Option
As name implies, an option contract gives the buyer an option to buy or sell an underlying asset (stock, bond, commodity etc.) at a predetermined price on or before a specified date. The predetermined price is known as “Strike Price” or “Exercise Price” and predetermined date is known as “Expiry date”
American Option and European Option
If the option can be exercised at any time between the writing of the contract and its expiration date, it is called American Option. If the option can be exercised only on the date of expiry it is known as European Option.
Types of Option
There are mainly three types of Option
1. Call Option :- A call option gives the option holder (Option Buyer) right to BUY the underlying asset at a predetermined price called “Exercise Price” or “Strike Price” (Example Option is nothing but a piece of paper on which it is written that “I will BUY XYZ co.’s share at Rs. 100 on 29th Febuary,2008” and in order to keep that paper I had paid PREMIUM). The holder of the option always pays premium to the seller (Writer). Writer is in obligation to sell the underlying without of any argument.
2. Put Option :- A call option gives the option holder (Option Buyer) right to SELL the underlying asset at a predetermined price called “Exercise Price” or “Strike Price” (Example Option is nothing but a piece of paper on which it is written that “I will SELL XYZ co.’s share at Rs. 100 on 29th Febuary,2008” and in order to keep that paper I had paid PREMIUM). Writer is in obligation to buy the underlying without of any argument.
3. Double Option :- A Double option gives the option holder both the rights either to buy or to sell the underlying assets at a predetermined price.
PREMIUM :- Premium is nothing but a price to be paid to buy “Right to buy” or “Right to sell” (In our example price to buy a legal piece of paper)
Features of Option
1. Highly Flexible :- Option contract are highly standardize and hence traded on exchanges.
2. Down Payment :- The option holder must pay a certain amount called “Premium” In case if option holder will not exercise the option, he has to forego the premium. If he exercises the option, he will get profit after deducting premium from it. Theoretically, writer of option needs not to pay any down payment (But in practical sense, even writer needs to keep some margin money with exchange to avoid risk of defaulter)
3. Settlement :- Contract terminates on expiry date or even before that as per discretion of Buyer and type of contract.
4. Non- Linearity :- Here Profit or loss is not linear to price movement. For Example if I am buying call option of XYZ co. ltd. with strike price of Rs. 100 and pays premium of Rs. 4. Suppose if on expiry date price of XYZ co.’s share is say Rs. 90 and hence I will not exercise option and will not buy share. Hence my loss will be Rs. 4 (equals to Premium ). But if price on the date of expiry is say Rs. 110. So I will buy at predetermined price of Rs. 100 and will earn profit of Rs. 6 (Rs. 10 – premium). So, for Rs.10 fluctuation on either side, my profit and loss is not same (Loss Rs. 4 and Profit Rs. 6). This is known non-linear profit or loss.
Factors affecting Option Prices
1. The current stock price (S0) Call+ Put -
2. The option strike price (K) Call- Put +
3. The time to expiration (T) Call+ Put +
4. The volatility of the stock price (σ) Call+ Put +
5. The risk-free interest rate (r) Call+ Put -
6. The value of dividends expected during the life of option Call - Put +
(Note :- + indicates that with increase in factor price will also increase. And – indicates that with increase in factor price will decrease)
Advantages of Option
1. Help in reducing risk
2. Proper portfolio management
3. Protection against price fluctuation
4. Boon to financial intermediaries
As name implies, an option contract gives the buyer an option to buy or sell an underlying asset (stock, bond, commodity etc.) at a predetermined price on or before a specified date. The predetermined price is known as “Strike Price” or “Exercise Price” and predetermined date is known as “Expiry date”
American Option and European Option
If the option can be exercised at any time between the writing of the contract and its expiration date, it is called American Option. If the option can be exercised only on the date of expiry it is known as European Option.
Types of Option
There are mainly three types of Option
1. Call Option :- A call option gives the option holder (Option Buyer) right to BUY the underlying asset at a predetermined price called “Exercise Price” or “Strike Price” (Example Option is nothing but a piece of paper on which it is written that “I will BUY XYZ co.’s share at Rs. 100 on 29th Febuary,2008” and in order to keep that paper I had paid PREMIUM). The holder of the option always pays premium to the seller (Writer). Writer is in obligation to sell the underlying without of any argument.
2. Put Option :- A call option gives the option holder (Option Buyer) right to SELL the underlying asset at a predetermined price called “Exercise Price” or “Strike Price” (Example Option is nothing but a piece of paper on which it is written that “I will SELL XYZ co.’s share at Rs. 100 on 29th Febuary,2008” and in order to keep that paper I had paid PREMIUM). Writer is in obligation to buy the underlying without of any argument.
3. Double Option :- A Double option gives the option holder both the rights either to buy or to sell the underlying assets at a predetermined price.
PREMIUM :- Premium is nothing but a price to be paid to buy “Right to buy” or “Right to sell” (In our example price to buy a legal piece of paper)
Features of Option
1. Highly Flexible :- Option contract are highly standardize and hence traded on exchanges.
2. Down Payment :- The option holder must pay a certain amount called “Premium” In case if option holder will not exercise the option, he has to forego the premium. If he exercises the option, he will get profit after deducting premium from it. Theoretically, writer of option needs not to pay any down payment (But in practical sense, even writer needs to keep some margin money with exchange to avoid risk of defaulter)
3. Settlement :- Contract terminates on expiry date or even before that as per discretion of Buyer and type of contract.
4. Non- Linearity :- Here Profit or loss is not linear to price movement. For Example if I am buying call option of XYZ co. ltd. with strike price of Rs. 100 and pays premium of Rs. 4. Suppose if on expiry date price of XYZ co.’s share is say Rs. 90 and hence I will not exercise option and will not buy share. Hence my loss will be Rs. 4 (equals to Premium ). But if price on the date of expiry is say Rs. 110. So I will buy at predetermined price of Rs. 100 and will earn profit of Rs. 6 (Rs. 10 – premium). So, for Rs.10 fluctuation on either side, my profit and loss is not same (Loss Rs. 4 and Profit Rs. 6). This is known non-linear profit or loss.
Factors affecting Option Prices
1. The current stock price (S0) Call+ Put -
2. The option strike price (K) Call- Put +
3. The time to expiration (T) Call+ Put +
4. The volatility of the stock price (σ) Call+ Put +
5. The risk-free interest rate (r) Call+ Put -
6. The value of dividends expected during the life of option Call - Put +
(Note :- + indicates that with increase in factor price will also increase. And – indicates that with increase in factor price will decrease)
Advantages of Option
1. Help in reducing risk
2. Proper portfolio management
3. Protection against price fluctuation
4. Boon to financial intermediaries
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