Financial and Commodity Derivatives Options Primer PDF

FINANCIAL AND COMMODITY DERIVATIVES OPTIONS PRIMER  A CALL OPTIONS CONTRACT 2 Spot price of the asset = Rs. 100. Anita has an agreement with Arun – the right to buy the asset if its price on 9.10.2024 > Rs. 110. Arun agrees and charges Rs. 2. This is a...

FINANCIAL AND COMMODITY DERIVATIVES OPTIONS PRIMER  A CALL OPTIONS CONTRACT 2 Spot price of the asset = Rs. 100. Anita has an agreement with Arun – the right to buy the asset if its price on 9.10.2024 > Rs. 110. Arun agrees and charges Rs. 2. This is an options contract. If the price on 9.10.2024 > Rs. 112, Anita will use her right to buy the asset. If not, her payment of Rs. 2 goes waste and Arun makes a profit. In this contract,  Rs. 100 is the spot price (S0);  Rs. 110 is the strike price (K);  Rs. 2 is the call premium (c);  9.10.2024 is the settlement day  CALL OPTIONS – PAY OFF 3 If the spot price remains below Rs. 110, say at Rs. 103, Anita finds no value in the option that she holds. She can buy the stock at Rs. 103 from the market and so she would not exercise the option. If the spot price goes above Rs. 110, say to Rs. 118, then she would exercise the option. She can now buy the stock at Rs. 110 from Arun, sell the stock at Rs. 118 in the market and get a profit of Rs. 6 (the spot price Rs. 118 – the exercise/strike price Rs. 110 – premium Rs. 2). What is Anita’s profit in this case is Arun’s loss. He has to sell the stock to Anita at Rs. 110, losing the opportunity to sell at the market price of Rs. 118. So a holder of long call options profits if the spot price > strike price.  LONG CALL OPTION – PAYOFF FOR ANITA Spot Payoff – premium Payoff with 4 price ignored premium taken 50 0 -2 60 0 -2 70 0 -2 80 0 -2 90 0 -2 100 0 -2 110 0 -2 120 10 8 130 20 18 140 30 28 150 40 38 160 50 48 170 60 58  LONG CALL OPTION – PAY OFF 5  SHORT CALL OPTION – PAY OFF (TAKING PREMIUM) 6 The payoff for Arun would be exactly the reverse of the gain to Anita.  CALL OPTIONS – PAY OFF 7 Anita has a long call position (buyer/holder of a call option) and Arun holds a short call position (seller/writer of a call option). Anita could have unlimited profit, but her loss is limited to Rs. 2. Correspondingly, Arun could have unlimited loss, but has limited profit of Rs. 2. An option is a contract where the gains are unlimited, but the loss is capped (for the holder). For the writer, the loss is unlimited and the profit is limited.  A PUT OPTIONS CONTRACT 8 Spot price of the asset = Rs. 100. Sandeep has an agreement with Shashank – the right to sell the asset if its price on 9.10.2024 < Rs. 90. Shashank agrees and charges Rs. 3. This is a put option contract. Sandeep is the buyer/holder of the put option and Shashank is the seller/writer of the option In this contract,  Rs. 100 is the spot price (S0);  Rs. 90 is the strike price (K);  Rs. 3 is the premium (p);  9.10.2024 is the settlement day  PUT OPTION – PAY OFF 9 If the spot price remains above Rs. 90, say at Rs. 97, Sandeep finds no value in the option that he holds. He can sell the stock at Rs. 97 in the market and so he would not exercise the option. If the spot price goes below Rs. 90, say to Rs. 81, then he would exercise the option. He can now sell the stock at Rs. 90 to Shashank, buy it at Rs. 81 in the market and get a profit of Rs. 6 (the exercise/strike price Rs. 90 – premium Rs. 3 – spot price Rs. 81). So a holder of long put option profits if the spot price < strike price.  LONG PUT OPTION – PAY OFF FOR SANDEEP Spot Payoff – premium Payoff with 10 price ignored premium taken 50 40 37 60 30 27 70 20 17 80 10 7 90 0 -3 100 0 -3 110 0 -3 120 0 -3 130 0 -3 140 0 -3 150 0 -3 160 0 -3 170 0 -3  LONG PUT OPTION – PAY OFF 11  SHORT PUT OPTION – PAY OFF (TAKING PREMIUM) 12 The payoff for Shashank would be exactly the reverse of the gain to Sandeep.  OPTIONS 13 A one sided contract – the buyer/holder of an option can exercise the right to ask the other party to perform the contract Health insurance is a kind of an options contract Four different types Long call – right to buy the asset at the strike price Long put – right to sell the asset at the strike price Short call – obligation to sell the asset at the strike price Short put – obligation to buy the asset at the strike price  OPTIONS PAY OFF 14 Long put - Sandeep Long call - Anita Short put - Shashank Short call - Arun  OPTIONS – WHEN PROFITABLE 15 Depends on the spot price and the class of options (call or put) and the position one holds (buy or sell) Long call – right to buy the asset at the strike price – profit if the spot price > strike price. If not, the premium paid is the loss. Long put – right to sell the asset at the strike price – profit if the spot price < strike price. If not, the premium paid is the loss. Short call – obligation to sell the asset at the strike price. Profit reverse of the long call holder Short put – obligation to buy the asset at the strike price. Profit reverse of the long put holder.  OPTION TERMINOLOGY 16 In the money call option – Spot price >K. At the money call option – Spot price = K Out of the money call option – Spot price < K Deep in the money call option – K is much below the current spot price of the asset Near the money call option – K is quite near to the current spot price of the asset. For a put option, all the above is reverse Option is exercisable only if it is in the money  OPTION TERMINOLOGY 17 Option class – options of the same type. We generally have two option classes – call options and put options. Option series – all options of a given class, for the same expiry Axis Bank call options are a class. Axis Bank put options are another class. Axis Bank call options with strike price 850, 860, 870, 880, 890, etc., for expiry date 9.10.2024 is an option series. These are the contracts that are traded. Axis Bank put options with strike price 850, 860, 870, 880, 890, etc., for expiry date 9.10.2024 is another option series.  OPTIONS - KINDS 18 European options – can be exercised only on the expiry date. Only these are traded in India. American options – can be exercised any time till the expiry date Bermudan option – can be exercised only on pre determined dates Equity options traded in India are European options – can be exercised on the settlement date. However, one can square off the trade at any time.  EQUITY OPTIONS IN INDIA 19 Monthly option contracts – expiry date or maturity date – the last Thursday of the month (same as Futures) Weekly option contracts – Tuesday for Finnifty, Wednesday for Bank Nifty and Thursday for Nifty. Likely to change from November 20th when the new regulations for options would be effective.  OPTION CONTRACTS 20 Strike price or exercise price, K.  The strike price scheme available depends on the volatility of the stock. Denoted as 10 – 1 – 10, etc., meaning that there is one option contract at or near the current spot price and 10 contracts above and below the spot price.  Additional strikes (in the direction of price movement) may be enabled intra day.  New contracts can also be introduced every trading day. Premium price step – Rs. 0.05 Lot size – same as Futures contracts. Varies with the stock.