OPTION MARKETS &

CONTRACTS
Master of Business & Administration
OUTLINE
Introduction
Terminology
Exercise styles
Moneyness of an Option
Option Payoff
Valuing option contracts
Types of options
Option strategies



2
WHAT IS AN OPTION?
o An option is a contract that gives the holder (buyer) of
the option the right, but not the obligation to buy (or sell)
a specified quantity and quality of a certain asset at an
agreed price on or before the expiration date of the
contract.

o For this right, the buyer pays a premium and the seller is
obliged to honour the contract if called on to do so by
the holder.
3
OPTION MARKET
Over- the- counter option contracts Exchange traded options
Buyer & seller of an option can arrange
their own terms and create an option
contact.
Traded in an organised and regulated
exchange. Contracts are standardised.
Buyer is subject to the credit risk of the
seller.
Option seller is not subject to the credit
risk of the buyer.
Buyer is not subject to the credit risk.
The Exchange through its clearing
house, guarantee the sellers
performance.
Difficult to terminate the option with a
sale or purchase of the identical option.
Party who buy or sell an option can re-
enter the market before the option
expires and offset the position with a
sale or a purchase of the identical
option. 4
TYPES OF OPTION CONTRACTS
o Call Option gives the holder (buyer) the right but not
the obligation to buy the underlying asset at some time in
the future at an agreed price.

o Put Option- gives the holder (buyer) the right but not the
obligation to sell the underlying asset at some time in the
future at an agreed price.
5
OPTION MARKET VOCABULARY
Option buyer / Long : The party holding the right

Option Seller / Short : The party granting the right or writer of
the option.

Premium : Price paid for the option. This is usually paid up
front.

Strike or Exercise rate (price) : is the rate at which the option
may be exercised.

Expiry date : final date on which the option can be exercised.



6
EXERCISE STYLES
European-style options : can only be exercised on the
expiry date.

American-style options: can be exercised at any time up
to and including the expiry date.

Bermudian option : can only be exercised at certain
dates during the life of the option and usually only after a
period of time has elapsed.



7
MONEYNESS OF AN OPTION
Call option Put option
In-the-money Spot > strike
Price price
Spot < strike
Price price

At-the-money Spot = strike
Price price

Spot = strike
Price price
Out-of-the- money Spot < strike
Price price

Spot > strike
Price price

8
MONEYNESS OF AN OPTION-CONT.
Eg. For an European style option
Expiry date: 04.10.2009
Strike price of the underlying asset: $100
At the expiry date,
9
If spot price = Moneyness of the call
option
Moneyness of the
put option
$150 In-the-money Out-of-the-money
$100 At-the-money At-the-money
$75 Out-of-the-money In-the-money
LONG CALL OPTION - PAYOFF
10
0
Loss
premium
Asset price
Exercise price
B
Profit
Profit unlimited
Loss limited to the premium paid
Buy call when expect a rise in the underlying
price
LONG CALL OPTION PAYOFF-CONT.
e.g.
Purchase price of the option (premium) (C
o
)=

$5
Spot price ( S
T
)= $ 100
Exercise Price ( X) = $80
Value at expiry (C
T
)

= max (0,S
T
- X) = $20
Profit = C
T
C
O
=$20 - $5 = $15
Breakeven point = X + C
O
= $80+$5=$85
11
SHORT CALL OPTION - PAYOFF
12
Profit

0
Loss
premium
Asset price
Exercise price
B
Profit - limited to premium received
Loss unlimited
Sell call when expect a fall in the underlying market price
SHORT CALL OPTION PAYOFF-CONT.
e.g.
Sale price of the option (premium) ( C
o
)=

$5
Spot price ( S
T
)= $ 100
Exercise Price ( X) = $80
Value at expiry (-C
T
)

= -max (0, S
T
- X) = -$20
Profit = -C
T
+ C
O
=-$20+$5 = -$15
Breakeven point = X + C
O
= $80+$5=$85

13
LONG PUT OPTION - PAYOFF
14
0
Loss
Exercise price
B
premium
Asset price
Profit
Profit unlimited
Loss limited to the premium paid
Buy a put when expect a fall in the underlying market
price
LONG PUT OPTION PAYOFF-CONT.
Purchase price of the option(premium) ( P
o
)=

