M.D.

College DERIVATIVE MARKET

T.Y.F.M

OPTION
In finance, an option is a derivative financial instrument that

establishes a contract between two parties concerning the buying or

selling of an asset at a reference price during a specified time frame.

During this time frame, the buyer of the option gains the right, but

not the obligation, to engage in some specific transaction on the

asset, while the seller incurs the obligation to fulfill the transaction if

so requested by the buyer. The price of an option derives from the

value of an underlying asset (commonly a stock, a bond, a currency

or a futures contract) plus a premium based on the time remaining

until the expiration of the option. Other types of options exist, and

options can in principle be created for any type of valuable asset.

An option which conveys the right to buy something is called a

call; an option which conveys the right to sell is called a put. The

price specified at which the underlying may be traded is called the

strike price or exercise price. The process of activating an option and

thereby trading the underlying at the agreed-upon price is referred

to as exercising it. Most options have an expiration date. If the option

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is not exercised by the expiration date, it becomes void and

worthless.

In return for granting the option, called writing the option, the

originator of the option collects a payment, the premium, from the

buyer. The writer of an option must make good on delivering (or

receiving) the underlying asset or its cash equivalent, if the option is

exercised.

An option can usually be sold by its original buyer to another

party. Many options are created in standardized form and traded on

an anonymous options exchange among the general public, while

other over-the-counter options are customized to the desires of the

buyer on an ad hoc basis, usually by an investment bank.

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Contract specifications
Every financial option is a contract between the two

counterparties with the terms of the option specified in a term sheet.

Option contracts may be quite complicated; however, at minimum,

they usually contain the following specifications:

 whether the option holder has the right to buy (a call option)

or the right to sell (a put option)

 the quantity and class of the underlying asset(s) (e.g. 100

shares of XYZ Co. B stock)

 the strike price, also known as the exercise price, which is the

price at which the underlying transaction will occur upon

exercise

 the expiration date, or expiry, which is the last date the option

can be exercised

 the settlement terms, for instance whether the writer must

deliver the actual asset on exercise, or may simply tender the

equivalent cash amount

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 The terms by which the option is quoted in the market to

convert the quoted price into the actual premium-–the total

amount paid by the holder to the writer of the option.

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Types of options
The primary types of financial options are:

 Exchange traded options (also called "listed options")

Is a class of exchange-traded derivatives. Exchange traded

options have standardized contracts, and are settled through a

clearing house with fulfillment guaranteed by the credit of the

exchange. Since the contracts are standardized, accurate pricing

models are often available. Exchange traded options include:

 stock options,

 commodity options,

 bond options and other interest rate options

 stock market index options or, simply, index options and

 options on futures contracts

 Over-the-counter options (OTC options, also called "dealer

options")

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Are traded between two private parties, and are not listed on

an exchange. The terms of an OTC option are unrestricted and

may be individually tailored to meet any business need. In

general, at least one of the counterparties to an OTC option is a

well-capitalized institution. Option types commonly traded over

the counter include:

1. Interest rate options

2. Currency cross rate options, and

3. Options on swaps or swaptions.

Other option types

Another important class of options, particularly in the U.S., is

employee stock options, which are awarded by a company to their

employees as a form of incentive compensation. Other types of

options exist in many financial contracts, for example real estate

options are often used to assemble large parcels of land, and

prepayment options are usually included in mortgage loans.

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However, many of the valuation and risk management principles

apply across all financial options.

Option styles

Naming conventions are used to help identify properties common

to many different types of options. These include:

 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.

 Barrier option - any option with the general characteristic that

the underlying security's price must pass a certain level or

"barrier" before it can be exercised

 Exotic option - any of a broad category of options that may

include complex financial structures.

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 Vanilla option - any option that is not exotic.

PUT OPTION
A put option (usually just called a "put") is a financial contract

between two parties, the writer (seller) and the buyer of the option.

The buyer acquires a short position by purchasing the right to sell

the underlying instrument to the seller of the option for a specified

price (the strike price) during a specified period of time. If the option

buyer exercises their right, the seller is obligated to buy the

underlying instrument from them at the agreed upon strike price,

regardless of the current market price. In exchange for having this

option, the buyer pays the seller or option writer a fee (the option

premium).

By providing a guaranteed buyer and price for an underlying

instrument (for a specified span of time), put options offer insurance

against excessive loss. Similarly, the seller of put options profits by

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selling options that are not exercised. Such is the case when the

ongoing market value of the underlying instrument makes the

option unnecessary; i.e. the market value of the instrument remains

above the strike price during the option contract period.

