An Introduction to Options

Dr. Rana Singh

Associate Professor
www.ranasingh.org
• Forward Contract: It is a simple derivative that
involves an agreement to buy/sell an asset on a
certain future date at an agreed price.
• Future Contract: It is a standardized contract
between two parties who do not necessarily know
each other and it is for performance by a clearing
corporation or clearing house.
• Options Contract:It is a legal contract which
gives the holder the right to buy or sell a specified
amount of underlying asset at a fixed price within
a specified period of time.The holder is not
obliged to buy or sell the underlying asset.
• (A) CALL &(B)PUT
 Options
• Options are of two types –Calls and Puts
• Call options give the buyer the right but not the obligation
to buy a given quantity of the underlying asset , at a given
price on or before a given future date.
• Put options give the buyer the right , but not the obligation
to sell a given quantity of the underlying asset at a given
price on or before a given date.
• Long=Buy= Holder
• Short=Sell=Writer
• C= Current Price of the Call
• E=Exercise Price=Strike Price
• So=The current price of the share
• S1=The stock price at the expiration date of the call.
 Terminology
• Spot Price: The price at which an asset trades in the spot
market.
• Future Price:The price at which the futures contract trades
in the futures market.
• Option Price:Option price is the price which the option
buyer pays to the option seller.
• Exercise Price:The price specified in the options contract is
known as the strike price or the exercise price.
• Basis: Basis is usually defined as the spot price minus the
future price.
 LONG CALL POSITION ON ACC

Strike price 140

Premium 5 5
Spot Price Buy Future Buy Put Synthetic Long Call Buy Call
120 -20 15 -5 -5
125 -15 10 -5 -5
130 -10 5 -5 -5
135 -5 0 -5 -5
140 0 -5 -5 -5
145 5 -5 0 0
150 10 -5 5 5
155 15 -5 10 10
160 20 -5 15 15
165 25 -5 20 20
170 30 -5 25 25
175 35 -5 30 30
180 40 -5 35 35
185 45 -5 40 40
190 50 -5 45 45
195 55 -5 50 50
200 60 -5 55 55
205 65 -5 60 60
210 70 -5 65 65
 LONG CALL POSITION ON ACC

Buy Call

70
60
50
40
30
20
10
0
-10
5

5
e

12

13

14

15

16

17

18

19

20
ic
Pr
ot
Sp
 Short Call Position ON ACC

Strike price 140

Premium 5 5
Spot Price Short Future Synthetic Short Call Short Call Sell Put
120 20 5 5 -15
125 15 5 5 -10
130 10 5 5 -5
135 5 5 5 0
140 0 5 5 5
145 -5 0 0 5
150 -10 -5 -5 5
155 -15 -10 -10 5
160 -20 -15 -15 5
165 -25 -20 -20 5
170 -30 -25 -25 5
175 -35 -30 -30 5
180 -40 -35 -35 5
185 -45 -40 -40 5
190 -50 -45 -45 5
195 -55 -50 -50 5
200 -60 -55 -55 5
205 -65 -60 -60 5
210 -70 -65 -65 5
Short Call Position ON ACC
 LONG PUT POSITION ON ACC

Strike price 140

Premium 5 5
Spot Price Short Future Buy Put Synthetic Long PutBuy Call
120 20 15 15 -5
125 15 10 10 -5
130 10 5 5 -5
135 5 0 0 -5
140 0 -5 -5 -5
145 -5 -5 -5 0
150 -10 -5 -5 5
155 -15 -5 -5 10
160 -20 -5 -5 15
165 -25 -5 -5 20
170 -30 -5 -5 25
175 -35 -5 -5 30
180 -40 -5 -5 35
185 -45 -5 -5 40
190 -50 -5 -5 45
195 -55 -5 -5 50
200 -60 -5 -5 55
205 -65 -5 -5 60
210 -70 -5 -5 65
 Sp
ot

-10
-5
0
5
10
15
20
Pr
ic e

12
5

13
5

14
5

15
5

16
5
Buy Put

Buy Put
17
5

18
5

19
5

20
5
 SHORT PUT POSITION ON ACC

Strike price 140

Premium 5 5
Spot Price Long Future Short Put SyntheticShort PutShort Call
120 -20 -15 -15 5
125 -15 -10 -10 5
130 -10 -5 -5 5
135 -5 0 0 5
140 0 5 5 5
145 5 5 5 0
150 10 5 5 -5
155 15 5 5 -10
160 20 5 5 -15
165 25 5 5 -20
170 30 5 5 -25
175 35 5 5 -30
180 40 5 5 -35
185 45 5 5 -40
190 50 5 5 -45
195 55 5 5 -50
200 60 5 5 -55
205 65 5 5 -60
210 70 5 5 -65
 Sp
ot

