Options &
Its CombinationsManav Preet Singh
2005A3PS295
MANAV PREET SINGH | 2005A3PS295
MANAV PREET SINGH | 2005A3PS295
What is an
OPTIONOPTION ???
MANAV PREET SINGH | 2005A3PS295
An option is a contract whereby one party (the holder or buyer)
has the right, but not the obligation, to exercise the
contract (the option) on or before a future date (the exercise date or
expiry).
MANAV PREET SINGH | 2005A3PS295
However…The other party (the writer or seller) has the obligation to
honour the specified feature of the contract.
MANAV PREET SINGH | 2005A3PS295
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Thus, the buyer has received something of value.
The amount the buyer pays the seller for the option is called the
Option Premium
MANAV PREET SINGH | 2005A3PS295
Let’s take an example…
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Unfortunately, you won't have the cash to buy it for another three months.
You discover a house that you'd love to purchase.
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You talk to the owner and negotiate a deal that gives you an option to buy the house in three months for a price of Rs.2,00,000.
The owner agrees, but for this option, you
pay a price of Rs.3,000.
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Let’s say, that the house turns out to be the true birthplace of a great man. As a result, the market value of the house rockets to Rs.1,00,00,000.
What happens? Does the owner of the house go through with the deal?
SCENARIO 1SCENARIO 1
MANAV PREET SINGH | 2005A3PS295
YES!Since the owner is the seller of
the option, he is obliged to honour the deal.
And you make a profit of
Rs.97,97,000 !!!MANAV PREET SINGH | 2005A3PS295
Now, say, while touring the house, you discover not only that the walls are full of asbestos, but also that a family of super-intelligent rats have
built a fortress in the basement. Though you originally thought you had found
the house of your dreams, you now consider it worthless.
You seem to be in a fix. What do you do?
SCENARIO 2SCENARIO 2
MANAV PREET SINGH | 2005A3PS295
Nothing…you simply walk away from the deal.
Because you bought an option, you are under no obligation to go through with
the sale.
Of course, you still lose the Rs.3,000 (price of the option).
MANAV PREET SINGH | 2005A3PS295
STYLES OF OPTIONS
MANAV PREET SINGH | 2005A3PS295
MANAV PREET SINGH | 2005A3PS295
TYPES OF OPTIONS
MANAV PREET SINGH | 2005A3PS295
MANAV PREET SINGH | 2005A3PS295
Call Options
Buyer of the option has the right, but not the
obligation, to buy the underlying instrument on the expiration date for a certain fixed price
(called strike price).
MANAV PREET SINGH | 2005A3PS295
A graphical interpretation of the payoffs and profits generated by a call option buyer is given below. A higher stock price means a higher profit. Eventually, the price of the underlying (e.g., stock) will be high enough to fully compensate the price of the option
MANAV PREET SINGH | 2005A3PS295
A graphical interpretation of the payoffs and profits generated by a call option writer is given below. Profit is maximized when the option expires worthless (when the strike price exceeds the
price of the underlying), and the writer keeps the premium.
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• When the price of the underlying instrument surpasses the strike price, the option is said to be "in the money.”
• It is clear that a call option has positive monetary value when the underlying instrument has a spot price (S) above the strike price (K). Since the option will not be exercised unless it is "in-the-money", the payoff for a call option is Max{(S − K), 0}.
MANAV PREET SINGH | 2005A3PS295
Put Options
Buyer of the option has the right, but not the
obligation, to sell the underlying instrument on the expiration date for a certain fixed price.
MANAV PREET SINGH | 2005A3PS295
A graphical interpretation of the payoffs and profits generated by a put option as by the writer of the option is given below.
Profit is maximized when the option expires worthless (when the price of the underlying exceeds the strike price), and the writer
keeps the premium.
MANAV PREET SINGH | 2005A3PS295
A graphical interpretation of the payoffs and profits generated by a put option by the purchaser of the option is given below. A lower stock price means a higher profit. Eventually, the price of
the underlying (i.e. stock) will be low enough to fully compensate the price of the option.
MANAV PREET SINGH | 2005A3PS295
The put option has positive monetary value when the underlying instrument has a spot
price (S) below the strike price (K). Since the option will not be exercised unless it is "in-the-money", the payoff for a put option is
max{(K − S) ; 0}.
MANAV PREET SINGH | 2005A3PS295
PARTICIPANTS IN THE OPTIONS MARKET
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WHY OPTIONS ???
1. Speculation
2. Hedging
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ADVANTAGES OF OPTIONS
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