Options• Option is the right to either buy or sell something, at a specified price within a specified period of time.• Is a contract in which the writer of the option grants the buyer of the option the right to purchase from or sell to the writer a designated instrument at a specific price within a specified period of time.
Right vs obligation• A ‘right’ is a privilege or a claim conferred upon the buyer whereas an ‘obligation’ is a compulsion.
Options• The writer grants the right to the buyer for a certain sum of money – option premium.• The price at which the buyer can exercise the option – Exercise price/ strike price/ striking price.• Call option & Put option• American option and European Option
Call option & Put option• Call option : • An option that grants the buyer the right to purchase a designated instrument.• Put option : • An option that grants the buyer the right to sell the designated instrument.
Options Terminology – American option & European option• American option : • can be exercised on or before the expiration date.• European option : • can be exercised only on the expiration date.
Return and risk of Buyer and seller of Option contract• Seller has an obligation and buyer has a right in option agreement• Buyer • Limited amount of risk (max loss is premium paid) • Return (profit) potential in unlimited• Seller • Unlimited risk • Limited return potential
Options – Underlying Assets• Financial options • Stock • Indices • Treasury Bonds, debentures • Forex rate• Commodity options • Agricultural commodities • Industrial commodities• In India, option trading in all commodities is prohibited by Forwards Contracts (Regulation) Act, 1952
Options Terminology• A std option contract : allows the buyer to buy or sell …. shares of stock at a specific price.• Call option & Put option• Expiration date : date on which the option contract expires.• Exercise price / Striking price• Premium : Synonymous with price
Options Terminologyo Buyer (holder).o original seller is called writer. Seller is not the same as writer for an existing option.o Option Buyer – is in Long positiono Option Writers – is in short positiono Writing calls covered : Writing call options against the shares owned by the writero Uncovered call options : Writing call options without owning the underlying shares.
Options Terminology At any time, option maybe: Call Put• At the money (ATM) : ExP = MP ExP = MP• In the money (ITM) : ExP < MP ExP > MP• Out of the money (OTM): ExP > MP ExP < MP
Why buy options• A Call option is cheaper than the underlying shares.• Buying a call rather than shares will • reduce the his profit by the amount of premium if the share price advances, • but it will limit his loss to the amount of the premium if it declines.• Put option is used for by the buyer as safer way of betting on decline in stock price.
Why sell options• Sold by conservative investors who want additional income.• Earn premium
Payoff Diagram – Call option buyer Net Payoff On a call Strike Price Price of underlying asset
Put option Strike price : 100; Premium : Rs 10/share;No of shares – 100; Expiration : 31.03.2012 On 31.03.2012, Market Profit (Loss) for buyer price of share 70 2000 80 1000 90 0 100 (1000) 110 (1000) 120 (1000)
Payoff Diagram - Put option buyer Net Payoff On Put Strike Price Price of underlying asset
Trading in derivatives• Trading in options on index and stocks commenced on NSE and BSE in 2001• Currency options in NSE and USE in October 2010• NSE or BSE • F&O Segment (Derivatives segment) • other segments are equity and debt
Derivatives permitted in India Derivatives Equity Debt Forex Commoditi es Interest rate Currency futuresIndex futures & futures &Options Currency options forwardsSingle stock Forwards Forwards Interest rateoptions & futures Cross currency swaps Futures swaps S.S.S. Kumar ( 2007). Financial Derivatives, New Delhi : Prentice Hall of India, p.4
Trading cycle of options - NSEo S&P CNX Nifty options o contracts have 3 consecutive monthly contracts, o additionally 3 quarterly months of the cycle March / June / September / December and 8 following semi-annual months of the cycle June / December would be available, so that at any point in time there would be options contracts with at least 5 year tenure available. o On expiry of the near month contract, new contracts (monthly/quarterly/ half yearly contracts as applicable) are introduced at new strike prices for both call and put options, on the trading day following the expiry of the near month contract.o All other index options and stock options have a maximum of 3-month trading cycle.
Trading in Options NSEo Index options o S&P CNX Nifty Index, o CNX IT index, o Bank Nifty Index, o Nifty Midcap 50 index o Mini Nifty o S&P 500 index (US index of 500 firms) (introduced in August 2011)o Long term Options on S&P CNX Nifty are also available.o Single stockso The average daily turnover in the F&O Segment of the Exchange during 2009-10 was Rs 72,392 crore (US $ 16,097 million).
Financial Options• Single stock options • Trading in options on individual securities commenced from July , 2001. • Option contracts are European style and cash settled and are available on 223 securities stipulated by the Securities & Exchange Board of India (SEBI). • The value of the option contracts on individual securities may not be less than Rs. 2 lakhs at the time of introduction for the first time at any exchange • Options contracts expire on the last Thursday of the expiry month. • If the last Thursday is a trading holiday, the contracts expire on the previous trading day.