$5
Spot price (S
T
)

= $ 70
Exercise Price ( X) = $80
Value at expiry (P
T
)

= max (0, X - S
T
) = $10
Profit = P
T
P
O

=$10 - $5 = $5
Breakeven point = X - P
O
= $80 - $5=$75

15
SHORT PUT OPTION PAYOFF
16
0
Loss
Exercise price
B
premium
Asset price
Profit
Profit - limited to premium received
Loss unlimited
Sell a put option when expect a rise
in underlying market price


SHORT PUT OPTION PAYOFF-CONT.
Sale price of the option(premium) ( P
O
)=

$5
Spot price (S
T
) = $70
Exercise Price (X) = $80
Value at expiry (-P
T
)

= -max (0, X - S
T
) = -$10
Profit = -P
T
+ P
O

=-$10 + $5 = -$5
Breakeven point = X - P
O
= $80 - $5=$75

17
VALUING OPTION CONTRACTS
The price of an option is depend on ,
o the strike price
o the term of the option
o the underlying asset price (spot)
o the prevailing risk free interest rate
o the volatility of the underlying asset price
18
THE OPTION GREEKS
Option price sensitivity measures have Greek names,
1) Delta
2) Gamma
3) Vega
4) Theta
5) Rho

19
THE OPTION GREEKS- CONT.
1) Delta

Price of underlying Call value put value
20
Price of underlying Call value put value
Delta refers to the sensitivity of the option price to a
change in the price of the underlying.
THE OPTION GREEKS- CONT.
Delta is expressed as a value between 0 and
1
Delta tends towards zero for out-of-the
money options.
Delta tends towards 1 for in-the-money
options.
At-the money options have a delta of
close to 0.5
Delta for call options are positive
Delta for put options are negative.
21
THE OPTION GREEKS- CONT.
2)Gamma

Gamma is a measure of how well the delta sensitivity
measure will approximate the option prices response to a
change in the price of the underlying.

22
THE OPTION GREEKS- CONT

3)Vega
Volatility Call value put value
23

Volatility Call value put value
Vega refers to the change in the option price resulting
from a change in the volatility of the underlying asset
price.
The more volatile the underling asset price, the more
likely the option will expire in the money.
THE OPTION GREEKS CONT.
Volatility Trading Traders could imply what volatility
value have been used by the market in order to derive the
premium value quoted, by a process of back calculation,
after inputting all the data to the option pricing model.
When a trader thinks that implied volatility currently
priced into the market is less than that estimated by him
for a future period, the trader may buy the option in
order to go long of volatility and vice versa in order to
make profit.
24
THE OPTION GREEKS- CONT.
4)Theta

Theta refers to the change in the option price resulting form a
change in the time to expiry of the option.
25
Time to expiry Call value put value
THE OPTION GREEKS- CONT.
5) Rho
This is refers to the change in the option price
resulting from a change in the risk free interest
rate.
26

Interest rate Call value put value

Interest rate Call value put value

OPTION PREMIUM
The value of an option is the premium which
someone is prepared to pay for the option.

Option premium = Intrinsic + Time
value value

o Intrinsic value represent the profit you would make if you were to
exercise the option you are holding, immediately.
o Time value is the amount by which an options premium exceeds its
intrinsic value.


.
27
TYPES OF OPTIONS
o Bond option
o Equity option
o Currency option
o Commodity option
o Interest rate option





28
BOND OPTION
Theses are options on bonds.

The option could be specified to settle with actual delivery
of the bond or with a cash settlement.

29
EQUITY OPTIONS
These are options on individual stocks.

Exchange listed options are available on most widely
traded stocks and option on any stock can potentially be
created on the over-the-counter market.


30
CURRENCY OPTION
A currency option allows the holder
to buy (if a call) or sell (if a put) an
underlying currency at a fixed exercise
rate, expressed as an exchange rate.



