Structure of Option Market

Unit 2

Option is a contract between two parties in which one party has the right but not obligation to do something, usually to buy or sell some underlying asset.

The right without obligation has some financial value. To realize the financial values, it is necessary to purchase the derivative instrument – the rights.

Concept of Options

At the day first, the option writer/seller receive certain percentage of exercise/strike price for the compensation of selling rights of assets (stocks, bonds, etc) to the option holder/buyer.

There are two types of option contracts – Call option and Put option.

The purchaser of an Option has rights (but not obligations) to buy or sell the asset during a given time for a specified price (the "Strike" price).

An Option to buy is known as a "Call," and an Option to sell is called a "Put. "

The seller of a Call Option is obligated to sell the asset to the party who purchased the option (rights). The seller of a Put Option is obligated to buy the asset.

Thus, the options is the rights of future which is granted by the option contract to the buyer or the seller (the option holder or option writer, respectively) against the payment of option premium.

Options

Call

European American

Put

European American

Types of Options

American options – can be exercised any time until exercise dateEuropean options – can be exercised only on exercise date

Call option is a contract that grants the holder the right to buy an asset at a fixed price at during a particular period of time.

As a option buyer, if the stock price is lower than the strike price, the holder would buy the stock at market price after considering the option premium, instead of exercising the option.

Call Option

The call option buyer anticipate the upward movement in stock price so that this is a bullish attitude.

The difference (+ve) between the market price and striking price is the reward for option holder.

The value of call option at expiration is as follows:

Vc = Max (Vs – E, 0)Where,Vc = Value of call optionVs = Market price of stock at expirationE = Exercise price

For example, if the exercise price is Rs 115 and current market price of the stock is Rs 132, what is the value of call? If the option premium is Rs 10, what is the profit and loss status for buyer?

Soln: Vc = Max (Vs – E, 0)= Max (132 – 115)= Max Rs 17

Profit = Vc – Pc = 17 – 10 = Rs 7 BEP for call option seller = (E + Pc) should

be equal to market price at expiration

Exercise: Call Option If the strike price is Rs 20 and the option

premium is Rs 10. Calculate the profit and loss of option buyer and option seller at different market prices (Rs 15, 17, 20, 23, 25, 30, 35)

(10 min)

Exercise region

No Exercise region

Value of stock

Valu

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f O

pti

on

E

Put option gives the put holder the right to sell the underlying assets at a specified price, within a specified period of time.

The writer of the put option promises to buy the stock.

The put option holder exercises the option if the stock price is lower than the exercise price.

Put Option

The put option holder anticipating downward movement in the stock price so that this is the bearish attitude.

The value of put option at expiration can be calculated as follows:

Vp = Max (E – Vs, 0)Where,Vp = Value of put optionVs = Market price of stock at expirationE = Exercise price

For example, if the exercise price is Rs 135 and market price of the stock is Rs 115, what is the value of put? If the option premium is Rs 10, what is the profit and loss status for buyer?

Soln: Vp = Max (E – Vs, 0)= Max (135 – 115)= Max Rs 20

Profit = Vp – Pp = 20 – 10 = Rs 10 BEP for put option buyer = (E - Pc) should be equal to market price at expiration

Exercise: Put Option If the strike price is Rs 20 and the option

premium is Rs 10. Calculate the profit and loss of option buyer and option seller at different market prices (Rs 15, 17, 20, 23, 25, 30, 35)

(10 min)

Exercise

region

No Exercise region

Value of stock

Valu

e o

f O

pti

on

E

Strike price or exercise price or contract price Option price or option premium The option buyer or option holder The option seller or option writer Expiration date Underlying assets (stock, bond, index, currency,

commodity, etc) Moneyness (at the money i.e. market price =

strike price; in the money i.e. market price > strike price; out of money i.e. market price < strike price)

Exercising the option Option position (Option seller is in short position,

Option buyer is in long position)

Terminologies/Features of Options

Option ExchangeAn exchange is a legal corporate entity organized for the trading of securities, options, or futures which is governed by corporate rules and regulations. It may utilize a trading floor or may be an electronic exchange.

Over the Counter (OTC)OTC options were written for specific buyers by particular seller, and traded in the OTC facilities. The cost establishing an of OTC options contracts, however, are higher than for exchange options.

Option Trading Mechanisms

Stock options

Index options

Currency options

Future options

Types of options based on underlying assets

A privilege, sold by one party to another, that gives the buyer the right, but not the obligation, to buy (call) or sell (put) a stock at an agreed-upon price within a certain period or on a specific date.

Stock option

A financial derivative that gives the holder the right, but not the obligation, to buy or sell a basket of stocks, such as the S&P 500, at an agreed-upon price and before a certain date. An index option is similar to other options contracts, the difference being the underlying instruments are indexes. Options contracts, including index options, allow investors to profit from an expected market move or to reduce the risk of holding the underlying instrument.

Index Option

A contract that grants the holder the right, but not the obligation, to buy or sell currency at a specified exchange rate during a specified period of time. For this right, a premium is paid to the broker, which will vary depending on the number of contracts purchased. Currency options are one of the best ways for corporations or individuals to hedge against adverse movements in exchange rates.

Currency Option

An option on a futures contract gives the holder the right to enter into a specified futures contract. If the option is exercised, the initial holder of the option would enter into the long side of the contract and would buy the underlying asset at the futures price. A short option on a futures contract lets an investor enter into a futures contract as the short who would be required to sell the underlying asset on the future date at the specified price. 

Future option

Thank you.