Chapter 3

There are four types of option positions:

1 . A long position in a call option , 2. A long position in a put option ,3. A short position in a call option , 4. A short position in a put option.

in Forwards contract

1. Both the parties -buyer and seller have the commitment to do the trade 2. They are traded on Over the Counter 3. No premium has to be paid

in an Options contract

1. Buyer of the option has the right to trade and writer has the obligation 2. They are traded in both -Exchange and Over the Counter 3. Option premium has to be paid

Operational Risk

Operational Risk risk in the business process.

Index Option

Option contract to buy or sell 100 times the index at the specified strike price is called Index Option FLEX Options

Options

Options are financial derivatives that give buyers the right, but not the obligation, to buy or sell an underlying asset at an agreed-upon price and date. Call options and put options form the basis for a wide range of option strategies designed for hedging, income, or speculation.

Call Option

Profit from buying one European call option: option price = $5, strike price = $100, option life = 4 months

TRUE

Put options should always be exercised at the expiration date if the stock price is less than the strike price.

Specification Of Stock Options

"1. Expiration Dates - month in which the expiration date occurs LEAPS long-term equity anticipation securities, are publicly traded options contracts with expiration dates that are longer than one year . 2. Strike Price"

FALSE

"A Baker signs a futures contract at 5 AED per kg for 3 months tenure. This contract is favorable to Baker as long a price is equal to or less than 5 AED per kg"

FALSE

"A Copper Mining Company signs a futures contract at 25000 AED per ton for 3 months tenure. This contract is favorable to Mining Company as long a price is equal to or tenure. This contract is favorable to Mining Company as long a price is equal to nongreater than 25000 AED per ton"

TRUE

"A Electric Copper Wire Manufacturing Company signs a futures contract at 2500 AED per ton for 3 months tenure. This contract is favouralbe to Electric Copper Wire Manufacturing Company as long a price is equal to or greater than 2500 AED per ton"

Forward

"A Forward is a contract in which one party commits to buy and the other party commits to sell a specified quantity of an agreed upon asset for a pre-determined price at a specific date in the future."

TRUE

"A Gold Jewelry Company signs a futures contract at 250 AED per gm for 3 months tenure. This contract is favorable to Jewelry Company as long a price is equal to or greater than 250 AED per kg"

TRUE

"A farmer signs a futures contract at 5 AED per kg for 3 months tenure. This contract is favorable to farmer as long a price is equal to or less than 5 AED per kg"

Credit Risk

"Credit Risk risk represents default from either Buyer or seller of the contract involved."

Exchange Traded Contract ETC

"Exchange Traded Contract(ETC) is to trade financial instruments such as stocks, bonds, commodities or derivatives directly between two parties without going through an exchange or other intermediary."

TRUE

"Futures contracts are traded on exchanges and have standardized contract structures, in terms of amount and maturity and other contractual features."

Over-the-counter (OTC) or off-exchange trading

"Over-the-counter (OTC) or off-exchange trading is to trade financial instruments such as stocks, bonds, commodities or derivatives directly between two parties without going through an exchange or other intermediary"

example of a put Option Scenario 2

"Suppose that the stock price is $55 on this date. The investor can buy 100 shares for $55 per share and, under the terms of the put option, sell the same shares for $70 to realize a gain of $15 per share, or $1,500. Again, transactions costs are ignored. When the $700 initial cost of the option is taken into account, the investor's net profit is $800. 1500 - 700 . There is no guarantee that the investor will make a gain. If the final stock price is above $70, the put option expires worthless, and the investor loses $700.

Tailor made

"The contract can be Tailor made to the two parties' liking no standardized contract structure exists on the OTC ."

Financial Contract

"is a financial instrument which derives its value from the underlying assets."

European options

European options can be exercised only on the expiration date itself

Call vs. Put Option

A call and put option are the opposite of each other. A call option is the right to buy an underlying stock at a predetermined price up until a specified expiration date. On the contrary, a put option is the right to sell the underlying stock at a predetermined price until a fixed expiry date. While a call option buyer has the right (but not obligation) to buy shares at the strike price before or on the expiry date, a put option buyer has the right to sell shares at the strike price.

A call option

A call option gives the holder of the option the right to buy an asset by a certain date for a certain price

What is a call option ?

A call option is a contract that gives an investor the right, but not obligation, to buy a certain amount of shares of a security or commodity at a specified price at a later time. Unlike put options, call options are banking on the price of a security or commodity to go up, thereby making a profit on the shares by being able to buy them later at a lower price.

