Basics of Options

Example of Options
You discover a house that you'd love to

purchase. Unfortunately, you won't have the cash to buy it for another three months. You talk to the owner and negotiate a deal that gives you an option to buy the house in three months for a price of $200,000. The owner agrees, but for this option, you pay a price of $3,000. Now, consider two theoretical situations that might arise

Situation 1
It's discovered that the house is actually the true birthplace of Elvis! As a result, the market value of the house skyrockets to $1 million. Because the owner sold you the option, he is obligated to sell you the house for $200,000. In the end, you stand to make a profit of $797,000 ($1 million $200,000 - $3,000).

Situation 2
While touring the house, you discover

that the ghost of Henry VII haunts the master bedroom; furthermore, a family of super-intelligent rats have built a fortress in the basement. Though you originally thought you had found the house of your dreams, you now consider it worthless. On the upside, because you bought an option, you are under no obligation to go through with the sale. Of course, you still lose the $3,000 price of

Meaning
Option is a contract between a buyer and a seller that gives the buyer the rightbut not the obligationto buy or to sell a particular asset (the underlying asset) at a later day at an agreed price. In return for granting the option, the seller collects a payment (the premium) from the buyer

Options-Terms
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 of an option: The writer 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.

Options-Terms
Expiration Date: The date specified in the

options contract is known as the expiration date, the exercise date, the strike date or maturity. Strike price: the price specified in the options contract is known as the strike price or the exercise price Options Price / Premium: Option price is the price which the option buyer pays to the option seller. It is

Difference between options and futures

The main fundamental difference

between options and futures lies in the obligations they put on their buyers and sellers. An investor can enter into a futures contract with no upfront cost whereas buying an options position does require the payment of a premium. Another key difference between options and futures is the size of the underlying position. Generally, the underlying position is much larger for futures contracts, and the obligation to buy or sell this certain amount at a given price makes futures more risky for the inexperienced investor.

Types of Options
First Type:

American Options: These are options that can be exercised at any time up to the expiration date European Option : These are options that can be exercised only on the expiration date itself

Types of Options
Second type:
Call option: A call 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.

Lets examine a typical Call Option quote on the stock ABC, which has a current stock market price of $50:

Option type Call

Security ABC

Expiry Apr

Strike Price Premium 55 2.50

Conti
Reading from left to right: This quote is for a

CALL OPTION on the security ABC. The option contract EXPIRES IN APRIL. The STRIKE PRICE of $55 is what the option holder can purchase the shares of ABC for anytime up until the 3rd Friday of April. To purchase the ability to do this would cost the option holder $2.50 per contract per share.

Various situationslets look at some examples of purchasing the above call option contract with three different outcomes: Stock goes up Stock price doesnt change Stock goes down.

$60

You bought the contract for $2.50, which

multiplied by 100 shares = $250 (cost) You exercise your option so you buy 100 shares at $55 = $5,500 (cost) You then sell your shares immediately for the market price of $60 x 100 shares = $6,000 (proceed) $6,000 - $5,500 - $250 = $250 In this case the option contract become in-themoney.

Scenario 2: ABC stays at $57.50

$5,750 - $5,500 - $250 = 0
In this case the option contract become at-the-

money.

Scenario 3: ABC goes down to $55

$5,500 - $5,500 - $250 = - $250
In this case the option contract become out-of-

the-money. Thus, anything Above 57.50 would give profits between 57.50 and 55 would minimize losses Less than 55, no exercise of call

Payoffs
Here is another example; Underlying: micro soft share

Type: Call Option Exercise Price: $25 Expiry Date: 25th May Let's imagine that this option is worth $1.2. This means that the shares have to be trading at $26.20 for us to break even (Exercise Price of $25 plus the Option Premium of $1.20). If the shares are trading anywhere above $26.20 then we can start counting the profits. Anywhere below $26.20 and we lose out by the premium - $1.20. So, with a long call we have limited risk (the Option Premium) while at the same time having unlimited

Graph of this concept

Put option
A put option (sometimes simply called a "put") is

a contract between two parties, the seller (writer) and the buyer of the option. The buyer acquires a short position offering the right, but not obligation, to sell the underlying instrument at an agreedupon price (the strike price). If the buyer exercises the right granted by the option, the seller has the obligation to purchase the underlying at the strike price. In exchange for having this option, the buyer pays the writer a fee (the option premium). The buyer of a put option estimates that the underlying asset will drop below the exercise price before the expiration

Example
Suppose the stock of XYZ company is

trading at $40. A put option contract with a strike price of $40 expiring in a month's time is being priced at $2. You believe that XYZ stock will fall sharply in the coming weeks and so you paid $200 to purchase a single $40 XYZ put option covering 100 shares.

