OPTIONS

MBA – III
Prof. (Dr.) Ajay Kumar Yadav
Definitions of Options

“An option is a contract that gives the buyer the right,

but not the obligation to buy or sell an underlying
asset at a specific price on or before a certain date”
Types of Options
• There are two types of Options:
• Call Option: It gives the right but not the obligation to buy
an asset by a certain date for a certain price
• Put Option: It gives the right but not the obligation to sell
an asset by a certain date for a certain price.
• Other types of Option are:
• Real Option: the option which the investor has when
investing in real economy
• Traded Option: Are those options which are traded in the
organized exchange.
• Plain Vanilla and Exotic options: Basic options are plain
vanilla options where as the hybrid options are exotic
options.
Categories of Options
• American Option: Are those options which can be
exercised any time prior to the date of expiration of
the contract.
• European Option: Are those options which can be
exercised only on the date of expiration of the
contract.
• Bermudan Option: Are those contract which can be
exercised on some specific days prior to the expiration
of the contract.
 Key Terms
• Exercising an Option
• When a holder of an option enforces the agreement and buys or sells a
share of stock at the agreed- upon price
• Strike Price (Exercise Price)
• The price at which an option holder buys or sells a share of stock when
the option is exercised
• Expiration Date
• The last date on which an option holder has the right to exercise the
option
 Key Terms

• At-the-money
• Describes an option whose exercise price is equal to the current stock price

• In-the-money
• Describes an option whose value if immediately exercised would be positive

• Out-of-the-money
• Describes an option whose value if immediately exercised would be negative
Options Pricing

• The price of an option is the price which the option

buyer(Option holder) pays to the option seller (Option
writer). This price is known as “Option Premium”.

• There are two types of option price:

• Intrinsic Value

• Time Value
Options pricing factors

• Current stock price

• Exercise price

• Volatility

• Risk-free rate.

• Cash Dividends

• Time of expiration
Pay-off Profile of Buyer of Call
Profit + Profit =
Unlimited

• 0 Increasing Underlying
Loss = (Stock Price)
Limited

Loss (-)
Pay-off Profile of Writer of Call
Profit +
Increasing Underlying
Profit = (Stock Price)
Limited

Loss =
Unlimited

Loss (-)
Pay-off Profile of Buyer of Put
Profit +

Profit = Increasing Underlying (Stock

Unlimited Price)

Loss =
Limited

Loss (-)
Pay-off Profile of Writer of Put
Profit + Profit = Limited

Increasing Underlying (Stock

Price)
Loss =
Unlimited

Loss (-)
Example 20.2

20-14
20-15
Short Position in an Option Contract

• An investor that sells an option has an obligation.

• This investor takes the opposite side of the contract to the

investor who bought the option. Thus, the seller’s cash
flows are the negative of the buyer’s cash flows.

20-16
Short Position in a Call Option at Expiration

20-17
 Concept of Margin in Call/Put Writing

Incase of Options writing the seller needs to maintain Margin

which is adjusted for every day price movements. Initial margin
(%) percentage is fixed by the respective exchange based on the
volatility of the stock.

Initial margin =

(Strike price x lot size) x Margin % fixed by exchange

100
Practice problem 2

On 5 September, 2021 option with series CE, RIL, 2100

September, 2021 is sold by Mr. Hitesh at a premium of
Rs. 68 per share and the spot price of RIL is Rs. 2245
per share. Initial margin deposit is 20% and the market
lot size of RIL is 250 shares. Calculate the initial margin
deposit which Mr. Hitesh is required to pay to the
exchange.
Example 20.3

20-20
20-21
Options Pricing
 Options Pricing
• The price of an option is the price which the option
buyer(Option holder) pays to the option seller (Option
writer). This price is known as “Option Premium”.
• There are two types of option price:
• Intrinsic Value
• Time Value
Value of an Option
• Value for Buyer of a Call:
– Profit = Spot rate – (Strike price + premium)
• Value for Writer of a Call:
– Profit = Premium – (Spot Rate - Strike price)
• Value for Buyer of a Put:
– Profit = Strike Price – (Spot rate + premium)
• Value for Writer of a Put:
– Profit (Loss) = Premium – (Strike price - Spot Rate)
Practice Question

