is one of the most popular, relatively simple and fast modes of option price calculation. Unlike the binomial model, it does not rely on calculation by iteration.

This model is used to calculate a theoretical call price (ignoring the dividends paid during the life of the option) using the five key determinants of an option's price: stock price, strike price, volatility, time to expiration, and short-term (risk free) interest rate.

C = SN(d1) – Xe^(-rt) N(d2) P = Xe^(-rt) N(-d2) − SN(-d1)

Where d1 = [In(S/X)+(r+v²/2)t]/(v√t) and d2 = d1 – v√t.*

Variables: S = stock price · X = strike price · t = time remaining until expiration, expressed in years · r = current continuously compounded risk-free interest rate · v = annual volatility of stock price (the standard deviation of the short-term returns over one year) · In = natural logarithm · N(x) = standard normal cumulative distribution function · e = the exponential function.

Five inputs, six outputs. INPUT: Spot Price · Strike Price · Volatility · Time to Expiry · Risk free rate. OUTPUT: Call and Put Option Premium · Delta · Gamma · Vega · Theta · Rho.

Its assumptions and their limits: the Black-Scholes model was designed to value options that can be exercised only at maturity and whose underlying assets do not pay dividends. In addition, options are valued based on certain assumptions like market movements are random, there are zero transaction costs etc. In practice, assets do pay dividends, options sometimes get exercised early, and exercising an option can affect the value of the underlying asset.

On dividends: the payment of a dividend reduces the stock price... Consequently, call options become less valuable and put options more valuable, as expected dividend payments increase.

Two ways of dealing with them:

1. Short-term options: estimate the present value of expected dividends that will be paid by the underlying asset during the option life and subtract it from the current value of the asset to use as S in the model. Modified stock price = Current stock price – Present value of expected dividends during the life of the option.

2. Long-term options: Since it becomes less practical to estimate the present value of dividends for longer maturity options... If the dividend yield (y = Dividends/Current value of the asset) on the underlying asset is expected to remain unchanged during the life of the option, the Black-Scholes model can be modified to take dividends into account.

And the Indian application: Indian exchanges use the Black-Scholes options pricing model for the computation of the theoretical price of exchange-traded currency options.

Black (1976) Model

One such development for the valuation of futures options is introduced by Black (1976). Black proposed a formula for options under the assumption that investors generate riskless hedges between options and the futures or forward contracts.

The problem of negative cost of carry was addressed by using 'forward prices' in the option pricing model instead of 'spot prices'. Black observed that actual forward prices not only incorporate cost of carry but also takes into account other irregularities in the market.

In his proposed model, he substituted spot price (S) by the discounted value of future price (F*e^-rt) in the original Black-Scholes model.

**C = Fe^(-rt)N(d1) – Xe^(-rt)N(d2) P = e^(-rt) [XN(-d2) − FN(-d1)]

Where F = future price and the other variables are as in Black-Scholes.

Its uses: Black's model found application in valuing options on physical commodities where the futures price is a better alternative input for valuing options. Its primary applications are for pricing options on futures contracts, bond options, interest rate caps and floors, and swaptions.

The distinction to remember: the important difference between Black's and Black-Scholes is that Black uses forward/future prices and Black-Scholes uses spot prices. Indian exchanges use the Black 1976 options pricing model for computation of the theoretical price of exchange-traded interest rate options (where the underlying is government securities).

So: Black-Scholes for currency options; Black 1976 for interest rate options.

4.7 Implied volatility

Different types of volatility that exist – Historical Volatility, Forecasted Volatility, and Implied Volatility.

Historical Volatility — we take the past closing prices of the stock/index/bonds/currency rate and calculate the historical volatility based on the past price movements. Historical volatility is very easy to calculate and helps us with most of the day-to-day requirements.

Forecasted Volatility refers to the act of predicting volatility over the desired time frame. A few good statistical models are available to forecast volatility.

Implied Volatility (IV) represents the market participant's expectation of volatility over the life of an option. Implied volatility can be thought of as consensus volatility arrived amongst all the market participants with respect to the expected amount of underlying price fluctuation over the remaining life of an option. Implied volatility is reflected in the price of the premium.

It is denoted by the symbol σ (sigma). It can often be thought to be a proxy of market risk. It is commonly expressed using percentages and standard deviations over a specified time horizon.

And an important limitation: IV does not predict the direction in which the price change will proceed. For example, high volatility means a large price swing, but the price could swing upward (very high), downward (very low), or fluctuate between the two directions.

A market pattern: when applied to the financial market, implied volatility generally increases in bearish markets, when investors believe equity prices will decline over time. IV decreases when the market is bullish.

How it is computed: in the case of a traded option, you know four of the five factors that determine the option price, i.e., you know the current underlying price, the option strike price, the time to maturity and the rate of interest. Volatility is the only factor in the model that is not directly observable in the market. But if you take the current traded price of the option as given, plug the other four factors in the Black-Scholes model and run the model in reverse, you can arrive at the implied volatility of the option.

Thus, implied volatility is that number, which when plugged into the Black-Scholes model along with the underlying price, strike price, time to maturity and rate of interest, makes the resulting option price equal to the current traded option price.

