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UNIT- 3 OPTIONS In this section, we look at the next derivative product to be traded on the Exchange, namely options. Options are fundamentally different from forward and futures contracts. An option gives the holder of the option the right to do something. The holder does not have to exercise this right. In contrast, in a forward or futures contract, the two parties have committed themselves to doing something. Whereas it costs nothing (except margin requirements) to enter into a futures contract, the purchase of an option requires an up-front payment. An option is a derivative contract between a buyer and a seller, where one party (say First Party) gives to the other (say Second Party) the right, but not the obligation, to buy from (or sell to) the First Party the underlying asset on or before a specific day at an agreed-upon price. In return for granting the option, the party granting the option collects a payment from the other party. This payment collected is called the premium or price of the option. The right to buy or sell is held by the option buyer (also called the option holder); the party granting the right is the option seller or option writer. Unlike forwards and futures contracts, options require a cash payment (called the premium) upfront from the option buyer to the option seller. This payment is called option premium or option price. Options can be traded either on the stock exchange or in over the counter (OTC) markets. Options traded on the exchanges are backed by the Clearing Corporation thereby minimizing the risk arising due to default by the counter parties involved. Options traded in the OTC market however are not backed by the Clearing Corporation. There are two types of optionscall options and put optionswhich are explained below. Call option A call option is an option granting the right to the buyer of the option to buy the underlying asset on a specific day at an agreed upon price, but not the obligation to do so. It is the seller who grants this right to the buyer of the option. It may be noted that the person who has the right to buy the underlying asset is known as the buyer of the call option. The price at which the buyer has the right to buy the asset is agreed upon at the time of entering the contract. This price is known as the strike price of the contract (call option strike price in this case).

Since the buyer of the call option has the right (but no obligation) to buy the underlying asset, he will exercise his right to buy the underlying asset if and only if the price of the underlying asset in the market is more than the strike price on or before the expiry date of the contract. The buyer of the call option does not have an obligation to buy if he does not want to. Put option A put option is a contract granting the right to the buyer of the option to sell the underlying asset on or before a specific day at an agreed upon price, but not the obligation to do so. It is the seller who grants this right to the buyer of the option. The person who has the right to sell the underlying asset is known as the buyer of the put option. The price at which the buyer has the right to sell the asset is agreed upon at the time of entering the contract. This price is known as the strike price of the contract (put option strike price in this case). Since the buyer of the put option has the right (but not the obligation) to sell the underlying asset, he will exercise his right to sell the underlying asset if and only if the price of the underlying asset in the market is less than the strike price on or before the expiry date of the contract. The buyer of the put option does not have the obligation to sell if he does not want to.

Illustration Suppose A has bought a call option of 2000 shares of Hindustan Unilever Limited (HLL) at a strike price of Rs 260 per share at a premium of Rs 10. This option gives A, the buyer of the option, the right to buy 2000 shares of HLL from the seller of the option, on or before August 27, 2009 (expiry date of the option). The seller of the option has the obligation to sell 2000 shares of HLL at Rs 260 per share on or before August 27, 2009 (i.e. whenever asked by the buyer of the option). Suppose instead of buying a call, A has sold a put option on 100 Reliance Industries (RIL) shares at a strike price of Rs 2000 at a premium of Rs 8. This option is an obligation to A to buy 100 shares of Reliance Industries (RIL) at a price of Rs 2000 per share on or before August 27 (expiry date of the option) i.e., as and when asked by the buyer of the put option. It depends on the option buyer as to when he exercises the option. As stated earlier, the buyer does not have the obligation to exercise the option.

Terminology of Derivatives In this section we explain the general terms and concepts related to derivatives. Spot price (ST) Spot price of an underlying asset is the price that is quoted for immediate delivery of the asset. For example, at the NSE, the spot price of Reliance Ltd. at any given time is the price at which Reliance Ltd. shares are being traded at that time in the Cash Market Segment of the NSE. Spot price is also referred to as cash price sometimes. Forward price or futures price (F) Forward price or futures price is the price that is agreed upon at the date of the contract for the delivery of an asset at a specific future date. These prices are dependent on the spot price, the prevailing interest rate and the expiry date of the contract. Strike price (K) The price at which t he buyer of an option can buy the stock (in the case of a call option) or sell the stock (in the case of a put option) on or before the expiry date of option contracts is called strike price. It is the price at which the stock will be bought or sold when the option is exercised. Strike price is used in the case of options only; it is not used for futures or forwards. Expiration date (T) In the case of Futures, Forwards, Index and Stock Options, Expiration Date is the date on which settlement takes place. It is also called the final settlement date. Definition Exchange Traded Options, OTC Options Specifications of Options Index options: These options have the index as the underlying. Some options are European while others are American. Like index futures contracts, index options contracts are also cash settled. Stock options: Stock options are options on individual stocks. Options currently trade on over 500 stocks in the United States. A contract gives the holder the right to buy or sell shares at the specified price. Buyer of an option: The buyer of an option is the one who by paying the option premium buys the right but not the obligation to exercise his option on the seller/writer.

