Derivatives. Memo & Basic Knowledge.

Options are derivative contracts that give the holder the right, but not the obligation, to buy or sell
the underlying instrument at a specified price on or before a specified future date. Although the
holder (also called the buyer) of the option is not obligated to exercise the option, the option writer
(known as the seller) has an obligation to buy or sell the underlying instrument if the option is
exercised.

Depending on the strategy, option trading can provide a variety of benefits including the security of
limited risk and the advantage of leverage. Options can protect or enhance an investor's portfolio in
rising, falling and neutral markets.

Basic option terminology:

European Options - An option that can only be exercised during a particular time period just before
its expiration.

American Options - An option that can be exercised at any point during the life of the contract. Most
exchange-traded options are American.

Early Exercise - The exercise of an option before its expiration date. Early exercise can occur with
American-style options.

Naked Option - An option position in which the writer of the option does not have an offsetting
position in the underlying security, thereby having no protection against adverse prices moves. The
opposite being a Covered Option

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Listed Option - A put or call option that is traded on an options exchange. The terms of the option,
including strike price and expiration dates, are standardized by the exchange.

Over-the-Counter - An option that is not traded over an exchange. An over-the-counter option is not
subjected to the standardization of terms such as strike prices and expiration dates.

Open Interest & volume - Options exchanges track the trading activity of option contracts. Two
important metrics are "volume" and "open interest." Volume represents the total number of
contracts traded in a given day, while open interest represents the total number of outstanding
(open) contracts in the market (contracts being created and still active / has not yet been exercised,
closed out, or expired). Open interest is a crucial indicator of the liquidity and trading activity of a
particular option contract.

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Call - An option that gives the holder (buyer) the right to buy the underlying security at a particular
price for a specified, fixed period of time.

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Put - An option that gives the holder (buyer) the right to sell the underlying security at a particular
price for a specifie

The Writer - An investor who sells an option (call or put) and who collects the premium payment
from the buyer. Writers are obligated to buy or sell if the holder chooses to exercise the option

In-the-Money - An option that has an intrinsic value. A call option is considered in-the-money if the
underlying security is higher than the strike price.

At-the-Money - An option whose strike price is equal to the market price of the underlying security.

Out-of-the-Money - An option with no intrinsic value that would be worthless if it expired on that
day. A call option is out-of-the-money when the strike price is higher than the market price of the
underlying security. A put option is out-of-the-money when the strike price is lower than the market
price of the underlying security

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Strike Price - The agreed-upon price at which an option can be exercised. The strike price for a call
option is the price at which the security can be bought (prior to the expiration date); the strike price
for a put option is the price at which the security can be sold (before the expiration date). The strike
price is sometimes called the exercise price.

Premium - The total cost of the option. An option holder pays a premium to the option writer in
exchange for the right, but not the obligation, to exercise the option. In general, the option's
premium is its intrinsic value combined with its time value.

The price, or cost, of an option is an amount of money known as the premium. The buyer pays
this premium to the seller in exchange for the right granted by the option. For example, a buyer
might pay a seller for the right to purchase 100 shares of stock XYZ at a strike price of $60 on or
before December 22. If the position becomes profitable, the buyer will decide to exercise the option;
if it does not become profitable, the buyer will let the option expire worthless. The buyer pays the
premium so that he or she has the "option" or the choice to exercise or allow the option to expire
worthless.

Premiums are priced per share. For example, the premium on an IBM option with a strike price of
$205 might be quoted as $5.50, as shown in Figure 1. Since equity option contracts are based on 100
stock shares, this particular contract would cost the buyer $5.50 X 100, or $550 dollars. The buyer
pays the premium whether or not the option is exercised and the premium is non-refundable. The
seller gets to keep the premium whether or not the option is exercised.

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 Figure 1 This option chain for the October 2012 IBM contract shows the
various premiums and strike prices. Chart created at CBOE.com.

The two components of an option premium are the intrinsic value and the time value. The intrinsic
value is the difference between the underlying's price and the strike price.

Intrinsic Value (Call) = Underlying Price – Strike Price

Intrinsic Value (Put) = Strike Price – Underlying Price

By definition, the only options that have intrinsic value are those that are in-the-money.

In-the-Money (Call) = Strike Price < Underlying Price

In-the-Money (Put) = Strike Price > Underlying Price

Any premium that is in excess of the option's intrinsic value is referred to as time value.

Time Value = Premium – Intrinsic Value

In general, the more time to expiration, the greater the time value of the option. It represents the
amount of time that the option position has to become more profitable due to a favorable move in
the underlying price. In general, investors are willing to pay a higher premium for more time
(assuming the different options have the same exercise price), since time increases the likelihood
that the position can become profitable. Time value decreases over time and decays to zero at
expiration. This phenomenon is known as time decay.

An option premium, therefore, is equal to its intrinsic value plus its time value.

Option Premium = Intrinsic Value + Time Value

There are six primary factors that influence option prices, as shown in Figure 2 and discussed below.

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 Figure 2: Six factors that affect option prices are shown on the
top row. As indicated, the underlying price and strike price
determine the intrinsic value; the time until expiration and
volatility determine the probability of a profitable move; the
interest rates determine the cost of money; and dividends can
cause an adjustment to share price.

Underlying Price
The most influential factor on an option premium is the current market price of the underlying asset.
In general, as the price of the underlying increases, call prices increase and put prices decrease.
Conversely, as the price of the underlying decreases, call prices decrease and put prices increase.

