OPTIONS

Option Basics
Pay-off Profiles
Option Terminology
Option Types
Option Values
Option Pricing
 OPTIONS

A n i n t r o d u c ti o n
O p ti o n s a r e d e fe r r e d d e l i v e r y c o n t r a c t s t h a t g i v e s t h e
b u y e r o r t h e h o l d e r t h e r i g h t , b u t n o t t h e o b l i g a ti o n , t o
b u y o r s e l l a g i v e n q u a n ti t y o f t h e u n d e r l y i n g a s s e t a t a
p r e d e t e r m i n e d p r i c e o n o r b e f o r e a s p e c i fi e d f u t u r e d a t e .
O p ti o n s h a v e a n u n s y m m e t r i c a l p a y - o ff p r o fi l e , u n l i ke t h e
F u t u r e s , b e c a u s e o f t h e u n u s u a l r e l a ti o n s h i p b e t w e e n t h e
b u y e r a n d t h e s e l l e r.
T h e b u y e r h a s t h e r i g h t b u t n o o b l i g a ti o n w h i l e t h e s e l l e r
h a s t h e o b l i g a ti o n b u t n o r i g h t .
 CALL OPTION BUYER

 A c a l l o p ti o n b u y e r h a s t h e r i g h t t o b u y a g i v e n q u a n ti t y o f
a n u n d e r l y i n g a s s e t a t a n e g o ti a t e d o r p r e d e t e r m i n e d p r i c e
o n o r b e f o r e a s p e c i fi e d f u t u r e d a t e .
 A c a l l o p ti o n b u y e r h a s n o o b l i g a ti o n t o b u y t h e s a i d a s s e t
i f t h e p r i c e d o e s n o t g o i n h i s f a v o r.
 A c a l l o p ti o n b u y e r p a y s a p r e m i u m t o a c q u i r e t h e r i g h t .
 H e n c e a c a l l o p ti o n b u y e r w i l l n o t b e m a r g i n e d b y t h e
e x c h a n g e b e c a u s e o f t h e l i m i t e d r i s k i n h i s p o s i ti o n .
 CALL OPTION SELLER

 A c a l l o p ti o n s e l l e r h a s t h e o b l i g a ti o n t o s e l l a g i v e n
q u a n ti t y o f a n u n d e r l y i n g a s s e t a t a n e g o ti a t e d o r
p r e d e t e r m i n e d p r i c e o n o r b e f o r e a s p e c i fi e d f u t u r e d a t e .
 A c a l l o p ti o n s e l l e r h a s n o r i g h t t o s e l l t h e s a i d a s s e t i f
t h e p r i c e g o e s i n h i s f a v o r.
 A c a l l o p ti o n s e l l e r r e c e i v e s a p r e m i u m f o r h i s o b l i g a ti o n
t o p e r f o r m t h e c o n t r a c t . A c a l l o p ti o n s e l l e r w i l l b e
margined by the exchange because of the inherent risk in
h i s p o s i ti o n .
 PUT OPTION BUYER

 A p u t o p ti o n b u y e r h a s t h e r i g h t t o s e l l a g i v e n q u a n ti t y o f
a n u n d e r l y i n g a s s e t a t a n e g o ti a t e d o r p r e d e t e r m i n e d p r i c e
o n o r b e f o r e a s p e c i fi e d f u t u r e d a t e .
 A p u t o p ti o n b u y e r h a s n o o b l i g a ti o n t o s e l l t h e s a i d a s s e t
i f t h e p r i c e d o e s n o t g o i n h i s f a v o r.
 A p u t o p ti o n b u y e r p a y s a p r e m i u m t o a c q u i r e t h e r i g h t .
 H e n c e a p u t o p ti o n b u y e r w i l l n o t b e m a r g i n e d b y t h e
e x c h a n g e b e c a u s e o f t h e l i m i t e d r i s k i n h i s p o s i ti o n
 PUT OPTION SELLER

 A p u t o p ti o n s e l l e r h a s t h e o b l i g a ti o n t o b u y a g i v e n q u a n ti t y o f
a n u n d e r l y i n g a s s e t a t a n e g o ti a t e d o r p r e d e t e r m i n e d p r i c e o n o r
b e f o r e a s p e c i fi e d f u t u r e d a t e .
 A p u t o p ti o n s e l l e r h a s n o r i g h t t o b u y t h e s a i d a s s e t i f t h e p r i c e
g o e s i n h i s f a v o r.
 A p u t o p ti o n s e l l e r r e c e i v e s a p r e m i u m f o r h i s o b l i g a ti o n t o
perform the contract.
 A p u t o p ti o n s e l l e r w i l l b e m a r g i n e d b y t h e e x c h a n g e b e c a u s e o f
t h e i n h e r e n t r i s k i n h i s p o s i ti o n .
 CALL OPTIONS

 The buyer (or holder) of a RELIANCE 2500 CE has the right to buy 250
RELIANCE shares (1 lot) @ 2500 on expiry.