Writer of an option: The writer of a call/put option is the one who receives the option premium and is thereby obliged to sell/buy the asset if the buyer exercises on him. There are two basic types of options, call options and put options.

Call option: A call option gives the holder the right but not the obligation to buy an asset by a certain date for a certain price.

Put option: A put option gives the holder the right but not the obligation to sell an asset by a certain date for a certain price.

Option price/premium: Option price is the price which the option buyer pays to the option seller. It is also referred to as the option premium.

Expiration date: The date specified in the options contract is known as the expiration date, the exercise date, the strike date or the maturity.

Strike price: The price specified in the options contract is known as the strike price or the exercise price.

Moneyness of an Option Moneyness of an option indicates whether an option is worth exercising or not i.e. if the option is exercised by the buyer of the option whether he will receive money or not. Moneyness of an option at any given time depends on where the spot price of the underlying is at that point of time relative to the strike price. The premium paid is not taken into consideration while calculating moneyness of an Option, since the premium once paid is a sunk cost and the profitability from exercising the option does not depend on the size of the premium. Therefore, the decision (of the buyer of the option) whether to exercise the option or not is not affected by the size of the premium. The following three terms are used to define the moneyness of an option. 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 (i.e. spot price > strike price). If the index is much higher than the strike price, the call is said to be deep ITM. In the case of a put, the put is ITM if the index is below the strike price.

An option is said to be in-the-money if on exercising the option, it would produce a cash inflow for the buyer. Thus, Call Options are in-the-money when the value of spot price of the underlying exceeds the strike price. On the other hand, Put Options are in-the- money when the spot price of the underlying is lower than the strike price. Moneyness of an option should not be confused with the profit and loss arising from holding an option contract. It should be noted that while moneyness of an option does not depend on the premium paid, profit/loss do. Thus a holder of an in-the-money option need not always make profit as the profitability also depends on the premium paid. At-the-money option: An at-the-money (ATM) option is an option that would lead to zero cash flow if it were exercised immediately. An option on the index is at-the-money when the current index equals the strike price (i.e. spot price = strike price). An at-the-money-option is one in which the spot price of the underlying is equal to the strike price. It is at the stage where with any movement in the spot price of the underlying, the option will either become in-the-money or out-of-the-money. Out-of-the-money option: An out-of-the-money (OTM) option is an option that would lead to a negative cash flow if it were exercised immediately. A call option on the index is out-of-the-money when the current index stands at a level which is less than the strike price (i.e. spot price < strike price). If the index is much lower than the strike price, the call is said to be deep OTM. In the case of a put, the put is OTM if the index is above the strike price. An out-of-the-money option is an opposite of an in-the-money option. An option-holder will not exercise the option when it is out-of-the-money. A Call option is out-of-the-money when its strike price is greater than the spot price of the underlying and a Put option is out-of-the money when the spot price of the underlying is greater than the options strike price. Illustration Consider some Call and Put options on stock XYZ. As on 13 August, 2009, XYZ is trading at Rs 116.25. The table below gives the information on closing prices of four options, expiring in September and December, and with strike prices of Rs. 115 and Rs. 117.50.

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Moneyness of call and put options Strike Price Rs 115.00 Rs 117.50 September Call option Rs. 8.35 Rs. 4.00 December Call option Rs. 12.30 Rs. 8.15 September Put option Rs. 4.00 Rs. 8.00 December Put option Rs. 8.00 Rs. 12.00

Suppose the spot price of the underlying (closing share price) as at end of September is Rs. 116 and at end of December is Rs. 118. On the basis of the rules stated above, which options are in-the-money and which ones are out-of-the-money are given in the following table.
Moneyness of call and put options In-the-money Options Option September 115 Call September 117.50 Put December 115 Call December 117.50 Call Justification Rs. 115 < Rs. 116 Rs. 117.50 > Rs. 116 Rs 115 < Rs 118 Rs 117.50 < Rs 118 Option September 115 Put September 117.50 Call December 115 Put December 117.50 Put Out-of-money Options Justification Rs. 115 < Rs. 116 Rs. 117.50 > Rs. 116 Rs 115 < Rs 118 Rs 115 < Rs 118

