Options

Option
• An Option is a derivative instrument which
gives a right to its buyer :
a) either to buy the asset; or
b) sell the asset
without obligation, at a specified time and for
a specified price.

Based on the right, Options are classified into:

1) A Call Option that gives a right to buy.
2) A Put Option gives the right to sell.
• Mr X bought a 1 month Call Option on
Reliance Ind. for a price of ₹1500. After 1
month, the price of Reliance Ind is ₹1400.
Will Mr X exercise his right ?

NO ! When the Price is 1400 why would he buy at 1500 ?

• What if the Price of Reliance on expiry is

₹1555 ?

Yes ! When the Price is 1555 , X would be happy to buy at 1500…

• You bought a 1 month Call Option expiring
on 31st March on US $ at ₹72. On expiry, the
reference rate for $ is ₹73.20. Will you
exercise your right ?
Yes ! When the Price is 73.20, you would be willing to buy at 72

• What if the Price of $ on expiry is ₹69.80 ?

No. When the Price is 69.80 , You would not pay ₹72 …
• Mr Y bought a 1 month Put Option on ITC Ltd. for
a price of ₹230. After 1 month, the price of ITC is
₹222. Will Y exercise his right ?
Yes ….
When the Price is 222, he would be happy to sell at 230

• What if the Price of ITC on expiry is ₹250 ?

No ….
When the Price is 250 , Y would not sell at 230
• You bought a 1 month Put Option on € for a price of
₹75. After 1 month, the price of € is ₹77.60. Will
you exercise your right ?
No ….
When the Price is 77.60, you would not sell it for 75

• What if the Price of € on expiry is ₹72 ?

Yes ….
When the Price is 72 , we would like to sell at 75
 Option Terminologies
• Strike Price / Exercise Price :

It is the price at which the buyer has a right to buy or sell.

The strike prices are set by the exchange.

The trader only chooses the strike price based on his view.

• Cash / Spot Price :

It is the price at which the underlying asset trades in the

Cash Market.

Options are settled based on the underlying cash price.

 At, In and Out of the Money
Moneyness of an Option is the relationship between the
strike price and spot price.
Type Call Put

At the Money Strike = Spot Strike = Spot

In the Money Strike < Spot Strike > Spot
Out of the Strike > Spot Strike < Spot
Money

If the Option has value, it is considered In the Money.

Options that are far in the money and far out of the money are called Deep In the
Money and Deep Out of the Money options.
Mr A bought a 1 month Call Option on
Dena Bank with a Strike Price of ₹50,
when the cash price is ₹48. This option is
At or In or Out of the Money ?

Out of the Money

Mr C bought a 1 month Put Option on Nifty
for a price of ₹5950 when Cash Nifty was
5900. This Option is ?

In the Money
You bought a 1 month Call option on
Ranbaxy for a Price of ₹340 when the
cash price of the share is ₹355. So is this
option At or In or Out of the money ?

In the Money
Mr D bought a 1 month Put Option on
Reliance Capital for a price of ₹330 when
the cash price of Reliance Capital is ₹352.
This Option is ?

OUT of the Money

 Option Terminologies
• Expiration Date :
Options are limited by time. It is the day on
which the option expires.

• Exchange listed options normally have a

short expiration dates. For eg. 1 to 3
months.

• Options with long expiration dates( > 1 year )

are called LEAPS ( Long Term Equity
Anticipatory Securities ).
 Premium
It is the cost of the right.

It is paid by the buyer to the seller.

It is paid as and when the contract is entered

into.

This is the only payment that the buyer has to

make in case the option is settled by cash.

This is the maximum loss that the buyer has to

bear.
 Intrinsic Value and Time Value
• Premium consists of two components.

• Intrinsic Value and Time Value ( Speculative Value )

• Premium = Intrinsic Value + Time Value

• Intrinsic Value is the value that an option would have if the

right is exercised immediately.

• The difference between the cost of the option and its

intrinsic value is called Time Value. ( Premium – Intrinsic )

• On expiry the time value becomes zero.

Mr James bought a 1 month call option on
SAIL with a Strike Price of ₹55 for a
premium of ₹0.25 when the cash price of
SAIL was ₹52.50. What is the Intrinsic and
Time Value of the Option?
Intrinsic Value = Rs 0
Time Value = 25 Paise
Mr Pai bought a 1 month call option on
GAIL with a Strike Price of ₹330 for a
premium of ₹8.25 when the cash price of
GAIL was ₹336. What is the Intrinsic and
Time Value of the Option?

