Option

An option is a Contract that gives the holder the right

to buy or sell a particular asset at a specified price, on
or before, a specific date.
Option can be of two types
Call Option - Right to Buy
Put Option - Right to sell

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Difference in Futures and Options
A futures contract gives the holder / buyer the
obligation to buy or sell at a certain price , while an
option gives the holder / buyer the right to buy or sell
at a certain price.
The buyer of an option can abandon the option if he or
she wishes , while the buyer of a futures contract
cannot abandon the contract.

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Key Terms
Agreement or an Option
Buy or Sell
Price: Exercise Price (Strike Price)
Time: Expiry Date
Premium
Long vs Short Position
American vs European Options

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Types of Options
Options are of two types which are Call Option and
Put Option.
A Call option is an option that gives the holder the
right to buy a particular asset at a specified price, on
or before, a specific date.
A Put option is an option that gives the holder the
right to sell a particular asset at a specified price, on
or before, a specific date.
Strike Price / Exercise Price
The price at which the option is exercisable is called
the strike price or the exercise price.
The Option buyer can buy or sell the underlying
asset, depending on as the case may be, on a specified
date at the strike price from the option writer.
Expiry Date
The date on which the option can be exercised is
called the expiry date or expiration date.
Option Premium/ Option Price
The amount paid by the option buyer to the option
writer in return for receiving the right to buy or sell a
specific asset at the specific price on or before the
exercise date is known as option premium or option
price.
American Option Vs. European Option
An option which can be exercised only on the expiry
of the contract, the option is known to be of European
style, while the option which can be exercised on or
before the expiry of the contract is known to be of
American style of option.
Settlement of an Option Contract
The settlement of an option can take place after
exercising the option in two ways.
It can be in the form of physical delivery of the asset
in which the actual delivery of the asset takes place in
return for payment of the strike price.
It can be in the form of cash settlement for the
difference between the market price of the asset at
the time of exercise of option and the strike price.
In the Money/ At the Money / Out of
the Money Options
Contract Specification Call Option Put Option

Market Price > Strike Price In the Money Out of the Money

Market Price < Strike Price Out of the Money In the Money

Market Price = Strike Price At the Money At the Money

Pay offs in Option Contract
Since there are two types of options; there can be four
types of positions which can be taken. These positions
can be
1. A long position in call option / Buying a call option
2. A short position in call option / Writing a call option
3. A long position in put option / Buying a put option
4. A short position in put option / Writing a put option
A long position in call option / Buying a
call option
K is the strike price of the underlying asset
ST is the price of the asset on the expiry of the
contract
Pay off in case of a long position in call option /
Buying a call option will be
= Max. (ST – K, 0)
A short position in call option / Writing
a call option
Pay off in case of a short position in call option /
Writing a call option
= Min. (K – ST, 0)
A long position in put option / Buying a
put option
Pay off in case of a long position in put option /
Buying a put option
= Max. (K – ST, 0)
A short position in put option /
Writing a put option
Pay off in case of a short position in put option /
Writing a put option
= Min (ST – K, 0)
Factors Influencing Option Prices
Price of underlying asset
Exercise Price
Time to maturity
Price volatility of underlying stock
Risk free interest rate
Dividend yield

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Price of underlying asset
Keeping all other factors constant, if cash price of the
underlying asset goes up, value of the call option
increases, but value of the Put option diminishes.
Similarly, if cash price of the underlying asset goes
up, value of the call option increases, but value of the
Put option diminishes.
Strike Price
If all other factors remain constant, with the increase
in the strike price of the option, intrinsic value of the
call option will decrease and hence its value will also
decrease. On the other hand, with all other factors
remaining constant, increase in strike price will
increase the intrinsic value of the put option and
hence its price will increase.
Similarly with the decrease in the strike price of the
option, value of the call option will increase and value
of put option will decrease
Volatility in Underlying Asset
Volatility in the price of the underlying asset affects
both the call option and put option in the same way.
Higher volatility in the underlying asset escalates the
chances of an option going in the money at any point
in time during the life of the contract.
It increases the risk of the option writer or seller.
Consequently, it makes the option, both call and put,
more expensive.
Time to Expiration
Effect of time to expiration on both call option and
put option is similar to that of volatility on option
premiums. The longer the maturity of the option, the
greater is the uncertainty and hence the prices of both
call option and put options are higher, keeping all
other factors constant.
Therefore, longer maturity options are always more
expensive than shorter maturity options as longer
maturity period increases the risk of the option seller.
Interest

Rate
Higher interest rate results in an increase in the value
of a call option and a decrease in the value of a put
option.
Call option may be treated as a variant to buying an
underlying asset in the spot market and carrying it to
the future.
Therefore, by means of a call option the buyer
postpones buying the underlying assets and earns
interest on his money.
The higher the interest rate, higher is the interest
component to him and therefore, cost of buying the
call option must also be higher.
Thanks