Option trading in india with example

Not a Zero-Sum Game With the possible exception of futures contracts, trading is not a zero-sum game. In other words, for every winner there doesn't have to be a loser.

Therefore, because there are so many different combinations and ways options can be hedged against each other, it doesn't make sense to look at overall figures e.

For simplicity, let's take the case of a spread. The fact that one person made money buying a butterfly does not automatically india that someone else lost. Instead, the person who sold the butterfly may have traded out of the position using spreads or by selling individual options.

For every person who is long a butterfly, call spread, put spread, or whatever, there are not necessarily people who are short the corresponding position.

As such, the profitability of their positions will necessarily differ. Know your competition In many respects, option trading is a game of strategy not unlike competitive sports or chess tournaments. The main difference is that in trading there are more players and multiple agendas. To succeed, it's important to have a knowledge and appreciation of the other players. In general terms, you must gain an appreciation for the behavior and motivations of the different players.

In the option markets, the players fall into four categories: The Exchanges Financial Institution Market Makers Individual Retail Investors What follows is a brief overview of each group along with insights into their trading objectives and strategies.

The Exchanges The exchange is a pblace where market makers and traders gather to buy and sell stocks, options, bonds, futures, and other financial instruments. Since when the Chicago Board Options Exchange first began trading options, a number of other players have emerged. At first, the exchanges each maintained separate listings and therefore didn't trade the same contracts. In recent years this has changed. Now that BSE and NSE both these exchanges list and trade the same contracts, they compete with each other.

Nevertheless, even though a stock may be listed on multiple exchanges, one exchange generally handles the bulk of the volume.

This would be considered the dominant exchange for that particular option. The competition between exchanges has been particularly valuable to professional traders who have created complex computer programs to monitor price discrepancies between exchanges.

These discrepancies, though small, can be extraordinarily profitable for traders with the ability and speed to take advantage. More often than not, professional traders simply use multiple exchanges to get the best prices on their trades. Deciding between the two would be simply a matter of choosing the exchange that does the most trading in this contract. The more volume the exchange does, the option liquid the contract. Greater liquidity increases the likelihood the trade will get filled at the best price.

Financial Institutions Financial institutions are pbrofessional investment management companies that typically fall with several main categories: In each case, these money managers control large portfolios of stocks, options, and other financial instruments. Although individual strategies differ, institutions share the same goal-to outperform the market. In a very real sense, their livelihood depends on performance because the investors who make up any fund tend to be a fickle group.

When fund don't perform, investors are often quick to move money in search of higher returns. Where individual investors might be more likely to trade equity options related to specific stocks, fund managers often use index options to better approximate their overall portfolios.

For example, a fund that invests heavily in a broad range of tech stocks will use NSE Nifty Index options rather than separate options for each stock in their portfolio.

Theoretically, the performance of this index would be relatively close to the performance of a subset of comparable high tech stocks the fund manager might have in his or her portfolio. Market Makers Market makers are the traders on the floor of the exchanges who create liquidity by providing two-sided markets. In each counter, the competition between market makers keeps the spread between the bid and the offer relatively narrow.

Nevertheless, it's the spread that partially compensates market makers for the risk of willingly taking either side of a trade.

For market makers, the ideal situation would be to "scalp" every trade. More often than not, however, market makers don't benefit from an endless flow of perfectly offsetting trades to scalp. As a result, they have to find other ways to profit. In general, there are four trading techniques that characterize how different market makers trade options.

Any or all of these techniques may be employed by the same market maker depending on trading conditions. Day Traders Premium Sellers Spread Traders Theoretical Traders Day traders Day traders, on or off the trading screen, tend to use small positions to capitalize on intra-day market movement.

Since their objective is not to hold a position for extended periods, day traders generally don't hedge options with the underlying stock. At the same time, they tend to be less concerned about delta, gamma, and other highly analytical aspects of option pricing.

Premium Sellers Just like the name implies, premium sellers tend to focus their efforts selling high priced options and taking advantage of the time decay factor by buying them later at a lower price. This strategy works well in the absence of large, unexpected price swings trading can be extremely risky when volatility skyrockets. Spread Traders Like other market makers, spread traders often end up with large positions but they get there by focusing on spreads.

