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Questions and Answers
What is the strike price in Anita's options contract with Arun?
What does Anita lose if she does not exercise her option by the settlement date?
If on the settlement day the spot price is Rs. 120, what is Anita's profit?
What is the relationship between the spot price and the profit for the holder of a long call option?
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If the spot price on the settlement day is Rs. 103, what action will Anita likely take?
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What would be Arun's outcome if he has to sell the asset to Anita at the strike price when the market price is significantly higher?
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What is the call premium in Anita's options contract?
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How is Anita's position categorized in the options market?
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Which type of options can be exercised only on predetermined dates?
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What is the typical expiry date for monthly equity option contracts in India?
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What is the premium price step for options trading in India?
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How are strike prices for options contracts determined?
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Which of the following statements about equity options is true?
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What is a long call option?
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Which scenario leads to a profit when holding a long put option?
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What defines an 'in the money' call option?
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What is the obligation of a short call option holder?
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In what condition is a long call option considered a loss?
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Which statement best describes European options?
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What is the relationship between the strike price and the profitability of a short put option?
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Which best describes the term 'option class'?
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Study Notes
Financial and Commodity Derivatives - Options Primer
- Options are contracts giving the right, but not the obligation, to buy (call) or sell (put) an asset at a specific price (strike price) on or before a certain date (expiry date).
- A call option allows the buyer to buy the underlying asset at the strike price, profitable if the asset price rises above the strike price.
- A put option allows the buyer to sell the underlying asset at the strike price, profitable if the asset price falls below the strike price.
- Option contracts frequently feature a premium paid by the buyer to the seller (writer) of the option.
- In a call option, the buyer profits if the asset price exceeds the strike price; otherwise, the premium is lost.
- In a put option, the buyer profits if the asset price falls below the strike price; otherwise, the premium is lost.
Call Options Contract
- Spot price of the asset is Rs. 100.
- Buyer (Anita) has the right to buy the asset from seller (Arun) if the price on 9/10/2024 is above Rs. 110.
- Arun charges Rs. 2 as a premium.
- If the asset price on 9/10/2024 is greater than Rs. 112, Anita can buy the asset.
- If the price is not greater than Rs. 112, Anita's payment of Rs. 2 is lost, and Arun profits.
- In this contract:
- Rs. 100 is the spot price (S).
- Rs. 110 is the strike price (K).
- Rs. 2 is the call premium (c).
- 9/10/2024 is the settlement day.
Call Options - Payoff
- If the spot price remains below Rs. 110 (e.g., Rs. 103), the call option has no value, and Anita would not exercise it.
- If the spot price exceeds Rs. 110 (e.g., Rs. 118), Anita exercises the option, buying the asset at Rs. 110 and selling it at the market price of Rs. 118, earning a profit of Rs. 6 (Rs. 118 - Rs. 110 - Rs. 2).
- Anita's profit is Arun's loss, as Arun has to sell the asset at the strike price.
Long Call Option - Payoff for Anita
- A table shows Anita's profit/loss depending on the spot price, taking into account the premium.
- The payoff is higher than the spot price minus the strike price for various spot prices.
Short Call Option - Payoff (Taking Premium)
- The payoff for Arun (seller) is the reverse of Anita's gain.
- Arun's profit is limited to the premium, but his loss is potentially unlimited if the spot price rises significantly.
Call Options - Payoff
- Anita has a long call option (buyer) and Arun has a short call option (seller).
- Anita's profit is unlimited, but her loss is limited to the premium.
- Arun's loss is unlimited, but his profit is limited to the premium.
- An option is a one-sided contract; the option holder may choose to exercise it.
Put Options Contract
- Spot price of the asset is Rs. 100.
- Buyer (Sandeep) has the right to sell the asset to seller (Shashank) if the price on 9/10/2024 is below Rs. 90.
- Shashank charges Rs. 3 as a premium.
- If the price on 9/10/2024 is less than Rs. 90, Sandeep can sell it.
- If not, Sandeep's Rs.3 premium is lost, and Shashank profits.
- In this contract:
- Rs. 100 is the spot price (S).
- Rs. 90 is the strike price (K).
- Rs. 3 is the put premium (p).
- 9/10/2024 is the settlement day.
Put Option - Payoff
- If the spot price remains above Rs. 90 (e.g., Rs. 97), Sandeep does not exercise the option.
- If the spot price drops below Rs. 90 (e.g., Rs. 81), Sandeep exercises the option, selling the asset at Rs. 90 to Shashank and buying it at Rs. 81 from the market, earning a profit of Rs. 6 (Rs. 90 - Rs. 81 - Rs. 3).
Long Put Option - Payoff for Sandeep
- Sandeep's profit/loss is tabulated based on various spot prices.
- Payoff increases when the spot price is lower than the strike price.
Short Put Option - Payoff (Taking Premium)
- Shashank's payoff is the reverse of Sandeep's gain.
- Shashank's profit is limited to the premium, but his loss is potentially unlimited if the spot price falls significantly.
Options
- A one-sided contract: the buyer/holder can ask the other party to fulfill the contract.
- Health insurance is an example of an options contract.
Options Types
- European: exercisable only on the expiry date.
- American: exercisable any time before or on the expiry date.
- Bermudan: exercisable on specific dates before expiry.
- Indian equity options are predominantly European style.
Equity Options in India
- Monthly contracts: expire on the last Thursday of the month.
- Weekly contracts: Tuesday (Finnifty), Wednesday (Bank Nifty), Thursday (Nifty).
- Possible adjustments around November 20th based on new regulations.
Option Contracts
- Strike price(K) scheme depends on stock volatility; usually price-centered with options at or near.
- Additional strikes may be available intraday.
Option Terminology
- In-the-money (ITM) call: Spot price > Strike Price
- At-the-money (ATM) call: Spot price = Strike Price
- Out-of-the-money (OTM) call: Spot price < Strike Price
- Deep ITM/OTM: Significant difference from current spot price.
- Near the money: Current spot price is close to the strike price
- Put options follow the same logic but reverse the above relationships.
- Options are exercisable only when in-the-money.
Option Classes and Series
- Option class: Options of the same type (e.g., all call options on a specific stock).
- Option series: All options of a given class with the same expiry date and varying strike prices.
- Axis Bank provides examples of the classes and series for expiry date 9/10/2024, with strikes varying slightly for comparison.
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Description
This quiz explores the fundamental concepts of options in financial derivatives, including call and put options, their pricing, and profitability scenarios. Test your understanding of how options work, the significance of strike prices, and how premiums affect the buyer's decisions.
