CO2: Options Market: Types of Options - American Options, European Options, Call Option,
Put Option, and Others. Option Premium – Relationship between strike price of an option and
market price of the underlying asset. Option Positions – Pay-offs – Trading Strategies: Covered
Calls and Protective Puts - Option Spreads – Horizontal Spread, Vertical, Spreads – Butterfly
Spreads; Combination Strategies Warrants and Convertibles.
OPTIONS MARKET
The options market makes up for a significant part of the derivative market, particularly in
India. I would not be exaggerating if I were to say that nearly 80% of the derivatives traded are
options and the rest is attributable to the futures market. Internationally, the option market has
been around for a while.
The Quick Background of the Options
International Story of Options
• Custom options were available as Over the Counter (OTC) since the 1920’s. These options
were mainly on commodities
• Options on equities began trading on the Chicago Board Options Exchange (CBOE) in
1972
• Options on currencies and bonds began in late 1970s. These were again OTC trades
• Exchange-traded options on currencies began on Philadelphia Stock Exchange in 1982
• Interest rate options began trading on the CME in 1985
Indian Story of Options
• Clearly the international markets have evolved a great deal since the OTC days.
• However, in India from the time of inception, the options market was facilitated by the
exchanges.
• However, options were available in the off market ‘Badla’ system.
• Think of the ‘badla system’ as a grey market for derivatives transactions. The badla system
no longer exists, it has become obsolete.
,• June 12th 2000 – Index futures were launched
• June 4th 2001 –Index options were launched
• July 2nd 2001 – Stock options were launched
• November 9th 2001 – Single stock futures were launched.
Though the options market has been around since 2001, the real liquidity in the Indian index
options was seen only in 2006! I remember trading options around that time, the spreads were
high and getting fills was a big deal. However in 2006, the Ambani brothers formally split up
and their respective companies were listed as separate entities, thereby unlocking the value to
the shareholders. In my opinion this particular corporate event triggered vibrancy in the Indian
markets, creating some serious liquidity. However if you were to compare the liquidity in
Indian stock options with the international markets, we still have a long way to catch up.
EXAMPLES TO UNDERSTAND THE MEANING OF OPTIONS
Suppose your company is considering moving to a new city, and you may need to move. You
could buy a house in the new city, just in case, but that may not be the best use of your capital.
And if the company decides not to move, then you have a house you don’t need.
But, what if you could buy an option on a house in the New City?
You will need to pay the owner of the house for this “right”, and the cost of that right is called
the option premium.
If the company moves, you would exercise your option to purchase the house at the
predetermined price. If the company does not move, then you would simply not exercise your
right or option to buy the house. When this happens, the owner of the house will still keep the
option premium.
Every option transaction must have a buyer and a seller. Buyers pay the premium to the seller,
and sellers hold the risk of price movement. As a thumb rule, in an options agreement the buyer
always has a right and the seller has an obligation.
, TYPES OF OPTIONS
Options based on Obligations Options based on Style of Exercising
American
Call Options
Types of Options Types of Options Options
Based on Based on
Obligation Excercise Style European
Put Options
Options
The Basic Classification of Options
Options consist of rights to buy or rights to sell, which can be exercised or foregone at the
discretion of the holder. The right to sell is called a put option and the right to buy is called
a call option. In either case, the party who acquires the right is the holder of the option,
whereas the party who has the liability, and who is paid a price or a premium, is the writer
of the option. The date specified in the contract is known as the expiration date or the
maturity date.
In either case, there are short and long positions. The party owning the right to buy in a call
option or the right to sell in a put option is on the long side of the contract. The party with the
liability is on the short side of the contact.
Call Put
Short liability to sell liability to buy
Long right to buy right to sell
The Classification of Options Based on the Exercise Styles
Options can be either American or European, a distinction that has nothing to do with
geographical location. Options are also distinguished by when the right in the contract may be
exercised.
In an American-style option, the right may be exercised at any time before expiry of the
contract. In a European-style option, the right may be exercised on only one date: the maturity
date of the contract. Options that may be exercised before maturity but only on certain pre-
specified dates are called Bermudan-style options.