Intrinsic Value = 6
Time Value = ₹ 2.25 i.e.(₹ 8.25 - 6 )
Mr Mohan bought a 1 month Put Option on
Nifty with a strike price of ₹5950 for a
premium of ₹60 when the cash nifty was
trading at ₹5970. What is the Intrinsic & Time
value of the Put ?

Intrinsic Value = 0
Time Value = 60
A Put option on DLF with a Strike Price of
₹135 is trading at a premium of ₹4.65 when
the cash price of DLF is 133. The Intrinsic
Value and Time Value of this Option is ?

Intrinsic Value = 2
Time Value = 2.65 i.e. ( 4.65 – 2 )
 American & European Options
• American Options can be exercised by the
buyer anytime before expiry.

• European Options can be exercised by the

buyer only on the day of expiry.

• Stock Options on NSE are traded on

European basis.

• American options are priced higher

compared to European Options.
1) Stock Price
2) Strike Price
3) Time to Expiry
4) Volatility
5) Dividend
6) Risk Free Interest Rate
 Factors affecting Premiums – Spot Price

• A Call Option Premium increases when stock price

increases.
• A Call Option Premium decreases when the stock
price decreases.
• At expiration, a call option is worth either zero or
the difference the underlying price and the exercise
price, whichever is greater.
• )
= Call Option
– X = Exercise price
= Price of the underlying asset at time 0 (today) and Time
(expiration)
Factors affecting Premiums – Spot Price
• Put Option Premium increases when the stock
price decreases.
• Put Option Premium decreases when the stock
price increases.
• At expiration, a Put option is worth either zero or the
difference between the exercise price and the
underlying price, whichever is greater.
)
= Put Option
– X = Exercise price
= Price of the underlying asset at time 0 (today) and Time
(expiration)
 Factors affecting Premiums – Strike Price

• Call Option Premium increases with lower Strike

Price.
• Call Option Premium decreases with higher Strike
Price.

• Put Option Premium increases with higher Strike

Price.
• Put Option Premium decreases with lower Strike
Price.
 Factors affecting Premiums :Time to Expiry
• More the time to expiry, more the time value
of an option.

• Option prices are directly related to the time

remaining.

• On expiry the time value of an option is zero.

• So time value of an option keeps on

decreasing along with the time.
 Factors affecting Premiums :Volatility
• Volatility is a measure of how fast the underlying changes in price.

• Volatility or Variability are indicators of risk.

• Buyer of a Call benefits from price increase.

• Buyer of a Call has a limited downside risk in case price decreases.

• Buyer of a Put benefits from price decrease.

• Buyer of a Put has limited downside risk in case price increases.

• So Volatility benefits the Buyer of an Option.

• The value of both calls and puts increase as volatility

increases.

• Higher the volatility more the speculative value of an option.

 Factors affecting Premiums : Dividends
• Dividends have the effect of reducing the stock price on ex dividend
date.

• With this Call Option loses value and Put Option gains value.

• Value of a Call Option is Negatively related to anticipated dividends.

• Value of a Put Options is Positively related to dividends.

 Factors affecting Premiums : Interest Rate
• The relationship is not clearly definable.

• In increasing interest rate situation, investors tends to buy Call Option rather
than buying the actual stock.

• With this the differential amount can be invested at a higher rate of interest.

• This pushes up the Call Option Prices and pushes down Put Premiums.

• Contrary View :

• When Interest Rate in the economy increases, the stock prices tend to fall.

• With this, Call Option Value decreases and Put Option Value increases.

• When Interest Rate in the economy decreases, the stock prices go up.

• This increases Call Value and reduces Put Value.

 Payoff for a Buyer of an Option
• The buyer has to pay the premium on entering
into the contract.

• Premium is the only payment that flows from the

buyer in case of cash settlement.

• Premium is the maximum loss that a buyer can

incur.

• The profit potential for the buyer of an option is

unlimited ( limited to price in case of a put ).
Pay Off Profile Graph
Payoff for a Buyer of a Call

Break Even
Payoff for a Buyer of a Put
Mr Raj buys 1 contract ( 1000 shares ) of 1month Call Option
on SAIL with a Strike Price of ₹ 60 for a premium of ₹ 2 when
the cash price is ₹ 58. On expiry, the price of SAIL in the Cash
market was ₹ 66. What is the net profit or loss to Mr. Raj on
expiry?

