Option Basic

7/30/2019 Option Basic

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Basics of Options


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Example of Options

You discover a house that you'd love topurchase. Unfortunately, you won't have the

cash to buy it for another three months. Youtalk to the owner and negotiate a deal thatgives you an option to buy the house in threemonths for a price of $200,000. The owner

agrees, but for this option, you pay a price of$3,000.

Now, consider two theoretical situations that

might arise


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Situation 1

It's discovered that the house is actuallythe true birthplace of Elvis! As a result,

the market value of the houseskyrockets to $1 million. Because theowner sold you the option, he is

obligated to sell you the house for$200,000. In the end, you stand to makea profit of $797,000 ($1 million -

$200,000 - $3,000).


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Situation 2

While touring the house, you discoverthat the ghost of Henry VII haunts themaster bedroom; furthermore, a family

of super-intelligent rats have built afortress in the basement. Though youoriginally thought you had found the

house of your dreams, you now considerit worthless. On the upside, because youbought an option, you are under noobligation to go through with the sale. Ofcourse, you still lose the $3,000 price of


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Meaning

Option is a contract between abuyer and a seller that gives thebuyer the rightbut not theobligationto buy or to sell aparticular asset (the underlyingasset) at a later day at an agreedprice. In return for granting theoption, the seller collects a payment(the premium) from the buyer
http://en.wikipedia.org/wiki/Underlyinghttp://en.wikipedia.org/wiki/Underlying


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Options-Terms

Buyer of an option: The buyer of anoption is the one who by paying the option

premium buys the right but not theobligation to exercise his option on theseller.

Writer of an option: The writer of a

call/put option is the one who receives theoption premium and is thereby obliged tosell/buy the asset if the buyer exercises onhim.


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Options-Terms Expiration Date: The date specified in the

options

contract is known as the expiration date, the

exercise date, the strike date or maturity. Strike price: the price specified in the options

contract is known as the strike price or theexercise

price Options Price / Premium: Option price is the

price

which the option buyer pays to the option seller. Itis


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Difference between options andfutures

The main fundamental differencebetween options and futures lies in theobligations they put on their buyers and sellers.

An investor can enter into a futures contract withno upfront cost whereas buying an optionsposition does require the payment of a premium.

Another key difference between options andfutures is the size of the underlying position.Generally, the underlying position is much largerfor futures contracts, and the obligation to buy orsell this certain amount at a given price makesfutures more risky for the inexperienced investor.


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Types of Options

First Type:

American Options: These areoptions that can be exercised atany time up to the expiration date

European Option : These are

options that can be exercised onlyon the expiration date itself


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Types of Options

Second type:

Call option: A call gives the holder the right but notthe obligation to buy an asset by a certain date for acertain price.

Put option: A put option gives the holder the rightbut not the obligation to sell an asset by a certaindate for a certain price.


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Lets examine a typical Call Option quote on thestock ABC, which has a current stock market priceof $50:

Option type Security Expiry Strike Price Premium

Call ABC Apr 55 2.50


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Conti

Reading from left to right: This quote is for aCALL OPTION on the security ABC. The optioncontract EXPIRES IN APRIL. The STRIKE PRICEof $55 is what the option holder can purchase theshares of ABC for anytime up until the 3rd Fridayof April. To purchase the ability to do this wouldcost the option holder $2.50 per contract pershare.


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Various situations-

lets look at some examples of purchasing

the above call option contract with three

different outcomes: Stock goes up

Stock price doesnt change

Stock goes down.


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$60

You bought the contract for $2.50, whichmultiplied by 100 shares = $250 (cost)

You exercise your option so you buy 100 sharesat $55 = $5,500 (cost)

You then sell your shares immediately for themarket price of $60 x 100 shares = $6,000

(proceed) $6,000 - $5,500 - $250 = $250

In this case the option contract become in-the-money.


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Scenario 2: ABC stays at$57.50

$5,750 - $5,500 - $250 = 0

In this case the option contract become at-the-money.


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Scenario 3: ABC goes down to$55

$5,500 - $5,500 - $250 = - $250

In this case the option contract become out-of-the-money.

Thus, anything

Above 57.50 would give profits

between 57.50 and 55 would minimize losses

Less than 55, no exercise of call


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Payoffs Here is another example; Underlying: micro soft share

Type: Call OptionExercise Price: $25

Expiry Date: 25th May Let's imagine that this option is worth $1.2. This

means that the shares have to be trading at $26.20for us to break even (Exercise Price of $25 plus

the Option Premium of $1.20). If the shares aretrading anywhere above $26.20 then we can startcounting the profits. Anywhere below $26.20 andwe lose out by the premium - $1.20. So, with along call we have limited risk (the OptionPremium) while at the same time having unlimited


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Graph of this concept


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Put optionA put option (sometimes simply called a "put") is

a contract between two parties, the seller (writer)and the buyer of the option. The buyer acquires ashort position offering the right, but not obligation,

to sell the underlying instrument at an agreed-upon price (the strike price). If the buyerexercises the right granted by the option, theseller has the obligation to purchase the

underlying at the strike price. In exchange forhaving this option, the buyer pays the writer a fee(the option premium). The buyer of a put optionestimates that the underlying asset will drop

below the exercise price before the expiration


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Example

Suppose the stock of XYZ company istrading at $40. A put option contract with

a strike price of $40 expiring in amonth's time is being priced at $2. Youbelieve that XYZ stock will fall sharply in

the coming weeks and so you paid $200to purchase a single $40 XYZ put optioncovering 100 shares.


