1. What is an Option ?
An option contract gives the holder of the option the right and not the obligation to buy or sell an underlysing asset at a certain future date and at a certain price.
For example,
On the 1st May 2000, A holds an option to buy 100 shares of Reliance at Rs. 500 on the 1st August 2000 whereas the current market price will be Rs. 400.
Here, the Time to expiration is the difference between 1st May 2000 (the Valuation Date) and 1st August 2000 (the Excercise Date) which is 90 days.
The Strike Price is Rs. 500.
When the Excercise Date is reached, there are 2 possiblities.
a. Strike Price < Market Price
If the market price of Reliance is quoting at a price more than the strike price, eg. Rs. 550, A will execute the option (ie) buy 100 shares of reliance at Rs. 500 and sell it in the market for Rs. 550 and make a profit of
100 * (550 - 500) = Rs. 5000
b. Strike Price > Market Price
If the market price of Reliance is quoting at a price less than the strike price, eg. Rs. 450, A will not execute the option, because it doesnt make sense to buy it Rs. 500 when you can get the same shares at Rs. 450 in the market.
This is how Options work
2. Types of Options
Call Options
A call option gives the right to buy the underlying asset at the strike price any time until the expiry date.
Put Options
A put option gives the right to sell the underlying asset at the strike price any time until the expiry date.
3. Parties to a Contract
Writer
A writer is someone who sold an option contract to open a position. The writer is the person who is taking on the risk, (underwriting the risk). Someone who sells an options contract they already own is not a writer, they are just closing an existing position. An option writer is said to be "short" the option they wrote.
Holder
The holder is the person who bought an option contract. Someone who buys an option they previously wrote is not a holder, they are just closing an existing position. An option holder is said to be "long" the option they bought.
4. Excercise Style
There are two styles of excercising an option which are:
American Style
American style options can be exercised any time until expiry. Some examples of American-style options are: stock options, bond options, and currency options, .
European Style
European style options can only be exercised on expiry (not before). Some examples of European-style options are: index options and interest rate options.
5. Dividend Yield
This is the cash yield of a stock or stock index. This is computed by dividing the dividend by the current share price, expressed as a percentage. Different companies have different policies on the size of their dividend payouts.
6. Volatility
It is a measure of the range the underlying security is expected to fluctuate over a given period of time. The measurement of volatility is the standard deviation of the daily price changes in the security. The more volatile the underlying security, the greater the price of the option. There are two different kinds of volatility. There is historical volatility; and there is implied volatility.
Historical volatility estimates volatility based on past prices.
Implied volatility starts with the option price as a given and works backward to ascertain the theoretical value of volatility equal to the market price minus any intrinsic value.The higher the volatility, the less predictable the return.
7. Factors Influencing The Price Of An Option
There are six factors which determine the price of an option. They are:
- The price of the underlying stock
- The strike price of the option itself
- The time remaining until the option expires
- The volatility of the underlying stock
- The current risk free interest rate (eg. Return on Government Bonds)
- Dividend rate of the underlying stock
8. How Options are Priced
There are many different option pricing models in practice. However, the original breakthrough was in the Black-Scholes model. It was a model for pricing options before options were widely traded. The Black Scholes model worked primarily for European style options.
In our tool, we use the Black and Schols model for pricing European Options and the Binomial Model for pricing American Options.
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