Basics of Options his/her right to trade.

In case the holder does

not exercise his/her right till maturity, the
What Is an Option? contract will lapse on its own, and no
settlement will be required.
Options are financial instruments that 7. No obligation to buy or sell: In case of
are derivatives based on the value of underlying option contracts, the investor has the option
securities such as stocks. An options contract offers the to buy or sell the underlying asset by the
buyer the opportunity to buy or sell—depending on the expiration date. But he is under no
type of contract they hold—the underlying asset. Unlike obligation to purchase or sell. If an option
futures, the holder is not required to buy or sell the asset holder does not buy or sell, the option
if they choose not to. lapses.
When understanding option contract, one needs to
understand that there are two parties involved, a buyer Types of options
(also called the holder), and a seller who is referred to as
CALL OPTION
the writer.
A call option is a type of options contract which gives
Features of an option contract
the call owner the right, but not the obligation to buy a
security or any financial instrument at a specified price
1. Premium or down payment: The holder of (or the strike price of the option) within a specified time
this type of contract must pay a certain frame.
amount called the ‘premium’ for having the
right to exercise an options trade. In case the If the price of a security is going to rise, a call option
holder does not exercise it, s/he loses the allows the holder to buy the stock at a lower price and
premium amount. Usually, the premium is sell it at a higher price to make profits.
deducted from the total payoff, and the
investor receives the balance. In the money call option: In this case, the strike price is
2. Strike price: This refers to the rate at which less than the current market price of the security.
the owner of the option can buy or sell the
Out of the money call option: When the strike price is
underlying security if s/he decides to
more than the current market price of the security, a call
exercise the contract. The strike price is
option is considered as an out of the money call option. 
fixed and does not change during the entire
period of the validity of the contract. It is PUT OPTION
important to remember that the strike price Put options give the option holder the right to sell an
is different from the market price. The latter underlying security at a specific strike price within the
changes during the life of the contract. expiration date. 
3. Contract size: The contract size is the
deliverable quantity of an underlying asset If the price of a security is falling, a put option allows a
in an options contract. These quantities are seller to sell the underlying securities at the strike price
fixed for an asset. If the contract is for 100 and minimize his risks.
shares, then when a holder exercises one
option contract, there will be a buying or In the money put options: A put option is considered in
selling of 100 shares. the money when the strike price is more than the current
4. Expiration date: Every contract comes price of the security.
with a defined expiry date. This remains Out of the money put options: A put option is out of
unchanged until the validity of the contract. the money if the strike price is less than the current
If the option is not exercised within this market price.
date, it expires.
5. Intrinsic value: An intrinsic value is the
strike price minus the current price of the
underlying security. Money call options Options can also be classified on the exercising style into
have an intrinsic value. American and European options.
6. Settlement of an option: There is no
American options: These are options that can be
buying, selling or exchange of securities
exercised at any time up to the expiration date. 
when an options contract is written. The
contract is settled when the holder exercises
European options: These options can be exercised only
on the expiration date. 

Option Pricing Principles

Basic Notation And Terminology

S₀ = Stock price today (time0 = today)
X = exercise price
T = time to expiration is expressed as a decimal fraction
of a year. 
r = risk free rate, is the rate earned on a riskless   
investment.
Value of Call at Expiration
Sᴛ =stock price at option expiration; that is, after the
passage of a period of time of length T.
C (S₀,T,X) = price of a call option in which the stock
price is S₀, the time to expiration is T, and the exercise
price is X.
P (S₀,T,X) = price of a put option in which the stock
Principles of Call Option Pricing
Minimum Value of a Call -  If the call holder sees that
it is advantageous to exercise it the call will be
exercised. If exercising it will decrease the call holder's
wealth, the holder will not exercise it. The option cannot
have negative value, because the holder cannot be forced
to exercise it.  
Therefore, C (S₀,T,X) ≥ 0 Profit/Loss Profile for Call Transactions
Maximum Value of  Call 

  
Intrinsic Value of Call

  
Call Price Curve

  
Principles of Put Option Pricing

Put Price Curve

   
Value of a Put

 
Profit and Loss Profile for Put Transactions

 
Summary Speculation – Sell calls or buy puts on bearish
securities

Investors can benefit from downward price movements

by either selling calls or buying puts. The upside to the
writer of a call is limited to the option premium. The
buyer of a put faces a potentially unlimited upside but
has a limited downside, equal to the option’s price. If the
market price of the underlying security falls, the put
buyer profits to the extent the market price declines
below the option strike price. If the investor’s hunch was
wrong and prices don’t fall, the investor only loses the
option premium.

