Options
- 1. Options GROUP NO. I MBA 2nd YEAR WELCOME TO SEMINAR ON Presented By - MR Shete Shubham Presented By-
- 3. CONTENTS 3 • Introduction to option - • Development Of Options Markets - • Types of option - • Organized options trading - • Listing requirements - • Contract size - • Exercise prices - • Expiration dates - • Position & exercise limits - • Exchange on option trade - • Option traders - • International Option Exchanges - • Put call parity relationship - • Option pricing models –The Black Scholes model and The binomial model - • Conclusion n- • Reference -
- 4. 4 INTRODUCTION • An option is a financial different from futures & forward contract. that gives an investor the right, but not the obligation, to either buy or sell an asset at a pre-determined price (known as the strike price) by a specified date (known as the expiration date). • There are two basics type of options. a CALL option and a PUT option • Options are derivative instruments, meaning that their prices are derived from the price of their underlying security, which could be almost anything: stocks, bonds, currencies, indexes, commodities, etc.
- 5. 5 DEFINATION “A formal definition of an option states that it is a type of contract between two parties that provides one party the right but not the obligation to buy or sell the underlying asset at a predetermined price before or at expiration day.”
- 6. Investors use options for two primary reasons : 6 - To Speculate - To Hedge Risks
- 7. 7 Development Of Options Markets – Options are among the most important inventions of contemporary finance. Whereas a futures contract commits one party to deliver, and another to pay for, a particular good at a particular future date, an option contract gives the holder the right, but not the obligation, to buy or sell. Options are attractive to hedgers because they protect against loss in value but do not require the hedger to sacrifice potential gains. Most exchanges that trade futures also trade options on futures.
- 8. 8 •There are other types of options as well. In 1973 the Chicago Board of Trade established the Chicago Board Options Exchange to trade options on stocks. •Many options are created in a standardized form and traded on an options exchange. Stock index option – A stock index option provides the right to trade a specific stock index at a specified price by a specified expiration date. A call option on a stock index gives you the right to buy the index, and a put option on a stock index gives you the right to sell the index. Commodity Options – Commodity trade options contracts are rights to buy (call option) or sell (put option) underlying commodity futures at predetermined prices on the date of contract expiry.
- 9. 9 currency option - A currency option (also known as a forex option) is a contract that gives the buyer the right, but not the obligation, to buy or sell a certain currency at a specified exchange rate on or before a specified date. Interest rate option - An interest rate option is a financial derivative that allows the holder to benefit from changes in interest rates. Investors can speculate on the direction of interest rates with interest rate options
- 10. 10 Call Option * Calls are the right without obligation to buy a certain underlying assets after a certain period at certain price. * The buyer of the call gets a right to buy the underlying asset without any obligation. *The buyer of the call option earns a right (it is not an obligation) to exercise his option to buy a particular asset from the call option seller for a stipulated period of time. * The buyer can enforce his right after the specified time.
- 11. 11 Put Option * The buyer of the put gets a right to sell the underlying assets without any obligation. * Put option is a derivative contract between two parties. The buyer of the put option earns a right (it is not an obligation) to exercise his option to sell a particular asset to the put option seller for a stipulated period of time. * The seller of put has no other choice than to purchase the asset at the strike price at which it was originally agreed. The buyer of put expects the value of asset to decrease so that he can purchase more quantity at lower price.
- 12. 12
- 13. 13 Organised Option Trading An exchange is an organized market where (especially) tradable securities, commodities, future and option contract are sold and bought. Exchanges bring together brokers and dealers who buy and sell these objects. These various financial instruments can typically be sold either through the exchange, clearinghouse or over-the-counter (OTC). Although OTC & clearinghouses have become more common over the years.
- 14. 14 Listing requirements are a set of conditions which a firm must meet before listing a security on one of the organized stock exchanges, such as the New York Stock Exchange (NYSE), the London Stock Exchange, or the Tokyo Stock Exchange. The listing requirements of non- stock options, such as bond and stock indices. foreign currency and futures includes satisfying an approved proposal that specifies condition such as the terms of the contract and if it’s an index, how it is to be constructed. Listing requirement -
- 15. 15 Under CBOE rules, there are four criteria a publicly company must meet before options on its stock can be traded on the options exchange - The underlying equity security must be listed on the NYSE, AMEX or Nasdaq. The closing price must have a minimum per-share price for a majority of trading days during the three prior calendar months. The company must have at least 7,000,000 publicly held shares. The company must have at least 2,000 shareholders. Listing requirement -
- 16. Contract size – Contract size is the deliverable quantity of a stock, commodity, or other financial instrument that underlies a futures or options contract. It is a standardized amount that tells buyers and sellers exact quantities that are being bought or sold, based on the terms of the contract. The size of the contract varies depending on the commodity or instrument.
