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Options

Presented by
Vishakh S
Vishnu Sankar S
Neethu Satheesh

What are options?


An option is a contract which gives
its holder the right, but not the
obligation, to buy (or sell) an asset at
some predetermined price within a
specified period of time.

What is the single most important


characteristic of an option?

It does not obligate its owner to take


any action. It merely gives the
owner the right to buy or sell an
asset.

Every option has four specific features:


1. It relates to a specific stock or other security, called the underlying security.
2. It is a right to buy (call) or sell (put), and every option controls 100 shares of
stock.
3. A specific strike price is the fixed price at which the option can be exercised.
4. Every option has a fixed expiration date. After that date, the option is worthless.
Two types of Options:
Call Option: Gives the holder right to buy an assets at certain price within the specific
period of time.
Put Option: Gives the holder right to sell an assets at certain price within the specific
period of time.

CALL AND PUT OPTIONS

A call option is a financial contract between two parties, the buyer and the
seller of this type of option. It is the option to buy shares of stock at a specified
time in the future. Often it is simply labelled a "call". The buyer of the option
has the right, but not the obligation to buy an agreed quantity of a particular
commodity The buyer pays a fee (called a premium) for this right.
Put Option is just opposite of the Call Option which gives the holder the right
to sell shares. A put becomes more valuable as the price of the underlying
stock depreciates relative to the strike price.

Merits Of Option
Options protect downside risk to the
buyer
The buyer of the option limits losses
to the premium paid on the purchase
of the options
Eg. If I buy a nifty 2900 put at Rs 34,
my loss is limited to Rs 34 while gain
potential is limitless
If the price goes above Rs 2900 I do
not exercise the option limiting my
loss to the premium paid.

Option Terminology
Call option: An option to buy a
specified number of shares of a
security within some future period.
Put option: An option to sell a
specified number of shares of a
security within some future period.
Exercise (or strike) price: The price
stated in the option contract at which
the security can be bought or sold.

Option price: The market price of the


option contract.
Expiration date: The date the option
matures.
Exercise value: The value of a call
option if it were exercised today =
Current stock price - Strike price.
Note: The exercise value is zero if
the stock price is less than the strike
price.

Covered option: A call option written


against stock held in an investors
portfolio.
Naked (uncovered) option: An option
sold without the stock to back it up.
In-the-money call: A call whose
exercise price is less than the current
price of the underlying stock.

Out-of-the-money call: A call option


whose exercise price exceeds the
current stock price.
LEAPS: Long-term Equity
AnticiPation Securities that are
similar to conventional options
except that they are long-term
options with maturities of up to 2 1/2
years.

Consider the following data:


Strike price = $25.
Stock Price
Call Option Price
$25
$3.00
30
7.50
35
12.00
40
16.50
45
21.00
50
25.50

Exercise Value of Option


Price of
stock (a)

Strike
price (b)

Exercise value
of option (a)(b)

$25.00
30.00
35.00
40.00
45.00
50.00

$25.00
25.00
25.00
25.00
25.00
25.00

$0.00
5.00
10.00
15.00
20.00
25.00

Market Price of Option


Price of Strike
Exer. Mkt. Price
stock
price val. (c) of opt. (d)
(a)
(b)
$25.00 $25.00 $0.00
$3.00
30.00
25.00
5.00
7.50
35.00
25.00 10.00
12.00
40.00
25.00 15.00
16.50
45.00
25.00 20.00
21.00
50.00
25.00 25.00
25.50

Time Value of Option


Price of Strike
Exer.
Mkt. P
of
stock
price Val. (c)
(a)
(b)
opt. (d)
$25.00 $25.00 $0.00
$3.00
30.00
25.00
5.00
7.50
35.00
25.00 10.00 12.00
40.00
25.00 15.00 16.50
45.00
25.00 20.00 21.00
50.00
25.00 25.00 25.50

Time
value
(d) (c)
$3.00
2.50
2.00
1.50
1.00
0.50

Call Time Value Diagram

What happens to the premium of the


option price over the exercise
value as the stock price rises?

The premium of the option price over


the exercise value declines as the
stock price increases.
This is due to the declining degree of
leverage provided by options as the
underlying stock price increases, and
the greater loss potential of options
at higher option prices.

What are the assumptions of the


Black-Scholes Option Pricing Model?

The stock underlying the call option


provides no dividends during the call
options life.
There are no transactions costs for
the sale/purchase of either the stock
or the option.
RRF is known and constant during the
options life.

Security buyers may borrow any fraction of the


purchase price at the short-term risk-free rate.
No penalty for short selling and sellers receive
immediately full cash proceeds at todays
price.
Call option can be exercised only on its
expiration date.
Security trading takes place in continuous
time, and stock prices move randomly in
continuous time.