 The seller (or writer) of a RELANCE 2500 CE has the obligation to sell 250
RELIANCE shares (1 lot) @ 2500 when exercised at expiry.
 PUT OPTIONS

 The buyer (or holder) of a RELIANCE 2400 PE has the right to sell 250
RELIANCE shares (1 lot) @ 2400 on expiry.

 The seller (or writer) of a RELANCE 2400 PE has the obligation to

buy 250 RELIANCE shares (1 lot) @ 2400 when exercised at expiry.
 LONG OPTIONS

 L o n g C a l l O p ti o n s a r e B u l l i s h o r i e n t e d p o s i ti o n s . T h e y
b e c o m e m o r e v a l u a b l e a s t h e u n d e r l y i n g m a r ke t p r i c e
increases.

 L o n g P u t O p ti o n s a r e B e a r i s h o r i e n t e d p o s i ti o n s . T h e y
b e c o m e m o r e v a l u a b l e a s t h e u n d e r l y i n g m a r ke t p r i c e
decreases.
 SHORT OPTIONS

S h o r t C a l l O p ti o n s a r e N e u t r a l t o B e a r i s h o r i e n t e d
p o s i ti o n s . T h e y b e c o m e m o r e v a l u a b l e a s t h e u n d e r l y i n g
m a r ke t p r i c e d e c r e a s e s .

S h o r t P u t O p ti o n s a r e N e u t r a l t o B u l l i s h o r i e n t e d p o s i ti o n s .
T h e y b e c o m e m o r e v a l u a b l e a s t h e u n d e r l y i n g m a r ke t p r i c e
increases.
 CALL BUYER v/s CALL SELLER

CALL BUYER CALL SELLER

PREMIUM PAYS RECEIVES
VIEW BULLISH NEUTRAL TO BEARISH
PROFITS UNLIMITED LIMITED TO PREMIUM
LOSSES LIMITED LOSSES UNLIMITED LOSSES
MARGINS NOT REQUIRED PAYS MARGIN
 PUT BUYER V/S PUT SELLER

PUT BUYER PUT SELLER

PREMIUM PAYS RECEIVES
VIEW BEARISH NEUTRAL TO BULLISH
PROFITS UNLIMITED LIMITED TO PREMIUM
LOSSES LIMITED LOSSES UNLIMITED LOSSES
MARGINS NOT REQUIRED PAYS MARGIN
 Pay-off Profile – Long call

SUNPHARMA Long 900 CE @ Rs. 20

160

140

120

100
Profit /Loss (Rs)

80

60

40

20

0
760 780 800 820 840 860 880 900 920 940 960 980 1000 1020 1040 1060
-20

-40
Share Price (Rs)
 Pay-off Profile – Short call

SUNPHARMA Short 900 CE @ Rs. 20

40

20

0
760 780 800 820 840 860 880 900 920 940 960 980 1000 1020 1040 1060
-20
Profit /Loss (Rs)

-40

-60

-80

-100

-120

-140

-160

Share Price (Rs)

 Pay-off Profile – Long Put

SUNPHARMA Long 900 PE @ Rs. 20

140

120

100
Profit /Loss (Rs)

80

60

40

20

0
760 780 800 820 840 860 880 900 920 940 960 980 1000 1020 1040 1060
-20

-40

Share Price (Rs)

 Pay-off Profile – Short Put
SUNPHARMA Short 900 PE @Rs. 20
40

20

0
760 780 800 820 840 860 880 900 920 940 960 980 1000 1020 1040 1060
-20
Profit /Loss (Rs)

-40

-60

-80

-100

-120

-140
Share Price (Rs)
 OPTION TERMINOLOGY

Option Premium
Price paid by the buyer to acquire the right
 Strike Price or Exercise Price
Price at which the underlying may be bought or sold
 Expiration Date
Last date for exercising the option
 Exercise Date
Date on which the option is actually exercised
 OPTION TERMINOLOGY

