Options (Basics) | CA Final SFM
Options are such derivative financial instruments that do not bind the option holder into a firm commitment. Options in fact provide the right to the option holder to exercise or not to exercise such rights as options.
Option Holder: One who, holds the right to buy or sale
Option Writer: One who, provides the right
X and Y enter into an agreement where X will have the right to purchase 1,000 equity shares in NJ Ltd. at a price of ` 32 per share on 01.01.2011.
In the above example, the contract between X and Y is an option contract where X is an Option Holder and Y is an Option Writer. The underlying asset in the contract is equity shares in NJ Ltd.
This derivative contract is known as “Call Option” because it provides a right to the option holder to purchase. The exercise price or the strike price is ` 32 per share. The maturity date of this option is 01.01.2011. On the date of maturity the option holder, i.e., X has a right and not an obligation to buy such equity shares. If X however, exercises his right to buy then Y will be under obligation to sell.
Therefore, the option holder is always at a benefit. For sake of such benefit the option holder has to pay option premium to the option writer. Such premium is payable irrespective of whether the option is exercised or not.
American Options V/s European Options
If an option can be exercised on any day up to the expiry date (in other words on or before the expiry date) then such option is known as “American Option”. Where an option can be exercised only at its maturity or expiry date, then such option is known as “European Option”.
Position of an Option Holder
Option Holder can have any of the following positions:
1. In-the-Money (ITM)
2. Out-of the-Money (OTM)
3. At-the-Money (ATM)
- If exercising the option, benefits the option holder then it is considered that his position is In-the-Money (ITM).
- If the option holder suffers a loss on exercising the option, then his position is Out-of the-Money (OTM).
- Where option holder is indifferent with whether to exercise the option or not then such position is known as At-the-Money (ATM).
Options – Basic Terms Clarified
- Option contract provide rights to option holder to buy or sell something in future at a price agreed today.
- Such agreed price is known as exercise price or strike price.
- Option holder is the party who holds the right to buy or sell.
- Option writer is the party who provides such rights to option holder.
- A call option conveys to the holder a right to buy.
- A put option conveys to the holder a right to sell.
- European options are options that can be exercised only at a specified date in future known as exercise date or maturity date.
- American options are options that can be exercised at any point on or before specified future date known as expiry date.
- Position of option holder can be identified as ITM, ATM and OTM. The position considered as In the Money only when exercising the option benefits the option holder.
- An option is exercised only when the option holder is In the Money.
- This is an upfront charge payable by option holder to option writer at the time of entering into option contract.
- By paying option premium the option holder purchases the option from option writer and option writer sells such option.
- Option premium is payable irrespective of whether the option is exercised or not.
- In order to decide whether an option should be exercised or not option premium already paid by holder to writer is completely irrelevant.
Determining Pay-off for Call Options
Determining Pay-off for Put Options
Options Pay-off & Breakeven
- A call option is exercised by the holder only when MP Exercise Price.
- A put option is exercised by the holder only when MP Exercise price.
- The gross pay-off for the option indicates its value on the date it is exercisable. It is also known as intrinsic value of the option.
- The net pay-off for option holder is always equal to Gross Pay-off – Premium.
- The net pay-off for option writer is always equal to Gross Pay-off + Premium.
- Break-even point is arrived at when Net Pay-off equals to Zero.
- Break-even point for call option is equal to Strike Price + Premium.
- Break-even point for put option is equal to Strike Price – Premium.
Outcome of Call Option
Holding a call option provides the holder an opportunity to make unlimited profits when the market price rises up with a limited risk of loss when market price falls. Such loss is limited to the amount of premium paid.
Writing a call option creates for the writer, a chance to incur unlimited loss when the market price rises up with a limited opportunity to make profit, when the market price falls. Such profit is limited to amount of premium received.
Call option holder makes money in a bullish market. Call option writer makes money in bearish market.
Outcome of Put Option
Holding a put option provides the option holder an opportunity to make limited profit when the market price falls. Such profit is limited to the extent of Strike Price – Premium. Holding a put option results into chance of limited loss for option holder when the market price rises up. Such loss is limited to amount of premium paid.
Writing a put option results into possibility of limited loss to the option writer when the market price falls, such loss is limited to the extent of Strike Price – Premium. Writing a put option provides the option writer an opportunity to make limited profit when the market price rises. Such profit is limited to the amount of premium received. Put option holder makes money in a bearish market. Put option writer makes money in bullish market.
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