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Situation 1

Say you were proven right and the price of XYZstock crashes to $30 at option expiration date.With underlying stock price now at $30, your put

option will now be in-the-money and you can sellit for that much. Since you had paid $200 topurchase the put option, your net profit for theentire trade is therefore $800 (4000-3000-200).


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Situation 2

With underlying stock price now at$38, your put option will now be at-the-money


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Situation 3

However, if you were wrong in your assessmentand the stock price had instead rallied to $50,your put option will expire worthless and your totalloss will be the $200 that you paid to purchase

the option

Thus, anything Below 38 would give profits

between 38 and 40 would minimize losses

more than 40, no exercise of put

P ff f t ti


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Payoff for a put optioncontract

Put option

Putoption


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Conclusion

Moneyness : In-the-money option (ITM)

For Call option: Market price > Strike price For Put option: Market price < Strike price

Out-of-the-money option (OTM) For Call option: Market price < Strike price For Put option: Market price > Strike price

At-the-money option (ATM)

Market price = strike price


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How To Read An Options Table


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Interpretation Column 1: Strike Price - This is the stated price per share for which an

underlying stock may be purchased (for a call) or sold (for a put) uponthe exercise of the option contract. Option strike prices typically moveby increments of $2.50 or $5 (even though in the above example itmoves in $2 increments).Column 2: Expiry Date - This shows the termination date of an optioncontract. Remember that U.S.-listed options expire on the third Friday

of the expiry month.Column 3: Call or Put - This column refers to whether the option is acall (C) or put (P).Column 4: Volume - This indicates the total number of optionscontracts traded for the day. The total volume of all contracts is listedat the bottom of each table.

Column 5: Bid - This indicates the price someone is willing to pay forthe options contract.Column 6: Ask - This indicates the price at which someone is willing tosell an options contract.Column 7: Open Interest - Open interest is the number of optionscontracts that are open; these are contracts that have neither expired

nor been exercised.
http://www.investopedia.com/terms/o/openinterest.asphttp://www.investopedia.com/terms/o/openinterest.asp


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Option Premium

The premium is the price at which thecontract trades. The premium is the price of

the option and is paid by the buyer to thewriter, or seller, of the option

It primarily consists of two components

Intrinsic value and Time value.

Option price = intrinsic value + time value


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Intrinsic value The intrinsic value of an option reflects the effective

financial advantage which would result from the immediateexercise of that option before adjusting the premium.

This is the value that any given option would have if it wereexercised today.

The intrinsic value of an option is the difference betweenthe actual price of the underlying security and the strikeprice of the option.

For call option = Max (0, St-K)

For put option = Max (0, K-St)

St is current stock price and k is strike price It is the amount by which the option is in-the-money

Only ITM options will have intrinsic value..? ( + / 0 /- )


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Interpretation

Condition Call Put

Strike price < underlying

security price

In-the-money

Intrinsic value >0

Out-of-the-money

Intrinsic value = 0

Strike price > underlying

security price

Out-of-the-money

Intrinsic value = 0

In-the-money

Intrinsic value >0

Strike price = underlying

security price

At-the-money

Intrinsic value = 0

At-the-money

Intrinsic value = 0

Intrinsic value cannot be negativesince option will not be exercised


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Time value (extrinsic value of theoption)

When an option is trading at more than the intrinsicvalue, the difference is known as Extrinsic Value, ormore commonly known as Time Value

Time value = Option premium intrinsic value

It is the compensation for the seller of the option forassuming future risks.

If a stock is trading at Rs.150 and its Rs.140 call optionis having a premium of Rs.15, then Rs. 10 is said to bethe "intrinsic value" and the balance Rs.5 denotes the

time value. As time passes on, the time value of optionpremium will come down and on the day of expiry therewill not be any time value for the option.


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Conti.

It is largely determined by the amount of volatility that themarket believes the stock will exhibit before expiration. If

the

market does not expect the stock to move much, then theoption's

time value will be relatively low. Meanwhile, the opposite istrue

for stocks that are expected to be very volatile

If you are an options seller, then you will probably be willingto sell options at very low prices on shares with lowvolatility. On the other hand, if you were to sell options onshares of a highly volatile stock like Amazon.com (AMZN),then you would require much greater compensation. Afterall, Amazon's stock has a much greater chance of moving

quickly in one direction or the other, which could end up


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For OTM or ATM, time value = option

premiumwhy ?

Option Stock OptionPremium

Strike IntrinsicValue

TimeValue

Call 30 $3 $29

Put 50 $4 $52

Call 25 $2 $25

Put 100 $6 $101

Call 15 $1 $16

Put 40 $18 $55

Documents

Option Basic