OPTIONS

A financial instrument created by investors and sold to investors Based on an underlying such as a common stock Types: CALL & PUT Call The right to BUY Put The right to SELL

Call Option - Sentiments

Would be purchased by a trader who believes that the price of the underlying asset would rise The writer of the call would sell it because he believes that the price of the underlying asset would either remain stable or would perhaps decline Purchaser/Long Position/Holder gains if price rises Seller/Short Position gains if the price falls

Put Option - Sentiments

Would be purchased by a trader who believes that the price of the underlying asset would fall The writer of the call would sell it because he believes that the price of the underlying asset would either remain stable or would perhaps rise Purchaser or Short Position Holder gains if price falls Seller or Short Position gains if the price rises

Option Terminologies Strike Price

It is the agreed price at which the common stock may be purchased or sold at a future date Most Stocks in options market have options available at several different prices with increments of $ 5.00

Options Terminologies Expiration Date

The last date on which the option can be exercised AMERICAN OPTION can be exercised any time prior to the expiration date EUROPEAN OPTION Can be exercised at the expiration date

Option Terminologies Option Premium

The price paid by the buyer to the seller (writer) Usually stated on per share basis for example $1.50 per share

Futures vs Options
A futures/forward contract gives the holder the obligation to buy or sell at a certain price An option gives the holder the right to buy or sell at a certain price but not an obligation

PURPOSE OF DERIVATIVES
To hedge risks To speculate (take a view on the future direction of the market) To lock in an arbitrage profit To change the nature of a liability To change the nature of an investment without incurring the costs of selling one portfolio and buying another

Exchanges Trading Options

Chicago Board Options Exchange American Stock Exchange Philadelphia Stock Exchange Pacific Exchange LIFFE (London) Eurex (Europe)

Types of Traders
Hedgers
Speculators Arbitrageurs
Some of the largest trading losses in derivatives have occurred because individuals who had a mandate to be hedgers or arbitrageurs switched to being speculators

Long Call
Profit from buying one European call option: option price = $5, strike price = $100, option life = 2 months 30 Profit ($) 20 10 70 0 -5 80 90 100 Terminal stock price ($) 110 120 130

Short Call
Profit from writing one European call option: option price = $5, strike price = $100

Profit ($)
5 0 -10 -20 -30 110 120 130 70 80 90 100 Terminal stock price ($)

Long Put
Profit from buying a European put option: option price = $7, strike price = $70 30 Profit ($) 20 10

0
-7

Terminal stock price ($)

40 50 60 70 80 90 100

Short Put
Profit from writing a European put option: option price = $7, strike price = $70 Profit ($) 7 0 -10 -20 -30 40 50 60 70 80 90 Terminal stock price ($) 100

Premium The Value of an Option

Premium depends on 4 key factors
Intrinsic value Time value (Maturity Period) Price Volatility of underlying asset Interest Rates

Intrinsic Value
Depends primarily on the money-ness IN, AT, and OUT the Money It is thus the relationship (difference) between the current market price of the underlying asset and the exercise price of the option The Money-Ness determines whether or not the option would actually have a value The greater the intrinsic value, the higher the premium

Intrinsic Value
Intrinsic value The market price of the underlying asset relative to the exercise price The greater the intrinsic value, the greater the premium Options with positive intrinsic value are called in-the-money options i.e. the buyer is able to exercise contract at a profit

Impact of Interest Rates on option value

Interest Rate Levels Interest rates have opposite impacts on put and call options
Positive relationship between interest rates and the price of a call
Present value of deferred payment if exercised versus lower present value of profit if exercised

Negative relationship between interest rates and the price of a put

Opportunity cost of holding asset Lower present value of the profit if exercised

Interest Rate Option Value

An investor is bullish about the price of an asset This investor can take advantage in two ways Purchase the asset in the physical market Hold it till price rises, sell it at a profit OR, buy a call option on the asset at a fraction The second strategy allows the investor to benefit if the price rises above the exercise price

Interest Rate Option Value

In the 2nd strategy the investor has also conserved funds by purchasing the option rather than purchasing the asset The funds conserved could be invested in money market to generate a +ve return The higher the rate of interest, the greater the would be the benefit from conserving the capital Thus the price of call option generally rises with the rise in rates of interest

Call Options & Interest Rates

Higher interest rates may reduce the value of the option through the interest effect on time value of money The present value of the future profit will decrease because of increase in interest rates Thus interest rates have two conflicting impacts on the value of a call option However it can be demonstrated that the first effect outweighs the second The price of a call option is positively related to interest rates

Interest Rates & PUT options

Negative (-ve) relationship b/w interest rates and the price of put options Here the time value of money concept also works in the same direction

HEDGE FUNDS
Hedge funds are not subject to the same rules as mutual funds and cannot offer their securities publicly. Mutual funds must
disclose investment policies, makes shares redeemable at any time, limit use of leverage take no short positions.

Hedge funds are not subject to these constraints. Hedge funds use complex trading strategies are big users of derivatives for hedging, speculation and arbitrage