Part – V Essentials of Options

1. Part – V Essentials of Options

2. A Quick Recap • Options are by design different from forward and futures contracts. • The buyer of the options contract is called the Holder or the Long, and he has a right. • The seller of the contract is called the Writer or the Short and he has an obligation.

3. Recap (Cont…) • Call Options give the holder the right to buy the underlying asset at a pre-specified price. • Put Options give the holder the right to sell the underlying asset at a pre-specified price. • All option contracts have a specified expiration date after which they become null and void.

4. Recap (Cont…) • Options contract which can be exercised only at the time of expiration are called European options. • Contracts which can be exercised at any time, upto and including the time of expiration, are called American options. • Most exchange traded options are American.

5. Associated Terms • The following terms are important in the context of options. • Option Price or Premium • Strike Price or Exercise Price • Expiration Date or Exercise Date or Strike Date or Maturity Date

6. Price or Premium • This is the cost of acquisition of the option. • It is payable by the buyer to the writer at the outset. • Thus unlike in the case of a forward or a futures contract, the long has to pay the short to get into an options contract.

7. Price or Premium (Cont…) • The difference is because in the case of a forward/futures contract, both the parties have an equivalent obligation. • In the case of an options contract however, one party is acquiring a right from the other. • And, no one will give away a right for free.

8. Strike Price or Exercise Price • This is the price payable per unit of the underlying asset, if a call option is exercised by the holder. • It is the price receivable per unit of the underlying asset, if a put option is exercised by the holder.

9. Exercise Price (Cont…) • Thus when the buyer of an options contract pays the option premium, he merely acquires the right to transact. • If he subsequently decides to go through with the transaction, he must pay to acquire the underlying asset in the case of call options.

10. Exercise Price (Cont…) • Or else he must be paid when he delivers the underlying asset in the case of put options.

11. Expiration Date • This is the point in time after which the contract becomes null and void. • It is the only point in time at which a European option can be exercised. • It is the last point in time at which an American option can be exercised

12. Example of a Call Option • Consider European calls on Reliance expiring on the last Thursday of September. • Let the exercise price be Rs 400. • Let the option premium be Rs 15. • Option premia are always quoted on a per share basis.

13. Example (Cont…) • The contract size, which is the number of shares of stock underlying the contract is 100 shares in the U.S., irrespective of the company on whose shares the contract is written. • In India the contract size varies from company to company.

14. Example (Cont…) • In the case of Reliance, the contract size is 600 shares. • Thus the buyer has to pay 15 x 600 = Rs 9000 to the writer at the outset. • This is a sunk cost and cannot be recovered. • In exchange the buyer acquires the right to buy 600 shares at the time of expiration at a price of Rs 400 per share.

15. Example (Cont…) • What will happen at expiration? • If the stock price is greater than Rs 400, then the option will be exercised. • This is because it is worth paying Rs 400 for an asset that is selling for more than Rs 400. • Otherwise the option will simply be allowed to expire worthless.

16. Example (Cont…) • For instance, why pay Rs 400 for an asset that is selling at say Rs 395. • Remember that since an option is a right, the holder cannot be forced to exercise. • Notice that the spot price at expiration need not be greater than the sum of the exercise price and the premium, in order to trigger off exercise.

17. Example (Cont…) • That is, the terminal stock price need not exceed Rs 400 + Rs 15 = Rs 415, before the holder opts to exercise. • This is because sunk costs are irrelevant while taking investment decisions.

18. The Irrelevance of Sunk Costs • Assume that the terminal stock price is Rs 405. • If the option is exercised the profit is: • Π = 600(405 – 400) – 9000 = (6000) • If the option is not exercised • Π = (9000) • Obviously it is better to lose Rs 6000.

19. The Case of Puts • If the options had been puts instead of calls, then the holder would exercise only if the spot price at expiration were to be less than Rs 400. • Obviously, it is attractive to sell the stock for Rs 400, when the prevailing market price is less than Rs 400.

20. Puts (Cont…) • Otherwise it is best to allow the options to expire worthless. • For instance if the spot price is Rs 405, why should the option holder deliver under the contract for Rs 400.

21. Profit Bounds • For a call holder the maximum profit is unlimited, since theoretically, there is no upper bound on the price of the asset. • Thus if the call is exercised: π = (ST – X) – C, which has no upper bound. • ST is the stock price, X is the exercise price and C is the premium.

22. Profit Bounds (Cont…) • If the call is not exercised: π = -C • For a call writer the maximum profit is the option premium. • This is because the best thing that can happen from his standpoint is that the holder does not exercise, and he consequently gets to retain the entire premium.

