Investors are required to pay the entire price (including premium) up

front when purchasing options. A stock futures contract only requires a

down payment (Initial Margin) with no premium attached until expiration.
Options can expire without an actual settlement. All futures contracts
must be settled on the expiration date.
 Option buyers have limited risk to the extent of the purchase price.
Futures carry unlimited risk.
Stock options can be used to execute many different investment
strategies. Futures are only effective when investing in a contract in
anticipation of a definitive move of the underlying stock in one direction or
the other.
Typically, there are more options written than futures contracts. That
gives options more liquidity.

What is 'Delta'
Delta is the ratio comparing the change in the price of the underlying asset to the
corresponding change in the price of a derivative.

Delta values can be positive or negative depending on the type of option.

For example, the delta for a call option always ranges from 0 to 1, because as the
underlying asset increases in price, call options increase in price.

Put option deltas always range from -1 to 0 because as the underlying

security increases, the value of put options decrease.

The behavior of call and put option delta is highly predictable and is very useful to
portfolio managers, traders and individual investors.

Call option delta behavior depends on whether the

option is "in-the-money," meaning the position is currently profitable,

"at-the-money," meaning the option's strike price currently equals the underlying
stock's price, or

"out-of-the-money," meaning the option is not currently profitable.

Put option delta behaviors also depend on whether the option is

"in-the-money," "at-the-money," or "out-of-the-money" and are the opposite of call

options. In-the-money put options get closer to -1 as expiration approaches. At-the-
money put options typically have a delta of -0.5, and the delta of out-of-the-money put
options approaches 0 as expiration approaches. The deeper in-the-money the put
option, the closer the delta will be to -1.

What is 'Vega'

Vega is the measurement of an option's sensitivity to changes in the volatility of

the underlying asset.

Volatility measures the amount and speed at which price moves up and down,
and is often based on changes in recent, historical prices in a trading instrument.

Vega changes when there are large price movements (increased volatility) in the
underlying asset, and falls as the option approaches expiration. Vega is one of a group
of Greeks used in options analysis and is the only lower order Greek that is not
represented by a Greek letter.

used to determine ------ an option is cheap or expensive.

Option Vega, represented by Greek symbol (nu), is a mathematical tool

used to capture the responsiveness of option value to changes in the

volatility of option's underlying asset's value. In other words, option vega is

option's sensitivity to fluctuations in the underlying asset price.

What does option vega say?

Option is a financial contract which gives one party the option to buy or sell

the underlying asset while the other party has obligation to honor the

contract.

The contract can be sold before its expiration, and it is possible to calculate

its value.

The value of the contract depends on many factors, for example the price of

the underlying asset (option delta & option gamma), interest rates, time

(option theta), volatility, and other factors.

If the volatility of the prices of the underlying asset changes, then the option

Vega changes as well.

What values can option vega take?

Option vega grows as the option comes from being out-the-money closer to

being at-the-money, and then it declines as the option starts being deeply in-

the-money. Option vega is greatest for options at-the-money. Option vega is

smaller for options completely out-the-money or very much valuable.

Option vega greek

This can be explained more easily by saying that if the option is worthless, it

does not matter much how volatile the underlying asset is because the

chance that the option suddenly flips into in-the-money is relatively small. If

the option is deep in the money, the chance that the option suddenly

becomes worthless with increased volatility is also relatively slim. But, if the

option is at-the-money, that is on the verge of being worthless or valuable,

then even a relatively small change in the volatility in the price of the
underlying asset can change the position. You can notice that option vega

takes values similar to option gamma.

Option vega implications

There are several important rules related to option vega.

Option vega is similar for call and put options. The price of the underlying

asset is more likely to go 50% up or down in long term than in short term.

Options are most sensitive to changes in the volatility of the underlying asset

when they are at-the-money. Options out-the-money and in-the-money are

not affected by volatility in the prices of the underlying assets. Option vega

can be hedged with another option only.

