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Options Basics

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11 views28 pages

Options Basics

Uploaded by

Hiten Sorathiya
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
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Unit 8

Options - Basic

Options are unique instruments that confer


right to buy/sell an asset at predetermined
price but create no obligation to do so.
Forwards and futures are the contracts that
create mutual and equal obligations on both
the parties, that is binding.
Options create obligation on one party while
confer a right on another.
Options - Basic

Options:
 Option is contract between buyer & seller.
 Buyer of option has right to buy or sell particular security
on or before a given date at a fixed price.
 Buyer of the option has option to buy or sell but not the
obligation, that is why it is called option.
 Options are traded on exchanges across globe.
 Options are traded on Securities like stock, bond,
interest rate, currency, commodity..etc.
 In 1970s first time options were traded on exchange –
Chicago Board of Trade (CBOT).
Options - Basic

Two types of options

Call Option

Put Option
Options - Basic

Call option:
 Buyer of call Option:
 Call option gives right to buy security at a fixed price on
or before particular date.
 But buyer of call option does not have any obligation to
compulsorily buy the option.
 So, buyer of call option will exercise his right to buy only
when he makes profit out of it otherwise he will not
exercise the right to buy the call option.
 Example: Investor buys call option for 50 shares on L&T
at strike price Rs. 1800, with 3-month expiry.
 It means in next 3 month investor has right to buy L&T
shares at Rs. 1800, if he does not buy the right to buy call
option, it will expire at the end of 3-month.
Options - Basic

Call option:
 Seller of call option:
 Seller of call option has obligation to sell security as and
when buyer of call option exercises his right to buy.
 So, seller of call option has no right but only obligation.
 For the above reason seller of the option charges
commission from buyer of option which is called “option
premium”.
 Till expiry of the contract if buyer of call option does not
exercise right to buy, then seller has nothing to lose he
will pocket the option premium.
 Option seller is called “Option writer”.
 Example: If investor exercise the right to buy call option
of 50 shares- L&T at strike price 1800, Option seller has
to sell 50 shares of L&T to the buyer.
Options - Basic

Put option:
 Buyer of put option:
 Put option gives right to sell security at a fixed price on or
before particular date.
 But buyer of put option does not have any obligation to
compulsorily sell the option.
 So, buyer of put option will exercise his right to sell only when
he makes profit out of it otherwise he will not exercise the right
to sell.
 Example: Investor buys put option for 50 shares on L&T at
strike price Rs. 1800, with 3-month expiry.
 It means in next 3 month investor has right to sell L&T shares
at Rs. 1800, if he does not buy the right to sell put option, it will
expire at the end of 3-month.
Options - Basic

Call option:
 Seller of call option:
 Seller of call option has obligation to sell security as and
when buyer of call option exercises his right to buy.
 So, seller of call option has no right but only obligation.
 For the above reason seller of the option charges
commission from buyer of option which is called “option
premium”.
 Till expiry of the contract if buyer of call option does not
exercise right to buy, then seller has nothing to lose he
will pocket the option premium.
 Option seller is called “Option writer”.
 Example: If investor exercise the right to buy call option
of 50 shares- L&T at strike price 1800, Option seller has
to sell 50 shares of L&T to the buyer.
Option Premium

While conferring a right to the holder, who is


under no obligation to perform, the writer is
entitled to charge a fee upfront. This upfront
amount is called the premium.
Premium is paid by holder to the writer to
induce him to grant the right.
The amount belongs to writer irrespective of
whether the option is exercised or not.
Premium is not adjustable against the future
payment that arise upon exercise of option.
Terminology used

 Call option: Buyer has right to buy security


 Put option: Buyer has right to sell security
 Strike price(exercise price) = Pre-agreed Price at
which option can be executed.
 Exercise date(Expiry date) = on or before this
date option contract can be executed.
 In the money(ITM): It is when buyer of option, is
already into profit.
 At the money(ATM) : It is when buyer of option has
strike price same as current market price.
 Out of the money(OTM): It is when buyer of option
is having loss if he exercise the option.
Call Option

A call option is a right but no obligation to


buy an asset at predetermined price within
the specified time.
 Holder of call option exercises the option when price
of underlying asset is more than the strike price.

