Option Markets & Contracts

OPTION OPTION MARKETS & MARKETS &

CONTRACTSCONTRACTS

Master of Business & Administration

OUTLINEOUTLINE Introduction Terminology Exercise styles Moneyness of an Option Option Payoff Valuing option contracts Types of options Option strategies

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WHAT IS AN OPTION?WHAT IS AN OPTION?

o An option is a contract that gives the holder (buyer) of the option the right, but not the obligation to buy (or sell) a specified quantity and quality of a certain asset at an agreed price on or before the expiration date of the contract.

o For this right, the buyer pays a premium and the seller is obliged to honour the contract if called on to do so by the holder.

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OPTION MARKETOPTION MARKET

Over- the- counter option contracts

Exchange traded options

Buyer & seller of an option can arrange their own terms and create an option contact.

Traded in an organised and regulated exchange. Contracts are standardised.

Buyer is subject to the credit risk of the seller.Option seller is not subject to the credit risk of the buyer.

Buyer is not subject to the credit risk. The Exchange through its clearing house, guarantee the seller’s performance.

Difficult to terminate the option with a sale or purchase of the identical option.

Party who buy or sell an option can re-enter the market before the option expires and offset the position with a sale or a purchase of the identical option.

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TYPES OF OPTION TYPES OF OPTION CONTRACTSCONTRACTSo Call Option – gives the holder (buyer) the

right but not the obligation to buy the underlying asset at some time in the future at an agreed price.

o Put Option- gives the holder (buyer) the right but not the obligation to sell the underlying asset at some time in the future at an agreed price.

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OPTION MARKET OPTION MARKET VOCABULARYVOCABULARY

Option buyer / Long : The party holding the right

Option Seller / Short : The party granting the right or writer of the option.

Premium : Price paid for the option. This is usually paid up front.

Strike or Exercise rate (price) : is the rate at which the option may be exercised.

Expiry date : final date on which the option can be exercised.

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EXERCISE STYLESEXERCISE STYLES

European-style options : can only be exercised on the expiry date.

American-style options: can be exercised at any time up to and including the expiry date.

Bermudian option : can only be exercised at certain dates during the life of the option and usually only after a period of time has elapsed.

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MONEYNESS OF AN MONEYNESS OF AN OPTIONOPTION

Call optionCall option Put optionPut optionIn-the-money Spot >

strike Price price

Spot < strike Price price

At-the-money Spot = strike Price price

Spot = strike Price price

Out-of-the- money

Spot < strike Price price

Spot > strike Price price

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MONEYNESS OF AN OPTION-CONT.

Eg. For an European style optionExpiry date: 04.10.2009Strike price of the underlying asset: $100

At the expiry date,

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If spot price =

Moneyness of the call option

Moneyness of the put option

$150 In-the-money Out-of-the-money

$100 At-the-money At-the-money

$75 Out-of-the-money

In-the-money

LONG CALL OPTION - PAYOFF

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0

Loss

premium

Asset price

Exercise priceB

Profit

Profit – unlimited

Loss – limited to the premium paid

Buy call when expect a rise in the underlying price

LONG CALL OPTION – PAYOFF-CONT.

e.g.Purchase price of the option (premium) (Co )= $5

Spot price ( ST)= $ 100

Exercise Price ( X) = $80Value at expiry (CT) = max (0,ST - X) = $20

Profit = CT – CO

=$20 - $5 = $15Breakeven point = X + CO

= $80+$5=$8511

SHORT CALL OPTION - PAYOFF

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Profit

0

Loss

premium

Asset priceExercise

price

B

Profit - limited to premium received

Loss – unlimited

Sell call when expect a fall in the underlying market price

SHORT CALL OPTION – PAYOFF-CONT.

e.g.Sale price of the option (premium) ( Co )= $5

Spot price ( ST )= $ 100Exercise Price ( X) = $80Value at expiry (-CT) = -max (0, ST - X) = -$20

Profit = -CT + CO

=-$20+$5 = -$15Breakeven point = X + CO

= $80+$5=$8513

LONG PUT OPTION - PAYOFF

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0

Loss

Exercise priceB

premium

Asset price

Profit

Profit – unlimited

Loss – limited to the premium paid

Buy a put when expect a fall in the underlying market price

LONG PUT OPTION – PAYOFF-CONT.