It may be noted that an option which is in-the-money at a particular instance may turn into out-ofthe money (and vice versa) at another instance due to change in the price of the underlying asset. Call and put Options Call option gives the buyer the right to buy the underlying asset by a certain date for a certain price Put option give the buyer the right to sell the underlying asset by a certain date for a certain price The holder does not have to exercise this right. No obligation There is a cost for buying this right

American and European Options (Styles of option) American options: American options are options that can be exercised at any time up to the expiration date. Most exchange-traded options are American. European options:

European options are options that can be exercised only on the expiration date itself. European options are easier to analyze than American options, and properties of an American option are frequently deduced from those of its European counterpart. Intrinsic Value and Time Value of Options Theoretically, the value of an option comprises of two components: intrinsic value and time value. Intrinsic value of an option: The intrinsic value of a call is the amount the option is In-The-Money, if it is In-The-Money. If the call is OTM, its intrinsic value is zero. Putting it another way, the intrinsic value of a call is Max [0, (St K)] which means the intrinsic value of a call is the greater of 0 or (St K). Similarly, the intrinsic value of a put is Max [0, (K St)], i.e. the greater of 0 or (K St). K is the strike price and St is the spot price. Time value of an option: The time value of an option is the difference between its premium and its intrinsic value. Both calls and puts have time value. An option that is Out-of-The-Money or At-The- Money has only time value. Usually, the maximum time value exists when the option is At-The-Money. The longer the time to expiration, the greater is an option's time value, all else equal. At expiration, an option should have no time value. Option payoff options on Securities, Stock Indices, Currencies and Futures OPTIONS PAYOFFS The optionality characteristic of options results in a non-linear payoff for options. In simple words, it means that the losses for the buyer of an option are limited; however the profits are potentially unlimited. For a writer, the payoff is exactly the opposite. His profits are limited to the option premium; however his losses are potentially unlimited. These non-linear payoffs are fascinating as they lend themselves to be used to generate various payoffs by using combinations of options and the underlying. We look here at the six basic payoffs.

Payoff profile for buyer of call options: Long call A call option gives the buyer the right to buy the underlying asset at the strike price specified in the option. The profit/loss that the buyer makes on the option depends on the spot price of the underlying. If upon expiration, the spot price exceeds the strike price, he makes a profit. Higher the spot price more is the profit he makes. If the spot price of the underlying is less than the strike price, he lets his option expire un-exercised. His loss in this case is the premium he paid for buying the option. Figure 3.5 gives the payoff for the buyer of a three month call option (often referred to as long call) with a strike of 4000 bought at a premium of 86.60. Payoff for buyer of call option

Profit 4000 0 Nifty

- 86.60

Loss

The figure shows the profits/losses for the buyer of a three-month Nifty 4000 call option. As can be seen, as the spot Nifty rises, the call option is in-the-money. If upon expiration, Nifty closes above the strike of 4000, the buyer would exercise his option and profit to the extent of the difference between the Nifty-close and the strike price. The profits possible on this option are potentially unlimited. However if Nifty falls below the strike of 4000, he lets the option expire. His losses are limited to the extent of the premium he paid for buying the option Payoff profile for writer of call options: Short call A call option gives the buyer the right to buy the underlying asset at the strike price specified in the option. For selling the option, the writer of the option charges a premium. The profit/loss that the buyer makes on the option depends on the spot price of the underlying. Whatever is the buyers profit is the

sellers loss. If upon expiration, the spot price exceeds the strike price, the buyer will exercise the option on the writer. Hence as the spot price increases the writer of the option starts making losses. Higher the spot price, more is the loss he makes. If upon expiration the spot price of the underlying is less than the strike price, the buyer lets his option expire unexercised and the writer gets to keep the premium. Figure 3.6 gives the payoff for the writer of a three month call option (often referred to as short call) with a strike of 4000 sold at a premium of 86.60.

Payoff for writer of call option Profit

86.60 4000 0 Nifty

Loss

The figure shows the profits/losses for the seller of a three-month Nifty 4000 call option. As the spot Nifty rises, the call option is in-the-money and the writer starts making losses. If upon expiration, Nifty closes above the strike of 4000, the buyer would exercise his option on the writer who would suffer a loss to the extent of the difference between the Nifty-close and the strike price. The loss that can be incurred by the writer of the option is potentially unlimited, whereas the maximum profit is limited to the extent of the up-front option premium of Rs.86.60 charged by him. Payoff profile for buyer of put options: Long put A put option gives the buyer the right to sell the underlying asset at the strike price specified in the option. The profit/loss that the buyer makes on the option depends on the spot price of the underlying. If upon expiration, the spot price is below the strike price, he makes a profit. Lower the spot price, more is the profit he makes. If the spot price of the underlying is higher than the strike price, he lets his option expire un-exercised. His loss in this case is the premium he paid for buying the option. Figure 3.7 gives the payoff for the buyer of a three month put option (often referred to as long put) with a strike of 4000 bought at a premium of 61.70.

