OPTIONS

CA.CS.CMA.MBA: Naveen. Rohatgi

MEANING OF OPTIONS

Options are a type of derivative product that allow investors to

speculate on or hedge against the volatility of an underlying stock.
Options are divided into call options, which allow buyers to profit if
the price of the stock increases, and put options, in which the
buyer profits if the price of the stock declines.
Options – Terminologies

Index option :
These options have index as the underlying asset.
For example options on Nifty, Sensex, etc.

Stock option:
These option have individual stocks as the underlying asset.
For example, option on ONGC, NTPC etc.

Buyer of an option:
The buyer of an option is one who has a right but not the obligation
in the contract.
For owning the right, he pays a price to the seller of this right called
‘option premium’ to the option seller.
Writer of an option:
The writer of an option is one who receives the option premium and
is thereby obliged to see/buy the asset if the buyer of option exercises
his right.

American option:
The owner of such option can exercise his right at any time on or
before the expiry date/day of the contract.

European option:
The owner of such option can exercise his right only on the expiry
date/day of the contract. In India, options are European.
Option price/premium
It is the price which the option buyer pays to the option seller.

Lot size
Lot size is the number of units of underlying asset in a contract .
Lot size of Nifty option contracts is 50.

Expiration Day:
The day on which a derivative contract cases to exist. It is the last
trading date/day of the contract.

Spot price :
It is the price at which the underlying asset trades in the spot market.
Strike price or Exercise price (X):

Strike price is the price per share for which the underlying security may be
purchased or sold by the option holder.

In the money (ITM) option:

This option would give holder a positive cash flow if it were exercised immediately.

At the money (ATM) option:

At the money option would lead to zero cash flow if it were exercised immediately.

Out of money (OTM) option:

This option would give the holder a negative cash flow if it were exercised
immediately.
Contract cycle

Options in India, except for long-dated contracts, have a maximum

of the 3-month trading cycle - 1 month, 2 months and 3 months.
New option contracts are introduced on the next trading day of the
expiration of the monthly contracts. The expiration day is the last
trading Thursday of the month.
Basic Understanding of Option Strategies:

Long option strategy

A long strategy is a strategy of buying an option according to the view

on future price movement of the underlying.

A person with a bullish opinion on the underlying will buy a call

option on that asset/security, while a person with a bearish opinion
on the underlying will buy a put option on the asset/security.
Consider the purchase of a call option at the price (premium) c.
We take,
ST = Spot price at time T
K = Strike price
Let us explain this with some examples.
Mr. A buys a Call on an index (such as Nifty 50) with a strike price of
₹ 2,000 for premium of ₹ 81. Consider the values of the index at
expiration as 1800, 1900, 2100, and 2200
For ST = 1800, Profit/Loss = 0 – 81 = - 81 (maximum loss =
premium paid)
For ST = 1900, Profit/Loss = 0 – 81 = - 81 (maximum loss =
premium paid)
For ST = 2100, Profit/Loss = 2100 – 2000 – 81 = 19
For ST = 2200, Profit/Loss = 2200 – 200 – 81 = 119
PUT OPTION
An investor having a bearish opinion on the underlying can
expect have positive returns by buying a put option on that
asset/security.

When a put option is purchased, the put option buyer has the
right to sell the stock at the strike price on or before the expiry date
depending on where the underlying price is.
Consider the purchase of a put option at price (premium) p. we take
ST = Spot price at time T
K = exercise price

Let us explain this with some examples.

Mr. X buys a put at a strike price of ₹ 2,000 for premium of ₹ 79.
Consider the values of the index at expiration as 1800, 1900, 2100, and
2200
For ST = 1800, Profit/Loss = 2000 – 1800 -79 = 121
For ST = 1900, Profit/Loss = 2000 – 1900 – 79 = 21
For ST = 2100, Profit/Loss = - 79 (maximum loss is the premium
paid)
For ST = 2200, Profit/Loss = - 79 (maximum loss is the premium
paid)
B. Short Option Strategy

A short option strategy is a strategy where options are sold to

make money upfront with a view that the options will expire out of
money at the expiry date (i.e., the buyer of the option will not
exercise the same and the seller can keep the premium).

As opposed to a long options strategy, here a person with a bullish

opinion on the underlying will sell a put option in the hope that
prices will rise and the buyer will not exercise the option leading to
profit for the seller.

On the other hand, a person with a bearish view on the

underlying will sell a call option in the hope that prices will fall and
the buyer will not exercise the option leading to profit for the seller.
Call
As investor with a bearish opinion on the underlying can
take advantage of falling stock prices by selling a call option on
the asset/security.
If the stock price falls, the profit to the seller will be the
premium earned by selling the option. He will lose in case the
stock price increase above the strike price.
Consider the seller of option at price (premium) p. we take
ST = Spot price at time T
K = exercise price

Now, consider this examples.

