Options – basic concepts

Session 5 – Derivatives & Risk Management

Prof. Aparna Bhat
 What this session will cover
⚫ Key terminology
⚫ Contract specifications
⚫ Concepts of moneyness, intrinsic value & time value
⚫ The four basic option positions
⚫ Option payoffs
⚫ Early exercise
⚫ Factors affecting option price
⚫ Put-call parity and arbitrage
⚫ Hedging with options

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 What are Options?
⚫ An option is a contract that gives the buyer of the option the right, but
not an obligation, to buy or sell the underlying asset on or before a
specified date at a predetermined price
⚫ Option holder / long position - person buying the option
⚫ Option seller/ option writer / short position - person selling the option
⚫ Option premium - Price paid by option buyer to seller for buying the
option
⚫ Strike price / Exercise price - predetermined price at which the underlying
asset can be bought or sold
⚫ Expiry date – date on or before which the option buyer can exercise the
option
⚫ Time to maturity – the number of days till the expiry date of the option

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 Type of Options

Call options Put options

An option which gives the An option which gives the
option buyer the right, but option buyer the right, but
not the obligation, to buy not the obligation, to sell
the underlying asset the underlying asset
The buyer can exercise his The buyer can exercise his
right to buy at a right to sell at a
predetermined price and on predetermined price and on
or before a predetermined or before a predetermined
date date
In both cases, the option seller is under obligation to honour the contract if
the option buyer decides to exercise his right 4
 Exercise style of options
⚫ A European option – Option buyer can exercise this only
on its expiry date
⚫ An American option – Option buyer can exercise this on
any day prior to expiry
⚫ All stock and index options in India are European style
options
⚫ When a buyer exercises an option, the same is randomly
allocated or assigned to any of the sellers of that option
contract

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 Specifications of index and stock
options - NSE
Nifty NiftyBank NiftyFinancial Nifty Midcap Nifty Next 50 Stock options
Services select

Contract size 25 15 40 75 10 Stock-specific

Contract cycle for weekly 4 weekly expiration contracts No weekly No weekly options
options options
Contract cycle for monthly 3 monthly expiration contracts - near month, mid-month and far month
options
Contract cycle for quarterly 3 quarterly expiries in March, No quarterly expiry cycles
options June, September and December
cycle
Contract cycle for long-term 8 half-yearly No long-term options
options expiries after
the quarterly
expiries

Expiry day Last Last Wednesday of Last Tuesday of Last Monday Last Friday of Last Thursday of expiry
Thursday of expiry month expiry month of expiry expiry month month
expiry month month

Tick size Rs.0.05 Rs.0.05 Rs.0.05 Rs.0.05 Rs.0.05 Rs.0.05

Final settlement price Closing price of underlying index or stock in cash market on last trading day
Trading hours 9:15 am to 3:30 pm
6 Delivery terms Cash settlement Physical settlement
 Option moneyness
⚫ At-the-money option (ATM)
⚫ An option with a strike price that is equal to or closest to the spot price
⚫ Leads to zero cashflow if exercised immediately
⚫ In-the-money option(ITM)
⚫ Leads to positive cashflow if exercised immediately
⚫ A call option is ITM when the spot price is higher than the option’s strike
price, i.e. S > K
⚫ A put option is ITM when the option’s strike price is higher than the spot
price, i.e. K > S
⚫ Out-of-the-money options (OTM)
⚫ Leads to negative cashflow if exercised immediately
⚫ A call is OTM when the spot price is lower than the strike price, i.e. S < K
⚫ A put is OTM when the strike price is lower than the spot price, i.e., K < S

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 Intrinsic value and Time value of an
option

Option
premium

Intrinsic
Time value
value

For call and

For call For put puts
options options Premium
max( max() less Intrinsic
value

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 Intrinsic value and Time value of an
option
⚫ Intrinsic value can be either zero or positive, but never negative;
why?
⚫ Intrinsic value is largest for ITM options, very small for ATM
options and zero for OTM options
⚫ An option with some days remaining till maturity will normally
trade at a premium that is higher than its intrinsic value
⚫ Time value = Option premium less option’s intrinsic value
⚫ The time value of an option is zero on the expiry date as the life of
the option comes to an end
⚫ On expiration date, the option will be worth either its intrinsic
value (if it is ITM) or zero (if it is OTM)
⚫ Time value is largest for ATM options and lowest for ITM options

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 Option positions

Opening purchase Opening sale

Or Or
“Buy to open” “Sell to open”
Creating a new/ adding to
Creating a new/ adding to
an existing long position
an existing short position

Closing purchase Closing sale

Or Or
“Buy to close” “Sell to close”
Reducing or eliminating an Reducing or eliminating an
existing short position existing long position

