MARKETS AND VOLATILITY - SECTION IV - CHAPTER 28 - Options

1. Lecture 45
Options
CMT LEVEL - I

2. What is Options ?
•Options are financial instruments that are
derivatives or based on underlying securities such
as stocks.
•An options contract offers the buyer the
opportunity to buy or sell—depending on the
type of contract they hold—the underlying asset.
•Unlike futures, the holder is not required to buy
or sell the asset if they choose not to.

3. What is Options ?
•Call options allow the holder to buy the asset at a
stated price within a specific timeframe.
•Put options allow the holder to sell the asset at a
stated price within a specific timeframe.
•Each option contract will have a specific expiration
date by which the holder must exercise their option.
•The stated price on an option is known as the strike
price.
•Options are typically bought and sold through online
or retail brokers.

4. Benefits for Investors
1) Leverage – The ability to gain price exposure to a given amount of assets for
a lower initial cost
2) Hedging – A setoff or insurance of a position in the spot markets
3) Position – The options investors has the right to buy or sell an asset at a
specific price .
4) Low Risk – Investor benefits from the move in the underlying asset for lower
cost & with lower risk.

5. Options Terminology
Call Option Put Option Strike Price Expiration Premium
Open
Interest
Exercise
In the
money
Out the
Money
At the
Money
Implied
Volatility
American
Style
Option
Writers
European
Style
Time Value
Intrinsic
Value
Long Short Assignment

6. Option Terminology
1) Call Options - A Contract you buy, you have the right (but not the
obligation) to purchase 100 shares of a specific security at a specific price
within a specific time frame.
2) Put Options – A Contact you buy, you have the right (but not the obligation)
to sell 100 shares of a specific security at a specific price within a specific
time frame.
3) Strike Price - That’s the pre-agreed price per share at which stock may be
bought or sold under the terms of an option contract. Some traders call this
the “exercise” price.
4) Expiration Day - The day on which a derivative contract ceases to exist. It is
the last trading date/day of the contract.
5) Options Premium - It is the price which the option buyer pays to the option
seller.

7. Option Terminology
6) Open Interest - open interest is the total number of option contracts
outstanding for an underlying asset.
7) Exercise - All these options are exercised with respect to the settlement
value/ closing price of the stock on the day of exercise of option.
8) In the Money - A call option is said to be ITM, when spot price is higher
than strike price. And, a put option is said to be ITM when spot price is
lower than strike price. In our examples, call option is in the money.
9) Out The Money - Out of the money option is one with strike price worse
than the spot price for the holder of option. A call option is said to be OTM,
when spot price is lower than strike price. And a put option is said to be
OTM when spot price is higher than strike price.
10) At the Money - At the money option would lead to zero cash flow if it were
exercised immediately. Therefore, for both call and put ATM options, strike
price is equal to spot price.

8. Option Terminology
11) Implied Volatility – The Calculated expectation of future volatility.
12) American Options -The owner of such option can exercise his right at any time on
or before the expiry date/day of the contract.
13) European Options - The owner of such option can exercise his right only on the
expiry date/day of the contract. In India, Index options are European.
14) Option Writes - The writer of an option is one who receives the option premium
and is thereby obliged to sell/buy the asset if the buyer of option exercises his right.
15) Assignment - Assignment of options means the allocation of exercised options to
one or more option sellers.

9. Intrinsic V/s Time Value
Intrinsic Value — The amount an option is in-the-
money. Obviously, only in-the-money options have
intrinsic value.
•Time Value — The part of an option price that is based
on its time to expiration. If you subtract the amount of
intrinsic value from an option price, you’re left with
the time value. If an option has no intrinsic value (i.e.,
it’s out-of-the-money) its entire worth is based on time
value.

10. Long V/s Short Position
• Long on options - Buyer of an option is said to be “long on option” When you are long on
equity 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 on Options - Seller of an option is said to be “short on option”.
• When you are short (i.e., the writer of) an equity option contract:
• Your maximum profit is the premium received.
• You can be assigned an exercised option any time during the life of option contract (for
American Options only). All option writers should be aware that assignment is a distinct
possibility.
• Your potential loss is theoretically unlimited as defined below.

11. Using the Options Market
• Hedging – Corporations, Investing Institutions, Banks and
Governments all use derivative products to hedge or reduce their
exposures to market variables such as interest rates, share values,
bond prices, currency exchange rates and commodity prices.
• Speculations - Options are very well suited to speculating on the
prices of commodities and financial assets and on key market
variables such as interest rates, stock market indices and currency
exchange rates. It is much less expensive to create a speculative
position using options than by actually trading the underlying
commodity or asset. As a result, the potential returns are much
greater.

12. Options Greeks
Delta Gamma Vega
Theta Rho

13. Options Greeks
Delta – A measure of the rate of change in an options theoretical value for a one-unit
change in the price of the underlying security.
Gamma – A measure of the rate of change in an options delta for a one-unit change in
the price of the underlying. In other words, the rate of change in delta. Measured in
Delta not dollars
Vega - A measure of the rate of change in an option’s theoretical value for a one-unit
change in implied volatility.
Theta - A measure of the rate of change in an option’s theoretical value for a one-unit
change in time to the option’s expiration date.
Rho - A measure of an option’s theoretical sensitivity to changes in the risk-free
interest

14. Implied Volatility
• Implied volatility isn’t based on historical pricing data on the stock.
Instead, it’s what the marketplace is “implying” the volatility of the
stock will be in the future, based on price changes in an option.
• Like historical volatility, this figure is expressed on an annualized
basis.
• But implied volatility is typically of more interest to retail option
traders than historical volatility because it's forward-looking .
• Implied volatility is a dynamic figure that changes based on activity
in the options marketplace.

15. Implied Volatility
• Usually, 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’s good for the option owner and bad for the option seller.
• Conversely, if implied volatility decreases after your trade is placed,
the price of options usually decreases.
• That’s good if you’re an option seller and bad if you’re an option
owner.