How can I calculate option vega?

What is 'Gamma'

Gamma is the rate of change in an option's delta per $1 change in the underlying
asset's price.

Gamma is an important measure of the convexity of a derivative's value, in relation

to the underlying.

A delta hedge strategy seeks to reduce gamma in order to maintain a hedge over
a wider price range.

A consequence of reducing gamma, however, is that alpha will also be reduced.

Mathematically, gamma is the first derivative of delta and

is used when trying to gauge the price movement of an option, relative to the amount it
is in or out of the money. In that same regard,

gamma is the second derivative of an option's price with respect to the underlying's
price. When the option being measured is deep in or out of the money, gamma is small.
When the option is near or at the money, gamma is at its largest.

Gamma calculations are most accurate ------for small changes in the price of the
underlying asset.

All options that are a long position have a positive gamma, while

all short options have a negative gamma.

The calculation of gamma is complex and

requires financial software or spreadsheets to find a precise value.

Gamma is an important metric because

it corrects for convexity issues when engaging in hedging strategies. Some

portfolio managers or traders may be involved with portfolios of such large values that
even more precision is needed when engaged in hedging.

Option Gamma, often expressed using the Greek letter , is a

mathematical tool used in the option theory to explain the relationship

between the value of an option and the price of the underlying asset.

Option gamma is the option's sensitivity to change in the sensitivity of the

option value to changes in the underlying asset price. An option is a

contract between two parties, between a buyer and seller, where one

party has the right to purchase the underlying asset (call option) or to sell
the underlying asset (put option) while the other party has the obligation

to honor the contract. The other party is compensated for the obligation

by so-called option premium which reflects the option's intrinsic value.

The price of the option is determined by the price of the underlying asset,

and the relationship between the price of the underlying asset and the

option value is given by many parameters. Option gamma tells us how

the option price responds to changes in the underlying asset price

changes.

Option gamma explained

Option gamma can be better explained using pictures. Option gamma

measures the curvature of the option price function curve. Option gamma

can also be described as the "speed" at which the value of an option

changes with changes in the price of the underlying asset.

Option gamma changes as the underlying asset price changes.

Option gamma is highest for options at-the-money. Any change, even a

small one, in the price of the underlying asset affects the value of the

option significantly. This is the point at the top of the curve on the picture

below. Gamma is lowest when an option is deeply in-the-money or

completely out-the-money. Any change in the price of the underlying

asset has little or no effect on the option value.

Option gamma example - What does option gamma tell me?

Option gamma measures the sensitivity of an option to the change in the

price of the underlying asset. We can demonstrate this on the following

two examples.

Example 1

When the price of the underlying asset changes by 1% (note, 1% not 1

dollar), the value of an out-of-money option changes by, let's say, 0.2%. In

the next step, the price of the underlying asset changes by another 1%.

Now, the value of the option changes by more than before, this time it

changes by 0.25%. The option delta changes by 0.05. 0.05 is the option

gamma.

Example 2

Let's say the price of the underlying asset changes by 1%. The value of an

at-the-money option changes by 0.5%. Now, the underlying stock price

changes by another 1% which leads to a 0.6% change in the value of the

option. The change in option delta, that is the option gamma, is 0.1.

How does option gamma compare to option delta?

Option gamma is one step above option delta.

Option delta measures the slope of the price curve.

Option gamma measures the curvature of the price curve.

Option gamma implications

Let us summarize a number of very important option gamma implications.

Options at-the-money have the highest gamma.

Short option positions are characterized by negative option gamma. This

applies to both call and put options.

Gamma is the same for call and put options.

Options with short term to expiration have higher option gamma then

long-term options. In other words, short-term options are more sensitive.

Option gamma increases as the option approaches its maturity.

When option gamma is high, option delta changes rapidly.

When option gamma is small, option delta changes relatively little.

How do we calculate option gamma?

Option Theta explained

Option theta is one of the sensitivity parameters used in option theory to

measure responsiveness of an option to change in time.

