Options are a type of derivative security. They are a derivative because the price of an option is intrinsically linked to the price of something else. Specifically, options are contracts that grant the right, but not the obligation to buy or sell an underlying asset at a set price on or before a certain date. The right to buy is called a call option and the right to sell is a put option. People somewhat familiar with derivatives may not see an obvious difference between this definition and what a future or forward contract does. The answer is that futures or forwards confer both the right and obligation to buy or sell at some point in the future. For example, somebody short a futures contract for cattle is obliged to deliver physical cows to a buyer unless they close out their positions before expiration. An options contract does not carry the same obligation, which is precisely why it is called an “option.”

1. Derivatives: Session II
OPTIONS
By: Dinesh Kumar

2. WHAT ARE DERIVATIVES?
 A derivative is a security with a price that is dependent upon or derived
from one or more underlying assets.
 The derivative itself is a contract between two or more parties based
upon the asset or assets. Its value is determined by fluctuations in the
underlying asset.
 The most common underlying assets include stocks, bonds,
commodities, currencies, interest rates and market indexes.
 Four most common examples of derivative instruments are:
 Forwards, Futures, Options and Swaps;
 Warrants, Convertible Bonds

3. WHAT IS AN OPTION?
 An option is a financial derivative that represents a contract sold by one
party (the option writer) to another party (the option holder).
 The contract offers the buyer the right, but not the obligation, to buy
(call) or sell (put) a security or other financial asset at an agreed-upon
price (the strike price) during a certain period of time or on a specific
date (exercise date).
 In return for granting the option, the seller collects a payment (the
premium) from the buyer.
 Options can be used for hedging, taking a view on the future direction
of the market, for arbitrage or for implementing strategies which can
help in generating income for investors under various market
conditions.

4. OPTION TERMINOLOGY
 Buyer of an option: The buyer of an option is the one who by paying the
option premium buys the right but not the obligation to exercise his
option on the seller/writer.
 Writer/seller of an option: The writer/seller of a call/put option is the
one who receives the option premium and is thereby obliged to sell/buy
the asset if the buyer exercises on him.
 Call option: A call option gives the holder the right but not the obligation
to buy an asset by a certain date for a certain price.
 Put option: A put option gives the holder the right but not the obligation
to sell an asset by a certain date for a certain price.
 Option price/premium: Option price is the price which the option buyer
pays to the option seller. It is also referred to as the option premium.
 Expiration date: The date specified in the options contract is known as
the expiration date, the exercise date, the strike date or the maturity.

5. OPTION TERMINOLOGY
 Strike price: The price specified in the options contract is known as the
strike price or the exercise price.
 American options: American options are options that can be exercised at
any time upto the expiration date.
 European options: European options are options that can be exercised
only on the expiration date itself.
 Bermudan options: An option that may be exercised only on specified
dates on or before expiration.
 In-the-money: Option is said to be in-the-money if the share price is above
the strike price (for a call). A put option is in-the-money when the share
price is below the strike price. The amount by which an option is in-the-
money is referred to as intrinsic value.
 Out-of-the-money: An option is out-of-the-money if the price of the
underlying asset remains below the strike price (for a call), or above the
strike price (for a put). An option is at-the-money when the price of the
underlying is on or very close to the strike price.

6. Buying and Selling Calls and Puts
 Owning a call option gives a long position in the market, and therefore
the seller of a call option is a short position.
 Owning a put option gives a short position in the market, and selling a
put is a long position.
 Keeping these four straight is crucial as they relate to the four things,
we can do with options: buy calls; sell calls; buy puts; and sell puts.
 People who buy options are called holders and those who sell options
are called writers of options. Here is the important distinction
between buyers and sellers.

7. Buying and Selling Calls and Puts
 Call holders and put holders (buyers) are not obligated to buy or sell.
They have the choice to exercise their rights if they choose.
 This limits the risk of buyers of options, so that the most they can ever
lose is the premium of their options.
 Call writers and put writers (sellers), however, are obligated to buy or
sell. This means that a seller may be required to make good on a
promise to buy or sell.
 It also implies that option sellers have unlimited risk, meaning that they
can lose much more than the price of the options premium.

8. The Factors Affecting Option Prices
 Option Price involves two components – Intrinsic Value and Option Premium.
Option Premium is the value we get by subtracting the Intrinsic Value of an Option
from the Current Market Price of that particular Option.
 Only In-the-Money Options have Intrinsic Value. Time Value of Option and
uncertainty in price of underlying security is reflected in Option Premium.
Intrinsic Value is a inherent value of an Option. For a particular Option to have an
Intrinsic Value, it is compulsory that the current market price of the underlying
security has crossed that Option Strike price.
E.g.: The price of Rs.980 Strike Call Option for the stock trading at Rs. 1000 is
Rs.28. The price split for this Option would be 1000-980=20 (Intrinsic Value) + 8
(Premium) = 28. Lower the Premium, the cheaper the Option is to buy.

