Page 74 - DCOM510_FINANCIAL_DERIVATIVES

Unit 5: Introduction to Options

Self Assessment Notes

State whether the following statements are true or false:
9. A put option gives the holder the right but not the obligation to buy an asset by a certain
date for a certain price.

10. A call option gives the holder the right but not the obligation to sell an asset by a certain
date for a certain price.
11. European options and American options on stock and bonds are usually considered to be
“plain vanilla”.
12. Asian options, look back options, barrier options are often considered to be exotic, especially
if the underlying instrument is more complex than simple equity or debt.
13. The price of options is decided between the buyers and sellers on the trading screens of the
exchanges in a transparent manner.
5.4 Distinction between Futures and Options

In case of futures, both the buyer and the seller are under obligation to fulfil the contract. They
have unlimited potential to gain if the price of the underlying moves in their favour. On the
contrary, they are subject to unlimited risk of losing if the price of the underlying moves against
their views. In case of options, however, the buyer of the option has the right and not the
obligation. Thus he enjoys an asymmetric risk profile. He has unlimited potential to profit if the
price of the underlying moves in his favour. But a limited potential to lose, to the extent of the
premium paid, in case the price of the underlying moves against the view taken. Similarly, the
seller of the option is under obligation. He has limited potential to profit, to the extent of the
premium received, in case the price of the underlying moves in his favour, but an unlimited risk
of losing in case the price of the underlying moves against the view taken.

Further with regards to behaviour of prices, trading in futures is one-dimensional as the price of
futures depends upon the price of the underlying only.

Did u know? Trading in options is two- dimensional as the price of an option depends
upon both the price and the volatility of the underlying.

5.4.1 Comparison between Futures and Options

Options are different from futures in several interesting senses. At a practical level, the option
buyer faces an interesting situation. He pays for the option in full at the time it is purchased.
After this, he only has an upside. There is no possibility of the options position generating any
further losses to him (other than the funds already paid for the option). This is different from
futures, which is free to enter into, but can generate very large losses. This characteristic makes
options attractive to many occasional market participants, who cannot put in the time to closely
monitor their futures positions. Table 5.2 presents the comparison between the futures and
options. Buying put options is buying insurance. To buy a put option on Nifty is to buy insurance
which reimburses the full extent to which Nifty drops below the strike price of the put option.
This is attractive to many people, and to mutual funds creating “guaranteed return products”.

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