Option theta is often represented by Greek symbol . Option theta

belongs to a group of option sensitivity parameters together called

"Greeks". Option theta is a mathematical tool used to capture how the

price or a value of an option reacts to time, specifically how it changes as

the option approaches its expiration or maturity date. Option theta is also

often called time decay which means exactly what it says.

Option theta can be quite confusing, but it helps to think about it in plain

logic.

Option theta is negative because the relationship between option's value

and the time to expiration is inverse. As the option ages, the time value

decreases.

Option theta gets affected not only by whether the option is in or out of

the money, but also as the option itself ages. As the option gets closer to

its expiration date, it tends to loose its time value more quickly. Having 90

days to the expiration date, an option changes its value (assuming other

factors are constant) from the 90th day to the 89th day only minimally.

However, the same option will loose a lot of its time value between the

3rd and 2nd day before its expiration.

Option theta time decay

Option theta is negative and its absolute value increases as the option

nears its expiration.

What are the important option theta characteristics?

The list below summarizes some important facts related to option theta.

Option theta is a function of time and value of the underlying asset.

The time value of either a call or put option decreases as the option

approaches its expiration.

Theta is the same for call and put options.

Option theta is minimal (or maximal when looking at its absolute value)

when an option is at-the-money.

Option theta - its absolute value - increases as the option approaches its

expiration.

Option theta is usually negative. European put option in-the-money is an

exception to the rule. Such an option can have a positive theta.

How can I calculate option theta?

The Delta of an option or simply the option delta is the sensitivity of an

option price relative to changes in the price of the underlying asset. It is

represented as the price change given a 1 point move in the underlying

asset and is usually displayed as a decimal value.

Option delta tells the option trader how fast the price of the option will

change as the price of the underlying asset moves up or down. We can

see this in the following picture. The price of the underlying asset changes

by a certain amount or percentage, this is shown on the horizontal axis,

and the price of the option or also the profit from the position changes by

another amount or percentage, this is shown on the vertical axis.

Option delta definition

Delta values range between 0 and 1 for call options and -1 to 0 for put

options. Some traders refer to the delta as a whole number between 0 to

100 for call options and -100 to 0 for put options.

Note that calls and puts have opposite deltas - call options are positive

and put options are negative.

Call Options

When the position is long a call option, the delta will always be a positive

number between 0 and 1. When the underlying stock or futures contract

increases in price, the value of the call option will also increase by the call

options delta value. On the other hand, when the underlying market price

decreases, the value of the call option will also decrease by the amount of

the delta. When the call option is deep in-the-money and has a delta of 1,

then the call option will move point for point in the same direction as

movements in the underlying asset.

Put Options

When the market price of the underlying asset increases, the value of the

put option will decrease by the amount of the delta value. Conversely,

when the price of the underlying asset decreases, the value of the put

option will increase by the amount of the delta value.

Put options have negative deltas, which range between -1 and 0.

Delta Option and Time to Expiration

As time passes, the delta of in-the-money options increases and the delta

of out-of-the-money options decreases.

Delta Option and Volatility

As volatility falls, the delta of in-the-money options increases and the

delta of out-of-the-money options decreases.

Hedge Ratio

Since the delta of option is a measure of how sensitive an options price is

to changes in the underlying, it is useful as a hedge ratio. A futures option

with a delta of 0.5 means that the option price increases 0.5 for every 1

point increase in the futures price.

Can you tell me more about option strategies where I can use option

delta?

Yes, delta plays an important role in risk management related to options

and financial positions. For example analyzing the risk profile of the

synthetic long call option strategy and also the synthetic long put option

strategy calls for assessment of option position delta.

Option valuation: Upper bounds
and lower bounds Part 1

What are upper and lower bounds of options?

One important principle while valuing options is that at any time, the value of a
call or a put cannot exceed certain limits on the higher side as well as on the
lower side. In option lingo, the maximum limit up to which an option value can
go on the higher side is commonly referred to as upper bounds of an option
and the maximum limit below which an option value cannot fall is called the
lower bounds of an option.