- 17. For example, the contract size of a stock or equity option contract is standardized at 100 shares. This means that, if an investor exercises a call option to buy the stock, they entitled to buy 100 shares per option contract (at the strike price, through the expiration). An owner of a put option, on the other hand, can sell 100 shares per one contract held, if they decide to exercise their put option.
- 18. Exercise price – The exercise price is the price at which an underlying security can be purchased or sold when trading a call or put option, respectively. The exercise price is the same as the strike price of an option, which is known when an investor takes a trade. An option gets its value from the difference between the fixed exercise price and the market price of the underlying security.
- 19. Let’s assume that Sam owns call options for Wells Fargo & Company (WFC) with an exercise price of $45, and the underlying stock is trading at $50. It means the call options are trading in the money by $5. The exercise price is lower than the price at which the stock is currently trading.
- 20. Expiration Dates – First of all, let's be clear that "Expiry" and "Expiration" mean the same thing. The expiry date of a call or put option is the date that the option expires. OR Option expiry generally refers to the last date of an option contract on which option holders can exercise their right according to the terms or it can been seen as the last date till which an option is valid. In Indian stock exchanges, option contract expires on last working Thursday of each month. While in U.S expiration of the option contract is on the 3rd Friday of each month.
- 21. Position limits – Position limits are established to inhibit any investing entity from exerting undue control over a market. The limits are made with respect to total control of stocks, options and futures contracts. The main point is to avoid allowing anyone to manipulate prices to their own benefit while hurting others.
- 22. Position limits are ownership restrictions that most individual traders are never going to need to worry about breaching, but form an important purpose in the derivatives world. Most position limits are simply set too high for an individual trader to reach. However, individual traders should be grateful these limits are in place because they provide a level of stability in the financial markets by preventing large traders, or groups of traders and investors, from manipulating market prices using derivatives to corner the market.
- 23. Exercise limit – An exercise limit is a restriction on the number of option contracts of a single class that any one person or company can exercise within a fixed time period such as five business days. This limit is in place so that no one person or company can corner or greatly impact the options market or the market in the underlying security. For Example - Copper options on the Chicago Mercantile Exchange (CME) have a five- day exercise limit of 5,000 contracts, meaning no person or group can exercise more than 5,000 copper contracts over any five-day period.
- 24. Exchanges On which options trade – Exchange-traded options contracts are listed on exchanges, such as the Chicago Board Options Exchange (CBOE), and overseen by regulators, like the Securities and Exchange Commission (SEC). A key feature of exchange-traded options that attract investor is that they are guaranteed by clearinghouses.
- 25. In India, NSE & BSE are option trading exchanges. Both the exchanges are regulated by SEBI and offer fair and transparent trading environment. In addition to NSE and BSE, Options can also be traded in OTC markets. However, those are non- standardized deals between two private individuals with no guarantor. And hence are risky.
- 26. International Option Exchanges – Option exchanges are primarily responsible for providing a location and framework for the trading of standardized options contracts. It is the physical or virtual marketplace for the trading of options. Very often such options are traded on an exchange along with futures and other derivatives. Such option exchanges manage their trading in a similar manner as a stock exchange handles its bonds and stocks.
- 27. Chicago Board Options Exchange (CBOE) Boston Options Exchange Montreal Stock Exchange Eurex Exchange NYSE Arca International Securities Exchange (ISE)
- 28. Option Trader – Retail Investor - Retail investors are individuals like you who are buying and selling options with their own money for personal profit. Their objective is usually to make a significant percentage gain on their initial investments. Institutional Traders – Institutional traders are professionals trading for large entities
- 29. Broker-dealers – Broker-dealers are in the game to facilitate trades. These are firms like Ally Invest, that accept orders on behalf of clients and then ensure they are executed in the open market at the best available price. Market makers - Market makers stand ready to take the opposite side of a trade, if and when one of the other players wants to buy or sell an option.
- 30. Put-call parity relationship – Put-call parity is an important concept in options pricing which shows how the prices of puts, calls, and the underlying asset must be consistent with one another. This equation establishes a relationship between the price of a call and put option which have the same underlying asset. For this relationship to work, the call and put option must have an identical expiration date and strike price.
