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Introduction To OPTIONS By : DINESH KUMARB.COM (HONS)III YEARRoll No.: 753OPTIONS Types WorkingTerminologiesProfits and payoffsAn 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.OptionsOption ClassificationsCall 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 OPTIONS A call option is a financial contract between two parties, the buyer and the seller of this type of option. It is the option to buy shares of stock at a specified time in the future. Often it is simply labelled a "call". The buyer of the option has the right, but not the obligation to buy an agreed quantity of a particular commodity The buyer pays a fee (called a premium) for this right. Put Option is just opposite of the Call Option which gives the holder the right to buy shares. A put becomes more valuable as the price of the underlying stock depreciates relative to the strike price. Call Option: Right but not the obligation to buyPut Option: Right but not the obligation to sellOption Price: The amount per share that an option buyer pays to the sellerExpiration Date: The day on which an option is no longer valid Strike Price: The reference price at which the underlying may be traded Long Position: Buyer of an option assumes long positionShort Position: Seller of an option assumes short position
Some TerminologiesCall Option Buying A Call option buyer basically is bullish about the underlying stock.
Put Option buyingA 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.
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 StylesOption Selling: Motives for selling options
The 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 sellers view the possibility of option being exercised by the buyer may be low.
Factors influencing Option PricingTime 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.
Exercise of calls
Exercise of Puts
Option Pay Off
Pay off from a Long Call
Payoff from Short Call
Summary of basic option strategies
Merits of OptionsOptions protect downside risk to the buyerThe buyer of the option limits losses to the premium paid on the purchase of the optionsEg. 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 PricingBlack Scholes formula is the most widely used for pricing optionsThe 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 volatilityThese are also called the greeks as changes in any one of these variables affect the option priceOptions contracts can be classified into out of the money, at the money and in the money
The BSOPM Formula The price of a correspondingput optionbased onput-call parityis: For both, asabove: is thecumulative distribution functionof thestandard normal distribution is the time to maturity is thespot priceof the underlying asset is the strike price is therisk free rate(annual rate, expressed in terms ofcontinuous compounding) is thevolatilityof returns of the underlying asset
Options A review
Options or option contracts are instrumentsRight, but not the obligation, is givenTo buy or sell a specific assetAt a specific priceOn or before a specified dateOptions can be exchange traded derivatives or even over the counter derivatives.
Options A reviewOptions have a buyer and a writerThe option writer receives premium for giving the buyer the right but not the obligation to sell an asset at a future dateThe option writer is not protected on the downside riskOption writers have to settle mark to market profit or loss on a daily basisOptions can be cash settled or settled by physical deliveryOptions in India are cash settled
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By: DINESH KUMAR
