Introduction To OPTIONSBy : DINESH KUMAR B.COM (HONS) III YEAR Roll No.: 753
OPTIONSTypesWorkingTerminologiesProfits and payoffs
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.
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.
CALL AND PUT OPTIONSA cal l opt i on i s a f i nanci al cont r actbet ween t w par t i es, t he buyer and t he sel l er oof t hi s t ype of opt i on. I t i s t he opt i on t obuy shar es of st ock at a speci f i ed t i m i net 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 eedquant i t y of a par t i cul ar com odi t y The buyer mpays 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 alO i on w ch gi ves t he hol der t he r i ght t o pt hibuy shar es. A put becom m e val uabl e as es ort he pr i ce of t he under l yi ng st ockdepr eci at es r el at i ve t o t he st r i ke pr i ce.
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Price: The amount per share that an option buyer pays to the seller• Expiration Date: The day on which an option is no longer valid• Strike Price: The reference price at which the underlying may be traded• Long Position: Buyer of an option assumes long position• Short Position: Seller of an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
Call Option BuyingA Call option buyer basically is bullishabout the underlying stock.
Put Option buying• A buyer of put option is bearish on underlying stock.
• 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.
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.
Option Selling: Motives for selling optionsThe 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.
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.
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.
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
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
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.
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