Contents

1. Options : Introduction 1.1 KEY ELEMENTS OF OPTIONS 1.2 OPTIONS STYLES 1.3 TYPES OF OPTIONS 1. Ca Option 2. Put Option 1.! Option Positions 1." #nder $in% &ssets o' Options 1. E(c)an%e Traded Options 2. O*er+ t)e+ counter Options 1., Option Strate%ies 1. Protecti*e Put 2. Co*ered Ca 3. Stradd e !. Spread ". Co ar 1.- Put+ Ca .e ations)ip 1. Put Parit$ T)eore/ 1.0 1a uation Mode s 1. 2ino/ia Option Pricin% 2. 2 ac3+Sc)o es Option Pricin% 1.4 I/p ied 1o ati it$ 3 2 2 1 1 1 1

OPTIONS: Introduction
An option is a derivative financial instrument. It is a contract between two parties for a future transaction on an asset at a reference price. The buyer of the options gains the right, but not the obligation, to engage in that transaction, while the seller incurs the corresponding obligation to fulfill the transaction.

1.1 KEY ELEMENTS OF OPTIONS

1) The date specified in the contract is known as the Expiration date, the exercise date, the strike date or the maturity. If the option is not exercised by the expiration date, it becomes void and worthless ) The reference price at which the underlying asset may be traded specified in the contract is known as the exercise price or strike price. !) The process of activating an option and thereby trading the underlying at the agreed" upon price is known as exercising the option. #) The premium is the purchase price of the option $paid when the option is purchased, regardless of whether the option is exercised or not) %) The writer is the person who initially sells the option

1.2 OPTIONS STYLES:

1) &/erican options : they can be exercised at any time up to the expiration date ) European options: they can be exercised only on the expiration date.

1.3 TYPES OF OPTIONS

There are two basic types of options. 1) Ca Options : A contract whose holder $buyer) has the right, but not the obligation, to buy The underlying asset at a fixed price $exercise price &), on or before the expiration date. For the holder of the call option, The net profit is Profit = Value at expiration Premium !" #ets take an example$ An investor buys a &uropean call option with a strike price of '1(( to purchase 1(( shares )urrent stock price * '+, &xpiration date of option * four months. The price of an option to purchase one share is '%. The initial investment is '%((. -ince the option is &uropean, the investor can exercise only on the expiration date. If the stock price on this date is less that '1((, the investor will choose not to exercise it. -o, the investor

loses the whole of initial investment of '%((. If the stock price is '11%. .y exercising the option, the investor is able to buy 1(( shares for '1(( per share. If shares are sold, the investor makes a gain of '1% per share or '1%((, ignoring the transaction cost. -o, the net profit of the investor is '1(((. .ut if the /icrosoft0s stock price is '1( at the expiration date. The investor would exercise the option at a gain of 1(( 1 $'1( " '1(() * ' ((. And there is a loss of '!((. If investors didn0t exercise the option, there would be an overall loss of '%((, which is worse than the '!(( loss. -o, call options should always be exercised on the expiration date if the stock price is above the strike price. 8ayoff * 9alue at 8ayoffs &xpiration :et 8rofit 1 -$T)

) Fi%. 1. C&LL OPTIONS : FO. 5OL6E.

728 Put Option: A contract whose holder $buyer) has the right to sell the underlying asset at a price before the expiration time. The purchaser of a put option hopes that the stock price will decrease. Profits for the holder of the put option, The net profit is Profit = Value at expiration Premium P" 2et0s take an example3 A &uropean put option is to sell 1(( shares in 4racle with a strike price of '5(. -uppose the current stock price is '6%, the expiration date of the option is in three months, and the price of an option to sell one share is '5. The initial investment in '5((. -uppose the stock price on expiration date is '%%. The investor can buy 1(( shares for '%% per share and sell the same shares for '5( to reali7e a gain of '1% per share or, '1%((. -o, the net profit is ',((. If the final stock price is above '5(, the put option is worthless, and the investor loses '5((.

8ayof 8rofit * 9alue at &xpiration

:et 8rofit

1 1

-$T)

Fi% 2. Put Options : 5o der

1.! OPTION POSITIONS

There are two sides to every option contract. 4n one side is the investor who has taken the long position $i.e. ;as bought the option) and the other side is the investor who has taken the short position $i.e. has sold or written the option). The writer of an option receives cash up front. The writer0s profit or loss is exactly opposite of that for the purchaser of the option. There are four types of option positions$ i" ii" % long position in a call option % short position in call option ii" a long position in a put option i&" % short position in put option

T)e ter/ina *a ue or t)e pa$o'' to t)e in*estor at /aturit$: If 9 is t)e stri3e price and S7T8 is t)e 'ina price of the underlying asset,

T)e pa$o'' 'ro/ a on% position in a European ca option is Pa$o'' to ca )o der : S7T8 ; 9 < i' S7T8 = 9 : > < i' S7T8 ? 9
The option will be exercised if -$T) < ( and will not be exercised if -$T) = (

