Chapter 3 Options

Mechanics & Properties of Options

1
 OPTIONS
Option contract offers the buyer the right, but not the obligation, to
●

buy (call) or sell (put) a security or other financial asset at an

agreed-upon price (the strike price) during a certain period of time
or on a specific date (exercise date).
●A call option is a contract that grants its owner the right, but not
the obligation to buy an asset at a given time
A put option is a contract that gives the option holder the right,
●

but not obligation to sell an asset at a given time

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 Mechanics & Properties of Options

Option buyer- has right but not obligation to buy by paying an

●

option premium to exercise his option on the seller

●Option seller- writer receives option premium and is obliged to
sell or buy the asset if the buyer exercises it
Exercise price- price at which contract is settled
●

Expiration date – date at which option expires

●

●Strike Price or Exercise Price :

●specified/ pre-determined price of the underlying asset at which

the same can be bought or sold if the option buyer exercises his
right to buy/ sell on or before the expiration day.

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 Mechanics & Properties of Options

When to Exercise an Call Option

If you own a call option and the stock price is HIGHER than the strike
●

price, then it makes sense for you to exercise your call.

●This way you can buy the stock at a lower price and immediately sell it
to the market at the higher price.
Eg – Right to buy at 50 rs a share, stock goes to 60 you can still buy at
●

50 and sell it for profit.

When to Exercise an Put Option
●

●If you own a put option and the stock price is LOWER than the strike
price, then it makes sense for you to exercise your put. This way you can
sell the stock at a higher price and immediately buy it back at the lower
price.
eg- Right to sell at 50 Rs per share, stock goes to 40 but can still sell at
●
4
50 making a profit..with the profit you can buy it back again if you wish.
 Options Premium

An options premium is the cost for buying a call or

put option.

The two components that affect options pricing are

the intrinsic value and time value.
 Option Premium
Buyer Seller
 Call option example

An investor purchases a call option for 100 shares from Company ABC at a strike price
of $110 and a June 30 expiration date and premium of 3 $. Given her knowledge of past
company announcements and how they’ve affected the company’s shares, she’s sure
that the stock price will rise above $110 before June 30.

Sure enough, on June 25, the company announces exciting new software arriving at
retail outlets worldwide before October 1. With this news, Company ABC’s stock price
rises rapidly to $120 per share.

The investor may now exercise her call option and purchase the 100 shares of
Company ABC’s stock for the strike price of $110 per share.

110 * 100= 11000 120*100=12000 difference is 1000.

Profit =1000- 3*100= 1000-300= 700

After paying a premium of $3 per share – and selling her new acquisition immediately –
she nets $7 per share profit for a total of $700.
Put option example
●Max purchases one March Rs 10 put option on Ford Motor Co., it gives
him the right to sell 100 shares of Ford at Rs 10 before the expiration date
in March.
The current market price has fallen to Rs 5. Analyze the situation for Max if
●

he has to exercise his put option.

Sol
Put option, ant price to fall. Price fallen to Rs 5.
●

●In this case, Max would realize a gain if the current price for which he could sell
the Ford shares in the market was below the Rs 10 exercise price.
After Max has purchased the put option, shares fall to Rs 5, he would still be
●

able to sell 100 shares at Rs 10 (Rs1,000) instead of the Rs 500 (Rs 5 x 100) for
which he could currently sell the shares in the market.
This transaction would represent an economic gain of Rs 500 for Max.
●

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 Mechanics & Properties of Options
Options are traded just like stocks—the buyer buys at the ask
●

price and the seller sells at the bid price.

The settlement time for option trades is 1 business day (T+1).
●

However, to trade options, an investor must have a brokerage

●

account and be approved for trading options

LOT SIZE:
●

●Lot size refers to a fixed number of units of the underlying asset

that form part of a single F&O contract. The standard lot size is
different for each stock and is decided by the exchange on which
the stock is traded.
E.g. options contracts for Reliance Industries have a lot size of
●

250 shares per contract. 9

 VALUE OF AN OPTIONS
●The value of an option/premium/current market
value has-
● Intrinsic value
● Time value
Intrinsic value- is the difference between strike
●

price and spot price

●Time value – difference between premium and
intrinsic value
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 VALUE OF AN OPTIONS

●Moneyness is the relative position of the current price (or

future price) of an underlying asset (e.g., a stock) with respect
to the strike price of a derivative, most commonly a call option
or a put option.