If underlying prices ... Call prices will ... Put prices will ...
Increase Increase Decrease
Decrease Decrease Increase

Expected Volatility
Option traders can evaluate historical volatility to determine possible volatility in the future. Implied
volatility, on the other hand, is a forecast of future volatility and acts as an indicator of the current
market sentiment.

The greater the expected volatility, the higher the

option value

Strike Price
The strike price determines if the option has any intrinsic value. Remember, intrinsic value is the
difference between the strike price of the option and the current price of the underlying.

Premiums increase as options become further in-the-

money

Time Until Expiration

The longer the time until expiration, the higher the

option price

Interest Rate and Dividends

Interest rates and dividends also have small, but measurable, effects on option prices. Professional
trader usually trades with interest-bearing loaned money for long positions and receives interest-
earning money for short positions. Increase in interest rates will lead to either saving in outgoing
interest on the loaned amount or an increase in the receipt of interest income on the savings

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account. Both will be positive for the call position + savings. Effectively, a call option’s price increases
to reflect this benefit from increased interest rates.

If interest rates
Call prices will ... Put prices will ...
...
Increase Decrease
Rise
marginally marginally
Decrease Increase
Fall
marginally marginally

Dividends can affect option prices because the underlying stock's price typically drops by the amount
of any cash dividend on the ex-dividend date. As a result, if the underlying's dividend increases, call
prices will decrease and put prices will increase. Conversely, if the underlying's dividend decreases,
call prices will increase and put prices will decrease.

If dividends ... Call prices will ... Put prices will ...
Rise Decrease marginally Increase marginally
Fall Increase marginally Decrease marginally

It is important to differentiate between an option premium and its theoretical value. As discussed
previously, the option premium is the price the option buyer pays to the seller (a market price base
on supply & demand)

The theoretical value of an option, on the other hand, is the estimated value of an option – a price
generated by means of a model. It is what an option should currently be worth using all the known
inputs, such as the underlying price, strike and days until expiration. These factors often change
during an option's lifetime, and some fluctuate in value on a continuing basis throughout any trading
session.

When options are first listed on a stock, for example, the market makers will not know what sort of
implied volatility to use, so they must make educated guesses (theoretical values). The implied
volatility will then change based upon the supply and demand for the options.

Option traders utilize various option price models to attempt to set a current theoretical value.
Models use certain fixed knowns in the present – factors such as underlying price, strike and days till
expiration – along with forecasts (or assumptions) for factors like implied volatility, to compute the
theoretical value for a specific option at a certain point in time. Variables will fluctuate over the life
of the option, and the option position's theoretical value will adapt to reflect these changes.

Most professional traders and investors who trade significant option positions rely on theoretical
value updates to monitor the changing risk and value of option positions and to assist with trading
decisions. Many options trading platforms provide up-to-the-minute option price modeling values,
and option pricing calculators can be found online at various Web sites, including the Options
Industry Council (http://www.optioneducation.net/calculator/main_calculator.asp). This particular
calculator allows users to select by model/exercise type, as shown in Figure 3.

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 Figure 3 The options calculator found on the Options Industry Council Web
site allows users to choose either a Binomial model (for American style
options) or the Black-Scholes model (for European options).

The Black-Scholes model for calculating the premium of an option was introduced in 1973 in a paper
entitled, "The Pricing of Options and Corporate Liabilities" published in the Journal of Political
Economy. The formula, developed by three economists – Fischer Black, Myron Scholes and Robert
Merton – is perhaps the world's most well-known options pricing model. Black passed away two
years before Scholes and Merton were awarded the 1997 Nobel Prize in Economics for their work in
finding a new method to determine the value of derivatives (the Nobel Prize is not given
posthumously; however, the Nobel committee acknowledged Black's role in the Black-Scholes
model).

The Black-Scholes model is used to calculate the theoretical price of European put and call options,
ignoring any dividends paid during the option's lifetime.

The model makes certain assumptions, including:

• The options are European and can only be exercised at expiration

• No dividends are paid out during the life of the option
• Efficient markets (i.e., market movements cannot be predicted)
• No commissions
• The risk-free rate and volatility of the underlying are known and constant
• Follows a lognormal distribution; that is, returns on the underlying are normally distributed.

The formula, shown in Figure 4, takes the following variables into consideration:

• Current underlying price

• Options strike price
• Time until expiration, expressed as a percent of a year
• Implied volatility
• Risk-free interest rates

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 Figure 4: The Black-Scholes pricing formula for call options.

The model is essentially divided into two parts: the first part, SN(d1), multiplies the price by the
change in the call premium in relation to a change in the underlying price. This part of the formula
shows the expected benefit of purchasing the underlying outright. The second part, N(d2)Ke^(-rt),
provides the current value of paying the exercise price upon expiration (remember, the Black-
Scholes model applies to European options that are exercisable only on expiration day). The value of
the option is calculated by taking the difference between the two parts, as shown in the equation.

The mathematics involved in the formula is complicated and can be intimidating. Fortunately,
however, traders and investors do not need to know or even understand the math to apply Black-
Scholes modeling in their own strategies.

Figure 5: An online Black-Scholes calculator can be used to get

values for both calls and puts. Users must enter the required fields
and the calculator does the rest. Calculator
courtesy www.tradingtoday.com

➢ The Cox-Rubenstein (or Cox-Ross-Rubenstein) binomial option pricing model is a

variation of the original Black-Scholes option pricing model. It was first proposed in 1979
by financial. It relies on Binomial trees and help to price American-type options.