T)e pa$o'' to t)e )o der o' a s)ort position in a European Put Option is Pa$o'' to put )o der :>< i' S7T8 = 9 : 9 ; S7T8 < i' S7T8 ? 9 1." T5E #N6E.LYIN@ &SSETS OF OPTIONS
The 4ptions can be classified into the following types 3 718 E(c)an%e+ traded Options: These are also called >listed 'ptions?. They are a class of exchange"traded derivatives. &xchange"traded 4ptions have standardi7ed contracts, and are settled through a clearing house with fulfillment guaranteed by the credit of the exchange. They also have accurate pricing models. These include3 $i) -tock options $ii) .ond options and other interest rate options $iii) -tock market index options $iv) 4ptions on futures contracts $v) )allable bull@bear contract $ ) O*er+t)e ; counter Options: They are also called >dealer 'ptions?. They are traded between two private parties that are not listed on an exchange. The terms of these options are unrestricted and may be individually tailored to meet any business need. -ome of the commonly traded over the counter options include3 i" (nterest rate 'ptions ii" !urrency cross rate 'ptions iii" 'ptions on )waps

1., OPTION ST.&TE@IES 718 P.OTECTI1E P#T :

An investor who purchases a put option while holding shares of the underlying stock from a previous purchase is employing a >8rotective 8ut?. The investor employing the protective put strategy owns shares of underlying stock from a previous purchase, has unreali7ed profits accrued from an increase in value of those shares. The main concern is about unknown, downside market risks in the near term and wants some protection for the gains in share value. 8urchasing puts while holding shares of underlying stock is a bullish directional strategy. T)e *a ue o' protecti*e put at e(piration: S7T8 ? 9 S7T8 = 9 Pa$o'' o' Stoc3 S7T8 S7T8 Pa$o'' o' Put 9 ; S7T8 > Tota Pa$o'' 9 S7T8 8rotective 8ut 8ayoff 8ayof f 8rotective 8ut 8rofit

-tock 1 D $-$T) G 8)

1 8ut 8ayoff -$T )

Fi% 3. Protecti*e Put ; Pro'it o' 5o der

728 CO1E.E6 C&LL The covered call is a strategy in which an investor writes a call option contract while at the same time owning an eAuivalent number of shares of the underlying stock. If this stock is purchased simultaneously with writing the call contract, the strategy is referred to as a >.BC DEFIT&?. If the shares are already held from a previous purchase, it is referred as >49&FEFIT&?. This strategy combines the flexibility of listed options with stock ownership. This strategy is most often employed when the investor, while bullish on the underlying stock, feels that its market value will experience a little range over the lifetime of the call contract. The investor desires to either generate additional income from shares of underlying stock, or provide a limited amount of protection against a decline in underlying stock value.

1a ue o' Co*ered Ca at E(piration:

Pa$o'' o' Stoc3 Pa$o'' o' Ca Tota Pa$o'' 8ayoff 1 S7T8 ? 9 S7T8 > S7T8 -tock )overed )all 8ayoff )overed )all 8rofit 1 9 S7T8 = 9 S7T8 + 7S7T8 ; 98

Fi% ! .Co*ered Ca ; Pro'it o' 5o der 738 ST.&66LE :

A straddle is the simultaneous purchase of a call and a put on the same underlying security with both options having the same expirations and the same strike price. -ince straddle includes both a call and a put, the investor should have a complete understanding of the risks and rewards associated with both calls and puts. This strategy may prove beneficial when the investor feels large price movement, either up or down, is imminent but is uncertain of the direction. 1a ue o' Stradd e at E(piration S7T8 ? 9 Pa$o'' o' Ca Pa$o'' o' Put Tota Pa$o'' > + 7 S7T8 ;98 9 ; S7T8 S7T8 = 9 S7T8 + 9 > S7T8+ 9

$1G)) D -$()

)all 8ayoff

-$ T)

8ayof f 1 1D8* ) "8 ") "$8G))

-traddle 8ayoff) 1

)a ll -traddle 8rofits

8u t

-$ T)

Fi%. ". Stradd e ; Pro'it o' 5o der 7!8 SP.E&6S

This involves the purchase of combinations of two or more call options $or 8ut options) on the same stock, with different exercise prices or expiration dates. The money spread is eAual to the difference between the option exercise price. The time spread is the difference between the options is an expiration date. 1a ue o' Spread at Maturit$: S7T8 ? 91 91 ? S7T8 ? 92 S7T8 = 92 Pa$o'' o' on Ca 1 > S7T8 ; 91 S7T8 ; 91 Pa$o'' o' on Ca 2 > > + 7S7T8 ; 928 Tota Pa$o'' > S7T8 ; 91 92 ; 91

8ayoff )

