INTRODUCTION TO OPTIONS AND OPTION

MARKETS

5th August, 2020

session 7,
SESSION PLAN
▷ WHAT ARE OPTIONS

▷ OPTION BASICS

▷ OPTION PRICING AND PAYOFFS

▷ OPTION MARKETS

▷ OPTION TRADING
WHAT ARE OPTIONS
OPTIONS
▷ A CONTRACT TO BUY OR SELL A SPECIFIC
FINANCIAL ASSET AS THE OPTION’S
UNDERLYING ASSET OR INTEREST

▷ DIFFERENT FROM FUTURES AND FORWARDS

OPTIONS

▷ GIVES THE BUYER RIGHT AND COMMITTS

THE SELLER TO AN OBLIGATION
TOCD
▷ TATA STEEL HAD ISSUED TOCD IN 1992

▷ RPL TOCD

▷ WARRANTS
WARRANTS VS OPTIONS
▷ WARRANTS ARE OPTIONS ISSUED BY THE
COMPANIES ON THEIR OWN SHARES

▷ NET SUPPLY OF WARRANTS IS NOT ZERO

WHILE OPTIONS IS
OPTIONS AS INSURANCE
▷ OPTION CONTRACTS ARE LIKE INSURANCE

STOCK OF RELIANCE WAS 2198.8 ON 27/7/20 AND

YOU ARE HOLDING 10000 SHARES IN YOUR
PORTFOLIO AND SINCE PRICES HAVE RUN
QUITE FAST IN 3 MONTHS ALMOST 2.5 TIMES
IN 4 MONTHS, YOU WANT TO INSURE
YOURSELF AGAINST LOSS OF VALUE
LIKELY OPTIONS
▷ SELL RELIANCE SHARES

▷ SELL RELIANCE FUTURE

▷ BUY PUT OPTION

OPTIONS AS INSURANCE
▷ ASSET INSURED RELIANCE
▷ CURRENT ASSET VALUE RS. 2198.80
▷ TERM OF POLICY 1 MONTH
▷ MAXIMUM COVERAGE RS.1800
▷ DEDUCTIBLE RS. 398.80
▷ INSURANCE PREMIUM

DIFFERENCES:

EARLY EXERCISE
MARKETABILITY
DIVIDENDS
OPTION BASICS
CRITICAL CONCEPTS
▷ UNDERLYING (CONTRACT SPECIFICATION)

▷ EXERCISE PRICE OR STRIKE PRICE

▷ EXPIRATION DATE AND MONTH

▷ TIME TO MATURITY

▷ OPTION OPEN INTEREST

▷ OPTION VOLUME
CRITICAL CONCEPTS
▷ VOLATILITY

▷ IV

▷ CASH SETTLED

▷ DELIVERY SETTLED OPTIONS

▷ VIX
OPTIONS TRADING BASICS
▷ CONTRACT VALUE
▷ TICK SIZE
▷ CIRCUIT FILTERS
▷ WEEKLY OR MONTHLY
▷ FINAL ASSIGNMENT
▷ DAILY MARGIN
▷ MARKET WIDE POSITION LIMITS
▷ BAN PERIOD
▷ CROSS MARGIN
NAKED VS COVERED POSITIONS
▷ COVERED BY UNDERLYING

▷ OPEN SPECULATIVE OPTIONS

TYPES OF OPTION?
▷ EXOTIC OPTIONS
FORWARD START OPTIONS
OPTIONS ON FUTURES
GAP OPTIONS
CLIQUET OPTIONS
COMPOUND OPTIONS
CHOOSER OPTIONS
BARRIER OPTIONS
BINARY OPTIONS
LOOK BACK OPTIONS
SHOUT OPTIONS
TYPES OF OPTION?
▷ VANILLA OPTIONS

CALL
PUT
CLASSIFICATION OF EXERCISE

▷ AMERICAN CA/PA

▷ BERMUDA

▷ EUROPEAN CE/PE
ECONOMIC AGENT
▷ BUYER
▷ SELLER

ACTION/TYPE BUY + SELL -

CALL + + -
PUT - - +

BID
ASK
EXAMPLE OF INDEX OPTION?
▷ NIFTY

▷ 11000

▷ 27AUG2020

▷ CE / PE
EXAMPLE OF STOCK OPTION?
▷ ITC

▷ 200

▷ 27AUG2020

▷ CE /PE
OPTION CHAIN OR STRING
▷ ALL STRIKES FOR A STOCK OR INDEX FOR
BOTH CALL AND PUT FOR AN EXPIRY

▷ ATM

▷ ITM

▷ OTM

▷ FOR EXAMPLE RELIANCE 1060 TO 2420 WITH A

PRICE INTERVAL OF RS. 20 OF 27AUG2020
EXAMPLE OPTION CHAIN
OPTION CHAIN OR STRING
▷ ALL STRIKES FOR A STOCK OR INDEX FOR
BOTH CALL AND PUT FOR AN EXPIRY

▷ ATM

▷ ITM

▷ OTM

▷ FOR EXAMPLE NIFTY 8000 STRIKE PRICE TO

12800 FOR 27AUG2020 WITH AN INTERVAL OF
RS. 50
OPTION CHAIN NIFTY
OPTION SERIES
▷ GROUP OF OPTIONS FOR A STOCK OR INDEX
SAME EXPIRY AND STRIKE PRICE

▷ FOR EXAMPLE NIFTY 11000 CALL/ PUT FOR

27AUG2020
UNDERWRITING RISK
▷ SELLER/ WRITER GETS PREMIUM FOR
UNDERWRITING RISK ON BEHALF OF THE
BUYER
ACCOUNTING
▷ FOR EVERY TRADED OPTION THERE IS A
BUYER AND A SELLER

▷ BUYER PAYS PREMIUM AND SELLER GETS THE

PREMIUM. PAYS FOR THE ABILITY TO CHOOSE
WHEN TO EXERCISE.

