What is Hedging and Speculation with Option?

Options are very handy derivative instruments in the financial market giving its owner right to Buy or Sale an Underlying at a Fixed Price on or before the Specified Period. An Option gives to the holder of it the right to do something but the holder does not have to Exercise this right compulsorily. Options can either be American or European. An American option can be exercised at any time before the Expiry of Exercise Period but European Option can be exercised only at the end of the Exercised Period. It’s nothing to do with the Geographical location. Type of Option in the Financial Market is Call Option and Put Option. Call Option give its Owner the right to buy an Underlying at a Fixed Price Known as Exercise Price before the specified Period Known as Exercise period Simultaneously Put Option Gives the Owner the right to sell an Underlying at Fixed Price before the Exercise Period at an Exercise Price. In Each Option there are two Parties first the Seller (Who writes the option) and other one is buyer of option (Who has the right to Exercise the option).

              The Call Option is Valuable when the Spot Price of an underlying is above the Exercise Price(In the Money) because in case if Exercise Price is above the Spot Price (Out of Money) then there is no rational to Exercise the option i.e. to buy the assets by exercising the option which has less worth in the open market. The Maximum profit to the holder of call option can be unlimited i.e. the Positive Difference between the Exercise Price and Spot Price on the date of Exercise the option but in the Reverse situation, The Maximum loss to the holder of call option will be the amount paid to seller of option at the time of purchasing the option typically Known as the Premium simultaneously the Seller of the option can have the Profit only in that case if the exercise Price of the option is below the spot Price because in this situation the holder of the option will not exercise the option and the amount received by the seller of the option at the time of sale(Premium) will be the Profit to the seller. The Maximum Profit to the seller can be the amount received as Premium but in the reverse situation the holder will Exercise and the maximum loss to the seller can be the negative difference between  the Exercise Price and Spot Price of an underlying. Finally the crux is that the amount of Profit to the holder will always be equal to the amount of loss to the seller and vice versa because in the option there is no involvement of intermediate Party as in the plain Vanilla Interest rate swap. 

         The Put Option is Valuable if the Exercise Price of an underlying is more than its spot Price (In the Money) in case if the Spot Price is more than Exercise Price (Out of Money) then there is no rational to Exercise the option i.e. to sale an underlying by exercising the option which has more worth in the open market

The Maximum profit to the holder of Put option can be up to strike pricewise. the negative Difference between the Exercise Price and Spot Price on the date of Exercise the option but in the Reverse situation, The Maximum loss to the holder of Put option will be the amount paid to seller of option at the time of purchasing the option typically Known as the Premium simultaneously the Seller of the Put option can have the Profit only in that case if the exercise Price of the option is above the spot Price because in this situation the holder of the option will not exercise the option and the amount received by the seller of the option at the time of sale(Premium) will be the Profit to the seller. The Maximum Profit to the seller can be the amount received as Premium but in the reverse situation the holder will Exercise and the maximum loss to the seller can be the positive difference between the Exercise Price and Spot Price of an underlying. Finally the crux is that the amount of Profit to the holder will always be equal to the amount of loss to the seller and vice versa.

Theoretically the value of the call option is the amount by which the Spot Price exceeds the exercise Price i.e. the call option value increases for every increase in the spot price, but in case of put option the value of option is the amount by which the Exercise Price Exceeds the spot Price, in fact the Value of put option increases for every Decline in the value of Spot Price. However the Value of Option depends up on the following factor.

• Exercise Price 

• Maturity Period

• Stock Price

• Variability of the Underlying Assets

• Interest Rate

As we discussed earlier the Value of Call Option is the Positive Difference between the Exercise Price and Spot Price the lower will be the Exercise Price the higher will be the value of call, if other thing being equal the higher is the maturity Period the higher will be the value of option, In Case of Stock Price, the higher is the Stock Price the higher will be the Value of Call option, The Greater the Variability in the price of Stock the greater will be the Value of Call option because the higher the variability in the stock Price gives a higher Probability of  abnormal higher return. Value of call option is positively related with Interest rate because the ability to delay Payment is more valuable when interest rate is high and less valuable when interest rates are low.

The Effect of three factors on put option is opposite in case of call option(Stock Price, higher the stock Price the lower will be the value of put option, The Value of Put option with higher Exercise Price is greater and interest rate are adversely effected the value of put option.)

Combinations of Options are many times used by the market trader (Speculation, Hedging, and arbitrage) to eliminate the risk of fluctuation in the spot price of an underlying. Buying a Stock and buying a Put option will eliminate the risk of lower side fluctuation i.e. in any case the value of the portfolio will always be equal to the Value of Portfolio at the time of purchase of shares and option, because if share price is greater than exercise Price the put option is worthless and value of combined position will always be equal to the value of common stock but instead the exercise Price is grater then Spot Price the decline in the value of share will exactly set off the rise in the value of put this strategy is known as Protective put strategy. 