)all .ought

8ayof f 1 D11 11

-pread 8ayoff

11

1 )all sold ) D )1

-pread 8rofit 1 -$T)

")1

Fi%. , Spread ;Ca s Pro'its and Pa$o''s

Fi% -. Pro'it o' 5o der

7"8 COLL&.
A collar can be established by holding shares of a stock, purchasing a protective put and writing a covered call on that stock. The option portion of this strategy is referred to as combination. The primary concern in employing a collar is protection of profits accrued from underlying shares rather than increasing returns on the upside. Investors use this strategy after accruing unreali7ed profits from the underlying shares, and want to protect these gains with the purchase of a protective put. 1a ue o' Co ar at Maturit$: S7T8 ? 91 91 ? S7T8 ? 92 S7T8 = 92 Pa$o'' o' on Stoc3 S7T8 S7T8 S7T8 Pa$o'' on Put 91 ; S7T8 > > Pa$o'' o' on Ca 2 > > + 7S7T8 ; 928 Tota Pa$o'' 91 S7T8 92 T)e Pa$o'' and t)e pro'it o' t)e )o der are eAua since t)e pre/iu/s cance out. 8ayoff -tock

)*8 11 1 1

)all -old

-$ T)

"8 * " )

8ut .ought

Fi% 0. Co ar ; Ca s Pro'its and Pa$o''s

1.- P#T ; C&LL P&.ITY .EL&TIONS5IP

This is an alternative strategy that provides the same type of protection as a protective put is a call with the same expiration date and strike price 1 and a riskless bond with a face value eAual to 1.

1a ue o' In*est/ent at Maturit$ :

Pa$o'' o' Stoc3 Pa$o'' o' Put Tota Pa$o'' S7T8 ? 9 > 9 9 S7T8 = 9 S7T8 + 9 9 S7T8

T)is is e(act $ t)e sa/e pa$o'' pattern as t)e protecti*e put.

Put ; Ca Parit$ T)eore/3 This is applicable only to &uropean 4ptions because they are
exercised only at maturity. &rBitra%e &r%u/ent : According to this argument, if two investments always have the same value, they should have the same price. The price of the protective put is the sum of put premium and the stock price at the time (. The sum of the price of the call and bond investment is the total of the call premium and the present discounted value of the bond $i.e. of 1)

So< C C 9D 71C r7'88ET : S7>8 C P

1.0 1&L#&TION MO6ELS:

The value of an option can be estimated using a variety of Auantitative techniAues based on the concept of risk neutral pricing and using stochastic calculus.

18 2ino/ia Option Pricin%:

This illustrates fundamental issues in option pricing. This shows how an option price can be derived from no"arbitrage"profits condition. 2et, - * current stock price

u * 1 G fraction of change in stock price if price goes up d * 1 G fraction of change in stock price if price goes down r * risk free interest rate. )* current price of call option )$u) * value of call next period if price is up )$d)* value of call next period if price is down & * strike price of the option ; * hedge ratio, number of shares purchased per call sold. The investor writes one call and buys ; shares of underlying stock. If price goes up, it will be worth u;- D )$u) If the price goes down, it will be worth d;- D )$d) ; * )$u) D )$d) @ $u"d) If an investor invested ;- D ) to achieve riskless return, the return must eAual to $1Gr) $;- D ))

728 2 ac3 ; Sc)o es Option Pricin%:

Hischer .lack and /yron -choles derived continuous time analogue of binomial formula, continuous trading for &uropean 4ptions only. The .lack"-choles continuous arbitrage is not really possible. )all T the time to exercise, I the variance of one"period price change $as fraction) and :$x) the standard cumulative normal distribution function $sigmoid curve, integral of normal bell"shaped curve) *normdist$x,(,1,1) &xcel $x, mean,standardJdev, ( for density, 1 for cum.)

C = SN( d1 ) EN(d 2 ) where S ln( ) + rT + 2T / 2 E d1 = T S ln( ) + rT 2T / 2 E d2 = T

1

3. I/p ied 1o ati it$ :

Turning around the .lack"-choles formula, one can find out what I would generate current stock price. I depends on the strike price, >options smile?

.e'erences 1. Fo)n C . 5u 7"t) Edition8 Options< Futures< and Ot)er 6eri*ati*es PuB is)er: Prentice 5a 2. Options Mar3ets : Introduction 3. .oBert G. Ko B 7 ! t) Edition8 Futures< options and SHaps Gi e$+2 ac3He < 2>>3 !. Mic)e Sincere< IKind e Edition #nderstandin% Options< 7Mc@raH+5i < 2>>,8. ". .. Ma)aJan< 7 3rd Edition8 < Futures K Options : Introduction to EAuit$ 6eri*ati*es< ,. N 6 1O5.&< 2 2a%ri< 7 2nd Edition8 < F#T#.ES &N6 OPTIONS< 7Mc@raH+5i 8.

-. S)e don NatenBer%< Option 1o ati it$ and Pricin%