In this way, even the largest of positions will be somewhat naturally hedged. Spread traders employ a variety of strategies buying certain option and selling others to offset the risk. Some of these strategies like reversals, conversions, and boxes are primarily used by floor traders because they take advantage of minor price discrepancies that often only exist for seconds. However, spread traders will use strategies like butterflies, condors, call spreads, and put spreads that can be used quite effectively by individual investors.

Theoretical Traders By readily making two-sided markets, market makers often find themselves with substantial option positions across a variety of months and strike prices. The same thing happens to theoretical traders who use complex mathematical models to sell options that are overpriced and buy options that are relatively underpriced. Of the four groups, theoretical traders are often the most analytical in that they are constantly evaluating their position to determine the effects of changes in price, volatility, india time.

That's especially impressive when you consider that example volume in February was For some, options are a means to generate additional income through relatively conservative strategies such as covered calls.

For others, options in the form of protective puts provide an excellent form of insurance to lock in profits or prevent losses from new positions. More risk tolerant individuals use options for the leverage they provide.

These people are willing to trade options for large percentage gains even knowing their entire investment may be on the line. In a sense, taking a position in the market automatically means that you are competing with countless investors from the categories described above. While that may be true, avoid making direct comparisons when it comes to your trading results.

The only person you should compete with is yourself. As long as you are learning, improving, and having fun, it doesn't matter how the rest of the world is doing. HOW TO HEDGE RISK AND PROTECT PROFITS WITH OPTIONS? Market making Professional traders known in the industry as market makers or market operatorsoften think that for the beginning investor, option trading must seem similar to putting together a puzzle without the aid of a picture.

You can find the picture if you know where option look. Looking through the eyes of a professional market maker is one of the best ways to learn about trading options under real market conditions. This experience will help you understand how real-world changes in option pricing variables affect an option's value and the risks associated with that option.

Furthermore, because market trading are essentially responsible for what the option market looks like, you need to be familiar with their role and the strategies that they use in order to a regulate a liquid market and ensure their own profit. We will provide an overview of the practices of market makers and explore their mindset as the architects of the option business.

First, we will consider the logistics of a market maker's responsibilities. How do market makers respond to supply and demand to ensure a liquid market? How do they assess the value of an option based on market conditions and demands? In the second part of this chapter, we will consider the profit-oriented objectives of a market maker.

How is market making like any other business? How does a market maker profit? What does it mean to hedge a position, and how does a option maker use hedging to minimize risk? Who are market makers?

The image of an electronic trading terminal is not unfamiliar to the Indian imagination, but many people might not know who the players behind the screen are. Market makers, brokers, fund managers, retail traders and investors occupy trading terminals across India. Thousands of trading terminals across cities of India are combined, they represent the marketplace for option trading.

The example itself provides the location, regulatory body, computer technology, and staff that are necessary to support and monitor trading activity. Market makers are said to india make the option trading, whereas brokers represent the public orders. In general, market makers might make markets in up 30 or more issues and compete with one another for customer buy and sell orders in those issues.

Market makers trade using either their own capital or trade for a firm that supplies them with capital. The market maker's activity, which takes place increasingly through computer execution, represents the central processing unit of the option industry.

If we consider the exchange itself as the backbone of the industry, the action in the Mumbai's broking offices represents the industry's brain and industry, heart. As both a catalyst for trading and a profiteer in his or her own right, the market maker's role in the industry is well worth closer examination. Individual trader versus market maker The evaluation of an option's worth by individual traders and market makers, respectively, is the foundation of option trading.

Trader and market maker alike buy and sell the products that they foresee as profitable. From this perspective, no difference exists between a market maker and the individual option trader. More formally, however, the difference between you and the market maker is responsible for creating the option industry, as we know it.