Applications of Options: Calls and Puts

Calls and puts are primarily used by investors to hedge
against risks in existing investments. It is frequently the
case, for example, that an investor who owns stock buys
or sells options on the stock to hedge his direct
investment in the underlying asset. His option
investments are designed to at least partially compensate
for any losses that may be incurred in the underlying
asset. However, options may also be used as
standalone speculative investments.
Hedging – Buying puts
If an investor believes that certain stocks in their
portfolio may drop in price, but they do not wish to
abandon their position for the long term, they can buy
put options on the stock. If the stock does decline in
price, then profits in the put options will offset losses in
the actual stock. Investors commonly implement such a
strategy during periods of uncertainty, such as earnings
seasonLinks to an external site. . They may buy puts on
particular stocks in their portfolio or buy index puts to
protect a well-diversified portfolio. Mutual fundLinks to
an external site. managers often use puts to limit the
fund’s downside risk exposure.
Speculation – Buy calls or sell puts

If an investor believes the price of a security is likely to

rise, they can buy calls or sell puts to benefit from such a
price rise. In buying call options, the investor’s total risk
is limited to the premium paid for the option. Their
potential profit is, theoretically, unlimited. It is
determined by how far the market price exceeds the
option strike price and how many options the investor
Illustrative Examples
holds.
For the seller of a put option, things are reversed. Their Example 1
potential profit is limited to the premium received for
Suppose that Microsoft (MFST) shares are trading at
writing the put. Their potential loss is unlimited – equal
$108 per share and you believe that they are going to
to the amount by which the market price is below the
increase in value. You decide to buy a call option to
option strike price, times the number of options sold.
benefit from an increase in the stock's price.
You purchase one call option with a strike price of $115
for one month in the future for 37 cents per contact.
Your total cash outlay is $37 for the position, plus fees
and commissions (0.37 x 100 = $37).
If the stock rises to $116, your option will be worth $1,
since you could exercise the option to acquire the stock
for $115 per share and immediately resell it for $116 per
share. The profit on the option position would be 170.3%
since you paid 37 cents and earned $1—that's much
higher than the 7.4% increase in the underlying stock
price from $108 to $116 at the time of expiry.
In other words, the profit in dollar terms would be a net
of 63 cents or $63 since one option contract represents
100 shares [($1 - 0.37) x 100 = $63].
If the stock fell to $100, your option would expire
worthlessly, and you would be out $37 premium. The
upside is that you didn't buy 100 shares at $108, which
would have resulted in an $8 per share, or $800, total
loss. As you can see, options can help limit your
downside risk.
Example 2

Amy owns 100 shares of ABC stock with a cost basis of

$35 a share. The stock is currently trading at $54 a share.
Amy believes the price of ABC stock will fall to $45 a
share in the near future but over the longer term of 3 to 5
years, increase in value to $75 a share. Amy would like
to benefit from the expected near-term decline if it
occurs. Therefore, Amy writes a covered call at a strike
price of $55 and a premium of $2.
(a) How will the covered call help Amy profit if the
expected price decline occurs?
(b) What is the maximum loss Amy can incur from the
call?
(c) What is the maximum profit Amy can incur from the
call?
Answers:
(a) If the stock declines to $45 a share, the call will not
be exercised and Amy can keep the option premium of
$200.
(b) If the call is exercised, Amy would have to sell her
shares at the $55 strike price and lose any additional
potential gain she could have realized by selling at a
higher price.
(c) The maximum profit is the option premium amount
of $200.