CHAPTER-3

Options
Meaning of options- Options are financial derivatives that give buyers the
right, but not the obligation, to buy or sell an underlying asset at an agreed-
upon price and date. Call options and put options form the basis for a wide
range of option strategies designed for hedging, income, or speculation.

There are many different types of options that can be traded and these can be
categorized in a number of ways. Calls give the buyer the right to buy the
underlying asset, while puts give the buyer the right to sell the underlying
asset.

Types of options

Options can be further categorized based on the method in which they are
traded, their expiration cycle, and the underlying security they relate to. There
are also other specific types and a number of exotic options that exist. On this
page we have published a comprehensive list of the most common categories
along with the different types that fall into these categories

1. Calls

Call options are contracts that give the owner the right to buy the underlying
asset in the future at an agreed price. You would buy a call if you believed that
the underlying asset was likely to increase in price over a given period of time.

Calls have an expiration date and, depending on the terms of the contract, the
underlying asset can be bought any time prior to the expiration date or on the
expiration date.

2. Puts

Put options are essentially the opposite of calls. The owner of a put has the
right to sell the underlying asset in the future at a pre-determined price.
Therefore, you would buy a put if you were expecting the underlying asset to
fall in value. As with calls, there is an expiration date in the contact.

3. American option

An American option is a version of an options contract that allows holders to

exercise the option rights at any time before and including the day of
expiration.
 4. European option

A European option is a version of an options contract that limits execution to

its expiration date. In other words, if the underlying security such as a stock
has moved in price an investor would not be able to exercise the option early
and take delivery of or sell the shares.

5. Exchange Traded Options

Also known as listed options, this is the most common form of options. The
term “Exchanged Traded” is used to describe any options contract that is listed
on a public trading exchange. They can be bought and sold by anyone by using
the services of a suitable broker.

6. Over The Counter Options

“Over The Counter” (OTC) options are only traded in the OTC markets, making
them less accessible to the general public. They tend to be customized
contracts with more complicated terms than most Exchange Traded contracts.

7. Employee Stock Options

These are a form of stock option where employees are granted contracts based
on the stock of the company they work for. They are generally used as a form of
remuneration, bonus, or incentive to join a company. You can read more about
these on the following page – Employee Stock Options.

8. Cash Settled Options

Cash settled contracts do not involve the physical transfer of the underlying
asset when they are exercised or settled. Instead, whichever party to the
contract has made a profit is paid in cash by the other party. These types of
contracts are typically used when the underlying asset is difficult or expensive
to transfer to the other party. You can find more on the following page – Cash
Settled Options.

9. Stock Options: The underlying asset for these contracts is shares in a

specific publically listed company.

10. Index Options: These are very similar to stock options, but rather
than the underlying security being stocks in a specific company it is an
index – such as the S&P 500.
 11. Asian Options

An Asian option is an option type where the payoff depends on the average
price of the underlying asset over a certain period of time. These options allow
the buyer to purchase (or sell) the underlying asset at the average price instead
of the spot price. For example these are mainly used for oil and base metals.

12. Uncovered options and Covered options

A naked option, also known as an "uncovered" option, is created when the

seller of an option contract does not own the underlying security needed to
meet the potential obligation that results from selling (also known as "writing"
or "shorting") an option.

13. Covered Options –A situation in which an investor writes an

option while holding an equal and opposite position on the underlying
asset.

14. Caps, Floors and Collar

Interest Rate Caps, Floors and Collars are option-based Interest Rate Risk
Management products. These option products can be used to establish
maximum (cap) or minimum (floor) rates or a combination of the two which is
referred to as a collar structure.

15. Exotic Options

Exotic option is a term that is used to apply to a contract that has been
customized with more complex provisions. They are also classified as Non-
Standardized options.

16. Vanilla Option

A vanilla option is a financial instrument that gives the holder the right, but
not the obligation, to buy or sell an underlying asset at a predetermined price
within a given timeframe.

17. Basket Options: A basket contract is based on the underlying

asset of a group of securities which could be made up stocks, currencies,
commodities or other financial instruments.

18. Regular Options These are based on the standardized expiration

cycles that options contracts are listed under. When purchasing a
 contract of this type, you will have the choice of at least four different
expiration months to choose from. The reasons for these expiration
cycles existing in the way they do is due to restrictions put in place when
options were first introduced about when they could be traded.

Terminologies used in Option Trading

• Option Premium- The price of an option is called its premium. Prices

are quoted per share, but premium is usually the entire dollar value of
the contract (price per share X 100 shares = total premium).