9. The Factors Affecting Option Prices
 Volatility: Volatility measures the possible price fluctuations in a
security. Rise in Volatility leads to rise in Option Premiums.
Underlying Security Price: Change in market price of an underlying
security has direct effect on Option Price.
Option Strike Price – Different Strike Prices for an Option show different
response to change in market price of underlying security.
Time to expiration – Greater the time to expiration, higher the value of
the options.

10. Exercise of Call

11. Exercise of Put

12. OPTION PAY OFF

13. PAY OFF from a LONG CALL

14. PAY OFF from a SHORT CALL

15. SUMMARY OF BASIC OPTION STRATERGIES

16. Understanding The Greeks
Delta (Price risk)
 Delta is the amount by which an option’s price is expected to change for each 1-
point change in the underlying asset price. That is, option prices move in same
proportion to the asset price, expressed as the delta.
 Delta ranges from 0 to +1 for a call and 0 to -1 for a put. This means that the
maximum delta for a call option is +1, and for a put option is -1.
The more In-the-Money a call option is, the closer to +1 the delta becomes; the
more In-the-Money a put option is, the closer to -1 the delta becomes; and the
more Out-of-the-Money an option is, call or put, the closer to 0 the delta
becomes.
An At-the-Money call option typically has a Delta of .5, which means if the asset
goes up one dollar, the option will increase in value by $0.50.
A long call position has a positive Delta, and a long put position has a negative
Delta. The positive or negative sign indicates whether the delta represents a value
positively or negatively correlated with the asset price movement.

17. Understanding The Greeks
Delta (Price risk)
Eg. XYZ stock is trading @ $39.00 a share. The XYZ May $40 Call is trading
for 1.50 (option price) and has a Delta of .45. If XYZ stock rises one point
to $40.00, the XYZ May $40 C is estimated to increase in price to 1.95 (1.50
+ .45). (plus or minus other factors).
The Delta for an option can give a trader a good indication of how the
overall value of an option position may increase or decrease with changes
in the underlying asset price. This is particularly helpful in assessing price
risk for a long-term or short-term options trade.
Delta, like all the Greeks, goes to zero at expiration.

18. Understanding The Greeks
Theta (Time risk)
 Theta is the amount by which an option’s price is expected to change for each
(one) calendar day that passes. That is, the time value portion of an option’s price
decays as the expiration date approaches.
 Theta has no set range of values. But Theta is always negative for both calls and
puts. However, when calculating the Theta of an options position, short options
will have a positive Theta.
Eg. XYZ stock is trading at $19.00 a share on April 1. A long XYZ May 19 Call is
trading for $1.50 (option price) with a Theta of -.08. If XYZ stock price stays
exactly the same today, the XYZ May 19 Call is estimated to decrease in price to
$1.42 (1.50 -.08) (plus or minus other factors).
 The Theta for an option can give a trader a good indication of how the passing of
time will affect the overall value of an option position. This is particularly helpful
in assessing time risk as expiration approaches.
 Understanding that nearer term At-the-Money options have a higher Theta value
than longer-term options of the same strike price allows you to choose the correct
option in order to optimize profits for the expected holding period of a position.
Theta values adjust over time as other risk factors change, so always monitor
Theta throughout the life of a position.

19. Understanding The Greeks
Vega (Volatility risk)
 Vega measures the expected change in the price of an option due to a 1
percentage-point increase in the volatility that is used to calculate theoretical
values.
 The volatility of the underlying asset has a major influence on the price of an
option. Knowing the volatility characteristics of an underlying asset, along with
how the volatility is expected to change the option’s price (Vega), is a valuable
risk-management tool for evaluating options trading strategies.
 Vega has no set range of values. But Vega is always positive for both calls and puts.
However, when calculating the Vega of an options position, short options will have
a negative Vega.
 It is important to note that Vega decreases as options go more and more In-the-
Money and more and more Out-of-the-Money and is highest when the options are
At-the-Money. Vega also tends to decrease as time to expiration gets closer.
XYZ stock is trading at $19.00 a share on April 1. A long XYZ May 19 Call is trading
for $1.50 (option price) with a Vega of .35. If XYZ volatility increases 1 percent
today, the XYZ May 19 Call is estimated to increase in price to $1.85 (1.50 + .35)
(plus or minus other factors).

20. Understanding The Greeks
Vega (Volatility risk)
 The Vega for an option can give a trader a good indication of
how changes in volatility will affect the overall value of an
option position. This is particularly helpful in assessing the
volatility risk of an option position.
 There are several independent factors that can affect
changes in volatility for stock options: earning cycles, news
events, adjustments for dividends, stock splits, and others.
Also, there is a tendency for volatility to rise in a declining
market.