These maximum limits will have to be discussed for European and American
options separately. We first take up the upper and lower bounds of European
calls.

Upper bounds of European call values:

Lets assume that the call value of an option is 55 and the underlying stock is
trading at 50 in the spot market. In such a scenario, anybody can write the call
and sell the stock on spot, and take home the difference of 5 per share. Hence,
its clear that the call value at expiry cannot rise beyond the value of the
underlying stock.

Now, lets further assume that the company has announced a dividend of 5 per
share. Dividend, when paid, decreases the value of shares to that extent. Hence
on expiry, the stock will be valued at 45 (50 5) in the spot market and
logically, the call value cannot exceed 45 per share.

This brings us to the first principle in option value the upper bound value
of an European call can never rise beyond the value of the underlying
stock. When the dividend is known with certainty, the call values cannot rise
beyond the spot value of the stock less present value of the dividend.

Lower bounds of European call values:

What would be the lowest value for an European call? It should be zero. It
cannot fall below that, Right? For the call value to be at zero, the stock value
should also fall to zero. If the stock value is above zero (say 2) the minimum
value of call should be the present value of Rs 2 (strike price).

Lets try an example assume that the stock value is at 102. One year
European option call at strike price 108 is available. If the risk free rate is
considered to be 8%, the present value of 108 discounted at 8% would be 100.
In this case, the value of the call cannot fall below 2 (102 100) If it falls to
(say, Re 1) then

You can buy the call at strike 108 you pay Re 1

You sell the stock at 102 You get 102. Your net gain = 101

From that 101, you invest 100 in risk free bonds and get 108 at the year end.

Use that 108 to exercise the call and get back your shares.

Get a profit of Rs 1, risk free immediately.

May be that was slightly confusing. Go through the calculation one more time
and youll get it.
As a next step, here also, we need to discus the effect of dividends. Lets take
another example where the stock value is at 50 and one year calls at strike price
20 are available. The dividend to be received a year later is estimated at Rs 5
per share. In this case, the value of the call cannot fall below the share value
Less (present value of dividend expected + present value of strike value)

The present value of 5 discounted at 8% would be = 4.63

The present value of 20 discounted at 8% would be =18.52

Hence, the lower bound value of a call cannot fall below 50-(4.63 +18.52) =
26.85

This brings us to the second principle in option value the lower bound value
of an European call can never fall below the difference between stock value
and the present value of strike price.

When the dividend is known with certainty, the call values cannot fall below
the spot value of the stock minus present value of the dividend minus
present value of the strike value.

Upper bound of European puts.

Lets take an example the stock of HFDC is trading at 800 right now. 1year
put options on this stock are available at a strike price of 900. If we calculate
the present value of 900 at 8% risk free interest rate, well get 833.50 as the
answer.
Logically, the upper bound price of a European put cannot exceed that
833.50 which is the present value of the strike. If price of the put is above
833.50, say 860, then
You can immediately sell a put and get 860 and Invest 833.50 at 8% to get back
900 at the end of one year. The difference of Rs 26.50 is your profit ion the
spot. (860-833.50).
Now, if the dividend on stock is known, it doesnt make any difference. The
only rule to be remembered in case of upper bound European out prices is
that it cannot exceed the present value of the strike price.
 Not that, in the worst case the maximum loss that a put writer will suffer is
the strike price. This loss is mitigated by investing the present value of strike
at 8% risk free investments.

So that brings us to the third principle An European put cannot have a

greater value than or equal to the present value of the strike price. The
dividend factor is irrelevant here.

Lower bound of European puts.

A European put cannot have a price thats lower than the difference between the
present value of the strike price and the stock price.
For example assume that the stock price is Rs 60 and the strike price is Rs 65.
Lets also assume that the present value of strike price is 63. In this case, the
value of a European put cannot be lower than Rs 3. That is, the difference
between the present value of the strike price and the stock price.
If it is less than Rs 3, an investor can buy the put , borrow the present value
of strike price and use it to buy the stock at current market price and profit from
the deal.