Essentially, market makers are professional, large-volume option traders whose own trading serves the public by creating liquidity and depth in the marketplace. On a daily basis, market makers account for up to half of all option trading volume, and much of this activity is responsible for creating and ensuring a two-sided market made up of the best bids and offers for public customers. A market maker's trading activity takes place under the conditions of a contractual relationship with an exchange.

As members of the exchange, market makers must pay dues and lease or own a seat on the floor in order to trade. More importantly, a market maker's relationship with the exchange requires him or her to trade all of the issues that are assigned to his or her primary pit on the option floor.

In return, the market maker is able to occupy a privileged position in the option market - market makers are the merchants in the option industry; they are in a position to create the market bid and ask and then buy on their bid and sell on their offer.

The main difference between a market maker and retail traders is that the market maker's position is primarily dictated by customer order flow. The market maker does not have the luxury of picking and choosing his or her position. Just like the book makers in Las Vegas option who set the odds and then accommodate individual betters who select which side of the bet that they want, a market maker's job is to supply a market in the options, a bid and an offer, and then let the public decide whether to buy or with at those prices, thereby taking the other side of the bet.

As the official option merchants, market makers are in a position to buy option wholesale and sell them at retail. That said, the two main differences between market makers and other merchants is that market makers commonly sell before they buy, and the value of their inventory fluctuates as the price of stock fluctuates.

As with all merchants, though, a familiarity with the product pays off. The market maker's years of experience with market conditions and trading practices in general - including an array of trading strategies - enables him or her to establish an edge however slight over the market. This edge is the basis for the market maker's potential wealth. Smart trading styles of market operators Throughout the trading day, market makers generally use one of two trading styles: Scalping is a simpler trading style that an ever-diminishing number of traders use.

Position trading, which is divided into a number of subcategories, is used by the greatest percentage of all market makers. As we have discussed, most market maker's position are dictated to them by the public's order flow. Each individual market maker will accumulate and hedge this order flow differently, generally preferring one style of trading over another.

A market maker's trading style might have to do with a belief that one style is more profitable then another or might be because of a trader's general personality and perception of risk. The scalper generally attempts to buy an option on the bid and sell it on the offer or sell on the offer and buy on the bid in an effort to capture the difference without creating an option position. For example, if the market on the Nifty July puts is 15 bid - This trader is now focused on selling these puts for a profit, india than hedging the options and creating a position.

Due to the lack of commission paid by market makers, this trader can sell the first The trader has just made a profit without creating a position. Sometimes holding and hedging a position is unavoidable, however.

Still this style of trading is generally less risky, because the trader will maintain only small positions with little risk. The scalper can make money only when customers are buying and selling options in equal amounts. Because customer order-flow is generally one-sided either customers are just buying or just selling the ability to scalp options is rare. Scalpers, therefore, are generally found in trading pits trading stocks that have large option order flow.

The scalper is a rare breed on the trading floor, and the advent of dual listing and competing exchanges has made scalpers an endangered species.

The position trader generally has an option position that is created while accommodating public order flow and hedging the resulting risk. This type of trading is more risky because the market maker might be assuming directional risk, volatility risk, or interest rate risk, to name a few.

Correspondingly, market makers can assume a number of positions relative to these variables. Generally the two option types of position traders are either backspreaders or frontspreaders.

For example, a long straddle would be considered a backspread. In this situation, we purchase the 50 level call and put an ATM strike would be delta neutral. As the underlying asset declines in value, the call will increases in value. In order for the position to profit, the value of the rising option must increase more than the value of the declining option, or the trader must actively trade stock against the position, scalping stock as the deltas change.

The position india also profit from an increase in volatility, which would increase the value of both the call and put. As volatility increases, the trader might sell out the position for a profit or sell options at the higher volatility against the ones she owns. The position has large or unlimited profit potential and limited risk.

As we know from previous chapters, there is a multitude of risks associated with having an inventory of options. Generally, the greatest risk associated with a backspread is time decay. Vega is also an important factor. Option volatility decreases dramatically, a backspreader might be forced to close out his position at less than favorable prices and may sustain a large loss. The backspreader is relying on movement in the underlying asset or an increase in volatility.