• Long- To be “long” an option simply means to have purchased it in an

opening transaction and thus to own or hold it.

• Short — o be short an option means to have sold the option in an

opening transaction. (A short position is carried as a negative on a
statement and must be purchased later to close out.)

• Strike Price — The pre-agreed price per share at which stock may be
bought or sold under the terms of an option contract.

• Exercise
Exercise is the process by which an option buyer (holder) invokes the
terms of the option contract. If exercising, calls will buy the underlying
stock, while put owners will sell the underlying stock under the terms set
by the option contract.

• EXPIRATION DATE
The expiration date is the last day on which the option may be exercised.

• In-The-Money (ITM) — For call options, this means the stock price is
above the strike price. (stock price>strike price)

For put options, it means the stock price is below the strike price. (Stock
price<strike price)

• Out-of-The-Money (OTM) — For call options, this means the stock price
is below the strike price. For put options, this means the stock price is
above the strike price. The price of out-of-the-money options consists
entirely of “time value.”
• At-The-Money (ATM) — An option is “at-the-money” when the stock
price is equal to the strike price. (Since the two values are rarely exactly
equal, when purchasing options the strike price closest to the stock price
is typically called the “ATM strike.”)

• Intrinsic Value
The intrinsic value of an option is the amount of profit that can be
theoretically obtained if the option is exercised at that moment and the
stock either purchased (for calls) or sold (for puts) at the current market
price. If an option has positive intrinsic value, it is said to be “in-the-
money” (ITM) and if it has negative intrinsic value it is said to be “out-of-
the-money” (OTM)

• Time Value — Time value is the amount by which an option’s market

price exceeds its intrinsic value.

Option Trading

Options Trading Example

We will go through two cases to better understand the call and put
options.

For simplicity’s sake, let us assume the following:

Price of Stock when the option is written: Rs100
Premium: Rs. 5
Expiration date: 1 month after the option is bought

Case 1:

Margin for options buyer

For the buyer, they need to pay only premium and not the full price of
the contract. The exchange transfers this premium to the broker of the
option seller who in turn transfers it to the client.
So the minimum loss to the option seller is restricted to the premium
amount. Margin for options seller
The option seller, on the other hand, has a potential for unlimited loss.
 Thus the seller has to deposit margin with the exchange as a security in
case of huge loss due to adverse price movement in the option price.

This amount is levied on the contract value and the amount is denoted in
% term as dictated by the exchange.

Usually, this % value is created based on the volatility of the price of the
underlying asset and the option. Higher the volatility, higher is the
premium.

Types of Margin

Initial margin– It requires the minimum amount of capital or equity that

an investor must provide during purchase. It is done to prevent over
speculation and excessive trading. It is that margin requirement which
investor talks about when dealing with margin trading.

Until there is enough margin in the account i.e. greater than or equal to
the initial requirement, the investor can freely use his account.
However, if the margin goes below the initial margin requirement, it will
lead to a situation of restricted account which requires investors to bring
back to the initial level

Maintenance margin– It is the minimum margin amount which an

investor must maintain at all time in the margin account.
Say if the margin goes back below the maintenance margin level, the
investor will get a call initially to remedy the position or else the broker
has an authority to sell the required equity to bring back to the initial
level.
It protects both investor and the brokerage house.
The broker does not have to absorb excessive investor losses while the
investor is in a situation to avoid being totally wiped out.

Settlement of Options

Physical Settlement

Physical settlement is the most commonly used form of settlement.

Physically settled options are those that involve the actual delivery of the
underlying security they are based on. The holder of physically settled
call options would therefore buy the underlying security if they were
exercised, whereas the holder of physically settled put options would sell
the underlying security.

Physically settled options tend to be American style, and most stock

options are physically settled.

In practice whether an option is physically settled or cash settled isn't

particularly relevant that often. This is because most traders don’t
actually exercise, but rather attempt to make their profits through
buying and selling contracts.

Cash Settlement
Cash settlement isn't as common as physical settlement, and it's
typically used for options contracts based on securities that aren't easily
transferred or delivered. For example, contracts based on indices, foreign
currencies, and commodities are typically cash settled. Cash settled
options are usually European style, which means they are settled
automatically at expiration if they are in profit.
Basically, if there's any intrinsic value in contracts at the time of
expiration, then that profit is paid to the holder of the contracts at that
point. If the contracts are at the money or out of the money, meaning
there is no intrinsic value, then they expire worthless and no money
exchanges hands.