-20
-15
-10
-5
0
5
10
Pr
ic
e

12
5

13
5

14
5

15
5

16
5
Short Put

17
5

Short Put
18
5

19
5

20
5
 Life of an option
• The life of an option is limited: it has an
expiration date. After the expiration date all
the rights and obligations conferred by the
option are null and void. The option holder
can exercise the option, i.e. declare he or
she wants to use the right to buy (or to sell)
conferred by the option.
 American-Style option
• American-Style option An option contract
that may be exercised at any time between
the date of purchase and the expiration date.
Most exchange-traded options are
American-style. In India options on stocks
are American option.
 European-style options
• European-style options
An option contract that may be exercised
only during a specified period of time just
prior to its expiration. In India Index options
are European-style options.
 QUESTION
You are reading the Wall Street Journal and you see the following table:
CALL PUT
Exercise M a r J u n S e p Mar Jun Sep
Price
30 10.15 10.85 11.65 0.05 0.35 0.85
35 5.40 6.90 8.10 0.25 1.35 2.15
40 1.90 4.00 5.35 1.75 3.40 4.35
45 0.40 2.10 3.45 5.30 6.50 7.40
50 0.05 1.05 2.15 10.05 10.50 11.15
Stock price: $40 Today's date: February

If you want to acquire the right to buy the underlying asset at $45 within 1 month, how much would that cost you per share?

a) $5.30
b) $40.00
c) $45.00
d) $5.40
e) $0.40
 QUESTION
CALL PUT
Exercise Mar Jun Sep Mar Jun Sep
Price
30 10.15 10.85 11.65 0.05 0.35 0.85
35 5.40 6.90 8.10 0.25 1.35 2.15
40 1.90 4.00 5.35 1.75 3.40 4.35
45 0.40 2.10 3.45 5.30 6.50 7.40
50 0.05 1.05 2.15 10.05 10.50 11.15
Stock price: $40 Today's date: February
Now you want to acquire the right to sell the underlying asset after 6 months at $50. How much would that cost you?

a) $2.15
b) $0.05
c) $10.50
d) $11.15
e) $0.85
 Terminology
• Let S0=The Stock Price. E=Exercise Price.

Condition Call Option Put option

S0>E In-the-Money Out-of-the-Money

S0<E Out-of-the-Money In-the-Money

S0=E At-the-Money At-the-Money

 Option terms

• Strike Price can be In-the-Money (ITM),

Out-of-the-money (OTM) or At-the-Money
(ATM)
• For example, if the current market price
of ACC = 166, Strike Price of:
• Call at 164 - ITM, Call at 166- ATM and
Call at 170 - OTM
• Put at 164 - OTM, Put at 166- ATM and
Put at 170 - ITM
In the Money Out of the Money
Market Price
Call Options Call Options

Strike Prices
Calls Strike Prices

Puts
160 162 164 166 168 170 172

Out the Money In the Money Put

Put Options Options
 Intrinsic & Time Value

• Option premiums can be divided into two

parts.
• Intrinsic value: Is the amount the option
is ITM. Its zero for ATM and OTM.
• Time value is the difference between its
premium and its intrinsic value.
• Usually Time Value is maximum when the
call/Put is ATM.
 IN, AT , OUT-
OF-THE-MONEY

• To identify whether an option is IN-, AT- or OUT-OF-

THE-MONEY, one need only compare the
EXERCISE PRICE of the option to the STOCK
PRICE of the underlying asset.
• KEEP IN MIND THAT...
• In-the-Money Options have INTRINSIC VALUE
• At-the-Money Options have INTRINSIC VALUE
EQUAL TO ZERO
 Stock Options: Example
• An Indian Investor has to deliver 100 shares of ACC in
60 days. He buys a call option at a price of Rs. 20 and
the strike price is Rs. 200 per share.
• Premium Paid by the Investor:
Rs. 2,000 or , (Rs. 20 X 100).
• If at the time of payment :-
 ACC has risen to Rs. 230 per share - In - the - Money
position (Profit = Rs. 3,000 – 2,000) = Rs. 1,000
 ACC declined to Rs.190 -Out-of-Money position
 Profit from Call Options

Profit
Profit
+ E
Rs. 200 S1
0 .
Rs. 220 Rs. Per ACC
-
Loss Call Premium “P”
Loss

Buy A Call Option

E = Exercise Price Profitable Above S1
 Profit from Put Options

Profit
+
S2 E . Rs. 200
0 . Rs per ACC
Rs. 180
-
Put Premium “q”
Loss

Buy A Put Option

E = Exercise Price
Profitable Below S2
 Options: Strategy

• An investor who expects a bull market

should buy a call option.
• An investor who expects a bear market
should buy a put option.
• The seller receives the premium but his
risk is unlimited.
• For this reason, the selling of options
should be considered only by experienced
traders.
 Buy Sell
Bullish

