Options & Its Combinations

Options &

Its CombinationsManav Preet Singh

2005A3PS295

MANAV PREET SINGH | 2005A3PS295


What is an

OPTIONOPTION ???


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).


However…The other party (the writer or seller) has the obligation to

honour the specified feature of the contract.



Thus, the buyer has received something of value.

The amount the buyer pays the seller for the option is called the

Option Premium


Let’s take an example…


Unfortunately, you won't have the cash to buy it for another three months.

You discover a house that you'd love to purchase.


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.


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


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


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).


STYLES OF OPTIONS



TYPES OF OPTIONS



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).


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


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.


• 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}.


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.


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.


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.


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}.


PARTICIPANTS IN THE OPTIONS MARKET



WHY OPTIONS ???

1. Speculation

2. Hedging


ADVANTAGES OF OPTIONS



Economy & Finance

Options & Its Combinations