STOCK OPTIONS
Module IV
OPTIONS - BASICS
Financial instrument that confers the right
without an obligation to buy or sell the
underlying asset
It is a derivative instrument – value derives
from the price of the underlying asset
The right is for a predetermined price and
for a predetermined period
The writer grants this right to a buyer for a
certain sum of money – called option
premium
OPTIONS - NATURE
Call option
An option that grants the buyer the right to
purchase a designated instrument
Put option
An option that grants the buyer the right to sell a
designated instrument
OPTIONS - TERMINOLOGY
Buyer/holder – person who obtains the right
to buy or sell
Writer/seller – one who confers the right
Premium – fee charged by the writer from
the holder(c) or(p)
Strike price – predetermined price at which
the option can be exercised (X)
Strike date/maturity date - the latest time
when the option can be exercised
OPTIONS - TERMINOLOGY
Long call – buy call option
Short call – sell/write call option
Long put – buy put option
Short put – sell/write put option
OPTION PAY OFF
CALL OPTIONS
Holder exercises the right only when price of
underlying asset (S) is more than the strike
price(X)
When S < X – holder lets the call expire, loss
= premium( c)
When S = X – holder is indifferent, loss =
premium( c )
When S > X - holder exercises the option,
Gain = S – X - c
PAYOFF DIAGRAM - CALL OPTION
CALL OPTION
March 2020 Call option on Bajaj Auto with exercise price of
Rs.1080 and expiration date March 31, 2020 for Rs. 35
Entitles the holder to purchase Bajaj Auto stock for a price
of Rs. 1080 at any time up to and including the expiration
date in March 2020. The holder will exercise the right only
if the market value of Bajaj Auto stock exceeds the exercise
price
Value of the call option is the difference between the
market price of the stock and exercise price
Profit to the call Buyer:
Value of the option – price paid to purchase the call
Profit to the option writer:
If call is not exercised – premium received
If call is exercised –[premium – value of the call]
CALL OPTIONS
Call option example:
March 2020 Call option on Bajaj Auto with exercise
price of Rs.1080 and expiration date March 31,
2020 for Rs. 35
Suppose Price of Bajaj Auto stock on 31 March 2020
= Rs.1120
Value of the Call option = 1120 – 1080 i.e Rs. 40
Profit = 40 – 35 = Rs.5
PUT OPTION
Holder exercises the option when the price
of the underlying asset(S) is less than the
strike price (X)
When S < X – holder exercises the option,
Gain = X – S -p
When S = X – holder is indifferent, loss =
premium( p )
When S > X - holder lets the option expire,
loss = premium( p )
PAYOFF DIAGRAM - PUT OPTION
PUT OPTIONS
Put option example:
April 2020 put option on Bajaj Auto with exercise price
of Rs.1050 for Rs.10
Entitles the holder to sell Bajaj Auto stock for a price of
Rs. 1050 at any time up to and including the expiration
date in April 2020. The holder will exercise the right
only if the exercise price exceeds the market value of
Bajaj Auto stock
Value of the call option is the difference between the
exercise price and market price of the stock
Profit to the option writer:
If call is not exercised – premium received
If call is exercised –[premium – value of the call]
PUT OPTIONS
Put option example:
April 2020 put option on Bajaj Auto with exercise
price of Rs.1050 for Rs.10
Suppose Price of Bajaj Auto stock on expiration
date = Rs.1000
Value of the put option = 1050 – 1000 i.e Rs. 50
Profit = 50 – 10 = Rs.40
QUESTIONS
[A] What will be the proceeds and net proceeds
to an investor who purchases the March
maturity Bajaj Auto calls at Rs.25 with
exercise price Rs. 1110 if the stock price at
maturity is 1150? What if the stock price is
1180?
[B] What will be the proceeds and net proceeds
to an investor who purchases the April maturity
Bajaj Auto puts at Rs.25 with exercise price
Rs. 1140 if the stock price at maturity is 1150?
What if the stock price is 1110?
