Page 232 - DCOM504_SECURITY_ANALYSIS_AND_PORTFOLIO_MANAGEMENT

Unit 8: Derivatives

8.5.3 Options Notes

“An option is a contractual agreement that gives the option buyer the right, but not the obligation,
to purchase (in the case of a call option) or to sell (in the case of a put option) a specified
instrument at a specified price at any time of the option buyer’s choosing by or before a fixed
date in the future. Upon exercise of the right by the option holder, an option seller is obliged to
deliver the specified instrument at the specified price.”
The growth in organised option markets has resulted with the developments in Option Pricing.
A theory, in this regard made by Black and Scholes (1973); and has been modified and extended.
The option market is not only extended to stocks dealings but also to foreign currencies,
commodities etc. An option is the right but not the obligation to enter into a transaction. An
option is the right, to buy or sell something at a stated date at a stated price. An option contract
gives the holder of the contracts the option to buy or sell shares at a specified price on or before
a specific date in the future. The buyer of the contract pays the writer (or seller) for the right, but
not the obligation, to purchase shares etc. or sell shares etc. to the writer at the price fixed by the
contract (the striking or exercise price). The right to choose, therefore the option, is sold by the
seller (writer) of the option to the purchaser (holder) in return for a payment (premium). The
right conveyed by the option only lasts a certain period of time and then the right expires – at its
maturity or expiration. The seller of an option has no choice. He must meet his obligation to
buy/sell if the right of the purchaser to do so is exercised at the agreed exercise/strike rate. It is
the purchaser who has choice, he does not have to exercise the right to buy/sell at the strike rate
agreed if it is better from his prospective to buy/sell out spot, he can instead walk away from the
option. In this respect, options differ from futures where holders of positions do have the
obligation to buy/sell the underlying asset. At worst the purchaser will lose the premium, but
can gain substantially if the option is worth exercising. Options come in two varieties – European
and American. In the European option, the holder of the option can only exercise his right (if he
so desire) on the expiration date. In an American option, he can exercise this right any time
between purchase date and the expiration date. Options are categorised into – (a) Call option,
and (b) Put option.

Features of Options

The important features of option contracts are as follows:
1. The option is exercisable only by the owner, namely the buyer of the option.

2. The owner has limited liability.
3. Owners of options have no right affordable to shareholders such as voting right and
dividend right.

4. Options have high degree of risk to the option writers.
5. Options are popular because they allow the buyer profits from favourable movements in
exchange rate.

6. Options involve buying counter positions by the option sellers.
7. Flexibility in investors needs.
8. No certificates are issued by the company.

9. An investor who writes a call option against stock held in his portfolio is said to be selling
‘covered options.’ Options sold without the stock to back them up are called ‘naked options.’

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