Page 138 - DCOM510_FINANCIAL_DERIVATIVES

Unit 8: Application of Options

Notes
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Case Study Option on Reliance

n investor buys one European Put option on Reliance at the strike price of ` 300 at
a premium of ` 25. If the market price of Reliance, on the day of expiry is less than
A` 300, the option can be exercised as it is ‘in the money’.
The investor’s Breakeven point is ` 275 (Strike Price - premium paid) i.e., investor will
earn profits if the market falls below 275.
Suppose stock price is ` 260, the buyer of the Put option immediately buys Reliance share
in the market @ ` 260 & exercises his option selling the Reliance share at ` 300 to the option
writer thus making a net profit of ` 15 {(Strike price - Spot Price) - Premium paid}.
In another scenario, if at the time of expiry, market price of Reliance is ` 320, the buyer of
the Put option will choose not to exercise his option to sell as he can sell in the market at
a higher rate. In this case the investor loses the premium paid (i.e. ` 25), which shall be the
profit earned by the seller of the Put option.
Question:
Analyse the case and give suitable option strategy.

Source: Kulkarni B. (2011). “Commodity Markets & Derivatives”. Excel Books.

8.3 Summary

 The opportunity characteristic of options means that the losses for the buyer of an option
are limited.
 A call option gives the buyer the right to buy the underlying asset at the strike price
specified in the option.

 For selling the option, the writer of the option charges a premium. The profits/loss that
the buyer makes on the option depends on the spot price of the underlying.

 A put option gives the buyer the right to sell the underlying asset at the strike price
specified in the option.
 For selling the option, the writer of the option charges a premium. The profit/loss that the
buyer makes on the option depends on the spot price of the underlying.
 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.
 An important way in which futures options differ from equity or index options is in
respect of their expiration.
 While in case of options on equity or stock indices a cash exchange occurs when an option
is exercised, the same does not happen in case of futures option. Instead, in a futures
option, the holder acquires a long position (in case of a call) or short position (in case of a
put) at a price equal to the exercise price of the option.
 The principles of speculation using futures options are similar to those with other options.
 Owners of stocks or equity portfolios often experience discomfort about the overall stock
market movement.

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