Options & Its Combinations

Manav Preet Singh 2005A3PS295 MANAV PREET SINGH | 2005A3PS295 Options & Its Combinations

MANAV PREET SINGH | 2005A3PS295

What is an OPTION ??? MANAV PREET SINGH | 2005A3PS295

An option is a contract whereby one party (the holder or buyer ) has the right , but not the obligation , to exercise the contract (the option) on or before a future date (the exercise date or expiry ).

However…

The other party (the writer or seller ) has the obligation to honour the specified feature of the contract.

Thus, the buyer has received something of value. The amount the buyer pays the seller for the option is called the Option Premium MANAV PREET SINGH | 2005A3PS295

Let’s take an example… MANAV PREET SINGH | 2005A3PS295

Unfortunately, you won't have the cash to buy it for another three months . You discover a house that you'd love to purchase. MANAV PREET SINGH | 2005A3PS295

You talk to the owner and negotiate a deal that gives you an option to buy the house in three months for a price of Rs.2,00,000 . The owner agrees, but for this option, you pay a price of Rs.3,000. MANAV PREET SINGH | 2005A3PS295

Let’s say, that the house turns out to be the true birthplace of a great man. As a result, the market value of the house rockets to Rs.1,00,00,000 . What happens? Does the owner of the house go through with the deal? SCENARIO 1 MANAV PREET SINGH | 2005A3PS295

Since the owner is the seller of the option, he is obliged to honour the deal. And you make a profit of Rs.97,97,000 !!! MANAV PREET SINGH | 2005A3PS295 YES!

Now, say, while touring the house, you discover not only that the walls are full of asbestos, but also that a family of super-intelligent rats have built a fortress in the basement. Though you originally thought you had found the house of your dreams, you now consider it worthless. You seem to be in a fix. What do you do? SCENARIO 2 MANAV PREET SINGH | 2005A3PS295

Nothing …you simply walk away from the deal. Because you bought an option, you are under no obligation to go through with the sale. Of course, you still lose the Rs.3,000 (price of the option). MANAV PREET SINGH | 2005A3PS295

STYLES OF OPTIONS MANAV PREET SINGH | 2005A3PS295

TYPES OF OPTIONS MANAV PREET SINGH | 2005A3PS295

Call Options

Buyer of the option has the right, but not the obligation, to buy the underlying instrument on the expiration date for a certain fixed price (called strike price ).

A graphical interpretation of the payoffs and profits generated by a call option buyer is given below. A higher stock price means a higher profit. Eventually, the price of the underlying (e.g., stock) will be high enough to fully compensate the price of the option MANAV PREET SINGH | 2005A3PS295

A graphical interpretation of the payoffs and profits generated by a call option writer is given below. Profit is maximized when the option expires worthless (when the strike price exceeds the price of the underlying), and the writer keeps the premium. MANAV PREET SINGH | 2005A3PS295

When the price of the underlying instrument surpasses the strike price, the option is said to be " in the money .”

It is clear that a call option has positive monetary value when the underlying instrument has a spot price ( S ) above the strike price ( K ). Since the option will not be exercised unless it is "in-the-money", the payoff for a call option is Max{(S − K), 0}.

Put Options

Buyer of the option has the right, but not the obligation, to sell the underlying instrument on the expiration date for a certain fixed price.

A graphical interpretation of the payoffs and profits generated by a put option as by the writer of the option is given below. Profit is maximized when the option expires worthless (when the price of the underlying exceeds the strike price), and the writer keeps the premium. MANAV PREET SINGH | 2005A3PS295

A graphical interpretation of the payoffs and profits generated by a put option by the purchaser of the option is given below. A lower stock price means a higher profit. Eventually, the price of the underlying (i.e. stock) will be low enough to fully compensate the price of the option . MANAV PREET SINGH | 2005A3PS295

The put option has positive monetary value when the underlying instrument has a spot price ( S ) below the strike price ( K ). Since the option will not be exercised unless it is "in-the-money", the payoff for a put option is max{(K − S) ; 0}.

PARTICIPANTS IN THE OPTIONS MARKET MANAV PREET SINGH | 2005A3PS295

WHY OPTIONS ??? 1. Speculation 2. Hedging MANAV PREET SINGH | 2005A3PS295

ADVANTAGES OF OPTIONS MANAV PREET SINGH | 2005A3PS295