MONEYNESS OF OPTION
Describes the relationship between the strike
price of the option and the current stock price
For call option:
When strike price < the underlying price – ITM
When strike price = the underlying price – ATM
When strike price > the underlying price – OTM
OPTIONS
All options are zero-sum game
What is gained by the holder is exactly the
amount lost by the writer
Depending of the payoff options are referred
to as:
In-the –money - if exercised would result in
positive cash flows to the holder
At-the-money - would have no cash flows
Out-of-the-money - if exercised would result
in cash outflows to the holder
OPTIONS
Type of Option S < X S=X S>X
Call OTM ATM ITM
Put ITM ATM OTM
MONEYNESS OF OPTION:
EXAMPLE
Call Option on RIL stock trading at Rs. 450
Strike price
420
430 ITM
440
450 ATM
460
470 OTM
480
MONEYNESS OF OPTION:
EXAMPLE
Put Option on RIL stock trading at Rs. 450
Strike price
420
430 OTM
440
450 ATM
460
470 ITM
480
TYPES OF OPTIONS
Exchange traded options
Also called "listed options
A class of exchange traded derivatives.
Exchange traded options have standardized contracts,
and are settled through a clearing house with
fulfillment guaranteed by the credit of the exchange.
Exchange traded options include:
stock options,
commodity options,
bond options and other interest rate options traded on
treasury bills, CDs
index (equity) options, and
options on futures contracts
Employee stock options are issued by a company to its
employees as compensation
EXCHANGE TRADED OPTIONS
Standardisation is done in terms of:
Quantity of underlying asset
Strike price
Expiration dates
Nature of exercise of option
Ways of settlement
TYPES OF OPTIONS
Over-the-counter, or OTC options
Traded between two private parties, and are not listed
on an exchange.
The terms of an OTC option are unrestricted and may be
individually tailored to meet any business need.
In general, at least one of the counterparties to an OTC
option is a well-capitalized institution.
Option types commonly traded over the counter include:
interest rate options
currency cross rate options, and
options on Swap or swaptions.
TYPE OF OPTIONS
Naming conventions are used to help identify properties
common to many different types of options. These
include:
European option - an option that may only be exercised on
expiration.
American option - an option that may be exercised on any
trading day on or before expiration.
Bermudan option - an option that may be exercised only
on specified dates on or before expiration.
Barrier option - any option with the general characteristic
that the underlying security's price must reach some
trigger level before the exercise
OPTIONS
Options are available on:
Stocks
Indices
Commodities
Currencies
Interest rates
Futures
Currently options cover up to 3 months in India
OPTIONS – TRADING AND
SETTLEMENT
Life of option contract is specified when the
contract is entered
Number of contracts that are not yet settled is
known as Open interest
Option contracts come to a close by:
Exercise
Expiry
Selling
Call written on ITC share for strike price
Rs.200 would stand nullified by buying a call on
ITC Share at the same strike price, expiration date
WHY OPTIONS?
Leverage
Trading volatility
LEVERAGE
Assume market price of ACC stock Rs.50
To buy 100 shares, need to pay Rs. 5000
When ACC stock price rises to Rs.60, profit Rs. 1000
(excluding commission & TC), on an investment of
Rs. 5000 (20% return)
If we buy 100 call options on ACC stock, at an
exercise price of Rs.50, and pay a premium of Rs.
500
When ACC stock price rises to Rs.60, we exercise
the option and pay Rs. 5000, immediately sell it at
Rs.60, profit is Rs.(1000 – 500), Rs.500 on an
investment of Rs. 500 (100% return)
OBLIGATIONS AND RIGHTS OF OPTION
BUYERS AND SELLERS – CALL OPTION
Buyer seller
Decides whether and Counter party decides
when an option will be whether and when an
exercised option will be exercised
Exercise occurs if S > X Exercise occurs if S > X
If option is exercised, If option is exercised,
Buyer: Seller:
Pays X Receives X
Acquires the security Delivers the security
Profit = S - X Loss = -( X – S)
OBLIGATIONS AND RIGHTS OF OPTION
BUYERS AND SELLERS – PUT OPTION
Buyer seller
Decides whether and when Counter party decides
an option will be exercised whether and when an
Exercise occurs if S < X option will be exercised
If option is exercised, Exercise occurs if S < X
Buyer: If option is exercised,
Seller:
Receives X Pays X
Delivers the security Acquires the security
Profit = ( X – S) Loss = - (S – X)