Now, we summarize the basic principles for upper and lower bounds of
European options:

The upper bound value of an European call can never rise beyond the
value of the underlying stock.

When the dividend is known with certainty, the call values cannot rise
beyond the spot value of the stock less present value of the dividend.

The lower bound value of an European call can never fall below the
difference between stock value and the present value of strike price.

When the dividend is known with certainty, the call values cannot fall
below the spot value of the stock minus present value of the dividend minus
present value of the strike value.
 An European put cannot have an upper bound value greater than or equal
to the present value of the strike price. The dividend factor is irrelevant here.

A European put cannot have a price thats lower than the difference
between the present value of the strike price and the stock price.

Put-call parity
Put-call parity is a financial relationship between the price of a put option and a call
option.

The put-call parity is a concept related to European call and put options.

The put-call parity is an option pricing concept that requires the values of call and put
options to be in equilibrium to prevent arbitrage.

How does the put-call parity work?

Believe it or not, prices of put options, call options, and their underlying stock are very
closely related.

A change in the price of the underlying stock affects the price of both call and put options
that are written on the stock. The put-call parity defines this relationship.

The put-call parity says that if all these three instruments are in equilibrium, then there is
no opportunity for arbitrage.

The concept of put-call parity is especially important when trading synthetic positions.
When there is a mispricing between an instrument and its synthetic position, the put-call
parity implies that an options arbitrage opportunity exists.

How can I explain the put-call parity?

The put-call parity is often explained on a risk-less borrowing portfolio. In other words, the
put-call parity also provides a way for borrowing indirectly through the options market.
You can create a borrowing portfolio when you:

buy stock
sell a call option
buy a put option with the same strike like the call option

Does the put-call parity really work?

Put-call parity requires that the extrinsic value of call and put options of the same strike price
is the same. However, values of put and call options are rarely in exact parity.

When for example the outlook of a stock is bullish, values of call options tend to be higher
than put options due to higher implied volatility. When outlook of a stock is bearish, values
of put options tend to be higher than call options.

The deviation from the put-call parity is however relatively small. Theoretically one could
profit from arbitrage if the put-call parity is broken, but because the deviations are
minimal, they usually do not provide enough profit to cover transaction costs and option
spreads.

What are the assumptions behind the put-call parity?

As with any model, put-call parity is also based on some assumptions. They are the
following:

(i) interest rate does not change in time,

(ii) it is constant for both borrowing and lending,

(ii) the dividends to be received are known and certain,

(iii) the underlying stock is highly liquid and no transfer barriers exist

I heard the put-call parity does not hold for American-style options

In general, the relation does not hold for American-style options. It is so because American
options allow early exercise prior to expiration. The put-call parity is a closed-end concept in
which you define your starting point and know the outcome at the end. American-style
options are a problem in this concept because they bring uncertainty into the model. With
American-style options, one of the options legs in the trade may disappear prior to expiration
because of an exercise. Closing the whole trade at this point produces a gain or a loss that is
unknown when the option position is initiated. Not closing the position leaves the investor
exposed

Black-Scholes model

The Black-Scholes model for calculating the premium of an option was introduced in 1973
in a paper entitled, "The Pricing of Options and Corporate Liabilities" published in
the Journal of Political Economy.

The formula, developed by three economists Fischer Black, Myron Scholes and Robert
Merton is perhaps the world's most well-known options pricing model.
Black passed away two years before Scholes and Merton were awarded the 1997 Nobel Prize
in Economics for their work in finding a new method to determine the value of derivatives
(the Nobel Prize is not given posthumously; however, the Nobel committee acknowledged
Black's role in the Black-Scholes model).

