18-12-2012, 04:56 PM
The National Stock Exchange of India Ltd. (NSE)
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INTRODUCTION TO OPTIONS
An option is a contract written by a seller that conveys to the buyer the right — but not the
obligation — to buy (in the case of a call option) or to sell (in the case of a put option) a
particular asset, at a particular price (Strike price / Exercise price) in future. In return for
granting the option, the seller collects a payment (the premium) from the buyer. Exchangetraded
options form an important class of options which have standardized contract features
and trade on public exchanges, facilitating trading among large number of investors. They
provide settlement guarantee by the Clearing Corporation thereby reducing counterparty
risk. Options can be used for hedging, taking a view on the future direction of the market,
for arbitrage or for implementing strategies which can help in generating income for
investors under various market conditions.
OPTION TERMINOLOGY
· Index options: These options have the index as the underlying. In India, they have
a European style settlement. Eg. Nifty options, Mini Nifty options etc.
· Stock options: Stock options are options on individual stocks. A stock option contract gives
the holder the right to buy or sell the underlying shares at the specified price. They have an
American style settlement.
· 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.
· Writer / seller of an option: The writer / seller 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.
· Call option: A call option 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.
OPTIONS PAYOFFS
The optionality characteristic of options results in a non-linear payoff for options. In simple
words, it means that the losses for the buyer of an option are limited, however the profits
are potentially unlimited. For a writer (seller), the payoff is exactly the opposite. His profits
are limited to the option premium, however his losses are potentially unlimited. These nonlinear
payoffs are fascinating as they lend themselves to be used to generate various
payoffs by using combinations of options and the underlying. We look here at the six basic
payoffs (pay close attention to these pay-offs, since all the strategies in the book are
derived out of these basic payoffs).
Payoff profile of buyer of asset: Long asset
In this basic position, an investor buys the underlying asset, ABC Ltd. shares for instance,
for Rs. 2220, and sells it at a future date at an unknown price, St. Once it is purchased, the
investor is said to be "long" the asset. Figure 1.1 shows the payoff for a long position on
ABC Ltd.
Payoff profile for buyer of call options: Long call
A call option gives the buyer the right to buy the underlying asset at the strike price
specified in the option. The profit/loss that the buyer makes on the option depends on the
ABC Ltd.
spot price of the underlying. If upon expiration, the spot price exceeds the strike price, he
makes a profit. Higher the spot price, more is the profit he makes. If the spot price of the
underlying is less than the strike price, he lets his option expire un-exercised. His loss in
this case is the premium he paid for buying the option. Figure 1.3 gives the payoff for the
buyer of a three month call option (often referred to as long call) with a strike of 2250
bought at a premium of 86.60.
SHORT CALL
When you buy a Call you are hoping that the underlying stock / index would rise. When
you expect the underlying stock / index to fall you do the opposite. When an investor is
very bearish about a stock / index and expects the prices to fall, he can sell Call options.
This position offers limited profit potential and the possibility of large losses on big
advances in underlying prices. Although easy to execute it is a risky strategy since the
seller of the Call is exposed to unlimited risk.