 If spot price is less than the strike price the holder


lets the option expire as it is worthless.
Call option pay off

Value of the call option = Max (0, S - X) – c


 Where,
 S = Price of underlying security
 X = Strike price
 C = Premium on Call option
Pay off graph for Buyer of call option:

Example: Current market price of L &T is 1750.


Investor believe that stock will go up in next 3 months. To
take benefit of that investor buys 3-month call option at strike
price Rs.1800.The option premium the option buyer has to
pay to the option writer(seller) is Rs.100. Let us try to
connect this in below graph.
Pay off graph for Seller of call option:

 Example: Current market price of L &T is 1750. Investor


believe that stock will go up in next 3 months. To take benefit
of that investor buys 3-month call option at strike price
Rs.1800.The option premium the option buyer has to pay to
the option writer(seller) is Rs.100. Let us try to connect this
in below graph.
Put Option

A put option is a right but no obligation to


sell an asset at predetermined price within
the specified time.
 Holder of put option exercises the option when price
of underlying asset is less than the strike price.
 If spot price is more than the strike price the holder
lets the option expire as it is worthless.
Put option pay off

Value of put option = Max (0, X – S) – p


 Where,
 S = Price of underlying security
 X = Strike price
 p = Premium on Put option
Pay off graph for Buyer of put option:

Example: Current market price of L &T is 1750.


Investor believe that stock will go down in next 3 months. To
take benefit of that investor buys 3-month put option at strike
price Rs.1700.The option premium the option buyer has to
pay to the option writer(seller) is Rs.100. Let us try to
connect this in below graph.
Pay off graph for Seller of put option:

 Example: Current market price of L &T is 1750. Investor


believe that stock will go down in next 3 months. To take
benefit of that investor buys 3-month put option at strike
price Rs.1700.The option premium the option buyer has to
pay to the option writer(seller) is Rs.100. Let us try to
connect this in below graph.
Moneyness of the options

Moneyness of the option tells the benefit the


holder gets if he exercises the option.
Call option is in the money when the spot
price is more than the exercise price.
Put option is in the money when the spot
price is less than the exercise price.
Types of Options

Options can be categorized in number of


ways, such as:
 Based on nature of exercise of options,
 Based on how are they generated, traded and settled,
 Based on the underlying asset on which options are
created.
Types of Options

Based on nature of exercise of options:

American Option: American options can be


exercised at any point of time before the
expiry date of the option.

European Option: European options are


exercisable only upon maturity.
Types of Options

Based on how are they generated, traded


and settled:
Exchange Traded Options: Options traded
on exchanges are termed as Exchange traded
options.

 OTC(Over The Counter) Options: It tailor-


made to the requirement of the parties
involved and not traded on exchange.
Types of Options

Based on the underlying asset on which


options are created:

 Options are traded on underlying assets like;


bonds, equity shares, indices, commodity,
currency ,interest rates…etc.
Options quotations
Options quotations
Trading & settlement

Prior to expiry options can be settled


 if American or by selling them prior to maturity OR
 On maturity, they expire automatically.

For exchange traded option the buyer and


seller enter the contract, with buyer and
seller unknown to each other.
Adjustment for Corporate Actions

 Adjustment of dividend: Options traded on the stock


exchanges do not provide for adjustment of dividend unless
they are special in nature.
 Adjustment for bonus shares: Bonus affects the price of
shares substantially as the larger number of shares becomes
available for the same value.
 For parity of cum-bonus and ex-bonus following adjustments
are made: Number of shares in the contract must increase by
(1+ bonus ratio),
 The strike price must reduce to 1/(1 + bonus ratio)

 Adjustment for the stock splits: Under stock splits the


number of shares increase with exercise price reduced
proportionately.
Forward/Futures V/S Options

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