Call Put

Put Call

Bearish
 FACTORS AFFECTING
PREMIA
• There are five major factors affecting
the Option premium:
 Price of Underlying
 Exercise Price Time to Maturity
 Volatility of the Underlying
• And two less important factors:
 Short-Term Interest Rates
 Dividends
Entities in the trading system

Trading Members
Clearing Members
Participants
TRADING
Entities in the trading system

Trading Members
Trading members are members of NSE. They can
trade either on their own account or on behalf of
their clients including participants. The exchange
assign a trading member ID to each trading
member. Each trading member can have more
than one user. The number of user for each
trading member is notified by the exchange from
time to time. Each user of a trading member must
be registered with the exchange and is assigned an
unique user ID.
Entities in the trading system

Trading Members (contd..)

The Unique trading member ID functions as a
reference for all orders/trades of different
users. This ID is common for all users of a
particular trading member. It is the
responsibility of the trading member to
maintain adequate control over persons
having access to the firm’s User IDs.
Entities in the trading system

Clearing Members
Clearing members are members of NSCCL.
They carry out risk management activities and
confirmation/inquiry of trades through the
trading system.
Entities in the trading system

Participants
A participant is a client of trading members like
financial institutions. These clients may trade
through multiple trading members but settle
through a single clearing member.
Order types and conditions

Time conditions
Price conditions
Other conditions
Order types and conditions

Time conditions
- Day Order:
A day order, as name suggest is an order
which is valid for the day on which it is
entered. If the order is not executed during
the day, the system cancels the order
automatically at the end of the day
Order types and conditions

Time conditions (contd…)

- Good till canceled(GTC):
A GTC order remains in the system until the
user cancels it. Consequently, it spans trading
days, if not traded on the day the order is
entered. The maximum number of days an
order can remain in the system is notified by
the exchange from time to time after which the
order is automatically cancelled by the system.
 Order types and conditions

Time conditions (contd…)

- Good till canceled(GTC): (contd…)
Each day counted is a calendar day inclusive of
holidays. The days counted are inclusive of
the days on which the order is placed and the
order is cancelled from the system at the end
of the day of the expiry period
Order types and conditions

Time conditions (contd…)

- Good till days/date (GTD):
A GTD order should stay in the system if not
executed. The maximum days allowed by the
system are the same as in GTC order. At the
end of this day/date, the order is cancelled
from the system. Each day/date counted are
inclusive of the day/date on which the order is
placed and the order is cancelled from the
system at the end of the day/date of the expiry
period
Order types and conditions

Time conditions (contd…)

- Immediate or Cancel (IOC):
An IOC order allows the user to buy or sell a
contract as soon as the order is released into
the system, failing which the order is cancelled
from the system. Partial match is possible for
the order, and the unmatched portion of the
order is cancelled immediately.
 Order types and conditions
Price conditions
- Stop – loss:
This facility allows the users to release an order into
the system, after the market price of the security
reaches or crosses at threshold price. E.g. if for
stop-loss buy order, the trigger is 1024.00, the limit
price is 1030.00 and the market (last traded) price is
1023.00 then this order is released into the system
once the market price reaches or exceeds 1024.00.
This order is added to the regular lot of books with
time of triggering as the time stamp, as a limit order
of 1030.00. For the stop-loss sell order, the trigger
price has to be greater than the limit price
 Order types and conditions

Other conditions (contd…)

- Market Price:
Market orders are for which no price is
specified at the time the order is entered (i.e.
price is market price). For such order, the
system determines the price.
- An opening price(ATO):
ATO price is the price arrived at by the system
after the pre-open phase is over
 The market watch window
The following windows are displayed
on the trader workstation screen.
 Title bar
 Ticker window of futures and option market
 Ticker window of underlying(capital) market
 Tool bar
 Market watch window
 Inquiry window
 Snap quote
 Order/trade window
 System message window
 Inquiry window

Market by order (MBO)

The purpose of the MBO is to enable the user to
view passive orders in the trading books in the
order of price/time priority for a selected security.
The F5 key invokes the selection window for
MBO. If a particular contract or security is
selected, the details of the selected contract or
security defaults in the selection screen or else
the current position in market watch defaults.
 Inquiry window

Market by order (MBO) (contd…)

Details of contract or security from the contract
list or from the last operation. The field that
are available on the selection screen are
instrument, symbol, expiry and book type.
The instrument type, symbol, expiry and book
type fields are compulsory.
Inquiry window

Market by price (MBP)

