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An Introduction to Options

An Introduction to Options. Dr. Rana Singh Associate Professor www.ranasingh.org. Forward Contract : It is a simple derivative that involves an agreement to buy/sell an asset on a certain future date at an agreed price.

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An Introduction to Options

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  1. An Introduction to Options Dr. Rana Singh Associate Professor www.ranasingh.org

  2. Forward Contract: It is a simple derivative that involves an agreement to buy/sell an asset on a certain future date at an agreed price. • Future Contract: It is a standardized contract between two parties who do not necessarily know each other and it is for performance by a clearing corporation or clearing house. • Options Contract:It is a legal contract which gives the holder the right to buy or sell a specified amount of underlying asset at a fixed price within a specified period of time.The holder is not obliged to buy or sell the underlying asset. • (A) CALL &(B)PUT

  3. Options • Options are of two types –Calls and Puts • Call options give the buyer the right but not the obligation to buy a given quantity of the underlying asset , at a given price on or before a given future date. • Put options give the buyer the right , but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given date. • Long=Buy= Holder • Short=Sell=Writer • C= Current Price of the Call • E=Exercise Price=Strike Price • So=The current price of the share • S1=The stock price at the expiration date of the call.

  4. Terminology • Spot Price: The price at which an asset trades in the spot market. • Future Price:The price at which the futures contract trades in the futures market. • Option Price:Option price is the price which the option buyer pays to the option seller. • Exercise Price:The price specified in the options contract is known as the strike price or the exercise price. • Basis: Basis is usually defined as the spot price minus the future price.

  5. LONG CALL POSITION ON ACC

  6. Short Call Position ON ACC

  7. Life of an option • The life of an option is limited: it has an expiration date. After the expiration date all the rights and obligations conferred by the option are null and void. The option holder can exercise the option, i.e. declare he or she wants to use the right to buy (or to sell) conferred by the option.

  8. American-Style option • American-Style option An option contract that may be exercised at any time between the date of purchase and the expiration date. Most exchange-traded options are American-style. In India options on stocks are American option.

  9. European-style options • European-style optionsAn option contract that may be exercised only during a specified period of time just prior to its expiration. In India Index options are European-style options.

  10. QUESTION

  11. QUESTION

  12. Terminology • Let S0=The Stock Price. E=Exercise Price. ConditionCall OptionPut option S0>E In-the-Money Out-of-the-Money S0<E Out-of-the-Money In-the-Money S0=E At-the-Money At-the-Money

  13. Option terms • Strike Price can be In-the-Money (ITM), Out-of-the-money (OTM) or At-the-Money (ATM) • For example, if the current market price of ACC = 166, Strike Price of: • Call at 164 - ITM, Call at 166- ATM and Call at 170 - OTM • Put at 164 - OTM, Put at 166- ATM and Put at 170 - ITM

  14. In the Money Call Options Out of the Money Call Options Market Price Calls Strike Prices Strike Prices Puts 160 162 164 166 168 170 172 In the Money Put Options Out the Money Put Options

  15. Intrinsic & Time Value • Option premiums can be divided into two parts. • Intrinsic value: Is the amount the option is ITM. Its zero for ATM and OTM. • Time value is the difference between its premium and its intrinsic value. • Usually Time Value is maximum when the call/Put is ATM.

  16. IN, AT , OUT-OF-THE-MONEY • To identify whether an option is IN-, AT- or OUT-OF-THE-MONEY, one need only compare the EXERCISE PRICE of the option to the STOCK PRICE of the underlying asset. • KEEP IN MIND THAT... • In-the-Money Options have INTRINSIC VALUE • At-the-Money Options have INTRINSIC VALUE EQUAL TO ZERO

  17. Stock Options: Example • An Indian Investor has to deliver 100 shares of ACC in 60 days. He buys a call option at a price of Rs. 20 and the strike price is Rs. 200 per share. • Premium Paid by the Investor: • Rs. 2,000 or , (Rs. 20 X 100). • If at the time of payment :- • ACC has risen to Rs. 230 per share - In - the - Money position (Profit = Rs. 3,000 – 2,000) = Rs. 1,000 • ACC declined to Rs.190 -Out-of-Money position

  18. Profit from Call Options Profit + 0 - Loss Profit E . S1 Rs. 200 Rs. Per ACC Rs. 220 CallPremium “P” Loss Buy A Call Option Profitable Above S1 E = Exercise Price

  19. Profit from Put Options Profit + 0 - Loss S2 E Rs. 200 . . Rs per ACC Rs. 180 Put Premium “q” Buy A Put Option Profitable Below S2 E = Exercise Price

  20. Options: Strategy An investor who expects a bull market should buy a call option. An investor who expects a bear market should buy a put option. The seller receives the premium but his risk is unlimited. For this reason, the selling of options should be considered only by experienced traders.

