Derivatives - What are Options ? in MARKETS - Options are one of the most popular derivatives. There are highly leveraged instruments.
They can be used for hedging, speculation ...
03-06-2011 05:36 PM
What are Options ?
Options are one of the most popular derivatives. There are highly leveraged instruments.
They can be used for hedging, speculation and arbitrage. Options derive their value from the underlying stocks, index, forex or other forms of assets.
An option is in simple terms a contract entered into two parties i.e.
a) buyer and
In options, buyer is also called as holder and seller is called as writer.
The buyer/holder of options contract is granted a privilege to buy or sell a security at a specific price for a specific period.
The seller/writer of options contract assumes obligation to buy or sell a security at a specific price for a specific period. In futures, buyers and sellers both have the rights as well
obligations to buy or sell the security.
In options, buyer of options has rights but no obligations to honour his contract and seller has only obligations and no rights to honour his commitment. This is the main difference between futures and options. In options, buyer has a right to buy or sell a security and he has got an option to exercise his right or leave it. Hence the name “option”. As the price of the security keeps on fluctuating during the
life of an option, there is a risk for the seller. Hence the
buyer pays the seller a fee for granting this privilege. This is
03-06-2011 05:37 PM
In The Money Option ?
When strike price is less than the spot price of the underlying, then call option is said to be in the money option.
Difference between the spot price and the strike price creates intrinsic value.
When exercising of call option at the strike price (without premium) creates an intrinsic value, the option is said to be In The Money.
For Instance. Call options, if spot price is 3000, then strike prices of 2950 and 2900 are provide In The Money Options, where intrinsic value is Rs 50 & Rs.1000 respectively.
03-06-2011 05:38 PM
At The Money Options
When the strike price is equal to or near to the spot price, then there is no intrinsic value.
Exercising at this price creates neither profit nor loss. This option is said to be At The Money Option.
At spot price of Rs 3000 and the strike price also at Rs.3000, the option is said to be At The Money option.
03-06-2011 05:38 PM
Out Of The Money Options
When the strike price is more than the spot price, then there is no intrinsic value and exercising of call option at the strike price, would result in a loss. Hence the option is said to be Out Of The Money Options.
For call option, if spot price is 3000, then strike price of 3050 and 3100 provide the Out Of The Money Options.
Now for the same strike prices, positions would be reversed for put options.
The positions, which are In The Money for call options, shall be Out Of The Money for Put ptions and vice versa.
03-06-2011 05:39 PM
What is a Premium?
Premium is the fee paid by the option buyer to option seller for granting him privileged of the right of exercising an option. Option premium is always positive. When things go bad, premium hover around zero. When things go well, premium can be very large. Premium can never be negative.
Premium = Intrinsic Value (I) + Time Value (T)
Intrinsic value = The difference between Strike Price and Spot Price. Only, In The Money Options have Intrinsic value. At The Money and Out Of The Money Options intrinsic value is
zero. It is never negative.
Time Value :
This is also known as extrinsic value. The is quantification of the probability of the change in the
underlying price during the remaining life of the Option. This value is function of two factors.
03-06-2011 05:41 PM
Risks and Returns in Options ?
Risks and returns in options are asymmetric, unlike in futures.
Option Buyer : He has limited risk, only to the extent of the option premium, whereas the profits can be limited.
Option Seller : He has limited profit, only to the extent of the option premium, whereas his risk can be unlimited.
03-06-2011 05:42 PM
Covered / Uncovered options
Here word covered means the risk covered.
In the case of option buyer, the risk of loss is very limited and hence there is no need to be covered. However in the case of option sellers or writer, the risk is unlimited. Hence
the question arises, whether the sold or written option is covered or uncovered.
An uncovered option seller means that he doesn’t have any protection against the unlimited risk that he faces, if the option is exercised against him. So the margins are levied against uncovered option writer. They are initial margins and mark to market margins.
A) Covered Calls
Call writer is said to be covered if
He owns the underlying security.
He is long in the futures market in the same security.
He holds a long position in the call of the same security, that has same or lower strike price and that expires at the same time or later.
B) Covered Puts
There is only one way for the put writers to be covered.
They must have a long position in the puts of the same security at the same or higher strike price an with the same or later expiration month.
A covered writer need not deposit margin, because effectively, he is only squaring off his previous position.
03-06-2011 05:44 PM
What is Straddle ?
When you are uncertain about the market, but expect a lot of volatility, then buying straddle is one of the strategies.
Typical example of this type of situation is around budget time, where a lot of volatility is certain, but the direction of the market is uncertain.
Straddle involves buying or selling combination of one call and one put at the same strike price and the same expiry. This is normally done at At-the-money or near – the – money strike prices.
Long straddle :
Here buy one Call (At-the-money ) and buy one Put (At-the-money )
Short Straddle: Anticipate Stability
Here one call and one put are sold at the strike price, which is at-the-money for the same expiry.
03-21-2011 03:12 PM
Option is just like other things that are put in to the option that means, that buyers and seller both are on the verge of options.. They have no obligation from others.
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