Purchasers of put options may also profit from the ability to sell the

underlying instrument at an inflated price (relative to the current

market value) and repurchase their position at the much reduced

current market price.

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CALL OPTION
A call option, often it is simply labeled a "call", is a financial

contract between two parties, the buyer and the seller of this type of

option.[1] The buyer of the call option has the right, but not the

obligation to buy an agreed quantity of a particular commodity or

financial instrument (the underlying) from the seller of the option at

a certain time (the expiration date) for a certain price (the strike

price). The seller (or "writer") is obligated to sell the commodity or

financial instrument should the buyer so decide. The buyer pays a

fee (called a premium) for this right.

The buyer of a call option wants the price of the underlying

instrument to rise in the future; the seller either expects that it will

not, or is willing to give up some of the upside (profit) from a price

rise in return for the premium (paid immediately) and retaining the

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opportunity to make a gain up to the strike price (see below for

examples).

Call options are most profitable for the buyer when the

underlying instrument moves up, making the price of the underlying

instrument closer to, or above, and the strike price. The call buyer

believes it's likely the price of the underlying asset will rise by the

exercise date. The risk is limited to the premium. The profit for the

buyer can be very large, and is limited by how high underlying's spot

rises. When the price of the underlying instrument surpasses the

strike price, the option is said to be "in the money".

The call writer does not believe the price of the underlying

security is likely to rise. The writer sells the call to collect the

premium. The total loss, for the call writer, can be very large, and is

only limited by how high the underlying's spot price rises.

The initial transaction in this context (buying/selling a call

option) is not the supplying of a physical or financial asset (the

underlying instrument). Rather it is the granting of the right to buy

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the underlying asset, in exchange for a fee - the option price or

premium.

Exact specifications may differ depending on option style. A

European call option allows the holder to exercise the option (i.e., to

buy) only on the option expiration date. An American call option

allows exercise at any time during the life of the option.

Call options can be purchased on many financial instruments

other than stock in a corporation. Options can be purchased on

futures on interest rates, for example (see interest rate cap), and on

commodities like gold or crude oil. A trade able call option should

not be confused with either Incentive stock options or with a

warrant. An incentive stock option, the option to buy stock in a

particular company, is a right granted by a corporation to a

particular person (typically executives) to purchase treasury stock.

When an incentive stock option is exercised, new shares are issued.

Incentive stock options are not traded on the open market. In

contrast, when a call option is exercised, the underlying asset is

transferred from one owner to another.

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TERMINOLOGIES
1. Spot price:-The price at which an asset trades in the spot market.

2. Futures price: The price at which the futures contract trades in the
futures market.

3. Contract cycle: The period over which a contract trades. The

index futures contracts on the NSE have one- month, two-month
and three months expiry cycles which expire on the last Thursday
of the month.

4. Expiry date: It is the date specified in the futures contract. This is

the last day on which the contract will be traded, at the end of
which it will cease to exist.

5. Contract size:- The amount of asset that has to be delivered under

one contract. Also called as lot size.

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6. Initial margin:- The amount that must be deposited in the margin

account at the time a futures contract is first entered into is
known as initial margin.

7. Maintenance margin:- This is somewhat lower than the initial

margin. This is set to ensure that the balance in the margin
account never becomes negative. If the balance in the margin
account falls below the maintenance margin, the investor receives
a margin call and is expected to top up the margin account to the
initial margin level before trading commences on the next day.

8. 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.

9. 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.

10. Strike price:- The price specified in the options contract is

Known as the strike price or the exercise price.

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11. American options:- American options are options that can be

exercised at any time up to the expiration date. Most exchange-
traded options are American.

12. 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.

13. In-the-money option:- In call option in the money is when strike

price is less than spot price. In put option in the money is when
strike price is greater than spot price

14. At-the-money option:- At the money is when strike price is

equal to spot price in both call option and put option.

15. Out-of-the-money option:- In call option out of the money is

when strike price is greater than spot price. In put option out of
the money is when strike price is less than spot price

16. Intrinsic value of an option: The option premium can be

broken down into two components - intrinsic value and time
value. The intrinsic value of a call is the amount the option is ITM,

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if it is ITM. 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.

17. 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 OTM or ATM has only
time value. Usually, the maximum time value exists when the
option is ATM. 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.

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