The Call Option
Put Option, and Others. Option Premium – Relationship between strike price of an option and
market price of the underlying asset. Option Positions – Pay-offs – Trading Strategies: Covered
Calls and Protective Puts - Option Spreads – Horizontal Spread, Vertical, Spreads – Butterfly
Spreads; Combination Strategies Warrants and Convertibles.
OPTIONS MARKET
The options market makes up for a significant part of the derivative market, particularly in
India. I would not be exaggerating if I were to say that nearly 80% of the derivatives traded are
options and the rest is attributable to the futures market. Internationally, the option market has
been around for a while.
The Quick Background of the Options
International Story of Options
• Custom options were available as Over the Counter (OTC) since the 1920’s. These options
were mainly on commodities
• Options on equities began trading on the Chicago Board Options Exchange (CBOE) in
1972
• Options on currencies and bonds began in late 1970s. These were again OTC trades
• Exchange-traded options on currencies began on Philadelphia Stock Exchange in 1982
• Interest rate options began trading on the CME in 1985
Indian Story of Options
• Clearly the international markets have evolved a great deal since the OTC days.
• However, in India from the time of inception, the options market was facilitated by the
exchanges.
• However, options were available in the off market ‘Badla’ system.
• Think of the ‘badla system’ as a grey market for derivatives transactions. The badla system
no longer exists, it has become obsolete.
,• June 12th 2000 – Index futures were launched
• June 4th 2001 –Index options were launched
• July 2nd 2001 – Stock options were launched
• November 9th 2001 – Single stock futures were launched.
Though the options market has been around since 2001, the real liquidity in the Indian index
options was seen only in 2006! I remember trading options around that time, the spreads were
high and getting fills was a big deal. However in 2006, the Ambani brothers formally split up
and their respective companies were listed as separate entities, thereby unlocking the value to
the shareholders. In my opinion this particular corporate event triggered vibrancy in the Indian
markets, creating some serious liquidity. However if you were to compare the liquidity in
Indian stock options with the international markets, we still have a long way to catch up.
EXAMPLES TO UNDERSTAND THE MEANING OF OPTIONS
Suppose your company is considering moving to a new city, and you may need to move. You
could buy a house in the new city, just in case, but that may not be the best use of your capital.
And if the company decides not to move, then you have a house you don’t need.
But, what if you could buy an option on a house in the New City?
You will need to pay the owner of the house for this “right”, and the cost of that right is called
the option premium.
If the company moves, you would exercise your option to purchase the house at the
predetermined price. If the company does not move, then you would simply not exercise your
right or option to buy the house. When this happens, the owner of the house will still keep the
option premium.
Every option transaction must have a buyer and a seller. Buyers pay the premium to the seller,
and sellers hold the risk of price movement. As a thumb rule, in an options agreement the buyer
always has a right and the seller has an obligation.
, TYPES OF OPTIONS
Options based on Obligations Options based on Style of Exercising
American
Call Options
Types of Options Types of Options Options
Based on Based on
Obligation Excercise Style European
Put Options
Options
The Basic Classification of Options
Options consist of rights to buy or rights to sell, which can be exercised or foregone at the
discretion of the holder. The right to sell is called a put option and the right to buy is called
a call option. In either case, the party who acquires the right is the holder of the option,
whereas the party who has the liability, and who is paid a price or a premium, is the writer
of the option. The date specified in the contract is known as the expiration date or the
maturity date.
In either case, there are short and long positions. The party owning the right to buy in a call
option or the right to sell in a put option is on the long side of the contract. The party with the
liability is on the short side of the contact.
Call Put
Short liability to sell liability to buy
Long right to buy right to sell
The Classification of Options Based on the Exercise Styles
Options can be either American or European, a distinction that has nothing to do with
geographical location. Options are also distinguished by when the right in the contract may be
exercised.
In an American-style option, the right may be exercised at any time before expiry of the
contract. In a European-style option, the right may be exercised on only one date: the maturity
date of the contract. Options that may be exercised before maturity but only on certain pre-
specified dates are called Bermudan-style options.
The Call Option