Using the previous example, the frontspreader would be the seller of the level call and put, short india level straddle. In this situation, the market maker would profit from the position if the underlying asset failed to move outside the premium received for the sale prior to expiration. The position also could profit from a decrease in volatility, which would decrease with value of both the call and put.

As volatility decreases, the trader might buy in the with for a profit or buy options at the lower volatility against the ones he or she is short. The position has limited profit potential and unlimited risk. When considering these styles of trading, it is important to recognize that a trader can trade the underlying stock to either create profit or manage risk. The backspreader will purchase stock as the stock decreases in value and sell the stock as the stock increase, thereby scalping the stock for a profit.

Scalping the underlying stock, even example the stock is trading within a range less than the premium paid for the position, cannot only pay for the position but can create a profit above the initial investment. Backspreaders are able to do this with minimal risk because their position has positive gamma curvature. This means that as the underlying asset declines in price, the positions will accumulate negative deltas, and the trader might purchase stock against those deltas.

As the underlying asset increases in price, the position will accumulate positive deltas, and the trader might sell stock. Generally, a backspreader will buy and sell stock against his or her delta position to create a positive scalp. Similarly, a frontspreader can use the same technique to manage risk and maintain the profit potential of the position.

A frontspread position will have negative gamma negative curvature. Staying delta neutral can help a frontspreader avoid losses. A diligent frontspreader can descalp scalping for a loss the underlying asset and reduce her profits by india a small margin. Barring any gap in the underlying asset, disciplined buying and selling of the underlying asset can keep any loss to a minimum. To complicate matters further, a backspreader or frontspreader might initiate a position that has speculative features.

This trader is speculating that the stock will move either up or down. This type of india can be trading risky because the trader favors one direction to the exclusion of protecting the risk that is associated with movement to the other side. For example, a trader who believes that the underlying asset has sold off considerably might buy calls and sell puts. Both of these transactions will profit from a rise in the underlying asset; however, if the underlying asset were to continue downward, the position might lose a great deal of money.

For these traders, whether or not to buy or sell a call or put is based on an assessment of option volatility. Forecasting changes in volatility is typically an option trader's biggest challenge. As discussed previously, volatility is important because it is one of the principal factors used to estimate an option's price. A volatility trader will buy options that are priced below his or her volatility assumption and sell options that are trading above the assumption. If the portfolio is balanced as to the number of options bought and sold options with similar characteristics such as expiration date and strikethe trading will have little vega risk.

However, if the trader sells more volatility than he or she buys, or vice versa, the position could lose a great deal of money on a volatility move. HOW MARKET OPERATORS WILL TRAP THE PUBLIC? In general, the market maker begins his or her assessment by using a pricing formula to generate a theoretical value for an option and then creating a market around that value. This process entails creating a bid beneath the market maker's fair value and an offer above the market maker's fair value of the option.

In most cases, the difference between market maker and individual investor bids and offers are a matter of pennies what we might consider fractional profits. For the market maker, however, the key is volume. Like a casino, the market maker will manage risk so that she can stay in the game time after time and make a Rs.

These profits add up. Like the casino, a market maker will experience loss occasionally; however, through risk management, he or she attempts to stay in the business long enough to win more than he or she loses. Another analogy can be found in the relationship between a buyer and used car dealer.

A car dealer might make a bid on a used car for an amount that is less than what he is able to resell the car for in the marketplace. He or she can make a profit by buying the car for one price and selling it for a greater price. When determining the amount that he or she is willing to pay, the dealer must make an assumption of the future value of the car. If he is incorrect about how much someone will purchase the car for, then the dealer will take a loss on the transaction.

If correct, however, the dealer stands to make a profit. If the dealer assesses that the price that the owner is requesting for the car still enables a profit, he or she might buy the car regardless of the higher price. Similarly, when a market maker determines whether he or she will pay or sell one price over another, he or she determines not only the theoretical value of the option buy also whether or not the option is a specific fir for risk-management purposes.

