Page 66 - DCOM510_FINANCIAL_DERIVATIVES

Unit 5: Introduction to Options

buyer has to take delivery. Options are one better than futures. In option, as the name indicates, Notes
gives one party the option to take or make delivery. But this option is given to only one party
in the transaction while the other party has an obligation to take or make delivery. The asset can
be a stock, bond, index, currency or a commodity. But since the other party has an obligation and
a risk associated with making good the obligation, he receives a payment for that. This payment
is called as premium.
In April 1973, the options on stocks were first traded on an organised exchange, i.e., Chicago
Board Options Exchange. Since then, there has been a dramatic growth in options markets.
Options are now traded on various exchanges in various countries all over the world. Options
are now traded both on organised exchanges and over-the-counter (OTC). The option trading
mechanism on both are quite different and which leads to important differences in market
conventions. Recently, options contracts on OTC are getting popular because they are more
liquid. Further, most of the banks and other financial institutions now prefer the OTC options
market because of the ease and customised nature of contract.

5.1 Options Contracts

Options are the most important group of derivative securities. Option may be defined as a
contract, between two parties whereby one party obtains the right, but not the obligation, to
buy or sell a particular asset, at a specified price, on or before a specified date. The person who
acquires the right is known as the option buyer or option holder, while the other person (who
confers the right) is known as option seller or option writer. The seller of the option for giving
such option to the buyer charges an amount which is known as the option premium.

Example: Suppose the current price of CIPLA share is ` 750 per share. X owns 1000 shares
of CIPLA Ltd. and apprehends in the decline in price of share. The option (put) contract available
at BSE is of ` 800, in next two-month delivery. Premium cost is ` 10 per share. X will buy a put
option at 10 per share at a strike price of ` 800. In this way X has hedged his risk of price fall of
stock. X will exercise the put option if the price of stock goes down below ` 790 and will not
exercise the option if price is more than ` 800, on the exercise date. In case of options, buyer has
a limited loss and unlimited profit potential unlike in case of forward and futures.

Options can be divided into two types: calls and puts. A call option gives the holder the right to
buy an asset at a specified date for a specified price whereas in put option, the holder gets the
right to sell an asset at the specified price and time. The specified price in such contract is known
as the exercise price or the strike price and the date in the contract is known as the expiration date
or the exercise date or the maturity date. The asset or security instrument or commodity covered
under the contract is called as the underlying asset. They include shares, stocks, stock indices,
foreign currencies, bonds, commodities, futures contracts, etc. Further options can be American
or European. A European option can be exercised on the expiration date only whereas an American
option can be exercised at any time before the maturity date.

Example: You discover a house that you would love to purchase. Unfortunately, you do
not have the cash to buy it for another three months. You talk to the owner and negotiate a deal
that gives you an option to buy the house in three months for a price of ` 200,000. The owner
agrees, but for this option, you pay a price of ` 3,000.
Now, consider two theoretical situations that might arise:

1. It has been discovered that the house is of historical importance and as a result, the market
value of the house skyrockets to ` 10,00,000. Because the owner sold you the option, he is
obligated to sell you the house for ` 200,000. In the end, you stand to make a profit of
` 7,97,000 (` 10,00,000 – ` 2,00,000 – ` 3,000).

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