●Moneyness is firstly a three-fold classification:

●if the derivative would make money if it were to expire today,

it is said to be in the money

●while if it would not make money it is said to be out of the

money
●if the current price and strike price are equal, it is said to be at

the money 11
 VALUE OF AN OPTIONS
In the money Out of the money
When exercise price is below the currentFor a call option:
price of the underlying asset
●Spot price < strike price
For a call option:
●
●Spot price>strike price

●For a put option:

●For a put option:

●Spot> strike price

●Spot price < strike price

● At the money
● Spot price = strike price
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 VALUE OF AN OPTIONS

Suppose the current spot price of IBM is Rs100.

●A call or put option with a strike of Rs 100 is at-the-money.

●A call option with a strike of Rs 80 is in-the-money (100 − 80

= 20 > 0).
● A put option with a strike at $80 is out-of-the-money (80 −

100 = −20 < 0).

● Conversely, a call option with a Rs 120 strike is out-of-the-

money
● Put option with a Rs 120 strike is in-the-money.

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 Option Markets

● Exchange traded
● Standardized
● Maturity fixed
● Can allow expiry of contracts unlike forwards
● For this privilege buyer pays premium
Options can be standardized or Over the counter like
●

exotic options which are customized

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 Eg Currency Option Markets

Types

●1 Listed currency markets with a clearing house as

intermediary and charges a small fee
Maturity fixed and expiration months are March, June,
●

September and December.

● 2 OTC currency market
● Also called interbank currency market
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 Options Types
American option- can be exercised before maturity date
●

European option- can be exercised on maturity date

●

Vanilla option- A vanilla option is a normal call or put option that

●

has standardized terms and no special or unusual features. It is

generally traded on an exchange
Exotic options-
●

●An option that differs from common American or European options

in terms of the underlying asset or the calculation of how or when
the investor receives a certain payoff.
These options are more complex than options that trade on an
●

exchange, and generally trade over the counter.

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 Options
Call option- right to buy, no obligation
1. Buy call option – buy right to buy
2. Sell call option- sell right to buy

Put option- right to sell, no obligation

1. Buy put option- buy right to sell
2. Sell put option- Sell right to sell
 Risk free - Arbitrage
The simultaneous purchase and sale of an asset in order to
●

profit from a difference in the price.

●It is a trade that profits by exploiting price differences of identical
or similar financial instruments, on different markets or in different
forms.
●Because the differences between the prices are likely to be small
(and not to last very long)

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 · Boundary Conditions for options
Option valuation models
Boundary conditions are used to estimate what an option
●

may be priced at, but the actual price of the option may be
higher or lower than what is set as the boundary condition.
Before the introduction of binomial pricing models and Black-
●

Scholes, investors used boundary conditions to set minimum and

maximum values for the call and put options that they were pricing.
●The maximum and minimum values used to indicate where
the price of an option must lie.

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 · Boundary Conditions for options

●Before binomial pricing models and Black-Scholes, investors

used boundary conditions to set minimum and maximum
values for the call and put options that they were pricing.

The absolute minimum value for an option is zero, since

●

an option cannot be sold for a negative amount of money.

The maximum value in a boundary condition is set to the
●

current value of the underlying asset.

The maximum value of a put option is reached when the
●

underlying asset has no worth. Put ( spot< strike)

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 Boundary Conditions for Call
options
●Upper boundary- The highest amount that a call can be sold
for is the current value of the underlying asset or share
●Lower boundary- The lowest amount that a call can be sold
for is its intrinsic value
● Graph
●C0= value of call option can never fall below zero (which
is when So<E).ie selling price < value on expiration(
strike price< spot price)
● Value cannot fall below S0- E( when So<E).
● S0=strike price
● E= spot price 24
Value of call option C0
Upper bound ( S0) Lower bound ( S0-E)

Price of call option must fall in

shaded region

O E Stock price
Upper and Lower bounds of call
option 25
 Boundary Conditions for call options

Consider a call option with E= 150 , S0=250 , and C0 = 75.How much

profit will the investor earn if he buys the call option? Plot the boundary
condition for the call option.
S0 - (C0+E)
= 250 -( 75+150)
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= 2.5
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This profit comes without any risk or cost which cannot occur in a real
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market.
Conclusion-
●

The upper limit of a call option can never be more than value of
●

underlying and lower limit cannot fall below zero. 26

 Boundary Conditions for call
options
Option prices must satisfy certain criteria or else there
●

will be opportunities to earn arbitrage profits.