Buying a stock with put Option has same pay off in case buying the Zero coupon Bond with call Option. Because in the case of Zero Coupon Bond it is Certain to receive the amount of face value of the Bond at the time of maturity so the question of Decline in the Value does not arise and now we have the Call option on Zero Coupon bond so if the Value of zero Coupon Bond increases the Value of Call option will rise and the combined Value will be equal to Spot Value of Zero coupon Bond so both the strategy has same cash flow, same return, so applying the Put Call parity Approach we can say that both the Strategy must have same cost otherwise the Possibility of Arbitrage will arise.  

In Equation Form,

               Price of Underlying+Price of Put = Price of ZCB+Price of Call,

If we rearrange the Formula then,

  Price of Underlying= Price of ZCB+Price of Call- Price of Put,

In practical world right side position of the investor is known as long call short put combo(LCSP Combo) at this position we can say that we can buy one share at the exercise price either at our own will or forcefully, this means we have the amount of exercise price and call option if the value of ZCB increases then we will exercise call option but if the value of ZCB decreases then the buyer of put option will exercise and we have to buy the same by paying the exercise price.

This situation of investor is known as purchase of Synthetic Stock.

Price of Underlying- Price of Call = Price of ZCB - Price of Put

The Position of the left hand side of the investor is known as Covered Call Strategy.

The Option Can is viewed as an Instrument for Speculation by making Various Strategy like Spread Straddles, Strip, and Strap.

Spread is the Combination of two similar type of Option the spread can be prepared by assuming the market behavior of a Particular type this means the market is raising or falling or constant with time but if the assumption gone wrong then also investor will have limited loss not unlimited. 

In Case of bull Call Spread that means we have assumed that the market is raising in this type of Strategy the investor need to buy a call Option with lower Strike Price and need to sale a Call option with a higher strike Price the reason behind this is a Call option with a higher strike Price will have low value as Compare to high strike Price option as we are selling High Strike Price Option so we will receive less amount of Premium and will need to Pay high amount of Premium because we are purchasing low strike Price option so the net effect is that we are payer of Premium. Now as per our assumption if the market is raising then the Maximum Profit to the option buyer will be the Difference between both the option strike Price less net Premium paid but if the market is falling then both the call option will be Value less and the loss to the option Buyer will be the amount Paid as Premium, if the market Price falls between both the Strike Price then the Profit to the Option Buyer will be the Positive Difference between spot price and Strike Price of the option. Now in case of Bull Put option Investor need to sell the option with a higher Strike Price and to buy the option with a lower Strike Price because the Put option with higher Strike Price will have more Value and put option with Lower Strike Price will have low value as Compare to high strike Price and net effect to the investor will be the receiver of Premium. As Per Our assumption if the Spot Price of the underlying is raising then both the Put option will be Value Less and the amount received as Premium will be the Profit to the option writer now if the assumption gone wrong the Spot Price of the underlying is reducing   and the maximum loss will be the difference between both the option Strike Price less the amount received as premium.

In Case of Bear Call or Put option we are assuming that the market Price of the Spot is declining to make bear call spread in this type of market we need to sale a option with low strike Price and to buy a option with a high strike price, the call option with a high strike price will have low value and call option with a low strike Price will high value and we are selling low strike price so in this spread Investor will be net receiver of premium as per our assumption the spot price is reducing  and it goes below the strike price of lower call option then both the call option will be value less and the amount received as premium will be the Profit to the option writer and but if the spot price lies above the lower strike Price call option but below the higher strike Price call option then  the loss  to the investor will be the difference between lower Strike Price option and spot Price but if the Spot price lies above both the option strike price then the maximum loss to the option writer will be the difference between both the strike price. In the case of Bear put option spread investor need to sale low strike Price put option and buy high Strike Price put option because low strike price put option will have less value as compare to high strike price and we are selling low strike price put option so we will pay more as compare to receive in this situation investor will be the net payer of Premium. Now as Per our assumption the market Price of the underlying will go down and if goes down below the underlying Price of both the option then the maximum profit to the option writer will be the difference between both the option strike Price less the amount Paid as Premium but if the spot Price of the underlying is above the lower strike price of option but below the higher strike price option then the difference between spot price and higher strike price of option will be the profit to the option writer but if spot price lies above the strike price of both the option then the maximum profit to the option writer will be the amount received as premium.

In case if the market is Constant then investor needs to make butterfly spread. There can be two type of butterfly spread long or short butter fly to make long butterfly investor need to sell two call options with same strike price and need to buy two option but different strike Price. Basically it is a combination of Bear or bull call option. However if the investors want to reduce the cost of investment then with slight modification investor can use long condor or short condor strategy, in the long condor we will sale two option at the intermediate strike price but at two different value and vice versa in the short condor.

The Strategy of Straddle is the combination of Call option and Put option. There can be two type of straddle long straddle or short straddle. The long straddle is profitable if there significant movement in any direction of spot price. Short straddle is valid when there is no movement in the spot price.

In case of Strip Strategy the investor need to create a Straddle and to buy one more call option. This Strategy is profitable when there is probability of high downward movement in the spot price with some protection from upward movement.

In strap Strategy the investor need to create a Straddle and to buy one more put option. This Strategy is profitable when there is probability of high upward movement in the spot price with some protection from downward movement. Options can be used for any type of market situation but with confidence.