What is a Call Option?

A call option, commonly referred to as a "call," is a form of a derivatives contract that gives the call option buyer the right, but not the obligation, to buy a stock or other financial instrument at a specific price - the strike price of the option - within a specified time frame. The seller of the option is obligated to sell the security to the buyer if the latter decides to exercise their option to make a purchase.

What is a call option ?

A call option, often simply labeled a "call", is a contract, between the buyer and the seller of the call option, to exchange a security at a set price. The buyer of the call option has the right, but not the obligation, to buy an agreed quantity of a particular commodity or financial instrument (the underlying) from the seller of the option at a certain time (the expiration date) for a certain price (the strike price). The seller (or "writer") is obligated to sell the commodity or financial instrument to the buyer if the buyer so decides. The buyer pays a fee (called a premium) for this right. The term "call" comes from the fact that the owner has the right to "call the stock away" from the seller.

FLEX Options Flexible Exchange Option

A non-standard option which can be customized, allowing both the writer and purchaser to define various terms such as strike price, expiration date and other features and benefits. OTC

A put option

A put option gives the holder the right to sell an asset by a certain date for a certain price.

Electronic Trading

Exchanges are increasingly replacing the open outcry system by Electronic Trading

what is a put option ?

A put option is a contract giving the owner the right, but not the obligation, to sell-or sell short-a specified amount of an underlying security at a pre-determined price within a specified time frame. This pre-determined price that buyer of the put option can sell at is called the strike price

American options

American options can be exercised at any time up to the expiration date

In the money

An in the money ITM option has positive intrinsic value as well as time value. A call option is in the money when the strike price is below the spot price. A put option is in the money when the strike price is above the spot price.

At-the-money option

An option is at the money ,ATM, if the strike price is the same as the current spot price of the underlying security. An at-the-money option has no intrinsic value, only time value.

Out of the money

An out of the money OTM option has no intrinsic value. A call option is out of the money when the strike price is above the spot price of the underlying security. A put option is out of the money when the strike price is below the spot price.

example of a Call Option Scenario 2

Assuming stock price is $115. By exercising the option, the investor is able to buy 100 shares for $100 per share. Now, if the shares are sold immediately, the investor makes a gain of $15 per share, i.e. $1,500 ignoring transactions costs. Considering initial investment $500,net profit to the investor is $1,500 - $500 =$1000 It is important to realize that an investor sometimes exercises an option and makes a loss overall.

Futures Options

Buyer has the right to assume a particular futures position at the specified strike price any time before the option expires, such option is called Futures Options

Long Call

Buyer of the Call Option is said to be taking __________ position

Long Put

Buyer of the Put Option is said to be taking Long Put position

why buy call opotions ?

Buying call options enables investors to invest a small amount of capital to potentially profit from a price rise in the underlying security, or to hedge away from positional risks. Small investors use options to try to turn small amounts of money into big profits, while corporate and institutional investors use options to increase their marginal revenues and hedge their stock portfolios.

TRUE

Call options should always be exercised at the expiration date if the stock price is above the strike price.

example of a put Option Scenario 1

Consider an investor who buys a European put option with a strike price of $70 to sell 100 shares of a certain stock. Assume that the current stock price is $65, the expiration date of the option is in 3 months, and the price of an option,option premium, to sell one share is $7. The initial investment is $700. As option is European, it will be exercised only if the stock price is below $70 on the expiration date. The initial investment is $700 . Profit = $5 * 100 Shares = $ 500 Over all loss will be $200 ,$700 - $500.

example of a Call Option Scenario 1

Consider the situation of an investor who buys a European call option with a strike price of $100 to purchase 100 shares of a certain stock. Suppose that the current stock price is $98, the expiration date of the option is in 4 months, and the price of an option to purchase one share is $5. The initial investment is $500. If the stock price on this date is < $100, the investor will choose not to exercise. So, investor's loss will be $500. If the stock price is above $100 on the expiration date, the option will be exercised.

example of a call option

For example, assume you bought an option on 100 shares of a stock, with an option strike price of $30. Before your option expires, the price of the stock rises from $28 to $40. Then you could exercise your right to buy 100 shares of the stock at $30, immediately giving you a $10 per share profit. Your net profit would be 100 shares, times $10 a share, minus whatever purchase price you paid for the option. In this example, if you had paid $200 for the call option, then your net profit would be $800 (100 shares x $10 per share - $200 = $800).

Foreign Currency Options

Foreign Currency Options: One contract is to buy or sell 10,000 units of a foreign currency (except Japanese yen) for US dollars.

