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is an option to buy
A put is an option to sell
A European option can be exercised only
at the end of its life
An American option can be exercised at
any time
Option Positions
Long
call
Long put
Short call
Short put
Long Call on
Profit from buying one JP Associates European call
option: option price = Rs5, strike price = Rs100, option
life = 2 months
30 Profit (Rs)
20
10
0
-5
70
80
90
100
Terminal
stock price (Rs)
110 120 130
Short Call on
Profit from writing one JP Associates European call
option: option price = Rs5, strike price = Rs100
Profit (Rs)
5
0
-10
-20
-30
80
90 100
Terminal
stock price (Rs)
Long Put on
Profit from buying an IDFC European put option: option
price = Rs7, strike price = Rs70
30 Profit (Rs)
20
10
0
-7
Terminal
stock price (Rs)
40
50
60
70
80
90 100
Short Put on
Profit from writing an IDFC European put option: option
price = Rs7, strike price = Rs70
Profit (Rs)
7
0
-10
-20
-30
40
50
Terminal
stock price (Rs)
60
70
80
90 100
Payoff
K
K
ST
Payoff
ST
Payoff
K
ST
ST
Assets Underlying
Exchange-Traded Options
Stocks
Foreign
Currency
Stock Indices
Futures
Specification of
Exchange-Traded Options
Expiration
date
Strike price
European or American
Call or Put (option class)
Terminology
Moneyness :
In-the-money
option (ITM)
Option is said to be in the money when the strike price is better than the
market price of the underlying asset.
For Call option: Market price > Strike price
For Put option: Market price < Strike price
Out-of-the-money
Strike price is worse than the market price of the underlying asset
For Call option: Market price < Strike price
For Put option: Market price > Strike price
At-the-money
option (ATM)
Near-the-money
option (OTM)
option (NTM)
Option Premium
Intrinsic
value
Example
Option Premium
Time
value.
K:
No adjustments are made to the option terms
for cash dividends
When there is an n-for-m stock split,
the strike price is reduced to mK/n
the no. of options is increased to nN/m
Stock dividends (bonus shares) are handled in
a manner similar to stock splits
Market Makers
Most
Margins
Notation
c : European call
option price
p : European put
option price
S0 : Stock price today
K : Strike price
T : Life of option
: Volatility of stock
price
r
D
?
+
+
+?
+
+
+
+
+
+
+
Calls: An Arbitrage
Opportunity?
Suppose
c=3
T=1
K = 18
Is
that
S0 = 20
r = 10%
D=0
Puts: An Arbitrage
Opportunity?
Suppose
p =1
T = 0.5
K = 40
Is
that
S0 = 37
r =5%
D =0
p Ke -rTS0
c + Ke -rT = p + S0
Arbitrage Opportunities
Suppose
that
c =3
S0 = 31
T = 0.25
r = 10%
K =30
D=0
What are the arbitrage possibilities when
p = 2.25 ?
p=1?
Early Exercise
Usually
An
An Extreme Situation
For
income is sacrificed
Payment of the strike price is delayed
Holding the call provides insurance
against stock price falling below strike
price
c S 0 D Ke
p D Ke
rT
rT
S0