Options

Background
Option is one of the derivate securities. Option is a contract between two parties in which the option buyer will have an option to buy or sell the specified no of securities of particular company at specified price within or at specified period in consideration of premium.

Parties of Option
Option Writer/ Seller A party who provides an option in consideration of premium. Option buyer A party receiving the right to exercise an option.

Example of options

Option writer Option 1. You can buy 10 shares of Nabil bank at Rs. 2200 on 10 May 2010. For this option pay Rs. 5. Option 2 You can sell 10 shares of NMB bank at Rs. 300 on 10 May 2010. For this option pay Rs. 5.

Example of options

Option buyer Ok I will buy this option at Rs. 5, which will help me to buy the 10 shares of Nabil bank at Rs. 2200 on 10 May 2010.

Feature of Option
By the name itself, it is an option which does not carry any obligation on the option buyer either to buy or sell the securities. Exercise price It is the price at which the option holder can buy or sell the shares of the particular company.

Feature of Option
Expiry Date It is the date after which the option no longer becomes valid.

Types of Option
Options

European
Option
Call Option Put Option

American
Option

Call Option

Put Option

Options
European Option can only be exercised at expiry date. American Option can be exercised on or until the expiry date.

Call Option
It is an option to in which the option buyer will have a right to buy the specified no of securities of particular company at specified price within or at specified period in consideration of premium. Option buyer will buy this option with an expectation to receive the benefit arising from increase the stock price.

Put Option
It is an option to in which the option buyer will have a right to sell the specified no of securities of particular company at specified price within or at specified period in consideration of premium. Option buyer will buy this option with an expectation to receive the benefit arising from decrease the stock price.

Valuation of Option
The value of option depends on the market price of stock. Theoretically, the value of option is calculated as below: Vc = max( Po- E,0) where,
Vc = Value of call option E = exercise price Po = market price of stock

Profit & loss in option

In option the profit or loss to one party will be at the expense of other party. Generally, in call option the option buyer will be in profit if the market price of stock is more than the exercise price. Generally, in put option the option buyer will be in profit if the market price of stock is less than the exercise price.

Profit to Option buyer in Call Option

Profit = when stock price is more than (exercise price + Premium) Break Even Market price of stock = Exercise price + premium

Profit to Call Option buyer

Profit = Vc - premium Profit = when stock price is more than (exercise price + Premium) Break Even Market price of stock = Exercise price + premium

Profit to Option seller in Call Option

If the stock price is below break even price

Valuation of Put Option

The value of option depends on the market price of stock. Theoretically, the value of option is calculated as below: Vp = max( E- P0,0) where,
Vp = Value of Put option E = exercise price Po = market price of stock

Profit to Put Option buyer

Profit = Vp- Premium or Profit = when stock price is less than (exercise price - Premium) Break Even Market price of stock = Exercise price premium

Profit to Put Option seller

If the stock price is above break even price