●Arbitrage is a trade or a set of trades that can produce
positive cash flows at one or more specified dates and
zero cash flows.
In a well functioning market , options and other
●

securities cannot be priced to yield arbitrage

opportunities
If such opportunities appear, investors will move to
●

exploit them and the prices will correct themselves

● No ARBITRAGE condition 27
 Location of call option value

●The location of option value in shaded region depends upon

five factors-
Exercise price- Higher the exercise price lower the value of an
●

option
Expiration date-longer the time to expiration, more valuable the
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option
Stock price- value of call option increases with stock price
●

Interest rate- higher the interest rate, greater the benefit from
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delayed payment
Stock price variability- higher the variability of stock price,
●

greater the chances of stock price exceeding exercise price. 28

 Value of call option for low and high
variability option
Low variance stock B High variance stock A
Payoff of call Payoff of call option
option

Stock
Stock price (S1)
price (S1)
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 Value of call option for low and high
variability option
There is a difference between holding a stock and holding a call
●

option on the stock

If you are a rise averse investor you will avoid buying a high
●

variance stock due to high risk

●However you will like to buy a call option on that stock
because you will profit from the right and avoid the loss on
the left.
In the fig. The price distribution of two stocks is given. A and B
●

have same expected value, A is more variable than B.

●Given an exercise price E, a call option on A is more valuable than
on B, as the holder of a call option gains when the stock price
exceeds the exercise price and does not lose when stock price is
less than exercise price. 30
 Put call parity theorem

Put Call Parity is a theorem that defines a price relationship between

a call option, put option and the underlying stock.
The conditions for the "official" theorem to hold true are;
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The options are of European style- held till maturity

●

Identical strike price for both call and put options

●

The stock pays no dividend

●

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 Put call parity
Understanding put-call parity
Put-call parity is stated using this equation-
-rt
C + PV(x) = P + S or C + E e = P + S0

Where
C = price of the call option
PV(x) = present value of option
P = price of the corresponding put
S = spot price (current market value) the underlying asset has

The risk-free rate is the minimum return an investor expects for any
investment because he will not accept additional risk unless the
potential rate of return is greater than the risk-free rate.
 Put call parity
Suppose an investor creates a neutral position with a portfolio P1 of
call ( buy) options and portfolio P2 of put ( sell) options for the same
underlying stock.
-rt
P1= C + E e
P2= P + S0

Value of portfolio P1 = Value of portfolio P2 , put call parity exists.

When,
-rt
C + PV(x) ≠ P + S or C + E e ≠ P + S0

Then Put call parity does not exist, arbitrage arises.

 Put call
Put call parity
parity
The put-call parity holds that the relationship between a
call and a put with the same underlying asset,
strike price, and maturity should not yield any profit of loss.

This happens because the call option expects that the

price will rise further and the put option expects that
the price will decline further.

Because the risk and return are identical, the return is

the same, yielding no profit or loss. Call put

In the case, that the call or the put option diverge from
the call-put parity, then there is an arbitrage opportunity. 34
 Scenario/ example

Value of P1=52.81
Value of P2= P+ S0
4+ 50=54
P1 ≠ P2 hence put call parity does not exist
Cash flow is = -6+4= 50= 48
 Put call parity- Application
Professionals use several factors to determine options
values.
Put-call parity also helps you understand the impact
supply and demand has on the price of options, and
how option values across all strikes and expirations are
interlinked when they belong to the same underlying
security.

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 Put call parity- Application
If you are aware of the value of a call option, you can
swiftly calculate the value the complimentary put option
(which has a matching expiration date and strike price)
would have.
This knowledge is essential for traders and investors for a
variety of reasons.
It can help you single out opportunities that are profitable
when the option premiums are not functional.
A thorough understanding of put-call parity is also
essential since it can help you figure out the relative value
that an option has when you are considering adding it to
your portfolio.
 Put call parity- Application
If an opportunity for arbitrage comes into existence, this means that
theoretically, skilled traders can still make a profit without taking any
risk.
In liquid markets, chances of this sort are a bit uncommon and have a
small window.
Concept of put-call parity- It will put you in a better place as far as
understanding markets is concerned, and provide you with an edge that
will help you outperform your competitors. Success in this trade often
comes to those who have the power to notice market divergence and
mispricing early.
In real life, however, the occasions where one can take advantage of
arbitrage are hard to come across and short-lived.
In addition to this, it might often happen that the margins offered by
these are so tiny that you would need to invest a huge sum of capital to
make use of them advantageously.
 1. Example/ Sum

-You have bought a European call option for TK stock. The

date of expiration is a year from the date of purchase, and
the strike price is Rs 150. The call option cost you Rs 50 to
purchase.