21. Understanding The Greeks
Gamma (Delta risk)
 Gamma measures the expected change in Delta of an option for a 1-point increase
in the price of the underlying asset. Gamma is the rate of change of Delta. Gamma
also shows the direction of Delta for a complex options strategy.
 A long call or long put both have a positive Gamma. But Gamma will be negative
for short options positions.
 Gamma decreases towards 0 as the option moves deeper In-the-Money or farther
Out-of-the-Money, with the At-the-Money options typically having the highest
options Gamma value.
XYZ stock is trading @ $39.00 a share. The XYZ May 40 Call is trading for 1.50 (option
price) and has a Delta of .45 and a Gamma of .02. If XYZ stock rises one point to
$40.00, the Delta is estimated to increase to .47 (.45 + .02).

22. Understanding The Greeks
Rho (Interest Rate risk)
 Rho measures the expected change in an option price based on a full 1% change in
the risk-free interest rate.
 Rho is positive for calls and negative for puts. Rho is higher, the further away from
expiration.
 Rho is rarely used by options traders. Currently, the risk free interest rate for the
13-week Treasury bills averages less than .5% and it has not been above 2% for
several years.
 Even an overnight increase in the risk-free interest rate to a full 2% would affect
long-term options positions less than 5% up or down, and most other positons
much less.

23. EXOTIC OPTIONS
 An exotic option is an option that differs in structure from common
American or European options in terms of the underlying asset, or the
calculation of how or when the investor receives a certain payoff.
 Exotic options are generally much more complex than plain vanilla
options, such as calls and puts that trade on an exchange.
 Because of the complexity and customization of exotic options, they
trade over-the-counter and are not found on regular exchanges, which
is why it is classified as an exotic option.
 Types of exotic options include: barrier options, Asian options, digital
options and compound options, among others.
Exotic options provide a great way for traders to take advantage of
different trading dynamics that traditional options can’t address.
However, the trade-off is that these options almost always trade over-
the-counter, are less liquid than traditional options, and are significantly
more complicated to value. Traders should keep these issues in mind
before using these options in live trading.

24. TYPES OF EXOTIC OPTIONS
 Compound options
 Barrier options
 Chooser options
 Lookback Option
 Chooser Options
 Rainbow Options
 Binary Options

25. OPTIONS STRATERGIES
 Understanding the basic options strategies and knowing which strategies
to use under different market conditions and outlooks is important for
long-term options trading success.
 The four basic building blocks for all options strategies are: Buy Call, Buy
Put, Write Call, and Write Put.
 Every options strategy is made up of one or more of these four basic
options positions or legs. These four positions can be combined into
many positions that can take advantage of almost any market situation:
rising markets, falling markets, quiet markets, rising volatility, falling
volatility, and other market situations.
 Options trading strategies also offer unique ways of managing and
limiting risk.

26. OPTIONS STRATERGIES
OPTION STRATEGIES MARKET OUTLOOK
Long Call Market is Moving Higher (Limited Risk)
Long Put Market is Moving Lower (Limited Risk)
Married Put Hedge a Long Position (Limited Risk)
Covered Call Lower Cost Basis (Unlimited Risk)
Bull Call Spread Market is Moving Higher (Limited Risk)
Bear Put Spread Market is Moving Lower (Limited Risk)
Long Straddle Market Neutral, Volatility Increasing (Limited Risk)
Long Strangle Market Neutral, Volatility Increasing (Limited Risk)
Butterfly Quiet Market (Limited Risk)

27. Why is the Chicago Board Options Exchange
important?
 The Chicago Board Options Exchange (CBOE) was the very first exchange to offer
standardized exchange-traded options on stocks.
 It is still the world's largest options exchange by far. The annual volume of trading on
the CBOE is in excess of 1 billion contracts.
 The total market capitalization of contracts for futures and options together is more
than $500 trillion, dwarfing the total market cap of U.S. stock exchanges (less than
$50 trillion) and the entire world's fixed income markets market capitalization
(estimated at $60 trillion).
 Only the forex markets, estimated to trade over $1 trillion daily, can challenge the
total market action of the Chicago Board of Trade (CBOT) and the CBOE.
 The CBOE currently offers trading in a countless variety of options, including options
on over 2,000 individual stocks, over 100 exchange-traded funds (ETFs) and more
than 20 stock indexes, including stock indexes of major emerging markets such as
China and Brazil.

28. WARRANTS
Warrants
Similar to options, warrants grant the holder the right - but not the obligation -
to buy the underlying asset (stock) at a specific future date.
Unlike options, warrants are issued by a company rather than an investor, and
are offered to holders of company bonds and preferred stock.
A warrant allows an investor to purchase (call warrant) or sell shares (put
warrant) of a company’s stock at a certain price, often much higher than the
price at the time the warrant was issued.

29. COVERTIBLE BONDS
Convertible Bonds
This is a type of bond that allows its holder to convert the bond into equity
(stock) in the underlying company.
The derivative still has the features of a bond, such as a coupon and a maturity
date, but also contains the conversion rate and price in which the bond can be
exchanged.
These bonds are generally considered safer than common stock because of its
bond provisions, and can be used in a convertible arbitrage strategy
(simultaneous purchase of a company’s convertible bond and shorting of the
company’s stock).

30. “Forecasts may tell you a great
deal about the forecaster; they
tell you nothing about the
future.” ~ Warren Buffet