 I n - t h e - m o n e y c a l l o p ti o n : W h e n t h e s t r i ke p r i c e i s l e s s
t h a n t h e m a r ke t p r i c e , s u c h c a l l o p ti o n s a r e c a l l e d a s I n -
t h e - m o n e y ( I T M ) c a l l o p ti o n s .
 At- t h e - m o n e y c a l l o p ti o n : W h e n t h e s t r i ke p r i c e i s e q u a l
t o ( o r n e a r ) t h e m a r ke t p r i c e , s u c h c a l l o p ti o n s a r e c a l l e d
a s At- t h e - m o n e y ( AT M ) c a l l o p ti o n s .
 O u t- o f - t h e - m o n e y c a l l o p ti o n : W h e n t h e s t r i ke p r i c e i s
g r e a t e r t h a n t h e m a r ke t p r i c e , s u c h c a l l o p ti o n s a r e
c a l l e d a s O u t- o f- t h e - m o n e y ( OT M ) c a l l o p ti o n s .
 OPTION TERMINOLOGY

 I n - t h e - m o n e y p u t o p ti o n : W h e n t h e s t r i ke p r i c e i s m o r e t h a n
t h e m a r ke t p r i c e , s u c h p u t o p ti o n s a r e c a l l e d a s I n - t h e -
m o n e y ( I T M ) p u t o p ti o n s .
 At - t h e - m o n e y p u t o p ti o n : W h e n t h e s t r i ke p r i c e i s e q u a l t o
( o r n e a r ) t h e m a r ke t p r i c e , s u c h p u t o p ti o n s a r e c a l l e d a s
A t - t h e - m o n e y ( AT M ) p u t o p ti o n s .
 O u t - o f - t h e - m o n e y p u t o p ti o n : W h e n t h e s t r i ke p r i c e i s l e s s
t h a n t h e m a r ke t p r i c e , s u c h p u t o p ti o n s a r e c a l l e d a s O u t - o f -
t h e - m o n e y ( O T M ) p u t o p ti o n s .
 OPTION TYPES

CALL OPTION PUT OPTION

In-the-money Strike Price is less than Strike Price is greater

the Market Price than the Market Price

At-the-money Strike Price is equal to Strike Price is equal to

the Market Price the Market Price

Out-of-the-money Strike Price is greater Strike Price is less than

than the Market Price the Market Price
 OPTION TYPES

If SUNPHARMA is trading at 900, then

 SUNPHARMA 880 CE is In-the-money Option (ITM)

 SUNPHARMA 900 CE is At-the-money Option (ATM)
 SUNPHARMA 920 CE is Out-of-the-money Option (OTM)

 SUNPHARMA 920 PE is In-the-money Option (ITM)

 SUNPHARMA 900 PE is At-the-money Option (ATM)
 SUNPHARMA 880 PE is Out-of-the-money Option (OTM)
 OPTION TYPES

American Options
 They can be exercised any time on or before the expiration date.
Options on individual stocks used to be American Options prior to
2011.

European Options
 They can be exercised only on the expiration date. Currently both
Index and Stock Options in India follow European type of settlement.
 OPTION VALUES

 A n O p ti o n Va l u e c o m p r i s e s o f T i m e Va l u e a n d
I n t r i n s i c Va l u e .
 I n t r i n s i c Va l u e i s t h e d i ff e re n c e b e t w e e n t h e
U n d e r l y i n g P r i c e a n d S t r i ke P r i c e .
 T i m e Va l u e o r E x t r i n s i c Va l u e i s t h e d i ff e r e n c e
b e t w e e n O p ti o n P re m i u m a n d I n t r i n s i c Va l u e .
 T i m e Va l u e i s t h e a m o u n t a b u y e r i s w i l l i n g t o p ay
o v e r a n d a b o v e t h e i n t r i n s i c Va l u e i n a n ti c i p a ti o n o f
a n e v e n t ( o r a m a r ke t m o v e ) t h a t w o u l d e v e n t u a l l y
b e n e fi t h i m .
 OPTION VALUES

W h e n SUNPHARMA i s t ra d i n g at 9 0 0 a n d i f t h e va l u e o f
SUNPHARMA 8 8 0 C E i s R s . 3 5 . 0 0 , t h e n
R s . 2 0 . 0 0 i s t h e I n t r i n s i c Va l u e .

R s . 1 5 . 0 0 i s t h e T i m e Va l u e .


W h e n SUNPHARMA i s t ra d i n g at 9 0 0 a n d i f t h e va l u e o f
SUNPHARMA 9 2 0 P E i s R s . 3 0 . 0 0 , t h e n
R s . 2 0 . 0 0 i s t h e I n t r i n s i c Va l u e .

