Option contracts

Option Contracts

1. Dr.Divya M
Assistant Professor in Commerce
MES Keveeyam College, Valanchery

2. Meaning
Need and Importance
Options and futures
Fundamental option strategies
Types of options
◦Call
◦Put
Trading strategies for risk instruments
Positions in options
Stock indices
Options in Indian stock market

3. Limitation of forwards and futures
The investor is under an obligation to
buy/sell the assets at predetermined prices…

4. Special type of contract which gives the
holder the rightbut not the obligation..
Option buyer will exercise the option only
when he is in profit
In case of loss he will not exercise the option

5. The offer coupon that comes along with the
newspaper inviting us to shop in a particular
mall and get a discount of 10% on purchases
by producing the coupon
No obligation to go to the mall and buy
He has the right to shop to get a discount

6. 1.Contractual agreement give the buyer right,
not the obligation to buy/sell a specified
asset at a specified price within a specified
period.
2.Two parties to an option contract
a.Option buyer(investor/owner)
b.Option seller (writer)
3.Premium –paid by buyer to seller
4.May or may not exercise his right
5.Seller has no choice. He must meet his
obligation to buy or sell if the buyer
exercises his right.

7. 6.Two types of options-call option and put
option.
7.In American option, the buyer of the option
should exercise his right at any time during
the period of contract (signing the
contract………..Expiry date)
8.Exercise/strike price(agreed price at which
the owner is allowed to buy/sell the
specified asset) is based on current quoted
prices.

8. Purchaser
(Investor)
Writer
(Seller)
•Who buys the option.
•Owner of the option
•Takes long position
•Has rights but no
obligation
•Who sells the option
•When the owner
exercise the option, he
has the obligation to
perform
•Takes short position

9. Exercise/Strike
price
•The agreed price at which the owner
can buy/sell the asset in the market
Spot price
•Prevailing actual rate in the market
Premium
•The amount that an option buyer needs to pay to the
option writer
•Amount which the seller charges the buyer in the form of
a return for guaranteeing the exercise of option

10. Exercis
e date
•The date on which the option is actually exercised by the
buyer
Expirat
ion
date
•The date on which the option expires
Option
class
•All listed options of a particular type (call/put) on a particular
underlying asset
Option
series
•All options of a given class with the same expiration date and
strike price

11. Intrinsic value=Difference between spot price
and strike price
Time value=difference between intrinsic value
and option premium

12. Call option
Option to buy
the underlying
asset
Useful when
the prices are
rising
Put option
Option that the gives
the purchaser the
right but not
obligation to sell the
underlying asset
Useful when the
prices are falling

13. Spot price =100
Exercise price =100
Expect price rise in future
Premium=8
If price actually increases to 140 on
expiration date
◦Profit =(140-100-8)=32
◦Percentage of profit =32/8*100=400%
◦In future , (140-100=40 profit and
40/100*100=40%profit)

14. If price fall to 80,
◦he has not exercise the option
◦Loss =8

15. Spot price and exercise price=200
Expect a fall in the price in future
Premium =18
If the price fall to 140 in the market, his
profit =(200-140-18=42)
If price rises above 200
◦loss=18

16. •Exercise his option only on the date of
expiration
•In India, not used
European
option
•Exercise his right at any time before
expiration date
•Extra flexibility, so high premium
American
option
•Exercise on few specific dates prior to
expiration
•Half way between America and Europe
Bermudan
option

17. Commodity
option
•In India not
available
Currency
option
•Right to buy/sell
foreign currency
at a specified
price at some
future date
Stock option
•Individual stock
of corporate
Stock index
option
•Trade in general
stock market
movements.

18. •Standardisedand are traded on
organisedexchanges
•Exchange specify the underlying asset,
limited number of strike price, limited
number of expiration date
•Like future
Exchange
traded
options
•Custom tailored agreements sold
directly by the dealers
•Terms of these contracts are
negotiated by the parties
•Like forward
Over the
counter
options

19. Real
option
•Choice that an investor-in the production of good or services
or making financial contracts
Traded
option
•Exchange traded derivative
Vannila
•Simple and well understood option
•Eg: European and American option
Exotic
option
•More complex and less understood option
•Eg: lokkback option, barrier option

20. Warrants
•Long dated option
•Over the counter
LEAPS
•Long term Equity Anticipation Securities
•Maturity upto3 years
Baskets
•Options on portfolio of underlying assets
•Underlying asset=moving average of underlying asset
•Eg. Equity index options

21. Capital gain
Tax advantage
Control their right on underlying asset
Enjoy a much wider risk return conditions
Possibility of giving a windfall profit
Reduce total portfolio transaction cost
Better return with limited amount of
investment
Additional income on stock holdings
Gives the ability to participate when the
market is moving upwards, downwards or
sideways.

22. Once premium paid, no further cash is
payable by the buyer
Limit the downside of risk, without limiting
upside (limit the loss, but maximise profit)
No obligation to exercise
Used for hedging, combined with futures and
forwards to achieve more complex hedges
Used for hedging as well as speculation

23. Premium payable , if volatility is high-
premium amount is also high
Factors affecting option premiums are very
complex
Future have more liquidity than options

24. Future Options
Have obligation
Margin is the basis
Both buyers and sellers face
possibility of gain or loss
Preferential contract for
speculators for maximise
profit
Cost of carry model,
backwardation, expectation
model and CAPM
No obligation to buyer
Option premium is the
basis
Buyer-Limited loss, unliited
profit
Seller-Limited profit, unlim
Preferential contract for
hedgers to minimise risk
Binominal model and Black
sholes model