An option gives its owner the right to buy or sell an underlying asset on or before a given date at a fixed price. For example, you may enjoy the option to buy a certain apartment on or any time before December 31 of the current year at a price of Rs 3 million.
There can be as many different option contracts as the number of items to buy or sell. Stock options, commodity options, foreign exchange options, and interest rate options are traded on and off organized exchanges across the globe.
Options belong to a broader class of assets called contingent claims. A contingent claim is an asset whose payoff in future depends (or is contingent upon) on the out come of some uncertain event.
The most popular model for pricing options is the Black-Scholes model which was published in 1973, the year in which the Chicago Board of Options Exchange (CBOE), the first organized options exchange in the world, was also set up – it was a rare occurrence in the field of finance when a seminal theoretical breakthrough coincided with a major institutional development. Black-Scholes formula is widely used by option traders. Such a rapid translation of theory to practice on such an extensive scale is perhaps without a precedent in the history of finance.
Since the option pricing modal has played such an important role in advancing the frontiers of finance, a basic understanding of this model is essential for students of finance.
This article describes how options work what are the payoffs of call and put options, what are the payoffs associated with popular option pricing strategies, what factors determine option values, how the value of options can be established using the simple binomial model, what is the Black Scholes formula and what are the features of index options and options on individual securities that have been introduced in India recently.
Read this article carefully because many believe that the option pricing theory represents the most important development of modern finance.
How Options Work:
An option is a special contract under which the option owner enjoys the right to buy or sell something without the obligation to do so. Options have a special teminology associated with them.
1. The option to buy is a call option (or just call) and the option to sell is a put option (or just put)
2. The option holder is the buyer of the option and the option writer is the seller of the option.
3. The fixed price at which the option holder can buy and/or sell the underlying asset is called the exercise price or striking price.
4. The date when the option expires or matures is referred to as he expiration date or maturity date. After the expiration date, the option is worthless.
5. The act of buying or selling the underlying asset as per the option contract is called exercising the option.
6. A European option can be exercised only on the expiration date whereas an American option can be exercised on or before the expiration date.
7. Options traded on an exchange are called exchange-traded options not traded on an exchange are called over-the-counter options.
8. Options are said to be at money (ATM) or in the money (ITM) or out of the money (OTM) as shown below.
Call Option Put option
ATM Exercise price = Market price Exercise price = Market price
ITM Exercise price market price
OTM Exercise price > Market price Exercise price < Market price
Exchange traded options are standardized in terms of quantity, trading cycle, expiration date, strike prices, type of option, and mode of settlement. For example option contracts on individual securities on the National Stock Exchange shall be in multiplies of 100, shall have a maximum of three month trading cycle, shall expire on the last Thursday of the month, shall have strike prices stipulated by the Exchange, shall be American style and shall be cash settled.
The value of an option, if it were to expire immediately is called its intrinsic value. The excess of the market price of any option over its intrinsic value is called the time value of the option. To illustrate suppose the market price of a share is Rs 260, the exercise price of a call option on the share is Rs 250, and the market price of the call option is Rs 15. In this case the intrinsic value of the option is Rs 10 (Rs 260-Rs 250) and the time value of the option is Rs 5 (Rs 15 – Rs 10).