Call and Put Option Guide

Why Now?

This title may leave you wondering. Why are we returning to “Call & Put Options” after thoroughly reviewing the concept of options throughout 21 chapters? We initially tackled Call & Put Options at the start of this module, so why revisit it?

I personally think that understanding options is a two-step process, the basics plus getting to know the option Greeks. Since we already have a good grasp of the latter, I think it would be beneficial to go back and examine the fundamentals of call and put options in light of our knowledge.

Let’s have a quick high-level recap:

If you anticipate the underlying price to rise, you would purchase a Call option which reveals your bullish sentiment

If you anticipate the underlying price will stay level or decrease, you would sell a Call option, not expecting an increase

Purchasing a Put option suggests a bearish sentiment on the underlying price, anticipating it to fall

You sell a Put option when you anticipate the market not to decline; you expect it to remain stable or increase, but definitely not drop

After introducing the fundamentals of call and put options, our focus will now shift to comprehending the role volatile markets and time play in this concept. Let us dive in.

Effect of Volatility

One should invest in a Call Option if they anticipate the underlying asset increasing in value. Suppose the Nifty index is predicted to increase by a certain amount. Would you still choose to purchase a Call Option?

The volatility is expected to go down whilst Nifty is expected to go up?

What would you do if the time to expiry is just 2 days away?

What would you do if the time to expiry is more than 15 days away?

Which strike would you choose to trade in the above two cases. OTM, ATM, or ITM and why would you choose the same?

Buying a call (or put) option is no simple matter, thorough investigation needs to be conducted before making a purchase. Analysis of volatility, time until maturity and the market’s directional movement are all necessary components.

I won’t address market direction assessment here; it’s up to you to decide which theory, technical analysis, quantitative analysis, or any other you want, best suits your needs.

By employing technical analysis, it is possible to predict that Nifty will rise 2-3% in the coming days. This raises the question of which option one should buy: ATM or ITM? Considering this expected growth, how can one best take advantage of the situation? This is what I intend to explore in this chapter.

Let’s examine the graph we discussed in the chapter on Vega. Recall what we learned there.

The graph above displays the effects of volatility on call option premiums in different ‘time to expiry’ frames. The blue line indicates 30 days to expiry, green 15 days, and red 5 days are shown.

The graph can help in informing our decisions when it comes to acquiring and selling call options. A few applicable conclusions can be drawn from it:

No matter how much time has elapsed, the premium always rises when volatility increases and falls when volatility decreases

A successful move with a long call option depends on having an accurate read of volatility; one should attempt to buy a call when volatility is set to rise, and avoid buying one when it looks like volatility will drop

In order to benefit from volatility when selling a call option, one should select the optimal timing by anticipating a decrease in volatility, rather than a surge

Here is the graph of the put option premium versus volatility:

This graph bears a striking resemblance to that of the call premium versus volatility, thus the same set of conclusions still stands for put options.

It is evident that the selection of strike depends on anticipated changes in the level of volatility. In making this decision, consideration of the time remaining until expiry must be taken into account.

For those exploring equity investment opportunities through a stock broker or consulting with a financial advisor, understanding how volatility and time interact with option pricing proves essential when navigating the stock market. Whether evaluating trading calls or utilising a stock screener to identify opportunities, comprehending these relationships enables more sophisticated option selection that considers not just directional views but also volatility expectations and time decay dynamics.

Effect of Time

Let us suppose volatility will rise as underlying prices go up. Buying a call is then clearly the right choice. What’s key however, is picking the correct strike. Indeed, one has to look at the amount of time remaining until expiry when they are deciding which strike to purchase.

You might find the chart a bit perplexing at first, but don’t be discouraged if you don’t comprehend it initially. Give it another try and you’ll get it!

Before we go forward, it is necessary to gain a grip on the time frames. Normally, an F&O series has a duration of 30 days, with the exception of February. Thus, I have divided it into two parts: the first part occurs during first 15 days and the second part the later 15 days. Please remember this whilst reading further.

Have a look at the image below; it contains 4 bar charts representing the profitability of different strikes. The chart assumes:

The equity is at 3,800 in the spot market, hence strike 3,800 is ATM

The trade is executed at some point in the 1st half of the series i.e. between the start of the F&O series and 15th of the month

We expect the equity to move 4% i.e. from 3,800 to 3,950

Given the above, the chart tries to investigate which strike would be the most profitable given the target of 4% is achieved within:

5 days of trade initiation

15 days of trade initiation

25 days of trade initiation

On expiry day

We should begin with the chart located at the top left. This figure displays the profitability of different call option strikes if executed during the first half of the F&O series, with a goal to be reached in 5 days.

Today, being the 7th of October, and the TCS results due on the 12th, if you are feeling positive about them, a call option can be purchased with plans to close it in five days. The question is: what strike price would you select?

The chart shows that when there is plenty of time until expiration (in the initial half of the series), and the equity moves as expected, all strikes can be profitable. It is, however, far out-of-the-money options that make the biggest gains; 4,100 and 4,200 strikes appear to be particularly lucrative.

When you anticipate the target will be achieved in a short span, buying OTM options is advantageous. It’s advisable to select two or three strikes away from the At-The-Money (ATM) option. Anything beyond that would not be recommended.

