Options

2-1 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 Definition
 An option is a contract that gives the buyer the
right, but not obligation to buy or sell an
underlying asset (commodities, foreign exchange,
stocks, shares etc.) at a predetermined price called
‘exercise price’ or ‘strike price’ on or before a
specific date in future.

2-2 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 Two parties are involved
 One party takes a long position i:e it buys the
option
 Other party takes a short position, i:e it sells the
option.
 The one who takes a short position is the one who
writes the option, and is the writer of the option

2-3 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 Types of options
 Call options: a call option is a contract who gives the owner the right
to buy an asset for a certain price on or before a specific date.
 Put options: a put option gives the owner the right to sell something
for a certain predetermined price on or before on or before a specified
date.
 Option type Buyer Option Writer of Option
(Long position) (Short position)
 Call right to buy obligation to sell asset
 Put right to sell obligation to buy asset

2-4 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 American Vs European Options

 An American option can be exercised by its

owner at any time on or before the expiration
date.
 In European options the owner can exercise his
right only on the expiration date and not before it.

2-5 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 Expiration Date

 The date mentioned in an options contract is called

expiration date or maturity date.

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 Exercise price
 In case of option on stocks the exercise price on which
option on a particular share are to be traded and selected
by the exchange
 Exercise price just above and below the current market
price of the underlying market share are opened for
trading.

2-7 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 Option Premium
 The buyer pays a premium to the seller which
belongs to the seller whether the option is
exercised or not.
 If the owner does not exercise the option the
amount premium becomes the profit of the option
writer.

2-8 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 Comparison of market price of the asset and the exercise price

 In-the-money: in a call option:

 If the price of the stock > Exercise price
 Out-of-the-money: in a call option:
 If the price of the stock < Exercise price
 In-the-money: in a put option:
 If the price of the stock < Exercise price
 Out-of-the-money: in a PUT option:
 If the price of the stock > Exercise price
 At-the-money: if the stock price = exercise price.

2-9 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 Comparison of market price of the asset and the exercise price

 Condition Call option Put Option

 So>E In-the-money out-of-the-money
 So<E out-of-the-money In-the-money
 So=E At-the-money At-the-money

2-10 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 Intrinsic value and time value

Termed as
Intrinsic value parity value
Premium or
price of an option
Termed as
Time value premium over
parity

2-11 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 Intrinsic value
 Intrinsic value refers to the amount by which it is in money if it is in-the-
money
 Therefore an option which is out-of-money or at-the-money has a zero
intrinsic value
 For call option which is in-the-money then intrinsic value is So-E
 While intrinsic value is zero other than in the money
 Intrinsic value of a call option= Max (0,So-E)
 For put option which is in-the-money then intrinsic value is E-So
 While intrinsic value is zero other than in the money
 Intrinsic value of a put option= Max (0,E-So)

2-12 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 Time Value
 Time value of an option is the difference between the
premium of the option and the intrinsic value
 For a call option or put option which is at-the-money or out-the-
money, the entire premium amount is the time-value
 In case of in the money options the time value is
 Time value of a call=C-{Max (0,So-E)}
 Time value of a put=P-{Max (0,E-So)}

2-13 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 Covered or Naked calls
 If the owner of the call decides to exercise the call, then the writer of
the call has the obligation to sell the underlying asset to the option
owner at the strike price
 The call writer might or might not be holding the asset.
 If the call writer owns the asset underlying the call, he/she is said to
have written a covered call
 If the call writer does not have the asset underlying the call option, the
call is said to be a naked call
 If it is a naked call the writer has to purchase the underlying asset at
the prevailing market price and give it to the call owner.
 Similar is in case of put option

2-14 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 Margin requirements
 The performance of the option contracts is assured by the Options
clearing corporations (OCC).
 Margin requirements exist as a form of collateral to ensure that the
writer of a naked call can fulfill the terms of the contract
 The requirements of margin vary depending upon the brokerage firm,
the price of the underlying asset, the price of the option and whether
the option is a call or a put.
 General rule: initial margins are at least 30% of the stock price when
option is written, plus the intrinsic value

2-15 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 Call option at expiration
 In-the-money condition:
 Intrinsic value=S1-E
 If the call price happens to be lower than the
intrinsic value, it would be profitable to buy the
call at C, exercise it immediately by paying an
amount E for the asset to be sold immediately in
the market at a price of S1to make a profit equal
to S1-E-C, because S1>E, and C<(S1-E)

2-16 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Value
Of call value
option

Exercise price Price of the share S1

E
Price of a call option is nil when the stock price falls short of the exercise price E, when
the stock price is greater than the exercise price, the call is worth S 1-E

2-17 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 value
Value of put
option

Exercise price
Price of the share S1
Put option is worthless for the range of stock prices greater than E, the exercise price
For the price below this, the worth of the put option equals the excess of exercise price
over the share price.
2-18 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 profit

1500

1000

500

500 90 100 110 120 130 140 150 160 stock price

1000

1500
2500

3000
Investor X
2-19 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 profit
3000
2000
1500
1000
500

500 90 100 110 120 130 140 150 160 stock price

1000

1500

For investor Y

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Possible price of ABC at Investor X Investor Y
call Maturity
90 1000 -1000
100 1000 -1000
110 1000 -1000
120 1000 -1000
130 0 0
140 -1000 1000
150 -2000 2000
160 -3000 3000
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Possible price of PQR at Investor X Investor Y
put Maturity
80 -2250 2250
90 -1250 1250
100 -250 250
110 750 750
120 750 750
130 750 750
140 750 750
150 750 750
2-22 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 Hedging using call and put options

 Hedging a long position in stock:

 Investor buying a common stock expects that its price
should increase
 However for the risk involved, a hedge can be formed
by buying a put.
 Consider an investor who buys a share for Rs. 100.
 To guard against risk he buys a put for Rs. 16 for an
exercise price of Rs. 110.

2-23 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Share price Exercise price Profit on Profit/loss on Net profit (i)+
exercise (i) share held (ii) (ii)
70 110 24 -30 -6

80 110 14 -20 -6

90 110 4 -10 -6

100 110 -6 0 -6

110 110 -16 10 -6

120 110 -16 20 4

130 110 -16 30 14

140 110 -16 40 24

2-24 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.