Purchase price of the option(premium) ( Po)=

$5Spot price (ST) = $ 70Exercise Price ( X) = $80Value at expiry (PT) = max (0, X - ST) = $10

Profit = PT – PO

=$10 - $5 = $5

Breakeven point = X - PO

= $80 - $5=$7515

SHORT PUT OPTION – PAYOFF

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0

Loss

Exercise price

Bpremium

Asset price

Profit

Profit - limited to premium received

Loss – unlimited

Sell a put option when expect a rise in underlying market price

SHORT PUT OPTION – PAYOFF-CONT.

Sale price of the option(premium) ( PO)= $5

Spot price (ST) = $70Exercise Price (X) = $80Value at expiry (-PT) = -max (0, X - ST) = -$10

Profit = -PT + PO

=-$10 + $5 = -$5

Breakeven point = X - PO

= $80 - $5=$75

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VALUING OPTION CONTRACTS

The price of an option is depend on ,o the strike priceo the term of the optiono the underlying asset price (spot)o the prevailing risk free interest rateo the volatility of the underlying asset price

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THE OPTION “GREEKS”

Option price sensitivity measures have Greek names,

1) Delta2) Gamma3) Vega4) Theta 5) Rho

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THE OPTION “GREEKS”- CONT.

1) Delta

Price of underlying Call value put value

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Price of underlying Call value put valueDelta refers to the sensitivity of the option price to a change in the price of the underlying.


Delta is expressed as a value between 0 and 1

Delta tends towards zero for out-of-the –money options.

Delta tends towards 1 for in-the-money options.

At-the –money options have a delta of close to 0.5

Delta for call options are positiveDelta for put options are negative.

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2)Gamma

Gamma is a measure of how well the delta sensitivity measure will approximate the option price’s response to a change in the price of the underlying.

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THE OPTION “GREEKS”- CONT

3)VegaVolatility Call value put value

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Volatility Call value put value

Vega refers to the change in the option price resulting from a change in the volatility of the underlying asset price.

The more volatile the underling asset price, the more likely the option will expire in the money.

THE OPTION “GREEKS” –CONT.

Volatility Trading – Traders could imply what volatility value have been used by the market in order to derive the premium value quoted, by a process of back calculation, after inputting all the data to the option pricing model.

When a trader thinks that implied volatility currently priced into the market is less than that estimated by him for a future period, the trader may buy the option in order to go “long of volatility” and vice versa in order to make profit.

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4)Theta

Theta refers to the change in the option price resulting form a change in the time to expiry of the option.

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Time to expiry Call value put value


5) RhoThis is refers to the change in the option price resulting from a change in the risk

free interest rate.

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Interest rate Call value put value

Interest rate Call value put value

OPTION PREMIUMThe value of an option is the premium which someone is prepared to pay for the option.

Option premium = Intrinsic + Time value value

o Intrinsic value represent the profit you would make if you were to exercise the option you are holding, immediately.

o Time value is the amount by which an option’s premium exceeds its intrinsic value.

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TYPES OF OPTIONS

o Bond optiono Equity optiono Currency option o Commodity optiono Interest rate option

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BOND OPTION

Theses are options on bonds.

The option could be specified to settle with actual delivery of the bond or with a cash settlement.

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EQUITY OPTIONS

These are options on individual stocks.

Exchange –listed options are available on most widely traded stocks and option on any stock can potentially be created on the over-the-counter market.

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CURRENCY OPTION

A currency option allows the holder to buy (if a call) or sell (if a put) an underlying currency at a fixed exercise rate, expressed as an exchange rate.

