Options
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Objectives
Definition.
Types of options.
Difference between call and put options.
Parties to options contract.
Options terminology.
Examples of options (Call and Put).
Option quotations.
Strategies for using options.
Calculation of options.
Exercise.
Accounting affects.
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Option contract
• A contract (agreement)
• Giving a right to buy/ sell
• A specific asset
• At a specific price
• Within a specific time period
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Types of Option
Call The right to buy a specified amount of
underlying asset at a specified rate
Option
Put The right to sell a specified amount of
Option underlying asset at a specified rate
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Call option chain
Call
Option
Holder kWriter
kBuy kExpire Sell kAssign kExpire Buy
Buy Underlying security Sell Underlying security
BUY WRITE
Call - right to buy Call - obligation to sell
Put - right to sell Put - obligation to buy
Pay a premium Receive a Premium
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Put option chain
kPut Option
Holder kWriter
kExcercise kExpire Sell kAssign kExpire Buy
Sell Underlying security Buy Underlying security
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Difference
Option BUYER Option WRITER
Call - right to buy Call - obligation to sell
Put - right to sell Put - obligation to buy
Pay a premium Receive a Premium
Call Option Put Option
Option Buyer Buys the right to buy the Buys the right to sell the
underlying asset at the underlying asset at the
Strike Price Strike Price
Option Seller Has the obligation to sell Has the obligation to buy
the underlying asset to the the underlying asset from
option holder at the Strike the option holder at the
Price Strike Price
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Types of options contract
In this the right can be exercised only on a fixed date in the
European contract; i.e. Option only exercisable on the expiry date.
Option
In this the right can be exercised on or before a fixed date
in the contract, i.e. Option exercisable at any time until
American Option expiry date.
This has pre-specified dates during its life till maturity,
Bermudan Option on which it can be exercised.
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Parties to Option contracts
Purchaser (trader)
Has right to exercise (may exercise or may not exercise)
Writer/ seller (dealer or speculator)
Has obligation to perform (when purchaser exercises the right)
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Options terminology
Option writer - One who gives/writes the option. He has an obligation to perform, in
case option buyer desires to exercise his option.
Option holder - One who buys the option. He has the right to exercise the option
but no obligation.
Call Option - Option to buy.
Put Option - Option to sell.
Strike Price/ Exercise Price - Price at which the option is to be exercised.
Expiration Date - Date on which the option expires.
Exercise Date - Date on which the option gets exercised by the option holder/buyer.
Option Premium - The price paid by the option buyer to the option seller for
granting the option.
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Illustration of a call Option
Example 1:- An investor buys one European Call option on one share of Reliance
Petroleum at a premium of Rs.2 per share on 31 July. The strike price is Rs.60 and
the contract matures on 30 September. It may be clear form the graph that even in
the worst case scenario, the investor would only lose a maximum of Rs.2 per share
which he/she had paid for the premium. The upside to it has an unlimited profits
opportunity.
On the other hand the seller of the call option has a payoff chart completely reverse
of the call options buyer. The maximum loss that he can have is unlimited though a
profit of Rs.2 per share would be made on the premium payment by the buyer.
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Illustration of a Put Option
Example 1:- An investor buys one European Put Option on one share of Reliance
Petroleum at a premium of Rs. 2 per share on 31 July. The strike price is Rs.60 and
the contract matures on 30 September. The adjoining graph shows the fluctuations
of net profit with a change in the spot price.
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Options in the money, out of the money
and at the money
An Option is said to be in-the-money when the underlying asset rate is superior
to the exercise price (in the case of call Option) and inferior to the exercise price
(in case of put Option).
Likewise, it is said to be out-of-the-money when the underlying asset rate is
inferior to the exercise price (in case of call Option) and superior to exercise
price (in case of put option).
Similarly, it is at-the-money when the asset rate is equal to the exercise price.
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Example
An American type call Option that enables purchase of US dollar at the rate of Rs
42.50 (exercise price) while the spot rate on the market is Rs 43.00 is in-the-
money. If the US dollar on the spot market is at the rate of Rs 42.50, then the
call Option is at-the-money. Further, if the US dollar in the Spot market is at the
rate of Rs 42.00, it is obviously out-of-the-money.
It is evident that an Option-in-the-money will have higher premium than
the one out-of-the-money, as it enables to make a profit.
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Strategies for using options
Anticipation of Appreciations of
Spot rate Gain (+)/Loss (-)
Underlying Security for the buyer of call
option
Buying of a call Option may result
into a net gain if market rate is
$ 0.6000 - $ 0.02
more than the strike price plus the $ 0.6200 -$0.02
premium paid. $ 0.6400 - $ 0.02
$ 0.6500 - $ 0.02
$ 0.6600 - $ 0.02
$ 0.6700 -$0.02
Call option will be exercised only if $ 0.6800 -$0.02
the exercise price is lower than $ 0.6900 -$0.01
$ 0.7000 $0.00
spot price. The profit profile will be $0.7100 + $0.01
exactly opposite for the seller $0.7200 + $ 0.02
$ 0.7400 + $ 0.04
(writer) of a call Option. $ 0.7600 + $ 0.06
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Strategies for using options
Spot rate Gain(+)/loss (-) for the
Anticipation of Depreciations buyer of a put option.