• Suppose you are buying a call/put option today at the strike

price of Rs. 125. The premium paid for buying this call/put is
Rs. 4. Prepare a pay-off schedule if the spot price at the time of
expiry of the contract is Rs. 120, Rs. 122, Rs. 123, Rs. 124, Rs.
125, Rs. 126, Rs. 127, Rs. 128, Rs. 129, Rs. And Rs. 130. Also
make the pay-off diagram.
Options pricing factors
• Current stock price
• Exercise price
• Volatility
• Risk-free rate.
• Cash Dividends
• Time of expiration
Put-call Parity
• Put-call parity states that the difference in the price
between the call option and put option is equal to the
price of the underlying asset less the present value of
strike price (exercise price)
• C + Ee-rt = P + So or P = C + Ee-rt – So
• C = The price of the call option
• P = The price of the put option
• S = The price of the underlying asset
• Ee-rt = Present discounted value of exercise price.
Black and Scholes
• Fisher Black and Myron Scholes developed this model
for options pricing.
• This model is based on simple assumption that in
future the price of the option will tend to increase or
decrease in comparison to the underlying assets spot
price.
• The is based on the assumption that a risk neutral
portfolio can be created with the help of hedge ratio.
• Hedge ratio is the area under the cumulative normal
distribution curve d1 & d2 represented by N(d1)
• In portfolio choice, a risk neutral investor able to
choose any combination of an array of risky assets
(various companies' stocks, various companies' bonds,
etc.) would invest exclusively in the asset with the
highest expected yield, ignoring its risk features
relative to those of other assets, and would even sell
short the asset with the lowest expected yield as
much as is permitted in order to invest the proceeds
in the highest expected-yield asset.
Log normal distributions

• A probability distribution in which the log of the

random variable is normally distributed, meaning it
conforms to a bell curve.
• A log normal distribution does not take into
consideration negative values.
Assumptions of Black and Scholes Model
• Call option for which the value is being calculated is European
style
• Price of the underlying asset changes continuously
• Share price has a lognormal distribution
• Transaction cost and taxes do not exist
• No restriction on short selling
• Funds can be borrowed at risk free return to create risk neutral
portfolio
• During the time of maturity of the Call option dividend is not
declared in the stock.
 Black and Scholes Model
• C = So N(d1) – Ee-rt N(d2)
• C = Theoretical Call premium
• So = Current Stock price
• N(d1) & N(d2) = Cumulative Normal probability
value of d1 & d2 Hedge ratio
• E = Exercise price
• e = Exponential term
• r = Risk-free Interest rate
• t = Time until option expiration
• d1=

• d2 = d1- σ√t
• S = Stock Price
• E = Exercise price
• R = Risk-free rate
• σ2 = Variance of the stocks
• t = Time of expiration of stock
• Spot price of a share is Rs 62 with an exercise price of
Rs. 55 with the time of expiration being 4 months. If
the standard deviation of the stock return is 30% and
risk free rate being 12% calculate the value of a call
premium.
• Spot price of a share is Rs 52 with an exercise price of
Rs. 56 with the time of expiration being 6 months. If
the standard deviation of the stock return is 25% and
risk free rate being 12% calculate the value of a call
premium. Also using the put call parity calculate the
value of Put option.
• James Kilts, the chief executive officer of Gillette, has
been granted options on 2 million shares. The average
stock price of Gillette, at the time of granting of the
options was $ 39.71. Assuming that the options are at
the money, the risk-free rate is 5% and the variance of
Gillette is estimated to be 0.0470. Calculate the
market value of his options if it expires in 5 years
Options Trading Strategies
Options Trading Strategies basically are hedging
strategies used for covering risks in options trading.
Option is a zero-sum game.
There are two levels in options trading strategies
1. Basic Strategies
2. Advanced Strategies
 Option Trading Strategies
• Long Call
• Short Call
• Long Put
• Short Put
• Covered Call: long underlying and short call
• Protective Put: Long Underlying and Long Put
• Option Spread
• Vertical Spread: Different Strike price but same expiration
• Horizontal Spread: Same Strike price but Diff. expiration
• Diagonal Spread: Different Strike price and diff. expiration
• Bull Call Spread: Long a call with (in the money) lower
strike price and Short a call at a higher strike price (out of
Money).
• Bull Put Spread: Short at higher strike price (above current
price level) and Long Put option with a below the current
price level
• Bear Call Spread: Buy above the current index level and
sell below the current index level
• Bear Put Spread: Sell below the current price level and
buy above the current price level.
• Butterfly Spread:
• Box Spread:
• Straddle: Buy or Short Call Buy or Short Put at same
strike price
• Strangle: Buy or Short Call at lower strike price & Buy
or Short Put at Higher strike price
• Condor Spread:
Basic Strategies
Long Call

