Study Notes

Derivatives - Options
Derivatives – Options

Options

An option is a derivative which gives the owner the right but not the obligation to sell/buy a
specified quantity of the underlying asset at a particular price on or before a specified time.

It is called a derivative because it derives its value from the underlying asset.

Features:
 It gives you the right but not obligation to buy/sell.
 Which means on or before the due date arrives the option holder has the option to choose
whether to execute the deal or not.
 Unlike futures, the holder is not required to buy or sell the asset if they choose not to.
 You pay a price to get this right to buy/sell which is called option premium.
 Options contract is also an exchange-traded derivative.

Types of Options
1. Call Option –
 Buyer has the right but not obligation to BUY the specified quantity of
underlying asset at specified price on or before specified date.
 For this right, the call buyer will pay an amount of money called a premium,
which the call seller will receive.
 Unlike stocks, which have no expiration, an option will cease to exist after
specified date, ending up either worthless or with some value.
 A call buyer profits when the underlying asset increases in price.

2. Put Option –
 Buyer has the right but not obligation to SELL the specified quantity of
underlying asset at specified price on or before specified date.
 For this right, the put buyer will pay an amount of money called a premium,
which the put seller will receive.
 Unlike stocks, which have no expiration, an option will cease to exist after
specified date, ending up either worthless or with some value.
 A put buyer profits when the underlying asset declines in price.

The two parties of option contract:

1. buyer of option (known as option holder)
2. seller of option (known as option writer)
 As such, the option holder pays premium to the option writer.
 The specified price in the option contract or the price at which the option is exercised is
known as Strike Price or Exercise Price.
 Fixed Maturity Date known as expiry date.
 Options are settled in cash mostly.

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 Depending on when an option can be exercised, an option can be:

1. American Style Option – such options contracts can be exercised at any time up to
the expiration date. Options on individual securities available at NSE are American
style options.
2. European Style Options - such options can be exercised only on the expiration
date. All index options traded at NSE are European Options

Concept of Money-ness in Option Contract

In an option contract, an option will be exercised only when the option holder is in profit. As
such, the option holder calculates his potential profit or loss to him if he exercises the option.
This potential profit or loss is referred to as the money-ness of the option.
There can be three scenarios:
Money-ness Call Option Put Option
(i.e. option to Buy) (i.e. option to Sell)
In the Money
(i.e. profit and hence option will be Spot Price > Strike Price Spot Price < Strike Price
exercised)
At the Money
Spot Price = Strike Price
(indifferent)
Out of the Money
(i.e. loss and hence option will not be Spot Price < Strike Price Spot Price > Strike Price
exercised)

Note – When the option is “in the money” for the option holder, it is “out of money for the option
writer

Options Contract – Example

ITC Ltd is going to announce its quarterly result in month. Animesh is bullish (i.e. thinks that the
price will rise in future) on the ITC Ltd as he expects the profit to be more than what the market
is estimating. But since he cannot be sure what the ITC profit will be, he decides to buy a Call
Option of ITC Ltd, instead of buying the ITC shares directly.
Animesh buys 1 Call option contract (lot size = 100 shares) of ITC far month (3 months) for
Rs.20 each. The strike price is Rs.250 and the current price of ITC shares is Rs.225/-

As per this transaction:

 Strike Price = Rs.250
 Expiry Date = 30th June, 3 months
 Value of Contract = Rs.25,000 (Rs.250 x 100 shares)
 Option premium paid = Rs.2000 (Rs.20 x 100 shares)

The total cost for Animesh is the value of the contract and the premium paid i.e. Rs.25,000 +
Rs.2000 = Rs.27,000. As such, when the price of ITC share is more than the cost, Animesh
(holder of option) will be in profit.

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Figure 1: Call Option Contract

Pay-off of Call Option contract

In the above case, depending on the spot price of the ITC share, the payoff and money-ness of
the option contract will change:
I. If the spot price is more than the strike price
 Say the spot price of ITC Ltd is Rs.300 which is more than the strike price of Rs.250.
In this case Animesh (holder of call option contract) is in profit and the call option is
said to be ‘in the money’ as Animesh can buy ITC share at Rs.250 per share as
per the Options contract vis-à-vis buying it at Rs.300 from the market.
 The profit for Animesh in this case is the cost of ITC as per spot price at expiry and
as per the Options contract i.e.
ITC share at expiration = Rs.300
less: strike price of ITC as per Call Option = Rs.250
Option value (in the money amount) = Rs.50
Less: option premium paid = Rs.20
Profit per ITC share = Rs.30
Profit on the Options contract = Rs.3000 (Rs.30 x 100 shares)

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 The holder, depending on the market condition and his perception, may sell the call
even before expiry also (i.e. American style option)
 When spot price is more than strike price, the possibility of profit for the call option
holder is unlimited. On the other hand, for the option writer the loss is unlimited in
nature.

