Page 125 - DCOM510_FINANCIAL_DERIVATIVES

Financial Derivatives Mahesh Kumar Sarva, Lovely Professional University

Notes Unit 8: Application of Options

CONTENTS
Objectives

Introduction
8.1 Payoff for Options Derivatives Contracts
8.2 Use of Options (Only Simple Strategies of Hedging, Speculation and Arbitrage)
8.2.1 Sample Contract
8.2.2 Speculation and Hedging with Futures Options

8.2.3 Index Options
8.2.4 Stock Options
8.3 Summary
8.4 Keywords

8.5 Review Questions
8.6 Further Readings

Objectives

After studying this unit, you should be able to:
 Interpret the basic payoffs for options derivatives contracts;

 Discuss the speculation and hedging with futures options;
 Explain the index options and stock options;
 Describe the sample contract involving options on NIKKEI 225.

Introduction

In the previous unit, we understand the payoff for futures derivatives contracts and the difference
between trading securities and trading futures on individual securities. We also discussed the
simple strategies of hedging, speculation and arbitrage.
This unit will helps you to understand six basic payoffs for options derivatives contracts. We
will also learn the simple strategies of hedging, speculation and arbitrage in options. The
various sections and sub-section of this unit will also summarise the speculation and hedging
with futures options, index options and stock options. To make the learning easier, we will take
the help of globally recognised best practices.

We look here at some applications of options contracts. We refer to single stock options here.
However since the index is nothing but a security whose price or level is a weighted average of
securities constituting the index, all strategies that can be implemented using stock futures can
also be implemented using index options.

8.1 Payoff for Options Derivatives Contracts

The opportunity 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

120 LOVELY PROFESSIONAL UNIVERSITY