Valuation of Options

Determinants of Option Value

There are six factors affecting the price of a stock options

1. Current stock price - If it is exercised at some time in the future, the

payoff from a call option will be the amount by which stock price exceeds
the strike price. Therefore call option becomes more valuable as the stock
price increases.
2. Exercise price - If it is exercised at some time in the future, the payoff
from a call option will be the amount by which stock price exceeds the
strike price. Therefore call option becomes less valuable the strike price
increases.
3. Time to expiration-Both put and call American options become more
valuable as the time to expiration increases. To see this, consider two
options that differ only as far as the expiration date is concerned. The
owner of the long-life option has all the exercise opportunities open to
the owner of the short-life option and more. The long-life option must
therefore always be worth at least as much as the short-life option.
European put and call options do not necessarily become more valuable
as the time to expiration increases.
4. Volatility [or Variance ] in stock prices - Roughly speaking, the
volatility of a stock price is a measure of how uncertain we are about
future stock price movements. As volatility increases, the chance that the
stock will do very well or very poorly increases. The owner of a call
benefits from price increases but has limited downside risk in the event
of price decreases. Therefore value of calls increases as volatility
increases. The same logic applies to put options.

5. Risk free interest -If the stock price is expected to increase, an

investor can choose to either buy the stock or buy the call. Purchasing
the call will cost far less than purchasing the stock. The difference can be
invested in risk-free bonds. If interest increase, the combination of calls
 and risk-free bonds will be more attractive. This means that the call price
will tend to increase with increases in interest rates.

6. Anticipated cash Payments on the stocks – Anticipated cash

payments on the stock tend to decrease the price of the call option
because the cash payment make it more attractive to hold stock than to
hold the option.

Properties of Option Values

1. The minimum value of an option is zero.

This is because an option is only a choice, not an obligation. The value of
an option cannot be negative, because you do not have to do anything to
get rid of it. The option will always have a zero, or a positive value.

2. The maximum value of a call option is equal to the value of the

underlying asset.
This makes a lot of economic sense. An option allows you to buy a given
asset at a certain exercise price. The most valuable option will be the one
that allows you to acquire the asset at no cost, and the value of this
option will be equal to the value of the underlying asset.
3. The total value of an option is the sum of its intrinsic value and
its time premium.

Option Valuation

Intrinsic value of the Options

Intrinsic value of the options is a gain to the holder of an option on immediate

excersice. The intrinsic value of an option represents the current value of the
option, or in other words how much in the money it is. When an option is in
the money, this means that it has a positive payoff for the buyer.

The intrinsic value of an option is calculated differently depending on if it is a

call option or a put option, but it always uses the strike price of the option and
the price of the underlying asset:

In the money call options:

 Intrinsic Value = Price of Underlying Asset - Strike Price

In the money put options:

Intrinsic Value = Strike Price - Price of Underlying Asset

Calculation of Intrinsic Value

(Underlying Stock Price: Rs.100)

Type Strike Price

Rs.85 Rs.90 Rs.95 Rs.100 Rs.105 Rs.110

Call Rs.15 Rs.10 Rs.5 Rs.0 Rs.0 Rs.0

Put Rs.0 Rs.0 Rs.0 Rs.0 Rs.5 Rs.10

In the table above, we can see how the intrinsic value of call and put options
changes based on the strike price when the price of the underlying stock is
Rs.100.

Time Value

The time value of an option is an additional amount an investor is willing to

pay over the current intrinsic value. Investors are willing to pay this because
an option could increase in value before its expiration date. This means that if
an option is months away from its expiration date, we can expect a higher time
value on it because there is more opportunity for the option to increase or
decrease in value over the next few months. If an option is expiring today, we
can expect its time value to be very little or nothing because there is little or no
opportunity for the option to increase or decrease in value.

Time value is calculated by taking the difference between the option’s premium
and the intrinsic value, and this means that an option’s premium is the sum of
the intrinsic value and time value:

Time Value = Option Premium - Intrinsic Value

Option Premium = Intrinsic Value + Time Value

For Example - For example, let’s say our Rs.85 call on IBM stock has a
premium of Rs.16. IBM stock is currently trading at Rs.100, so our intrinsic
value is Rs.15 (100 - 85). This means that our time value is Rs.1 (16 - `15).

For options that are at the money (ATM) or out of the money (OTM), the
premium will be equal to the time value, because ATM or OTM options always
have an intrinsic value of zero.

The Black-Scholes Options Pricing Model

Introduction

The Black Scholes model, also known as the Black-Scholes-Merton (BSM)

model, is a mathematical model for pricing an options contract.

It is developed by three economists—Fischer Black, Myron Scholes and Robert

Merton—it is perhaps the world's most well-known options pricing model. It
was introduced in their 1973 paper, "The Pricing of Options and Corporate
Liabilities," published in the Journal of Political Economy.