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Payoff for buyer of put option Profit

0 - 61.70

4000

Nifty

Loss The figure shows the profits/losses for the buyer of a three-month Nifty 4000 put option. As can be seen, as the spot Nifty falls, the put option is in-the-money. If upon expiration, Nifty closes below the strike of 4000, the buyer would exercise his option and profit to the extent of the difference between the strike price and Nifty-close. The profits possible on this option can be as high as the strike price. However if Nifty rises above the strike of 4000, he lets the option expire. His losses are limited to the extent of the premium he paid for buying the option. Payoff profile for writer of put options: Short put A put option gives the buyer the right to sell the underlying asset at the strike price specified in the option. For selling the option, the writer of the option charges a premium. The profit/loss that the buyer makes on the option depends on the spot price of the underlying. Whatever is the buyers profit is the sellers loss. If upon expiration, the spot price happens to be below the strike price, the buyer will exercise the option on the writer. If upon expiration the spot price of the underlying is more than the strike price, the buyer lets his option expire un-exercised and the writer gets to keep the premium. Figure 3.8 gives the payoff for the writer of a three month put option (often referred to as short put) with a strike of 4000 sold at a premium of 61.70. Payoff for writer of put option Profit

61.70 4000 0 Nifty

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Loss The figure shows the profits/losses for the seller of a three-month Nifty 4000 put option. As the spot Nifty falls, the put option is in-the-money and the writer starts making losses . If upon expiration, Nifty closes below the strike of 1250, the buyer would exercise his option on the writer who would suffer a loss to the extent of the difference between the strike price and Nifty-close. The loss that can be incurred by the writer of the option is a maximum extent of the strike price( Since the worst that can happen is that the asset price can fall to zero) whereas the maximum profit is limited to the extent of the up-front option premium of Rs.61.70 charged by him. Options pricing models PRICING OPTIONS An option buyer has the right but not the obligation to exercise on the seller. The worst that can happen to a buyer is the loss of the premium paid by him. His downside is limited to this premium, but his upside is potentially unlimited. This optionality is precious and has a value, which is expressed in terms of the option price. Just like in other free markets, it is the supply and demand in the secondary market that drives the price of an option. There are various models which help us get close to the true price of an option. Most of these are variants of the celebrated Black-Scholes model for pricing European options. Today most calculators and spread-sheets come with a built-in Black- Scholes options pricing formula so to price options we don't really need to memorize the formula. All we need to know is the variables that go into the model. Six important factors influencing the option pricing Current Price of the stock Strike Price of the option Time to expiration of the option Expected price volatility of the stock Risk Free Interest Rate Anticipated cash payment on the stock Influence of these factors on option price: Factor Current Price of the stock Symbol (S) Call Price Increase Put Price Decrease

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Strike Price of the option Time to expiration of the option Expected price volatility of the stock Risk Free Interest Rate Anticipated cash payment on the stock

(K) (t) () (R) (c)

Decrease Increase

Increase Increase

Increase Increase Decrease

Increase Decrease Increase

The Black-Scholes Option Pricing Model The Black-Scholes (B S) option pricing model is probably the most commonly used option pricing model in finance. It was initially developed in 1973 by two academicians, Fisher Black and Myron Scholes and was designed to price European options on non-dividend paying stocks. Later on, other academicians further modified the model to make it applicable to American option, option on dividendpaying stock, option on other instruments like futures contracts. The reason for popularity of the model is that it allows for an analytical solution. It means that there is a formula into which certain values are input and from which an option price is forthcoming. However, this formula when programmed into a computer, it can produce results (option price) within seconds. Assumptions underlying Black Scholes Model: The mode is based on certain assumptions which are as under : Stock price behavior corresponds to the log normal distribution which have been explained earlier. It assumes that u and are constant. There are no transaction costs or taxes. All securities/stocks are perfectly divisible. No dividends payments on stock during the life of the option There are no riskless arbitrage opportunities. Stock trading is continuous. Investors can borrow or lend at the same risk free rate of interest. The short-term risk free interest rate r is constant.