1.6050 +0.050
of Underlying Security 1.6150 +0.040
1.6250 +0.030
Buying of a put Option 1.6350 +0.020
anticipates a decline in the 1.6450 +0.010
underlying currency. The profit 1.6500 +0.005
profile of a buyer of put Option is 1.6550 +0.000
given by the equation. A put 1.6600 -0.005
Option will be exercised only if 1.6650 -0.010
the exercise price is higher than 1.6750 -0.020
spot rate. 1.6850 -0.030
1.6950 -0.040
The opposite is the profit 1.7050 -0.050
profile for the seller of a put 1.7150 -0.060
Option. 1.7250 -0.060
1.7350 -0.060
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Calculations of options
There are two formulas that are crucial to understanding options. These two
formulas calculate the premium and the contract value. The most important factor
that influences the premium is the relationship between the contract’s exercise price
and the current market value of the underlying security.
The premium is the amount the buyer pays the writer for the contract. The premium
is the price that is quoted in the newspaper.
The contract value is the market value of the contract.
15 Pepsi Jan 35 CALL @ 2 and the multiplier is 100.
Premium : the premium is calculated by
Number of contracts x multiplier x premium = 15 x 100 x 2 = 3000
Contract value: The contract value is calculated by:
Number of contracts x multiplier x strike price = 15 x 100 x 35 = 52,500
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Excercise
A) 10 NIK AUG 450 CALL @ 4 , Multiplier 10,000
Calculate premium and value of contract
B) 8 DIS DEC 44 PUT @ 1 1/2 , Multiplier 100
Calculate premium and value of contract
C) 3 DAX Jun 10 CALL @ 1 , Multiplier 1000
Calculate premium and value of contract
D) 6 PEPSI JAN 55 PUT @ 2 , Multiplier 100
Calculate premium and value of contract
E) 6 OAT SEP 39 PUT @ 1, Multiplier 100
Calculate premium and value of contract
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Accounting Affect
Options
•Reflected as any other investment. Appreciation / depreciation is calculated daily.
•Option expires at maturity; the entire premium paid represents a loss to the holder
•Sale before maturity; a realized gain / loss similar to a security sale is recognized.
•A loss is reported if the proceeds of the sale is less than the cost paid, and a gain is recorded if the
proceeds are greater than the cost paid.
•Exercise at or before maturity; cost of purchased option added to security cost basis.
Examples of option entries are illustrated below.
DR Cost of Options
2125
Purchased
Option Purchased;
10 Pepsi Feb 40 Calls @ 2 1/8 CR Payable for
Options Purchased
2125
Premium – 10 x 100 x 2.125 = 2125
DR Receivable for
1250
Investment Sold
Selling an Option; DR Realized Gain /
875
10 Pepsi Feb 40 calls at 1 ¼ Loss Options
Premium = 10 x 100 x 1.25 = 1250 CR Cost of
2125
Investments
DR Realized Gain /
2125
Expiring an Option; Loss Options
10 Pepsi Feb 40 Calls at $2,125 original cost CR Cost of
Investments 2125
options
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Accounting Affect
Exercising a Call Option; The premium will be added to the cost of the purchased
underlying security. 10 Pepsi 40 Calls (10 contracts x 100 shares per contract =
1,000 shares)
DR Cost of LT Investments 42,125
CR Payable for Inv. Purchased 40,000
CR Cost of Investments options 2,125
Exercising a Put Option, The premium will be subtracted from the proceeds of
the underlying security and reflected in the gain / loss. 10 Pepsi 40 Calls (10
contracts x 100 shares per contract = 1,000 shares)
DR Adj. To Realized Gain / Loss
2,125
CR Cost of Investments options 2,125
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Accounting Affect
DR Receivable of Investments Sold 40,000
CR Cost of LT Investments 37,875
CR ID Gain / Loss on Investments 2,125
DR Realized Gain / Loss
2,125
CR Adj to Realized Gain / Loss 2,125
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Accounts in MCH that are hit by
Options trading.
10500/400 Identified Cost, Options
10600/400 Adj. ID Cost – Security Purchase Due to Options
15000/400 Receivable for Investment Sold – Options
20000/400 Payable for Investments – Options
21010/400 Liability ID Cost, Options
37300/400 Currency Gain/Loss – Option Settlement
54100/400 LT Security Gain – Options
54250/400 LT Security Gain/Loss – Options
54300/400 ST Security Gain, Options
54450/400 ST Security Gain/Loss – Options
54700/400 Adj. Gain/Loss Security Sold Due to Options
54750/400 Adj. To Gain/Loss of Security Sold due to Options LT
54760/400 Adj. To Gain/Loss of Security Sold due to Options ST
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Process Flow- Daily Accounting
Manager Signoff
Release Pricing Information
6 p.m. SLA 12
Accuracy -99.90 Verify all NAV component
NAVigator Pricing* distribute fund data to applicable
Timeliness – 99.80 11 parties (NASDAQ and others)
5 p.m. Mark-to-Market Apply individual prices to funds (including FV)
10
NAV Alert Review Monitor and account for exchange rate
fluctuations
9
4 p.m.
Ensure that all alert situations
Check Test Price are satisfactorily resolved
8
Submit fund to manager for QC check before beginning
Allocate to Shares Classes the pricing process
3 p.m. 7
Allocate net income, gain / loss to share classes at adjusted prior day
Corporate Actions net assets ratio
6
Monitor and verify accounting of all corporate actions
Future Contracts
5
2 p.m.
Trade Verifications Monitor and account for future contracts
1 p.m. 4
Income Changes Verify all trades
3
12 p.m. Expense Accrual Account for interest, dividends, amortization and distributions
11 a.m. 2
Cap Stock Monitor and reconcile operating expenses
10 a.m.
1
Monitor and verify subscriptions and redemptions
* Tasks are completed by Fund Groups at StateStreet
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Thank you
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