Profit = ( 66 -60) – 2 = ₹ 4 x 1000 shares = ₹ 4000

What is the net profit or loss if the closing price is ₹ 70 ?

Profit = ( 70-60 ) – 2 = ₹ 8 x 1000 Shares = ₹ 8000

What is the net profit or loss if the closing price is ₹ 42 ?

As there is no obligation to buy, Mr. Raj will forego his right.

The premium is lost. So, loss = ₹2 x 1000 = ₹2000
Ms. Mala buys 4 contracts ( 50 per contract ) of 1
month Nifty Puts with a strike price of ₹5880 for a
premium of ₹54 when cash nifty was at 5871. What
is her net profit or loss if the closing price of nifty is
₹5726 ?
Profit = ( 5880 -5726) – 54 = 100 x 50 x 4 = ₹20000

What is the P / L if Nifty is 5968 ?

Loss = Premium = 54 x 50 x 4 = ₹10800

 Liquidating an Option
• The Buyer of an option can liquidate his
position :
a) by squaring up (entering into an opposite trade –Sale )
b) by exercising the right
c) by letting the option expire
Liquidating an Option – Squaring Up
• Options are traded based on Premium.

• Premiums on Options go up and down due to various factors.

• Such factors includes change in the price of the underlying asset and
changes in time.

• In squaring up, the buyer enters into an opposite trade ie. sells the
option.

• On sale of the Option he receives premium.

• So, the profit or loss on squaring up, depends on the difference of

premiums – ( Prem. recd. on Sale – Prem. paid on Purchase )

• Irrespective of the expiry, an option can be squared up anytime.

Mr. James bought 31st Oct. expiry Call (E) option
on Tisco with a Strike Price of ₹300 for a
premium of ₹14.50 when the Cash Price is ₹293.
After 10 days, the same Strike Price is trading at
a premium of ₹24 and the Cash Price is ₹306.

What is the P / L to Mr James if he liquidates this

option by squaring up ?

Profit = ( 24 – 14.5 ) = ₹9.50

You bought 31st Oct. expiry Put (E) option on
Hind. Unilever with a Strike Price of ₹600 for a
premium of ₹13.50 when the Cash Price is ₹627.
After 10 days, the same Strike Price is trading at
a premium of ₹9.50 and the Cash Price is ₹642.

What is the P / L if you square up ?

Loss = ( 9.50 – 13.5 ) = ₹4.00

 Liquidating an Option - Exercise
• The buyer of an option has the right to buy or sell the
underlying asset.
• This right can be exercised by him any time in case of an
American Option.
• The right can be exercised by the buyer only on expiry
date in case of a European Option.
• Exercise is done by notifying the exchange.
• When an option is exercised the same is assigned by
the exchange to a writer randomly.
 Liquidating an Option – Exercise

• Options are exercised when the premiums do

not reflect the intrinsic value. ( Normally deep in
the money and very near to expiration )

• Options can also be exercised if the buyer

requires delivery of the underlying asset.
You bought a 31st Oct. Call option(A) on SBI with a Strike
Price of ₹1700 for a premium of ₹85 when the Cash Price is
₹1685. After 25 days, the same Strike Price is trading at a
premium of ₹32 and the Cash Price is ₹1750. What would
you do if you want to liquidate the option ?

Loss on Square Off = ( 32 – 85 ) = - 53

Loss on Exercise = (1750 - 1700) - 85 = - 35

As the Option is American, to exit the option we Exercise the Option

You bought a 31st Oct. Put (A) on ONGC with a Strike Price
of ₹270 for a premium of ₹9 when the Cash Price is ₹275.
After 15 days, the same Strike Price is trading at a premium
of ₹14 and the Cash Price is ₹260. What would you do if you
want to liquidate the option ?

Profit on Square Off = ( 14 – 9 ) = 5

Profit on Exercise = ( 270 - 260) – 9 = 1

 Liquidating the Option – Letting it Expire
• Options are limited by time.

• Options expire on the expiry date.

• A buyer can sell or exercise the option before expiry.

• If the buyer does not sell nor exercise before expiry, then
the option expires automatically.

• At and Out of the Money Options expire worthless.

• In the money options expire with intrinsic value.

