Options
The Upside Without Downside
Prof Mahesh Kumar
Amity Business School
profmaheshkumar@rediffmail.com
What is an Option?
An option is a contract between two parties in
which one party has the right but not the
obligation to do the something-usually to buy
or sell some underlying asset.
There are two parties to option contract-one
party that takes a long position i.e. buys the
option is known as the holder of the option and
the other party that takes a short position i.e.
sells the option is known as the writer of the
option.
Difference between forward futures and options
Forwards/ Future Option
Both the parties have The holder of the
committed to some option has the right
action. but not the obligation
to some action.
It costs a trader Purchase of an option
nothing (except for the requires an upfront
margin requirements) fees.
to enter into forward
or futures contract.
Types of Options
There are two basic types of options:
1. A call option which gives the holder of the
option the right to buy an asset by a certain
date for certain price.
2. A put option gives the holder of the right to
sell an asset by a certain date for a certain
price.
Option Type Buyer of Option Writer of Option
(Long Position) (Short Position)
Call Right to buy an asset Obligation to sell asset
Put Right to sell an asset Obligation to buy asset
Types of Options
The date specified in the contract is known as
the expiration date, the exercise date, the
strike date or the maturity.
The price specified in the contract is known as
the exercise price or strike price.
American option can be exercised at any time
up to the expiration date.
European option can be exercised only on the
expiration date itself.
Most of the options traded on exchange are
American.
Call Option
An investor buys a call option to purchase 100 IDBI
shares
Strike price= Rs.100
Current price= Rs.98
Price of an option to buy one share= Rs.5
The total initial investment is 100*5= Rs.500
1. If the price of IDBI at the expiration of option is say
Rs.90, then investor will lose Rs.500 (the price of
purchasing the option for 100 shares).
2. If the price of IDBI at the expiration of option is say
Rs.115. At this time option is exercised for a gain of
(Rs.115-Rs.100)*100= Rs.1500
When the initial cost of the option is taken into account
the net gain is Rs.1500-Rs.500= Rs.1000
Long Call
Profit from buying one European call option: option price
= Rs.5, strike price = Rs.100.
30 Profit (Rs.)
20
10 Terminal
70 80 90 100 stock price (Rs)
0
-5 110 120 130
Short Call
Profit from writing one 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
Put Option
An investor buys a European put option to purchase 100 ICICI
Bank shares
Strike price= Rs.700
Current price= Rs.650
Price of an option to buy one share= Rs.70
The total initial investment is 100*70= Rs.7000
1. If at the expiration of the option, ICICI Bank’s share price is above
Rs.700, then the holder of the option will not exercise the option
and will suffer the loss of Rs.7000 (Rs.70*100)- price of the
option.
2. If at the expiration of the option, ICICI Bank’s share price is say
Rs.550. At this time, the investor buys 100 ICICI Bank’s shares
and under the terms of put option, sells them for Rs.700 per share
to realize a gain of Rs.150 per share or Rs.15000 in total. When
the initial cost of the option is taken into account, the net gain is
Rs.15000-Rs.7000=Rs.8000
Long Put
Profit from buying a European put option: option price
= Rs.70, strike price = Rs.700
300 Profit (Rs)
200
100 Terminal
stock price (Rs)
0
400 500 600 700 800 900 1000
-70
Short Put
Profit from writing a European put option: option price
= Rs.70, strike price = Rs700
Profit (Rs.)
Terminal
70
400 500 600 stock price (Rs.)
0
700 800 900 1000
-100
-200
-300
Option Positions
There are four types of option positions:
1. A long position in a call option.
2. A long position in a put option.
3. A short position in a call option.
4. A short position in a put option.
Payoffs from Options
What is the Option Position in Each Case?
K = Strike price, ST = Price of asset at maturity
Payoff Payoff
K
K ST ST
Long call Short Call
Payoff Payoff
K
K ST ST
Long Put Short Put
Options: A Zero Sum Game
Write & Purchase Call Option:
Profit and Loss
Long Call
Zero-Sum-Game
Premium Earned
x
Stock Price at Expiration
Premium Paid
Short Call
Options: A Zero Sum Game
Write & Pull Call Option:
Profit and Loss
Long Put
Premium Earned
Stock Price at Expiration
Premium Paid
Short Put
Terminology
Options are referred to as:
1. In-the-money:
In-the-money an option which would give the holder a
positive cash flow if it were exercised immediately.
2. At-the-money:
At-the-money an option which would lead to zero cash
flow if it were exercised immediately.
3. Out-of-the-money:
Out-of-the-money an option which would lead to a
negative cash flow if it were exercised immediately.
If S is the stock price and X is the strike price then,
Condition Call Option Put Option
S>X In the money Out of money
S=X At the money At the money
S<X Out of money In the money
Terminology
All options of the same type (calls or puts) are
referred to as an option class e.g. SBI calls are
one class whereas SBI puts are another class.
An option series consists of all the options of a
given class with the same expiration date and
strike price. In other words, an option series
refers to a particular contract that is traded.
The SBI 50 calls are an option series.
Other Types of Options
Apart from call and put options, there are types of
options.
Example: bonds have options like features.
The two most frequently encountered features are
conversion features associated with convertible bonds
and the call feature associated with callable bonds.
A convertible bond is a bond in which the bondholder
has the right but not the obligation, to convert the bond
into some other asset of the issuer.