And who benefits from a change: when implied volatility increases, the price of options will increase as well, assuming all other things remain constant. So, when implied volatility increases after a trade has been placed, it is good for the option owner and bad for the option seller. Conversely, if implied volatility decreases after you enter the trade, the price of options usually decreases. That is good if you are an option seller but bad if you are an option owner.

4.8 The four payoff positions

Long Option position. The buyer of an option is said to be "long on the option"... When you are long an option contract: You have the right to exercise that option. Your potential loss is limited to the premium amount you paid for buying the option. Profit would depend on the level of underlying asset price at the time of exercise/expiry of the contract.

Short Option position. The seller of an option is said to be "short the option"... When you are short (i.e., the writer of) an option contract: Your maximum profit is the premium received. You can be assigned the option on exercise by the option buyer. All option writers should be aware that assignment is a distinct possibility. Your potential loss is theoretically unlimited.

4.8.1 Long Call

On March 1, 2024, USDINR is trading at Rs. 82.80. You buy a call option with a strike price of 83 expiring on March 26, 2024, by paying a premium of Rs. 0.10.

If the USDINR rate is above Rs. 83 at expiry, you will exercise the option, else you will let it expire.

Below the strike: if on expiry USDINR rate is Rs. 82.75, you will not exercise the right to buy the underlying... Why will you buy something at Rs. 83 when you can have the same thing at Rs. 82.75? So, you will give up the right to buy at 83. In such a situation, your loss will be equal to the premium paid, which in this case is Rs. 0.10.

At the break-even: if on expiry if USDINR rate was at Rs. 83.10, you will exercise the option and buy USD at Rs. 83 and sell it at the market price of Rs. 83.10. You will pocket a gain of Rs.0.10 in this transaction, but you have already paid this much money to the option seller... So, Rs.83.10 is the Break-Even Point (BEP) for this option contract, the price level at which the option buyer makes neither a profit nor any loss.

A general formula for calculating BEP for call options is the strike price plus premium (X + c).

In profit: if USDINR were to close at Rs. 83.50, you will exercise the option and buy USD at Rs. 83 and sell it in the market at Rs.83.50, thereby making a profit of Rs. 0.50. But since you have already paid Rs. 0.10 as option premium, your net profit would be 0.50-0.10 = 0.40.

And in India: in the case of cash-settled option contracts, the option buyer receives only the profit amount on exercise i.e. the difference between the strike price of the option and the spot price on the exercise date, which is Rs.0.50 in this example.

Note that distinction carefully — the cash received is Rs. 0.50; the net profit is Rs. 0.40 after the premium already paid.

Maximum loss for such option buyer will be Rs. 0.10. The lot size of Exchange traded currency option is 1000 USD, so the maximum loss per lot will be Rs. 100 (=1000*0.10).

4.8.2 Short Call

Whenever someone buys a call option, there has to be a counterparty, who has sold that call option. If the maximum loss for a long call position is equal to the premium paid, it automatically means that the maximum gain for the short call position will be equal to the premium received. Similarly, if maximum gain for long call position is unlimited, then the maximum loss for the short call position must be unlimited.

Whenever, the long call position makes losses, the short call position makes profits and vice versa. Hence, the short call pay off chart is just the mirror image of the long call pay off.

Maximum gain for an option seller, as explained earlier, is equal to the premium received, whereas maximum loss can be unlimited (when price starts moving above BEP).

And a point that saves time in the exam: BEP for a short call position will also be equal to X + P. BEP is independent of position (long or short), it is instrument specific (call option).

4.8.3 Long Put

On March 1, 2024 USDINR is trading at Rs. 82.80. You buy a put option with strike price of 83.00 at a premium of Rs. 0.075 with expiry date March 26, 2024.

If USDINR trades below Rs. 83 at expiry, you will exercise the option; else you will let it expire.

Above the strike: if on expiry USDINR rate is Rs. 83.25, you will not exercise the right to sell the underlying... Why will you sell something at Rs.83 when you can sell the same thing at Rs. 83.25? So, you will forego the right. In such a situation, your loss will be equal to the premium paid, which in this case is Rs. 0.075.

At break-even: if on expiry if USDINR rate were at Rs. 82.925, you will exercise the option and sell USD at Rs.83 and make profit by buying it at Rs. 82.925. In this transaction you will make a profit of Rs. 0.075, but you have already paid this much money to the option seller... So Rs.82.925 is the Break-Even Point (BEP).

A general formula for calculating BEP for put options is strike price minus premium (X - P).

In profit: if USDINR were to close at Rs. 82.50, you will exercise the option and sell USD at Rs.83 and buy it in the market at Rs.82.50, thereby making a profit of Rs. 0.50. But since you have already paid Rs. 0.075 as option premium, your actual profit would be 0.50-0.075 = 0.425.

Maximum loss for such option buyer will be Rs.0.075. The lot size of Exchange traded currency option is 1000 units, so the maximum loss per lot will be Rs. 75 (=1000*0.075).

