Mechanics & properties of options

Mechanics & Properties of
Options

Options
An Option is a contract which gives the right,
but not an obligation, to buy or sell the
underlying at a stated date and at a stated
price.
While a buyer of an option pays the premium and
buys the right to exercise his option, the writer
of an option is the one who receives the option
premium and therefore obliged to sell/buy the
asset if the buyer exercises it on him.

A typical options transaction
On July 1, 2006, 'A' sells a call option (right to
buy), with strike price of Rs.500, which expires
after one month on "ABC Ltd." to 'B' for a price of
say Rs.3.00.
Now 'B' has the right to approach 'A'
on July 31, 2006 and buy 1 share of "ABC Ltd." at
Rs.500. Here Rs.3.00 is called the option price,
Rs.500 is the exercise price and July 31, 2006 is
called the expiration date.

A typical options transaction
'B' does not have to necessarily buy 1 share of
"ABC Ltd." on July 31, 2006 at Rs.500 from 'A'.
'B' may find it worthwhile to exercise his right
to buy only if "ABC Ltd." trades above Rs.500.
If "B” exercises his option, A has to necessarily
sell "B“ one share of "ABC Ltd." at Rs.500 on
July 31, 2006. So if the price of "ABC Ltd." goes
above Rs.500 'B' may exercise his option, or
else the option may lapse. Then 'B' loses the
original option price of Rs.3.00 and 'A' has
gained it.

What is the underlying for an
Option?
Options can be traded on any underlying like
individual stocks, Indices etc. NSE introduced
trading in S&P CNX Nifty Options from June 4,
2001 and options on individual securities
from July 2, 2001.

How Nifty options would help an
investor?
Nifty options allows the investor to trade a large
segment of the equities market with one decision
and thus provide a different perspective and new
dimension to investing in equities.
Nifty options help the investors in reflecting their
views on the market-bullish, bearish or neutral,
in planning their investment strategies and
thus trade efficiently.

Who should trade in Options?
Investors belonging to the following categories,
depending on their financial goals and investment
objectives generally consider trading in options.
 Investors who want to participate in the market
without trading or holding a large stock portfolio.
 Investors who have strong views on the market and
its future movement and want to take advantage of
the same
 Investors who are following the equities market
very closely
 Investors who want to protect the value of their
diversified equities portfolio

Why should one trade in
Options?
Buying options can be compared to buying
insurance.
For example to cover the risk of burglary, fire, etc. you
buy insurance and pay premium. In the event of any
untoward happening, the insurance cover
compensates you for the losses.
Otherwise, the insurance cover expires after the
specific period of time. The insurance premium is
the cost for the cover. Similarly, in the case of
options, the right to buy or sell the underlying is
acquired by payment of a premium.

Why should one trade in
Options?
This affords protection against a general fall in
market and thus can be attractive to various
investors including Mutual Funds, who may like to
bundle Nifty funds with Nifty options.
The option could be exercised in the event of adverse
market movement. Otherwise, the option will expire
after the specific period. The cost of the option, i.e.
the premium, is paid at the time of purchase.
There is no further loss that is generated by the option
for the buyer. This feature of option makes it
attractive for the market participants.

Types of Options
Options are of two types –
1. Calls options
2. Puts options

Calls options
“Calls” give the buyer the right but not the
obligation to buy a given quantity of the
underlying asset, at a given price on or
before a given future date.

Puts options
“Puts” give the buyer the right, but not the
obligation to sell a given quantity of
underlying asset at a given price on or
before a given future date. All the options
contracts are settled in cash.

Type of exercise
Options are classified based on type of exercise
American Option - American options are
options contracts that can be exercised at any
time up to the expiration date. Options on
individual securities available at NSE are
American type of options.
European Options - European options are
options that can be exercised only on the
expiration date. All index options traded at NSE
are European Options.

