Chapter 15

Options and Futures

 Learning Objectives

 To understand the concept of derivatives

 To know call and put option

 To learn about the option buyers and

sellers position

 To understand the nature of futures

 Derivatives
 Derivatives are financial contracts which derive their
values from the underlying assets or securities.

 Some examples are:

 Options

 Futures

 Swaps
 Option
 An option is the right, but not the obligation to buy or
sell something on a specified date at a specified price.

 In the securities market, an option is a contract

between two parties to buy or sell specified number
of shares at a later date for an agreed price.

 Three parties are involved in the option trading, the

option seller, buyer and the broker.
 Process
 The option seller or writer is a person who grants
someone else the option to buy or sell. He receives a
premium on its price.

 The option buyer pays a price to the option writer to

induce him to write the option.

 The securities broker acts as an agent to find the

option buyer and the seller, and receives a
commission or fee for it.
 Call Options
 The call option that gives the right to buy.
 The contract gives the particulars of:
 The name of the company whose shares are to be bought or
the underlying asset.
 The number of shares to be purchased.
 The purchase price or the exercise price or the strike price
of the shares to be bought.
 The expiration date, the date on which the contract or the
option expires.
 Put Options
 Put option gives its owner the right to sell (or put) an
asset or security to someone else.
 Like the call option the contract contains:
St r o ngl y ef f i c i e nt m ar k et
A l i n f o r m at i o n i s
r e f l e ct e d on pr i c es .
Sem i s t r o ng ef f i c i e nt m ar k et
A l publ i c i n f o r m at i o n i s
r e f l e ct e d on s e cur i t y pr i c es
W eakl y ef f i c i e nt m ar k et
A l hi s t o r i c al i n f o r m at i o n
i s r e f l e ct e d on s e cur i t y

 The name of the company whose shares are to be sold.

 The number of shares to be sold.

 The selling price or the striking price.

 The expiration date of the option.

 Factors Affecting
the Value of Call Option
1. The market price of the underlying asset
2. The striking price
3. Option period
4. Stock volatility
5. Interest rates
6. Dividends
 Intrinsic Value and Time Value
The price of an option has two components
intrinsic value or expiration value and time value.
 Call option intrinsic value
or expiration value = Stock price – Striking price
 Put option intrinsic value
or expiration value = Striking price – Stock price

 Time value = Premium – Intrinsic value

 Gain or Loss of Call Buyer
 When the market price exceeds the strike price by just
enough to cover the premium, the profit is zero for
the buyer if he exercises the option.

 This is the point of no profit and no loss and hence

known as break-even point.

 If there is a rise in the price of the stock beyond the

break-even point, the call buyer gains profit.
 Call Buyer’s Position
Option Profit
30
25 Profit line to
20 Call option buyer
Market price of
15 optioned stock
10 Exercise Price
Intrinsic
(Rs 50)
5 value
0
10 20 30 40 60 70 80 90 100
–5
Loss of Premium
– 10 Break-even Rs 55
– 15
– 20
– 25
 Call Writer’s Gain or Loss
 When the market price is lower than the strike price,
the call buyer may not exercise his option, hence the
premium is the only profit the call writer can gain.

 If the price increases further it would be a loss to the

call writer.
 Writing a Call
O ption profit
25

20

15

10 In trinsic va lue
M a rke t price of
5 op tio ne d stock
P re m ium ga in
0
10 20 30 40 60 70 80 90 10 0
–5 B re ak-even R s 55
E xe rcise P rice
(R s 50 )
– 10

– 15
Lo ss lin e to
call w riter
– 20

– 25
 Put Buyers Position
 Put buyer gains in the bearish market when the price
falls.

 When the price increases, the put buyer has to pay the
premium alone and his liability is limited to the
premium amount he has paid.
Put Buyers Gain or Loss
40

Profit line to p ut buyer

30

20
Intrin sic value

10
Break-even Exercise Price Rs 50
Rs 45 Price of the
optioned stock
30 70 90
Premium loss

10

20
 Put Writer’s Position
 The gains of the put buyer are the losses of
the put writer.

 If the market price increases the put writer will gain

the premium because the put buyer may not be
willing to sell the shares at the lower rate i.e., the
strike price is lower than the market price.
 Writing a Put
30

20 Break-even Rs 45
Strike Price Rs 50
10 Intrinsic value

Premium gain
0
20 40 60 80
–5 Price of the
optioned stock

– 15
Loss line of put writer

– 25

– 35
 Profits in
Stocks, Bonds and Options
Stock, Bond and Option Details
Stock Bond Call Put
Current price Rs 70 Rs 100 Rs 5 Rs 5
Exercise price --- --- Rs 70 Rs 70
Terms to expiration - - - 6 months 6 months 6 months
Prices at termination Variable Rs 100 Variable Variable
 Bond Return
Profit Rs

30

20

10
Return
Stock Price at
Termination
40 50 60 80 90 100
10

20

Exercise Price
30 = 70

LOSS Rs
 Stock Return
PROFIT Rs

30

20

10

Stock Price at
40 50 60 80 90 100 Termination
10

20

Exercise Price
30 = 70
LOSS Rs
Selling the Stock Short
P R O FIT R s

30
E xercise P rice
20 = 70

10

Stock Price at
40 50 60 80 90 100 Term ination
10

20

30

LO S S R s
 Investment in Calls
 Protective – buy the stock and buy a put

 Covered call writing – own the stock and sell a call

 Artificial convertible bonds – buy bonds and buy calls

 The Black-Scholes Option
Pricing Model
The Black-Sholes model (1973) is given below:


V = P{N(d1 )}  e RTS{N(d 2 )}
ln(P/S) + (R + 0.5σ 2 )T
d1 =
σ T
d 2 = d1   T
where V = Current value of the option
P = Current price of the underlying share
N(d1), N(d2) = Areas under a standard normal function
S = Striking price of the option
R = Risk free rate of interest
T = Option period
 = Standard deviation
e = Exponential function
 Futures
 Futures is a financial contract which derives its value
from the underlying asset.
 There are commodity futures and financial futures.
 In the financial futures, there are foreign currencies,
interest rate, stock futures and market index futures.
 Market index futures are directly related with the
stock market.
 Forward and Futures
 In a forward contract, two parties agree to buy or sell
some underlying asset on some future date at a stated
price and quantity.
 The forward contract involves no money transaction
at the time of signing the deal.
 Forward contract safeguards and eliminates the price
risk at a future date.
 But the forward market has the problem of:
(a) lack of centralisation of trading
(b) liquidity
(c) counterparty risk
 Future Market
The three distinct features of the future markets are:
 Standardised contracts

 Centralised trading

 Settlement through clearing houses to avoid counterparty risk

 Benefits of the Index Based Futures
 Liquidity: The index based futures attract a much more substantial order
flow and have greater liquidity in the market.
 Information: Information flow is more in the index than in the case of
securities. The insiders are privileged to have more information in securities.
 Settlement: In the settlement, stocks have to be delivered either in the
physical mode or in the depository mode. No such delivery is needed in the
index based futures. They are settled through cash.
 Less volatile: The changes that occur in index values are less compared to
the price changes that occur in the individual securities. This leads to lower
prices for the index futures and can work with lower margins.
 Manipulation: The securities in the index are carefully selected, keeping the
liquidity considerations and as such are hard to manipulate. But security
prices could be manipulated more easily than the index.
 Beneficial to the mutual funds.
 Chapter Summary
By now, you should have:

 Understood the concept of derivates

 Learnt about call and put option

 Learnt the option buyer's and seller's position

 Understood the nature of futures