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The Black Scholes formula: Black Scholes drive the following equation for pricing European call options on non-dividend paying stocks: C = SN(d1) Ke-rtN(d2) P = Ke-rT N(-d2) SN(-d1)

Call Option Price :

Put Option Price:

Where, ln(S/K) + rT d1 = ----------------------- T + 0.5 T

ln(S/K) + rT d2 = ------------------------ - 0.5 T T where, S = Stock Price K = Strike Price e is exponential (which has the constant value of 2.7182818) r = risk free interest rate ( annualize) T = time to expiry (in years) = annualized standard deviation of stock returns (volatility) as a decimal e-rt is a discount term similar to 1/(1+r)t and as such it determines the present value of future sum of money and its discount on continuous compounding ln(.) is the natural logarithm N(.) is the cumulative probability distribution function for a standardized normal variable N(d1) is the area under the distribution to the left of d1 and N(d2) is the area under the distribution to the left of d2.

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The value is determined on the assumption that no dividend is paid on the stock and option is not American rather European. It means the investor can not exercise his option before maturity.

Unfortunately no exact analytic formula for the value of an American put on a non-dividend paying stock has been produced so far. Bionomial Option Pricing Model Another important technique of pricing a stock option is through constructing a binomial tree. This is a tree which represent different possible paths that might be followed by the stock price over the life of the option. This model was advocated by Cox, Ross and Rubinstein in 1979 and take the form of binomial model. This model, like B-S model does not permit an analytical solution rather solves the problem numerically. It means there is no formula that can be programmed into a computer or calculator, instead a computer must be programmed to ascertain solution. Although the explanation of this model will treat the time to expiry of an option as being one period, or divided into 2 periods, and much large number of periods. A One-step binomial model To understand the logic behind this model, we start with a single period (one step) example and then gradually generalize it. Consider a very simple situation where a stock price is currently Rs. 20, and it is known that after three months, it may be either Rs. 22 or Rs. 18. We further assume that we are considering in valuing a European call option to buy the stock for Rs. 21 in three months. In this option, we are estimating two values, ie., Rs. 22 and Rs. 18, if the value turns upto Rs. 22, the option value Re 1, and if Rs.18, the value will be zero. This situation is shown below: Stock Price Rs. 22 (Option Price 1) S1 = U0 (S0) After Three Months, if Stock Price moves Up

(Today) Stock (S0)

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Price Rs. 20

After Three Months, if Stock Price moves down

Stock Price Rs. 18 (Option Price 0) S1 = D0 (S0)

Where S1 = Stock price after the period S0 = Initial Stock Price U0 = Up factor D0 = Down factor Exercise price = 21 The Binomial Pricing Model is based upon the following standard assumptions: There are not market frictions. It means there are no transaction costs, no bid/ask spreads, no margin requirements, no restriction on short sales, no taxes etc., Market participants entail no counter party risk. In other words, there is risk of default by the other party in the contract. Markets are competitive. It means that market participants act as price takers, and not the makers. There are no arbitrage opportunities. Prices have adjusted in such a way so that there are no arbitrage opportunities in the market. There is no interest rate uncertainty. This is assumed to reduce the complexity of the pricing problems. It is reasonable approximation in case of short dated options or futures contracts, say less than a year. Similarly we can extend the analysis to a two step binomial trees with the same information. The above binomial model is just introductory for understanding the basics of binomial concept for using in stock option pricing. It can be used both call option as well as put option valuation. In brief, when stock price movements are governed by a multistep binomial tree, we can treat each binomial step separately and work back from the end of the life of the option to starting for determining the current value of the option. In this technique, no arbitrage arguments are used to find out the value at the each node. It can be extended to American type option also. THE Geeks of Option Pricing

