OPTIONS

CHAPTER-3
• 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.

Basic Types
1. Call
2. Put
3. American Options
4. European Options
5. Exchange Traded Options
6. Over The Counter Options
7. Employee Stock Options
8. Cash Settled Options
9. Stock Options
10. Index Options
11. Asian Options
12. Uncovered options and Covered options
13. Covered Options
14. Caps, Floors and Collar
15. Exotic Options
16. Vanilla Option
17. Basket Options
18. Regular Options
Terminologies used in Option Trading

• Time Value
• Intrinsic Value
• At-The-Money (ATM)
• Out-of-The-Money (OTM)
• In-The-Money (ITM)
• Expiration date
• Exercise
• Strike Price
• Short
• Long
• Option Premium
 VALUATION OF OPTIONS

Determinants of Option Value

• Anticipated cash Payments on the stocks

• Risk free interest
• Volatility [or Variance ] in stock
• Time to expiration
• Exercise price
• Current stock price
 PROPERTIES OF OPTION VALUES

• The minimum value of an option is zero

• The maximum value of a call option is equal to the value
of the underlying asset.
• The total value of an option is the sum of its intrinsic
value and its time premium.
Intrinsic Value of Options
In Call
• Intrinsic Value = Price of Underlying Asset - Strike Price

In put
• Intrinsic Value = Strike Price - Price of Underlying Asset

Time Value
• Time Value = Option Premium - Intrinsic Value
• Option Premium = Intrinsic Value + Time Value
THE BLACK-SCHOLES OPTIONS PRICING MODEL

• 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

• 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. No dividends
2. European-style
3. Markets are efficient
4. No commissions
5. Interest rates are assumed to be constant
6. Lognormal distribution
• 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
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
 BINOMIAL MODEL

• The binomial option pricing model(BOPM) was first

proposed by Mr.Cox Rossand Mr.Rubinsten developed in
1979.
Assumptions
• 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.
Advantages of Binomial Option Pricing Model
• simple to use
• valuing American options
• Bermudan options
• 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.