Payoff profile of buyer of asset: Long asset

In this basic position, an investor buys the underlying asset, ABC Ltd. shares for instance,
for Rs. 2220, and sells it at a future date at an unknown price, St. Once it is purchased, the
investor is said to be "long" the asset. Figure 1.1 shows the payoff for a long position on
ABC Ltd.

Figure 1.1 Payoff for investor who went Long ABC Ltd. at Rs. 2220
The figure shows the profits/losses from a long position on ABC Ltd.. The investor bought ABC
Ltd. at Rs. 2220. If the share price goes up, he profits. If the share price falls he loses.

OPTIONS PAYOFFS

OPTIONS PAYOFFS

The optionality characteristic of options results in a non-linear payoff for options. In simple
words, it means that the losses for the buyer of an option are limited, however the profits
are potentially unlimited. For a writer (seller), the payoff is exactly the opposite. His profits
are limited to the option premium, however his losses are potentially unlimited. These nonlinear
payoffs are fascinating as they lend themselves to be used to generate various
payoffs by using combinations of options and the underlying. We look here at the six basic
payoffs (pay close attention to these pay-offs, since all the strategies in the book are
derived out of these basic payoffs).

Time value of an option:

The time value of an option is the difference between its premium and its intrinsic value. Both calls and puts have time value. An option that is OTM or ATM has only time value. Usually, the maximum time value exists when the option is ATM. The longer the time to expiration, the greater is an option's time value, all else equal. At expiration, an option should have no time value.

Intrinsic value of an option:

The option premium can be broken down into two components - intrinsic value and time value. The intrinsic value of a call is the amount the option is ITM, if it is ITM. If the call is OTM, its intrinsic value is zero. Putting it another way, the intrinsic value of a call is Max[0, (St — K)] which means the intrinsic value of a call is the greater of 0 or (St — K). Similarly, the intrinsic value of a put is Max[0, K — St],i.e. the greater of 0 or (K — St). K is the strike price and St is the spot price.

Out-of-the-money option:

An out-of-the-money (OTM) option is an option that would lead to a negative cashflow if it were exercised immediately. A call option on the index is out-of-the-money when the current index stands at a level which is less than the strike price (i.e. spot price < strike price). If the index is much lower than the strike price, the call is said to be deep OTM. In the case of a put, the put is OTM if the index is above the strike price.

At-the-money option:

An at-the-money (ATM) option is an option that would lead to zero cashflow if it were exercised immediately. An option on the index is at-the-money when the current index equals the strike price (i.e. spot price = strike price).

In-the-money option:

In-the-money option: An in-the-money (ITM) option is an option that would lead to a
positive cashflow to the holder if it were exercised immediately. A call option on the index
is said to be in-the-money when the current index stands at a level higher than the strike
price (i.e. spot price > strike price). If the index is much higher than the strike price, the
call is said to be deep ITM. In the case of a put, the put is ITM if the index is below the
strike price.

European options:

 European options are options that can be exercised only on the expiration date itself.

American options:

 American options are options that can be exercised at any time upto the expiration date.

Strike price:

The price specified in the options contract is known as the strike price or the exercise price.

Expiration date:

The date specified in the options contract is known as the expiration date, the exercise date, the strike date or the maturity.

Option price/premium:

 Option price is the price which the option buyer pays to the option seller. It is also referred to as the option premium.

Put option:

 A put option gives the holder the right but not the obligation to sell an asset by a certain date for a certain price.

Call option:

 A call option gives the holder the right but not the obligation to buy an asset by a certain date for a certain price.

Writer / seller of an option:

The writer / seller of a call/put option is the one who receives the option premium and is thereby obliged to sell/buy the asset if the buyer exercises on him.

Buyer of an option:

The buyer of an option is the one who by paying the option premium buys the right but not the obligation to exercise his option on the seller/writer.

