Option Contract

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By: Dr. Sachita Yadav

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Option Contract

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 Introduction
• The options market makes up for a significant part of the derivative market, particularly
in India. Nearly 80% of the derivatives traded are options and the rest is attributable to
the futures market. Internationally, the option market has been around for a while now,
here is a quick background on the same –
• Custom options were available as Over the Counter (OTC) since the 1920’s. These
options were mainly on commodities.
• Options on equities began trading on the Chicago Board Options Exchange (CBOE) in
1972.
• Exchange-traded options on currencies began on the Philadelphia Stock Exchange in
1982.

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• Clearly the international markets have evolved a great deal since the OTC days. However
in India from the time of inception, the options market was facilitated by the exchanges.
However options were available in the off market ‘Badla’ system. Think of the ‘badla
system’ as a grey market for derivatives transactions. The badla system no longer exists,
it has become obsolete. Here is a quick recap of the history of the Indian derivative
markets –
• June 12th 2000 – Index futures were launched
• June 4th 2001 –Index options were launched
• July 2nd 2001 – Stock options were launched
• November 9th 2001 – Single stock futures were launched.
• Though the options market has been around since 2001, the real liquidity in the Indian 3
index options was seen only in 2006.
Options Contract
• The options are important financial derivatives where the instruments have additional features of
exercising an option which is a right and not an obligation. Hence, options provide better scope
for risk coverage and making a profit at any time within the expiration date. The price of the
underlying is also derived from the underlying asset.
• There are two types of options –

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• The Call option and the Put option.
• You can be a buyer or seller of these options.

Fundamentals of Futures and Options Markets, 9th Ed, Ch 9,

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Copyright © John C. Hull 2016
Case to understand an Option Contract

• Consider this situation; there are two good friends, Ajay and Venu. Ajay is actively evaluating an
opportunity to buy 1 acre of land that Venu owns. The land is valued at Rs.50,00,000/-. Ajay has
been informed that in the next 6 months, a new highway project is likely to be sanctioned near
the land that Venu owns. If the highway indeed comes up, the valuation of the land is bound to
increase and therefore Ajay would benefit from the investment he would make today. However if
the ‘highway news’ turns out to be a rumor- which means Ajay buys the land from Venu today and
there is no highway tomorrow, then Ajay would be stuck with a useless piece of land!

• So what should Ajay do? This situation has put Ajay in a dilemma as he is uncertain whether to
buy the land from Venu or not. While Ajay is muddled in this thought, Venu is quite clear about
selling the land if Ajay is willing to buy.

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• Ajay wants to play it safe, he thinks through the whole situation and finally proposes a special
structured arrangement to Venu, which Ajay believes is a win-win for both of them, the details of
the arrangement is as follows –

• Ajay pays an upfront fee of Rs.100,000/- today. Consider this as nonrefundable agreement fees
that Ajay pays.
• Against this fees, Venu agrees to sell the land after 6 months to Ajay
• The price of the sale( which is expected 6 months later) is fixed today at Rs.50,00,000/-
• Because Ajay has paid an upfront fee, only he can call off the deal at the end of 6 months (if he
wants to that is), Venu cannot
• In the event Ajay calls off the deal at the end of 6 months, Venu gets to keep the upfront fees
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 Features of options
• Contract: Option is an agreement to buy or sell an asset. The buyer of option contract has the
right to exercise or not but the seller of an option contract has the obligation.
• Premium: In case of option a premium in cash is to be paid by one party (buyer) to the other
party (seller).
• Pay off: From an option in case of buyer is the loss in option price and the maximum profit a
seller can have in the options price.
✔ Buyer- unlimited profits and limited losses
✔ Seller - limited profits and unlimited losses

•
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• Holder and writer: The holder of an option is the buyer while the writer is known as seller of
the option. The writer grants the holder a right to buy or sell a particular underlying asset in
exchange for a certain money for the obligation taken by him in the option contract.
Exercise price: There is a call strike price or exercise price at which the option holder buys
(call) or sells (put) an underlying asset.
• Variety of underlying assets: The underlying asset traded as option may be variety of
instruments such as commodities, metals, stocks, stock indices, currencies etc.
• Tool for risk management: Options is a versatile and flexible risk management tools which can
mitigate the risk arising from interest rate, hedging of commodity price risk. Hence options
provide custom-tailored strategies to fight against risks.

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Types of Options
• A call is an option to buy
• A put is an option to sell
• A European option can be exercised only at the end of its life
• An American option can be exercised at any time
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Fundamentals of Futures and Options Markets,

9th Ed, Ch 9, Copyright © John C. Hull 2016 7
Call Option and Put Option
Call options
• Calls give the buyer the right, but not the obligation, to buy the underlying asset at the strike
price specified in the option contract. Investors buy calls when they believe the price of the
underlying asset will increase and sell calls when they believe it will decrease.
Put options
• Puts gives the buyer the right, but not the obligation, to sell the underlying asset at the strike

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price specified in the contract. The writer (seller) of the put option is obligated to buy the asset
if the put buyer exercises their option. Investors buy puts when they believe the price of the
underlying asset will decrease and sell puts if they believe it will increase.

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Option Positions
• Long call (holder of the contract)- right to execute the contract or not-
pay option premium

• Long put (holder of the contract)- right to execute the contract or not-
pay option premium

• Short call (writer of the contract)- obligation to execute the contract-

receive option premium
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• Short put (writer of the contract)- obligation to execute the contract-
receive option premium

Fundamentals of Futures and Options Markets,

9th Ed, Ch 9, Copyright © John C. Hull 2016 9
Buying Call Option
• The buyer of a call option pays the option premium in full at the time of entering the contract. Afterward, the buyer enjoys
a potential profit should the market move in his favor. There is no possibility of the option generating any further loss
beyond the purchase price. This is one of the most attractive features of buying options. For a limited investment, the
buyer secures unlimited profit potential with a known and strictly limited potential loss.