Futures Options

Futures Options: The buyer of a futures option contract has the right to assume a particular futures position at the specified strike price any time before the option expires.

FALSE

If S is the stock price and K is the strike price then, Call Option is said to be In-the-money when S < K

TRUE

If S is the stock price and K is the strike price then, Call Option is said to be Out-of-the-money when S < K

TRUE

If S is the stock price and K is the strike price then, Put Option is said to be In-the-money when S < K

what is a put option ?

In finance, a put or put option is a stock market instrument which gives the holder (i.e. the purchaser of the put option) the right to sell an asset (the underlying), at a specified price (the strike), by (or at) a specified date (the expiry or maturity) to the writer (i.e. seller) of the put. The purchase of a put option is interpreted as a negative sentiment about the future value of the underlying stock. The term "put" comes from the fact that the owner has the right to "put up for sale" the stock or index.

Long and Short Positions

In the trading of assets, an investor can take two types of positions: long and short. An investor can either buy an asset (going long) or sell it (going short). Long and short positions are further complicated by the two types of options: the call and put. An investor may enter into a long put, a long call, a short put, or a short call.

Index Options

Index Options: One contract is usually to buy or sell 100 times the index at the specified strike price. Settlement is always in cash.

LEAPS

LEAPS publicly traded options contracts with expiration dates that are longer than one year

example of a Call Option Scenario 3

Let's assume stock price as $102 on the maturity date. The investor would exercise the option for a gain of 100* $102-$100 = $200 and realize a loss overall of $300 However, not exercising would lead to an overall loss of $500, which is worse than the $300 loss when the investor exercises. In general, call options should always be exercised at the expiration date if the stock price is above the strike price.

Stock Options

Stock Options: One contract gives the holder the right to buy or sell 100 shares at the specified strike price.

why sell call option ?

The buyer of a call option seeks to make a profit if and when the price of the underlying asset increases to a price higher than the option strike price. On the other hand, the seller of the call option hopes that the price of the asset will decline, or at least never rise as high as the option strike/exercise price before it expires, in which case the money received for selling the option will be pure profit. If the price of the underlying security does not increase beyond the strike price prior to expiration, then it will not be profitable for the option buyer to exercise the option, and the option will expire worthless or "out-of-the-money". The buyer will suffer a loss equal to the price paid for the call option. Alternatively, if the price of the underlying security rises above the option strike price, the buyer can profitably exercise the option.

expiration date / maturity date

The date specified in the contract is known as the expiration date or the maturity date.

maturity date

The date specified in the options contract is known as the

what is The initial cost of the option ?

The initial cost of the option is then not included in the calculation. K = Strike price, ST = Price of asset at maturity

exercise price or the strike price.

The price specified in the contract is known as the exercise price or the strike price.

strike price

The price specified in the options contract is known as the

options writer

The writer Exchange / OTC of an option receives cash up front, but has potential liabilities later. The writer's profit or loss is the reverse of that for the purchaser of the option.

what are the sides to every option contract ?

There are two sides to every option contract. On one side is the investor who has taken the long position i.e., has bought the option. On the other side is the investor who has taken a short position i.e., has sold or written the option.

what are the sides of Option Positions ?

There are two sides to every option contract. On one side is the investor who has taken the long position i.e., has bought the option. On the other side is the investor who has taken a short position i.e., has sold or written the option. The writer Exchange / OTC of an option receives cash up front, but has potential liabilities later. The writer's profit or loss is the reverse of that for the purchaser of the option.

why to buy a Put Options ?

Whereas the purchaser of a call option is hoping that the stock price will increase, the purchaser of a put option is hoping that it will decrease.

Call Option vs. Put Option

While a call option allows you the ability to buy a security at a set price at a later time, a put option gives you the ability to sell a security at a set price at a later time. Unlike a call option, a put option is essentially a wager that the price of an underlying security (like a stock) will go down in a set amount of time, and so you are buying the option to sell shares at a higher price than their market value.

Short Call

Writer of the Call Option is said to be taking Short Call position

Option payoff diagrams

option payoff diagrams are profit and loss charts that show the risk/reward profile of an option or combination of options. As option probability can be complex to understand, P&L graphs give an instant view of the risk/reward for certain trading ideas you might have. If you've never seen a payoff chart, then below we'll go through two examples of what the P&L looks like for an easy long call option buying a call and then a short call option selling a call.

Liquidity Risk

risk represents failure of the contract with any one party.