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Index Options
These options have the index as the underlying.
Stock Options
These are options on individual stocks. A contract gives
the holder the right to buy or sell shares at specified
price.
Buyer of an option
The buyer of an option is the one who by paying the
option premium buys the right but not the obligation
to exercise his option on the seller.

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Writer of an option
The writer of a call/put option is the one who receives
the option premium and is thereby obliged to sell/buy
the asset if the buyer exercises on him.
Call option
A call gives the holder the right but not the obligation
to buy an asset by a certain date for a certain price.
Put option
A put option gives the holder the right but not the
obligation to sell an asset by a certain date for a
certain price.

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Options Price / Premium
Option price is the price which the option buyer pays to
the option seller. It is also referred to as the option
premium.
Expiration Date
The date specified in the options contract is known as
the expiration date, the exercise date, the strike date
or maturity.
Strike price
The price specified in the options contract is known as
the strike price or the exercise price

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American Options are options that can be exercised at
any time up to the expiration date
e.g. Stock options

European Option are options that can be exercised only

on the expiration date
e.g. Index options

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In-the-money option
An 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 ITM when the
current index stands at a level higher than the strike
price (spot price>strike price).
In case of a put, the put is ITM if the index is below the
strike price.

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

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Out-of-the money option
An OTM option is an option that would lead to a
negative cash flow if it were exercised immediately.
A call option on the index is OTM when the current
index stands at a level which is less than the strike
price.
In the case of a put, the put is OTM if the index is above
strike price.

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Call Option Put Option

Spot>strike ITM Spot<strike ITM

Spot=strike ATM Spot=strike ATM

Spot<strike OTM Spot>strike OTM

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Option Premium
Premium = Intrinsic value + Time value of an option
The intrinsic value of a call is the amount the option
is ITM, it is in-the-money. If the call is OTM its
intrinsic value is zero.
Time value of an option is the difference between its
premium and its intrinsic value. Both calls and puts
have time value. An option that is OTM or ATM has
only time value.
At expiration, an option should have no time value.

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 Illustration on Call Option

An investor buys one European Call option on one share of Neyveli Lignite
at a premium of Rs.2 per share on 31 July. The strike price is Rs.60 and the
contract matures on 30 September. It may be clear form the graph that
even in the worst case scenario, the investor would only lose a maximum
of Rs.2 per share which he/she had paid for the premium. The upside to it
has an unlimited profits opportunity.

On the other hand the seller of the call option has a payoff chart
completely reverse of the call options buyer. The maximum loss that he
can have is unlimited though a profit of Rs.2 per share would be made on
the premium payment by the buyer.

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 Illustration on Put Options

An investor buys one European Put Option on one

share of Neyveli Lignite at a premium of Rs. 2 per
share on 31 July. The strike price is Rs.60 and the
contract matures on 30 September. The adjoining
graph shows the fluctuations of net profit with a
change in the spot price.

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 Operators in the derivatives market

•Hedgers - Operators, who want to transfer a

risk component of their portfolio.
•Speculators - Operators, who intentionally take
the risk from hedgers in pursuit of profit.
•Arbitrageurs - Operators who operate in the
different markets simultaneously, in pursuit of
profit and eliminate mis-pricing.

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 USING STOCK OPTIONS

Hedging:Have stock, buy puts

Speculation: bullish stock, buy calls or sell puts

Speculation : bearish Stock, buy put or sell calls

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 Put-Call Ratio
The put-call ratio is a indicator of
market sentiment. It is the ratio of
number of puts to the number of calls in
the market on a given day.

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Reasons for writing option
contracts
1. Additional income on a securities portfolio
2. Option buyers are not as sophisticated as writers
3. Hedge on a long position
Reasons for buying options
1. Leverage: buyer will be able to control more
securities than could be done with realistic margin
2. To change the risk complexion of a portfolio
Fundamental Value
Value of call = (MP of underlying – Strike Price in the
call) * lot size
V = (MP-SP)*lot size

E.g SP = 50; CMP = 60

V = (60-50)*100 = 1000

Value of put = (Strike Price in the put - MP of

underlying ) * lot size
Factors determining option price
Contract price / striking price
Volatility of the underlying
Expiration date
Dividends
Interest rates
Strike Price
Price at which the stock under option may be put or
called
Closer the strike price to the CMP of the security,
greater the buyer’s chance of making money
Volatility
Buyers like volatility and writers don’t
Hence, highly volatile stocks have higher premiums
Expiration Date
Odds of stock make a profitable move increase with
time
Buyers benefit from the extended periods of time and
sellers suffer
Hence, premiums are high for longer lasting options
Therefore, options are a wasting asset
As time increases, option value decreases
Dividends
For firms paying high dividends, stock price doesn’t
move up much
Therefore, prospective call buyers avoid such options
because writers receive both dividends and premiums
Interest Rates
High interest rates mean option writers sacrifice
considerable income by holding stocks instead of
bonds. Hence, they expect and get higher premiums
Binomial Model
General formula for the value of a
call option with one period of
expiry
r : risk free rate

[ ]
Pl
Vc = H P0 - P0 : CMP of the
1+r underlying
Pl : lower value of the
share at the end of the
period
Vu - Vl
Hedging Ratio =
Pu - Pl
Black-Scholes Model
Assumptions
1. No transaction costs or taxes
2. Constant interest rate
3. Market operates continuously
4. Stock price is continuous and log normally
distributed => no jumps in share prices; smooth
curves
5. Share pays no dividends
6. No restrictions/penalties on short selling
7. Option is European -> can be exercised only at
maturity
Black-Scholes Model
Gives the equilibrium value of an option.
If the actual price of the option price differs, the
investor could establish a riskless hedged position
Gives the theoretical call price….ignores dividends
paid during the life of the option
Uses CMP, strike price, volatility, time to expiration
and risk-free rate
 Px
Vc = Ps [ Nd1 ] - [ Nd2 ]
e RT

σ2 Ps : CMP

d1 =
ln
( )
Ps
Px
+ T
[R + 2
] Px : exercise price of call
N(d) : value of the
σ √T cumulative normal density
function

R : risk free rate,

σ2 continuously compounded

d2 =
ln
( )
Ps
Px
+ T
[R - 2
] σ : standard deviation

ln : natural log
σ √T
T : time to expiration

e : 2.7183