4.8.4 Short Put

The position of a put option seller/writer is simply the opposite of that of the put option buyer. When the long put makes profit, the short put makes a loss. If the maximum loss for the long put is the premium paid, then maximum profit for the short put must be equal to the premium received. If the maximum profit for the long put is when price of underlying falls to zero at expiry, then that also is the time when the short put position makes its maximum loss.

Maximum gain for an option seller... will be equal to the premium received, whereas maximum loss will be up to underlying price become zero (when price starts moving below BEP). BEP for a short put position will also be equal to (X – P).

The asymmetry

Options are products with asymmetric risk exposure i.e., the gains when the underlying asset moves in one direction is significantly different from the losses when the underlying asset moves in the opposite direction.

For example, under a call option, when a stock price goes down, the loss incurred by the buyer of this option is limited to the purchase price of the option. But if the stock price goes up, the buyer of the call gains in proportion to the rise in the stock's value, thereby giving asymmetric pay off. In contrast to this, futures have symmetric risk exposures (symmetric pay off).

4.8.5 Squaring off

Similar to futures, options positions can also be squared off (closing of position) before expiry of contracts.

The worked example: an exporter hedges 20000 USD by buying March 2024 USDINR put option at a strike of Rs 83.00 when the available price was Rs 0.07/0.075. He received USD in his account of 15th March. The exporter decided to cancel the option on 15th March when the available price for the same contract was Rs 0.04/0.045.

Premium paid: Rs.1500 (20000 * 0.075) Premium received at the time of square off: Rs.800 (20000 * 0.04) Net gain / (loss): (Rs. 700).

Note both sides use the customer-unfavourable side of the quote — he paid the offer of 0.075 and received the bid of 0.04, exactly as Chapter 1's two-way quote rule requires.

4.9 Contract specifications

In 2010, the first exchange traded currency option was launched on USDINR pair and then on EURINR, GBPINR and JPYINR. Subsequently, Exchange-traded currency options were launched on cross currency pairs (contracts involving other than Indian Rupee) namely EURUSD, GBPUSD and USDJPY.

Contracts involving the Indian Rupee

Contract Trading Cycle — 3 Serial monthly contracts followed by 3 quarterly contracts of the cycle March/June/September/December. For Weekly USDINR Options — 11 serial weekly contracts expiring on Friday, excluding expiry week wherein monthly contracts expires on a Friday.

Note that weekly options exist only for USDINR.

Expiry Day — For weekly contract: Every Friday at 12:30 pm. If the Friday of the expiring week is a trading holiday, then the expiry day is the previous trading day. For monthly contract: Two working days prior to the last business day of the expiry month at 12:30 PM.

Price Band — and here options differ from futures: the price bands for options shall be based on the delta of the options contract and calculated using the previous close price of the underlying and volatility. The price band so computed shall be subject to a minimum operating range which would be applicable for all contracts. The bands shall be computed for each options contract on a daily basis and shall be applicable from the next trading day. The operating range may be flexed during the day in case the option traded prices crosses certain percentage of the set range.

Cross currency options

Trading Hours — Monday to Friday: 9:00 a.m. to 7:30 p.m., expiry day to 12:30 pm.

Contract Trading Cycle — 3 serial monthly contracts, followed by 3 quarterly contracts of the cycle March/June/September/December. No weekly contracts.

Expiry Day — Two working days prior to the last business day of the expiry month at 12:30 PM.

Mode of Settlement — Cash Settled in Indian Rupees.

Final Settlement Price — computed using the FBIL reference rate for USD-INR and the corresponding exchange rate published by FBIL for EUR-INR, GBP-INR and JPY-INR, as applicable, on the last trading day of the contract.

Final Settlement: T+2 where T denotes the expiry date.

4.10 Exchange-traded versus OTC options

The differences between Exchange-Traded Currency Options and OTC Options are similar to those between futures and forward contracts.

In India, currently only European Options i.e. right to exercise option on specific date only, are allowed in the OTC market as well as in the ETCD segment.

Exchange-traded currency options have some distinct advantages over OTC currency options as they eliminate counterparty risk and offer more liquidity and price transparency. However, it should be noted that OTC products enjoy the benefit of being customized to meet specific client requirements.

OTC advantages: since the products are customized, they can provide almost a perfect hedge · delivery-based settlement is more helpful to importers and exporters · less operation issues related to margin.

Exchange advantages: price transparency · elimination of counterparty credit risk as settlement guarantee by clearing corporation of Exchanges · access to all types of market participants · the credit risk profile of counterparties does not matter · lower liquidity risk compared to OTC options · generally lower impact cost · easy entry and exit · flexibility in using various option strategies.

OTC limitations: liquidity risk · counter party risk · limited market participants · certain restriction on use of various option strategies.

Exchange limitations: may lead to imperfect hedge as the contract size and settlement dates are standardized · since, it is cash settled, users need to access cash/spot market for actual delivery of currency · operational issues related to margin.

Two items are unique to the options comparison and do not appear in the futures/forwards table: flexibility in using various option strategies as an exchange advantage, and certain restriction on use of various option strategies as an OTC limitation.