It is an approach for calculating the value of stock option (call or Put).

The Model or Formula calculates an theoretical value of an option based on 6

variables. These variables are:

• Whether the option is a call or a put

• The current underlying stock price
• The time left until the option's expiration date
• The strike price of the option
• The risk-free interest rate
• The volatility of the stock

Assumptions

1. The underlying stock pays no dividends during the option’s life;

2. The options contract to be priced is a European-style call option;
3. Markets are efficient;
4. There are no commissions in the transaction;
5. Interest rates are assumed to be constant;
6. Returns of the underlying assets follow a lognormal distribution.

Explanation
We can determine the value of call option using the following formula:

C - theoretical option value(Call Premium)

S - current stock price

N – Cumulative standard Normal distribution

E -exercise price written in the option contract

e – Exponential term(2.7183)

r - risk-free interest rate

t - time in years until option expiration

σ - is a measure of annual volatility of the underlying stock, which is often

measured by the standard deviation of stock returns.

ln = natural logarithm

The model is used to find the current value of a call option whose ultimate
value depends on the price of the stock at the expiration date. Because the
stock price keeps changing, the value of this call option will change too.
Therefore, if we want to trade this option contract, then we need to use some
probabilities to estimate what expected values are involved in the call option
today. We need to think about the value we can expect to obtain by buying this
option and what we will pay if we exercise the option.

Advantages

• It is relatively easy to understand

• Use to calculate large number of option prices in short time.
• Standard way to quote prices
• High accuracy.
Limitations

There are limitations to the Black-Scholes model, which is one of the most
popular models for options pricing. Some of the standard limitations of the
Black-Scholes model are

• Assumes constant values for risk free rate of return and volatility over
the option duration—none of those may remain constant in the real
world
• Ignoring liquidity risk and brokerage charges
• Assumes stock prices to follow lognormal pattern, e.g., a random walk (or
geometric Brownian motion pattern)—ignoring large price swings that are
observed more frequently in the real world
• Assumes no dividend payout—ignoring its impact on the change in
valuations
• Assumes no early exercise (e.g., fits only European options)—the model is
unsuitable for American options

Other assumptions, which are operational issues, include assuming no penalty

or margin requirements for short sales, no arbitrage opportunities and no
taxes—in reality, all these do not hold true; either additional capital is needed
or realistic profit potential is decreased.

Conclusion

Blindly following any mathematical or quantitative trading model leads to

uncontrolled risk exposure. Models will continue to be the primary basis for
trading, especially for complex instruments such as derivatives.

Binomial Model

The binomial option pricing model(BOPM) was first proposed by Mr.Cox Ross
and Mr.Rubinsten developed in 1979. The binomial option pricing model uses
an iterative procedure, allowing for the specification of nodes, or points in time,
during the time span between the valuation date and the option's expiration
date.

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)
• There are no market frictions – no transaction cost
• Market participants enter no counterparty risk
• Markets are competitive
• There is no opportunity for arbitrage
• There is no interest rate uncertainty.

Binomial model is best represented using binomial trees which are

diagrams that show option payoff and value at different nodes in the
option’s life. The following binomial tree represents the general one-
period call option.

Advantages of Binomial Option Pricing Model

• Binomial option pricing models are mathematically simple to use.
• Binomial option pricing model is useful for valuing American options in
which the option owner has the right to exercise the option any time up
till expiration.
• Binomial option model is also useful for pricing Bermudan options which
can be exercised at various points during the life of the option.

Limitations of Binomial Option Pricing Model - One major limitation

of binomial option pricing model is its slow speed. Computation
complexity increases in multi period binomial option pricing model.
 Difference between Futures and Options

FUTURES OPTIONS
Meaning Futures contract is Options are the
a binding contract in which
agreement, for the investor gets
buying and selling the right to buy or
of a financial sell the financial
instrument at a instrument at a set
predetermined price price, on or before
at a future specified a certain date,
date. however the
investor is not
obligated to do so.
Trading Desk Exchange traded OTC or Exchange
Traded
Upfront cost There are no Buyers must pay a
upfront costs for premium to
futures trades, just purchase an
margin option, and option
requirements sellers collect his
premium.
Obligation of buyer Yes, to execute the No, there is no
contract. obligation.
Execution of On the agreed date Anytime before the
contract expiry of the agreed
date.
Risk High Limited
Advance payment No advance Paid in the form of
payment premiums.
Degree of Unlimited Unlimited profit
profit/loss and limited loss.
Size More expensive Less expensive