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• If the spot price of the underlying asset does not rise above the option strike price prior to the option’s expiration, then
the investor loses the amount they paid for the option. However, if the price of the underlying asset does exceed the
strike price, then the call buyer makes a profit.

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• The call option seller’s downside is potentially unlimited. As the spot price of the underlying
asset exceeds the strike price, the writer of the option incurs a loss accordingly (equal to the
option buyer‘s profit). However, if the market price of the underlying asset does not go higher
than the option strike price, then the option expires worthless. The option seller profits in the

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amount of the premium they received for the option.

Fundamentals of Futures and Options Markets, 9th Ed, Ch 9,

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Copyright © John C. Hull 2016
Buying Put Option
• A put option gives the buyer the right to sell the underlying asset at the option strike price. The
profit the buyer makes on the option depends on how far below the spot price falls below the
strike price. If the spot price is below the strike price, then the put buyer is “in-the-money.” If
the spot price remains higher than the strike price, the option will expire unexercised. The
option buyer’s loss is, again, limited to the premium paid for the option.

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Selling Put Option
• The writer of the put is “out-of-the-money” if the spot price of the underlying asset is
below the strike price of the contract. Their loss is equal to the put option buyer’s
profit. If the spot price remains above the strike price of the contract, the option
expires unexercised, and the writer pockets the option premium.

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Fundamentals of Futures and Options Markets, 9th Ed, Ch 9,

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Copyright © John C. Hull 2016
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Payoffs from Options
(without adjusting options premium)
What is the Option Position in Each Case?

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Fundamentals of Futures and Options Markets,

9th Ed, Ch 9, Copyright © John C. Hull 2016 15
Options P/L Formulas

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Example
There is a person who has entered in a Call option contract at Rs. 550 stock
price with a premium of Rs. 5.
Situation-
1. If there is a decrease in the stock price to Rs. 540.
2. If there is an increase in the stock price to Rs. 560.

Call Buyer
Situation 1
550
540
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What is the position of the buyer and seller in the mentioned situations?
Situation 2
550
560
Max loss Rs. 5 Payoff- Rs. 10 Premium Rs. 5
net profit Rs. 5

Call Seller/Writer
Situation 1 Situation 2
Max Profit is limited Rs. 5 Profit Rs 5 Loss 10
Net loss Rs. 5

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There is a person who has entered in a Long Put
option contract at Rs. 550 stock price with a
premium of Rs. 5.
Situation-
1. If there is a decrease in the stock price to Rs.
540.
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2. If there is an increase in the stock price to Rs.
560.
• Find out profit/loss for buyer of put option.

Fundamentals of Futures and Options Markets, 9th Ed, Ch 9,

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Copyright © John C. Hull 2016
Long Call

Profit from buying one European call option: option price = $5,
strike price = $100.

30 Profit ($)

20

10
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70 80 90 100 stock price ($)
0
-5 11 120 130
0
Fundamentals of Futures and Options Markets,
9th Ed, Ch 9, Copyright © John C. Hull 2016 19
Short Call

Profit from writing one European call option: option price = $5,
strike price = $100

Profit ($)
5 11 120 130
0

-10
70 80 DSY
90 100
0
stock price ($)

-20

-30
Fundamentals of Futures and Options Markets,
9th Ed, Ch 9, Copyright © John C. Hull 2016 20
Long Put

Profit from buying a European put option: option price = $7,

strike price = $70

30 Profit ($)

20

10
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stock price ($)
0
40 50 60 70 80 90 100
-7

Fundamentals of Futures and Options Markets,

9th Ed, Ch 9, Copyright © John C. Hull 2016 21
Short Put
Profit from writing a European put option: option price = $7,
strike price = $70

Profit ($)
7
40 50 60 stock price ($)
0

-10
DSY 70 80 90 100

-20

-30
Fundamentals of Futures and Options Markets,
9th Ed, Ch 9, Copyright © John C. Hull 2016 22
Moneyness of Option

The moneyness of an option contract is a classification method wherein each

option (strike) gets classified as either – In the money (ITM), At the money (ATM),

or Out of the money (OTM) option.

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This classification helps the trader to decide which strike to trade, given a

particular circumstance in the market. However, before we get into the details,

we will try to understand the concept of intrinsic value.

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Concept of Intrinsic Value
• The intrinsic value of an option is the money that the option buyer makes from an options contract provided
he has the right to exercise that option on the given day. Intrinsic Value is always a positive value and can
never go below 0. Consider this example –

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Intrinsic Value of a Call
option
= Spot Price – Strike
Price
Let us plug in the values
= 8070 – 8050
= 20

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Intrinsic Value (IV)
• Call option Intrinsic Value: Spot Price – Strike Price
• Put option Intrinsic Value: Strike Price – Spot Price
• The intrinsic value is always positive and it is never negative.

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Moneyness of a Call and Put option

1. In The Money (ITM)

If the option contract is ITM, then it has an intrinsic value.
A call option is ITM if the spot price is higher than the strike price.
On the other hand, a put option is ITM, if the spot price is less than the strike price.
2. At The Money (ATM)

3. Out of The Money (OTM) DSY

If the options contract strike price is the same as the spot price then it is said to be ATM.

If an option contract is OTM, then it does not have intrinsic value.

A call option is OTM if the spot price is lower than the strike price.
On the other hand, a put option is OTM, if the spot price is more than the strike price. The same rule applies to
both call options as well as put options.

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