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Delta is the rate of change of option price with respect to the price of the underlying asset. For example, the delta of a stock is 1. It is the slope of the curve that relates the option price to the price of the underlying asset. Suppose the delta of a call option on a stock is 0.5. This means that when the stock price changes by one, the option price changes by about 0.5, or 50% of the change in the stock price. Delta = Change in the option price / change in the price of the underlying asset Gamma is the rate of change of the option's Delta with respect to the price of the underlying asset. In other words, it is the second derivative of the option price with respect to price of the underlying asset. Gamma = Change in the Options delta / Change in the price of the underlying asset Theta of a portfolio of options, is the rate of change of the value of the portfolio with respect to the passage of time with all else remaining the same. Is also referred to as the time decay of the portfolio. Theta is the change in the portfolio value when one day passes with all else remaining the same. We can either measure "per calendar day" or "per trading day". To obtain the per calendar day, the formula for Theta must be divided by 365; to obtain Theta per trading day, it must be divided by 250. Theta = Change in the value of the premium / change in the time Vega of a portfolio of derivatives is the rate of change in the value of the portfolio with respect to volatility of the underlying asset. If is high in absolute terms, the portfolio's value is very sensitive to small changes in volatility. If is low in absolute terms, volatility changes have relatively little impact on the value of the portfolio. Vega = Change in the value of the premium / Change in the volatility Rho of a portfolio of options is the rate of change of the value of the portfolio with respect to the domestic interest rate. It measures the sensitivity of the value of a portfolio to foreign interest rates. Rho = Change in value of the premium / Change in the domestic interest rate Phi of the portfolio of options is the rate of change of the value of the portfolio with respect to the foreign interest rate. It measures the sensitivity of the value of the portfolio to the foreign interest rates. Phi = Change in value of premium / Change in the foreign interest rate.

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Differences between future and Option contracts. Distinction between futures and options After going through the basic concept of the options and futures contracts, one can visualize the basic difference between these two, and that is to obligation. In the option contracts, one party (the buyer) is not obligated to transact the contract at a later date, only the other party (seller) is under obligation to perform the option contract, and only if the buyer desires so. On the other hand, in case of futures contract, both the parties, buyer and seller, are under obligation to perform the contract. In case of options contracts, one party (the buyer) has to pay in cash the option price (premium) to the other party (seller) and this is not returned to the buyer whether he insists for actual performance of the contract or not. In case of futures contract, no cash is transferred to either party at the time of the formation of the contract. The risk and reward characteristics of these tow contracts also differ. In the case of futures contract, the buyer of the contract realizes the gains in cash when the price of the futures contract increases and incurs losses in case of fall in the prices. The position is opposite in case of the seller of the futures contract. However, in the case of options contracts, such symmetric risk/reward relationship does not arise. The most that the buyer of an option can lose is the option price against which he possesses all the potential benefits. The maximum profit that the seller of the option contract may realize is the options price. This is to offset against substantial down side risk. In case of option contract, they are brought into existence by being traded; if none is traded, none exists; conversely, there is no limit to the number of option contracts that can be in existence at any time. However, in the case of futures contracts, there is process of closing out position which cause contracts to cease to exit, hence, diminishing the total number in comparison to options. Futures Both the buyer and the seller are under an obligation to fulfill the contract. Options The buyer of the option has the right and not an obligation whereas the seller is under obligation to fulfill the contract if and when the buyer exercises his right. The seller is subjected to unlimited risk of losing whereas the buyer has limited potential to lose (which is the option premium).

The buyer and the seller are subject to unlimited risk of loss.

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The buyer has potential to make unlimited gain The buyer and the seller have potential to make unlimited gain or loss. while the seller has a potential to make unlimited gain. On the other hand the buyer has a limited loss potential and the seller has an unlimited loss potential.

-Option Strategies An option strategy is implemented to try and make gains from the movement in the underlying price of an asset. As discussed above, options are derivatives that give the buyer the right to exercise the option at a future date. Unlike futures and forwards which have linear pay-offs and do not require an initial outlay (upfront payment), options have non linear pay-offs and do require an initial outlay (or premium). In this section we discuss various strategies which can be used to maximize returns by using options. Long option strategy A long option strategy is a strategy of buying an option according to the view on future price movement of the underlying. A person with a bullish opinion on the underlying will buy a call option on that asset/security, while a person with a bearish opinion on the underlying will buy a put option on that asset/security. An important characteristic of long option strategies is limited risk and unlimited profit potential. An option buyer can only lose the amount paid for the option premium. At the same time, theoretically, the profit potential is unlimited. Calls An investor having a bullish opinion on underlying can expect to have positive returns by buying a call option on that asset/security. When a call option is purchased, the call option holder is exposed to the stock performance in the spot market without actually possessing the stock and does so for a fraction of the cost involved in purchasing the stock in the spot market. The cost incurred by the call option holder is the option premium. Thus, he can take advantage of a smaller investment and maximize his profits. Consider the purchase of a call option at the price (premium) c. We take ST = Spot price at time T K = Strike price

The payout in two scenarios is as follows:

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Profit/Loss = c, if S T = K Profit/Loss = (ST - K) c if S T = K