Options products available for
trading at NSE
Options contracts are traded on Indices and
on Single stocks.
Presently options contracts on the following
products are available at NSE:
1. Indices : Nifty 50, CNX IT Index, Bank Nifty
Index, CNX Nifty Junior, CNX 100 , Nifty
Midcap 50, Mini Nifty and Long dated
Options contracts on Nifty 50.
2. Single stocks

Contract specifications – Nifty
OptionsUnderlying Index : CNX Nifty
Exchange of Trading : National Stock Exchange of India Limited
Contract size : Permitted lot size shall be 50 or multiples thereof
Price steps : Rs.0.05
Strike Price Interval : Rs. 10.00
Price Bands : Not applicable
Trading cycle : The options contracts will have a maximum of three
month trading cycle – the near month (one), the next month
(two) and the far month (three) New contract will be introduced
on the next trading day following the expiry of near month
contract
Expiry day : The last Thursday of the expiry month or the previous
trading day if the last Thursday is a trading holiday.
Settlement basis : Cash settlement
Style of option : European

Premium
Premium the price that the holder of an
option pays and the writer of an option
receives for the rights conveyed by the
option.
The premiums are not fixed by the Exchange
and are subject to fluctuations in response
to market and economic forces.

Premium
 The factors affecting pricing of an option include
 current value of the underlying,
 the exercise price,
 current values of futures on the underlying,
 style of option,
 individual opinion and estimates of the future volatility of
the underlying,
 historical volatility of the underlying,
 the time remaining till expiration,
 cash dividends payable on the underlying stock,
 current interest rates,
 depth of the market, available information, etc.

Opening & Closing transaction
Opening transaction a purchase or a sale transaction
by which a person establishes or increases a
position either as the holder or the writer of an
option.
Closing transaction a transaction by which a person
reduces or cancels out previous position either as
the holder or the writer of that option. For example,
an investor, at some point prior to expiration, may
make an offsetting sale of an identical option, if he is
an option holder or make an offsetting purchase of
an identical option, if he is an option writer.

Long and short
Long refers to a position as the holder of an
option.
Short refers to a position as the writer of an
option.

Why should one trade in Options
Options trading will be of interest to those
who wish to :
1) Participate in the market without trading
or holding a large quantity of stock.
2) Protect their portfolio by paying small
premium amount.

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

At-the-money-option (ATM)
An at-the money option is an option that
would lead to zero cash flow if it were
exercised immediately.
An option on the index is said to be “at-the-
money” when the current price equals the
strike price.

Out-of-the-money-option (OTM)
An out-of- the-money Option is an option that would
lead to negative cash flow if it were exercised
immediately.
A Call option is out-of-the-money when the current
price stands at a level which is less than the strike
price.
If the current price is much lower than the strike price
the call is said to be deep out-of-the money. In case
of a Put, the Put is said to be out-of-money if current
price is above the strike price.

Terminology
• CALL AND PUT OPTIONS
• OPTION HOLDER AND OPTION WRITER
• EXERCISE PRICE OR STRIKING PRICE
• EXPIRATION DATE OR MATURITY DATE
• EUROPEAN OPTION AND AMERICAN OPTION
• EXCHANGE-TRADED OPTIONS AND OTC
OPTIONS
• AT THE MONEY, IN THE MONEY, AND OUT OF
THE MONEY OPTIONS
• INTRINSIC VALUE OF AN OPTION
• TIME VALUE OF AN OPTION

Option Payoffs
PAYOFF OF A CALL OPTION
PAYOFF OF A
CALL OPTION
E (EXERCISE PRICE) STOCK PRICE
PAY OFF OF A PUT OPTION
PAYOFF OF A
PUT OPTION
E (EXERCISE PRICE) STOCK PRICE

Payoffs To The Seller Of Options
PAYOFF
E
STOCK PRICE
(a) SELL A CALL
PAYOFF
E
STOCK PRICE
(b) SELL A PUT

Options
BUYER/HOLDER SELLER/WRITER
RIGHTS/ BUYERS HAVE RIGHTS- SELLERS HAVE ONLY
OBLIGATIONS NO OBLIGATIONS OBLIGATIONS-NO RIGHTS
CALL RIGHT TO BUY/TO GO OBLIGATION TO SELL/GO
LONG SHORT ON EXERCISE
PUT RIGHT TO SELL/ TO OBLIGATION TO BUY/GO
GO SHORT LONG ON EXERCISE
PREMIUM PAID RECEIVED
EXERCISE BUYER’S DECISION SELLER CANNOT
INFLUENCE
MAX. LOSS COST OF PREMUIM UNLIMITED LOSSES
POSSIBLE
MAX. GAIN UNLIMITED PROFITS PRICE OF PREMIUM
POSSIBLE
CLOSING • EXERCISE • ASSIGNMENT ON OPTION
POSITION OF • OFFSET BY SELLING • OFFSET BY BUYING BACK
EXCHANGE OPTION IN MARKET OPTION IN MARKET
TRADED • LET OPTION LAPSE • OPTION EXPIRES AND KEEP
WORTHLESS THE FULL PREMIUM