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CURRENCY OPTION - CONT.

e.g. An importer who needs USD 50 million in 1 month ( when spot USD/LKR is 114.00)

He is in risk of appreciating USD against LKRHe can hedge the requirement by buying a USD call option with exercise price 114.50 for USD 50 million expiring in 1 month

If the USD/LKR spot rate at the expiry date- is above 114.50 importer can exercise the option & can

buy USD at 114.50 - is below 114.50 importer does not exercise the option

and can buy USD at the market rate.However, this is expensive than buying a forward contract

- in forward contract importer block the rate ( hedge against the loss, but could not enjoy the gain.

- in option contract can hedge against the loss as well as if market is favourable can enjoin the gain.

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COMMODITY OPTION

These are options which the underlying is a commodity such as oil, gold, wheat, or soybeans or combinations or derivatives of the products.

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INTEREST RATE OPTION

Is an option in which the underlying is an interest rate.

At expiration, the option payoff is based on the difference between the underlying rate in the market and the exercise rate.

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INTEREST RATE CALL OPTION.

An interest rate call is an option in which the holder has the right to make a known interest payment and receive an unknown interest payment.if unknown interest is higher than known rate the option is in-the-money

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INTEREST RATE PUT OPTION

An interest rate put is an option in which the holder has the right to make an unknown interest payment and receive a known interest payment.

If unknown interest is lower than exercise rate (known rate) the option is in-the-money

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Borrowers- use interest rate call options to hedge the risk of rising rates on floating-rate loans.

Lenders- use interest rate put options to hedge the risk of falling rates on floating rate loans.

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INTEREST RATE CAP AND FLOOR

Interest Rate Cap- is a series of call options on an interest rate, with each option expiring at the date on which the floating rate loan will be reset and with each option having the same exercise rate.

Interest Rate Floor - is a series of put options on an interest rate, with each option expiring at the date on which the floating rate loan will be reset and with each option having the same exercise rate.

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INTEREST RATE COLLAR

A combination of a long cap and a short floor or a short cap and a long floor.This can be used by both lenders and borrowers where they reduce the cost of a hedge by limiting the upside benefit.

Zero cost collar- cap and floor premiums cancel out

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Borrower’s collar-long cap short floor-this is described

as being LONG the collar. Lender’s collar-

long floor short cap-this is described as being SHORT the collar.

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OPTION STRATEGIES Long Straddle Short Straddle Long Strangle Short Strangle

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LONG STRADDLE

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0

Loss

Asset price

ProfitLong put Long call

E

To establish the position : Long call & Long put with the same strike “E” and the same expiry date, usually at- the-money When to use: trader believes the market is about to move from point “E”, but unsure of the directionProfit characteristic: profit is open-ended in the either direction, loss is limited to premium paid

SHORT STRADDLE

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0

Loss

Asset price

Profit

short put

Short call

E

To establish the position: short call & short put with the same strike “E” and the same expiry date, usually at the moneyWhen to use: the trader believes the market will generate stagnate around point “E”, i.e. trader hope decrease in volatilityProfit characteristics: profit is maximised if the market is point “E “at expiry, losses are open ended in either direction.

LONG STRANGLE

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0

profit

Loss

A B

To establish the position:Buy a call with strike “B” and buy a put with strike “A” with same a same expiry date. (out-of-the-money strikes)When to use: trader believes the market is about to move strongly, but unsure of the direction.Profit characteristics: profit is open-ended in the either direction, loss is limited to premium paid. This is cheaper strategy than the long straddle as the options bought are out-the-money.

Long callLong put

Asset price

SHORT STRANGLE

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To establish the position: sell a call with strike “B” sell a “put” with strike “A”. (out-of-the-money) with the same expiry date.When to use: the trader believes the market will generate stagnate around point “A” and “B”, i.e. trader hope decrease in volatilityProfit characteristics: profit is maximised if the market is within point “A” and “B” at expiry, losses are open ended in either direction.

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profit

Loss

Short put

Short call

A B

Asset price

Sanjeewa Guruge

B.Sc, M.Sc, FCA, FCMA

[email protected]

071 4433130

THANK YOUTHANK YOU

Option Markets & Contracts

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