Stock options:

Stock options are options on individual stocks. A stock option contract gives
the holder the right to buy or sell the underlying shares at the specified price. They have an
American style settlement.

Index options:

These options have the index as the underlying. In India, they have a European style settlement. Eg. Nifty options etc.

OPTION TERMINOLOGY

OPTION TERMINOLOGY

· Index options: These options have the index as the underlying. In India, they have
a European style settlement. Eg. Nifty options, Mini Nifty options etc.

· Stock options: Stock options are options on individual stocks. A stock option contract gives
the holder the right to buy or sell the underlying shares at the specified price. They have an
American style settlement.

· Buyer of an option: The buyer of an option is the one who by paying the option premium
buys the right but not the obligation to exercise his option on the seller/writer.

· Writer / seller of an option: The writer / seller of a call/put option is the one who receives
the option premium and is thereby obliged to sell/buy the asset if the buyer exercises
on him.

· Call option: A call option gives the holder the right but not the obligation to buy an asset by
a certain date for a certain price.

· Put option: A put option gives the holder the right but not the obligation to sell an asset by
a certain date for a certain price.

· Option price/premium: Option price is the price which the option buyer pays to the
option seller. It is also referred to as the option premium.

· Expiration date: The date specified in the options contract is known as the expiration
date, the exercise date, the strike date or the maturity.

· Strike price: The price specified in the options contract is known as the strike price or the
exercise price.

· American options: American options are options that can be exercised at any time upto the
expiration date.

· European options: European options are options that can be exercised only on the
expiration date itself.

· In-the-money option: An in-the-money (ITM) option is an option that would lead to a
positive cashflow to the holder if it were exercised immediately. A call option on the index
is said to be in-the-money when the current index stands at a level higher than the strike
price (i.e. spot price > strike price). If the index is much higher than the strike price, the
call is said to be deep ITM. In the case of a put, the put is ITM if the index is below the
strike price.

· At-the-money option: An at-the-money (ATM) option is an option that would lead to zero
cashflow if it were exercised immediately. An option on the index is at-the-money when the
current index equals the strike price (i.e. spot price = strike price).
· Out-of-the-money option: An out-of-the-money (OTM) option is an option that would
lead to a negative cashflow if it were exercised immediately. A call option on the index is
out-of-the-money when the current index stands at a level which is less than the strike
price (i.e. spot price < strike price). If the index is much lower than the strike price, the call
is said to be deep OTM. In the case of a put, the put is OTM if the index is above the
strike price.

· Intrinsic value of an option: The option premium can be broken down into two
components - intrinsic value and time value. The intrinsic value of a call is the amount
the option is ITM, if it is ITM. If the call is OTM, its intrinsic value is zero. Putting it
another way, the intrinsic value of a call is Max[0, (St — K)] which means the intrinsic
value of a call is the greater of 0 or (St — K). Similarly, the intrinsic value of a put is Max[0,
K — St],i.e. the greater of 0 or (K — St). K is the strike price and St is the spot price.
· Time value of an option: The time value of an option is the difference between its
premium and its intrinsic value. Both calls and puts have time value. An option that is OTM
or ATM has only time value. Usually, the maximum time value exists when the option is
ATM. The longer the time to expiration, the greater is an option's time value, all else equal.
At expiration, an option should have no time value.

INTRODUCTION TO OPTIONS

An option is a contract written by a seller that conveys to the buyer the right — but not the obligation — to buy (in the case of a call option) or to sell (in the case of a put option) a particular asset, at a particular price (Strike price / Exercise price) in future. In return for granting the option, the seller collects a payment (the premium) from the buyer. Exchangetraded options form an important class of options which have standardized contract features and trade on public exchanges, facilitating trading among large number of investors. They provide settlement guarantee by the Clearing Corporation thereby reducing counterparty risk. Options can be used for hedging, taking a view on the future direction of the market, for arbitrage or for implementing strategies which can help in generating income for investors under various market conditions.