Options

An option agreement is a contract in which the writer of the option grants the buyer of the option the right to purchase from or sell to the writer a designated instrument at a specific price (or receive a cash settlement) within a specified period of time

Options vs. Futures
Points of difference Performance Premium Risk Buyer Settlement Options Only seller to writer ↓ premium and ↑ potential on or before expiry date Futures Both No Premium ↓ and ↑ at settlement date

Options Terminology
Call Option An option that grants the buyer the right to buy a designated instrument . (Pc ; Call Option Price) Put Option An option that grants the buyer the right to sell a designated instrument . (Pp ; Put Option Price) Expiration Date The date on which the contract expiresthe last day on which the option can be exercised.

Options Terminology contd..
Exercise Price/ Strike Price - The price at which the buyer of a call can purchase the underlying asset (stock/currency/commodity etc.) during the life of the option.(X) Spot Rate Current Stock price/currency rate (S)

Options Terminology contd..
Premium The Price which the buyer pays to the seller/writer for an option contract .(C) Intrinsic Value- ≥ 0 American Option An option, call or put , which can be exercised on any business day from initiation to maturity. European Option An option which can be exercised only on maturity date.

Money ness
In-the-money S>X Out-of-money S<X At -the-money S=X Call Options or Put Options?

Types of Strategies
• Simple - Position in the option and the underlying • Spread - Position in two or more options of the same type • Combination - Position in a mixture of calls & puts (A combination)

Spreads
Spread consists of a put and a call option on the same security for the same time period at different prices.

Spread Types
Bullish- selling the call with higher strike price and buying the
call with lower strike price.(for call options) and vice-versa for put options on expectation of increase in stock price/ currency rate.

Bears - selling the call with lower strike price and buying the
call with higher strike price.(for call options) and vice-versa for put options on expectation of decline in stock price/ currency rate.

Spread Types contd..
Butterfly- Buying Two calls with middle strike price and writing one each on either side. Time - Both options having same exercise price but different maturity. Price- Both options having same maturity but different exercise price.

Combinations
Strap two calls and one put at contracted exercise price and for period. Strip two puts and one call at contracted exercise price and for period. the same the same the same the same

Combinations contd..
Ratio Call Spread • Purchasing a certain amount of calls at one strike and simultaneously selling more calls than purchased at a higher strike. It is generally a neutral options strategy.
• Maximum profit = the initial credit + difference between the two strikes (or) • Maximum profit = difference between the two strikes - the initial debit • Upside break even point = higher strike price + the points of maximum profit

Combinations contd..
• Straddle is an options strategy, which involves the purchase of a call and a put with the same strike price, the same expiration date, and the same underlying security.

Assets Underlying Exchange-Traded Options
• Stocks • Foreign Currency • Stock Indices • Futures

Warrants
• Warrants are options that are issued by a corporation or a financial institution • The number of warrants outstanding is determined by the size of the original issue and changes only when they are exercised or when they expire

Positions in an Option & the Underlying
Profit Profit

K K
(a) Profit Profit

ST
(b)

ST

K ST
(c)

K
(d)

ST

Bull Spread Using Calls
Profit ST K1 K2

Bull Spread Using Puts
Profit K1 K2 ST

Bear Spread Using Puts
Profit

K1

K2

ST

Bear Spread Using Calls
Profit K1 K2 ST

Box Spread
• A combination of a bull call spread and a bear put spread • If all options are European a box spread is worth the present value of the difference between the strike prices • If they are American this is not necessarily so.

Butterfly Spread Using Calls
Profit K1 K2 K3 ST

Butterfly Spread Using Puts
Profit K1 K2 K3 ST

Calendar Spread Using Calls
Profit ST K

Calendar Spread Using Puts
Profit ST K

A Straddle Combination
Profit

K

ST

Strip & Strap
Profit Profit

K Strip

ST

K Strap

ST

A Strangle Combination
Profit K1 K2 ST

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