The existing position may be in a call or a put option

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 The basic option positions

Long call – Call buyer has the right but not

obligation to buy underlying asset at the strike
price
Short call – Call seller is under obligation to sell
the underlying stock to call buyer if the call
buyer exercises the call
Long put – Put buyer has the right but not
obligation to sell underlying asset at the strike
price
Short put – Put seller is under obligation to buy
the underlying stock from put buyer if the put
buyer exercises the put

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 Long Call

Profit from buying one European call option: option price =

Rs.5, strike price = Rs.100, option life = 2 months

30 Profit (Rs.)

20

10 Terminal
70 80 90 100 stock price (Rs.)
0
-5 110 120 130

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 Short call
⚫ Profit from writing a European call option: option price =
Rs.5, strike price = Rs.100

Profit (Rs.)
5 110 120 130
0
70 80 90 100 Terminal
-10 stock price (Rs.)

-20

-30

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 Long put
Profit from buying a European put option: option price = Rs.7,
strike price = Rs.70

30 Profit (Rs.)

20

10 Terminal
stock price (Rs.)
0
40 50 60 70 80 90 100
-7

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 Short Put
⚫ Profit from writing a European put option: option price =
Rs.7, strike price = Rs.70

Profit (Rs.)
Terminal
7
40 50 60 stock price (Rs.)
0
70 80 90 100
-10

-20

-30

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 Option payoff
Option payoff is the amount that option
holder receives on exercising the option

Payoff for call buyer = max(

Payoff for put buyer = max()
Option payoff is either positive or zero for
option buyer

Payoff for call seller = - max(

Payoff for put seller = - max()
Option payoff is either zero or negative for
option seller

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 Question
⚫ Shares of RIL are being traded at Rs.3120. What is the
break-even price beyond which a put position on RIL
with a strike price of 3050 and sold at Rs.12, will incur
a loss?
⚫ Rs.3062
⚫ Rs.3132
⚫ Rs.3108
⚫ Rs.3038

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 Early exercise of options

⚫ Early exercise means exercising the option before its expiry

date; only possible for American options
⚫ An American call option on a stock should not be exercised
early if no dividend is expected before expiry date
⚫ No income is sacrificed
⚫ Payment of the strike price is delayed
⚫ By selling the call instead of exercising, holder gets time value as
well as intrinsic value
⚫ An American put option on a stock should be exercised early
if the put is sufficiently in-the-money; i.e. stock price is well
below the exercise price

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 Factors affecting the option price

Parameter Call price Put price

Spot price (S) Increases as S rises Declines as S rises

Strike price (K) Declines for higher K Increases for higher K

Time to expiry (T) Increases for higher T Increases for higher T
Volatility of underlying Increases with higher v Increases with higher v
(v)
Interest rates (r) Increases with higher r Declines with higher r
Dividend (D) Declines with higher D Increases with higher D

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 Put-call parity
⚫

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 Arbitrage with put-call parity

⚫ Suppose that
c=2 S0 = 80
T = 2 months r = 6%
K = 85 D=0
⚫ What is the price of put with strike of 85 and 2
months to maturity?
⚫ What if the put is selling at 8?

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 Example of Put-call parity arbitrage
SBI shares are traded at Rs.841.40. A call with a strike price
of 840 and expiring after 14 days is traded at Rs.17.10.
What should be the fair price of a similar put on SBI, if the
interest rate is 8% p.a.? If the put is traded at Rs.15.75, is
there an arbitrage opportunity?

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 Solution

• The put is overpriced • Scenario 1

• Short the put @15.75, short the stock • The stock price is Rs.830 on expiry
@ 841.40 and buy the call @17.10 • Investment yields Rs.842.63
• Invest the net proceeds @8% p.a. for • The short put will be exercised at
14 days 840 and the call will expire OTM
• Take delivery of the stock by paying
Rs.840 and close the short stock
position
• Scenario 2
• Profit = Rs.2.63
• The stock price is Rs.850 on expiry
• Investment yields Rs.842.63
• Exercise the long call while the short put
expires OTM
• Take delivery of the stock by paying Rs.840
and close the short stock position
• Profit = Rs.2.63

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 Hedging using options
⚫ Both call and put options can be used for hedging

To protect To protect
against risk of against risk of
rise in the fall in the
underlying underlying
price price

Buy a call on Buy a put on

the underlying the underlying

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 Example – hedging with call options
Mr. A wants to buy shares of ABC Ltd one month from
today. The shares are currently trading at Rs.432. He
buys a one-month call option on the shares with a strike
price of 435 and a lot size of 1600 paying a premium of
Rs. 9600 (1600 X 6).

• After 1 month, the • After 1 month, the

stock price is stock price is
Rs.450. Rs.410
• Mr. A exercises • The call expires
the call OTM
• Purchases the • He buys the
shares at Rs.435. shares at Rs.410
• Total cost = 441 • Total cost = 416
(435 + 6) (410 + 6)

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