31
CURRENCY OPTION - CONT.
e.g. An importer who needs USD 50 million in 1 month ( when spot
USD/LKR is 114.00)

He is in risk of appreciating USD against LKR
He can hedge the requirement by buying a USD call option with
exercise price 114.50 for USD 50 million expiring in 1 month

If the USD/LKR spot rate at the expiry date
- is above 114.50 importer can exercise the option & can buy USD at
114.50
- is below 114.50 importer does not exercise the option and can
buy USD at the market rate.
However, this is expensive than buying a forward contract
- in forward contract importer block the rate ( hedge against the
loss, but could not enjoy the gain.
- in option contract can hedge against the loss as well as if
market is favourable can enjoin the gain.

32
COMMODITY OPTION
These are options which the underlying is a commodity
such as oil, gold, wheat, or soybeans or combinations or
derivatives of the products.
33
INTEREST RATE OPTION
Is an option in which the underlying is an interest rate.
At expiration, the option payoff is based on the difference
between the underlying rate in the market and the exercise
rate.
34
INTEREST RATE CALL OPTION.
An interest rate call is an option in which the holder has
the right to make a known interest payment and receive an
unknown interest payment.
if unknown interest is higher than known rate the option is
in-the-money


35
INTEREST RATE PUT OPTION
An interest rate put is an option in which the holder
has the right to make an unknown interest payment and
receive a known interest payment.

If unknown interest is lower than exercise rate (known
rate) the option is in-the-money


36
Borrowers-
use interest rate call options to hedge the risk of rising rates on
floating-rate loans.
Lenders-
use interest rate put options to hedge the risk of falling rates on
floating rate loans.

37
INTEREST RATE CAP AND FLOOR
Interest Rate Cap- is a series of call options on an
interest rate, with each option expiring at the date on
which the floating rate loan will be reset and with each
option having the same exercise rate.

Interest Rate Floor - is a series of put options on an
interest rate, with each option expiring at the date on
which the floating rate loan will be reset and with each
option having the same exercise rate.


38
INTEREST RATE COLLAR

A combination of a long cap and a short floor or a
short cap and a long floor.This can be used by both
lenders and borrowers where they reduce the cost of a
hedge by limiting the upside benefit.

Zero cost collar- cap and floor premiums cancel out

39

Borrowers collar-
long cap short floor-this is described as being
LONG the collar.
Lenders collar-
long floor short cap-this is described as being
SHORT the collar.
40
OPTION STRATEGIES
Long Straddle
Short Straddle
Long Strangle
Short Strangle


41
LONG STRADDLE
42
0
Loss
Asset price
Profit
Long put Long call
E
To establish the position : Long call & Long put with the same strike E
and the same expiry date, usually at- the-money
When to use: trader believes the market is about to move from point E,
but unsure of the direction
Profit characteristic: profit is open-ended in the either direction, loss is
limited to premium paid


SHORT STRADDLE
43
0
Loss
Asset price
Profit
short put
Short call
E
To establish the position: short call & short put with the same
strike E and the same expiry date, usually at the money
When to use: the trader believes the market will generate
stagnate around point E, i.e. trader hope decrease in volatility
Profit characteristics: profit is maximised if the market is point
E at expiry, losses are open ended in either direction.

LONG STRANGLE
44
0
profit
Loss
A B
To establish the position:Buy a call with strike B and buy a put with
strike A with same a same expiry date. (out-of-the-money strikes)
When to use: trader believes the market is about to move strongly, but
unsure of the direction.
Profit characteristics: profit is open-ended in the either direction, loss is
limited to premium paid. This is cheaper strategy than the long straddle as
the options bought are out-the-money.


Long call
Long put
Asset price
SHORT STRANGLE
45
To establish the position: sell a call with strike B sell a
put with strike A. (out-of-the-money) with the same expiry
date.
When to use: the trader believes the market will generate
stagnate around point A and B, i.e. trader hope decrease in
volatility
Profit characteristics: profit is maximised if the market is
within point A and B at expiry, losses are open ended in
either direction.

0
profit
Loss
Short put
Short call
A B
Asset price
Sanjeewa Guruge
B.Sc, M.Sc, FCA, FCMA

sanjeewaguru@gmail.com
071 4433130
THANK YOU