Examine the chart on the top right; it presumes that the trader will engage in a transaction early in the series with an expected equity shift of 4%. However, a target must be accomplished within 15 days. Apart from this time-frame difference, the other elements stay unchanged. Pay attention to how profitability shifts; buying distant Out-of-the-Money (OTM) options is not sensible at all. In fact, investing in these OTM options may even lead to losing money (observe the profitability of 4,200 strike).

In conclusion, when we’re in the initial phase of the expiration series, expecting a target to be reached within 15 days, purchasing ATM or slightly OTM options is wise. Going any more than one strike away from ATM should be avoided.

In the bottom left chart, the trade is initiated in the initial part of the series and the target expectation (4% move) remains unchanged but the time frame is distinct. Here, the goal is anticipated to be accomplished 25 days from when the trade was initiated. It’s obvious that OTM options are not advisable to buy, for in most cases one ends up losing money with them. As opposed to this, ITM options make sense.

At this point I have to reiterate something, do not be fooled by the low premiums of OTM options, as there is a substantial risk involved. Such options will not generate profits if the market moves slowly, as you need swift action in order for far OTM options to move smartly. On the other hand, choosing such options can prove profitable when the market moves by a certain percentage within a short amount of time.

At the beginning of an expiry series, ITM options are the ideal choice, as it’s conceivable that the target will be reached in 25 days. OTM and ATM options should be avoided.

The bottom right chart is practically identical to the third, with the only obvious difference being that the goal should be met on expiration day (or very close to it). The conclusion then is clear: under this situation, all option strikes except ITM will lose money. Therefore, traders should stay away from ATM or OTM options.

Let us examine a different set of charts. We must decide which strikes to select when trading in the second half of the series, ranging from the fifteenth of each month until expiration. Remember that time decay intensifies during this period, so as we approach expiry, the nature of options alters.

The 4 charts below assist us in pinpointing the most accurate strike to get the target within various time frames, all whilst bearing theta in mind.

Chart 1 (top left) displays the profitability of different strikes when a trade is carried out in the 2nd half of the series with a target fulfilled on its initiation day. An instance of such news-driven option trading is buying an option due to some corporate news, or purchasing an index option in response to RBI’s monetary policy decision. According to this chart, all strikes will make money when the goal is met on the same day, yet maximum benefit lies in far Out-of-the-Money (OTM) options.

Remember, when the market fluctuates significantly (e.g. 4% movement in a single day), trading far OTM options is always the best approach.

In conclusion, for expectations of reaching the target on the same day, it’s best to purchase far OTM options; 2 or 3 strikes away from ATM is a reasonable amount. ITM and ATM options provide little value in this case.

Chart 2 (top right) reveals that the profitability of options with strikes far from the current market price diminishes when the trade is executed in the second half of a series, and when the target is reached within five days of initiating it. In contrast to Chart 1, where the target was expected to be accomplished in one day and consequently buying OTM options was justified, here the trade remains open for longer due to its five day time frame, making it more vulnerable to time decay (theta). Therefore, investing in further OTM options would not be a wise decision. The safest bet in this case is slightly OTM strikes.

In conclusion, when you are in the second stage of trading, with a desired target reachable within five days, it is best to purchase slightly out-of-the-money strikes. It is recommended that you do not go further than one strike away from the at-the-money option.

Charts 3 and 4, placed at the bottom right and left respectively, are both alike excluding the target achievement. Chart 3 reveals that its objective is realised 10 days from when the trade began, meanwhile it’s forecasted to be accomplished on expiry day with Chart 4. It wouldn’t make much difference in terms of days, so I’d consider them to be pretty similar. Evaluating both charts we can comprehend one fact. Far OTM options regularly lose money when their aim is near expiry. In actuality, when the termination draws nearer, far OTM options suffer a greater loss in value. The only option strikes which benefit are ATM or slightly ITM varieties.

We have looked at the purchase of call options, and similar techniques can be used to buy put options. These two graphs give us insight into which strikes are ideal to choose under varying scenarios.

These charts can be a great guide when deciding which strikes to trade initially, as well as what type of time frames should be targeted to meet desired goals.

Using these charts, we can determine which strikes to trade in the 2nd half of the series, and if our target is met, at what time frames.

If one looks at the graphs closely, they will understand that the outcomes for the Call options are true for Put options as well. Therefore, it can be concluded that there are certain fundamentals when considering buying options.

When you are considering purchasing a naked Call or Put option, ensure that the period and timeline for achieving the required target have been planned adequately. After this is done, you can refer to the table given to decide which strikes should be traded and more vitally, which ones should not.

We are almost done with this module. Going into the next chapter, I would like to demonstrate some of my simple trades over the recent days and explain the rationale behind each one of them. My aim is that these case studies give you an idea of how to approach simple option trades.

For those exploring equity investment opportunities through a stock broker or consulting with a financial advisor, understanding strike selection based on time to expiry and target timeframes proves essential when navigating the stock market. Whether evaluating trading calls or utilising a stock screener to identify opportunities, comprehending which strikes perform best under different time scenarios enables more profitable option selection and helps avoid common pitfalls like buying far OTM options when insufficient time remains for the move to materialise.