options

• Before defining what is option let us consider the following example.

• You discover a house and love to purchase. You don’t have money. you talk and negotiate with the owner 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 the option you pay Rs. 3000/-

• Case 1. Suddenly the house value increases and the value is Rs. 10,00,000 . The owner obliged tosell the house for Rs.2,00,000. But you stand to make a profit of 7,97,000 (10,00,000-2,00,000-3,000)

• Case2: You changed your mind . You lose Rs. 3000/- which is non refundable

OPTIONS

• So an option is a contract whereby one party (the holder or buyer) has the right but not the obligation to exercise a feature of the contract on or before the future date. But the other party (seller or the writer) has the obligation to honour specified feature of the contract.

Terminologies of options

• Call option: A right to buy the underlying asset at the pre determined price within specified interval of time is called a CALL option

• Put option: A right to sell the underlying asset at a pre determined price within specified interval of time is called a PUT option

• Buyer or holder: The person who has the right but has no obligation. But he has to pay premium.

• Writer of seller. One who gives or confer the right and undertakes the obligation is called seller or writer.

• Premium: It is otherwise known as option price. It is the price which the buyer pays to the seller.

• Strike price: It is otherwise known as exercise price . It is the pre determined price which the holder of an option buys/ sells the asset

• Strike or maturity date:The right to exercise the option is valid for a limited period of time . It is called maturity date of strike date

Categories of option

• European Option:Option that can be exercised only at the time of maturity is called European option

• American option : Option that can be exercised before the maturity is called American option

• Burmudan Option: An option that is exercised with Over the counter (OTC) is called as Burmudan option

Other types of options

• Real Options• Traded options• Vannila and exotic options

• Real option: A real option is a choice that an investor has when investing in the real economy. (the production of goods and services rather than financial assets). This option may be something as simple as the opportunity to expand production inputs. Real options are an increasingly influencial tool in corporate finance

• Traded option ( Exchanged traded Option ) Traded options are exchange traded derivatives as the name implies. AS for other classes of exchange traded derivatives they are standardized contracts, quick systematic pricing and are settled through clearing houses

• Vanilla and exotic option: Vanilla option is a plain simple and well understood option, whereas an exotic option is more complex or less easily understood. (hybrid option). The European and American options on stock and bonds are usually considered to be “ plain Vanilla”. Asian option option , look back option, barrier option are considered to be exotic where the underlying asset is more complex

Participants of options

• Buyers of calls• Seller of calls• Buyer of puts• Seller of puts

Call option

• Holder of an option exercises theoption when price of the underlying asset is more than the strike price

• S< X buyer lets the call expire loss=Premium c• S=X Buyer is indifferent loss = premium c• S>X Buyer exercise the option Gain= S-X-c• Value of the option =Max (0,S-X)-c

Put option

• When• S<X Buyer exercises the option Gain= X-S- P• S=X Buyer is indifferent Loss= premium p• S>x Buyer lets the contract price Loss=pm p• Value of option = Max(0,X-s)-p

Zero sum game

Option are a Zero sum game. The gain of the holder is the los of the writer and vice versa.

Money of option

• In the money (ITM) • Out of the money (OTM)• At the money (ATM) .• Moneyness of the option tells the benefit the

holder gets if he exercises.

In the money option

• An in- the- money(ITM) option is an option that would lead to a positive cash flow to the holder if it were exercised immediately . A call option on the index is said to be in the money when the current index stands at a level higher than the strike price (Spot price > strike price)If the index is much higher than the strike price, the call is said to be deep ITM. In case of put, the put is ITM of the index is below the strike.

Out of the money option

• An out- the- money (OTM)option is an option that would lead to a NEGATIVE cash flow to the holder if it were exercised immediately . A call option on the index is said to be in OUT the money when the current index stands at a level higher than the strike price (Spot price < strike price)If the index is much lower than the strike price, the call is said to be deep OTM. In case of put, the put is OTM of the index is above the strike.

At-the-money option

• An at- the- money (ATM)option is an option that would lead to a ZEROcash flow to the holder if it were exercised immediately . A call option on the index is said to be in AT the money when the current index stands equal to the strike price (Spot price = strike price).In other words, an option holder must poay to exercise the option, is the same as current price of the underlying security on which the option is written.

Underlying value (S)

S<X S=X S>X

Call Option Out –of-the- money At-the-money In-the-money

Pull option In the money At-the-money Out-of-the-money

Differences between forward/future and Option

Forwards/Futures Options

Pay off(profit&loss) linear Non linear

Obligation to perform Bother buyer and seller Only seller of option with right to the buyer

Trading OTC for forward and Exchange traded for futures

Both OTC and Exchange traded

Margin None – Forward As required by exchange in Futures

None in OTC and as per exchange requirement if exchange traded

Initial payment None Buyer pays premium

• Meaning of pay off ( profit & Loss) is un limited in case of in forwards and futures. (Linear)