1. Unit 2

2.  Option is a contract between two parties in
which one party has the right but not obligation
to do something, usually to buy or sell some
underlying asset.
 The right without obligation has some financial
value. To realize the financial values, it is
necessary to purchase the derivative instrument
– the rights.

3.  At the day first, the option writer/seller
receive certain percentage of exercise/strike
price for the compensation of selling rights of
assets (stocks, bonds, etc) to the option
holder/buyer.
 There are two types of option contracts – Call
option and Put option.

4.  The purchaser of an Option has rights (but not
obligations) to buy or sell the asset during a given
time for a specified price (the "Strike" price).
 An Option to buy is known as a "Call," and an
Option to sell is called a "Put. "
 The seller of a Call Option is obligated to sell the
asset to the party who purchased the option
(rights). The seller of a Put Option is obligated to
buy the asset.
 Thus, the options is the rights of future which is
granted by the option contract to the buyer or the
seller (the option holder or option writer,
respectively) against the payment of option
premium.

5. American options – can be exercised any time until exercise date
European options – can be exercised only on exercise date

6.  Call option is a contract that grants the
holder the right to buy an asset at a fixed
price at during a particular period of time.
 As a option buyer, if the stock price is lower
than the strike price, the holder would buy
the stock at market price after considering
the option premium, instead of exercising the
option.

7.  The call option buyer anticipate the upward
movement in stock price so that this is a
bullish attitude.
 The difference (+ve) between the market
price and striking price is the reward for
option holder.
 The value of call option at expiration is as
follows:
Vc = Max (Vs – E, 0)
Where,
Vc = Value of call option
Vs = Market price of stock at expiration
E = Exercise price

8.  For example, if the exercise price is Rs 115
and current market price of the stock is Rs
132, what is the value of call? If the option
premium is Rs 10, what is the profit and loss
status for buyer?
 Soln: Vc = Max (Vs – E, 0)
= Max (132 – 115)
= Max Rs 17
 Profit = Vc – Pc = 17 – 10 = Rs 7
 BEP for call option seller = (E + Pc) should be
equal to market price at expiration

9.  Exercise: Call Option
 If the strike price is Rs 20 and the option
premium is Rs 10. Calculate the profit and
loss of option buyer and option seller at
different market prices (Rs 15, 17, 20, 23, 25,
30, 35)
(10 min)

10. Exercise
region
No Exercise
region
Value of stock
ValueofOption
E

11.  Put option gives the put holder the right to
sell the underlying assets at a specified price,
within a specified period of time.
 The writer of the put option promises to buy
the stock.
 The put option holder exercises the option if
the stock price is lower than the exercise
price.

12.  The put option holder anticipating downward
movement in the stock price so that this is
the bearish attitude.
 The value of put option at expiration can be
calculated as follows:
Vp = Max (E – Vs, 0)
Where,
Vp = Value of put option
Vs = Market price of stock at expiration
E = Exercise price

13. For example, if the exercise price is Rs
135 and market price of the stock is Rs
115, what is the value of put? If the option
premium is Rs 10, what is the profit and
loss status for buyer?
Soln: Vp = Max (E – Vs, 0)
= Max (135 – 115)
= Max Rs 20
Profit = Vp – Pp = 20 – 10 = Rs 10
BEP for put option buyer = (E - Pc) should
be equal to market price at expiration

14.  Exercise: Put Option
 If the strike price is Rs 20 and the option
premium is Rs 10. Calculate the profit and
loss of option buyer and option seller at
different market prices (Rs 15, 17, 20, 23, 25,
30, 35)
(10 min)

15. Exercise
region
No Exercise
region
Value of stock
ValueofOption
E

16.  Strike price or exercise price or contract price
 Option price or option premium
 The option buyer or option holder
 The option seller or option writer
 Expiration date
 Underlying assets (stock, bond, index, currency,
commodity, etc)
 Moneyness (at the money i.e. market price =
strike price; in the money i.e. market price >
strike price; out of money i.e. market price <
strike price)
 Exercising the option
 Option position (Option seller is in short
position, Option buyer is in long position)

17.  Option Exchange
An exchange is a legal corporate entity
organized for the trading of securities, options,
or futures which is governed by corporate rules
and regulations. It may utilize a trading floor or
may be an electronic exchange.
 Over the Counter (OTC)
OTC options were written for specific buyers by
particular seller, and traded in the OTC
facilities. The cost establishing an of OTC
options contracts, however, are higher than for
exchange options.

19.  Stock options
 Index options
 Currency options
 Future options

20. A privilege, sold by one party to another, that
gives the buyer the right, but not the
obligation, to buy (call) or sell (put) a stock at
an agreed-upon price within a certain
period or on a specific date.

21. A financial derivative that gives the holder the
right, but not the obligation, to buy or sell a
basket of stocks, such as the S&P 500, at an
agreed-upon price and before a certain date.
An index option is similar to other options
contracts, the difference being the underlying
instruments are indexes. Options contracts,
including index options, allow investors to
profit from an expected market move or to
reduce the risk of holding the underlying
instrument.

22. A contract that grants the holder the right,
but not the obligation, to buy or sell currency
at a specified exchange rate during a
specified period of time. For this right,
a premium is paid to the broker, which
will vary depending on the number of
contracts purchased. Currency options are
one of the best ways for corporations or
individuals to hedge against adverse
movements in exchange rates.

23. An option on a futures contract gives the
holder the right to enter into a specified
futures contract. If the option is exercised,
the initial holder of the option would enter
into the long side of the contract and would
buy the underlying asset at the futures price.
A short option on a futures contract lets an
investor enter into a futures contract as the
short who would be required to sell the
underlying asset on the future date at the
specified price.