The Black-Scholes model is used to calculate the theoretical price of European put and
call options, ignoring any dividends paid during the option's lifetime. While the original
Black-Scholes model did not take into consideration the effects of dividends paid during the
life of the option, the model can be adapted to account for dividends by determining the ex-
dividend date value of the underlying stock.

The model makes certain assumptions, including:

The options are European and can only be exercised at expiration

No dividends are paid out during the life of the option

Efficient markets (i.e., market movements cannot be predicted)

No commissions

The risk-free rate and volatility of the underlying are known and constant

Follows a lognormal distribution; that is, returns on the underlying are normally
distributed.

The formula, shown in Figure 4, takes the following variables into consideration:

Current underlying price

Options strike price

Time until expiration, expressed as a percent of a year

Implied volatility

Risk-free interest rates

 Figure 4: The Black-Scholes pricing formula for
call options.

The model is essentially divided into two parts:

first part, SN(d1), multiplies the price by the change in the call premium in relation to
a change in the underlying price. This part of the formula shows the expected benefit
of purchasing the underlying outright.
The second part, N(d2)Ke^(-rt), provides the current value of paying the exercise
price upon expiration (remember, the Black-Scholes model applies to European
options that are exercisable only on expiration day). The value of the option is
calculated by taking the difference between the two parts, as shown in the equation.

Options Pricing: The Greeks

Many option traders rely on the "Greeks" to evaluate option positions. The Greeks are a
collection of statistical values that measure the risk involved in an options contract in relation
to certain underlying variables. Popular Greeks include Delta, Vega, Gamma and Theta.

Delta - Sensitivity to Underlying's Price

Delta, the most popular options Greek, measures an option's price sensitivity relative to
changes in the price of the underlying, and is the number of points that an option's price is
expected to move for each one point change in the underlying. Delta is important because it
provides an indication of how the option's value will change with respect to price fluctuations
in the underlying instrument, assuming all other variables remain the same.

Delta is typically shown as a numerical value between 0.0 and 1.0 for call options and 0.0
and -1.0 for put options. In other words, option delta will always be positive for calls and
negative for puts. It should be noted that delta values can also be represented as whole
numbers between 0.0 and 100 for call options and 0.0 to -100 for put options, rather than
using decimals. Call options that are out-of-the-money will have delta values approaching
0.0; in-the-money call options will have delta values that are close to 1.0.

Vega - Sensitivity to Underlying's Volatility

Vega measures an option's sensitivity to changes in the volatility of the underlying. Vega
represents the amount that an option's price changes in response to a 1% change in volatility
of the underlying market. The more time that there is until expiration, the more impact
increased volatility will have on the option's price.

Because increased volatility implies that the underlying instrument is more likely to
experience extreme values, a rise in volatility will correspondingly increase the value of an
option and, conversely, a decrease in volatility will negatively affect the value of the option.

Gamma Sensitivity to Delta

Gamma measures the sensitivity of delta in response to price changes in the underlying
instrument. Gamma indicates how delta will change relative to each one point price change
in the underlying. Since delta values change at different rates, gamma is used to measure and
analyze delta. Gamma is used to determine how stable an option's delta is; higher gamma
values indicate that delta could change dramatically in response to even small movements in
the underlying's price.

Gamma increases as options become at-the-money and decrease as options become in- and
out-of-the-money. Gamma values are generally smaller the further away from the date of
expiration; options with longer expirations are less sensitive to delta changes. As expiration
approaches, gamma values are typically larger as delta changes have more impact.

Theta Sensitivity to Time Decay

Theta measures the time decay of an option - the theoretical dollar amount that an option
loses every day as time passes, assuming the price and volatility of the underlying remain the
same. Theta increases when options are at-the-money; theta decreases when options are in-
and out-of-the money. Long calls and long puts will usually have negative theta; short calls
and short puts will have positive theta. By comparison, an instrument's whose value is not
eroded by time, such as a stock, would have zero theta.