Financial Options• Index Options • NSE introduced trading in index options on June 4, 2001. • The options contracts are European style and cash settled • The value of the option contracts on Nifty may not be less than Rs. 2 lakhs at the time of introduction • Nifty Index contract multiplier is 100 • BSE Senses contract multiplier is 50
ET reading of options• Open interest • Number of outstanding contracts at a particular point of time, typically at the end of the trading day. • Total no of long positions will always be equal to the total number of short positions, only one side of the contract will be counted• Contracts
Determinants of option value Determining Effect of increase holding factors others constant Put Call1 Current stock price Decreases Increases2 Striking price Increases Decreases3 Time to expiration Increases Increases4 Stock volatility Increases Increases5 Interest rates Decreases Increases6 Cash dividends Increases Decreases
Option value• Rate of change in option price due to change in price of the underlying asset is known as Delta.• Rate of change in option price due to time left to expiration is known as Theta.• Rate of change in option price due to change in volatility of the underlying asset is known as Vega.• Rate of change in option price due to change in interest rate is known as Rho.
Option Pricing Black – Scholes Option Pricing Model• By Black and Scholes in 1973.• Pc = Ps N(d1) – Pe e-rT N (d2) Pc = Market value of the call option Ps = Current market price of the underlying asset N(d1) & N(d2) = cumulative normal distribution function of d1 and d2 respectively. Pe = Exercise price, e = Exponential constant 2.71828 r = Risk free interest rate, T = Time to expiration (in years) d1 = [ln (Ps/Pe) + (r + 0.5σ2)T] / σ√T d2 = d1 – (σ√T)
Black – Scholes Option Pricing Model - Assumptions• The stock underlying the call option provides no dividends during the option’s life.• There are no transaction costs involved in buying and selling the option.• The risk free interest is assumed to be constant during the life of the option.• The call option can be exercised only on its expiration date.• The movement of stock prices is taken to be random.
Option trading strategies• Basic elementary strategies • Long call (Buy Call) • Long put (Buy a Put) • Short call (Sell a Call) • Short put (Sell a Put)• Combinations of call and put options • Straddle, Strip, Strap, Strangle, Spread
Basic elementary strategies● Long call ● Buying call options ● Expectation of a price rise - Bullish ● Advantages ● If stock sells below the striking price when the option expires, buyer loses his entire investment. But his max risk exposure is limited to the amount of premium ● Call option buyer participates in any advance in the price of the stock above the striking price. Profit increases point for point no matter how high the price of the stock may rise over the life of the option. ● Leverage ● Limiting the downside risk
Basic/Elementary strategieso Short call o Expects that stock price will not rise o Limited profit (premium) and losses are unlimitedo Long put o Bearish view o Losses limited & profit unlimitedo Short put o Selling put option o Can never gain more than premium o Loss unlimited, loss could be many time the amount of premium
Combinations of Put and Call Options or Option Strategies • Straddle • Strip • Strap • Strangle • Spread
Options Strategies– Straddle• A straddle is a put and a call option on the same security at the same exercise price and for the same time period.• Also called double option or put- and- call option.
Options Strategies – Strip• A strip is two puts and one call at the same exercise price for the same period.• Buyer of a strip believes that the security’s price is more likely to fall than to rise.
Options Strategies– Strap• A strap is two calls and one put at the same contracted exercise price and for the same period.• Buyer of a strap believes that the security’s price is more likely to rise than to fall.
Options Strategies -Strangle• Buying a put and a call option with the same expiration date but with different exercise prices.• Profit can be made if stock price is lower than price of put or stock price exceeds price of call.
Options Strategies – Spread• A spread means combining 2 or more call options (or 2 or more put options) on the same stock with different exercise prices or different expiration dates.• Time spread : options have same exercise price but different expiration dates.• Price spread : Expiration date same, Exercise prices different
Additional Areas where options are availableCompany issued option Rights – Short lived Warrants – Medium to long lived Convertible Securities – Long lifeOption on Physical Assets Real Options
Stock rightso Short lived options issued by company.o Pre emptive right to existing shareholders.o Ex Price < Prevailing Market Priceo Value of a right Vr = (Pm-Pe)/r Pm = Market price, Pe = Exercise Price, r = No of rights to buy one new share
Warrantso Medium to long term company issued call options.o Warrant is a call option to buy stated number of shares at a specified price.o Warrants are given as sweeteners attached to bonds or preferred stocko American / European optiono Detachable / non detachable warrants.
Convertible Securitieso Periodic fixed payments until conversion.o Price fluctuations resulting from changes in market interest rate.o Price fluctuations resulting from the changes in price of the underlying equity shareso Conversion rate and conversion value.
LEAPs• Long Term Equity AnticiPation Securities:- Long dates put and call options on common stocks and ADRs.• Expiration date is a longer period which can be three years.