3. Options
• An option is a derivative financial instrument
that specifies a contract between two parties
for a future transaction on an asset at a
reference price.
• The buyer of the option gains the right, but
not the obligation, to engage in that
transaction, while the seller incurs the
corresponding obligation to fulfill the
transaction.
4. Option Classifications
• Call Option : an option which gives a
right to buy the underlying asset at a
strike price.
• Put Option : an option which gives a
right to sell the underlying asset at
strike price.
5. CALL AND PUT OPTIONS
A cal l opt i on i s a f i nanci al cont r act
bet ween t w par t i es, t he buyer and t he sel l er
o
of t hi s t ype of opt i on. I t i s t he opt i on t o
buy shar es of st ock at a speci f i ed t i m i ne
t he f ut ur e. O t en i t i s si m y l abel l ed a
f pl
"cal l ". The buyer of t he opt i on has t he r i ght ,
but not t he obl i gat i on t o buy an agr eed
quant i t y of a par t i cul ar com odi t y The buyer
m
pays a f ee (cal l ed a pr em um f or t hi s r i ght .
i )
Put O i on i s j ust opposi t e of t he C l
pt al
O i on w ch gi ves t he hol der t he r i ght t o
pt hi
buy shar es. A put becom m e val uabl e as
es or
t he pr i ce of t he under l yi ng st ock
depr eci at es r el at i ve t o t he st r i ke pr i ce.
6. Some Terminologies
• Call Option: Right but not the obligation to buy
• Put Option: Right but not the obligation to sell
• Option Price: The amount per share that an option
buyer pays to the seller
• Expiration Date: The day on which an option is no
longer valid
• Strike Price: The reference price at which the
underlying may be traded
• Long Position: Buyer of an option assumes long
position
• Short Position: Seller of an option assumes short
position
7. Call Option Buying
A Call option buyer basically is bullish
about the underlying stock.
9. • Both the Call and Put option buyers
are buying the rights, that is they are
transferring their risks to the sellers of
the option.
• For this transfer of risk to the sellers,
buyers have to compensate by paying
Option Premium.
• Option premium is also known as
Price of the option, Cost or Value of
the option.
10. Option Styles
• European option – an option that may only
be exercised on expiration.
• American option – an option that may be
exercised on any trading day on or before
expiry.
• Bermudan option – an option that may be
exercised only on specified dates on or
before expiration.
11. Option Selling: Motives for
selling options
The seller is ready to assume the risk in option
exercise. The incentives for the seller to
assume that risk are two :
• Option Premium – This is the actual
amount received by him for selling an
option to the buyer.
• The possibility of non-exercise of
option – In seller’s view the possibility of
option being exercised by the buyer may
be low.
12. Factors influencing Option
Pricing
• Time to expiration – greater the time to
expiration, higher the value of the options.
• Volatility –higher the volatility, higher the
value of the options.
• Risk free Rate of Interest – If interest rate
goes up, calls gain in value while puts lose
value.
19. Merits of Options
• Options protect downside risk to the buyer
• The buyer of the option limits losses to
the premium paid on the purchase of the
options
• Eg. If I buy a nifty 2900 put at Rs 34, my
loss is limited to Rs 34 while gain potential
is limitless
• If the price goes above Rs 2900 I do not
exercise the option limiting my loss to the
premium paid.
20. Option Pricing
• Black Scholes formula is the most widely used
for pricing options
• The factors going into the pricing of options are
the share price(S), time to expiry (t), risk free
rate of interest r, and risk of underlying asset
measured by standard deviation or volatility
• These are also called the greeks as changes in
any one of these variables affect the option price
• Options contracts can be classified into out of
the money, at the money and in the money
21. The price of a corresponding put option based on put-call parity is:
For both, as above:
• is the cumulative distribution function of the standard normal distribution
• is the time to maturity
• is the spot price of the underlying asset
• is the strike price
• is the risk free rate (annual rate, expressed in terms of continuous compounding)
• is the volatility of returns of the underlying asset
22. Options – A review
• Options or option contracts are
instruments
• Right, but not the obligation, is given
• To buy or sell a specific asset
• At a specific price
• On or before a specified date
• Options can be exchange traded
derivatives or even over the counter
derivatives.
23. Options – A review
• Options have a buyer and a writer
• The option writer receives premium for giving
the buyer the right but not the obligation to sell
an asset at a future date
• The option writer is not protected on the
downside risk
• Option writers have to settle mark to market
profit or loss on a daily basis
• Options can be cash settled or settled by
physical delivery
• Options in India are cash settled