Trading and analysis platforms, as well as online calculators, can provide options traders with
current Greek values for any options contract. Figure 12, for example, shows the Delta,
Gamma, Theta, Vega and Rho values for both call and put options. These values will change
as other variables, such as strike price, change.

What is the 'Binomial Option Pricing Model'

The binomial option pricing model is an options valuation method developed in 1979.
The binomial option pricing model uses an iterative procedure, allowing for the specification
of nodes, or points in time, during the time span between the valuation date and the
option's expiration date. The model reduces possibilities of price changes, and removes
the possibility for arbitrage. A simplified example of a binomial tree might look something
like this:

BREAKING DOWN 'Binomial Option Pricing Model'

The binomial option pricing model assumes a perfectly efficient market. Under this
assumption, it is able to provide a mathematical valuation of an option at each point in the
timeframe specified. The binomial model takes a risk-neutral approach to valuation and
assumes that underlying security prices can only either increase or decrease with time
until the option expires worthless.

Binomial Pricing Example

A simplified example of a binomial tree has only one time step. Assume there is a stock that
is priced at $100 per share. In one month, the price of this stock will go up by $10 or go
down by $10, creating this situation:
Stock Price = $100

Stock Price (up state) = $110

Stock Price (down state) = $90

Next, assume there is a call option available on this stock that expires in one month and has a
strike price of $100. In the up state, this call option is worth $10, and in the down state, it is
worth $0. The binomial model can calculate what the price of the call option should be today.
For simplification purposes, assume that an investor purchases one-half share of stock and
writes, or sells, one call option. The total investment today is the price of half a share less the
price of the option, and the possible payoffs at the end of the month are:

Cost today = $50 - option price

Portfolio value (up state) = $55 - max ($110 - $100, 0) = $45

Portfolio value (down state) = $45 - max($90 - $100, 0) = $45

The portfolio payoff is equal no matter how the stock price moves. Given this outcome,
assuming no arbitrage opportunities, an investor should earn the risk-free rate over the course
of the month. The cost today must be equal to the payoff discounted at the risk-free rate for
one month. The equation to solve is thus:

Option price = $50 - $45 x e ^ (-risk-free rate x T), where e is the mathematical constant
2.7183

Assuming the risk-free rate is 3% per year, and T equals 0.0833 (one divided by 12), then the
price of the call option today is $5.11.

Due to its simple and iterative structure, the binomial option pricing model presents certain
unique advantages. For example, since it provides a stream of valuations for a derivative for
each node in a span of time, it is useful for valuing derivatives such as American options. It is
also much simpler than other pricing models such as the Black-Scholes model.

What is the 'Cost Of Carry'

The cost of carry refers to costs incurred as a result of an investment position. These costs
can include financial costs, such as the interest costs on bonds, interest expenses on margin
accounts, and interest on loans used to purchase a security. They can also include economic
costs, such as the opportunity costs associated with taking the initial position.
BREAKING DOWN 'Cost Of Carry'

Cost to carry may not be an extremely high financial cost if it is effectively managed. For
example, the longer a position is made on margin, the more interest payments will need to be
made on the account. When making an informed investment decision, consideration must be
given to all of the potential costs associated with taking that position. In capital markets, the
cost of carry is the difference between the yield generated from the security and the cost of
entering and maintaining the position. In the commodities markets, the cost of carry includes
the cost of necessary insurances and the expense of storing the physical commodity over a
period of time.

The Cost of Carry Model

There is a financial model that is used in the forwards market to determine the cost of carry
(if the forward price is known), or the forward price (if the cost of carry is known). While
this works for forwards, it provides a good approximation for futures prices as well. The
formula is expressed as follows:

F = Se ^ ((r + s - c) x t)

Where:

F = the forward price of the commodity

S = the spot price of the commodity

e = the base of natural logs, approximated as 2.718

r = the risk-free interest rate

s = the storage cost, expressed as a percentage of the spot price

c = the convenience yield, which is an adjustment to the cost of carry

t = time to delivery of the contract, expressed as a faction of one year

This model expresses relationship between the forward price, the spot price and the cost of
carry. For example, assume that a commodity's spot price is $1,000. There is a one-year
contract available, the risk-free rate is 2%, the storage cost is 0.5%, and the convenience
yield is 0.25%. The equation would be set up as follows:
F = $1,000 x e ^ ((2% + 0.5% - 0.25%) x 1) = $1,000 x 1.0228 = $1,022.80.

