Options

An option agreement is a contract in which

the writer of the option grants the buyer of
the option the right to purchase from or sell
to the writer a designated instrument at a
specific price (or receive a cash settlement)
within a specified period of time
 Options vs. Futures
Points of difference Options Futures

Performance Only seller Both

Premium to writer No Premium

Risk Buyer ↓ premium and ↑ potential ↓ and ↑

Settlement on or before expiry date at settlement date

 Options Terminology

Call Option An option that grants the buyer the right to

buy a designated instrument . (Pc ; Call Option Price)

Put Option An option that grants the buyer the right to

sell a designated instrument . (Pp ; Put Option Price)

Expiration Date The date on which the contract expires-

the last day on which the option can be exercised.
 Options Terminology contd..

Exercise Price/ Strike Price - The price at which the

buyer of a call can purchase the underlying asset
(stock/currency/commodity etc.) during the life of the
option.(X)

Spot Rate Current Stock price/currency rate (S)

 Options Terminology contd..
Premium The Price which the buyer pays to the
seller/writer for an option contract .(C)

Intrinsic Value- ≥ 0

American Option An option, call or put , which can be

exercised on any business day from initiation to maturity.

European Option An option which can be exercised only

on maturity date.
 Money ness

In-the-money S>X
Out-of-money S<X
At -the-money S=X
Call Options or Put Options?
 Types of Strategies

• Simple - Position in the option and the

underlying
• Spread - Position in two or more options of
the same type
• Combination - Position in a mixture of calls
& puts (A combination)
 Spreads

Spread consists of a put and a call

option on the same security for the
same time period at different prices.
 Spread Types

Bullish- selling the call with higher strike price and buying the
call with lower strike price.(for call options) and vice-versa for
put options on expectation of increase in stock price/ currency
rate.

Bears - selling the call with lower strike price and buying the
call with higher strike price.(for call options) and vice-versa for
put options on expectation of decline in stock price/ currency
rate.
 Spread Types contd..
Butterfly- Buying Two calls with middle strike
price and writing one each on either side.

Time - Both options having same exercise price

but different maturity.

Price- Both options having same maturity but

different exercise price.
 Combinations

Strap two calls and one put at the same

contracted exercise price and for the same
period.
Strip two puts and one call at the same
contracted exercise price and for the same
period.
 Combinations contd..
Ratio Call Spread
• Purchasing a certain amount of calls at one strike
and simultaneously selling more calls than
purchased at a higher strike. It is generally a
neutral options strategy.
• Maximum profit = the initial credit + difference between
the two strikes (or)
• Maximum profit = difference between the two strikes - the
initial debit
• Upside break even point = higher strike price + the points
of maximum profit
 Combinations contd..

• Straddle is an options strategy, which

involves the purchase of a call and a put
with the same strike price, the same
expiration date, and the same
underlying security.
 Assets Underlying
Exchange-Traded Options

• Stocks
• Foreign Currency
• Stock Indices
• Futures
 Warrants

• Warrants are options that are issued by a

corporation or a financial institution
• The number of warrants outstanding is
determined by the size of the original issue
and changes only when they are exercised
or when they expire
 Positions in an Option & the
Underlying

Profit Profit

K
K ST ST
(a)
(b)
Profit Profit

K
ST K ST

(c) (d)
 Bull Spread Using Calls

Profit

ST
K1 K2
 Bull Spread Using Puts

Profit

K1 K2 ST
 Bear Spread Using Puts

Profit

K1 K2 ST
 Bear Spread Using Calls

Profit

K1 K2 ST
 Box Spread

• A combination of a bull call spread and a

bear put spread
• If all options are European a box spread is
worth the present value of the difference
between the strike prices
• If they are American this is not necessarily
so.
Butterfly Spread Using Calls

Profit

K1 K2 K3 ST
Butterfly Spread Using Puts

Profit

K1 K2 K3 ST
Calendar Spread Using Calls

Profit

ST
K
Calendar Spread Using Puts

Profit

ST
K
 A Straddle Combination

Profit

K ST
 Strip & Strap

Profit Profit

K ST K ST

Strip Strap
 A Strangle Combination

Profit

K1 K2
ST