• Buying any Call option is called a log call strategy. This

strategy is followed when the market momentum is
positive, and you expect a upswing in the stock price
in near future.
Short Call

• Shorting a Call option is also called Call writing. This

strategy is followed when the market momentum is
negative to neutral and you expect either a negative
or no movement in the price of the stock in near
future.
Long Put

• Buying any Put option is called a log Put strategy. This

strategy is followed when the market momentum is
negative, and you expect a downward movement in
the stock price in near future.
Short Put

• Shorting a Put option is also called Put writing. This

strategy is followed when the market momentum is
positive to neutral, and you expect either a positive or
no movement in the price of the stock in near future.
Covered Call

• Under this strategy Long position is created in the

underlying asset and Call is written at the strike
price which is closer to the spot price. This
strategy is followed when the holder of long
position in a stock feels that the prices are going
to go down.
Practical Problem

The spot price of a stock is Rs. 100. You hold this stock and fear that
the price of the stock will fall in the near future. However, you feel
that this fall will be temporary therefore you do not wish to sell it
from your portfolio, and you decide to write a call at Rs. 102. The
premium received by you for writing the call is Rs.4. what will be the
pay-off from this strategy if the spot price at the time of expiry is
between Rs. 95 through Rs. 110
You are an active trader in the derivative segment of the market, and you feel that the
market in the near future is likely to go down but seeing the past history of the
market you have the fear that the things may not work the way you are aiming at. So,
taking the past into account you wish to use a strategy which gives you safety as well
as good profit. Which strategy you suggest for this if the market goes down as you
think and what will be the profit or loss from the strategy. The value of stock you is
105 and the strike price available are 100, 105, 110, 115 and 120. and the respective
premium on these strike prices for the call are 18, 13, 10, 7 and 5 and for Put it is 7,
12, 16, 18 and 22. Prepare the pay-off if the stock is in the range of 95 to 125 on the
day of expiry.
Protective Put

• A protective put is a situation similar to hedging using futures

contract. Under a protective put we go long in the underlying
asset and also go long on a put option.

• This strategy is a limited risk and limited profit strategy.

Practical Problem
• The spot price of a stock is Rs. 100. You hold this stock
and fear that the price of the stock will fall in the near
future. How ever you feel that this fall will be
temporary therefore you do not wish to sell it from
your portfolio and you decide to buy a Put option at
Rs. 95. The premium paid by you for buying the put is
Rs.4. what will be the pay-off from this strategy if the
spot price at the time of expiry is between Rs. 90
through Rs. 105
Spreads
• Option Spread
• Vertical Spread: Different Strike price but same
expiration
• Horizontal Spread: Same Strike price but Diff.
expiration
• Diagonal Spread: Different Strike price and diff.
expiration
 Bull Call Spread

• Buying a Call at lower than spot price strike and

selling a call at higher than spot price strike.

• This position is undertaken from preventing total loss

from options position.
Bull Put Spread

• Writing Put at higher than spot price strike and Buying

the lower than spot strike put.