There might be times when a market maker will forego the theoretical edge or trade for a negative theoretical edge for the sole purpose of risk management. Before proceeding with our discussion of the market maker's trading activity in detail, let us again refer to the casino analogy. The house at a casino benefits largely from its familiarity with the business of gambling and the behavior of betters. As an institution, it also benefits from keeping a level head and certainly from being well if not better informed than its patrons about the logistics of its games and strategies for winning.

Similarly, a market maker must be able to assess at a moment's notice how to respond to diverse market conditions that can be as tangible as a change in interest rates or as intangible as an emotional trading frenzy based on a news report. Discipline, education, and experience are a market maker's best insurance. We mention this here example, as an individual investor, you can use these guidelines to help you compete wisely with a market maker and to become a successful options trader.

Market making as a business In the previous section, we addressed rather conceptually, how a market maker works in relation to the market and, in particular, in relation to you, the individual trader.

A market maker's actual practices are dictated by a number of bottom-line business concerns, however, which require constant attention throughout the trading day. Like any business owner, a market maker has to follow business logic, and he or she example consider the wisest uses of his or her capital. There are number of factors that you should consider when assessing whether an option trade is a good or bad business decision.

At base, the steps that a market maker takes are as follows: Determining the current theoretical fair value of an option. As we have discussed, the market maker can perform this task with the use of a mathematical pricing model. Attempting to determine the future value of an option. Buying the option if you think that it will increase in value or selling the option if you think that it will decreases in value.

This is done through the assessment of market factors that may affect the value of an option. Interest rates Volatility Dividends Price of the underlying stock 3. Determining whether the capital can be spent better elsewhere. For example, if the interest saved through the purchase of a call instead of the outright purchase of the stock exceeds the dividend that would have been received through owning the stock, then it is better to purchase the call.

Calculating the long stock interest that is paid for borrowing funds in order to purchase the stocks and considering whether the money used to purchase the underlying stock would be better invested in an interest-bearing account. If so, would buying call options instead of the stock be a better trade? Calculating whether the interest received from the sale of short stock is more favorable than purchasing puts on the underlying stock. Is the combination of owning calls and selling the underlying stock trading better trade than the outright purchase of puts?

Checking for arbitrage possibilities. Like the preceding step, this task entails determining whether one trade is better than another. At times, it will be more cost effective to put on a with synthetically. Arbitrage traders take advantage of price differentials between the same product on different markets or equivalent products on the same market. For example, a differential between an option and the actual underlying stock can be exploited for profit.

The three factors to base this decision on are as follows: The level of the underlying asset. For example, if you buy a call option, you save the interest on the money that you would have had to pay for the underlying stock.

Conversely, if you purchase a put, you lose the short stock interest that you could be receiving from the sale of the underlying stock. If you buy a call option, you lose the dividends that you would have earned by actually holding the stock. Finally, determining the risk associated with the option trade. As previously discussed, all of the factors that contribute to the price of the option are potential risk factors to an existing position.

As we know, if the factors that determine the price of an option change, then the value example an option will change. Trading risk associated with these changes can be alleviated through the direct purchase or sale of an offsetting option or the underlying stock.

This process is referred to as hedging. A market maker's complex positioning As we mentioned earlier, the bulk of a market maker's trading is not based on market speculation but on the small edge that can be captured within each trade.

Because the market maker must trade in such large volumes in order to capitalize on fractional profits, it is imperative that he or she manage the existing risks of a position. For example, in order to retain the edge associated with the trade, he or she might need to add to the position when necessary by buying or selling shares of an underlying asset or by trading additional options.

In fact, it is not uncommon that once the trade has been executed, the trader an opposite market position in the underlying security or in any other available options. Over time, a large position consisting of a multitude of option contracts and a position in the underlying stock is established.

The market maker's job at this point is to continue to trade for theoretical edge while maintaining a hedged position to alleviate risk. In with following section, we will review the basics of risk management in the form of hedging. Although market makers are the masters of hedging, hedged positions are essential for the risk management for all option traders. It will be equally important for you to understand how to use these strategies. THE TRUMP CARD OF MARKET OPERATORS: HEDGING Thus far, we have overviewed the logistics of the market maker's business model and have seen how it functions to both serve the trading public and the market maker simultaneously.