  21. Buy Sell Bullish Call Put Call Put Bearish

  22. FACTORS AFFECTING PREMIA • There are five major factors affecting the Option premium: • Price of Underlying • Exercise Price Time to Maturity • Volatility of the Underlying • And two less important factors: • Short-Term Interest Rates • Dividends

  23. Entities in the trading system • Trading Members • Clearing Members • Participants

  24. TRADING

  25. Entities in the trading system • Trading Members Trading members are members of NSE. They can trade either on their own account or on behalf of their clients including participants. The exchange assign a trading member ID to each trading member. Each trading member can have more than one user. The number of user for each trading member is notified by the exchange from time to time. Each user of a trading member must be registered with the exchange and is assigned an unique user ID.

  26. Entities in the trading system Trading Members (contd..) The Unique trading member ID functions as a reference for all orders/trades of different users. This ID is common for all users of a particular trading member. It is the responsibility of the trading member to maintain adequate control over persons having access to the firm’s User IDs.

  27. Entities in the trading system Clearing Members Clearing members are members of NSCCL. They carry out risk management activities and confirmation/inquiry of trades through the trading system.

  28. Entities in the trading system Participants A participant is a client of trading members like financial institutions. These clients may trade through multiple trading members but settle through a single clearing member.

  29. Order types and conditions Time conditions Price conditions Other conditions

  30. Order types and conditions Time conditions -Day Order: A day order, as name suggest is an order which is valid for the day on which it is entered. If the order is not executed during the day, the system cancels the order automatically at the end of the day

  31. Order types and conditions Time conditions (contd…) - Good till canceled(GTC): A GTC order remains in the system until the user cancels it. Consequently, it spans trading days, if not traded on the day the order is entered. The maximum number of days an order can remain in the system is notified by the exchange from time to time after which the order is automatically cancelled by the system.

  32. Order types and conditions Time conditions (contd…) - Good till canceled(GTC):(contd…) Each day counted is a calendar day inclusive of holidays. The days counted are inclusive of the days on which the order is placed and the order is cancelled from the system at the end of the day of the expiry period

  33. Order types and conditions Time conditions (contd…) - Good till days/date (GTD): A GTD order should stay in the system if not executed. The maximum days allowed by the system are the same as in GTC order. At the end of this day/date, the order is cancelled from the system. Each day/date counted are inclusive of the day/date on which the order is placed and the order is cancelled from the system at the end of the day/date of the expiry period

  34. Order types and conditions Time conditions (contd…) - Immediate or Cancel (IOC): An IOC order allows the user to buy or sell a contract as soon as the order is released into the system, failing which the order is cancelled from the system. Partial match is possible for the order, and the unmatched portion of the order is cancelled immediately.

  35. Order types and conditions Price conditions - Stop – loss: This facility allows the users to release an order into the system, after the market price of the security reaches or crosses at threshold price. E.g. if for stop-loss buy order, the trigger is 1024.00, the limit price is 1030.00 and the market (last traded) price is 1023.00 then this order is released into the system once the market price reaches or exceeds 1024.00. This order is added to the regular lot of books with time of triggering as the time stamp, as a limit order of 1030.00. For the stop-loss sell order, the trigger price has to be greater than the limit price

  36. Order types and conditions Other conditions (contd…) - Market Price: Market orders are for which no price is specified at the time the order is entered (i.e. price is market price). For such order, the system determines the price. - An opening price(ATO): ATO price is the price arrived at by the system after the pre-open phase is over

  37. The market watch window The following windows are displayed on the trader workstation screen. • Title bar • Ticker window of futures and option market • Ticker window of underlying(capital) market • Tool bar • Market watch window • Inquiry window • Snap quote • Order/trade window • System message window

  38. Inquiry window Market by order (MBO) The purpose of the MBO is to enable the user to view passive orders in the trading books in the order of price/time priority for a selected security. The F5 key invokes the selection window for MBO. If a particular contract or security is selected, the details of the selected contract or security defaults in the selection screen or else the current position in market watch defaults.

  39. Inquiry window Market by order (MBO) (contd…) Details of contract or security from the contract list or from the last operation. The field that are available on the selection screen are instrument, symbol, expiry and book type. The instrument type, symbol, expiry and book type fields are compulsory.

  40. Inquiry window Market by price (MBP) The purpose of MBP is to enable the user to view passive orders in the market aggregated at each price and are displayed in order of best prices. The window can be involved by pressing the (F6) key. If a particular contract or security is selected the details of the selected contract or security can be seen on this screen.

  41. Inquiry window Market Inquiry (MI) contd…. The market inquiry screen can be involved by using the (F11) key. If a particular contract or security is selected, the details of the selected contract or selected security defaults in the selection screen or else the current position in the market watch defaults. Fig. 8.2 shows the detailed market inquiry output screen. The first line of the screen gives the instrument type, symbol, expiry, contract status, total traded quantity, life time high and life time low.

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