Black-Scholes Option Pricing


Model
Call
price

Value of
upside potential

Opportunity cost
of invested funds

X
C S N (d1 ) rt N (d 2 )
e
Where C: current price of a call option
S: current market price of the underlying stock
X: exercise price
r: risk free rate
t: time until expiration
N(d1) and N (d2) : cumulative density functions for d1 and d2

Example
Current stock price: 50
Risk free rate: 6.25%
months
Volatility: 40%

exercise price : 55
time to expiration: 6
What is the call price?

Solution

d1

ln 50 55 0.0625 0.5 0.4 2 0.5

0.4 0.5
0.0953 0.0713

0.0851
0.2828

N(d1) = 0.4661

d 2 0.0851 0.4
0.3679

N(d2) = 0.3564

X
N ( d 2 )
e rt
55
50[0.4661] ( 0.0625)( 0.5) [0.3564] $4.30
e

Call price S N ( d1 )

0.5

What impact do the following parameters have on a call options value?

Current stock price: Call option value


increases as the current stock price
increases.
Exercise price: As the exercise price
increases, a call options value
decreases.

Option period: As the expiration date is


lengthened, a call options value increases
(more chance of becoming in the money.)
Risk-free rate: Call options value tends to
increase as rRF increases (reduces the PV of
the exercise price).
Stock return variance: Option value
increases with variance of the underlying
stock (more chance of becoming in the
money).

Six basic strategies


Six option strategies are especially interesting in the way
they allow you to leverage capital, reduce risks, and
control shares of stock.
These six are:
1.
2.
3.
4.
5.
6.

Covered call.
Ratio write.
Variable ratio write.
Insurance put.
Collar.
Synthetic stock.

Six basic strategies


These strategies share a few common themes and attributes.
These are:
- They can be constructed with conservative goals in
mind: reducing or eliminating risk and hedging long
positions in your portfolio.
- The positions either eliminate risk or generate
income.
- The level of capital placed at risk can be controlled
by offsetting long and short positions, or limited by
selecting modestly priced options.

Covered call
A covered call has two parts:
- ownership of 100 shares of stock
- 1 short call
A short call is created by selling it. When you
sell a call you receive cash.
A short transaction is sequenced as sell-holdbuy instead of the more familiar long
position, buy-hold-sell.

Covered call
A covered call becomes profitable if the underlying security
remains at or below the strike.
In that case, the call will expire worthless, or it can be closed
(bought) at a lower price.
If the underlying security moves above the strike, the call
will be exercised and your stock will be called away.
Being exercised is profitable as long as your original cost of
the stock was lower than the strike. In that case, you earn a
capital gain, the option premium, and any dividends during
your holding period.

Ratio write
The ratio write is an expansion of the
covered
call. Instead of 1 call per 100 shares, you
write
more calls than you can cover.
For example, if you own 200 shares and sell 3 calls, you
create a 3:2 ratio write. If you own 300 shares and sell 4
calls, you create a 4:3 ratio write.
Although this strategy is higher-risk than a covered call,
some or all of the exposed calls can be closed to avoid
exercise.

Variable ratio write


This a further expansion of the covered call.
In the variable ratio write, you use two
different strikes.
For example, the stock price is $49 and you
own 300 shares. If you sell two $50 calls
and two $52.50 calls, you have created a
variable ratio write.

Insurance put
This strategy protects your stock position against the risk of
loss. A put is the right to sell stock at a fixed price.
For example, you bought stock at $45 and it is now worth $49.
You sell a 50 put and pay 2 ($200).
If the stock falls below 50, you can exercise the put and sell it
at the fixed strike of 50. However, because the put cost you
$200, your breakeven is $48 per share.
In this example, the insurance put locks in profits of at
least $300 the strike less cost of the put, minus your
original basis: $50 - $2 - $45 = $300

Collar
A collar is a three-part strategy that
combines the covered call with the
insurance put. It consists of:
100 shares of stock
1 short call
1 long put

Collar
A collar costs little or nothing to open. The
short call should be higher than the current
price, and the long put should be lower.
The cost of the long put is all or mostly
paid for by the short put.
The collar is a smart strategy when you want
to protect paper profits, and you are willing
to have shares called away at the calls
strike.

Synthetic stock
This is a strategy similar to the collar. But both options
are opened at the same strike price.
When you open a long call and a short put, it creates a
synthetic long stock position, because the options grow
in value as the stock rises, mirroring price changes
point for point.
When you open a short call and a long put,
it creates a synthetic short stock position,
because the options grow in value as the
stock falls, mirroring price changes point for point.