The forward price of $1,022.80 shows that the cost of carry in this situation is 2.28%,
($1,022.80 / $1,000) - 1.

DEFINITION of 'Reverse Cash-and-Carry-Arbitrage'

A combination of a short position in an asset such as a stock or commodity, and a long

position in the futures for that asset. Reverse cash-and-carry arbitrage seeks to exploit pricing
inefficiencies for the same asset in the cash (or spot) and futures markets in order to make
riskless profits. The arbitrageur or trader accepts delivery of the asset against the futures
contract, which is used to cover the short position. This strategy is only viable if the futures
price is cheap in relation to the spot price of the asset. That is, the proceeds from the short
sale should exceed the price of the futures contract and the costs associated with carrying the
short position in the asset.

BREAKING DOWN 'Reverse Cash-and-Carry-Arbitrage'

This strategy is only viable if the futures price is cheap in relation to the spot price of the
asset. That is, the proceeds from the short sale should exceed the price of the futures contract
and the costs associated with carrying the short position in the asset.

Consider the following example of reverse cash-and-carry-arbitrage. Assume an asset

currently trades at $104, while the one-month futures contract is priced at $100. In addition,
monthly carrying costs on the short position (for example, dividends are payable by the short
seller) amount to $2. In this case, the trader or arbitrageur would initiate a short position in
the asset at $104, and simultaneously buy the one-month futures contract at $100. Upon
maturity of the futures contract, the trader accepts delivery of the asset and uses it to cover
the short position in the asset, thereby ensuring an arbitrage or riskless profit of $2.

What is 'Cash-And-Carry-Arbitrage'

Cash-and-carry-arbitrage is a combination of a long position in an asset such as a stock or

commodity, and a short position in the underlying futures. This arbitrage strategy seeks to
exploit pricing inefficiencies for the same asset in the cash (or spot) and futures markets, in
order to make riskless profits. The arbitrageur would typically seek to "carry" the asset until
theexpiration date of the futures contract, at which point it would be delivered against the
futures contract. Therefore, this strategy is only viable if the cash inflow from the short
futures position exceeds the acquisition cost and carrying costs on the long asset position.

BREAKING DOWN 'Cash-And-Carry-Arbitrage'

Consider the following example of cash-and-carry-arbitrage. Assume an asset currently

trades at $100, while the one-month futures contract is priced at $104. In addition, monthly
carrying costs such as storage, insurance and financing costs for this asset amount to $3. In
this case, the trader or arbitrageur would buy the asset (or open a long position in it) at $100,
and simultaneously sell the one-month futures contract (i.e. initiate a short position in it) at
$104. The trader would then carry the asset until the expiration date of the futures contract,
and deliver it against the contract, thereby ensuring an arbitrage or riskless profit of $1.

Long call means you own call options. (Bullish)

Short call means you have sold call options. (Bearish)

Long put means you own put options. (Bearish)
Short put means you have sold put options. (Bullish)

How can I tell the difference among long call, long put, short call and short put?
In finance, a long position in a security, such as a stock or a bond, or equivalently to be long
in a security, means the holder of the position owns the security and will profit if the price of
the security goes up. Going long is the more conventional practice of investing and is
contrasted with going short.
In contrast, a short position in a futures contract or similar derivative means that the holder
of the position will profit if the price of the futures contract or derivative goes down. An
option's investor goes long on the underlying instrument by buying call options or writing put
options on it, while he goes short on the underlying instrument by buying put options or
writing call options on it.