A callable bond is a bond in which the issuer has the
right, but not the obligation, to call the bond (for
redemption) prior to maturity.
Warrants, Executive Stock Options
and Convertibles
Usually when a call option on a stock is exercised, the
party with short position acquires shares that have
already been issued and sell them to the party with
the long position for the strike price. The company
whose stock underlies the option is not involved in
any way.
Warrants & executive stock options are call options
that are written by the company on its own stocks
and sells them to the option holder for the strike
price. The exercise of a warrant or executive stock
option, therefore leads to an increase in the number
of shares of the company stock that are outstanding.
Warrants, Executive Stock Options
and Convertibles
Warrants are call options that often come into
existence as a result of a bond issue. They are added
to the bond issue to make it more attractive to
investors. Typically, a warrant lasts for number of
years. Once they have been created, they sometimes
trade separately from the bonds to which they are
originally attached.
Executive stock options are call options issued to
executives to motivate them to act in the best interest
of the company’s shareholders. They are usually at-
the-money when they are first issued. After a period
of time they become vested and can be exercised.
Warrants, Executive Stock Options
and Convertibles
A convertible bond is a bond issued by a company
that can be converted into equity at certain times
using a predetermined exchange ratio. It is therefore
a bond with an embedded call option on the
company’s stock. Convertibles are like warrants and
executive stock options in that their exercise leads to
more shares being issued by the company.
The Underlying Asset
The asset that can be bought or sold with an
option is known as the underlying asset, or
simply, the underlying. There is a wide variety
of assets on which options are traded the
world over and include:
1. Agricultural commodities
2. Foreign currencies
3. Interest rates
4. Stock indices and individual stocks (as of now
31 stocks permitted).
5. Futures
Specification of Stock Options
Expiration Date:
Date Standardized options have specified
mentioned dates mentioned on maturity. The date
mentioned on in option contract is called expiration date
or the maturity date. After the maturity date, an option
has no worth.
Stock options are on January, February or March cycles.
The three cycles and the various months included in
various cycles are indicated below:
January cycle: January, April, July, October.
February cycle: February, May, August, November.
March cycle: March, June, September, December.
Option Premium
A consideration which the writer of the option
receives for the obligation he undertakes to
sell/buy an asset whenever the other party
desires is known as the price or the premium of
the option.
If the owner of an option decides not to
exercise the option, the option expires
worthless, the amount of premium becomes
the profit of the option writer, while if the
option is exercised, the premium gets adjusted
against the loss the writer incurs upon such
exercise.
Intrinsic Value and Time Value
The premium or the price of the option is made of two
components:
1. The intrinsic value also termed as parity value.
2. The time value also termed as premium over parity.
The intrinsic value refers to the amount by which it is in
money if it is in-the-money.
An option which is out-of-money or at-the-money has a
zero intrinsic value.
Intrinsic Value and Time Value
For a call option, which is in-the-money, the intrinsic
value is the excess of stock price (S) over the exercise
price (X) while for at-the-money and out-of-money
option, the intrinsic value is zero. Symbolically it is
represented as:
Intrinsic value of call option = Max(0,S-X)
In case of an in-the-money put option, the intrinsic
value is represented as Max(0,X-S)
Intrinsic Value and Time Value
Often it is optimal for the holder of an in-the-money
option to wait rather than exercise immediately. The
option is then said to have time value.
The time value of an option is the difference between
the premium of the option and the intrinsic value of the
option.
For a call or put option, which is at-the-money or out-
of-money, the entire premium amount is the time
value.
For an in-the-money option, time value may or may not
exist. In case of a call which is in-the-money, the time
value exists if the call price, C, is greater than the
intrinsic value, S-X
Intrinsic Value and Time Value
Generally, other things being equal, the longer the time
of call to maturity, the greater shall the time value be.
Time value of a call=C-Max(0,S-X)
Time value of a put= P-Max(0,X-S)
Consider the following data about calls on a stock:
Option Exercise Stock Call Classification
Price (X) Price (S) Option Price (C)
1 Rs.80 Rs.83.50 Rs.6.75 In the money
2 Rs 85 Rs.83.50 Rs.2.50 Out of money
Find the intrinsic value and time value of the stock.
Option Stock Exercise Call Intrinsic Val Time Value
Price (S) Price (X) Option Price (C) Max (0,S-X) C- Max(0,S-X)
1 Rs.83.50 Rs.80 Rs.6.75 Rs.3.50 6.75-3.50=Rs.3.25
2 Rs.83.50 Rs.85 Rs.2.50 0 2.50-0=Rs.2.50
Open Interest
The number of outstanding positions at a given
time is known as open interest.
The open interest in an option contract is an
index of its liquidity.
The financial press regularly publishes
information on the open interest position in
addition to the usual price data.
Covered and Naked Calls
If the holder of a call decides to exercise the call, then the
writer of the call has the obligation to sell the underlying
asset to the holder of the call at the strike price.
The writer of the option would receive an amount equal to
the exercise price.
The call writer may or may not be holding the underlying
asset.
If a call writer own the asset underlying the call, he is said
to have written a covered call.
If a call is written where the writer does not have the asset
underlying the call option, the call is said to be naked call.
Similarly in case of put option, if the holder of the option
decides to exercise the option, the put writer is obliged to
accept the underlying asset at the strike price.
Buyer-Seller Attitudes
Call holders- Bullish
Call writers- Bearish
Put holders- Bearish
Put writers- Bullish