• Conditions:……….?
Bear Call Spread

• Bear Call Spread: Buy above the current index level

and sell below the current index level

• Bear Put Spread: Sell below the current price level

and buy above the current price level.
Practice question
• Suppose the spot price of yes bank is Rs 130 and the call
option on this is available with exercise price of rs. 120,
Rs. 130, Rs 140 and Rs 150 each at a premium of Rs 12,
9, 6, and 5 and the expiry of all options is 30th
September 2021. Construct a Bull Call spread strategy
and show the pay-off, if, the spot price on the day of
expiry is between 100 to 120. Take the tick size as 2.
• Butterfly Spread: Buying one call at higher strike
price and one call at lower strike price and selling
two calls at intermediate strike price. Loss under
this strategy is limited to the total investment
made.
• Box Spread: Buy one bull call spread and one bear
put spread. The pay-off will always be the
difference between the highest and the lowest
strike and net pay-off will be this difference minus
the net cash outflow. Net pay-off under this
strategy is the difference between (Higher call –
lower call) - Investment
 Practice Question

• The spot price of XYZ Ltd is Rs 100 and the call options
are available at strike price of Rs 110, 120 and 130 of the
same expiry. The current premium on these options is
Rs. 12, 7 and 5. construct a Butterfly spread and show
the pay-off if the spot price on expiry remains in the
range of Rs 100 to 160 with a tick size of Rs. 10
Practical Question
• The spot price of XYZ Ltd is Rs 120 and the call & put
options are available at strike price of Rs 110, 120 and
130 of the same expiry. The current premium on the
call options is Rs. 15, 11 and 8 and Premium for the
Put options are 6, 10, 15. Construct a Box spread and
show the pay-off if the spot price on expiry remains in
the range of Rs 100 to 160 with a tick size of Rs. 10
Combination Strategy
• Long Straddle: Buy a Call and Put at the same strike
price.
• Short Straddle
• Long Strangle: Buy Out of Money Call and a Out of the
money Put.
• Straps: When we buy one put option and two call
options on the same strike price and expiry it is called
straps
• Straps: When we buy one put option and two call
options on the same strike price and expiry it is called
straps
• Spot price of a share is Rs 60 with an exercise price of
Rs. 60 with the time of expiration being 6 months. If
the standard deviation of the stock return is 30% and
risk free rate being 12% calculate the value of a call
premium. Also using the put call parity calculate the
value of Put option.
• Assets price today is Rs. 120. Calls are available at the
strike price of Rs. 125 at a premium of Rs. 4 prepare
the pay-off chart along with the diagram of the stock
expires in the range of Rs. 120 through Rs 130. Also
given comment on your findings.
Q. No. 2. Stock price is Rs. 60. Call premium at this level
is Rs. 1.75 and the put premium is Rs 5.50 Show the pay-
off using the Straddle Strategy. When will you use such a
strategy. Draw the pay-off diagram.
• Calculate the price of a three-month European Put
Option on a non-dividend paying stock with a strike
price of Rs. 50 when the current stock price is also Rs.
52. The risk free interest rate is 10% per annum, and
the volatility is 30% per annum.
Assume a share is trading at Rs. 100. A dividend of Rs. 3
each is expected at the end of 3, 6, 9, and 12 months.
The risk free rate of interest is 6% and the stock price
has volatility of 25%. What is the value of:

• A call option with exercise price of Rs. 110 with

maturity of 6 months and

• A call option with exercise price of Rs 100 with

maturity of 12 months
Today is 24th December, 2011 and the price of the stock of X ltd
stands at Rs.100. The next option expiry date is 24th February,
2012 and the next dividend is due in April, 2012. The two-month
interest rate is 6% p.a., and the estimated share price volatility at
10% p.a. Use the Black-Scholes option pricing model to calculate
the fair price for at-the-money call option expiring February,
2012. Why might be the fair-price of the option expiring August,
2012 less reliable?