Basic Principles of

Derivatives

Introduction to Options
What is so special about Options?
To answer this let’s go back to Forward Contracts:

Its an agreement to buy or sell an asset at a certain future

time for a certain price.

Long Position in a Forward Contract

The one who agrees to buy the underlying the asset on a
certain specified future date for certain specified price.

Short Position in a Forward Contract

The other party agrees to sell the asset on the same date for
the same price.
Example:
On Jan 20, 2010, a refiner enters into an agreement with a
crude oil supplier to buy 1 million barrels in 3 months at a rate
of $50/barrel.
Basics of forward contracts
Spot Gain/
Who is going long
in this forward Price ($) Loss ($)
contract? 35
And short? 40
Now calculate the
gain/loss for the 45
long party at spot 50
prices on maturity
of the contract 55
given in the table: 60
65
Payoff for Long Forward
Spot Price ($) Gain/
Loss ($)
35 -15
40 -10
45 -5
50 0
55 5
60 10
65 15
Payoff for Long Forward

15
P
a
y Spot Price
0
o 35 50 65
f
f
-15
Payoff for Short Forward
Spot Price ($) Gain/
Loss ($)
35 15
40 10
45 5
50 0
55 -5
60 -10
65 -15
Payoff for Short Forward

15
P
a
y Spot Price
0
o 35 50 65
f
f
-15
What did we learn?
Now we can conclude that Forwards
can be risky as they are capable of
giving loss as much as they can give
us profits.
Because once we enter into such
contracts
we are under an ‘obligation’ to honour
the commitment to buy/sell
at the price we locked at the beginning
of the contract.
What is so special about Options?

So, how are Options different from

Forwards?

An Option Contract gives its owner the

right, but not legal obligation, to conduct
a transaction in an underlying asset at a
predetermined future date (the exercise
date) and a predetermined price (the
exercise price)
Call and Put Options
The owner of a call option has the
right to purchase the underlying
asset at a specified price for a
specified time period

The owner of a put option has the

right to sell the underlying asset at a
specified price for a specified time
period
Buyer and Seller of Options

For every owner of an option, there

must be a seller.
The seller of the option is also called
the option writer.
The owner of the option has to pay a
price to the seller of the option for
acquiring this right. This is called
option premium.
Option Characteristics
The Option buyer Long Short
gets a right to (Buyer of (Seller of
decide whether or Option) Option)
not the trade will Call Right to Obligation
eventually take (Choice buy to sell
place. to buy)

The Option seller

has the obligation Put Right to Obligation
to perform if the (Choice sell to buy
buyer exercises the to sell)
option.
Example
Long Short
(Buyer of Option) (Seller of Option)

Call Right to buy Obligation to

(Choice to buy) oil at $50 sell oil at $ 50
A Refiner buys a
call option to buy 1
million barrel oil in 3
months at a rate of
$50/barrel
Put Right to sell Obligation to
(Choice to sell) oil at $50 buy oil at $ 50
A crude oil Supplier
buys a put option to
sell 1 million barrel
oil in 3 months at a
rate of $50/barrel
Payoff for a Long Call
A Refiner buys a call Spot Gain/
option to buy 1 million
barrel oil in 3 months at a Price ($) Loss ($)
rate of $50/barrel.
40
Now Calculate the payoffs. 45
50
52
55
60
65
Payoff for a Long Call
A Refiner buys a call Spot Gain/
option to buy 1 million
barrel oil in 3 months at a Price ($) Loss ($)
rate of $50/barrel.
40 0
45 0
50 0
52 2
55 5
60 10
65 15
Payoff for a Long Call

15
P
a
y Spot Price
0
o 35 50 65
f
f
-15
Payoff for a Long Put
A crude oil Supplier buys a Spot Gain/
put option to sell 1 million
barrel oil in 3 months at a Price ($) Loss ($)
rate of $50/barrel
35
40
45
48
50
55
60
Payoff for a Long Put
A crude oil Supplier buys a Spot Gain/
put option to sell 1 million
barrel oil in 3 months at a Price ($) Loss ($)
rate of $50/barrel
35 15
40 10
45 5
48 2
50 0
55 0
60 0
Payoff for a Long Put

15
P
a
y Spot Price
0
o 35 50 65
f
f
-15
Moneyness for Puts and Calls
Moneyness Call Put Option
Option
In the Money S>X S<X

At the Money S=X S=X

Out of the Money S<X S>X

Intrinsic Value
Intrinsic Value of an Option is the payoff
from immediate exercise of the option.
It is the amount by which the option is in-
the-money.
It is amount of money that the option owner
would receive if the option were exercised.
An option has zero intrinsic value if its at
the money or out of the money.
Intrinsic Value of Call and Put option:
C = Max [0, S - X]
P = Max [0, X - S]
Payoff for a Long Call
A Refiner buys a call Spot Gain/
option to buy 1 million
barrel oil in 3 months at a Price ($) Loss ($)
rate of $50/barrel and pays
a premium of $5/barrel 40 -5
45 -5
Thus, a long call 50 -5
has unlimited gain 52 -3
potential and 55 0
limited loss
60 5
potential.
65 10
Payoff for a Long Call

15
P
a
y Spot Price
0
o 35 50 55 65
f -5

f
-15
The Zero Sum Game!
Long Call Short Call
Spot Gain/ Spot Gain/
Price ($) Loss ($) Price ($) Loss ($)
40 -5 40 5
45 -5 45 5
50 -5 50 5
52 -3 52 3
55 0 55 0
60 5 60 -5
65 10 65 -10
Payoff: Long Call Vs Short Call

15 Long Call
P
a 5
y Spot Price
0
o 35 50 55 65
f -5
f
-15 Short Call
Payoff for a Long Put
A crude oil Supplier buys a Spot Gain/
put option to sell 1 million
barrel oil in 3 months at a Price ($) Loss ($)
rate of $50/barrel and pays
a premium of $5/barrel 35 10
40 5
Thus, a long put 45 0
has a greater gain
48 -3
potential and
limited loss 50 -5
potential. 55 -5
60 -5
Payoff for a Long Put

15
P
a
y Spot Price
0
o 35 45 50 65
f -5

f
-15
The Zero Sum Game!
Long Put Short Put
Spot Gain/ Spot Gain/
Price ($) Loss ($) Price ($) Loss ($)
35 10 35 -10
40 5 40 -5
45 0 45 0
48 -3 48 3
50 -5 50 5
55 -5 55 5
60 -5 60 5
Payoff: Long Put Vs Short Put

15
P
Short Put
a 5
y Spot Price
0
o 35 45 50 65
f -5 Long Put
f
-15
American Vs European Options
American Options can be exercised
at any time up to the option’s
expiration date.
European Options can only be
exercised at option’s expiration date.
American Options values will equal or
exceed European Option values.
European Options are easier to
analyze.