Page 130 - DCOM510_FINANCIAL_DERIVATIVES

Unit 8: Application of Options

2. A ………………… option gives the buyer the right to buy the underlying asset at the Notes
strike price specified in the option.
3. The profit/loss that the buyer makes on the option depends on the …………………… of
the underlying.
4. For selling the option, the writer of the call /put option charges a ……………………….
5. Whatever is the buyer’s profit is the seller’s ……………………………...

6. If upon expiration, the spot price exceeds the …………………………., the buyer will exercise
the option on the writer.
7. As the spot price …………………………. the writer of the call option starts making losses.

8. If upon expiration the spot price of the underlying is …………………. than the strike price,
the buyer lets his option expire unexercised and the writer gets to keep the premium.

8.2 Use of Options (Only Simple Strategies of Hedging, Speculation
and Arbitrage)

The options on futures are similar to options on individual stocks and options on stock indices
except that holders acquire the right to buy or sell futures contracts on the underlying assets
rather than the assets themselves. A call option gives the holder a right to buy a futures contract
while a put option gives a right to sell a futures contract.

!
Caution It is significant that the underlying in options on futures is a futures contract and
not a commodity or financial asset represented by the futures contract.

To illustrate, the buyer of an S&P CNX Nifty futures contract call option has the right to assume
a long position in the S&P CNX Nifty futures contract at the specified exercise price. Similarly,
the buyer of an S&P CNX Nifty futures put option has the right to take a short position in the S&P
CNX Nifty futures contract at the agreed exercise price. The seller of futures option on the other
hand, assumes an obligation of taking a position (in futures contract) opposite to that of the
buyer of the option. Thus, the writer of a call futures option has to be ready to take a short
position in the S&P CNX Nifty futures and the writer of an S&P CNX Nifty put futures option has
to be ready to accept a long position in the S&P CNX Nifty futures contract.

Did u know? In case of American style futures options, the exercise can take place on any
trading day up to the date of expiration. Similarly, the option writers can liquidate their
obligations by taking opposite positions (to the ones they hold) before exercise of their
options.

An important way in which futures options differ from equity or index options is in respect of
their expiration. Usually, for commodities, the option month refers to the delivery month of the
futures contract while it (the option) expires on a specific date in the preceding month. The actual
expiration date of a futures option varies with each contract in accordance with the stipulation
laid in it in this regard. However, since futures on stock indices do not involve deliveries, and
are only cash-settled, futures options on them may expire much earlier than the futures expiration.

Example: It is possible to trade July option on September futures contract with the
option expiring at usual time in July and if exercised, then the position in the futures contract
settled in September.

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