options

Before defining what is option let us

consider the following example.
You discover a house and love to
purchase. You dont have money.
you talk and negotiate with the
owner a deal that gives you an
option to buy the house in three
months for a price of
Rs.2,00,000.The owner agrees, but
for the option you pay Rs. 3000/-

 Case 1. Suddenly the house value

increases and the value is Rs.
10,00,000 . The owner obliged tosell
the house for Rs.2,00,000. But you
stand to make a profit of 7,97,000
(10,00,000-2,00,000-3,000)
Case2: You changed your mind . You
lose Rs. 3000/- which is non
refundable

OPTIONS
So an option is a contract whereby
one party (the holder or buyer) has
the right but not the obligation to
exercise a feature of the contract on
or before the future date. But the
other party (seller or the writer) has
the obligation to honour specified
feature of the contract.

Terminologies of options
Call option: A right to buy the
underlying asset at the pre
determined price within specified
interval of time is called a CALL
option
Put option: A right to sell the
underlying asset at a pre determined
price within specified interval of time
is called a PUT option

 Buyer or holder: The person who has

the right but has no obligation. But
he has to pay premium.
Writer of seller. One who gives or
confer the right and undertakes the
obligation is called seller or writer.

 Premium: It is otherwise known as option

price. It is the price which the buyer pays to
the seller.
Strike price: It is otherwise known as exercise
price . It is the pre determined price which
the holder of an option buys/ sells the asset
Strike or maturity date:The right to exercise
the option is valid for a limited period of time
. It is called maturity date of strike date

Categories of option
European Option:Option that can be
exercised only at the time of maturity
is called European option
American option : Option that can be
exercised before the maturity is called
American option
Burmudan Option: An option that is
exercised with Over the counter (OTC)
is called as Burmudan option

Other types of options

Real Options
Traded options
Vannila and exotic options

 Real option: A real option is a choice

that an investor has when investing
in the real economy. (the production
of goods and services rather than
financial assets). This option may be
something as simple as the
opportunity to expand production
inputs. Real options are an
increasingly influencial tool in
corporate finance

 Traded option ( Exchanged traded

Option ) Traded options are
exchange traded derivatives as the
name implies. AS for other classes of
exchange traded derivatives they are
standardized contracts, quick
systematic pricing and are settled
through clearing houses

 Vanilla and exotic option: Vanilla option is

a plain simple and well understood
option, whereas an exotic option is more
complex or less easily understood. (hybrid
option). The European and American
options on stock and bonds are usually
considered to be plain Vanilla. Asian
option option , look back option, barrier
option are considered to be exotic where
the underlying asset is more complex

Participants of options

Buyers of calls
Seller of calls
Buyer of puts
Seller of puts

Call option
Holder of an option exercises
theoption when price of the
underlying asset is more than the
strike price
S< X buyer lets the call expire
loss=Premium c
S=X Buyer is indifferent
loss =
premium c
S>X Buyer exercise the option Gain=
S-X-c

Put option
When
S<X Buyer exercises the option
Gain= X-S- P
S=X Buyer is indifferent
Loss=
premium p
S>x Buyer lets the contract price
Loss=pm p
Value of option = Max(0,X-s)-p

Zero sum game

Option are a Zero sum game. The
gain of the holder is the los of the
writer and vice versa.

Money of option

In the money (ITM)

Out of the money (OTM)
At the money (ATM) .
Moneyness of the option tells the
benefit the holder gets if he
exercises.

In the money option

An in- the- money(ITM) option is an option
that would lead to a positive cash flow to the
holder if it were exercised immediately . A
call option on the index is said to be in the
money when the current index stands at a
level higher than the strike price (Spot price
> strike price)If the index is much higher
than the strike price, the call is said to be
deep ITM. In case of put, the put is ITM of
the index is below the strike.

Out of the money option

An out- the- money (OTM)option is an option
that would lead to a NEGATIVE cash flow to
the holder if it were exercised immediately .
A call option on the index is said to be in
OUT the money when the current index
stands at a level higher than the strike price
(Spot price < strike price)If the index is
much lower than the strike price, the call is
said to be deep OTM. In case of put, the put
is OTM of the index is above the strike.

At-the-money option
An at- the- money (ATM)option is an option
that would lead to a ZEROcash flow to the
holder if it were exercised immediately . A
call option on the index is said to be in AT
the money when the current index stands
equal to the strike price (Spot price =
strike price).In other words, an option
holder must poay to exercise the option, is
the same as current price of the underlying
security on which the option is written.

Underlying
value
(S)

S<X

S=X

S>X

Call Option

Out of-themoney

At-the-money

In-the-money

Pull option

In the money

At-the-money

Out-of-themoney

Differences between forward/future

and Option
Forwards/Futures

Options

Pay off(profit&loss)

linear

Non linear

Obligation to perform

Bother buyer and

seller

Only seller of option

with right to the
buyer

Trading

OTC for forward and

Exchange traded for
futures

Both OTC and

Exchange traded

Margin

None Forward
As required by
exchange in Futures

None in OTC and as

per exchange
requirement if
exchange traded

Initial payment

None

Buyer pays premium

 Meaning of pay off ( profit & Loss) is

un limited in case of in forwards and
futures. (Linear)