The document provides an overview of options terminology and concepts. It defines an option as a contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a predetermined price on or before a specified date. It also describes the key characteristics of call and put options, American and European style options, factors that affect option value, and the Black-Scholes options pricing model.

1. Module 2
OPTIONS

2. 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.

3. Right vs obligation
• A ‘right’ is a privilege or a claim
conferred upon the buyer whereas
an ‘obligation’ is a compulsion.

4. 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

5. 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.

6. 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.

7. 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

8. 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

9. 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

10. Options Terminology
o 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 position
o Option Writers – is in short position
o Writing calls covered : Writing call options against
the shares owned by the writer
o Uncovered call options : Writing call options
without owning the underlying shares.

11. 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

12. 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.

13. Why sell options
• Sold by conservative investors who want
additional income.
• Earn premium

14. Call 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
80 (1000)
90 (1000)
100 (1000)
110 0
120 1000
130 2000
140 3000

15. Payoff Diagram – Call option buyer
Net Payoff
On a call
Strike Price
Price of
underlying asset

16. 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)

17. Payoff Diagram - Put option buyer
Net Payoff
On Put
Strike
Price Price of underlying
asset

18. 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

19. Derivatives permitted in India
Derivatives
Equity Debt Forex Commoditi
es
Interest rate Currency futures
Index futures & futures &
Options Currency options
forwards
Single stock Forwards Forwards
Interest rate
options & futures Cross currency
swaps Futures
swaps
S.S.S. Kumar ( 2007). Financial Derivatives, New Delhi : Prentice Hall of India, p.4

20. Trading cycle of options - NSE
o 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.

21. Trading in Options NSE
o 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 stocks
o The average daily turnover in the F&O Segment of the Exchange
during 2009-10 was Rs 72,392 crore (US $ 16,097 million).

22. 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.

23. 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

24. ET Reading - Options

25. 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

26. Determinants of option value
Determining Effect of increase holding
factors others constant
Put Call
1 Current stock price Decreases Increases
2 Striking price Increases Decreases
3 Time to expiration Increases Increases
4 Stock volatility Increases Increases
5 Interest rates Decreases Increases
6 Cash dividends Increases Decreases

27. 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.

28. 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)

29. 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.

30. 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

31. 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

32. Basic/Elementary strategies
o Short call
o Expects that stock price will not rise
o Limited profit (premium) and losses are unlimited
o Long put
o Bearish view
o Losses limited & profit unlimited
o 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

33. Combinations of Put and Call Options
or Option Strategies
• Straddle
• Strip
• Strap
• Strangle
• Spread

34. 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.

35. 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.

36. 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.

37. 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.

38. 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

39. Additional Areas where options are available
Company issued option
Rights – Short lived
Warrants – Medium to long lived
Convertible Securities – Long life
Option on Physical Assets
Real Options

40. Stock rights
o Short lived options issued by company.
o Pre emptive right to existing shareholders.
o Ex Price < Prevailing Market Price
o Value of a right
Vr = (Pm-Pe)/r
Pm = Market price,
Pe = Exercise Price,
r = No of rights to buy one new share

41. Warrants
o 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 stock
o American / European option
o Detachable / non detachable warrants.

42. Convertible Securities
o 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 shares
o Conversion rate and conversion value.

43. 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.