- 31. Put-call parity is an important relationship between the prices of puts, calls, and the underlying asset This relationship is only true for European options with identical strike prices, maturity dates, and underlying assets Put-call parity can be used to identify arbitrage opportunities in the market
- 32. Put-Call Parity Equation - St = Spot Price of the Underlying Asset pt = Put Option Price ct = Call Option Price X/(1 + r)^T = Present Value of the Strike Price, discounted from the date of expiration r = The Discount Rate, often the Risk-Free Rate
- 33. Suppose a European call option on a barrel of crude oil with a strike price of $50 and a maturity of one-month, trades for $5. What is the price of the put premium with identical strike price and time until expiration, if the one- month risk-free rate is 2% and the spot price of the underlying asset is $52?
- 34. The Black Scholes model, also known as the Black-Scholes- Merton (BSM) model, is a mathematical model for pricing an options contract. In particular, the model estimates the variation over time of financial instruments such as stocks, and using the implied volatility of the underlying asset derives the price of a call option.
- 35. The Black-Scholes Merton (BSM) model is a differential equation used to solve for options prices. The model won the Nobel prize in economics. The standard BSM model is only used to price European options and does not take into account that U.S. options could be exercised before the expiration date. Also called Black-Scholes-Merton, it was the first widely used model for option pricing. It's used to calculate the theoretical value of options using current stock prices, expected dividends, the option's strike price, expected interest rates, time to expiration and expected volatility. .
- 36. The formula, developed by three economists—Fischer Black, Myron Scholes and Robert Merton—is perhaps the world's most well- known options pricing model. It was introduced in their 1973 paper, "The Pricing of Options and Corporate Liabilities," published in the Journal of Political Economy.
- 37. Assumptions – The option is European and can only be exercised at expiration. No dividends are paid out during the life of the option. Markets are efficient (i.e., market movements cannot be predicted). There are no transaction costs in buying the option. The risk-free rate and volatility of the underlying are known and constant. The returns on the underlying are normally distributed.
- 38. The Black Scholes Formula –
- 39. C = price of a call option P = price of a put option S = price of the underlying asset S = price of the underlying asset r = rate of interest t = time to expiration s = volatility of the underlying N = Normal distribution
- 40. Binomial Option Pricing Model - The binomial option pricing model which is a very versatile numerical method for valuating American and European options. A binomial trees assumes that during a short interval of time, the stock can take only two values – the up move and the down move. However, over a longer period of time after several such moves, the stock can take a large number of distinct values that approximates the observed behaviour of stock prices.
- 41. Suppose that the stock price is currently 120 and that there are only two possibilities of how it will go next year - it can either go up by 25 percent to 150 or down by 20 percent to 96 . Assume that risk free- rate is 5% . Suppose also that the probability of the up move to 150 is 70 percent and that the probability of the down move to 96 is 30 percent. 120.00 150.00 96.00 p = 70% 1 – p = 30%
- 42. The expected stock price for the next year is therefore , 150*0.70+96*.30 = 133.80 The Expected return of stock is 133.80/120 = 11.5% We can find a set of risk-neutral probability p* of the up move is 5/9 and the risk-neutral probability 1-p* of the down move is 4/9 . This is because 5/9*25%+4/9*(-20%) = 5%
- 43. 120.00 150.00 96.00 p = 5/9 1 – p = 4/9 Under risk-neutral probabilities, the expected stock price in the coming year is 150*5/9+96*4/9 = 126. The expected rate of return on the stock is now 126/120-1 = 5%. In other words, the current price 1of 120 is obtained by discounting the risk-neutral expected stock price next year of 126 by the risk free rate of 5 %.
- 44. conclusion We have Conclude about the Option strategies also can be evaluated in terms of their profit and stock price relation prior to expiration and in terms of now the portion changes in value in response to changes in such parameters as time to expiration and the variability of the underlying stock. • An option is a contract which gives buyer the right, but not the obligation, to buy or sell an underlying asset specific price on or before a certain date. Option comprises of two types which is Call Option & Put Option. Put call parity is a relationship between the prices of put and call options and the price of the underlying assets.. • The valuing an option is the two types, the binomial option pricing model and black- Scholes option pricing model. • Derivative is a virtual market used for minimizing the risk, using various of its types such as option swap future. The risk is minimized through various option strategies and by various option valuation models.
- 45. Reference – Options, Futures & Other Derivatives – John Hull, Sankarshan Basu (Pearson Education) 7th Edition. Stock Markets, Investments and Derivatives- Ragunathan and Rajib, P. - 3rd Edition, Tata McGraw-Hill Education, 2007. Derivatives and Risk Management – Jayanth Varma (Tata McGraw Hill) 4th Edition.
Editor's Notes
- #47: Shrikant gurav..MBA II Year.