A sells a call at a strike price of ₹ 2000 for a premium of ₹ 81.
Consider, values of index at expiration at 1800, 1900, 2100, and
2200.
For ST = 1800, Profit/Loss = 81 (maximum profit = premium
receives)
For ST = 1900, Profit/Loss = 81 (maximum profit = premium
receives)
For ST = 2100, Profit/Loss = 81 – (2100 – 2000) = -19
For ST = 2200, Profit/Loss = 81 – (2200 – 2000) = -119
Put
An investor with a bullish opinion on the underlying can take
advantage of rising prices by selling a put option on the
asset/security.
If the stock price rises, the profit to the seller will be the premium
earned by selling the option. He lose in case the stock price falls
below the strike price.
Consider the sale of a put option at the (premium) p. We take:
ST = Spot price at time T
K = exercise price
We sell a put at a strike price of ₹ 2000 for ₹ 79. Consider values of
index at expiration as 1800, 1900, 2100, and 2200.
For ST = 1800, Loss = 79 – (2000 – 1800) = (-) 121
For ST = 1900, Loss = 79 – (2000 – 1900) = (-) 21
For ST = 2100, Profit = 79 (maximum profit = premium received)
For ST = 2200, Profit= 79 (maximum profit = premium received)
Valuation of Options Contract

Like in case of any traded good, the price of any option is

determined by the demand for and supply of that option. This price
has two components: intrinsic value and time value.

Intrinsic Value

For and option, intrinsic value refer to the amount by which option is
in the money i.e. the amount an option buyer will realize, before
adjusting for premium paid, if he exercises the option instantly.

Therefore, only in-the-money options have intrinsic value whereas at

the money and out-of-the-money options have zero intrinsic value.
The intrinsic of an option can never be negative.
Time Value of option = Option Premium - Intrinsic Value

As a general rule, the more time that remains until expiration, the
greater the time value of the option.

Investors are willing to pay a higher premium for more time since the
contract will have longer to become profitable due to a favorable
move in the underlying asset.

Conversely, the less time that remains on an option, the less of a

premium investors are willing to pay, because the probability of the
option having the chance to be profitable is shrinking.
Intrinsic and Time Value for call options:
Spot Price Strike Price Premium Intrinsic Time Value
(₹) (₹) value (₹) (₹)

100 90 12 10 2
101 90 13 11 2
103 90 14 13 1
88 90 1 0 1
95 90 5.50 5 0.50
Intrinsic and Time Value for Put Options: Examples
Spot Price Strike Price Premium intrinsic Time Value
(₹) (₹) value (₹) (₹)
100 110 12 10 2
99 110 13 11 2
97 110 14 13 1
112 110 1 0 1
105 110 5.50 5 0.5
Factors affecting option premium:

1. Underlying asset.
2. Strike price.
3. Time for expiration.
4. Volatility.
5. Risk free rate.
OPTIONS PAYOFF NUMERICAL

Q1) Vandana buys a call option of Malti Pharma Ltd. At an

exercise price of ₹ 100 with a premium of ₹ 3.

Calculate the profit or loss on the option position for Vandana if

the spot price on expiry is an follows:₹ 96, ₹ 97, ₹ 98, ₹ 99, ₹
100, ₹ 101, ₹ 102, ₹ 103, ₹ 104, ₹ 105.

Also draw the Pay-off diagram for the same.

Q2) Anurag buys a call option of XL Media Ltd. At an exercise
price of ₹ 500 with a premium of ₹ 30.

Calculate the profit or loss on the option position for Anurag if

the spot price on expiry is an follows:₹ 460, ₹ 470, ₹ 480, ₹ 490,
₹ 500, ₹ 510, ₹ 520, ₹ 530, ₹ 540, ₹ 550.

Also draw the Pay-off diagram for the same.

Q3) Mrs. Malti takes a short position on a call option of
Sangram Industries Ltd. Calculate the profit or loss on the
option position At an exercise price of ₹ 100 with a premium of
₹ 3 if the spot price on expiry ₹ 96, ₹ 97, ₹ 98, ₹ 99, ₹ 100, ₹
101, ₹ 102, ₹ 103, ₹ 104, ₹ 105.

Also draw the Pay-off diagram for the same.

Q4) Anurag short a call option of XL Media Ltd. At an exercise
price of ₹ 500 with a premium of ₹ 30.

