Option Market

OPTION
Options
With options, one pays money to have a choice in
the future
Essence of options is not that I buy the ability to
vacillate, or to exercise free will. The choice one
makes actually depends only on the underlying
asset price
Options are truncated (reduced) claims on assets
N.Ramesh Kumar., Associate professoer, NCM,
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Terms of Options Contract
Exercise date
Exercise price
Definition of underlying and number of shares

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Two Basic Kinds of Options
Calls, a right to buy
Puts, a right to sell
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Two Basic Kinds of Options
American options can be exercised any time
until exercise date
European options can be exercised only on
exercise date
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Buyers and Writers
For every option there is both a buyer and a
writer
The buyer pays the writer for the ability to choose
when to exercise, the writer must abide(stand for)
by buyers choice
Buyer puts up no margin, naked writer must post
margin
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In and Out of the Money
In-the-money options would be worth something if
exercised now
Out-of-the-money options would be worthless if
exercised now
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Options
Traded market
Types of option
Exercise price & expiration date
American & European options
Four types of participants in options markets
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Options
Options are traded both on exchanges and in the over-
the-counter market.
There are two types of option:
Call option gives the holder the right to buy the underlying
asset by a certain date for a certain price.
Put option gives the holder the right to sell the underlying
asset by a certain date for a certain price.
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Options
The price in the contract is known as the exercise price or
strike price.
The date in the contract is known as the expiration date
or maturity.
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Options
American options can be exercised at any time up to the
expiration date.
European options can be exercised only on the expiration
date itself.
Most of the options that are traded on exchanges are
American.
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Participants in Option
OR
Options Payoff

1. Buyers of calls (Long Call)
2. Seller of calls (Short Call )
3. Buyer of puts (long put)
4. Seller of puts (Short Put )

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Call Options

A call option is a contract that gives the owner of the call
option the right, but not the obligation, to buy an
underlying asset, at a fixed price ($K), on (or sometimes
before) a pre-specified day, which is known as the
expiration day.

The seller of a call option, the call writer, is obligated to
deliver, or sell, the underlying asset at a fixed price, on
(or sometimes before) expiration day (T).

The fixed price, K, is called the strike price, or the
exercise price.

Because they separate rights from obligations, call
options have value.
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Payoff Diagram for a Long Call
Position, at Expiration
Expiration Day Value, C
T
0
S
T K
45
o
Profit Diagram for a Long Call
Profit
0
K S
T
We lower the payoff diagram by the call
price (or premium), to get the profit diagram
call premium
Profit Diagram for a Short Call
K
0
S
T
Profit
Call premium
Put Option Contracts
A put option is a contract that gives the owner of the put option
the right, but not the obligation, to sell an underlying asset, at
a fixed price, on (or sometimes before) a pre-specified day,
which is known as the expiration day (T).

The seller of a put option, the put writer, is obligated to take
delivery, or buy, the underlying asset at a fixed price ($K), on (or
sometimes before) expiration day.

The fixed price, K, is called the strike price, or the exercise price.

Because they separate rights from obligations, put options
have value.

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Payoff diagram for a long put
position, at expiration
S
T
0
Value on
Expiration
Day, P
T

K
K
Profit Diagram for a Long Put
S
T
Profit
0
K
Lower the payoff diagram by
the put price, or put premium,
to get the profit diagram
put premium
Profit Diagram for a Short Put
S
T
0
Profit
K
Types of traders
Hedgers
Speculators
Arbitrageurs
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Types of traders

Hedgers use derivatives to reduce the risk that they face
from potential future movements in a market variable.
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Types of traders

Speculators use them to bet on the future direction of a
market variable.

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Types of traders

Arbitrageurs take offsetting positions in two or more
instruments to lock in a profit.
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Summary
A forward or futures contract involves an obligation to
buy or sell an asset at a certain time in the future for a
certain price.
There are two types of options: calls and puts.
A call option gives the holder the right to buy an asset by
a certain date for a certain price.
A put option gives the holder the right to sell an asset by a
certain date for a certain price.
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Three main types of traders can be identified:
hedgers, speculators, and arbitrageurs.

Hedgers are in the position where they face risk
associated with the price of an asset. They use derivatives
to reduce or eliminate this risk.
Speculators wish to bet on future movements in the price
of an asset. They use derivatives to get extra leverage.
Arbitrageurs are in business to take advantage of a
discrepancy between prices in two different markets.
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Speculative Markets
The Binomial Model
How to Price an Option
Step One
First, we make an ASSUMPTION about the
precise way that the stock price randomly
changes over time.
In other words, we assume a stochastic
(random) process for the underlying
asset.
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Step Two
Then we try to find a trading strategy that:
only involves investing in cash and the underlying
stock.
Requires no further cash inflow after the initial
investment
has the same payoff as the option
In other words, we try to find a
Self-financing replicating portfolio
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Step Three
In order to prevent arbitrage, the option price
must be equal to initial investment required to
set up the replicating portfolio.
If the option price were higher, you could make
arbitrage profits by selling the option and following
the replicating strategy
If it were lower, you would buy the option and follow
the reverse of the replicating strategy
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32
Introduction
Option pricing developments are among the
most important in the field of finance during
the last 30 years

The backbone of option pricing is the Black-
Scholes model
Option Pricing Models
I. Binomial Model
II. Black-Scholes Model (Non-
dividend paying European
Option)
The Black-Scholes option
pricing model (BSOPM) was
developed in 1973

34
Introduction (contd)
The Black-Scholes model:

t d d
t
t r
K
S
d
d N Ke d SN C
rt
o
o
o
=
|
|
.
|
\
|
+ +
|
.
|
\
|
=
=

1 2
2
1
2 1
and
2
ln
where
) ( ) (
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Where:
S- Stock Price
E- Strike Price
t time remaining until expiration, expressed as a
percent of a year
r current continuously compounded risk free
interest rate
o- annual volatility of stock price(the standard
deviation of the short term returns over one year)
In- natural logarithm
e exponential function

Factors that determine the option value

Exercise price
Underlying stock price
Time to expiration
Interest rate
Underlying stock volatility

Option Market

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