What happens in the following scenarios-

a. TK trading stock is at Rs 100
b. TK trades stock is at Rs 200
c. TK stocks go up to Rs 300 .
 Solution
As you know, by buying this contract, you get the right to buy TK
stocks on the date of expiration for Rs 150, no matter what the
market price is at that time.

a. After a year, you see that TK is trading its stocks at Rs 100, so

you choose not to make use of your option.
b. If TK trades shares at Rs 200 each, you will make use of your
option and buy the shares at Rs 150.
Here, you will be breaking even since you spent Rs 50 to buy the
option in the first place.
c. If TK stocks go to 300, then you will exercise ( 300-150+50) that
amount becomes your profit, if we assume that there was no
transaction fee.
 Put-call parity

The quotations from Nifty July 2020 option contracts

Spot
● 1113
July 2020 call- 1120
● Rs 27
July 2020 put -1120
● Rs 36
The risk free rate @10 percent per annum and time to expiry at
●

90 days . One Nifty option taken as 200.

Find out if there is a arbitrage opportunity in put- call prices for the
●

Nifty 2020 contracts with strike price at 1120 and the present value
of strike price from the contracts.

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 Put-call parity - Solution
1 Value of the Nifty contract call/put =1120*200
= Rs 2,24,000
2 Value of Nifty spot= 1113*200= 2,22,600
3 C= Call will be worth = 27 * 200 = Rs 5,400
4 P= Put will be worth = 36 * 200= Rs 7200
From the above calculation its clear that put and call are not in a
●

parity relationship.
The put is sold at more expensive rate than call.
●

Hence there is no put call parity.

●

5 PV = value of nifty*100 = 2,24,000 *100 = Rs 2,48,888

●

● days to expiry 90 42
 Sum- Intrinsic value

●The market price of a Infosys share is 520. The strike price of

a call option on the share is Rs 500 and the market price of
the call option is Rs 30. Calculate the intrinsic value and the
time value of the option.
● Solution
● Intrinsic value is Rs 520- 500 = 20
● Time value of the option
● = 30-20
● =10

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 Sum – Intrinsic value

Assume a stock is selling for Rs 48.50 with options available at

40, 50, and 60 strike prices. The 50 call option price is at 2.75.

a. What is the intrinsic value of the 50 call?

b. Is the 50 call in the money?
c. What is the speculative premium on the 50 call option?
d. What percentage of common stock price does the
speculative premium represent?
e. Are the 40 and 60 call options in the money?

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 Sum

a) Intrinsic Value (Call) = Underlying Price – Strike Price

Intrinsic Value (Put) = Strike Price – Underlying Price

=48.50−50 = −$1.50
b) No. It is not 'in the money' 48.50 is less than the strike price
50

c)

d) % of common stock =4.25/48.50 = 8.76%

e) The 40 call option is because the market price is
above the strike price. The 60 is not. 45
 Option sensitivity
Change in options price with respect to change in
●

variables.
1)Underlying
2) Volatility
3) Strike price
4) Interest rate
5)Time to expiration
6) Stock price

46
 1 Volatility

● Sensitivity of an option to volatility changes

● It decreases as an option reaches maturity
The sensitivity is maximum when option is at the
●

money with a long time to expiration

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 2 Strike/ Exercise price
Other things being constant the higher the
●

exercise price the lower the value of call option.

● Value of call option can never be negative .
It will have a positive value if the stock price is
●

greater than the exercise price before expiration

date.

48
 3 Interest rate
There is a positive relationship between stock
●

option premium and interest rate

When we buy a call option we do not pay the
●

exercise price until we decide to exercise the

option
● The payment if any will be made in future
●The higher the interest rate, the greater the
benefit will be from delayed payment and vice
versa.
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● So value of a call option is positively related to
 4 Time to expiration
This is the rate of change in the value of the
●

option with respect to time to maturity

●The longer the options time to expiration , the
more valuable the option, if other factors are kept
constant
●As time to expiration approaches option becomes
less valuable.

50
 5 Stock price
●An increase in the underlying stock price causes the call value to
increase and the put value to decrease , other factors being
constant.
The value of a call option, other things being constant increases
●

with stock price.

Variability of stock price
●

A call option has a value when there is a possibility that the

●

stock price exceeds the exercise price before the expiration

date.
Other things being equal , the higher the variability of the
●

stock price, greater the likelihood that stock price will exceed
exercise price.
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 Functional Relationship
●The manner in which the five variables influence
value of call option is
● C0 = f ( S0, E, σ,t, rf )
● +-+++
Where
●

C0 is value of call option

●

S0 is price of underlying
●

E is exercise price
●

σ variance return
●

52
rf is risk free rate
●