▷ BUYER PAYS ONLY PREMIUM AND SELLER

PUTS UP MARGIN.
ACCOUNTING
▷ BUYER PAYS PREMIUM AND SELLER GETS
THE PREMIUM
OPTION PRICING AND PAYOFFS
 INTRINSIC VALUE

▷ THE VALUE THAT IS INRINSIC TO THE OPTION

▷ DIFFERENCE BETWEEN THE SPOT PRICE AND

STRIKE PRICE

▷ FOR EXAMPLE RELIANCE PRICE WAS RS. 2198.8 AS

ON 27/7/20.

▷ A CALL OPTION OF 2100 FOR 27AUG2020 WILL HAVE

98.80 AS INTRINSIC VALUE
▷ SPOT PRICE- STRIKE PRICE
TIME VALUE

▷ SAME EXAMPLE OF RIL A CALL OF 2250 HAS NO

INTRINSIC VALUE BUT HAS TIME VALUE TILL
27TH AUGUST 2020
TOTAL VALUE

▷ CALL = INTRINSIC VALUE + TIME VALUE

PAYOFFS

▷ PAYOFF AT MATURITY
 PAYOFF CALL BUYER
▷ For the SBI 27AUG2020 200 Call buyer:

Maximum profit
is unlimited
Breakeven Point = Rs. 206.55

0
Rs.-6.55

Maximum loss

Rs.200
 PAYOFF SHORT CALL
▷ For SBI 27AUG2020 200 Call writer:

Maximum profit Breakeven Point = Rs.206.55

Rs.6.55
0

Maximum loss
is unlimited

Rs.200
 PAYOFF LONG PUT OPTION
▷ For the SBI 27AUG2020 180 Put buyer:

Maximum profit = Rs. 175.75

Breakeven Point = Rs. 175.75

Rs.0
Rs.-4.25

Maximum loss
Rs. 180
PAYOFF SHORT PUT OPTION
▷ For the SBI 27AUG2020 180 Put seller:

Maximum profit = Rs. 4.25

Breakeven Point = Rs. 175.75

Rs.4.25

Rs.0

Maximum loss
Rs. 180
OPTION PRICING
▷ AT MATURITY T PAYOFF OF CALLS AND PUTS

C (T) = CALL PRICE , P (T) = PUT PRICE

S (T) = SPOT PRICE AT EXPIRY
K = STRIKE PRICE

C (T) = MAX [ 0, S(T)-K]

P (T) = MAX [K- S(T), 0]

OPTION PRICING
▷ PAY-OFFS ARE ASYMMETRIC, LOSS LIMITED,
PROFIT UNLIMITED OR VICE VERSA. NON-
LINEAR PAY-OFFS AS COMPARED TO
STOCKS/BONDS

▷ IN PAY-OFF DIAGRAM THERE IS A KINK AT THE

STRIKE PRICE AND THAT’S WHY IT IS CALLED
KINKY SECURITIES ALSO.
FORWARD AND OPTION
▷ FORWARDS ARE ZERO NPV AT THE BEGINNING
WHILE OPTIONS ARE NOT
OPTION P&L
CONSIDER THE FOLLOWING
Strike price = Rs. 25.
Stock Price Rs. Call Option Price
25 3.00
30 7.50
35 12.00
40 16.50
45 21.00
50 25.50
EXERCISE VALUE
Price of Strike Exercise value
stock (a) price (b) of option (a)–(b)

25.00 25.00 0.00

30.00 25.00 5.00
35.00 25.00 10.00
40.00 25.00 15.00
45.00 25.00 20.00
50.00 25.00 25.00
MARKET PRICE OF OPTION
Price of Strike Exer. Mkt. Price
stock (a) price (b) val. (c) of opt. (d)

25.00 25.00 0.00 3.00

30.00 25.00 5.00 7.50
35.00 25.00 10.00 12.00
40.00 25.00 15.00 16.50
45.00 25.00 20.00 21.00
50.00 25.00 25.00 25.50
TIME VALUE OF OPTION
Price of Strike Exer. Mkt. P of Time value
stock (a) price (b) Val. (c) opt. (d) (d) – (c)

25.00 25.00 0.00 3.00 3.00

30.00 25.00 5.00 7.50 2.50
35.00 25.00 10.00 12.00 2.00
40.00 25.00 15.00 16.50 1.50
45.00 25.00 20.00 21.00 1.00
50.00 25.00 25.00 25.50 0.50
CONCEPT
▷ OPTIONS ARE KINKY SECURITIES AND UNIQUE
DUE TO NON-LINEAR AND ASYMMETRIC PAY-
OFFS.
 “
▷ KEY IS FINDING
MISPRICED OPTIONS
Thanks for Your time
and Attention!