Example: Let us explain this with some examples. Mr. A buys a Call on an index (such as Nifty 50) with a strike price of Rs. 2000 for premium of Rs. 81. Consider the values of the index at expiration as 1800, 1900, 2100, and 2200. For ST = 1800, Profit/Loss = 0 81 = 81 (maximum loss = premium paid) For ST = 1900, Profit/Loss = 0 81 = 81 (maximum loss = premium paid) For ST = 2100, Profit/Loss = 2100 2000 81 = 19 For ST = 2200, Profit/Loss = 2200 2000 81 = 119 As we can see from the example, the maximum loss suffered by the buyer of the Call option is Rs. 81, which is the premium that he paid to buy the option. His maximum profits are unlimited and they depend on where the underlying price moves. Puts An investor having a bearish opinion on the underlying can expect to have positive returns by buying a put option on that asset/security. When a put option is purchased, the put option buyer has the right to sell the stock at the strike price on or before the expiry date depending on where the underlying price is. Consider the purchase of a put option at price (premium) p. We take ST = Spot price at time T K = exercise price The payout in two scenarios is as follows: Profit/Loss = (K ST ) p if ST = K Profit/Loss = p if ST = K Example: Let us explain this with some examples. Mr. X buys a put at a strike price of Rs. 2000 for a premium of Rs. 79. Consider the values of the index at expiration at 1800, 1900, 2100, and 2200. For ST = 1800, Profit/Loss = 2000 1800 79 = 121 For ST = 1900, Profit/Loss = 2000 1900 79 = 21

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For ST = 2100, Profit/Loss = 79 (maximum loss is the premium paid) For ST = 2200, Profit/Loss = 79 (maximum loss is the premium paid) As we can see from the example, the maximum loss suffered by the buyer of the Put option is Rs. 79, which is the premium that he paid to buy the option. His maximum profits are unlimited and depend on where the underlying price moves. Short options strategy A short options strategy is a strategy where options are sold to make money upfront with a view that the options will expire out of money at the expiry date (i.e., the buyer of the option will not exercise the same and the seller can keep the premium). As opposed to a long options strategy, here a person with a bullish opinion on the underlying will sell a put option in the hope that prices will rise and the buyer will not exercise the option leading to profit for the seller. On the other hand, a person with a bearish view on the underlying will sell a call option in the hope that prices will fall and the buyer will not exercise the option leading to profit for the seller. As opposed to a long options strategy where the downside was limited to the price paid for the option, here the downside is unlimited and the profit is limited to the price of selling the option (the premium). Call An investor with a bearish opinion on the underlying can take advantage of falling stock prices by selling a call option on the asset/security. If the stock price falls, the profit to the seller will be the premium earned by selling the option. He will lose in case the stock price increases above the strike price. Consider the selling of a call option at the price (premium) c. We take ST = Spot price at time T K = exercise price The payout in two scenarios is as follows: Profit/Loss = c if ST = K Profit/Loss = c (ST K) if S T = K Now consider this example: A sells a call at a strike price of Rs 2000 for a premium of Rs 81. Consider values of index at expiration at 1800, 1900, 2100, and 2200. For ST = 1800, Profit/Loss = 81 (maximum profit = premium received) For ST = 1900, Profit/Loss = 81 (maximum profit = premium received)

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For ST = 2100, Profit/Loss = 81 (2100 2000) = 19 For ST =2200, Profit/Loss = 81 (2100 2200) = 119 As we can see from the example above, the maximum loss suffered by the seller of the Call option is unlimited (this is the reverse of the buyers gains). His maximum profits are limited to the premium received. Puts An investor with a bullish opinion on the underlying can take advantage of rising prices by selling a put option on the asset/security. If the stock price rises, the profit to the seller will be the premium earned by selling the option. He will lose in case the stock price falls below the strike price. Consider the sale of a put option at the price (premium) p. We take: ST = Spot price at time T K = exercise price The payout in two scenarios is as follows: Profit/Loss = p (K ST) if S T = K Profit/Loss = p if ST = K Example: We sell a put at a strike price of Rs. 2000 for Rs. 79. Consider values of index at expiration as 1800, 1900, 2100, and 2200. For ST = 1800, Profit/Loss = 79 (2000 1800) = () 121 For ST = 1900, Profit/Loss = 79 (2000 1900) = () 21 For ST = 2100, Profit/Loss = 79 (maximum profit = premium received) For ST = 2200, Profit/Loss = 79 (maximum profit = premium received) As we can see from the example above the maximum loss suffered by the seller of the Put option is unlimited (this is the reverse of the buyers gains). His maximum profits are limited to the premium received. Determination of option prices Like in case of any traded good, the price of any option is determined by the demand for and supply of that option. This price has two components: intrinsic value and time value. Intrinsic value of an option:

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Intrinsic value of an option at a given time is the amount the holder of the option will get if he exercises the option at that time. In other words, the intrinsic value of an option is the amount the option is in-the-money (ITM). If the option is out-of-the-money (OTM), its intrinsic value is zero. Putting it another way, the intrinsic value of a call is Max [0, (St K)] which means that the intrinsic value of a call is the greater of 0 or (St K). Similarly, the intrinsic value of a put is Max [0, K St] i.e., the greater of 0 or (K S t) where K is the strike price and S t is the spot price. Time value of an option: In addition to the intrinsic value, the seller charges a time value from the buyers of the option. This is because the more time there is for the contract to expire, the greater the chance that the exercise of the contract will become more profitable for the buyer. This is a risk for the seller and he seeks compensation for it by demanding a time value. The time value of an option can be obtained by taking the difference between its premium and its intrinsic value. Both calls and puts have time value. An option that is Out-of-the-money (OTM) or At-themoney (ATM) has only time value and no intrinsic value. Usually, the maximum time value exists when the option is ATM. The longer the time to expiration, the greater is an options time value, all else being equal. At expiration, an option has no time value. Illustration In the following two tables, five different examples are given for call option and put option respectively. As stated earlier, premium is determined by demand and supply. The examples show how intrinsic value and time value vary depending on underlying price, strike price and premium.

Intrinsic and Time Value for Call Options: Examples Underlying Price (Rs.) 100 101 103 88 95 Strike Price (Rs.) 90 90 90 90 90 Premium (Rs.) 12 13 14 1 5.50 Intrinsic Value (Rs.) 10 11 13 0 5 Time Value (Rs.) 2 2 2 1 0.50

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Intrinsic and Time Value for Put Options: Examples Underlying Price (Rs.) 100 99 97 112 105 Strike Price (Rs.) 110 110 110 110 110 Premium (Rs.) 12 13 14 1 5.50 Intrinsic Value (Rs.) 10 11 13 0 5 Time Value (Rs.) 2 2 1 1 0.50

FACTORS IMPACTING OPTION PRICES The supply and demand of options and hence their prices are influenced by the following factors: The underlying price, The strike price, The time to expiration, The underlying assets volatility, and Risk free rate Each of the five parameters has a different impact on the option pricing of a Call and a Put.

The underlying price: Call and Put options react differently to the movement in the underlying price. As the underlying price increases, intrinsic value of a call increases and intrinsic value of a put decreases. Thus, in the case of a Call option, the higher the price of the underlying asset from strike price, the higher is the value (premium) of the call option. On the other hand, in case of a put option, the higher the price of the underlying asset, the lower is the value of the put option. The strike price: The strike price is specified in the option contract and does not change over time. The higher the strike price, the smaller is the intrinsic value of a call option and the greater is the intrinsic value of a put option. Everything else remaining constant, as the strike price increases, the value of a call option decreases and the value of a put option increases. Similarly, as the strike price decreases, the price of the call option increases while that of a put option decreases.

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Time to expiration: Time to expiration is the time remaining for the option to expire. Obviously, the time remaining in an options life moves constantly towards zero. Even if the underlying price is constant, the option price will still change since time reduces constantly and the time for which the risk is remaining is reducing. The time value of both call as well as put option decreases to zero (and hence, the price of the option falls to its intrinsic value) as the time to expiration approaches zero. As time passes and a call option approaches maturity, its value declines, all other parameters remaining constant. Similarly, the value of a put option also decreases as we approach maturity. This is called time-decay. Volatility: Volatility is an important factor in the price of an option. Volatility is defined as the uncertainty of returns. The more volatile the underlying higher is the price of the option on the underlying. Whether we are discussing a call or a put, this relationship remains the same. Risk free rate: Risk free rate of return is the theoretical rate of return of an investment which has no risk (zero risk). Government securities are considered to be risk free since their return is assured by the Government. Risk free rate is the amount of return which an investor is guaranteed to get over the life time of an option without taking any risk. As we increase the risk free rate the price of the call option increases marginally whereas the price of the put option decreases marginally. It may however be noted that option prices do not change much with changes in the risk free rate. The impact of all the parameters which affect the price of an option is given in the table below: With an increase in the parameter: Asset Price Exercise Price Time to expiration Volatility Risk free rate Price of Call Option Price of Put Option

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Even though option prices are determined by market demand and supply, there are various models of getting a fair value of the options, the most popular of which is the Black Scholes- Merton Model. In this model, the theoretical value of the options is obtained by inputting into a formula values of the abovementioned five factors. It may be noted that the prices arrived at by using this model are only indicative.