II. If the spot price is less than the strike price

 Say the spot price of ITC Ltd is Rs.200 which is less than the strike price of Rs.250.
In this case Animesh (holder of option contract) is in loss and the call option is said
to be ‘out of the money’ as Animesh can buy ITC share at Rs.200 per share from
the spot market vis-à-vis buying at Rs.250 as per the Options contract.
 The loss for Animesh in this case is the cost of ITC as per spot price at expiry and
as per the Options contract i.e.
ITC share at expiration = Rs.200
less: strike price of ITC as per Call Option = Rs.250
Option value (out of money amount) = - Rs.50
Loss on Option value =0
Now since the option is out of money, Animesh can choose to NOT exercise it
and therefore not suffer the loss.
However, he paid the premium to buy the option:
Option premium paid = Rs.20
Loss (loss on option value + premium) = Rs.0 + Rs.20 = Rs.20
Loss on the Options contract = Rs.2000 (Rs.20 x 100 shares)

 As such, for the holder of the option

(buyer or long the option contract)
o the loss is limited to the extent of
the option premium paid, while
o the possibility of the profit is
unlimited
 On the other hand, for option writer
(seller of option, short the option
contract)
o the profit is limited while
o the possibility of loss is unlimited
 The break-even point (BEP) for the call
option holder is the point of no profit or
no loss which can be calculated as:
BEP = strike price + option premium

Figure 3: Payoff – Call Option

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Derivatives – Options

Pay-off of Put Option contract

Suppose Animesh feels that the price of the Reliance Industries share is going to fall in coming
month. Since he cannot be sure, he decides to buy a Put Option on Reliance Industries. This
way he gets the right to sell the shares in future if prices fall but if they do not, he may choose
not to exercise that option.
Animesh buys 1 Put option contract (lot size = 50 shares) Reliance for near month (1 month) for
Rs.50 each. The strike price is Rs.1500 and the current price of Reliance Industries shares is
Rs.1600/-

As per this transaction:

 Strike Price = Rs.1500
 Expiry Date = 30th April, 1 month away
 Value of Contract = Rs.75,000 (Rs.1500 x 50 shares)
 Option premium paid = Rs.2500 (Rs.50 x 50 shares)

In the above case, depending on the spot price of the Reliance Industries share, the payoff and
money-ness of the option contract will change:

I. If the spot price is more than the strike price

 Say the spot price of Reliance Industries Ltd is Rs.1700 which is more than the
strike price of Rs.1500. In this case Animesh (holder of put option contract) is in loss
and the put option is said to be ‘out of the money’ as Animesh can sell Reliance
share at Rs.1700 per share in the market as against at only Rs.1500 as per the Put
Options contract. Alternatively, if Animesh does not own the shares already, he will
have to buy those shares from the market at Rs.1700 per share to be able to sell
under the options contract at Rs.1500 per share.

 The payoff for Animesh in this case is:

Reliance share at expiration = Rs.1700
Sell price for Reliance as per put option = Rs.1500
Less: buy cost of Reliance share at spot = Rs.1700
Loss as per option = - Rs.200
Loss on Option value = 0 (put option not exercised)
Less: option premium paid = Rs.50
Actual Loss = Rs.50

In this case, Animesh will not exercise the put option and his loss is limited to the option
premium paid.
For the put option writer, the profit is limited to the option premium received

II. If the spot price is less than the strike price

 Say the spot price of Reliance Industries Ltd is Rs.1400 which is less than the strike
price of Rs.1500. In this case Animesh (holder of put option contract) is in profit and
the put option is said to be ‘in the money’ as Animesh can buy those shares from

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the market at Rs.1400 per share to be able to sell under the options contract at
Rs.1500 per share.
 The payoff for Animesh in this case is:
Reliance share at expiration = Rs.1400
Sell price for Reliance as per put option = Rs.1500
Less: buy cost of Reliance share at spot = Rs.1400
Profit as per option = Rs.100
Less: option premium paid = Rs.50
Actual Profit = Rs.50

In this case, Animesh will exercise the put option and his profit possibility is unlimited depending
on the spot price of underlying asset.
For the put option writer, the loss is unlimited.

