Options Basics

Option Terminology Option Payoffs Components of an option price Put Call Parity
Prem Prakash

July 26, 2011

Shrusti Institute Of Management

W hat is deferred delivery contract which an Option? An Option is a

gives the buyer( holder) the right but not the obligation , to buy or sell specified quantity of the underlying assets at a specific price( strike price) on or before a specified time( expiration date).

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Options gives the buyer the right but not the obligation to buy or sell the contract.

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Components of Option
Option

type (Put or Call) Expiry Date of Option Option Exercise Type ( American/ European) Exercise Price of Option ( Strike Price) Price or Premium of Option

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Types of Option
Call Option Call Option gives its owner the right to buy stock at a specified exercise or strike price on or before a specified exercise date. Put Option Put Option gives its owner the right to sell stock at a specified exercise or strike price on or before a specified exercise date.
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Options Terminology
Underlying
It refers to the specific security/asset on which an options contract is based.

Option Premium
Option Premium is the price paid by the buyer to the option seller to acquire the right to buy or sell the underlying.

Strike Price
Strike Price of an option is the pre-determined price of the underlying asset at which the same can be bought/sold

Expiration Date

The date of expiration of Option. In India its the last trading Thursday of the Calender Month

Exercise Date

The date of exercise of the option by the buyer.

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Let the Closing Price of Arvind Mills in June 2006 was Rs 60

Option Maturity July 2006 Exercise Price Price of Call Option Rs 40 Rs 45 Rs 50 Rs 55 Rs 60 Rs 65 Rs 70 Rs 18 Rs 13.45 Rs 9.5 Rs 5.6 Rs 3.15 Rs 1.65 Rs .85
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Example:-

Price of Put Option Rs 0 Rs .60 Rs 1.6 Rs 3.35 Rs 5.25 Rs 9.35 Rs 13.30

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Pay Off Diagrams

Call

Option when Strike Price = Rs 60

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Pay Off Diagrams

Put

Option when Strike Price = Rs 60

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Equation for Option

Call Put

Option Ct = max[ 0;(St-X)] Option Pt = max [ 0; (X-St)]

St :- Stock Price X :- Strike Price Ct :- Value of Call Option at Expiry Pt :- Value of Put Option at Expiry
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Profit Diagrams

Call Option when Strike Price = Rs 60 and option premium is Rs 5.

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Profit Diagrams

Put Option when Strike Price = Rs 60 and option premium is Rs 5.

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Style of Options
American

Style An American Style of Option is the one which can be exercised by the buyer any time on or before the expiration date. European Style An European Option is the one which can be exercised by the expiration date only and not anytime before that.
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Obligations and rights of Option Buyers and Sellers

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Obligations and rights of Option Buyers and Sellers

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Moneyness of Options
Moneyness of an option describes the relationship between the strike price of the option and the current stock price. Types: In the Money At the Money Out of the Money

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Call Option Moneyness

In

the Money Strike price < Stock price eg:- Stock price Rs 450 , Strike Price Rs 430 At the Money Strike price = Stock price eg:- Stock price Rs 450 , Strike Price Rs 450 Out of the Money Strike price > Stock price eg:- Stock price Rs 450 , Strike Price Rs 470

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Put Option Moneyness

In

the Money Strike price > Stock price eg:- Stock price Rs 450 , Strike Price Rs 470 At the Money Strike price = Stock price eg:- Stock price Rs 450 , Strike Price Rs 450 Out of the Money Strike price < Stock price eg:- Stock price Rs 450 , Strike Price Rs 430

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Settlement of Option Contracts

An option can be settled in three ways to make a profit or avoid loss
Exercise

it Offset it with another option Let it expire worthless

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Offsetting
Its

the method of reversing the original transaction to exit the trade. similar calls/put with same strike price and expiration date can be offset.

Only

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Option Premium
Option holders or buyers have to pay a price for having the right to buy /sell the underlying asset and the price of the conferred rights without any obligations is known as Option Price or Option Premium Eg:July 26, 2011 Shrusti Institute Of Management 21

Components of Option Premium

Intrinsic

Value or Intrinsic Worth (IV/IW) It is defined as the maximum of difference between price of asset (St) and exercise price or zero ( Call Option )before or at expiration date. Eg: Time Value (TV) Its the difference between the price of Call and Intrinsic Value.

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Bounds for Option Prices

Three Simple Bounds on Option prices
Option

Prices are always nonnegative

Stock Price
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Bounds for Option Prices

Option

Prices must always be less than the or equal to the value of the underlying asset price.

Stock Price
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Bounds for Option Prices

Option

Prices must always be greater than or equal to the intrinsic value.

Stock Price
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Put- Call Parity

Price

of a call option and a put option are linked through the put-call parity relationship + Present Value of (X) = Put + S

Call

S:- Stock Price X:- Exercise Price

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American Call Options

Stock Price
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