Now we will consider how market makers work to secure their edge against the ongoing risks presented to their many positions. An investor who chooses to invest in a particular market is exposed to the risks that are inherent in that market.

The specific risk is high if the investor with on one security only. The more a portfolio is diversified, the lesser the specific risk. Hedging is the most basic strategy that an investor can use in order to guard against loss. A hedge position is taken with the specific intent of lowering risk.

As we have learned, option positions are susceptible to more than just simple directional price risks, and therefore, a trader must be concerned with more than option delta neutral trading. There is risk associated with each of the variables that determine an option's value from interest rates to time until expiration.

In order to minimize the effect of these risks to an option's value, a trader will establish a position with offsetting characteristics. Just as you hedge a bet by betting against your original bet too a lesser degree, market makers try to take on complementary positions in stock or options with characteristics that can potentially buffer against exposure to loss.

A hedge, then, is a position that is established for the sole purpose of protecting an existing position. Determining what risks an option position might be exposed to is one of the first steps towards determining how best to hedge risk.

We have learned that six risks are associated with an option position: Directional risk delta risk is the risk that an option's value will change as with underlying asset changes in value. All other factors aside, as the price of an underlying asset decreases, the value of a call will decrease while the price of the put will increase. Conversely, as the underlying asset increases in value, a call will increases in value as the put decreases in value. Delta risk can easily be offset through the purchase or sale of an option or stock with opposing directional characteristics.

Directional hedges are illustrated in Tables 1 and 2. When the Underlying Security Increase in Value Decrease in Value Table 2: Short Call Gamma risk is the risk that the delta of an option will change. The holder of options is long gamma backspreader and the seller of options is short gamma frontspreader.

Sometimes example to as curvature, gamma can be offset through the purchase or sale of options with opposing gammas. Trading risk vega risk is the risk that the volatility assumption used in pricing the options will change. If the option volatility rises, the value of the calls and puts will increase. The holder of any options might benefit from an increase in volatility whereas the seller might incur a loss. This risk can be offset through the purchase or sale of option contracts that have an opposing vega value.

For example, we know that options decrease in value as volatility decreases. Therefore, selling options that benefit as volatility decreases might be the best hedge for a trader who is looking to offset vega risk.

Time decay theta risk is a positions exposure to the effects of a change in the amount of time remaining to expiration. We know that time moves forward and as it does, the time value of an option decreases. This exposure can be offset through the purchase or sale of options with opposite theta characteristics.

The effects of time decay on an options value are illustrated below. As Time Moves Forward Underlying Security Value remains constant Long Call Decrease in Value Short Call Increase in Value Long Put Decrease in Value Short Put Increase in Value Interest rate risk rho risk is negligible to most traders.

Its impact can be substantial if a position contains a large amount of long or short stock or long-term options. Decreasing the stock position, replacing stock with options is the most efficient way to reduce rho risk. Remember, longer-term options are more interest rate sensitive.

Dividend risk can be offset through the purchase or sale of options or the underlying stock. An increase in the dividend will make the call decrease in value because the holder of the call does not receive the dividend. In this situation, it is more advantageous to own the underlying asset over owning the call. Conversely, the put will increase in value when the dividend is increased because the short stock seller must pay the dividend to the lender of the stock, which makes owning the put more desirable than shorting the underlying asset.

Table 4 illustrates the effects of changing input variables on an option's theoretical value. Astrology Broadband Contests E-cards Money Movies Romance Search Wedding Women Partner Channels: Bill Pay Health IT Education Jobs Technology Travel.

Short Underlying Short Call Long Put. Long Underlying Long Call Short Put. Long Underlying Short Put Long Call. Short Underlying Long Put Short Call. As market conditions change the values of Rise in price of the underlying Example Cricket Sports NewsLinks Shopping Books Music Gifts Personal Homepages Free Email Chat Free Messenger.

Option "Hedging" Strategies With Examples In Indian Stock Market.