Situation 1
Say you were proven right and the price of XYZ

stock crashes to $30 at option expiration date. With underlying stock price now at $30, your put option will now be in-the-money and you can sell it for that much. Since you had paid $200 to purchase the put option, your net profit for the entire trade is therefore $800 (4000-3000-200).

Situation 2
With underlying stock price now at

$38, your put option will now be atthe-money

Situation 3
However, if you were wrong in your assessment and the stock price had instead rallied to $50, your put option will expire worthless and your total loss will be the $200 that you paid to purchase the option

Thus, anything Below 38 would give profits between 38 and 40 would minimize losses more than 40, no exercise of put

Payoff for a put option contract

Put option

Put option

Conclusion
Moneyness : In-the-money option (ITM) For Call option: Market price > Strike price For Put option: Market price < Strike price Out-of-the-money option (OTM) For Call option: Market price < Strike price For Put option: Market price > Strike price At-the-money option (ATM) Market price = strike price

How To Read An Options Table

Interpretation
Column 1: Strike Price - This is the stated price per share for which an

underlying stock may be purchased (for a call) or sold (for a put) upon the exercise of the option contract. Option strike prices typically move by increments of $2.50 or $5 (even though in the above example it moves in $2 increments). Column 2: Expiry Date - This shows the termination date of an option contract. Remember that U.S.-listed options expire on the third Friday of the expiry month. Column 3: Call or Put - This column refers to whether the option is a call (C) or put (P). Column 4: Volume - This indicates the total number of options contracts traded for the day. The total volume of all contracts is listed at the bottom of each table. Column 5: Bid - This indicates the price someone is willing to pay for the options contract. Column 6: Ask - This indicates the price at which someone is willing to sell an options contract. Column 7: Open Interest - Open interest is the number of options contracts that are open; these are contracts that have neither expired nor been exercised.

Option Premium
The premium is the price at which the

contract trades. The premium is the price of the option and is paid by the buyer to the writer, or seller, of the option It primarily consists of two components Intrinsic value and Time value. Option price = intrinsic value + time value

Intrinsic value
The intrinsic value of an option reflects the effective

financial advantage which would result from the immediate exercise of that option before adjusting the premium. This is the value that any given option would have if it were exercised today. The intrinsic value of an option is the difference between the actual price of the underlying security and the strike price of the option. For call option = Max (0, St-K) For put option = Max (0, K-St) St is current stock price and k is strike price It is the amount by which the option is in-the-money Only ITM options will have intrinsic value..? ( + / 0 /- )

Interpretation
Condition Call Put Out-of-the-money Intrinsic value = 0 In-the-money Intrinsic value >0 Strike price < underlying In-the-money security price Intrinsic value >0 Strike price > underlying Out-of-the-money security price Intrinsic value = 0

Strike price = underlying At-the-money security price Intrinsic value = 0

At-the-money Intrinsic value = 0

Intrinsic value cannot be negative since option will not be exercised

Time value (extrinsic value of the option)

When an option is trading at more than the intrinsic value, the difference is known as Extrinsic Value, or more commonly known as Time Value Time value = Option premium intrinsic value It is the compensation for the seller of the option for assuming future risks. If a stock is trading at Rs.150 and its Rs.140 call option is having a premium of Rs.15, then Rs. 10 is said to be the "intrinsic value" and the balance Rs.5 denotes the time value. As time passes on, the time value of option premium will come down and on the day of expiry there will not be any time value for the option.

Conti.
It is largely determined by the amount of volatility that the market believes the stock will exhibit before expiration. If the market does not expect the stock to move much, then the option's time value will be relatively low. Meanwhile, the opposite is true for stocks that are expected to be very volatile
If you are an options seller, then you will probably be willing

to sell options at very low prices on shares with low volatility. On the other hand, if you were to sell options on shares of a highly volatile stock like Amazon.com (AMZN), then you would require much greater compensation. After all, Amazon's stock has a much greater chance of moving quickly in one direction or the other, which could end up

For OTM or ATM, time value = option premiumwhy ?

Option Call Put Stock 30 50 Option Premium $3 $4 Strike $29 $52 Intrinsic Value Time Value

Call
Put Call Put

25
100 15 40

$2
$6 $1 $18

$25
$101 $16 $55