Calculate the profit or loss on the option position for Anurag

if the spot price on expiry is an follows:
₹ 460, ₹ 470, ₹ 480, ₹ 490, ₹ 500, ₹ 510, ₹ 520, ₹ 530, ₹ 540,
₹ 550.

Also draw the Pay-off diagram for the same.

Q5) Yash takes a short position on a call option of Sun Pharma
Ltd. At an exercise price of ₹ 790 with a premium of ₹ 50.

Calculate the profit or loss on the option position for Yash if

the spot price on expiry is an follows:
₹ 750, ₹ 760, ₹ 770, ₹ 780, ₹ 790, ₹ 800, ₹ 810, ₹ 820.

Also draw the Pay-off diagram for the same.

Q6) Nitu buys a Put option of Savi Infotech Ltd. At an exercise
price of ₹ 100 with a premium of ₹ 3.

Calculate the profit or loss on the option position for Nitu if the
spot price on expiry is an follows:
₹ 96, ₹ 97, ₹ 98, ₹ 99, ₹ 100, ₹ 101, ₹ 102, ₹ 103, ₹ 104, ₹ 105.

Also draw the Pay-off diagram for the same.

Q7) Aakash buys a Put option on the stock Aman Enterprises.
He pays an option premium of ₹ 20. The exercise price being ₹
500.

Calculate the profit or loss if the spot price on maturity is any of

the following:₹ 470, ₹ 480, ₹ 490, ₹ 500, ₹ 510, ₹ 520, ₹ 530.

Also draw the Pay-off diagram for the same

Q8) Siddharth writes a Put option of Tata steel Ltd. At an
exercise price of ₹ 100 with a premium of ₹ 3.
Calculate the profit or loss on the option position for
Siddharth if the spot price on expiry is an follows:
₹ 96, ₹ 97, ₹ 98, ₹ 99, ₹ 100, ₹ 101, ₹ 102, ₹ 103, ₹ 104, ₹ 105.

Also draw the Pay-off diagram for the same.

 
 
Binomial option pricing model is very simple model that is used
to price options.

Assumptions in Binomial Option Pricing Model

There are only two possible prices for the underlying asset on
the next day. From this assumption, this model has got its name
as Binomial option pricing model (Bi means two).
 The two possible prices are the up-price and down-price.
The underlying asset does not pay any dividends.
The rate of interest (r) is constant throughout the life of the
option.
Markets are frictionless i.e. there are no taxes and no
transaction cost.
Investors are risk neutral i.e. investors are indifferent towards
risk.
Q) Current market price = Rs 500
Exercise price = Rs 510
Period = 1 year
Risk free rate 10%
Option : call option
Price on maturity
Upper price =Rs 600
Lower price = Rs 400
Calculate price under binominal model
Step 1: Given
S= Rs 500
R=1.10
u= 600/500 = 1.20
d=400/500= 0.80

Step 2: Calculation of risk neutral probability approach

P= r-d/u-d= 1.10-0.8/1.20-0.8 = 0.75

Step 3: binomial tree

Step 4: Calculation of value option

Value = cup + (1-d)cd/ r

= (90* 0.75+ 0.25*0)/1.10= 61.36
Q) The current market price of an equity share of penchant ltd
is Rs 420 within 3 months, the maximum price and minimum
price is expected to be Rs 500 and Rs 400 respectively. If the risk
free rate of interest 8% p.a. what should be value of 3 month call
option under risk neutral method at the strike price of Rs 450.
Given that e^0.02= 1.0202.
Step 1: Given
u = 500/ 420= 1.1905
d= 400/420 = 0.9524
R= e^rt
= e ^ (0.08*3/12)
= e ^ 0.02
= 1.0202

Step 2: Risk neutral probability

P= e^rt – d/ u-d = 1.0202- 0.9524/ 1.1905- 0.9524 = 0.2847
Step 3 : Binomial tree

Step 4: Value of call

C0 = cup + (1-d)cd/ e^rt
= 50*0.2847+ 0/ 1.0202
= 13.95
 BASIS FOR
COMPARISON FUTURES OPTIONS

1.Meaning Futures contract is a binding Options are the contract

agreement, for buying and in which the investor
selling of a financial gets the right to buy or
instrument at a sell the financial
predetermined price at a instrument at a set
future specified date. price, on or before a
certain date, however
the investor is not
obligated to do so.

2.Obligation of Yes, to execute the contract. No, there is no

buyer obligation.
3.Execution of On the agreed date. Anytime before the
contract expiry of the agreed
date.

4.Risk High Limited

 BASIS FOR
FUTURES OPTIONS
COMPARISON
5.Advance payment No advance payment Paid in the form of
premiums.
6.Degree of Unlimited Unlimited profit and
profit/loss limited loss.