• If the option is in the money on expiry, the intrinsic value

is paid out to the buyer of the option.
Mr Kishore bought 1 Contract ( 1000 USD ) of a 29th Oct. Put
(E) on $ with a Strike Price of ₹82 for a premium of ₹1.50
when the reference rate was ₹82.60. He did not square up
nor exercise the option. On expiry date, if the reference rate
of $ is ₹81.20, what will happen to the Option ?

• In the money …. ( 82 – 81.20 ) = ₹0.80 x 1000 = ₹800

• Option expires with intrinsic value and exchange pays out ₹800

• Loss to Kishore = ( 800 -1500 ) = -700

What happens if the reference price on expiry is ₹82.40 ?

• The Option on expiry is Out of the money … so expires worthless

• Loss to Kishore = 1500

You bought 1 Contract ( 50 ) of a 31st Oct. Call (A) on Nifty
with a Strike Price of 5950 for a premium of ₹160 when cash
Nifty was 5880. He did not square up nor exercise the option.
On expiry date, cash Nifty closed at ₹5930. What will happen
to the Option ?
• The Option on expiry is Out of the money … so expires worthless

• Loss = 160 x 50 = ₹8000

What happens if the Nifty on expiry is ₹6040 ?

• In the money …. ( 6040 – 5950 ) = ₹90 x 50 = ₹4500

• Option expires with intrinsic value and exchange pays out ₹4500

• Profit = 4500 – ( 160 x 50 ) = 3500

 Selling / Writing an Option
• Seller of an Option is called the Writer of Option.

• He receives the premium paid by the buyer on entering into the

contract.

• He is obligated to buy or sell the underlying if the right is exercised

by the buyer.

• His payoff is just the opposite of the buyer.

• Profits are limited to premium received.

• Losses are unlimited / undetermined.

• The seller of an option since carries an unlimited loss is subject to

margin requirements.
• Mr Anand wrote a 1 month Call Option on SBI with a Strike
Price of ₹1650 for a Premium of ₹70 when the Cash Price
was ₹1620. On expiry the Cash Price of SBI was ₹1720.
What is the Net Profit or Loss to Mr. Anand ?

Net Profit = (1650-1720)+70

Net Profit = 0
• Mr Ahmed wrote a 1 month Put Option on TISCO with a
Strike Price of ₹270 for a Premium of ₹15 when the Cash
Price was ₹270. On expiry the Cash Price of TISCO was
₹242. What is the Net Profit or Loss to Mr Ahmed ?

Net Loss = (242-270) +15 = 13

 Liquidating a Sale Position
• The writers position can be liquidated in either of the following
modes :

1) Cover the Sale Position :

In such a case, he will buy back the option he sold earlier. The profit
or loss is the difference in premiums received and paid.

2) Option is Assigned :
When a buyer exercises the option, the exchange assigns the same
to a writer.
In such a case, the profit or loss is the difference in the prices.

3) Let the Option Expire :

An At and Out of the money option expires worthless. In such a case
the writer retains the premium received by him on sale.

An In the money option expires with intrinsic value. In such a case,

the writer has to pay up the intrinsic value.
Payoff for Writer of a Call
Payoff for Writer of a Put
Mr Rakesh wrote a 1 month Call with a
Strike Price of ₹180 for a premium of ₹14
when the cash price of the asset was
₹184. After 5 days, the same strike price
call was trading at a premium of ₹6. What
is the P / L to Mr Rakesh if he buys back
his position ?

Profit = ( 14 – 6 ) = ₹8
Mr Gopal wrote a 1 month Put with a Strike
Price of ₹640 for a premium of ₹22 when the
cash price of the asset was ₹636. After 5
days, the contract was assigned to him by the
exchange. On the day of assignment, the
strike price closed at a premium of ₹26 and
the closing price of the underlying stock was
₹630. What is P / L to Mr. Gopal on
assignment ?

In the money …. Gopal has to pay up the intrinsic value

= ( 640 -630 ) = ₹10
Net Profit = ( 22 -10 ) = ₹12
A 1 month Put Option on Nifty was written
with a Strike Price of ₹5100 for a Premium
of ₹74 when Nifty was trading at 5110.
This option was not bought back nor
assigned. On the day of expiry, Nifty
closed at 5021. What happens to this
Option ?

In the money …. Writer has to pay the intrinsic value.

= ( 5100 -5021 ) = ₹79
Net Loss = ( 79 -74 ) = ₹5