R s . 1 0 . 0 0 i s t h e T i m e Va l u e .

 SETTLEMENT TYPE

C a s h S e tt l e d
 O n e x e r c i s e r e s u l t s i n fl o w o f c a s h s t r e a m d e p e n d i n g o n t h e
s e tt l e m e n t p r i c e . O n l y t h e d i ff e r e n c e a m o u n t i s s e tt l e d i n c a s h
a t t h e ti m e o f e x p i r y. A t p r e s e n t e q u i t y o p ti o n s i n N S E a r e c a s h
s e tt l e d o r f u t u r e s s e tt l e d .

S t o c k / P h y s i c a l S e tt l e d
 On exercise results in physical deliver y of the underlying in
the spot market. Both NSE & BSE have introduced stock
s e tt l e m e n t i n r e c e n t ti m e s .
 Factors affecting option values

Current Price of the underlying asset (S)

Exercise Price of the option (K)
Interest Rates (Rf)
Time to Expiry (t)
Volatility of prices of the underlying asset (σ)
Dividend (d)
 Factors affecting option values

Current Price of the underlying asset (S)

When the market price begins to approach the strike price the options
start becoming more and more expensive.
When the strike price moves away from the market price the options start
becoming cheaper.
Option price depends on where the underlying is trading with respect to
the strike price.
 Factors affecting option values

Exercise Price of the Option (K)

 In-the-money call and put options will be more expensive than at-the-
money options.
At-the-money call and put options will be more expensive than out-of-the-
money options.
Out-of-the-money call or put options will always have lesser value
compared to the other two types of options.
 Factors affecting option values

Interest Rates (Rf)

When interest rates rises in the economy, call options start becoming
expensive and put options start becoming cheaper.
When interest rates falls in the economy, call options becomes cheaper
and put options start becoming expensive.
In general interest rates do not affect the option pricing as much as the
other factors do.
 Factors affecting option values

Time to Maturity (t)

Options with longer time to maturity will have greater values than options
with shorter time frame.
SUNPHARMA SEP 900 CE/PE will have a greater value than SUNPHARMA
AUG 900 CE/PE.
Options have large time values at the beginning of the series.
Option gradually loses its value because of time value decay.
The time value decay is very sharp or exponential as we approach expiry.
 Factors affecting option values

Volatility (σ)
 Volatility plays a very important role in options pricing.
 The value of both the call and put options rises with increase in volatility.
 Most of the trading strategy in options are based on deep understanding of
volatility.
 Option prices can fluctuate wildly under different volatility condition in the
markets.
 Implied Volatility (IVs) is the volatility of the options that is determined through its
pricing.
 PAY-OFF LONG CALL
LONG NIFTY Premium (Rs) Cash Flows from Net Cash Flow (Rs)
17300CE @ 120 Strike (Rs) (Profit/Loss)
16900 -120 0 -120
17000 -120 0 -120
17100 -120 0 -120
17200 -120 0 -120
17300 -120 0 -120
17400 -120 100 -20
17500 -120 200 80
17600 -120 300 180
17700 -120 400 280
 PAY-OFF SHORT CALL
SHORT NIFTY Premium (Rs) Cash Flows from Net Cash Flow (Rs)
17300CE @ 120 Strike (Rs) (Profit/Loss)
16900 120 0 120
17000 120 0 120
17100 120 0 120
17200 120 0 120
17300 120 0 120
17400 120 -100 20
17500 120 -200 -80
17600 120 -300 -180
17700 120 -400 -280
 PAY-OFF LONG PUT
LONG NIFTY Premium (Rs) Cash Flows from Net Cash Flow (Rs)
17400PE @ 150 Strike (Rs) (Profit/Loss)
16900 -150 500 350
17000 -150 400 250
17100 -150 300 150
17200 -150 200 50
17300 -150 100 -50
17400 -150 0 -150
17500 -150 0 -150
17600 -150 0 -150
17700 -150 0 -150
 PAY-OFF SHORT PUT
SHORT NIFTY Premium (Rs) Cash Flows from Net Cash Flow (Rs)
17400PE @ 150 Strike (Rs) (Profit/Loss)
16900 150 -500 -350
17000 150 -400 -250
17100 150 -300 -150
17200 150 -200 -50
17300 150 -100 50
17400 150 0 150
17500 150 0 150
17600 150 0 150
17700 150 0 150
THANK YOU