23. Profit Bounds (Cont…) • Thus if the call is not exercised: π = C. • If the call were to be exercised the writer has to deliver a share, whose price is theoretically unbounded, at the exercise price. That is: • Π = C – (ST – X)

24. Profit Bounds (Cont…) • Thus the maximum possible loss for a call writer is infinite.

25. Puts and Profits • In the case of a put holder the profit is given by: (X – ST) – P The maximum possible value is X – P. This is because the lowest possible stock price is 0, since stocks have limited liability. The maximum possible loss is once again equal to the premium paid: π = -P

26. Puts and profits (Cont…) • For a put writer the maximum possible profit is the premium. • This is because the best thing that can happen to him is that the option is not exercised. • His loss if the put is exercised is: π = P – (X – ST) which has a lower bound of (P – X) = -(X-P)

27. Zero Sum Games • Thus both calls and puts are Zero Sum Games. • One man’s profit is always another man’s loss.

28. Payoffs and Profits • Symbolically the payoff from an option for a call holder is: Max[0, ST – X] The profit is Max[0, ST – X] – C The payoff for a call writer is -Max[0, ST – X] = Min[0, X – ST] The profit isMin[0, X – ST] + C

29. Payoffs and Profits (Cont…) • The payoff for a put holder is: Max[0, X – ST] The profit is Max[0, X – ST] – P The payoff for a put writer is: Min[0, ST - X] The profit is Min[0, ST - X] + P

30. Exchange Trade & OTC Options • Exchange traded options were introduced for the first time by the Chicago Board Options Exchange (CBOE) in 1973. • Until then options were only traded Over the Counter.

31. Exchange Traded vs. OTC (Cont…) • OTC options are customized, in the sense that the exercise price, the expiration date, and the contract size are negotiated between the buyer and the seller. • Exchange traded options are however standardized like futures contracts. • That is the allowable exercise prices and expiration dates are specified by the exchange.

32. Exchange Traded vs. OTC (Cont…) • Individual buyers and sellers can incorporate any of the allowable exercise prices and expiration dates into their agreements, but cannot design their own contracts. • The contract size too is specified by the exchange.

33. Exchange Traded Options (Cont…) • The advantage of standardization is that volumes tend to be high and transactions costs tend to be low. • Secondly because of high volumes, these markets tend to be liquid. • Besides standardized option contracts can be offset by taking counter-positions, without necessarily involving the original counter-party.

34. Counter-Positions • Taking a counter-position means that if you have originally bought a call/put, you now sell an identical call/put. • By identical we mean that the offsetting contract should be on the same asset, and have the same exercise price and time to expiration.

35. Counter-Positions (Cont…) • Similarly if you have sold a call/put, you would now have to buy an identical call/put in order to offset.

36. Illustration • Aditi had bought an options contract on Reliance from Rakesh a week ago. • The contract terms have specified an exercise price of Rs 350 and the contract is scheduled to expire at the end of June. • Now assume that Aditi wants to get out of her position.

37. Illustration (Cont…) • All she has to do, is to find a person on the floor of the exchange who would like to go long in a contract on Reliance expiring in June, with an exercise price of 350. • This person need not be Rakesh, the individual with whom she initially traded.

38. Standardization & Offsetting • Offsetting is easy when the contracts are standardized. • In the case of customized contracts, there is an infinite number of exercise prices and expiration dates that can be specified, as a consequence of which the odds of finding a third party who is willing to transact as per the original contract are severely reduced.

39. Credit Risk • In the case of exchange traded options, credit risk is minimized because there is a clearinghouse which becomes the effective buyer for every seller and the effective seller for every buyer. • However, unlike in the case of a futures contract, the clearinghouse has to guarantee only the performance of the writer.

40. Credit Risk (Cont…) • This is because a performance guarantee is required only when a party has an obligation and not when he has a right. • And remember both call and put holders have rights, as a consequence of which there is no fear of non-performance.

41. OTC Markets • The OTC market is dominated by institutional investors. • Contracts are entered into privately by large corporations, financial institutions, and sometimes even governments. • When buying an OTC option you have to be either familiar with the creditworthiness of the writer or else seek a guarantee.

42. OTC Markets (Cont…) • Nevertheless OTC markets always carry an element of credit risk. • They do offer certain advantages however. • Firstly terms and conditions like expiration dates and exercise prices can be tailored to the specific needs of the two parties.

43. OTC Markets (Cont…) • Often the contract may be on an asset on which an exchange traded contract is not available. • Since the market is private, neither the public nor other investors need to know about the transaction taking place. • However, seeking privacy need not mean that an illegal activity is taking place.

44. OTC Markets (Cont…) • The OTC market is unregulated. • Consequently government approval is not required to design new types of contracts.

45. FLEX Options • Their disadvantages not withstanding, customized contracts have an appeal particularly for institutional investors. • For many institutions, exchange designed contracts are often inadequate and they desire their freedom to create their own contracts.

46. FLEX Options (Cont…) • Traditionally, an institution in need of a tailor-made contract has had to seek out another like minded institution like a commercial bank who is seeking to write an option with similar features. • Of late, in response to competition the exchanges have been making an effort to grab a slice of the growing OTC market.

47. FLEX Options (Cont…) • To do this, they have created products known as FLEX options for stock indices and E-FLEX options for equity shares, where FLEX stands for FLexible EXchange. • In order to trade in these options, an investor has to submit what is called a Request for Quote or RFQ.

48. RFQs • The RFQ will contain the details of the contract sought by the investor, namely whether it is a call or a put, the exercise price, the time to maturity, and whether they want a European or an American style contract. • The RFQ is then acted upon by market makers who submit quotes for the premium.

49. FLEX Options • Both FLEX and E-FLEX options are cleared by the clearinghouse.

50. Major U.S. Equity Options Exchanges & Contract Volumes in Millions in 2001