Figure 3: Payoff – Put Option

Option Premium
Option Premium = Intrinsic Value + Time Value

Intrinsic Value refers to the amount by which option is in the money. It is the profit that the
option holder/buyer will get before adjusting for premium paid.
 Intrinsic value of call option = spot price – strike price
 Intrinsic value of put option = strike price – spot price
 Only in-the-money options have intrinsic value
 at-the-money and out-of-the-money options have zero intrinsic value

Time Value refers to the value due to time left in the expiry of the option.
 Longer the time for expiration greater is the time value.
 Time Value is maximum for ‘at the money options’ and decreases with options becoming
‘in the money’.

Option premium pricing is a complex calculation. the most commonly used methodology is the
Black and Scholes Model which uses five key determinants of an option’s price: stock price,

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strike price, volatility, time to expiration, and short-term (risk free) interest rate to calculate the
options premium.

Additional (higher level) information on Options

Options Greeks
Options traders often refer to the delta, gamma, vega, and theta of their option positions.
Collectively, these terms are known as the Greeks, and they provide a way to measure the
sensitivity of an option's price to various quantifiable factors. As such, they help to understand
the risk exposures related to an option position.

The meaning of various greeks are as follows:

 Delta - measures the sensitivity of an option's premium to a change in the price of the
underlying asset. It ranges from -1 to 1. Call options have positive deltas and put options
have negative deltas.
 Gamma – measures the rate of change in the delta for each one-point increase in the
underlying asset. Unlike delta, gamma is always positive for both calls and puts.
 Theta – Theta is a measure of the time decay of an option, the dollar amount an option
will lose each day due to the passage of time. For at-the-money options, theta increases
as an option approaches the expiration date. For in- and out-of-the-money options, theta
decreases as an option approaches expiration.
 Vega - Vega measures the sensitivity of the price of an option to changes in volatility.
 Rho - measures the expected change in an option’s price per one-percentage-point
change in interest rates. As interest rates increase, the value of call options will generally
increase, and that of put option will decrease.

Put-Call Parity for European Options

Put-Call Parity is based on the payoff of two portfolio combinations:

a) Fiduciary Call: It is a combination of calls with an exercise price of S and a pure-

discount riskless bond that pays S at maturity (when the option expires). The payoff for a
fiduciary call at the expiration is S when the call is out of money. If the current price of
the stock is T at the expiry time and when a call is in the money, then the payoff is
S + (T – S) [Bond payoff + Payoff from a call option when it is in the money]
b) Protective Put: It is a combination of shares of stock with a put option on the stock.
When put is in the money, the payoff would be: (S – T) + T [Payoff from in the money
Put option plus stock value at the expiry period]

If at the expiry period, T is greater than or equal to S:

 The protective Put pays T on the stock, while the put expires out of the money
and total payoff becomes T

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 The fiduciary call pays S on the riskless bond portion, while the call pays (T – S),
so the total payoff becomes = S + (T – S) = T

If at the expiration S is greater than T

 The protective put pays T on the share of stock, while the put option pays (S – T),
So the payoff becomes = T + (S – T) = S
 The fiduciary call pays S on the bond portfolio and the call option expires out of
money, so the payoff becomes = S

In both cases, the payoff on a protective put is the same as the payoff on a fiduciary call. This
holds good the no-arbitrage condition. Portfolios with identical payoffs regardless of future
conditions must sell for the same price to prevent arbitrage. Put-Call parity relationship is:

C (Call price) + Present Value of bond payoff = Stock Value + Put Price.
Stock Value = Call Price + present value of the bond – Put price

(Positive sign indicates the long position and a negative sign indicates short position)

Note: the options must be European style and puts and call options must have the same
exercise price and time to expiration for this relationship to hold.

After exercising the Put-Call Parity relationship, the value of a security can be synthetically
created with a long call option, short put option, and a long position in a riskless bond.

Example:

Suppose that the current stock price is Rs 108 and the risk-free rate is 5%. The 3-month put
option is available with a quote of the exercise price of Rs 102. The Put price is Rs 3 but
due to less trading in call options, there is no quote of a 3-month call option available.
Estimate the 3-month price of a call option with a Put-Call Parity relationship.

Put-call Parity Relationship

Call Price = Put price + Stock value – Present Value of bond

= 3 + 108 – 102/1.05*0.25
= 6.27

Price of call option is 6.27.