The purpose of MBP is to enable the user to
view passive orders in the market aggregated
at each price and are displayed in order of best
prices. The window can be involved by
pressing the (F6) key. If a particular contract
or security is selected the details of the
selected contract or security can be seen on
this screen.
Inquiry window
Market Inquiry (MI) contd….
The market inquiry screen can be involved by
using the (F11) key. If a particular contract or
security is selected, the details of the selected
contract or selected security defaults in the
selection screen or else the current position in
the market watch defaults. Fig. 8.2 shows the
detailed market inquiry output screen. The
first line of the screen gives the instrument
type, symbol, expiry, contract status, total
traded quantity, life time high and life time low.
Inquiry window
Market Inquiry (MI)
The second line displays the closing price, open
price, high price, low price, last traded price and
indicator for net change from closing price. The
third line displays the last traded quantity, last
traded time and last traded date. The fourth line
displays the closing open interest, the opening
open interest, day high open interest, day low
open interest, current open interest, life time high
open interest, life time low open interest and net
change from closing open interest.
 Inquiry window

Market Inquiry (MI)

The fifth line display very important information,

namely the carrying cost in percentage terms. It
also displays the present value of dividends, best
buy price, best buy quantity, best sell quantity
and best sell price
Placing orders on the trading system
For both the futures and the options market,
while entering orders on the trading system,
members are required to identify orders as being
proprietary or client orders. Proprietary orders
should be identified as “Pro” and those of clients
should be identified as “Cli”. Apart from this, in
the case of “Cli” trades, the client account number
should also be provided. Client orders should be
marked as either:
Buy “Open”
Sell “Open”
Buy “Close”
Sell “Close”
Placing orders on the trading system
Buy “Open” client orders are those wherein
the client has first opened a buy position
before sell. At the time the client wishes to
close out this open positions, the respective
sell order should be identified as Sell “Close”
and when the same Sell “Open” position is to
be closed out the respective buy order should
be marked as “Buy “Close” order.
The futures market is a zero sum game I.e. the
total number of long in any contract always
equals the total number of short in any
market.
Placing orders on the trading system

The total number of long in any contract

(long/ short) in any point of time is called the
“open interest”. This Open interest figures is
a good indicator of the liquidity in every
contract. Based on studies carried out in
international exchanges, it is found that open
interest is maximum in near mouth expiry
contracts.
 Options market instruments

Index based option

Individual stock option
 Contract specifications for futures
S&P CNX Nifty Options

Underlying index S&P CNX Nifty Options

Exchange of trading National Stock Exchange of
India Limited Permitted lot
Contract size size shall be 200 and multiples
thereof Rs. 0.05
Price steps Not applicable
Price bands
 Contract specifications for futures
S&P CNX Nifty Options

Trading Cycle The Options contracts will

have a maximum of three
month trading cycle – the near
month (one), the next month
(two) and the far month(three).
New contract will be
introduced on the next trading
day following the expiry of
near month contract
 Contract specifications for futures

S&P CNX Nifty Options

Expiry day The last Thursday of the

expiry month or the previous
trading day if the last
Thursday is a trading holiday.
Cash settlement
Settlement basis European.
Style of option
 RILCJUL0320
As at 11.7.2001
• Spot price: 320
• Contract multiplier: 600
• Strike prices: 280;300;320;340;360
• Share price return
volatility: 35% p.a.
• Risk-free rate: 10% p.a.
• Time to maturity: 15 days
• Premium: Rs.10
 Charges
The maximum brokerage chargeable by a
trading member in relation to trades effected
in contract admitted to dealing on the
derivatives segment of the exchange is fixed
at 2.5% of the contract value, exclusive of
statutory levies.
The transaction charges payable by each
trading member for the trades executed by
him on the derivatives segment are fixed at
Rs. 2 per lakh of turnover(0.002%) (each
side) or Rs. 1 lakh annually, whichever is
higher
 Charges

The trading members contribute to Investor

Protection Fund of derivatives segment at the
rate of Rs.10 per crore of turnover (0.0001%)
(each side)
 REFERENCES
• Black-Scholes and Beyond:Option Pricing
Models: By Neil A.Chriss
• Applied Maths for Derivatives: By John S.Martin .
• Derivative: By Paul Wilmott
• An Introduction to Derivative:-By Don M.Chance
• Advanced Modelling in Finance using Excell and
VBA: By Marry Jackson and Mike Staunton
Thank you
TOPIC FOR PRESENTATIONS
• The Fall of Barings.
• Is Future with stock lending a Synthetic Badla?
• The Function of CBOE and lessons for Indian
Stock Exchanges.
• The best Derivative product.
• Can US-64 survive with the help of Derivatives?
• Market Integration & Derivatives.
• Development of World Derivatives’ market and
lessons for India.