NISM SERIES - VIII
EQUITY DERIVATIVES
CHAPTER 4
INTRODUCTION TO
OPTIONS
Option contract
Buyer(Holder) has the Right Two types:
to Buy/Sell, but no Call Option (Right to Buy)
obligation Put Option (Right to Sell)
OPTION
Buyer pays the non- Seller doesn’t have a choice
refundable premium to the on exercise, he has to
Seller (Writer) honour buyer’s decission
ARINDAM BAKSHI
Basic Terminologies of Option Contract
• Buyer / Holder of an Option
– Limited Risk, maximum loss is premium amount
– Unlimited profitability
• Seller / Writer of an Option
– Limited Profit, maximum profit is premium amount when buyer
doesn’t exercise
– Unlimited risk
• Spot Price
• Strike Price
• Premium (Option Price)
• Contract Cycle
• Expiration Day
• Contract Size / Lot Size
ARINDAM BAKSHI
Basic Terminologies of Option Contract
• Index Option
• Stock Option
• European Option
• The owner of such option can exercise his right only on the
expiry date
• In India, Index options are European
• American Option
• The owner of such option can exercise his right at any time
on or before the expiry date
ARINDAM BAKSHI
ADVANCED TERMINOLOGIES IN
OPTION CONTRACTS
ITM – ATM – OTM OPTIONS
• IN THE MONEY (ITM) OPTIONS
• This option would give holder a positive cash flow, if it
were exercised immediately.
• Call Option is ITM if Sp > Xp
• Put Option is ITM if Xp > Sp
• AT THE MONEY (ATM) OPTIONS
• This option would give holder a zero cash flow, if it
were exercised immediately.
• Both Call & Put Option is ATM if S p = Xp
ITM – ATM – OTM OPTIONS
• OUT of THE MONEY (OTM) OPTIONS
• This option would give holder a negative cash flow, if it
were exercised immediately.
• Call Option is ITM if Sp < Xp
• Put Option is ITM if Xp < Sp
INTRINSIC VALUE
• Option premium consists of two components ‐
intrinsic value and time value
• Intrinsic value refers to the amount the
amount an option buyer will realize, if he
exercises the option instantly
• Only in‐the‐money options have intrinsic
value, whereas at‐the‐money and
out‐of‐the‐money options have zero intrinsic
value. The intrinsic value of an option can
never be negative.
INTRINSIC VALUE - Equations
• For a CALL OPTION:-
IV = Max[0; (Sp-Xp)]
• For a PUT OPTION:-
IV = Max[0; (Xp-Sp)]
TIME VALUE
• It is the difference between premium and
intrinsic value, if any, of an option.
• ATM and OTM options will have only time
value
CALCULATION OF IV & TV
1. A stock is currently selling at Rs.70. The call
option to buy the stock at Rs.65 costs Rs.9.
What is the time value of the option?
2. A stock currently sells at 120. The put option
to sell the stock at Rs.134 costs Rs.18. What
is the time value of the option?
3. Dec ITC Call option with Strike price 290 is
trading at Rs.15. ITC trades in the cash
market at a price of Rs.285. Calculate the IV
& TV of the option.
OPEN INTEREST
• Open interest is the total number of open or
outstanding options contracts that exist at a given
time.
EXERCISE OF OPTIONS
• If the holder of an option decides to buy or sell the
underlying instrument, he or she will exercise the option,
and make use of the right available in the contract.
• In case of American option, buyers can exercise their
option any time before the maturity of contract
• In The Money Options are compulsorily exercised by the
exchange
• All options are exercised with respect to the settlement
value/ closing price of the stock on the day of exercise of
option.
ASSIGNMENT OF OPTIONS
• Assignment of options means the allocation of
exercised options to one or more option sellers
• Assignment is done with option sellers in SAME
SERIES at RANDOM BASIS
• The issue of assignment of options arises mainly in
case of American options because a buyer can
exercise his options at any point of time.
Opening a position
• It means a transaction that adds to, or creates
a new trading position.
• It can be either a purchase (Long) or a sale
(Short).
Closing a position
• A closing transaction is one that reduces or
eliminates an existing position by an
appropriate offsetting purchase or sale
• To be done with option of same series
• Also called “Squaring off”
• Closing a short position by offsetting Buy
transaction is also known as ‘Covering’ of
short position.
Leverage
• An option buyer pays a relatively small
premium for market exposure in relation to
the contract value. This is known as leverage.
• A trader can see large percentage gains from
comparatively small, favourable percentage
moves in the underlying equity.
• Leverage also has downside implications
Leverage
Pay off Diagram for Options
• Pay off for Call Options:
• LONG CALL
• SHORT CALL
• Pay off for Put Options:
• LONG PUT
• SHORT PUT
Variables in Option Pricing
STRIKE TIME TO INTEREST
SPOT PRICE VOLATILITY
PRICE EXPIRATION RATE
5
Variables in Option Pricing
SPOT PRICE OF THE
UNDERLYING ASSET
CALL OPTION
PUT OPTION
Variables in Option Pricing
STRIKE PRICE OF THE
OPTION
PUT OPTION
CALL OPTION
Variables in Option Pricing
VOLATILITY OF THE
UNDERLYING ASSET
CALL OPTION
PUT OPTION
Variables in Option Pricing
TIME TO EXPIRATION
CALL OPTION TIME
DECAY
PUT OPTION
Variables in Option Pricing
INTEREST RATE
CALL OPTION
PUT OPTION
OPTION GREEKS
• Option Greeks provide a way to measure the
sensitivity of an Option’s Price to
quantifiable variable factors as discussed
earlier.
• The most popular Greeks are
✓Delta
✓Gamma
✓Theta
✓Vega
✓Rho
Greek What it With respect to Points to remember
Name measures
DELTA Change in Change in PRICE 1. The delta is often called THE HEDGE
option of the underlying RATIO
premium asset 2. No. of Calls to sell = No. of shares /
Delta
GAMMA Change in Change in PRICE 1. Second derivative option with regard to
Delta of the underlying price of the underlying asset
asset
THETA Change in Change in TIME 1. used to gain an idea on time decay
option TO EXPIRATION 2. Theta is negative for Long term options
premium
VEGA Change in Change in
option VOLATILITY of the
premium underlying asset
RHO Change in Change in COST
option OF FINANCING of
premium the underlying
asset
Option Pricing Models
BINOMIAL PRICING MODEL
BLACK SCHOLES MODEL
Binomial Pricing Model
➢ Developed in 1978 by William Sharpe
➢ Most flexible & popular pricing model
➢ It is based on Binomial Tree formation
➢ Accuracy level is high
➢ Lengthy and time consuming process as it
involves iteration
Black & Scholes Model
➢ Developed in 1973 by Fisher Black and Myron
Scholes in their 1973 paper, "The Pricing of
Options and Corporate Liabilities," published
in the Journal of Political Economy
➢ Comparatively simple and faster process, as it
doesn’t depend on iteration.
➢ The standard BSM model is only used to price
European options
END OF CHAPTER -
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