Financial Derivatives : Option Contract - Call & Put with characteristics 2022

Option Contract 

Options are agreements between two counter parties that provide one of the counter parties a right, but not an obligation, to transact in the future. The party taking a long position i.e. buying the option is called buyer/ holder of the option and the party taking a short position i.e. selling the option is called the seller/ writer of the option. The option buyer has the right but no obligation with regards to buying or selling the underlying asset, while the option writer has the obligation in the contract. Therefore, option buyer/ holder will exercise his option only when the situation is favourable to him, but, when he decides to exercise, option writer would be legally bound to honour the contract.

Options may be categorised into two main types:- 

• Call Options
• Put Options

What are Call Options?

A call option gives the holder (buyer/ one who is long call), the right to buy a specified quantity of the underlying asset at the strike price on the expiration date. The seller (one who is short call) however, has the obligation to sell the underlying asset if the buyer of the call option decides to exercise his option to buy.

Example: An investor buys one call option on Stock "A" at the strike price of Rs. 3500 at a premium of Rs. 100. If the market price of Stock "A" on the day of expiry is more than Rs. 3500, the option will be exercised. The investor will earn profits once the share price crosses Rs. 3600 (Strike Price + Premium i.e. 3500+100).

Suppose stock price is Rs. 3800, the option will be exercised and the investor will buy 1 share of Stock "A" from the seller of the option at Rs 3500 and sell it in the market at Rs 3800 making a profit of Rs. 200 {(Spot price - Strike price) - Premium}.

In another scenario, if at the time of expiry stock price falls below Rs. 3500 say suppose it touches Rs. 3000, the buyer of the call option will choose not to exercise his option. In this case the investor loses the premium (Rs 100), paid which shall be the profit earned by the seller of the call option.

CALL OPTION CHARACTERISTICS

The characteristics of a call option are as follows

• The two counter parties to a call option are the long call and the short call.

• A call option gives the long call the right, but not the obligation, to purchase an underlying asset from the short call in the future. Hence, the long call can choose in the future whether or not to exercise its right to purchase. The expression “exercise” means “take advantage of.”

• The short call is obligated to sell the underlying asset to the long call should the long call exercise its right to purchase.

• The long call is also referred to as the “buyer” and the short call is also referred to as the “writer” or the “seller” of the call option.

• The price at which the long call has the right to purchase the underlying asset is known as the “strike price.” Another commonly used name for the strike price is the “exercise price.”

• It is advantageous to have a right and not an obligation. Hence, the long call must pay the short call a fee for providing the right. The fee   is known as the “call premium.” The call premium is paid at initiation. Other names for the call premium are the “call price” or simply the “premium.”

• We can distinguish between a European-style and an American-style call option. In a European-style call option the right to exercise is only at expiration. In an American-style call option the long call has the right to exercise either at expiration or before expiration. Both American-style and European-style call options trade in the United States.

• The asset can be any asset. Examples of assets include stocks, bonds, currencies and commodities.

• All details are specified at initiation, including:

1. The counter parties 
2. The underlying asset 
3. The strike price
4. The call  premium 
5. The expiration date

• Whether the option is American-style or European-style

• Options can trade either OTC (over-the-counter) or through an exchange. Hence, options are described as OTC options or exchange- traded options. A prominent example of an options exchange is the Chicago Board Options Exchange (CBOE).

What are Put Options?

A Put option gives the holder (buyer/ one who is long put), the right to sell a specified quantity of the underlying asset at the strike price on or the expiry date. The seller of the put option (one who is short put) however, has the obligation to buy the underlying asset at the strike price if the buyer decides to exercise his option to sell.

Exa-mple: An investor buys one European Put option on Stock 'B' at the strike price of Rs. 300, at a premium of Rs. 25. If the market price of Stock 'B', on the day of expiry is less than Rs. 300, the option can be exercised as it is 'in the money'. The investor's Break-even point is Rs. 275 (Strike Price - premium paid) i.e., the investor will earn profits if the market falls below 275. Suppose stock price is Rs. 260, the buyer of the Put option immediately buys Stock 'B' from the market @ Rs. 260 & exercises his option selling the Stock 'B' at Rs 300 to the option writer thus making a net profit of Rs. 15 {(Strike price - Spot Price) - Premium paid}.

In another scenario, if at the time of expiry, market price of Stock 'B' is Rs 320; the buyer of the Put option will choose not to exercise his option to sell as he can sell in the market at a higher rate. In this case the investor loses the premium paid (i.e. Rs 25), which shall be the profit earned by the seller of the Put option.

PUT OPTION CHARACTERISTICS

• The two counter parties to a put option are the long put and the short put.

• The price at which the long put has the right to sell the asset is known as the strike price or exercise price.

• A put option gives the long put the right, but not the obligation, to sell an underlying asset to the short put in the future. Hence, the long put can choose in the future whether or not to exercise its right to sell.

• The short put is obligated to purchase the underlying asset from the long put should the long put exercise its right to sell.

• The long put is also referred to as the “buyer” of the put option. The short put is also referred to as the “writer” or “seller” of the put option.

• The long put must pay a fee to the short put for providing the right. The fee is known as the “put premium.” The put premium is paid at initiation. Other names for the put premium are the “put price” or simply the “premium.”

• A European-style put option provides the long put the right to exercise only at expiration. An American-style put option provides the right to exercise either at expiration or before expiration. Both American-style and European-style put options trade in the United States.

• Put options trade both OTC and through exchanges. All details are specified at initiation, including: 

1. The counter parties 
2. The underlying asset 
3. The strike price
4. The put premium 
5. The expiration date

• Whether the option is American-style or European-style

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