FEW BASIC STRATEGIES
Assumption: Bullish on the market over the
short term Possible Action by you:
Buy Nifty calls

Example:
Current Nifty is 5880. You buy one contract (lot size 50) of Nifty near
month calls for Rs.20 each. The strike price is 5900. The premium
paid by you : (Rs.20 * 50) Rs.1000. Given these, your break-even
Nifty level is 5920 (5900+20). If at expiration
Nifty advances to 5974, then
Nifty expiration level 5974
Less Strike Price 5900
Option value 74.00 (5974-5900)
Less Purchase price 20.00
Profit per Nifty 54.00
Profit on the contract Rs. 2,700 (Rs. 54* 50)

Assumption: Bearish on the market over the
short term Possible Action by you:
Buy Nifty puts

Example:
Current Nifty is 5880. You buy one contract (lot size 50) of Nifty near
month puts for Rs.17 each. The strike price is 5840. The premium paid
by you will be Rs.850 (17*50). Given these, your break-even Nifty
level is 5823 (i.e. strike price less the premium). If at expiration Nifty
declines to 5786, then
Put Strike Price 5840
Option value 54 (5840-5786)
Less Purchase price 17
Profit per Nifty 37
Profit on the contract Rs.1850 (Rs.37* 50)

Use Put as a portfolio Hedge?
Assumption: You are concerned about a
downturn in the short term in the market
and its effect on your portfolio. The portfolio
has performed well and you expect it to
continue to appreciate over the long term
but would like to protect existing profits or
prevent further losses.
Possible Action: Buy Nifty puts.

Example:
You hold a portfolio of 5000 shares of ABC Ltd. Ltd. valued at Rs. 10
Lakhs (@ Rs.200 each share). Beta of ABC Ltd. is 1. Current Nifty
is at 4250.
You wish to protect your portfolio from a drop of more
than 10% in value (i.e. Rs. 9,00,000). Nifty near month puts of strike
price 3825 (10% away from 4250 index value) is trading at Rs. 2. To
hedge, you buy 5 puts, i.e. 250 Nifties, equivalent to Rs.10 lakhs*1
(Beta of ABC Ltd) /4250 or Rs. 1000000/4250.
The premium paid by
you is Rs.500, (i.e.250 * 2). If at expiration Nifty declines to 3500,
and ABC Ltd. falls to Rs.164.70, then

Put Strike Price 3825
Option value (per Nifty) 325 (3825-3500)
Less Purchase price (per Nifty) 2
Profit per Nifty 323
Profit on the contract Rs.80,750 (Rs.323* 250)
ABC Ltd. shares value Rs.8,23,500
Profit on the Nifty put contracts Rs.80,750
Total value Rs.9,04,250
Rs. 9,04,250 is approx. 10% lower than the original value of the
portfolio. Without hedging using puts the investor would have lost
more than 10% of the value.

Risks associated with trading in
Options
Example 3.
An investor buys 100 Nifty call options at a strike
price of Rs. 4000 on June 15. Nifty index is at
4050. Premium paid = Rs. 10,000 (@Rs. 100
per call X 100 calls).
Expiry date of the contract is June 26
On June 26, Nifty index closes at 3900.
The call will expire worthless and the investor
losses the entire Rs.10,000 paid as premium.

Risks associated with trading in
Options
Example 2.
An investor buys 100 ABC Ltd. put options at a
strike price of Rs. 400 on June 15. ABC Ltd.
share price is at 380. Premium paid =
Rs. 5,000 (@Rs. 50 per put X 100 calls).
Expiry date of the contract is June 26
On June 26, ABC Ltd. shares close at Rs. 410.
The put will expire worthless and the investor
losses the entire Rs. 5,000 paid as premium.

Mechanics & properties of options

More Related Content

What's hot (20)

Viewers also liked (8)

Similar to Mechanics & properties of options (20)

More from Ameya Ranadive (9)

Recently uploaded (20)

Mechanics & properties of options